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Deferred taxes on foreign earnings: A road map

Background and financial reporting overview

The accelerating growth of foreign economies, driven by the mobility of technology and enhanced communications, has led to a significant rise in corporate earnings generated outside of home country markets.  Multinational businesses have pursued increasing sources of profit, supply and capital abroad while managing the regulatory and foreign exchange risks of international business operations.  Foreign earnings growth often also benefits from favorable local tax rates or holidays intended to attract foreign investment.  Multinationals based in home countries with a territorial system of taxation may permanently benefit from a reduced level of foreign taxation; for others that follow a worldwide system of taxation, such as that of the US, tax benefits generally inure as long as the foreign earnings remain outside the home country market.

Based upon a presumption that earnings generated by a foreign subsidiary or foreign corporate joint venture will ultimately be distributed, a liability would be recorded in the consolidated financial statements for eventual home country taxation.  This deferred tax liability would apply not only to undistributed foreign earnings, but more broadly to what is known as the "outside basis difference."  That amount represents the difference between a parent's book and tax basis in the subsidiary, often including currency translation and other accounting adjustments.

The calculation of a deferred tax liability for undistributed foreign earnings is at once both complex and subjective. It must consider a wide variety of domestic and foreign tax laws coupled with the application of such laws to the company's expectations regarding the manner and timing of future repatriations. The potentially hypothetical nature of the calculation introduces implementation issues and other challenges. For that reason, a company may overcome the presumption of repatriation and forgo recording a deferred tax liability in its financial statements, as long as it can assert that management has the intent and ability to indefinitely reinvest the profits or otherwise indefinitely postpone taxation in the home country market. This is known as the indefinite (or permanent) reinvestment assertion.1 Numerous financial and operational considerations factor into whether a company can assert indefinite reinvestment. Such considerations include:

It is important to note that the determination of whether an assertion of indefinite reinvestment applies is not based solely upon the authority of corporate accounting and tax department management. Rather, the expectations upon which the assertion is based require alignment with multiple business functions within a company's global organization; this may include treasury, operations, legal, and business development.

Once management has confirmed and documented its intent and ability to indefinitely reinvest foreign earnings, the company is required to disclose the amount of undistributed foreign earnings (and other components of the applicable outside basis difference) in the notes to the financial statements. The required disclosure also includes a description of the events that would give rise to taxation of the unremitted earnings and a reasonable estimate of the unrecorded deferred tax liability or a statement indicating that a reasonable estimate is not practicable.

Current business, economic and fiscal environment

Asserting indefinite reinvestment traditionally has been a widespread practice among multinational businesses. A majority of large companies make the assertion with respect to much, if not all, of their foreign earnings.  This has the effect of generally reducing the overall effective tax rate when compared with the statutory home country rate.

In a study of the 2009 list of Fortune 500 companies, it was reported that more than 300 US multinationals asserted indefinite reinvestment and disclosed the amount of undistributed earnings in the notes to their respective 2008 financial statements. The study identified the amount of unremitted earnings of the group to be $1.02 trillion, with a per-company mean of $3.74 billion2.    In 2012, a similar study reviewed the 2011 annual and 2012 first quarter financial statements of over 1,000 US multinational companies, reporting $1.7 trillion of unremitted earnings for the group. 3

The 2012 study also reported that such companies have a large portion of accumulated cash and other liquid assets outside the US. Compared with the results of prior research these studies suggest the amount of undistributed foreign earnings of US multinationals has increased in the past decade.

A combination of developments in recent years, however, has led many companies, analysts, and regulators to pay closer attention to the possibility that an indefinite reinvestment financial statement assertion may become less viable. At the same time, expectations for transparency have increased along with concerns about a lack of comparability or consistency in disclosures.

Management should consider the following when evaluating whether an assertion of indefinite reinvestment, partially or fully, continues to apply:

Measuring deferred taxes on foreign earnings

Whether for the purpose of disclosure or recording a liability, significant judgment must be applied in measuring the deferred taxes on foreign earnings. Management needs to make assumptions about the operations of its business and consider the impact of planning opportunities. Consideration must be given to the tax rules and regulations of the relevant jurisdictions, including the availability of tax holidays and exemptions, appropriate foreign exchange rates and the amount of available home country foreign tax credits or other benefits.  The assessment will also reflect the impact that cumulative foreign currency translation adjustments and other components of other comprehensive income (OCI) can have on the measurement of unremitted earnings.

Because most multinationals assert indefinite reinvestment and have not historically disclosed an estimate of the unrecorded liability (on the basis that the calculation is not practicable), measuring the liability may be a new experience even for large sophisticated businesses.  In today's environment, a decision-useful model for assessing what a reversal of an indefinite reinvestment assertion will mean from a financial reporting perspective may prove more timely and valuable than ever. 

With that in mind, PwC is pleased to provide the following illustrative checklist to assist companies with the calculation of deferred taxes on foreign earnings. This type of resource, along with the respective references to the PwC 2012 Guide to Accounting for Income Taxes, offers a helpful platform for the development or refinement of an effective assessment process. 











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Edward Abahoonie
Tax Accounting Services Technical Leader
Phone: 973.236.4448
Email:
edward.abahoonie@us.pwc.com

Leah Alfonso
Tax Accounting Services Director
Phone: 703.918.4554
Email:
leah.n.alfonso@us.pwc.com

Ken Kuykendall
Global Tax Accounting Services Leader
Phone: 312.298.2546
Email: 
o.k.kuykendall@us.pwc.com