An analysis of the relationship between the permanently reinvested earnings, repatriation taxes, and earnings management incentives of United States multinationals

Abstract

This paper investigates factors that influence the amount of foreign retained earnings permanently reinvested abroad and the market valuation of these earnings. I examine the effects of repatriation taxes and the difference between foreign and domestic profitability on the amount of foreign subsidiary earnings that firms reinvest abroad using the permanently reinvested earnings designation as a proxy for foreign retained earnings. This extends prior work that examines the effect of repatriation taxes on repatriations by including both foreign and domestic profitability and by allowing the effects to vary by the firm's foreign tax credit position. The results are consistent with the hypotheses and indicate that foreign retained earnings increase with the difference between foreign and domestic after-tax-returns. Foreign retained earnings decrease with the foreign tax rate for firms in binding foreign tax credit positions, but are not related to the foreign tax rate for firms in nonbinding foreign tax credit positions. Next, I examine how earnings management incentives affect the amount of foreign subsidiary earnings designated as permanently reinvested, controlling for the effects of profitability and repatriation taxes. I examine whether firms that are close to debt covenant violation or that fail to meet their target earnings have higher permanently reinvested earnings. The permanently reinvested earnings designation provides the opportunity to manage earnings because U.S. repatriation taxes need not be recognized in financial statement income if the earnings are designated as permanently reinvested. I find no evidence of earnings management to meet debt covenants; however, I do find evidence of earnings management to meet target earnings. Finally, I examine the market valuation of taxes on permanently reinvested earnings and whether this valuation differs for earnings managers and non-earnings managers. I hypothesize that because the tax estimate is undiscounted, the market values taxes on permanently reinvested earnings more negatively for earnings managers than for non-earnings managers because it perceives the investment to be of a shorter duration. The results support this hypothesis and suggest that the market recognizes earnings management attempts and values the tax estimate as if the reinvestment of foreign subsidiary earnings by earnings managers is not permanent.