The Tax Cuts and Jobs Act of 2017 (TCJA) was enacted on December 22, 2017. Among other things, the TCJA amended Internal Revenue Code (IRC) section 965 to impose a one-time transition tax on previously unrepatriated foreign earnings of 15.5% if held as cash and cash equivalents, and of 8% if held as illiquid assets. The purpose of this provision was to stimulate domestic economic investment and growth by encouraging multinational corporations (MNC) to repatriate some of the estimated $1 trillion in cash held offshore (Michael Smolyansky, Gustavo Suarez, and Alexandra Tabova, “U.S. Corporations’ Repatriation of Offshore Profits,” Fed Notes, Sept. 4, 2018, During the first half of 2018, MNCs repatriated cash of approximately $465 billion (Jeffry Bartash, “Repatriated Profits Total $465 Billion After Trump Tax Cuts—Leaving $2.5 Trillion Overseas,” MarketWatch, Sept. 19, 2018, In comparison, the effect of the 2004 tax holiday on offshore assets was repatriation of approximately $312 billion of an estimated $750 billion. The TCJA also closed a tax loophole by switching from a worldwide tax system, under which foreign-source income was taxed only when repatriated, to a quasi-territorial tax system, under which foreign-source income is substantially exempt from U.S. taxation, except for the additional tax imposed on certain foreign earnings [known as the Global Intangible Low-Taxed Income (GILTI) provision]. This article demonstrates how, in doing so, the TCJA also helps close an accounting loophole used by some MNCs to overstate financial reporting earnings.

Accounting for Unrepatriated Foreign Earnings

U.S. GAAP requires that MNCs record deferred taxes on foreign earnings unless “sufficient evidence shows that the subsidiary has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation” [Accounting Standards Codification (ASC) 740-30-25]. To avoid recording taxes, ASC Topic 740 requires that MNCs both intend and be able to permanently recommit their foreign permanently reinvested earnings (PRE). While there are certainly legitimate reasons to leave some or all foreign earnings offshore, such as when foreign investment returns are greater than returns available domestically or when foreign operating capital is needed, there are also reasons MNCs may be unable to permanently reinvest their foreign earnings, most obviously when cash is needed to support domestic operations. By requiring a great deal of judgment and permitting a significant amount of discretion in the designation of PRE, the accounting rules effectively create a loophole that MNCs may use to overstate financial reporting earnings. Although ASC Topic 740 requires MNCs to disclose both the amount of PRE and deferred taxes associated with PRE, many fail to do so (Benjamin C. Ayers, Casey M. Schwab, and Steven Utke, “Noncompliance with Mandatory Disclosure Requirements: The Magnitude and Determinants of Undisclosed Permanently Reinvested Earnings,” Accounting Review, January 2015,; even when disclosures are made, they frequently lack detail (Thomas D. Schultz and Timothy J. Fogarty, “The Fleeting Nature of Permanent Reinvestment: Accounting for the Undistributed Earnings of Foreign Subsidiaries,” Advances in Accounting, June 2009,

The SEC has expressed concerns about PRE. One comment letter to an MNC said, “Please explain to us how you evaluated the criteria for the exception to recognition of a deferred tax liability in accordance with ASC 740-30-25-17 and -18 for undistributed earnings that are intended to be indefinitely reinvested. Describe the type of evidence and your specific plans for rein-vestment for these undistributed earnings that sufficiently demonstrates that remittance of earnings will be postponed indefinitely” (Ernst & Young, SEC Comments and Trends: An Analysis of Current Reporting Issues, New York, 2016). Researchers have found that cash-constrained MNCs with a large estimated hypothetical tax on repatriation are more likely to receive PRE-related SEC comment letters (Lisa Eiler and Lisa Kutcher, “SEC Comment Letters Related to Permanently Reinvested Earnings,” Advances in Accounting, September 2016, In other words, the SEC appears to question whether certain MNCs meet the ability criterion to avoid recording deferred taxes.

Researchers have also found that even if repatriation is the optimal decision from a real income perspective, accounting income considerations tend to prevail, resulting in foreign earnings that are never repatriated.

Evidence of the Manipulation of PRE

Researchers have also found that even if repatriation is the optimal decision from a real income perspective, accounting income considerations tend to prevail, resulting in foreign earnings that are never repatriated (Douglas A. Shackelford, Joel Slemrod, and James M. Sallee, “Financial Reporting, Tax, and Real Decisions: Toward a Unifying Framework,” International Tax and Public Finance, August 2011, Since it is fairly easy to meet the intention criterion, it should not be surprising that there is empirical evidence that MNCs use PRE to manage earnings, manipulating it to reduce effective tax rates, meet earnings targets, and increase managers’ compensation (e.g., Linda K. Krull, “Permanently Reinvested Foreign Earnings, Taxes, and Earnings Management,” Accounting Review, February 2004,; C. Fritz Foley, Jay C. Hartzell, Sheridan Titman, and Garry Twite, “Why Do Firms Hold So Much Cash? A Tax-based Explanation,” Journal of Financial Economics, December 2007,; Zhan Furner, “The Relationship between Permanently Reinvested Foreign Earnings, Analysts’ Expectations, and Executive Compensation,” working paper, 2017). Earnings management requires a confluence of pressure or incentive, rationalization, and opportunity; in the case of PRE, these are provided by the combination of earnings targets and executive compensation, potential tax savings afforded by offshore tax havens, and the discretion available under ASC Topic 740. The authors wondered whether this propensity to overstate PRE when MNCs would otherwise miss analysts’ expectations is mitigated by domestic cash needs. In other words, does the ability criterion reduce the likelihood that MNCs will overstate PRE?

To evaluate this question, the authors examined MNCs with PRE and with U.S. effective tax rates greater than their foreign effective tax rates during the period 2006 to 2013 (1,915 firm-year observations). The MNCs in the sample averaged $11 billion in assets, of which approximately $2 billion (18%) were held in foreign jurisdictions. PRE averaged $2 billion, and foreign earnings were approximately $460 million. The average foreign effective tax rate of the sample MNCs was 22%. (Note that the post-TCJA U.S. corporate tax rate is 21%.)

On average, the sample MNCs beat analysts’ earnings expectations by $0.01; without changes in PRE, they would have missed analysts’ earnings expectations by $0.04. In other words, MNCs appear to manage earnings to meet analysts’ expectations by manipulating PRE. To rule out competing explanations, the authors estimated a regression equation similar to that used in prior PRE-related studies that controls for, among other things, the impact of leverage (i.e., ability to borrow), finding that when an MNC would otherwise miss analysts’ expectations, the need to fund domestic operations did not constrain the recognition of PRE—that is, the ability criterion was not met, and PRE and earnings were overstated. This suggests that the pressure (or incentives) to meet analysts’ expectations outweigh strict adherence to the accounting rules.

Next, to determine whether there are common factors among MNCs that appear to overstate PRE, the authors more fully examined the 50 observations with the largest overstatements. These overstatements occurred most frequently during the years 2009 to 2012 (89%). It may not be a coincidence that this period of “shifting” income coincides with the first term of the Obama administration, when there was much speculation that corporate tax rates would increase. Manufacturing (including biotech) and technology MNCs made up 74% of the observations; this is consistent with reports that technology companies would likely be the largest beneficiaries of the TCJA (Laurie Meisler, “The 50 Largest Stashes of Cash Companies Keep Overseas,” Bloomberg, June 13, 2017, Nine MNCs appeared on the top 50 list in more than one year; of these, seven were technology-related companies, one was a pharmaceutical manufacturer, and one was a financial services firm. Four of the nine have been in popular press articles discussing companies that leave cash offshore to avoid U.S. taxes.

How Will the TCJA Affect PRE?

Collectively, the evidence suggests that to avoid missing analysts’ earnings expectations, MNCs kept cash that they might otherwise have repatriated offshore. Mechanisms in place to increase the likelihood that managers will follow the accounting rules, such as the requirement that CEOs and CFOs of publicly traded companies (i.e., most MNCs) certify the accuracy of financial statements, are insufficient to eliminate manipulation of PRE. When making location, rein-vestment, and repatriation decisions, MNCs care as much about being able to defer taxes for accounting purposes as saving taxes (J. Graham, M. Hanlon, T. Shevlin, and N. Shroff, “Inside the Corporate Tax Department: Insights on Corporate Decision Making and Tax Aggressiveness,” working paper, 2011).

When making location, reinvestment, and repatriation decisions, MNCs care as much about being able to defer taxes for accounting purposes as saving taxes.

By removing tax incentives to leave cash offshore, the TJCA helps close an accounting loophole (the intention criterion of ASC 740) that had facilitated earnings manipulation using PRE. While the judgment and lack of transparency afforded by ASC Topic 740 will continue to provide opportunity for misstatement of PRE, and MNCs may still be able to rationalize some misstatement of PRE (particularly in cases where foreign jurisdictions impose withholding tax on assets not indefinitely reinvested), the extent and impact of these misstatements should be much less.

In 2016, FASB issued a proposed Accounting Standard Update (ASU), Income Taxes (Topic 740): Disclosure Framework—Changes to the Disclosure Requirements for Income Taxes (revised March 2019), in part to provide greater transparency in the recording and reporting of PRE. The ASU would require, among other things, disclosure by all entities of—

  • income (or loss) from continuing operations before income tax expense (or benefit) and before intra-entity eliminations disaggregated between domestic and foreign;
  • income tax expense (or benefit) from continuing operations disaggregated between federal, state, and foreign; and
  • income taxes paid disaggregated between federal, state, and foreign.

It would also require that public business entities disclose—

  • the line items in the statement of financial position in which the unrecognized tax benefits are presented and the related amounts of such unrecognized tax benefits,
  • the amount and explanation of the valuation allowance recognized or released during the reporting period, and
  • the total amount of unrecognized tax benefits that offsets the deferred tax assets for carryforwards.

Notably, the March 2019 update eliminated a requirement proposed in the 2016 version of the ASU to disclose “an explanation of circumstances that caused a change in assertion about the indefinite reinvestment of undistributed foreign earnings and the corresponding amount of those earnings” and “the aggregate of cash, cash equivalents, and marketable securities held by foreign subsidiaries.”

The authors suggest additional disclosures could be helpful. For example, requiring a tabulated summary that covers each balance sheet period would enable financial statement users to more easily (i.e., without computation) understand an MNC’s available domestic liquid assets and operating cash flows.

Zhan Furner, PhD, CPA is an assistant professor at East Carolina University, Greenville, N.C.
Denise Dickins, PhD, CPA, CIA is a professor at East Carolina University, Greenville, N.C.