This Insights article was contributed by Zhan Furner, Ph.D., assistant professor of accounting.

In August, the European Competition Commission determined that Ireland had given Apple’s Irish subsidiaries illegal tax benefits, and it calculated that these subsidiaries owe Ireland nearly $14.5 billion in back taxes. 

The size of this ruling has reignited the debate in here in the United States about tax policies that permit U.S.-based multinational corporations (MNCs) to accumulate their foreign earnings overseas without paying U.S. taxes.

Apple is not alone.

According to the Citizens for Tax Justice’s March 2016 estimate, MNCs in America held over $2.4 trillion in foreign earnings abroad for the sake of avoiding U.S. taxes, which if repatriated, could represent $695 billion in potential tax revenue. For reference - the U.S. budget deficit for fiscal year 2016-17 is $590 billion.

The American tax system is widely blamed for creating incentives for U.S. firms to hold foreign subsidiaries' profits in low-tax countries, to the detriment of domestic investment and employment opportunities. Under the U.S. worldwide tax system, American-based MNCs pay taxes on their global incomes without including foreign subsidiaries in their U.S. consolidated tax returns. Earnings generated by foreign subsidiaries are taxed in the U.S. only when those earnings are repatriated (i.e. returned to the United States).

On the other side, current U.S. financial reporting standards also strongly encourage MNCs to keep their foreign earnings abroad. Under GAAP, U.S. MNCs are exempted from accruing tax liabilities on undistributed foreign earnings for financial reporting purposes if those earnings are designated to be reinvested overseas permanently.

The advantages of not recognizing tax on permanently reinvested earnings (PRE) are critical for U.S. MNCs because they can therefore enjoy a lower GAAP effective tax rate, which results in higher accounting performance measures (i.e. after-tax profits), thus affecting stock prices, shareholder returns and executive compensation contracts, such as stock options and bonuses.

Although MNCs are required to disclose the amount of PRE on their financial statements, the disclosure requirement affords managers a great deal of discretion in terms of the amount of PRE to report, as well as the timing of the designation. And the consequences of having incomplete or inaccurate disclosure are negligible.

Prior research suggests that MNCs use the PRE designation as a way to manage earnings – or make earnings appear better to investors - by taking advantage of the PRE loophole and the subjectivity in the interpretation of the disclosure requirements.

Dr. Furner’s research demonstrates that:

• U.S. MNCs that hoard large amounts of PRE overseas experience lower investment efficiency and growth and those MNCs designating PRE for the purpose of earnings management are suffering even more.
• Executives of U.S. MNCs are more likely to engage in earnings management through PRE designation when they receive equity compensation.