Read the full story by Michael Blanding, published by the Tuck School of Business.
By the end of 2010, 90 percent of firms in the S&P 500 owned and operated a subsidiary in a foreign country. Globalization in full flower, right? Yes, but it might not be so pretty for America’s tax revenue. With the increase in foreign business have come fears that offshore earnings will never come back to the U.S.—as with the recent controversy over Apple’s use of foreign entities to avoid paying taxes on $100 billion in profits and sales.
When overseas earnings are expected to be subject to U.S. tax, accounting rules generally require companies to include this tax as a liability on their balance sheets, decreasing their near-term profits. However, these rules provide an exception for earnings deemed by a company to be “permanently reinvested” abroad. “The intuition is that the actual tax will be paid so far out in the future that it’s too complicated to determine the appropriate amount of the expected liability today,” says Leslie Robinson, associate professor of business administration at the Tuck School of Business.
Because permanently reinvested earnings (PREs) are exempt from the requirement to accrue a tax liability in the financial statements, industry observers worry that companies may be tempted to overstate their PREs to make their profits look better. But is that happening? Robinson addresses the question in a new working paper, “The Location, Composition, and Investment Implications of Permanently Reinvested Earnings,” written with colleagues Linda Krull of the University of Oregon and Jennifer Blouin of the University of Pennsylvania.
Companies are required to report so little about their overseas business that it’s difficult to ascertain their underlying motivation for asserting that their foreign earnings are PREs. “The notion of PREs is a bit of a black box to people,” says Robinson. “One firm may say earnings are PREs because they don’t want to accrue the tax liability, while another firm may have genuine long-term reinvestment plans.” Enforcement, therefore, is difficult.