Deferred taxes on foreign earnings: a road map.

• Author: Abahoonie, Edward J.

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 outside investment. Multinationals based in home countries with a territorial system of taxation may permanently benefit from a reduced level of foreign taxation; for those in countries that follow a worldwide system of taxation, such as that of the United States, tax benefits generally inure as long as the foreign earnings remain outside the home country market.

Based upon an assumption that earnings generated by a foreign subsidiary or corporate joint venture will ultimately be distributed, a liability will be recorded in the consolidated financial statements for eventual home country taxation. This deferred tax liability will 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 complex and subjective. The company must consider a wide variety of domestic and foreign tax laws coupled with the application of such laws to 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, U.S. Generally Accepted Accounting Principles (GAAP) permit a company to overcome the presumption of repatriation and forgo recording a deferred tax liability, as long as it can support the assertion 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:

* Financing requirements of the parent company

* Financing requirements of the subsidiary

* Operational and financial objectives of the parent company, both long-term and short-term

* Anticipated foreign or home country mergers and acquisitions

* Remittance restrictions imposed by local governments

* Remittance requirements imposed by debt, lease, or other financial agreements

* Tax consequences of remittance

The determination whether an assertion of indefinite reinvestment applies is not based solely upon the judgment 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 assert indefinite reinvestment, the company is required to disclose the amount of undistributed foreign earnings in the notes of the financial statements. The required disclosure also includes a reasonable estimate of the 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 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 2009 study of the...