By J.G. Collins
Posted: May 29, 2013, 06:30
With all due respect to Senators Levin, McCain, and the others on the Senate Permanent Committee on Investigations, Apple, Inc., is, indeed, avoiding taxes, albeit legally. What the senators seem to overlook is that much of that avoidance results from tax accounting rules that discourage US investment. These same rules could also permit Apple and most other Fortue 500 companies to legally manipulate their earnings. The good news is that if the tax accounting is fixed, a good deal of the rest of the problems go away.
To understand why the accounting rules discourage US investment and how the earnings manipulation could occur, one should have at least a brief primer on US tax accounting for the profits of foreign subsidiaries.
An Incentive for Foreign Investment
The first modern corporate tax accounting pronouncement, APB 111, was issued in 1967. Prior to the digital age, e-mail, and low-cost, highly reliable international couriers like FedEx and DHL, foreign tax data collection came mostly from Telex and less-reliable courier services. The logistics of determining US tax accounting for earnings in foreign jurisdictions was overwhelming. Since foreign income would be subjected to US tax only if it was paid up to the US parent as a dividend, the accounting rule-writers clarified in a subsequent pronouncement, APB 232, that companies could ignore any profits that were “permanently” invested overseas. Subsequent pronouncements, principally FAS 109((Statement of Financial Accounting Standards No. 109 Accounting for Income Taxes)) (now codified as ASC 740) adopted this long-standing rule.
This treatment of foreign profits made the lives of corporate controllers much easier, but it also incentivized American companies to develop profit centers overseas instead of in the USA. All other things being equal, US profits would be subjected to US tax whereas profits that were earned and “permanently invested” overseas were exempt from US tax. These “permanently invested” foreign profits were only subject to generally lower foreign tax rates (and, in many instances, accumulated in overseas tax havens.) While those foreign taxes were mostly creditable, dollar-for-dollar, against US taxes, the difference in the foreign rate versus the US rate on profits still made it more costly to repatriate them then to simply leave them overseas.
Consider, then, that if your company invested $ 1 million in the United States, you might earn $100,000 assuming a 10% rate of return. After tax, though, that amount was trimmed by about 40% (including state taxes) leaving a net after-tax income of only $60,000. But if your company invested the same $1 million overseas, assuming all other things were equal, and the net income after tax could often be closer to the full $100,000 if you kept it “permanently invested” overseas. (In Ireland, for example, at current rates, you’d be able to retain about $86,000, after tax.)
Of course there might be a currency risk to leaving the profits overseas, but you can hedge that, and usually at relatively small cost. And you won’t have access to the cash in the USA without borrowing from the foreign subsidiary or actually paying up a dividend. (Either way, the return of the cash to US shores as a dividend or a borrowing is taxable under US tax rules.) But if you needed cash for US operations, you can borrow it from a bank. (After all, you have collateral readily available in your accumulated overseas profits, right?) And you have the side benefit of being able to deduct the interest on the borrowings from your US income tax! In fact, this strategy of keeping cash overseas while borrowing for US operations is precisely the way that Apple intends to fund its first-ever dividend to its shareholders. Borrowing to pay the dividend avoids the return of the foreign subsidiary profits to the US and, therefore, the US tax.
Given these circumstances, why would any American company invest in the USA? Or return foreign profits to the USA? Returning accumulated earnings to the USA is the corporate equivalent of an individual taking money out of his IRA before he has reached the miniumum age: if he does so, he will be taxed; if he leaves it in his IRA, he won’t be (at least until after he’s required to.) In 2009, researchers determined that, “the ability to avoid or defer the recording of income tax expense on financial statements is an important consideration in real corporate investment decisions regarding location of operations and whether to repatriate foreign earnings to the U.S. or reinvest the foreign earnings overseas.”3 Its easy to see why.
A Device to Manipulate Earnings
If a company does not elect to treat foreign profits as “permanently invested” overseas – that is, it elects to bring them back to the USA — the company’s financial statements will show a deferred liability for the taxes it will pay in the future when it elects to return the foreign profits to the USA as a dividend. While the company’s income statement will show the tax as an expense, the actual payment of the tax on the foreign earnings to the IRS is deferred until they are repatriated. Thus, a company can create a deferred tax expense for foreign profits it “plans to” return to the United States, but still leave the foreign profits overseas.
Its this deferred tax expense on a “planned” repatriation of foreign earnings that opens the door to the potential for earnings manipulation. That’s because the rules in the accounting literature to determine whether accumulated profits are “permanently invested” or not are largely vague and subjective; there is no “bright line” test.
While profits are “presumed to be” repatriated to the USA under APB 23, there is no requirement to provide ironclad evidence to overcome the presumption, such as a signed contract to build a building or acquire a competitor for cash. Companies can simply claim the foreign subsidiary has “plans” to invest funds permanently overseas, no matter how vague. In practice, foreign profits cam simply be deposited in a foreign bank account in anticipation of some overseas investment. The assertion that foreign profits are “permanently invested” overseas is simply the whim of management. More troubling, there are no consequences if a company decides that foreign profits that were “permanently” invested are no longer to be.
Since tax expense is incurred only if there is a repatriation of profits, management has control over its tax expense, irrespective of the company’s income or its tax rates. If management decides foreign accumulated profits are to be returned, tax expense is incurred and profits are reduced. If management subsequently decides to invest those profits “permanently” overseas, the tax expense is reversed from the prior year and profits are increased. And this manipulation of earnings – up or down — is entirely at the whim of management.
Under the accounting literature, such manipulations incur no consequences: the tax expense – or income – that results from the decision to repatriate foreign profits – or to reverse the decision – does not require a restatement of the prior years’ earnings and there is not even a requirement to treat the additional tax expense (or income) as an extraordinary item in the financial statements.
In 2009, General Electric reversed its decision to repatriate $2 billion in profits accumulated in its foreign subsidiaries and, instead, decided to “permanently” invest them overseas.4 The decision permitted GE to reverse an accrual of $700 million of deferred tax expense into income, boosting the multinational’s income by around 7%. The additional income from the tax change boosted per share earnings by about 7 cents a share in an otherwise very disappointing year.
In 2004, lobbyists persuaded a mostly naïve and even more compliant Congress that American companies with substantial earnings overseas would invest in the USA and create jobs if only Capitol Hill would cut taxes on remitted profits. Congress dutifully complied and reduced the US tax rate for repatriated foreign profits, ostensibly with the requirement that such profits would be invested in the USA. Companies repatriated billions of dollars to the USA, but at a 5% tax rate. The one-time tax holiday that took effect in 2005 is widely regarded as a failure.; a “give-away” to the Fortune 500 with only a minimal level of job growth and investment. In many instances, many Fortune 100 companies that repatriated large amounts of foreign earnings actually laid off thousands of workers.5
Calculating tax expense on all the foreign earnings of US-owned subsidiary, as a deferred expense in a company’s financial statement, would make the decision to earn income in the US or overseas entirely tax neutral from a US financial reporting perspective, as it should be. Accruing US taxes on foreign subsidiary earnings in the year they are earned (instead of when management decides they are to be distributed to the US parent as dividends) would make the decision as to whether to remit those earnings tax neutral in the financial statements.
Similarly, accruing the tax expense on foreign profits without respect to whether they will be remitted would remove the possibility of earnings manipulation. The tax would be accrued whether the profits remained overseas or were repatriated.
J.G. Collins is the managing director of The Stuyvesant Square Consultancy. © 2013 The Stuyvesant Square Consultancy. All rights reserved. For press inquiries or reproduction, please contact us.
Graham, et. al., “Real Effects of Accounting Rules: Evidence from Multinational Firms’ Investment Location and Profit Repatriation Decisions“(Draft, December 21, 2009) ↩