Tuesday, July 24, 2012

Is Apple deliberately understating its earnings?

This MSNB story by Peter Svensson offers an interesting twist on U.S. companies' - or more specifically Apple's - international tax planning, and on an important interaction between U.S. tax and U.S. accounting rules.

The usual story, of course, is that U.S. multinationals defer U.S. tax by playing tax planning and reporting games to locate the income in tax havens.  But for publicly traded companies, there's a problem.  In theory, they will eventually have to pay the tax upon repatriating the earnings to the U.S.

What is more, if this is certain to happen and the U.S. repatriation tax rate will always be the same, they actually don't reduce the present value of the tax liability by deferring the repatriation.  This is what the "new view" of dividend repatriations tell us - and it is a mathematically provable tautology under its assumptions.  It does not, of course, refute the point that it's better to have further earnings on the earnings accrue in a low-tax foreign environment than in the higher-tax domestic one, but that's a separate issue.  And the new view conclusion does not apply if one will never have to repatriate the funds, or if the future repatriation tax rate will be lower than the present one (e.g., in the case where it is zero, due to the adoption of a territorial tax system without transition features that result in collecting deferred taxes to date).

Anyway, back to the accounting bit.  Even though it is often plausible to think that repatriation is in fact greatly reducing the expected negative value (if any) of the deferred tax, accounting rules have a practice of frequently ignoring time value benefits.  Thus, a publicly traded company generally gets no earnings boost whatsoever from parking its earnings in a tax haven, given that the U.S. tax will be counted in full as if payable today.  But - if you say that particular earnings are permanently reinvested abroad, and if your accountants believe you, then you can treat the deferred taxes on those earnings as worth zero, and hence as not requiring any reduction of your pre-tax earnings by reason of U.S. international income taxation.

Publicly traded companies tend to love this.  Indeed, it's a key reason why they are so reluctant to repatriate foreign earnings, even if they could use the cash in the U.S.  It would result in a negative accounting hit if done with "permanently reinvested" earnings (PRE), and what's more might lead their accountants to question more rigorously whether they should accept the PRE label for other money that remains abroad.

OK, that's enough windup, on to the pitch concerning Apple.  The fun thing about the MSNBC article that I linked above is that it shows Apple to be doing the opposite.  Apple has billions of dollars in profits parked in tax havens, which a knowledgeable individual (although he has no association with Apple) recently told me that he believes they will NEVER bring home to the U.S. if it costs U.S. tax.  But they have declined to seek the PRE label.  So their reported earnings are billions of dollars too low, compared to the likely reality.

They do this, apparently, so that they will look like good corporate citizens.  After all, if you look at their financial statements, it shows them paying substantial U.S. taxes that they are not actually paying, given the current deferral and the fact that it may end up being permanent.

In the meantime, they are lobbying for the enactment of an exemption system that, if done without the transition hit, would give them a positive reported earnings shock of many billions of dollars, in addition to giving them full U.S. access to the overseas funds without a tax hit.

Under-reporting earnings, in order to over-report U.S. taxes paid and look like a good citizen, accompanied with the political aim of getting those taxes eliminated - that is unusual.  No wonder that those guys are also smart enough to keep on making products that people such as me are eager to buy.  (I am waiting for the new iPhone 5, as my prehistoric 3 is limping along pretty feebly at this point.)

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