Permanently Reinvested Earnings and the Profitability of Foreign Cash Acquisitions

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday March 5, 2012 at 9:26 am
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Editor’s Note: The following post comes to us from Alexander Edwards of the Rotman School of Management at the University of Toronto, Todd Kravet of the Naveen Jindal School of Management at the University of Texas at Dallas, and Ryan Wilson of the Tippie College of Business at the University of Iowa.

Prior research has documented that current U.S. corporate tax laws create incentives for some U.S. multinational corporations (MNC) to delay repatriation of foreign earnings in order to defer taxation on those earnings and hold greater amounts of cash abroad. The current financial accounting treatment for taxes on foreign earnings under ASC 740 potentially exacerbates this issue and increases the incentive to avoid the repatriation of foreign earnings by allowing firms to designate foreign earnings as permanently reinvested and to defer the recognition of the U.S. tax expense related to foreign earnings for financial reporting purposes. In our paper, Permanently Reinvested Earnings and the Profitability of Foreign Cash Acquisitions, which was recently made publicly available on SSRN, we predict and document that the combined effect of these tax and financial reporting incentives likely lead to significant agency costs. Namely, managers of U.S. MNCs with high levels of both permanently reinvested earnings and cash holdings are more likely to make value-destroying acquisitions of foreign target firms. Our findings are consistent with anecdotal evidence from the popular press. For example it has been suggested that a significant determinant of Microsoft’s decision to acquire Skype for $8.5 billion was that Skype was a foreign company with headquarters in Luxemburg, enabling Microsoft to use foreign cash “trapped” overseas to make the acquisition (Bleeker 2011).

We also examine the impact of the 2004 repatriation tax holiday created as part of the AJCA. During the tax holiday U.S. MNCs were able to repatriate earnings previously designated as PRE at a temporarily decreased tax rate of 5.25% (from 35%) through an 85% dividends received deduction. During this tax holiday, firms without profitable foreign investment opportunities and who had excess cash had the opportunity to repatriate foreign earnings. Consistent with predictions, we document that the negative association between announcement returns for foreign cash acquisition and earnings designated as PRE and cash holdings is significantly attenuated following the AJCA repatriation tax holiday.

The findings of this study are of direct interest to policymakers. We document a significant indirect cost of having both a tax and financial reporting system that encourage firms to retain earnings abroad. The issue of repatriation taxes and the relative merits of a territorial versus worldwide system of taxation have been at the forefront in recent years with interested parties arguing both for and against the issues (see Drucker 2010 and Washington post 2011). The U.S. government is also currently contemplating the issue as the Committee on Ways and Means recently released a discussion draft that would move the U.S. towards a territorial tax system by providing a deduction from income equal to 95% of foreign-source dividends received by U.S. parent companies (U.S. Government 2011). Our findings should be of interest and informative in both the context of a decision to move to a territorial tax system and the creation of a new repatriation tax holiday.

The full paper is available for download here.

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