Indefinite Reinvestment :

Corporate Finance Topics Issue No. 2 2014 Indefinite Reinvestment : An Accounting Election With a Big Impact

Indefinite Reinvestment : An Accounting Election With a Big Impact In this issue of Corporate Finance Topics, we will begin to untangle the somewhat mysterious accounting rules that dictate how U.S. corporations account for U.S. income taxes on earnings generated by their offshore subsidiaries. Although a treatise on U.S. tax policy and the taxation of foreign earnings is beyond the scope of this article, certain general principles are fairly straightforward, and these will be our focus. What was once a topic for tax gurus and accounting experts, APB 23, the accounting standard governing foreign earnings, and its usage are now a key area of attention for corporate executives as they consider and contemplate new capital allocation. Executive Summary 1. Macro landscape: foreign cash continues to build Over the last decade, foreign earnings have skyrocketed, totaling approximately $2.1 trillion in 2013. 1 Not only has accounting treatment and tax law incentivized companies to avoid remitting foreign earnings to U.S. soil, accommodating credit markets have also allowed companies to finance domestic operations, return of capital and growth initiatives via cheap debt. As a result, a record amount of cash has accumulated offshore. 2. Regulatory landscape: heightened focus by regulators, auditors and Congress Increasingly, the gap between effective and statutory rates has received scrutiny from internal auditors, regulators and Congress. Although the SEC now requires issuers to disclose the breakdown of foreign vs. U.S. cash/ earnings, some members of U.S. Congress see APB 23 as a tax gimmick. As high profile corporations testify in front of the U.S. Senate Permanent Subcommittee for Investigations on tax matters, understanding indefinite reinvestment has never been more important, and we have observed a substantially higher level of rigor being required to assert intent to permanently reinvest offshore. 3. Understanding market expectations and potential valuation impact Seemingly, managing to a lower effective tax rate (ETR) leads to higher profits, and consequently higher valuations, particularly for companies valued on P/E. However, growing cash balances need to be analyzed and compared against ROIC considerations and investor expectations (for an in-depth analysis of ROIC, please see Calibrating ROIC to Drive Shareholder Value on the Corporate Finance website: http://corp.bankofamerica.com/ documents/16303/72084/calibratingroic_driveshareholdervalue.pdf). Low-yielding cash balances generate a significant drag on ROIC, and high cash balances may attract the attention and focus of an activist campaign. Additionally, we illustrate that investor expectations overwhelmingly endorse investment in the business either via capital expenditures or acquisitions. Potential tax savings should be weighed against the after-tax benefits of growth initiatives and return of capital across a range of financial metrics, including ROIC and NPV. Focusing solely on accounting can lead to suboptimal decisions. 4. Reviewing APB 23 basic concepts and the indefinite reinvestment assertion APB 23 applies broadly to all U.S. multinationals. Generally, offshore earnings are not subject to U.S. tax until repatriated (or deemed repatriated, a complex topic unto itself). U.S. generally accepted accounting principles (GAAP), on the other hand, generally require current accrual for future U.S. taxes to be incurred upon repatriation unless a narrow exception applies. The primary exception relied on by issuers is set forth in ABP 23. In short, APB 23 presumes foreign earnings will be repatriated, but the APB 23 exception establishes specific criteria for the issuer to rebut such presumption via assertion of permanent reinvestment this provides issuers with a technique to defer the GAAP tax expense and establishment of a deferred tax liability. 2 Corporate Finance Topics Issue No. 2 2014 3 Corporate Finance Topics Issue No. 2 2014

1 Macro landscape: foreign cash continues to build Figure X. Undistributed Figure 1. Total Foreign Earnings Indefinitely 2001 2013, Reinvested Earnings, S&P 500 Russell 1000 1 Source: To come. Foreign earnings have grown significantly since the last repatriation holiday, which was incorporated into the American Jobs Creation Act in 2005. Current tax law and accommodating credit markets since the credit crisis have helped U.S. multinationals to defer repatriation of foreign cash. U.S. $ in billions 2,500 $2,119 2,000 $1,885 $1,628 1,500 $1,362 $1,188 $1,098 1000 500 0 2008 2009 2010 2011 2012 2013 2 Regulatory landscape: heightened focus by regulators, auditors and Congress Along with, and as a result of, the growing stockpile of offshore cash, ETRs in the S&P 500 have declined significantly below the U.S. federal statutory tax rate of 35%. 2 Given the current budget deficit, potential tax avoidance has been a hot-button issue in Congress. As a result, we have observed a higher level of rigor defending the APB 23 exception from external and internal auditors, as well as the SEC. Since subcommittee hearings began examining the issue of corporate tax avoidance, congressmen and journalists have, fairly or unfairly, lumped APB 23 and the APB 23 exception in with other tax schemes, including, for example, transfer pricing. Recent headlines include: 3 Ambiguity in Accounting Standard APB 23, Sub-Committee Hearing to Examine Billions of Dollars in U.S. Tax Avoidance by Multinational Corporations, Caterpillar s Offshore Tax Strategy, Offshoring Profits, and Apple to Face U.S. Senate Committee on Tax Avoidance. These headlines illustrate that the offshore cash practices are not simply used within the healthcare and technology sectors, but are applicable more generally to all U.S. multinationals. Additionally, although APB 23 is clear in its intent and application, providing U.S. GAAP reporters with the ability to defer an accounting tax charge and the corresponding financial reporting implications, U.S. corporations are nevertheless increasingly under the microscope of regulators, Congress, and investment professionals. As a result, internal accounting and audit teams seek the support and guidance of corporate executives more and more to justify and evidence the APB 23 indefinite reinvestment assertion please see section 4 for further information on this topic. Accounting principles presume that all foreign earnings will be repatriated, and therefore require a U.S. multinational to book a deferred U.S. tax liability on those earnings. However, if those earnings are respected under APB 23 as permanently reinvested, the multinational would not have to recognize that liability. Consequently, corporations achieve lower effective tax rates (ETRs) by asserting that either all or a portion of foreign earnings are permanently reinvested. In addition, accommodating credit markets have provided a readily accessible alternative to repatriation. Since the credit crisis, yields have remained low as the Fed deploys quantitative easing into 2015. Furthermore, yield-seeking investors have only reinforced positive market reception to bond issuance. Instead of taking the cash tax hit or utilizing valuable foreign tax credits, U.S. multinationals simply borrow in the U.S. at attractive rates and defer the day of reckoning. Even though the math generally shows that there is a negative spread between the after-tax cost of borrowing in the U.S. and reinvesting foreign cash abroad, the potential for a lower cash tax rate or simply deferring the cash tax hit on those foreign earnings often outweighs the running negative carry over a meaningful time horizon, and thus provides the economic rationale for the domestic cash deficit positions we see many U.S. corporations maintain. Within the past 18 months, a number of corporations have felt obliged to explain and defend their corporate tax practices, often with a particular focus on accounting rather than the actual U.S. federal tax code. Despite clear exposition of complex tax provisions and application of APB 23 by numerous companies and audit teams, Congress continues to summon management teams to testify about their practices. 4 In short, the accounting and financial implications of offshore cash practices, especially surrounding APB 23, have become an executive-level issue. A change in ETR will affect reported GAAP profitability and valuation, and as regulators become increasingly focused on foreign earnings treatment via the APB 23 exception, corporate executives need to be well-versed in the benefits, considerations and implications of managing ETR. Investors, too, need to be proficient in matters relating to a company s ETR. While altering an assertion that foreign earnings will no longer be permanently reinvested offshore has an accounting implication, it is not necessarily connected to an immediate or actual cash tax impact. 4 Corporate Finance Topics Issue No. 2 2014 5 Corporate Finance Topics Issue No. 2 2014

3 Understanding market expectations and potential valuation impact Figure X. Investor Capital Allocation Priority Source: Global Fund Manager Figure 2. Survey report. Survey Increased of top Investor global fund managers on a monthly Demand for Growth basis as of April 2014. 5 Managing to a lower ETR seemingly leads to higher after-tax profits, and consequently higher valuations (particularly for companies that trade on PE or net income-based multiples). But growing cash balances need to be analyzed and compared against ROIC considerations and investor expectations. Potential tax savings from keeping foreign earnings permanently reinvested should be weighed against the after-tax benefits of growth initiatives and return of capital. In response to the financial crisis, corporations hoarded cash and built significant stockpiles to repair and further immunize struggling balance sheets. Yet even today, corporate cash reserves remain inflated, in contrast to investor expectations. Since early 2010, investors have mostly demanded cash be allocated toward growth initiatives and, to a lesser extent, return of capital. There are many risks of holding too much cash, including inefficiencies in capital structure and perceived poor capital allocation, which could attract activist campaigns. % of Fund Managers Wanting Increased Capex Cash Returned to Shareholders Balance Sheet Improvement 70% 60% 50% 40% 30% 20% 10% 0% May-04 Apr-04 May-05 Apr-05 May-06 Apr-06 May-07 Apr-07 May-08 Apr-08 May-09 Apr-09 May-10 Apr-10 May-11 Apr-11 May-12 Apr-12 May-13 Apr-13 May-14 Apr-14 Figure 3. Calculating ROIC (EBIT + Interest Income) (1 Tax Rate) ROIC = Average Capital Employed Excluding Goodwill 1 Operational Performance (EBIT) 2 Underperforming Capital (Low yielding assets) When thinking about excess cash, ROIC improvement can be achieved by returning excess cash to shareholders (decreasing the denominator) or investing in higher ROIC businesses (increasing the numerator). A recent wave of activist focus has reemphasized the need for capital structure efficiency and realignment. In that light, prudent capital management requires a continual assessment of break-even economics vs. expected offshore cash usage. For example, if a company would incur 15% incremental tax on repatriated cash but could earn a 7% return on that cash for its shareholders (either by reinvesting in the business domestically or returning capital to shareholders) vs. leaving the cash abroad and earning 1%, the break-even period would be under three years. The probability of that cash being put to better use abroad within that time period should be assessed, and if the probability is low, the benefits of cash repatriation should be considered. While this example is an extreme case and reality often is more complex, it is useful in illustrating a simple approach toward answering the question of whether it is New Present Value (NPV) positive to leave cash offshore rather than to repatriate. Against this backdrop, leverage capacity and ratings implications must also be considered. The most recent BofAML Global Fund Survey as of May 2014 shows that investor expectations overwhelmingly endorse investment in the business, either via capital expenditures or acquisitions as a corollary, investors prefer high-yielding assets in a low growth environment. 5 In a previous Corporate Finance Topics piece, Calibrating ROIC to Drive Shareholder Value, we highlighted the importance of improving ROIC in determining shareholder value over time. We found that consistently calibrating a portfolio of earning assets to drive ROIC is critical to long-term value creation, and reducing the level of lowyielding cash on the balance sheet is one of the simplest ways to improve ROIC. 6 Corporate Finance Topics Issue No. 2 2014 7 Corporate Finance Topics Issue No. 2 2014

4 Reviewing APB 23 basic concepts and the indefinite reinvestment assertion APB 23 addresses the treatment of foreign earnings generated by U.S. multinational companies. Generally, APB 23 presumes that all foreign earnings of controlled foreign subsidiaries will ultimately be repatriated to the U.S. parent, and requires companies to book both the current foreign cash tax expense and an accrual for future U.S. tax liability. The APB 23 exception is an assertion a U.S. parent can make that earnings generated offshore are indefinitely reinvested and therefore will never become subject to U.S. tax. The exception allows an issuer to avoid booking a deferred tax liability on such foreign earnings, and requires evidence of both the intent and ability of an issuer to indefinitely reinvest foreign earnings or forgo repatriation of foreign earnings. APB 23 and the exception prove a key issue for all multinationals with material financial and accounting implications. In fact, APB 23 is a key element in the determination of a corporation s ETR, which has far-reaching financial Figure 5. Assumptions and Examples Key Assumptions/Inputs Foreign Earnings ($/% of Total) $10bn/40% Foreign Tax Rate 10% U.S. Tax Rate 35% Usable Foreign Tax Credits Repatriated Earnings Illustrative Examples Foreign Cash Taxes Paid GAAP Tax Provision Deferred Tax Liability Case 1 No APB 23 Exception <$1bn> <$3.5bn> Case 2 APB 23 Exception <$1bn> <$1bn> $2.5bn 100% Reported ETR 35% 25% $0 Impact on ETR None 10% consequences ranging from valuation to forecasting, particularly for companies valued on P/E or other net income or tax-affected valuation metrics. Anecdotally, there is more focus than ever on the degree of evidence and documentation required to support an assertion that foreign earnings will be indefinitely reinvested. Within this documentation, there are two items that must General APB 23 Application APB 23 Exception: Asserting Indefinite Reinvestment Accounting for the APB 23 Exception be supported. First, a company must identify specific investment opportunities in active business opportunities in the foreseeable future. Second, the company must demonstrate that it can support domestic operations and liquidity needs Figure 4. U.S. parent is a multinational company Multinational company generates significant foreign earnings Can the U.S. parent assert APB 23 exception of indefinitely reinvested earnings? Does the U.S. parent have substantial U.S. liquidity and ability to permanently reinvest? YES NO Does not accrue deferred U.S. tax liabilities on foreign earnings deemed permanently reinvested Company accrues deferred U.S. tax liabilities on foreign earnings (Generally the difference between foreign cash taxes and U.S. Corporate tax rate) in the absence of a repatriation. APB 23 presumes repatriation, but this presumption can be rebutted by evidence. It is important to remember that the APB 23 exception is neither an election nor a one-time determination, but must be both affirmative and continuing in nature. The exception requires companies to continually assert, on a quarterly basis, that foreign earnings are indefinitely reinvested. In order to qualify for the ABP 23 exception, generally, the U.S. parent must establish that it generates or has access to sufficient cash flow and resources so that repatriation would not be required. The APB 23 Exception In applying APB 23, companies may designate full, partial or no intent to reinvest indefinitely and must do so at a subsidiary-by-subsidiary level. When analyzing APB 23 or the exception, it is important to review the basic accounting concepts. In brief, foreign earnings create a book-and-tax basis differential. For book purposes, foreign earnings are recognized when earned, whereas for U.S. tax purposes, foreign earnings generally are not recognized until they are repatriated in the form of a dividend or a deemed dividend. Therefore, a company records a future or deferred U.S. tax liability on those foreign earnings. The critical question becomes how does the APB 23 exception affect a multinational s ETR? The example in Figure 5 illustrates the impact a simple accounting election can have on a corporation s ETR. 8 Corporate Finance Topics Issue No. 2 2014 9 Corporate Finance Topics Issue No. 2 2014

Figure 6. Evidence considered to support indefinite reinvestment assertion 6 The presumption in paragraph 740-30-25-3 that all undistributed earnings will be transferred to the parent entity may be overcome, and no income taxes shall be accrued by the parent entity, for entities and periods identified in the following paragraph if 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. A parent entity shall have evidence of specific plans for reinvestment of undistributed earnings of a subsidiary which demonstrate that remittance of the earnings will be postponed indefinitely. ASC 740-30-25-17 Past experience Plans for future operations and remittances Projected working capital and long-term capital needs in the locations where those earnings are generated Merger and acquisition plans in foreign locations Availability of capital markets to provide funds for domestic needs Long-term liquidity needs For more information, please contact: Souren Ouzounian Head of Americas Corporate Finance souren.ouzounian@baml.com 646.855.5300 Jay Bliley jay.bliley@baml.com 646.855.4666 Amir Mirza amir.mirza@baml.com 646.855.4331 Philip Turbin philip.turbin@baml.com 646.855.4708 5 Conclusion When considering the treatment of foreign earnings, especially in utilizing the indefinite reinvestment assertion, corporate executives should weigh the implications of a higher vs. lower ETR, and the after-tax benefit or loss to key financial metrics, including earnings and ROIC. Prudent offshore cash management should align with both the company s capital allocation strategy and investor expectations. As focus by market participants on offshore cash and earnings continues to sharpen, the rigor required to defend the permanent reinvestment assertion has increased, and we expect this scrutiny to continue. Leonard Chung leonard.chung@baml.com 310.209.4062 Works Cited 1 Overseas Earnings of Russell 1000 Tops $2 Trillion in 2013. Posted April 1, 2014. http://www.auditanalytics.com/blog/overseasearnings-of-russell-1000-tops-2-trillion-in-2013/ 2 Compustat 3 Subcommittee Hearing to Examine Billions of Dollars in U.S. Tax Avoidance By Multinational Corporations. Posted September 20, 2012. http://www.hsgac.senate.gov/subcommittees/investigations/media/subcommittee-hearing-to-examine_billions-of- dollars-in-us-tax-avoidance-by-multinational-corporations- Caterpillar s Offshore Tax Strategy. Posted April 1, 2014. http://www.hsgac.senate.gov/subcommittees/investigations/hearings/ caterpillars-offshore-tax-strategy Accountancy Live. Apple to Face US Senate Committee on Tax Avoidance. Posted May 21, 2013. https://www.accountancylive. com/apple-face-us-senate-committee-tax-avoidance Accountancy Live. Offshoring Profits. Posted November 26, 2012. https://www.accountancylive.com/offshoring-profits 4 Written Testimony for Senate Permanent Subcommittee on Investigations [Panel Three: Beth Carr] (testimony presented at Hearing on Offshore Profit Shifting and the U.S. Tax Code). September 20, 2012. http://www.hsgac.senate.gov/subcommittees/ investigations/hearings/offshore-profit-shifting-and-the-us-tax-code 5 Global Fund Manager Survey. BofAML Research. May 13, 2014 6 Tax Accounting for Multinational Corporations (presentation at the Eight Annual Global Compliance and Reporting Conference, Boston, Massachusetts, April 4, 2013) Ernst and Young. http://www.ey.com/publication/vwluassets/tax_accounting_for_ multinational_corporations/$file/gcr_2013_tx_acctg_mncs_fiore_bos.pdf 10 Corporate Finance Topics Issue No. 2 2014

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