The fleeting nature of permanent reinvestment: Accounting for the undistributed earnings of foreign subsidiaries

Over the last decade, an increasing percentage of the profits reported by U.S. corporations were earned by their foreign subsidiaries and retained outside the United States resulting in the deferral of income taxes. The American Jobs Creation Act of 2004 provided a temporary federal tax incentive to remit such earnings, which resulted in the repatriation of $140 billion by the 30 firms comprising the Dow Jones Industrial Average. An analysis of the financial reporting disclosures made by these firms reveals that a tax expense was not fully recognized on a substantial portion of the earnings until repatriation because of an exception for foreign reinvestments deemed to be essentially permanent in duration. The implications of the currently acceptable accounting for undistributed foreign earnings are discussed as well as recommendations to improve the relevancy and reliability of the disclosures required for this exception to comprehensive recognition of deferred taxes.     

Using Financial Accounting Data to Examine the Effect of Foreign Operations Located in Tax Havens and Other Countries on U.S. Multinational Firms' Tax Rates

This paper investigates the effect tax havens and other foreign jurisdictions have on the income tax rates of multinational firms based in the United States. We develop a new regression methodology using financial accounting data to estimate the average worldwide, federal, and foreign tax rates on worldwide, federal, and foreign pretax book income for a large sample of U.S. firms with and without tax haven operations. We find that on average U.S. firms that disclosed material operations in at least one tax haven country have a worldwide tax burden on worldwide income that is approximately 1.5 percentage points lower than firms without operations in at least one tax haven country. Our results also show that U.S. firms face a 4.4% current federal tax rate on foreign income whether or not they have tax haven operations. Finally, we find that U.S. firms with operations in some tax haven countries have higher federal tax rates on foreign income than other firms. This result suggests that in some cases, tax haven operations may increase U.S. tax collections at the expense of foreign country tax collections.     

Do foreign purchases of U.S. stocks help the U.S. stock market?

This paper investigates the relationship between the U.S. S&P 500 stock market and purchases of U.S. corporation stocks by foreign investors. Estimations using monthly data from 1978:1 to 2008:7 under various methodologies show that, controlling for asset prices (interest rates and the yield curve) and inflation, purchases of U.S. stocks by foreign investors have a positive and statistically significant impact on the U.S. stock market performance. We also show that their relationship is time variant. In a global world, the demand-side variable captured by the foreign appetite for U.S. stocks attenuates the negative effects associated with the domestic forces.     

International operations and voluntary disclosures by U.S.-based multinational corporations

This study uses analysts' ratings of firms' disclosures to examine how the differences between U.S. and foreign disclosure environments affects the voluntary disclosures of U.S.-based multinational corporations. We hypothesize that these different disclosure environments discourage U.S-based multinationals from releasing costly information to competitors. Examining how these differences impact U.S. MNCs' reporting may further our understanding of the relationship between voluntary disclosures and differences among countries' accounting standards. Furthermore, it may explain how convergence of mandated accounting standards might impact voluntary disclosures. Controlling for industry membership, firm size, profitability, earnings-return relations, and capital market activity, we find that U.S. firms with more extensive foreign operations tend to provide fewer voluntary disclosures. These results are most robust for informal and flexible disclosures, such as investor relations, where the findings indicate a negative relation between foreign operations and disclosure.     

Trafficking in foreign tax credits: A case study of Compaq Computer Corporation

This paper describes a complex tax sham perpetrated by Compaq Computer Corporation and presumably many other U.S. firms during the 1990s. Using a novel trading strategy designed to exploit the tax code and accounting regulations, Compaq purchased what would otherwise be unusable foreign tax credits held by tax-exempt institutions, likely pension funds that held American Depository Receipts (ADRs) for international diversification. These tax-exempt institutions were paid for selling their foreign tax credits occasioned by foreign withholding taxes on dividend income. Obscure trading regulations promulgated by the Securities and Exchange Commission and the New York Stock Exchange (NYSE) facilitated the trading strategy. In 1999, a U.S. Federal District Tax Court ruled that Compaq's strategy lacked economic substance and was a sham. Compaq has appealed the ruling. A similar lower court ruling against IES Industries was overruled in 2001 by the U.S. Appeals Court for the Eighth Circuit in St. Louis. In September 2001, The Wall Street Journal reported that the U.S. Supreme Court may hear the matter depending on the disposition of the Compaq appeal. Recent changes to the Internal Revenue Code presumably preclude this type of trading strategy from being implemented in the future.     

The Revenue Consequences of Using Formula Apportionment to Calculate U.S. and Foreign-Source Income: A Firm-Level Analysis

This paper examines the 1989–1993 publicly available financial reports of 46 U.S.-based multinationals to estimate the revenue implications of implementing a U.S. federal formula apportionment system. Ignoring behavioral responses, we estimate shifting to an equal-weighted, three-factor formula would have increased their U.S. tax liabilities by 38 percent, with an 81 percent increase for oil and gas firms. We find the firms report a lower percentage of their worldwide profits as American profits than their American share of assets, sales, or payroll. The results may be attributed to more profitable foreign operations, tax-motivated income shifting, or measurement error.     

Taking the Long Way Home: U.S. Tax Evasion and Offshore Investments in U.S. Equity and Debt Markets

We empirically investigate one form of illegal investor‐level tax evasion and its effect on foreign portfolio investment. In particular, we examine a form of round‐tripping tax evasion in which U.S. individuals hide funds in entities located in offshore tax havens and then invest those funds in U.S. securities markets. Employing Becker's ( 1968 ) economic theory of crime, we identify the tax evasion component by examining how foreign portfolio investment varies with changes in the incentives to evade and the risks of detection. To our knowledge, this is the first empirical evidence of investor‐level tax evasion affecting cross‐border equity and debt investment.     

Asymmetric foreign exchange risk exposure: Evidence from U.S. multinational firms

This paper examines how U.S. multinational firms are affected by foreign currency movements. In light of detailed exchange rate data, we find that 29% of our sample of 935 U.S. firms with real operations in foreign countries is significantly affected by currency movements between 1990 and 2001. Results show moreover that U.S. stock returns react asymmetrically to currency movements. By introducing nonlinearity in foreign currency risk exposure, we noticeably increase the precision and the significance of exposure estimates. We demonstrate moreover that asymmetries are more pronounced towards large versus small currency fluctuations than over depreciation and appreciation cycles.     

IFRS and U.S. GAAP: Assessing the impact of reporting incentives on firm restatements in foreign and U.S. markets

This study examines the impact of reporting incentives on firm restatements in foreign and U.S. markets. We investigate whether financial reporting, using International Financial Reporting Standards (IFRS) results in quality disclosures, given differences in institutional and market forces. This study examines the quality of financial statements prepared in accordance with IFRS and U.S. GAAP by concentrating on firm restatements as a measure of earnings management. Our results indicate that there is no significant difference in the value of restatements due to differences in accounting standards when the rule of law is high in the international market. Furthermore, firms with better law enforcement and higher traditions of law and order, tend to have smaller restatement amounts or less earnings manipulation. This study contributes to the literature by providing evidence of the quality of financial information prepared under IFRS and its dependency on the institutional factors and market forces of a country.     

Earnings Predictability,Bond Ratings,and Bond Yields

We examine the role that earnings predictability plays in establishing a firm’s cost of debt capital by measuring its influence on establishing a new issue’s bond rating. In addition, we also examine the effects of earnings predictability on the initial pricing of the firm’s debt. Using new corporate bond issues from the period 1990–2000, our results indicate that the degree of predictability of a firm’s earnings is positively associated with a firm’s bond rating. Moreover, earnings predictability is also documented to be negatively associated with the offering yield. Importantly, bond rating classification accuracy is improved when specific measures of a firm’s earnings predictability are added to a robust model.JEL Classification:     

Foreign macroeconomic and industry-related information transfers around earnings announcements: Evidence from U.S.-listed non-U.S. firms

This study examines information transfer regarding how investors react to new foreign macroeconomic and industry-related information embedded in foreign firms' earnings releases. Using non-U.S. firms listed in the U.S. as our main setting, we find that U.S. investors react significantly to foreign macroeconomic information and to information generated by the interaction between macroeconomic and industry-related information. We also find that the benefits (costs) of processing earnings reports increase (decrease) both types of information transfers. In addition, we find macroeconomic information transfers in an international cross-listing setting and both types of information transfers in an international non-cross-listing setting.     

Currency Denomination of Intercompany Debt and Multinational Taxes

For multinational companies (MNCs) with foreign subsidiaries, the currency denomination of intercompany debt can have important effects on both taxes and financial statements. This paper analyzes the choice between an intercompany loan denominated in the home currency and one denominated in the subsidiary's functional currency. Using U.S. rules for financial accounting and taxes, the author demonstrates the expected impact of the loan's currency denomination on the expected level and variability of an MNCs overall taxes in the case where it has excess foreign tax credits.
The author's analysis shows that the foreign currency loan denomination leads to lower expected tax if the foreign withholding tax rate on interest is higher than the parent's home income tax rate. At the same time, the parent currency denomination leads to lower expected taxes if the parent's home income tax rate is higher than the foreign withholding tax rate on interest. Moreover, if an MNCs excess foreign tax credits are attributable to the subsidiary, the foreign currency loan denomination leads to lower variability in overall taxes. But in cases where the excess foreign tax credits arise from other foreign operations, the parent currency denomination leads to lower variability of overall tax.     

The value of the PCAOB’s international audit oversight on U.S. listed foreign companies: Evidence from an initial enforcement breakdown

Using, as a natural experiment, the Public Company Accounting Oversight Board’s May 18, 2010, release stating that its oversight of certain foreign auditors had been denied, we examine investors’ early valuation of the PCAOB’s international audit oversight on U.S.-listed foreign companies. Comparing reactions for the release-exposed U.S.-listed foreign companies to reactions for other U.S.-listed foreign companies, we find a significant decline in the share values of the release-exposed companies. The decline is driven by companies with auditors from China; the on-list companies from the 19 on-list European jurisdictions do not experience significantly negative stock market reactions. Using difference-in-differences analyses of earnings response coefficients, abnormal stock returns and trading volumes surrounding earnings announcements, and analyst forecast dispersions, we find a decline in perceived financial reporting quality for the release-exposed foreign listings from China but not for the release-exposed companies from the 19 European jurisdictions—a finding in line with the results of the stock market reaction analyses. These results are consistent with the view that the PCAOB’s international inspection would create a net value for U.S.-listed companies from China.     

Effectiveness of Severance Tax Incentives in the U.S. Oil Industry

This paper develops a dynamic empirical framework that can be used to test the effectiveness of state-level severance tax incentives in the U.S. oil industry. The framework embeds U.S. state-level panel data estimates into Pindyck's (1978) widely received theoretical model of exhaustible resource supply and can be applied to any of 20 states that produce significant quantities of oil. The model allows for interactions between taxes levied by different levels of government and for the first time addresses potential interstate differences in exploration costs, extraction costs, and reserve additions. In general, results show that severance tax incentives (in the form of tax rate reductions) substantially reduce state tax revenue collected, but yield moderate to little change in oil drilling and production activity. This outcome suggests that states should be wary of arguments asserting that large swings in oil field activity can be obtained from changes in severance tax rates.     

Destination taxation and evasion: Evidence from U.S. inter-state commodity flows

Tax evasion has been an important issue in the accounting literature for several decades, but the focus has been on corporate income taxes. We develop a new way to examine tax evasion that focuses on corporate transactions, rather than corporate profits. Specifically, we examine how commodity flows respond to destination sales taxes, allowing for tax evasion as a function of distance between trade partners. After accounting for transportation costs, we find that the effect of taxes decreases as distance increases. This is consistent with the notion that longer distances between trade partners hinder government oversight and increase the likelihood of successful tax evasion. Our results are robust with respect to outliers, strategic neighbor effects, information sharing agreements and other re-specifications. These results are important to policymakers because they evidence the difficulty of enforcing destination taxation in open economies such as U.S. states and the European Union.     

Statement of the Financial Economists Roundtable: Corporate Tax Reform

Corporate tax reform has been a controversial issue in the U.S. for several years, particularly as U.S. companies have accumulated cash in lower‐tax overseas subsidiaries, while some have used “inversions” to establish overseas corporate domiciles. Two features of U.S. corporate taxation stand out: 1. U.S. corporate income tax rates are the highest in the industrialized world. The federal rate is 35%; and, when combined with state taxes, it averages 39%, as compared to an OECD average of 24%. 2. U.S. corporations pay U.S. tax on their worldwide income, but can choose to avoid indefinitely corporate tax on foreign profits by not repatriating them. Neither feature is present in most other Western countries, where the norm is a “territorial” system that taxes companies only on their domestic profits. The Trump administration has proposed to cut U.S. corporate tax rates to 20%, thereby bringing them down to the OECD average, and to adopt a territorial tax regime like those found in most other Western nations. In this statement signed by 31 senior financial economists, the authors recommend cutting U.S. corporate tax rates, but retaining the current system of taxing the worldwide profits of U.S. companies (while giving them credit for taxes paid in overseas jurisdictions). Once U.S. rates drop to the international average, the economists point out, U.S. companies would have much less incentive under the worldwide system to use transfer pricing schemes to shift their profits to low‐tax jurisdictions than under the proposed territorial alternative. Indeed, under the current system, if the lower rates under consideration are enacted, the location of a company's business activity (including the firm's underlying intellectual property) would not affect its taxation. Along with lower corporate tax rates, the economists also recommend that Congress limit or remove the corporate option to defer the taxation of offshore profits and provide a schedule for repatriating off‐shore funds, using the inducement of the now lower rates as well as the possibility of a “tax holiday.”     

An Empirical Study of the Consequences of U.S. Tax Rules for International Acquisitions by U.S. Firms

This article examines the effect of tax factors on the equity values of U.S. multinational corporations making foreign acquisitions. Abnormal stock returns are found to be related to a tax variable that captures differences in the international tax status of acquiring firms but not related to a naive tax variable that captures differences between tax rates in target countries and the United States. Our evidence suggests that aggregate intercountry differentials in after-tax returns are competed away, while firm-specific, tax-related advantages (or disadvantages) are reflected in abnormal returns around the announcement date of the acquisition.     

Pricing of Foreign GAAP Earnings in U.S. Capital Market Prior to the SEC Required Reconciliation Disclosure

The Securities and Exchange Commission (SEC) requires foreign registrants to include in their annual reports on Form 20-F reconciliation to U.S. GAAP of net income, earnings per share, and shareholders' equity, if materially different. Previous research indicates that foreign firms usually file their reports with the SEC near or at the deadline, that is six months after the fiscal year-end and about three months after the earnings announcement. The purpose of this study is to examine U.S. investors' ability to interpret foreign GAAP earnings before the SEC regulated disclosure becomes publicly available. Presented empirical evidence indicates that market participants are able to infer U.S. GAAP earnings from the foreign GAAP earnings at the time of initial earnings announcements.     

Eliminating the 20-F reconciliation from IFRS to U.S. GAAP: Short-term and long-term liquidity effects

This paper examines the effects of the SEC’s 2008 decision to no longer require foreign private issuers using IFRS and trading on U.S. exchanges to reconcile their financial statements to U.S. GAAP. Extant research has found conflicting results using short event windows, while studies using longer event windows have found limited capital market impact from eliminating the reconciliation. Motivated by the SEC’s interest in understanding how disclosure rules impact market liquidity, we examine changes in effective bid-ask spreads, the price impact of trades, and quoted depth around 20-F filing dates for a sample of foreign private issuers. We find that effective spreads increase more around 20-F filing dates for filers using IFRS than for filers using U.S. GAAP, suggesting the 20-F report is more informative for filers using IFRS. We then find, in a subsample of filers using IFRS, that the increase in effective spreads for IFRS firms around 20-F filing dates is directly related to the magnitude of differences in book values between IFRS and U.S. GAAP. In sum, our results suggest a loss of useful information after the SEC’s rule change.     

Strategies and dividend imputation: the effect of foreign and domestic ownership on average effective tax rates

This study examines how dividend imputation affects the incentive of New Zealand firms to minimize tax. By effectively eliminating double taxation on company income, imputation reduces firms’ incentives to engage in costly tax minimization strategies. Before September 1993, resident and nonresident shareholders were treated differently under New Zealand’s imputation system. Because imputation credits cannot be passed to shareholders unless dividends are paid, we expect firms to pursue different tax paying strategies depending on their level of foreign ownership and their dividend payout ratios. After September 1993 when imputation credits were extended to nonresident portfolio shareholders, we expect that firms with high foreign ownership and high dividend payouts would have less incentive to minimize tax. Our results provide some support for these expectations.