When a U.S. company owns a subsidiary overseas, it has a big decision to make when it comes to the earnings of that subsidiary. Does it send the money back to the parent company in the U.S. and pay U.S. corporate taxes or does it avoid the U.S. tax by permanently reinvesting the money abroad?
Given that the U.S. has one of the highest corporate tax rates of any country in the world, it’s not surprising that many companies choose not to repatriate the money.
Our current system in the U.S. — known as the worldwide tax system — is one where U.S. companies’ earnings are taxed in the U.S. even if earned overseas. However, companies are not required to pay the U.S. taxes on operating income of foreign subsidiaries until they bring cash home to the U.S. parent company.
The taxation of foreign earnings also affects financial accounting numbers reported to shareholders. For financial accounting purposes, companies expense taxes paid and accrued. But companies are not required to record the U.S. tax expense related to overseas operating earnings if the company thinks that the earnings will not be repatriated back to the U.S.
Both of these effects – the saving of cash taxes and the ability to report a lower income tax expense to shareholders – provide incentives for companies to both operate and leave cash overseas. Usually, countries want to attract assets and investments within their borders, but our tax policy does the exact opposite.
To better understand the impact of U.S. tax policy on corporate decisions about investment location and profit repatriation, I recently surveyed 600 tax executives. It turned out that more than one-third of the respondents indicated that the reduction of financial accounting income tax expense is important in their choice about whether to locate operations outside of the U.S. and more than 40% reported it as important in their decision to reinvest funds outside of the U.S. For publically traded firms, those percentages were even higher.
Overall, the study showed that both the tax and the financial accounting effects lead to greater foreign direct investment by U.S. ompanies and lower repatriations. This finding is particularly relevant in light of the recent talks about corporate tax reform and/or another repatriation act.
With such incentives created by the current U.S. corporate tax system, it is indeed in need of reform. The goal should be to encourage more companies to stay in the U.S., resulting in greater production and more jobs here as well as decisions based on business reasons rather than tax and accounting benefits.
Prof. Michelle Hanlon is a coauthor of the paper, “The Real Effects of Accounting Rules: Evidence from Multinational Firms’ Investment Location and Profit Repatriation Decisions,” published in the March 2011 issue of the Journal of Accounting Research.