Wednesday, January 29, 2014

Shaheen's colloquium paper on the repatriation tax and lockout, part 2

OK, at the end of my last post I had laid out the new view and noted Shaheen's reliance instead on managerial accounting incentives to explain lockout in the international realm.  Managers of publicly traded companies love to have high financial accounting income, even at the expense of favorable economics, so I suppose they do all they can (bake cookies, issue firing threats) to persuade their accountants that particular foreign source income of their overseas subsidiaries has been permanently reinvested abroad.  This causes the deduction from financial accounting income for the deferred U.S. repatriation tax to flip on a dime to 100% of what it would be if incurred today, to zero.  Sounds really stupid as a matter of rule design, but I am not an accountant.

Anyway, once they declare PRE (permanently reinvested earnings) they can't bring it home without both (a) taking an earnings hit from the repatriation tax, if any, and (b) making the accountants feel disrespected and hence more skeptical about other PRE claims.  So Shaheen posits that it's fruitful to think of the PRE as if it simply cannot come home.

Note, by the way, how bad for the shareholders this is.  The PRE designation doesn't make actual taxes lower - it just causes the possible future repatriation tax, if any, to be reported differently.  But once we build in a constraint on managerial behavior to the effect that the funds now can't come home, we are in the scenario where the company may keep funds abroad even if (a) the new view holds sufficiently that they in fact can't reduce the expected repatriation tax via optionality by deferring it, and also (b) they are earning less by reason of keeping the funds in broad.  In short, the value of optionality aside, the PRE designation may induce managers to make shareholders worse-off - from the company's being genuinely less profitable after-tax over the long haul - simply due to their mania for high reported earnings and/or their being subject to a binding PRE constraint once they have voluntarily subjected themselves to it.

The paper explores the possibility that the firm would benefit from investing locked-out earnings in passive assets, even if they earn a lower after-tax rate of return than available active-business investment opportunities that are available to the form.  The idea is that, because the passive income is taxed currently and thus can't become PRE (there are no deferred taxes to claim you will be permanently avoiding), the firm is now free to invest properly from the shareholders' standpoint, including by bringing the money home if the best opportunities are here.  At the same time, the paper concedes that managers may not feel inclined to do this, given that they like to defer the current repatriation tax (even if they are not reducing its expected value) so that reported earnings can be boosted via the PRE route.

Same point holds for active income earned abroad that the managers are able to resist giving PRE status.  A key broader conclusion from the paper is that it highlights some of the costs of the deferral regime once the new view either doesn't hold or is being ignored for accounting reasons.  Hence my view, discussed at some length in my book, that it is important to try to delink intellectually the questions (a) what should be the domestic tax burden on foreign source income from (b) what do we think of deferral and the foreign tax credit, which are two singularly awful ways of lowering that tax burden other than by expressly applying a lower statutory rate to it.

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