Agency Costs of Permanently Reinvested Earnings

Abstract:     
Current U.S. tax laws create an incentive for some U.S. firms to avoid the repatriation of foreign earnings as the U.S. government charges additional corporate taxes upon repatriation of foreign earnings. Under ASC 740, the financial accounting treatment for taxes on foreign earnings exacerbates this effect and increases the incentive to avoid repatriation by allowing firms to designate foreign earnings as permanently reinvested earnings (PRE) and delay recognition of the deferred tax liability associated with the U.S. repatriation tax resulting in higher after-tax income. Prior research suggests the combined effect of these incentives leads some U.S. multinational corporations to delay the repatriation of foreign earnings and, as a result, hold a significant amount of cash overseas. In this study, we examine the potential agency costs for firms with PRE through an examination of their cash acquisitions. Consistent with expectations, we observe firms with both high levels of cash overseas and high levels of foreign earnings designated as PRE are more likely to make value-destroying acquisitions of foreign target firms. The AJCA of 2004 appears to have reduced this effect by allowing firms to repatriate foreign earnings held as cash abroad at a much lower tax cost.

Keywords: Taxes, Mergers and Acquisitions, Permanently Reinvested Earnings, Foreign Subsidiaries

working papers series