Corporate Finance Topics | Issue No. 2 2014
“Indefinite Reinvestment”:
An Accounting Election With a Big Impact
“Indefinite Reinvestment”:
An Accounting Election With a Big Impact
2
In this issue of Corporate Finance Topics, we will begin to untangle
Subcommittee for Investigations on tax matters, understanding “indefinite
reinvestment” has never been more important, and we have observed
a substantially higher level of rigor being required to assert intent to
“permanently reinvest” offshore.
the somewhat mysterious accounting rules that dictate how U.S.
corporations account for U.S. income taxes on earnings generated
by their offshore subsidiaries. Although a treatise on U.S. tax policy
3.
Understanding market expectations and potential valuation impact
Seemingly, managing to a lower effective tax rate (ETR) leads to higher
profits, and consequently higher valuations, particularly for companies
valued on P/E. However, growing cash balances need to be analyzed and
compared against ROIC considerations and investor expectations (for an
in-depth analysis of ROIC, please see Calibrating ROIC to Drive Shareholder
Value on the Corporate Finance website: http://corp.bankofamerica.com/
documents/16303/72084/CalibratingROIC_DriveShareholderValue.pdf).
Low-yielding cash balances generate a significant drag on ROIC, and high
cash balances may attract the attention and focus of an activist campaign.
Additionally, we illustrate that investor expectations overwhelmingly
endorse investment in the business either via capital expenditures or
acquisitions. Potential tax savings should be weighed against the after-tax
benefits of growth initiatives and return of capital across a range of financial
metrics, including ROIC and NPV. Focusing solely on accounting can lead
to suboptimal decisions.
4.
Reviewing APB 23 basic concepts and the “indefinite reinvestment” assertion
APB 23 applies broadly to all U.S. multinationals. Generally, offshore earnings
are not subject to U.S. tax until repatriated (or deemed repatriated, a complex
topic unto itself). U.S. generally accepted accounting principles (GAAP), on
the other hand, generally require current accrual for future U.S. taxes to be
incurred upon repatriation unless a narrow exception applies. The primary
exception relied on by issuers is set forth in ABP 23. In short, APB 23
presumes foreign earnings will be repatriated, but the APB 23 “exception”
establishes specific criteria for the issuer to rebut such presumption via
assertion of permanent reinvestment — this provides issuers with a
technique to defer the GAAP tax expense and establishment of a
deferred tax liability.
and the taxation of foreign earnings is beyond the scope of this
article, certain general principles are fairly straightforward, and
these will be our focus. What was once a topic for tax gurus and
accounting experts, APB 23, the accounting standard governing
foreign earnings, and its usage are now a key area of attention
for corporate executives as they consider and contemplate new
capital allocation.
Executive Summary
1.
2.
Macro landscape: foreign cash continues to build
Over the last decade, foreign earnings have skyrocketed, totaling approximately
$2.1 trillion in 2013.1 Not only has accounting treatment and tax law incentivized
companies to avoid remitting foreign earnings to U.S. soil, accommodating
credit markets have also allowed companies to finance domestic operations,
return of capital and growth initiatives via cheap debt. As a result, a record
amount of cash has accumulated offshore.
Regulatory landscape: heightened focus by regulators, auditors and Congress
Increasingly, the gap between effective and statutory rates has received
scrutiny from internal auditors, regulators and Congress. Although the SEC
now requires issuers to disclose the breakdown of foreign vs. U.S. cash/
earnings, some members of U.S. Congress see APB 23 as a “tax gimmick”.
As high profile corporations testify in front of the U.S. Senate Permanent
Corporate Finance Topics | Issue No. 2 2014
3
Corporate Finance Topics | Issue No. 2 2014
1
Macro
landscape:
foreign cash
continues
to build
Foreign earnings have grown significantly since the last repatriation holiday,
which was incorporated into the American Jobs Creation Act in 2005. Current tax
law and accommodating credit markets since the credit crisis have helped U.S.
multinationals to defer repatriation of foreign cash.
U.S. $ in billions
2,500
$2,119
2,000
$1,885
2
Regulatory
landscape:
heightened
focus by
regulators,
auditors and
Congress
$1,628
1,500
$1,362
$1,098
$1,188
1000
Figure X.
Figure 1. Total
Undistributed
Foreign Earnings
Indefinitely
Foreign
Reinvested
2001– 2013,Earnings,
S&P 500
Russell 10001
500
0
2008
2009
2010
2011
2012
2013
Source: To come.
4
Accounting principles presume that all foreign earnings will be repatriated, and
therefore require a U.S. multinational to book a deferred U.S. tax liability on those
earnings. However, if those earnings are respected under APB 23 as “permanently
reinvested,” the multinational would not have to recognize that liability. Consequently,
corporations achieve lower effective tax rates (ETRs) by asserting that either all
or a portion of foreign earnings are permanently reinvested.
Within the past 18 months, a number of corporations have felt obliged to
explain and defend their corporate tax practices, often with a particular focus on
accounting rather than the actual U.S. federal tax code. Despite clear exposition
of complex tax provisions and application of APB 23 by numerous companies and
audit teams, Congress continues to summon management teams to testify about
their practices.4 In short, the accounting and financial implications of offshore
cash practices, especially surrounding APB 23, have become an executive-level
issue. A change in ETR will affect reported GAAP profitability and valuation, and
as regulators become increasingly focused on foreign earnings treatment via the
APB 23 exception, corporate executives need to be well-versed in the benefits,
considerations and implications of managing ETR. Investors, too, need to be
proficient in matters relating to a company’s ETR. While altering an assertion
that foreign earnings will no longer be “permanently reinvested offshore” has an
accounting implication, it is not necessarily connected to an immediate or actual
cash tax impact.
In addition, accommodating credit markets have provided a readily accessible
alternative to repatriation. Since the credit crisis, yields have remained low as the
Fed deploys quantitative easing into 2015. Furthermore, yield-seeking investors
have only reinforced positive market reception to bond issuance. Instead of taking
the cash tax hit or utilizing valuable foreign tax credits, U.S. multinationals simply
borrow in the U.S. at attractive rates and defer the day of reckoning. Even though
the math generally shows that there is a negative spread between the after-tax
cost of borrowing in the U.S. and reinvesting foreign cash abroad, the potential for
a lower cash tax rate or simply deferring the cash tax hit on those foreign earnings
often outweighs the running negative carry over a meaningful time horizon, and
thus provides the economic rationale for the domestic cash deficit positions we
see many U.S. corporations maintain.
Corporate Finance Topics | Issue No. 2 2014
Along with, and as a result of, the growing stockpile of offshore cash, ETRs in
the S&P 500 have declined significantly below the U.S. federal statutory tax rate
of 35%. 2 Given the current budget deficit, potential tax avoidance has been a
hot-button issue in Congress. As a result, we have observed a higher level of rigor
defending the APB 23 exception from external and internal auditors, as well as the
SEC. Since subcommittee hearings began examining the issue of corporate tax
avoidance, congressmen and journalists have, fairly or unfairly, lumped APB 23 and
the APB 23 exception in with other tax schemes, including, for example, transfer
pricing. Recent headlines include: 3 “Ambiguity in Accounting Standard APB 23,”
“Sub-Committee Hearing to Examine Billions of Dollars in U.S. Tax Avoidance by
Multinational Corporations,” “Caterpillar’s Offshore Tax Strategy,” “Offshoring Profits,” and
“Apple to Face U.S. Senate Committee on Tax Avoidance”. These headlines illustrate
that the offshore cash practices are not simply used within the healthcare and
technology sectors, but are applicable more generally to all U.S. multinationals.
Additionally, although APB 23 is clear in its intent and application, providing
U.S. GAAP reporters with the ability to defer an accounting tax charge and the
corresponding financial reporting implications, U.S. corporations are nevertheless
increasingly under the microscope of regulators, Congress, and investment
professionals. As a result, internal accounting and audit teams seek the support
and guidance of corporate executives more and more to justify and evidence the
APB 23 “indefinite reinvestment” assertion — please see section 4 for further
information on this topic.
5
Corporate Finance Topics | Issue No. 2 2014
3
Understanding
market
expectations
and potential
valuation
impact
Managing to a lower ETR seemingly leads to higher after-tax profits, and
consequently higher valuations (particularly for companies that trade on PE
or net income-based multiples). But growing cash balances need to be analyzed
and compared against ROIC considerations and investor expectations. Potential
tax savings from keeping foreign earnings permanently reinvested should be
weighed against the after-tax benefits of growth initiatives and return of capital.
In response to the financial crisis, corporations hoarded cash and built significant
stockpiles to repair and further immunize struggling balance sheets. Yet even today,
corporate cash reserves remain inflated, in contrast to investor expectations. Since
early 2010, investors have mostly demanded cash be allocated toward growth
initiatives and, to a lesser extent, return of capital. There are many risks of holding
too much cash, including inefficiencies in capital structure and perceived poor capital
allocation, which could attract activist campaigns.
ROIC
60%
50%
40%
6
30%
20%
10%
1
Operational Performance (EBIT)
2
Underperforming Capital (Low yielding assets)
May-14
Apr-14
May-13
Apr-13
May-12
Apr-12
May-11
Apr-11
May-10
Apr-10
May-09
Apr-09
May-08
Apr-08
May-07
Apr-07
May-06
Apr-06
May-05
Apr-05
0%
May-04
Apr-04
Average Capital Employed Excluding Goodwill
When thinking about excess cash, ROIC improvement can be achieved by returning
excess cash to shareholders (decreasing the denominator) or investing in higher
ROIC businesses (increasing the numerator). A recent wave of activist focus has
reemphasized the need for capital structure efficiency and realignment. In that
light, prudent capital management requires a continual assessment of break-even
economics vs. expected offshore cash usage. For example, if a company would incur
15% incremental tax on repatriated cash but could earn a 7% return on that cash
for its shareholders (either by reinvesting in the business domestically or returning
capital to shareholders) vs. leaving the cash abroad and earning 1%, the break-even
period would be under three years. The probability of that cash being put to better
use abroad within that time period should be assessed, and if the probability is low,
the benefits of cash repatriation should be considered. While this example is an
extreme case and reality often is more complex, it is useful in illustrating a simple
approach toward answering the question of whether it is New Present Value (NPV)
positive to leave cash offshore rather than to repatriate. Against this backdrop,
leverage capacity and ratings implications must also be considered.
70%
Source: Global Fund
Figure 2.
Manager
Survey report.
Survey
of top
global fund
Increased
Investor
managers on a monthly 5
Demand for Growth
basis as of April 2014.
(EBIT + Interest Income) × (1 – Tax Rate)
Figure 3.
Calculating ROIC
% of Fund Managers Wanting
■ Increased Capex ■ Cash Returned to Shareholders ■ Balance Sheet Improvement
Figure X.
Investor Capital
Allocation Priority
=
The most recent BofAML Global Fund Survey as of May 2014 shows that investor
expectations overwhelmingly endorse investment in the business, either via capital
expenditures or acquisitions — as a corollary, investors prefer high-yielding assets in
a low growth environment.5
In a previous Corporate Finance Topics piece, “Calibrating ROIC to Drive Shareholder
Value,” we highlighted the importance of improving ROIC in determining shareholder
value over time. We found that consistently calibrating a portfolio of earning assets
to drive ROIC is critical to long-term value creation, and reducing the level of lowyielding cash on the balance sheet is one of the simplest ways to improve ROIC.
Corporate Finance Topics | Issue No. 2 2014
7
Corporate Finance Topics | Issue No. 2 2014
4
Reviewing
APB 23 basic
concepts and
the “indefinite
reinvestment”
assertion
APB 23 addresses the treatment of foreign earnings generated by U.S. multinational
companies. Generally, APB 23 presumes that all foreign earnings of controlled foreign
subsidiaries will ultimately be repatriated to the U.S. parent, and requires companies
to book both the current foreign cash tax expense and an accrual for future U.S.
tax liability.
The APB 23 “exception” is an assertion a U.S. parent can make that earnings
generated offshore are “indefinitely reinvested” and therefore will never become
subject to U.S. tax. The exception allows an issuer to avoid booking a deferred
tax liability on such foreign earnings, and requires evidence of both the intent and
ability of an issuer to indefinitely reinvest foreign earnings or forgo repatriation of
foreign earnings. APB 23 and the exception prove a key issue for all multinationals
with material financial and accounting implications. In fact, APB 23 is a key element
in the determination of a corporation’s ETR, which has far-reaching financial
consequences ranging from valuation to forecasting, particularly for companies
valued on P/E or other net income or tax-affected valuation metrics.
General APB 23
Application
APB 23 Exception: Asserting
“Indefinite Reinvestment”
U.S. parent
is a
multinational
company
Multinational
company
generates
significant
foreign
earnings
Does the U.S.
parent have
substantial
U.S. liquidity
and ability to
permanently
reinvest?
NO
Figure 4.
The APB 23 “Exception”
8
Illustrative
Examples
Case 1
No APB 23
Exception
Foreign Earnings
($/% of Total)
$10bn /40%
Foreign Cash
Taxes Paid
<$1bn>
<$1bn>
Foreign Tax Rate
10%
GAAP Tax
Provision
<$3.5bn>
<$1bn>
U.S. Tax Rate
35%
Deferred
Tax Liability
$2.5bn
—
Usable Foreign
Tax Credits
100%
Reported ETR
35%
25%
$0
Impact on ETR
None
10%
Repatriated
Earnings
Case 2
APB 23
Exception
Anecdotally, there is more focus than ever on the degree of evidence and
documentation required to support an assertion that foreign earnings will be
“indefinitely reinvested.” Within this documentation, there are two items that must
be supported. First, a company must identify specific investment opportunities
in active business opportunities in the foreseeable future. Second, the company
must demonstrate that it can support domestic operations and liquidity needs
in the absence of a repatriation.
Accounting for the
APB 23 Exception
YES
Can the
U.S. parent
assert APB 23
exception of
indefinitely
reinvested
earnings?
Figure 5.
Assumptions
and Examples
Key Assumptions /Inputs
Does not accrue
deferred U.S. tax liabilities
on foreign earnings
deemed permanently
reinvested
APB 23 presumes repatriation, but this presumption can be rebutted by evidence.
It is important to remember that the APB 23 exception is neither an election nor a
one-time determination, but must be both affirmative and continuing in nature.
The exception requires companies to continually assert, on a quarterly basis, that
foreign earnings are indefinitely reinvested. In order to qualify for the ABP 23
exception, generally, the U.S. parent must establish that it generates or has access
to sufficient cash flow and resources so that repatriation would not be required.
Company accrues
deferred U.S. tax liabilities
on foreign earnings
(Generally the difference
between foreign cash taxes
and U.S. Corporate tax rate)
In applying APB 23, companies may designate full, partial or no intent to “reinvest
indefinitely” and must do so at a subsidiary-by-subsidiary level.
When analyzing APB 23 or the exception, it is important to review the basic
accounting concepts. In brief, foreign earnings create a book-and-tax basis
differential. For book purposes, foreign earnings are recognized when earned,
whereas for U.S. tax purposes, foreign earnings generally are not recognized until
they are repatriated in the form of a dividend or a deemed dividend. Therefore, a
company records a future or deferred U.S. tax liability on those foreign earnings.
The critical question becomes how does the APB 23 exception affect a
multinational’s ETR? The example in Figure 5 illustrates the impact a simple
accounting election can have on a corporation’s ETR.
Corporate Finance Topics | Issue No. 2 2014
9
Corporate Finance Topics | Issue No. 2 2014
“The presumption in paragraph 740-30-25-3 that
all undistributed earnings will be transferred to the
parent entity may be overcome, and no income taxes
shall be accrued by the parent entity, for entities
and periods identified in the following paragraph 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. A parent entity shall
have evidence of specific plans for reinvestment
of undistributed earnings of a subsidiary which
demonstrate that remittance of the earnings will
be postponed indefinitely.”
Figure 6.
Evidence
considered to
support “indefinite
reinvestment
assertion”6
5
Conclusion
10
ASC 740-30-25-17
• Past experience
• Plans for future operations
and remittances
• Projected working capital
and long-term capital
needs in the locations
where those earnings
are generated
• Merger and acquisition
plans in foreign locations
• Availability of capital
markets to provide funds
for domestic needs
• Long-term liquidity needs
When considering the treatment of foreign earnings, especially in utilizing
the “indefinite reinvestment” assertion, corporate executives should weigh the
implications of a higher vs. lower ETR, and the after-tax benefit or loss to key
financial metrics, including earnings and ROIC. Prudent offshore cash management
should align with both the company’s capital allocation strategy and investor
expectations. As focus by market participants on offshore cash and earnings
continues to sharpen, the rigor required to defend the permanent reinvestment
assertion has increased, and we expect this scrutiny to continue.
Works Cited
“ Overseas Earnings of Russell 1000 Tops $2 Trillion in 2013.” Posted April 1, 2014. http://www.auditanalytics.com/blog/overseasearnings-of-russell-1000-tops-2-trillion-in-2013/
2
Compustat
3
“Subcommittee Hearing to Examine Billions of Dollars in U.S. Tax Avoidance By Multinational Corporations.” Posted September
20, 2012. http://www.hsgac.senate.gov/subcommittees/investigations/media/subcommittee-hearing-to-examine_billions-ofdollars-in-us-tax-avoidance-by-multinational-corporations“Caterpillar’s Offshore Tax Strategy.” Posted April 1, 2014. http://www.hsgac.senate.gov/subcommittees/investigations/hearings/
caterpillars-offshore-tax-strategy
Accountancy Live. “Apple to Face US Senate Committee on Tax Avoidance.” Posted May 21, 2013. https://www.accountancylive.
com/apple-face-us-senate-committee-tax-avoidance
Accountancy Live. “Offshoring Profits.” Posted November 26, 2012. https://www.accountancylive.com/offshoring-profits
4
“Written Testimony for Senate Permanent Subcommittee on Investigations [Panel Three: Beth Carr]” (testimony presented at
Hearing on Offshore Profit Shifting and the U.S. Tax Code). September 20, 2012. http://www.hsgac.senate.gov/subcommittees/
investigations/hearings/offshore-profit-shifting-and-the-us-tax-code
5
“Global Fund Manager Survey.” BofAML Research. May 13, 2014
6
“Tax Accounting for Multinational Corporations” (presentation at the Eight Annual Global Compliance and Reporting Conference,
Boston, Massachusetts, April 4, 2013) Ernst and Young. http://www.ey.com/Publication/vwLUAssets/Tax_accounting_for_
multinational_corporations/$File/GCR_2013_Tx_Acctg_MNCs_FIORE_BOS.pdf
1
Corporate Finance Topics | Issue No. 2 2014
For more
information,
please contact:
Souren Ouzounian
Head of Americas Corporate Finance
souren.ouzounian@baml.com
646.855.5300
Jay Bliley
jay.bliley@baml.com
646.855.4666
Leonard Chung
leonard.chung@baml.com
310.209.4062
Amir Mirza
amir.mirza@baml.com
646.855.4331
Philip Turbin
philip.turbin@baml.com
646.855.4708
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Corporate Finance Topics | Issue No. 2 2014