Financial accounting guidance related to unremitted earnings of a foreign subsidiary hasn’t changed, but recent scrutiny of the guidance, including corporate compliance with it, certainly has. Weighing in are the government, the media, regulators, tax reform advocates, taxing authorities, analysts and investors — and even foreign governments and agencies.
For a U.S.-based multinational corporation, the financial accounting guidance includes a rebuttable presumption that the undistributed earnings of its foreign subsidiaries will be repatriated to the U.S. parent at some point in the future. To the extent that the future repatriation would result in U.S. taxes, the U.S. parent is required to accrue a deferred, or future, tax liability relating to those taxes and to record the related tax expense on its financial statements.
Congress has expressed concern about the role the guidance has played in encouraging corporate earnings to be shifted to lower-tax jurisdictions. Global concerns around base erosion and profit shifting (BEPS) are rampant as a result of action plans by the Organisation for Economic Co-operation and Development (OECD) to address BEPS in a cohesive and comprehensive manner. As a result, companies that do not record U.S. deferred taxes on earnings of foreign subsidiaries face increasing regulatory scrutiny while companies that report earnings in low-tax jurisdictions face increasing global tax risks.
A two-part test
A U.S.-based multinational corporation can avoid recognizing the U.S. deferred tax liability (and expense) if the earnings of the foreign subsidiary will be indefinitely reinvested. To achieve this outcome, the company must meet two requirements:
The foreign subsidiary must have specific plans to invest its earnings — for example, to fund R&D or capital expenditures, to finance an acquisition, to retire its own debt or to fund organic growth.
The U.S. parent must have sufficient liquidity and cash flow, without repatriating the foreign earnings, to meet all its liquidity needs, including working capital, acquisitions or organic growth, R&D, debt servicing, capital expenditures, pension obligations, dividend payments and stock buybacks, and so on.
To be clear, a foreign subsidiary still pays and records taxes on its foreign earnings. Yet as long as the two-part test is met, the incremental U.S. tax on those foreign earnings — generally, the spread between the foreign tax rate and the U.S. tax rate — will not have to be accrued and recorded for financial statement purposes. Currently the U.S. corporate tax rate is 35%. If the tax rate is 10% in the foreign jurisdiction, the incremental U.S. tax rate — the difference between the two rates — is 25%. By not having to record this incremental U.S. tax because the foreign earnings are being indefinitely reinvested, a U.S.-based multinational corporation may obtain considerable financial accounting benefit. A downside of asserting that the foreign earnings are indefinitely reinvested is that the cash related to the foreign earnings is generally not available for use by the U.S. parent. To that extent, investors and analysts are interested in knowing the amount of cash and accumulated earnings being retained in foreign jurisdictions.
To demonstrate the magnitude of the financial statement benefits, companies in the Russell 1000 reported a total of $2 trillion-plus of indefinitely reinvested earnings of foreign subsidiaries as of the end of 2013, marking an average annual increase of $204 billion during the five-year period ending as of that date. The sheer level of this accumulation has raised the alarm of the U.S. government and foreign tax authorities, who are concerned about BEPS, or tax strategies that shift profits to places where taxes are low to avoid paying corporate tax.
Congress — and that hot topic of inversions
Early in 2014, a U.S. Senate subcommittee concluded that the financial accounting guidance relating to indefinitely reinvested foreign earnings is contributing to the shifting of profits offshore by U.S.-based multinationals. The subcommittee went further to say the financial reporting benefits of the guidance are encouraging multinationals to move and keep their businesses and earnings offshore. It also concluded that the increase in the amount of indefinitely reinvested earnings is due in part to the shifting of income offshore into tax havens.
There is also concern that the stockpiling of cash in foreign jurisdictions is a factor in fueling inversion transactions, a very hot topic these days with Burger King Worldwide recently completing its merger with Tim Hortons and Medtronic shareholders recently approving its acquisition of Covidien. In a typical inversion transaction, a U.S.-based company merges with a foreign business and takes a foreign address for tax purposes. President Obama has labeled inversions the work of “corporate deserters.”
Congress, meanwhile, urged the FASB to consider issuing additional guidance or restrictions on applying the standard applicable to indefinitely reinvested foreign earnings. In August 2014, the FASB declined to do so; however, earlier this month, the FASB affirmed that the disclosure requirements are being reconsidered as part of the FASB’s existing disclosure framework project, particularly given concerns that the current financial statement disclosures regarding foreign earnings may not be sufficiently detailed to meet investor and analyst needs.
SEC and PCAOB focus
The adequacy of financial statement disclosures regarding foreign earnings is a big issue. Studies of the disclosure practices of public companies have shown that a significant number of companies have not fully complied with the disclosure requirements. Similarly, the SEC has continued to observe that many U.S. public companies are not providing sufficient information regarding their foreign earnings. SEC officials have stated that improved disclosures about the tax effects of those earnings, including in the management discussion and analysis (MD&A) section of their filings, is required to facilitate informed investor decision-making. It is not surprising that in statements made in November and December of 2014, SEC officials indicated that the SEC will be issuing even more comment letters inquiring into the disclosure practices of U.S. businesses with foreign operations.
Even officials of the Public Company Accounting Oversight Board (PCAOB) have entered the picture by expressing concerns in December 2014 about the audit work performed on companies’ foreign earnings. One PCAOB official stated that undistributed earnings and cash that U.S. companies hold overseas raise potential audit risks. A heightened concern is the audit work performed around significant tax structuring transactions, including companies’ internal controls for those structures.
The U.S. Senate subcommittee mentioned earlier also expressed concerns about a tax-structuring transaction implemented by a public company with the assistance of its auditor, which resulted in the shifting of significant corporate profits into a lower-tax jurisdiction. Congress asked the PCAOB whether the scope of auditor independence rules, which permit non-audit tax services, is appropriate. The PCAOB announced in November 2014 that it will examine the tax services that accounting firms provide to their audit clients to help it determine whether to propose new rulemaking or offer some recommendation to the SEC about the independence rules that the agency promulgates. An SEC official stated last month that the SEC is monitoring the nature of tax work that firms provide to their audit clients and will examine those practices that can lead to what it considers to be aggressive tax positions and potential violations of the auditor independence rules.
The OECD has stepped in to help governments with the growing concern that multinational corporations are engaging in BEPS to avoid paying tax where profits are earned. Even though the practices may be lawful under existing rules, the OECD is examining them from a fairness perspective: Is every country getting its fair share of taxes based on the economic activity conducted in that country?
The OECD efforts consist of 15 specific BEPS actions to be finalized in three phases, with completion no later than December 2015. Although the OECD is not a law-making authority, its actions are intended to result in changes in local country tax laws, tax treaties and OECD transfer pricing guidelines.
The BEPS project is putting unprecedented public attention on corporate tax affairs, with potential reputation and financial statement risks. Certain countries have already enacted or introduced legislation to address BEPS. In addition, taxing authorities around the globe have become increasingly aggressive in challenging transactions that are perceived to have eroded their tax base.
With this change in the international tax landscape, any foreign earnings, including those that are indefinitely reinvested, are at risk for increased scrutiny and taxation.
What you need to do
To stay compliant with financial accounting requirements and to undertake appropriate risk management, companies should consider these best practices.
. Cross-functional collaboration is imperative to understand and apply the two-part test to determine whether earnings of foreign subsidiaries are considered indefinitely reinvested for financial statement purposes. A tax professional needs to collaborate with professionals in the treasury, accounting, operations, legal and corporate development departments — and also across geographies — to monitor foreign subsidiary cash balances, determine foreign country remittance restrictions, get advice on repatriation and so on. Whether earnings of a foreign subsidiary can be reinvested without impairing U.S. parent liquidity needs is a global cash management determination, driven by a company’s overall business and cash management strategy, and its financial and investment plans.
. The two-part test requires a company to have both the intent and the ability to indefinitely reinvest foreign earnings, with sufficient evidence to show both tests are met on an entity-by-entity and jurisdiction-by-jurisdiction basis. The company has to demonstrate and document its specific plans for reinvestment of the foreign earnings and show evidence that it will meet U.S. cash flow obligations without a repatriation of the foreign earnings. To do so, a company must determine and evaluate the relevant data.
. Interim-period monitoring and analysis with respect to the earnings of foreign subsidiaries is essential, through cross-functional meetings that take place throughout the year. A standing agenda item should be a discussion of global cash management, including specific plans for reinvestment of foreign earnings, with real-time visibility as to where cash is, on an entity-by-entity basis. This may involve soliciting foreign subsidiaries for information that may affect whether earnings can be indefinitely reinvested or remitted to the U.S. parent. Information should include risks emanating from enacted or planned tax or other law changes at the local country level that would affect the reinvestment or taxation of the foreign earnings.
Another agenda item should be the monitoring of milestone events to determine if they would cause a change in judgment as to whether foreign earnings from prior periods continue to meet the two-part test. The milestone events may include new or restructured debt, cost reduction initiatives, significant variances (unfavorable or favorable) to budget or forecast foreign earnings or cash needs, acquisition or divestitures, a change in dividend policy or stock repurchases, or tax law changes.
A memorandum with cross-functional reviews and sign-offs will assist in documenting the existence and effectiveness of the internal control process related to the earnings of foreign subsidiaries.
. The hypothetical nature of the calculation required to compute the unrecorded U.S. deferred tax liability on indefinitely reinvested earnings can be complex. Technology can enable calculations including automated data extraction and analysis. Automation can also facilitate updating and real-time planning and decision-making regarding potential earning repatriations by treasury, tax and others in the organization.
MD&A and footnote disclosures
. A fresh look at existing MD&A discussion and footnote disclosures may help to determine whether the SEC will have concerns regarding them. Go beyond boilerplate language to provide as much clarity and transparency as possible to meet the needs of investors and analysts, including how indefinitely reinvested foreign earnings affect reported earnings, foreign and domestic liquidity needs, and foreign asset composition (including cash). Look at the details and consider providing more (but not confidential) information. For example, consider disclosing separately the accumulated amount of indefinitely reinvested foreign earnings for any jurisdiction for which the amount is significant. Also use the income tax rate reconciliation, which shows the effect of foreign earnings on the company’s effective tax rate as a separate reconciling line item, as only a starting point for the disclosure regarding foreign earnings.
Review the tax work papers to identify the various components included in that reconciling line item for purposes of expansion of the disclosure. Examples of items that may warrant further disclosure include permanent book-to-tax differences that caused a materially higher or lower tax rate in foreign jurisdictions, significant portions of foreign earnings generated in a particular tax jurisdiction, and specific factors that caused any material year-over-year changes in the percentage of pre-tax foreign earnings to total pretax earnings. In the MD&A section, discuss trends and uncertainties that will inform investors about the companies’ expectations within specific countries. This is particularly important if a substantial portion of the foreign earnings is generated in a particular country, and the tax laws in that country are subject to change. In that case, the potential risks may become sufficiently significant to merit disclosure.
Global tax risk management
. Accounting for foreign earnings is not just a U.S. deferred tax liability issue but a potential global tax risk. Risks need to be anticipated, identified, managed and mitigated. Effective global tax risk management includes the monitoring of potential tax and other law changes and managing tax controversy risks. It includes reviewing tax planning strategies on an ongoing basis to make sure they’re still viable even under the OECD’s BEPS action plans and any local country law changes. It includes anticipating the potential impact of the changing international tax landscape on people, data, technology and processes, including an increase in transparency with taxing authorities, the anticipated increase in cross-border tax disputes and the expected burden caused by the OECD’s proposed country-by-country reporting requirements. Think about the big picture — what’s going on in the United States and globally.
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