tax notes international - Tuck School of Business - Dartmouth College

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A few years ago, Lillian Mills, Kaye Newberry, and William Trautman7 turned the spotlight on areas where the tax community may wish to start looking. First, financial firms and multinational corporations report the largest gap between book and taxable income, and the gap is concentrated among the largest firms. Second, off-balance-sheet structured transactions or special purpose entities accounted for part of the differences. These researchers may be on to something big. Offbalance-sheet structured transactions and special purpose entities have been identified as culprits behind the economic crisis. And financial institutions are the primary players in this game. As much as he might have liked to use that evidence to conclude that firms exploit book-tax differences, Shackelford could not reassure users of financial statements that their data were up to the task. As the study notes, because we do not know whether using the best publicly available firm-level tax data ‘‘leads to minor mismeasurement or substantial errors in scholarship, practice, and policy,’’ we should ‘‘interpret scholarly findings with caution.’’ Firms’ ability to increase their book income without increasing their tax liability has led many to call for conformity between the two measures. However, there is no agreement on the wisdom of that move. John McClelland of the Treasury Department and Lillian Mills of the University of Texas8 summarized the pros and cons of conformity and came out in favor of continuing nonconformity. Shackelford also reports that a study by Danqing Young and David A. Guenther9 of book and tax conformity in 13 countries reveals that countries with a high degree of conformity exhibit reduced international capital mobility. From his survey of the issue, Shackelford concludes that ‘‘the empirical evidence suggests that conformity would adversely affect the information that financial reports provide the capital markets.’’ Shackelford calls for more research rather than for continued nonconformity. International Financial Reporting Standards Some conference participants mentioned that because they require more disclosure than U.S. generally accepted accounting principles, the move to international financial reporting standards might help address the issues that arise under book-tax nonconformity. In 7 Lillian Mills, Kaye Newberry, and William Trautman, ‘‘Trends in Book-Tax Income and Balance Sheet Differences,’’ Tax Notes, Aug. 19, 2002, p. 1109, Doc 2002-19155, or2002 TNT 161-49. 8 John McClelland and Lillian Mills, ‘‘Weighing Benefits and Risks of Taxing Book Income,’’ Tax Notes, Feb. 19, 2007, p. 779, Doc 2007-1810, or2007 TNT 35-61. 9 Danqing Young and David A. Guenther, ‘‘Financial Reporting Environments and International Capital Mobility,’’ 41 Journal of Accounting Research, 553-579 (2003). HIGHLIGHTS August 2008 the Securities and Exchange Commission issued for comment a proposal to start allowing voluntary adopting of IFRS, and eventual mandatory adoption beginning in fiscal 2014. A more general move to adapt U.S. rules to IFRS may be postponed. The Global Oversight Committee of the Financial Executives Institute recently removed the Accounting Principles Board (APB) Opinion No. 23, ‘‘Accounting for Income Taxes — Special Areas,’’ exception for the treatment of permanently reinvested earnings (PRE) from the convergence project. Other conference participants warned that although the accounting profession is moving toward international rules, the U.S. Congress might be unwilling to cede its ability to provide tax incentives to an international forum. Earnings Management The General Rule With Congress considering reintroducing a temporary dividend repatriation tax holiday, the way that corporations account for their foreign earnings may greatly influence whether a corporation repatriates dividends. That only a fraction of the firms that could have participated in the 2004 dividend repatriation tax holiday took advantage of it suggests that the repatriation decision may be more complicated than initially understood. In general, a U.S. multinational pays U.S. tax on foreign earnings only when it receives the dividend from its foreign subsidiary. However, the accounting and the tax rules differ in how they treat the tax liability associated with those foreign earnings. And it is that difference that can lead firms to alter their financial decisions to benefit from the tax provisions. Under GAAP, firms immediately recognize both their foreign earnings and the expected tax associated with those foreign earnings, although they pay the tax only when the earnings are repatriated to the United States. Thus, for accounting purposes, the firm takes a hit on its financial earnings, but it benefits by avoiding an earnings reduction when it later repatriates the earnings. That companies may continually reinvest their foreign earnings complicates the decision. Because many firms never expect to return their foreign earnings to the U.S., the accounting rules under APB 23 have, since 1972, provided an exception to that general rule that allows the firm to disclose its potential U.S. tax liability only in a footnote to its financial statements. This treatment creates a permanent difference between book and taxable income. The firm immediately benefits when it declares that it is permanently reinvesting its foreign earnings, because it recognizes those earnings without recognizing a related tax expense for the residual U.S. tax on those earnings. TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 373 (C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
HIGHLIGHTS However, if the firm reconsiders and later decides to repatriate those earnings, it faces a disadvantage because it must recognize an income tax expense on those earnings but cannot recognize any earnings because it has already recognized the income in an earlier accounting period. So firms that decide to repatriate PRE face a dilemma: Should they take advantage of the tax holiday and repatriate the earnings despite the reduction in earnings, or should they continue to reinvest the earnings abroad and skip the tax holiday? As demonstrated by the surge in dividend repatriations, many firms decided the tax benefit outweighed the adverse impact on earnings. The bottom line is that firms can increase their financial earnings without increasing their tax liability by increasing the amount of foreign profits designated as PRE. This incentive to manipulate earnings is one of many possibly unintended consequences that the differences between book and tax accounting may have on real behavior — the repatriation of foreign earnings. International Effects of the PRE Multinational firms benefit from their PRE in many ways. Empirical evidence suggests that they take advantage of the discretion allowed under GAAP to designate at least some portion of their foreign earnings as permanently reinvested abroad so that they have the flexibility to manage their earnings as needed to meet market expectations. Shackelford and his coauthors discussed research showing that the amount firms report as PRE depends on the difference between analysts’ forecasts and their premanaged earnings. This discretion in the treatment of foreign earnings may have unintended consequences. Linda Krull10 of the University of Oregon examined the disclosures in the financial statements of 267 multinational firms from the 1990s and found that firms took advantage of the discretion allowed under the accounting rules to actively manage their PRE. Her research revealed that when the firms increased their PRE, their earnings rose by an amount sufficient to meet analyst expectations. Krull also noted that given the minimal information that firms report about their foreign operations, it is difficult for analysts to understand the source of these additional earnings. As one conference participant noted, stock analysts sometimes lack the expertise or experience to understand these variations in earnings reporting. So it isn’t surprising that multinational firms have accumulated more than $600 billion in permanent reinvestment foreign earnings since the dividend repatria- 10 Linda Krull, ‘‘Permanently Reinvested Foreign Earnings, Taxes, and Earnings Management,’’ 79 The Accounting Review 745-767 (2004). tion tax holiday expired. The discretion allowed under the accounting rules makes this behavior an acceptable way to manage earnings. However, as Krull noted in her paper, firms that report large fluctuations in PRE as the tax treatment of dividend repatriations changes might deserve greater scrutiny regarding how long the firms actually intend to reinvest the earnings abroad. More on the Lock-In Effect Krull and Leslie Robinson, in a paper titled ‘‘Is U.S. Multinational Intra-Firm Dividend Policy Influenced by Capital Market Incentives?,’’ revisited the issue of the lock-in effect of the dividend repatriation tax. The paper identifies two major disincentives public firms face — an actual cash tax liability and a reduction in their reported pretax earnings — when deciding whether to repatriate their foreign earnings to the United States. That research shows that financial accounting rules can and do have large impacts on the real economy. For example, because the accounting rules do not require firms to report a tax expense on PRE, firms (such as those operating in low-tax countries that did not have foreign tax credits from high-tax countries that would shield their repatriations) may have been encouraged to accumulate their earnings abroad rather than repatriate them to the United States. Prior research on the impact of the American Jobs Creation Act of 2004 largely ignored the financial accounting cost of repatriation. Krull and Robinson’s study shows that capital market pressures to report high earnings deter firms from repatriating their foreign earnings and that those pressures are consistent with both the buildup in undistributed foreign earnings and the surge in dividend repatriations under the Jobs Act. This example demonstrates that financial rules had a clear impact on real tax decisions. Firms have many avenues to minimize the repatriation tax cost, whether through borrowing funds abroad, corporate reorganizations, or by routing income through low-tax locations and expenses through hightax locations. As Krull noted, however, ‘‘These effects are not costless.’’ Firms incur many costs — whether in the form of actual tax expenses or in compliance and tax planning costs — to minimize the tax on returning their earnings to the United States. To the list of well-known tax costs to repatriation, Krull and Robinson add financial reporting costs. The tax and accounting rules converge in one area. Because firms can defer their U.S. tax liability on foreign earnings until they are repatriated, the tax code creates a lock-in effect to keep earnings offshore, and the accounting rules reinforce that effect. As Krull and Robinson noted, ‘‘The results of this study provide evidence that APB 23 creates incentives to leave earnings offshore.’’ Conference participants added another cost 374 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL (C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
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tax notes international - Tuck School of Business - Dartmouth College

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