Permanently Reinvested Foreign Earnings, Taxes, and Earnings Management

Abstract

United States multinational corporations can delay financial statement recognition of U.S. taxes on repatriations by designating foreign subsidiary earnings as "permanently reinvested" under APB Opinion No. 23. This paper examines 1) whether firms use the permanently reinvested earnings (PRE) designation to manage reported earnings, and 2) whether amounts reported as permanently reinvested reflect investment and tax incentives to reinvest foreign subsidiary earnings abroad. Consistent with the prediction that firms use PRE to manage earnings, year-to-year changes in amounts reported as PRE are positively related to the difference between analyst forecasts and pre-managed earnings. Additionally, changes in reported PRE are positively related to the difference between the foreign and domestic after-tax return on assets and negatively related to the tax benefit of deductible repatriations, thus reflecting investment and tax incentives to reinvest abroad.

Keywords: earnings management, income tax expense, foreign tax credit, income shifting

JEL Classification: F23, K34, H25, M41, M43