tax notes international - Tuck School of Business - Dartmouth College

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.