foreign earnings tax

Undistributed foreign earnings (UFE) — foreign profits earned by overseas subsidiaries that have not, at least not yet, been remitted back to the U.S. parent — are a good deal for U.S. multinationals. Too good, says Fitch Ratings in a report released Thursday, because investors are forgetting about an important aspect of this corporate cash building up overseas.

The growing profits earned by U.S. companies in foreign jurisdictions are in many cases sitting subsidiaries’ bank accounts and are being rolled up into the parent company’s consolidated balance sheet, boosting overall reported cash balances. But many investors and creditors are forgetting are that these cash balances in most cases have strings attached; namely, the hefty tax on them owed to the United States if the funds are remitted back to the parent, says Fitch.

So, while creditors include the cash in leverage calculations and investors count UFE in their valuation models, “the cash held in foreign subsidiaries may not be fully available to remunerate shareholders, or repay debt issued elsewhere in the group,” says Fitch.

foreign profitsA sample of 40 large, nonfinancial multinational corporates studied by Fitch had on average had $28 billion of UFE, having added an average $3.1 billion in UFE in the last reporting year. Microsoft, for example, had $76 billion stashed in foreign jurisdictions as of the end of 2013. 

While companies pay local taxes on the profits when they earn them, they don’t have to pay the incremental U.S. tax due until the earnings are distributed back to the U.S. parent. In addition, U.S. accounting rules exempt the recognition of deferred tax liabilities on foreign earnings if they are intended to be “indefinitely reinvested” outside the United States, which many companies claim. So multinationals are not recognizing a deferred tax liability on these profits and no tax deduction is being made from reported earnings in the income statement.

“[The accounting] standard provides a way for companies to report higher than ‘normal’ post-tax earnings,” Fitch says in its report. “As a result, investors may then ascribe a higher value to the company and perceive better credit metrics and therefore lower credit risk to the company, discounting perhaps that accessing these foreign earnings could come at a significant tax cost.”

Despite the accounting rules and current U.S. tax law, Fitch says that “credit investors should not be complacent about avoiding a tax liability on foreign undistributed earnings.”

As Fitch explains, “Domestic debt amounts relative to domestic profits can become unbalanced as [U.S.] companies increase domestic leverage to fund the dividend and share buybacks that investors expect given the consolidated profile,” Fitch says. In an extreme example, Fitch says, “investors could think that significant overseas earnings and cash can readily and fully reduce the escalating domestic debt, when in fact only the domestic profits service the debt.”

In other circumstances, the issuer could be required to remit back to the United States cash that its subsidiary is holding aboard. That can happen, for example when the “domestic U.S. business requires liquidity, for example, to finance a domestic acquisition, onshore capex, share buybacks or debt service including financing redemptions; because it is not performing sufficiently well to support all of its cash expenses; or debt maturities … arise at a time when markets are shut.”

According to Fitch, there is also a risk that the tax mitigation strategies “to access foreign cash balances without crystalizing a tax liability” won’t be sustainable. “The structures could be sensitive to legal challenges or to changes in the application of the rules, if not the rules themselves. Issuers may then face cash outflows related to the tax liabilities that were until then exempt even from being recorded as a liability,” Fitch says.

Fitch doesn’t see an end to this problem anytime soon. Even if U.S. lawmakers passed another “repatriation holiday” that temporarily reduced the corporate tax rate on unremitted foreign earnings, the credit rating agency says companies may not want to use it.

“Hitherto corporates have typically been able to maintain an assertion that they intend indefinite reinvestment [abroad], even if they did previously take advantage of the tax holiday,” Fitch says. “But over time such an assertion becomes more difficult to justify. By again repatriating for a tax holiday, auditors and the IRS would receive an incremental piece of evidence to debunk corporates’ reinvestment claims.”

Image: Thinkstock

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2 responses to “Offshore Corporate Profits Pose Hidden Risks”

  1. When will the IRS issue an accumulated earning taxes on cash held by these companies. Also, shareholders should be tax on the earnings that these companies are holding offshore over seas. Lastly, their accountants should place a liability on the books for the potential tax that will occur for holding the funds offshore because the value of the companies are overstated to the shareholders.

  2. We have long advocated for an end to the GAAP rule that exempts accumulated profits “permanently invested” in foreign countries from US taxation. (See our blog post, “Apple’s Tax Bite is Cut by Tax Accounting, Not the Tax Code”.)

    In our view, financial statements should present the most conservative view of the financial condition of the company. Ignoring the US tax consequences of remitting profits to the US overstates that condition. Fitch should be lauded for highlighting how the rule assists in overstating assets. It also assists in artificially boosting profits.

    The rule for “permanent” investment was first adopted with APB 23 in the early 1970’s. It is a legacy of convenience from the “Madmen” era when overseas communications were handled by Telex and business computing was done exclusively (if at all) on mainframes. Today, CFO’s at most publicly held companies can compile a US tax provision for their foreign profits using any one of a number tax provision computer programs.

    Whether foreign profits are “permanently” or “temporarily” invested overseas is nebulous as there are no evidentiary standards, such as a binding contract, to prove the assertion. It allows an easy an easy manipulation of earnings, too. (We have seen instances where earnings were increased by as much as 7%, via the tax provision, by asserting that profits that had been “temporarily” invested overseas in Year 1 were declared to be “permanently” invested overseas in Year 2 with an accompanying adjustment to the tax provision and the P&L.)

    Aside from the financial aspects, from a policy perspective, exempting foreign profits that are “permanently” invested in foreign subsidiaries from tax under GAAP tends to incent foreign investment over that in the United States. Why invest in the USA where profits will assuredly be taxed when one can boost book profits by investing overseas and assert the profits from the investment are “permanently” invested to avoid US tax?

    It’s time for the FASB to update foreign tax accounting to take account of today’s circumstances and bring it into the 21st Century.

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