Yesterday at the colloquium, Scott Dyreng presented the above-named paper, coauthored by Kevin Markle and Jon Medrano. It examines how having U.S. net operating losses (NOLs) affects U.S. multinationals' repatriation of foreign earnings. Where the repatriated earnings are IRFE (indefinitely reinvested foreign earnings) for financial accounting purposes, repatriation can (a) reduce the present value of the taxpayer's expected long-term U.S. tax liability, and also (b) free up cash to be used more easily as the company prefers,. However, this comes at the cost of (c) a negative effect on financial accounting income, relative to keeping the funds abroad (with an assumed future repatriation tax of zero) and acquiring a tax asset in the form of the NOL. The authors' premise, therefore, is that the companies should be expected to trade off (b) against (c), taking (a) as given.
Here are some quick thoughts on the issues that this interesting, although at this pioint still preliminary, research raises. The first set of issues concerns tax policy in relation to repatriation decisions; the second, financial accounting's effect on behavior by publicly traded companies.
1. Taxes and repatriation
(a) Time value, NOLs, and FTCs - One way of thinking about the underlying issue of how to minimize present value U.S. taxes is as follows. NOLs don't earn interest. Hence, they lose value in present value terms if they must be carried forward. (Not a problem for carrybacks, and subsequent drafts of the paper may try to ease this aspect more.)
Likewise, foreign tax credit (FTC) carryforwards don't earn interest. Note, by the way, that even low-taxed, though not zero-taxed, foreign source income can generate FTC carryforwards if used to wipe out NOLs. For example, suppose Acme would have a $10 million NOL but for its repatriating $9 million in cash that is associated with $1 million in foreign taxes paid. This is treated as a $10M repatriation, raising taxable income to zero, so there is no U.S. tax liability for the $1M in FTCs to offset. Hence, one has a $1 million FTC carryforward even though this was low-taxed income by U.S. standards. One issue that the paper examines is whether companies were especially keen to avoid turning NOLs into FTC carryforwards in the era when the latter had a much shorter carryforward period than the former.
The tradeoff between the two types of carryforwards should be a wash insofar as they have the same carryforward period and the chances or convenience of using one or the other look about the same. Neither carryforward bears interest. But what about implicit or unripe FTCs, associated with taxes paid on foreign earnings, where the earnings haven't been repatriated yet? Here, while there is not literally interest being earned on the deferral of the foreign tax credit claim, they may be growing in an interest-like way.
Suppose I have $X of unrepatriated foreign earnings, associated with $Y of unripe FTCs. If I am continuing to earn a normal rate of return and am paying foreign tax on that return, then Y may be growing at a normal rate of return. Subject to a lot more analysis that I won't attempt here, this might mean that the present value of unripe FTCs is remaining constant. Or, if there is a disparity between relevant rates of return, it might be growing or shrinking in present value terms once one has determined the proper discount rate for a given taxpayer.
I will not attempt further analysis here. It's the type of topic that might appeal, say, to Al Warren or Fadi Shaheen – writers whose recent work has often looked closely at equivalences and incentive effects under particular rate-of-return assumptions, I also agree that one has to think, not just about the FTCs, but also about the earnings and the residual U.S. taxes with which they may be associated. But insofar as taxpayers can still engage in “splitter”-type transactions, despite section 909 of the Internal Revenue Code, there may be some point to thinking about the FTCs in particular, albeit keeping in mind their connection to all the rest.
For now, however, it's enough to note that the unripe FTCs may be preferable to both NOL and FTC carrtyforwards because (or if) they are growing at a positive r of some kind.
(b) FTC carryforwards now vs. in the past - One point of empirical interest in the paper is that, pre-2005 but not post-2005, FTC carryforwards were much shorter than those for NOLs. My quick thought is that FTC carryforwards have probably become much less important over time than they used to be. Not only have foreign corporate tax rates declined relative to that in the U.S. over the last twenty-odd years, but foreign-to-foreign tax planning has improved, e.g., by reasom of companies' ability to take advantage of the check-the-box rules.
(c) 2005 tax holiday - Recent empirical work appears to confirm the ongoing importance of the 2005 tax holiday for foreign dividends, which enabled companies to repatriate earnings at a greatly reduced tax rate for a limited period. If companies had believed that it was a one-time-only event, never to recur, then it might not have affected expectations going forward. But of course speculation has been rife for years that Congress might do it again.
When companies anticipate the possible enactment of a new tax holiday, this both reduces the expected level for them of the ultimate U.S. repatriation tax that they might pay, and increases its volatility. These are distinct effects, each meriting analysis, although in one respect they push in the same direction – both discourage further repatriations before the next holiday.
2. Accounting and behavior
This is our second paper of the semester (Lily Batchelder's was the first) to look at financial accounting's effects on companies' behavior. Here the issues center around the accounting treatment of deferred repatriation taxes.
(a) Two accounting rules, both of them wrong - Say that Acme, a U.S. company, has $10 million of foreign earnings, stashed in a tax haven, with no associated FTCs. Under financial accounting rules, in the standard case Acme will book the deferred U.S. tax liability of $3.5 million as a current expense. This is wrong because Acme surely doesn't expect to pay that much tax in present value terms. Even assuming that there is a taxable repatriation at some point, Acme's managers surely (and reasonably) anticipate that they will get to pay a much lower repatriation tax rate than 35% – for example, due to another a tax holiday, a reduction in the U.S. corporate rate, a shift to territoriality in which any deemed repatriation tax applies at a much lower rate, etc. So the standard accounting rule here likely overstates the expected liability in realistic present value terms.
Now suppose instead that Acme persuades its auditors (which may not be too hard) that the funds have been indefinitely reinvested abroad, making them IRFE. Now the assumed repatriation tax is zero. This is also probably wrong. There surely is some chance of a taxable repatriation, even if at less than a 35% rate, and also the company may be paying an implicit tax, reducing the value of the funds, to put off the repatriation. (This is why it might be willing to pay a repatriation tax above zero, even if it truly anticipates being able to keep the funds abroad indefinitely.)
(b) What would the “correct” accounting rule do? - I would say that, building on the model that I gather financial accountants use for, say, uncertain litigation that has big bottom-line effects, the right answer would involve making a presenr value estimate for the deferred tax liability. Now, this is admittedly hard, as it depends not only on the company's long-term plans but also on future legislation. But if the grounds for the calculation were disclosed, mightn't this be better than using either of the existing methods? It might not only be more accurate on average, but would eliminate the discontinuity between the existing methods.
Okay, I'm not an accountant, but I suspect that this approach merits more attention than it has been getting. The fact that accountants might dislike it, because it forces them to do something that is inherently rather tuncertain, does not prevent its being potentially better borh for investors and for the tax system – the latter, because once companies have chosen IRFE treatment that may create lock-in wholly apart from the tax analysis.
(c) What if the FASB simply repealed the IRFE rule? - From the standpoint of informing investors, this is no panacaea, given the overstatement in many or most cases of actual expected U.S. liability. While we often hear that financial accounting should be “conservative,” under-valuing companies can be as harmful to investors as over-valuing them, and can also create undesirable special advantages for the better-informed. But it would certainly be interesting to observe how greatly (or not) managerial behavior would change if keeping funds abroad, despite creating a likely true economic benefit (if the U.S. repatriation tax rate might be significantly lower in the future), created no accounting benefit.
BTW, no colloquium next week – it's our spring break. We will resume on Monday, March 20 with Daniel Hemel's The Federalist Safeguards of Progressive Taxation.