A change in U.S. tax law with respect to foreign earnings produces a swamp of reporting and strategy issues for companies to consider around historic financial statement assertions that those earnings are indefinitely reinvested overseas.
The Tax Cuts and Jobs Act made it clear that companies could no longer escape the consequences of U.S. corporate income tax on their foreign earnings by asserting that those earnings are being held in offshore locations and retained there for investment purposes. Now they must decide what to do with that assertion going forward under a new tax landscape.
Historic tax policy gave companies good reason to avoid bringing foreign earnings back to the United States. The longtime corporate tax rate of 35 percent, high compared with other countries, was not levied on foreign earnings unless or until those earnings were repatriated, or sent back to U.S. corporate treasuries. Keeping the earnings invested in foreign operations meant they would never be subject to that tax.
Accounting rules governing the reporting of income tax, contained under Accounting Standards Codification Topic 740, require companies to make an assertion in financial statements with respect to the status of such earnings. If they are to be reinvested indefinitely abroad, companies must say so, and the Securities and Exchange Commission made a point a handful of years ago of scrutinizing those assertions. While the SEC has no jurisdiction over tax compliance, it wanted to be sure companies were being fully transparent with investors if they were keeping piles of cash offshore to avoid U.S. tax.
Under the new tax law, U.S. tax policy moves to a more territorial system of taxation, removing disincentives companies faced for repatriating foreign earnings. Companies must pay a one-time transition tax or “toll charge” on earnings they’ve held offshore since 1986, with rates differing for assets held in cash versus those held in more illiquid forms. The charge is levied whether companies actually bring the assets back to the United States or not.
Going forward, the new tax law provides a 100-percent deduction on dividends received for certain qualified dividends from foreign subsidiaries, removing one of the key incentives companies had for keeping foreign earnings out of the United States. Many companies are still working through how the new tax on global intangible low-taxed income or GILTI will work, but for most companies the repatriation decision and the reporting in financial statements might not be so straightforward.
“While many companies may choose to repatriate cash back to the U.S. due to the U.S. transition tax on foreign earnings, there are a multitude of factors that influence a company’s decision about the amount of earnings that are indefinitely reinvested,” says Joan Schumaker, a partner and Americas co-director of tax accounting and risk advisory services at EY.
As examples, says Schumaker, companies may have already invested those earnings in bricks and mortar overseas, or they may have additional acquisition plans. Companies must also consider local country withholding taxes that would be imposed on any earnings they would distribute, she says.
“The misperception is you have 100 in earnings, so you have 100 sitting offshore,” says Joe Calianno, tax partner and international technical tax practice leader at BDO USA. “You may have invested that cash into a new plant, a new operating facility, or a supply chain.”
Companies are likely at different points along a spectrum where some indeed are holding earnings abroad in liquid assets and some have fully re-invested those earnings over time, says Calianno. Some companies may repatriate significant parts of their foreign earnings, but some may choose to repatriate only enough to pay the toll charge, or transition tax.
Under new tax rules, many companies are still working through new positions on whether or to what extent they are keeping foreign earnings abroad to reinvest in businesses there, says John Forry, managing director at CBIZ MHM. “With an imposed deemed repatriation at a tax rate that’s much lower than the full corporate rate before 2018, the question arises of whether companies now have a continuing reason why they would want to not repatriate profits beginning in 2018,” he says.
Mike Williams, a partner and national practice leader in income tax provision services at BDO, says companies need to be mindful that while the tax rules have changed significantly, the accounting rules under ASC 740 have not. “They still require companies to revisit their indefinite reinvestment assertions periodically,” he says. Companies may still have basis differences, or differences between values for financial reporting purposes compared with tax purposes, to continue tracking, says Williams.
For accounting purposes, companies have long been permitted to defer recognition of any tax obligation associated with foreign earnings if they asserted those earnings were indefinitely reinvested. That assertion signals the company would have no need to book a future tax liability on foreign earnings because it had no intention of ever bringing the funds into the United States.
The analysis of whether it made good financial sense to keep foreign profits reinvested abroad was simpler under old tax rules, says Mark Winiarski, financial services director at CBIZ MHM. “It was an easier hurdle to clear because you could say you’re going to reinvest and get a return in that country and save the 35-percent tax,” he says. “That 35-percent savings was a strong indicator that the investment opportunity in the foreign country would justify reinvestment.”
Now companies will have to perform a more careful analysis to arrive at their assertions regarding foreign earnings, using strong internal controls and procedures, because the assertion may be important to financial positions, says Winiarksi. From a financial reporting perspective, the assertion needs to focus on three specific things, he says. Those include any foreign taxes that would be affected by repatriating foreign profits, any historic basis differences that arise from transactions like business combinations, and any foreign currency adjustments that would affect the tax basis.
“The assertion is still very relevant and something companies really need to think about,” says David Sites, international tax partner within Grant Thornton’s Washington national tax office. “As a result of tax reform a lot of companies have realized they need to evaluate what their plans really are now with respect to those earnings.”