Wiley IFRS 2010

Barry J.Epstein
Eva K. Jermakowicz

IFRS Policies & Procedures

Barry J.Epstein
Eva K. Jermakowicz

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Considering Another Tax Holiday For Foreign Earnings

Attorneys, who often are corporate clients only significant outside advisers, commonly offer advice on a wide range of business management issues, in some cases even extending to matters pertaining to financial reporting, selection of accounting principles and tax strategies. One current, hotly debated tax law change may provide another opportunity for advisory service to clients.

Calls are increasingly being heard for what amounts to a replay of the tax holiday granted by the 2004 American Jobs Creation Act (AJCA), which included a one-year-only provision that granted an 85 percent dividends-received deduction for earnings of foreign subsidiaries of U.S. corporations that were repatriated.

The goal then and now, if replicated was to bring home cash held abroad, with the hope and expectation that this would be invested in domestic productive facilities (plant and equipment, research and development) and the hiring of American workers, thus boosting the domestic economy. Implicitly, enacting such a provision manifests a belief that the nonremittance decisions of those taxpayers were and are driven by the availability of the tax deferral.

Of the estimated $1 trillion of earnings held abroad in 2004, it was estimated that as much as $350 billion in repatriations were stimulated, albeit at a cost in lost taxes of up to $104 billion (= 85 percent x 35 percent x $350 billion). Today, with as much as $1.5 trillion allegedly being held abroad by foreign subsidiaries, as much as $500 billion of fresh capital inflows could presumably be stimulated (again, however, at a cost in lost taxes as much as $155 billion, and assuming the same fraction of remittances to amounts held abroad prevail as in 2005, when the effects of the 2004 AJCA were felt).

Academic and other research findings suggest, contrary to intent, that the repatriated funds generated by the 2004 AJCA failed to stimulate investment in domestic productive facilities or to expand employment, but rather funded stock buy-backs and dividends by the domestic parent companies that were the recipients of the program.

It has been reported that over 90 percent of these remittances were used for those unauthorized purposes although in fairness it should be said that, if funds returned to shareholders via dividends or stock repurchases were later deployed for consumer purchases or personal or business investments, the ultimate impact on U.S. economic health could well have been similar, if perhaps less immediate or observable.

Economists and other academicians have a different view of these happenings. They more often attribute American companies disinclination to repatriate the earnings of their foreign subsidiaries to a perceived lack of profitable domestic investment opportunities.

One comprehensive study of the impact of AJCA concluded that the domestic operations of U.S. multinationals were not financially constrained at the time of the act, meaning that the paucity of job-boosting domestic investing was not due to a lack of investable funds, but rather reflected a perceived scarcity of investment opportunities.

Accordingly, the sudden ability to access a low-cost internal source of capital (i.e., via the tax-favored repatriated foreign earnings) should not have been expected to boost domestic investment, domestic employment or R&D. To the extent that there is similar liquidity among American companies today, repatriation of foreign earnings would also not be likely to spur new investment.

In addition to the real economic considerations affecting behavioral responses to the 2004 AJCA, a financial reporting concern likely affected repatriation decisions. If a similar tax holiday were to be declared today, this concern would be made even more complicated by the fact that, increasingly, companies are able to choose between U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) for general purpose external reporting a choice unavailable in 2005.

The financial reporting implications of earnings being invested or retained by foreign subsidiaries differ as between the U.S. GAAP and IFRS rules, as explained below.

An exception to the Internal Revenue Codes rule of taxing worldwide income is found in IRC 951-965, which provides for deferral (not exemption) of taxes if earnings of foreign subsidiaries of U.S. corporations are not repatriated. Under U.S. GAAP (and also under IFRS), accrual-basis financial statements are to report the tax effects of income and expense reported in the current period, without regard to when the taxes are actually remitted to the taxing authorities.

Under this general principle, income taxes would be reported in the consolidated financial statements in the period when the related foreign income is being reported (i.e., currently), notwithstanding any permitted deferral of the actual payment obligations. Since there would be no current cash outflow, the resulting tax expense would be accompanied, in the financial statements, by recognition of a deferred tax liability.

Notwithstanding this fundamental tenet, the availability of an indefinite deferral of tax payments associated with unremitted foreign earnings under IRC 965 inspired arguments in favor of the nonrecognition of tax effects until remittances actually occur or at least become very likely.

The then-accounting rule-making body promulgated APB 23 (issued in 1972), an amendment to APB 11, that adopted this view, stating that although it should be presumed that all undistributed earnings of a subsidiary will be transferred to the parent company [and that accordingly] the undistributed earnings of a subsidiary included in consolidated income should be accounted for as a temporary difference, it created an exception if sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation.

In other words, for financial reporting purposes tax expense is not recognized currently in those situations where the earnings will not be taxed in the U.S. until repatriated, if the parent (reporting) entity has evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely.

Companies may cite their historical experience as well as their definite future programs for operations and remittances to justify such nonrecognition under U.S. GAAP, and many have done so which is one reason why effective tax rates of U.S. multinationals are low overall.

Of course, when plans and expectations change, they are supposed to fully accrue their income tax obligations, even if repatriation (and thus tax payment) lies in the distant future.

Under this so-called indefinite reversal criterion, domestic reporting entities can avoid accruing income tax expense on earnings of their foreign subsidiaries and equity method investees if they can assert that those earnings would be indefinitely invested in foreign tax jurisdictions (or would be repatriated in tax-free liquidations, a less likely outcome).

This longstanding rule was carried forward and incorporated into the current standard on accounting for income taxes when it was promulgated in 1992.

Strictly interpreting this standard, there should be a relatively high hurdle for the nonrecognition of the tax effects of the earnings of foreign subsidiaries of domestic corporations, whatever the tax laws might otherwise provide regarding current tax payment obligations.

It is thus incumbent upon the reporting entity to demonstrate, by reference to its historical actions and its current, documented plans, that foreign earnings will be reinvested abroad indefinitely, with no realistic intent to repatriate those earnings. For the entity's independent accountants, of course, the challenge will be to audit managements intentions always among the more difficult of undertakings, fraught with risks of later second-guessing and possible litigation.

The simple concept that deferred taxes are to be provided on all timing differences, including those arising from unremitted earnings of foreign subsidiaries that remain untaxed in the parent company's jurisdiction until repatriated, is subscribed to not only by U.S. GAAP, but also by IFRS.

Likewise, IFRS provides an exception that supports the nonrecognition of the tax effects of the unremitted foreign earnings, under limited circumstances. However, the criteria for nonrecognition differ between these two financial reporting regimes, and this difference could influence behaviors of companies that may have reasons to maintain foreign earnings outside the U.S., particularly if partially motivated by the financial reporting ramifications of those actions (which would be described by some as a form of earnings management).

Under the corresponding international financial reporting standard (IAS 12), the company is to recognize a deferred tax liability for all taxable temporary differences associated with investments in subsidiaries, branches and associates, and interests in joint ventures, except to the extent that both of the following conditions are satisfied:

a) The parent, investor or venturer is able to control the timing of the reversal of the temporary difference.

b) It is probable that the temporary difference will not reverse in the foreseeable future.

Two of the terms in the foregoing rule could be subject to some degree of confusion or debate: probable and foreseeable future. Reasonable preparers, auditors and users of the financial statements could be expected to occasionally disagree over the meanings of these terms, and such disagreements could lead to serious contention, including litigation, particularly if investors believe management committed misrepresentations in the financial statements relied upon for investment decisions. Corporate counsel are therefore advised to assist clients in correctly applying these terms and the standards in which they appear.

In particular, under IFRS the term probable is generally defined as being a likelihood over greater than 50 percent, which is formally expressed as being more likely than not to occur.

However, that definition is not found in IAS 12, and indeed, although the term probable is used some 28 times in that standard, it is never given a formal or operational definition, adding to the likely frustration of preparers, users and auditors.

Under U.S. GAAP, although also not officially defined as such, probable is taken to imply a likelihood of upwards of 85 percent clearly a higher threshold than more likely than not.

For the present discussion, probable, when used as a threshold condition for the nonrecognition of the tax effects of unremitted foreign earnings, will be taken to mean more likely than not, consistent with the terms general use under IFRS.

This provides a much lower threshold criterion than the corresponding one under U.S. GAAP, which demands a firm management assertion that foreign earnings are to be indefinitely reinvested abroad and thus shielded from U.S. corporate income taxes indefinitely.

Similarly, the standard does not define foreseeable future, which therefore remains a matter of subjective judgment.

Nevertheless, the foreseeable future implies a more proximate horizon than is suggested by the corresponding U.S. GAAP term, indefinite. Thus, it would be easier for management to assert that any repatriation of foreign earnings is not expected in the foreseeable future (the IFRS guideline) than it would be to assert a positive intention to indefinitely reinvest those earnings abroad (the U.S. GAAP criterion).

Taken together, the terms probable and foreseeable future as used under IFRS suggest that it would be much more feasible for corporations reporting under IFRS to justify not providing deferred taxes on unremitted foreign earnings, where (as for U.S. corporations) those taxes are not to become payable until there has been repatriation to the domestic parent company.

Inasmuch as the U.S. now permits the optional use of IFRS for financial reporting by U.S. corporations  and may eventually mandate the use of IFRS as the successor to U.S. GAAP this would suggest that deferred taxes on unremitted foreign earnings will increasingly go unreported until, and if, repatriation occurs.

Attorneys should be aware of these differing rules regarding the current recognition of tax effects of foreign earnings that have yet to be remitted to the U.S. It is possible that this could be a deciding factor when clients are contemplating electing to report under either U.S. GAAP or IFRS, and at the minimum needs to be given consideration, among a range of other factors, in making such an important decision.

--By Barry Jay Epstein, Russell Novak & Company LLP

Barry Epstein is a partner at Russell Novak & Company LLP, a provider of accounting, tax and financial litigation advisory services in Chicago. He is the author of "The Handbook of Accounting and Auditing" and a consulting expert on GAAP, auditing standards and financial reporting matters.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360. This article is for general information purposes and is not intended to be and should not be taken as legal advice.