Policy makers are worried that U.S. companies are using Permanently Reinvested Earnings (PRE) as a tax loophole rather than legitimately trying to grow their overseas operations. They are also concerned about cash trapped overseas instead of being invested in the U.S. economy. The SEC is focused on whether companies are using the rules concerning PRE as a means to overstate their profits. New research shows that a majority of companies are serious about overseas growth rather than looking for tax loopholes. However, cash trapped abroad is still a problem for the U.S. economy.
When overseas earnings by U.S. multinationals are brought back to the U.S., those earnings are taxed as income. However, multinational companies have the option of leaving those earnings abroad and for accounting purposes may designate all or some of those earnings as Permanently Reinvested Earnings or PRE.
Tax policy makers and the U.S. Securities and Exchange Commission (SEC) are very interested in these PRE, especially given their rapid growth: as one expert testified to Congress, PRE nearly doubled in the five years between 2006 and 2011. Policy makers are concerned that 1) earnings are escaping taxation and 2) money that could be invested in the U.S. economy is trapped overseas. The SEC is concerned that companies are misleading investors by overstating their profits since the U.S. tax due on overseas earnings (with the exception of PRE) is supposed to be labelled as liabilities.
Both policy makers and the SEC are taking steps to address these various issues. Policy makers are considering tax cuts as an incentive to get firms to repatriate more of their overseas earnings. The SEC, for its part, has recently started requesting companies with heavy PRE to declare how much of their total cash is held abroad. The intention is to reveal which companies may face liquidity issues related to overseas earnings trapped abroad.
A team of researchers analysed the data from annual fiscal reports of nearly a thousand multinational companies collected by the U.S. Bureau of Economic Analysis to try to uncover the motivations behind PRE designations. The researchers looked at three factors:
In response to the first two questions, the researchers found that about 25% of PRE is held in tax haven affiliates, while a little less than 40% located the PRE in high-growth affiliates. The conclusion: both tax and growth considerations play a factor in PRE designation, with neither dominating the other. Thus, while some companies confirmed the SEC’s suspicions, the problem is not as bad as might have been assumed. This finding also has policy implications: given the relative small part of PRE tucked in tax havens, measures such as tax cuts that are meant to encourage repatriation of funds may have little effect.
In answer to the third question, the researchers found that 45% of PRE were held in financial assets. By this measure, the issue of PRE tax havens deserves more scrutiny. In addition, the research also showed that companies were hampered in their ability to invest domestically by a high level of PRE. In other words, domestic investment in companies with a high level of PRE was driven by cash flow rather than investment opportunities. The implication is clear: PRE is indeed a signal of potential liquidity issues within multinational firms' internal capital markets.
The SEC and policy makers are becoming increasingly concerned about the growth of PRE. The research indicates that there are companies that have in the past used the PRE exception as an opportunity to avoid recognizing the residual U.S. tax expense and thus inflate their profit figures. Such deception is not recommended with a truly vigilant SEC seeking to ferret out cash that is hiding from tax authorities.
The research also indicates, through the domestic investment choices of companies with high PRE, that cash is being trapped overseas. As a result, future tax breaks might still be implemented to incentivize the repatriation of overseas earnings.
The Location, Composition, and Investment Implications of Permanently Reinvested Earnings. Jennifer Blouin, Linda Krull & Leslie Robinson. Working Paper (July 2014).
Bringing It All Back Home. Michael Blanding. Tuck Newsroom (23rd April 2014).
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