'Tax Inversions' Are Tip Of An Iceberg That Already Cost The U.S. Treasury Hundreds Of Billions
Summary
- The Dow 30 components, alone, have collectively disclosed at least $50B in (mostly unrecognized) “deferred” US taxes on foreign earnings.
- US-headquartered multinational companies have accumulated hundreds of billions of dollars (>$630B from the Dow 30) of “undistributed foreign earnings” not subject to US taxes unless and unless repatriated.
- Undistributed foreign earnings disclosures and deferred tax liability (future repatriation taxes) estimation methodologies can vary significantly by company.
- A tax code that incentivizes indefinite foreign re-investment, relative to capital repatriation, is indefensibly bad public policy with an uncertain future - future effective tax rate assumptions should reflect this uncertainty.
Summary
Tax "inversions" have been in the news a lot lately, and have become a political football, since the announcement of the role tax arbitrage played in the expected Burger King/Tim Hortons merger. On Friday, September 26, 2014 the White House sent an infographic to its mailing list declaring that Tax Inversions are "costing Americans nearly $20 billion over the next ten years" while conservative news outlets, like the Daily Caller, have questioned the importance of a mere $20 billion to the overall US economy. If the $20 billion number (which is from the Joint Committee on Taxation) is accurate, then "inversions" are merely the very small tip of a very large iceberg. Current US tax policy, as it relates to foreign earnings, is costing the US Treasury many billions in lost tax revenue while incentivizing offshore investment costs the US economy many billions more.
The Dow 30 components, alone, collectively disclosed nearly at least $50 billion in (mostly unrecognized) "deferred tax liabilities on undistributed foreign earnings" in their most recent annual reports. Other public multinational tech and biotech companies also have eye-popping deferred tax liabilities from undistributed foreign earnings. However, even this tells only a small part of the story, since "permanently reinvested" foreign earnings are not subject to repatriation tax (and therefore may not contribute to companies' deferred tax liabilities). The Dow 30, alone, has over $630 billion in total "undistributed foreign earnings." Even at historically low interest rates, the net cost to US taxpayers of "deferred taxes," and "indefinite foreign re-investment" is staggering.
Since companies are effectively incentivized to re-invest their foreign profits in foreign markets, the existing US tax policy encourages multinational firms to make investments outside of the US. This is unambiguously bad public policy that is unlikely to persist indefinitely. Investors often rely on high-level metrics like P/E, which incorporate a company's after-tax earnings. Earnings forecasts for companies with material amounts of "undistributed foreign earnings" from past operations should take the effect of uncertain tax policy into account when estimating future net income.
Analysis
Our company is preparing to launch a new add-in that allows users to perform advanced fundamental and technical analysis efficiently in Excel. It has the ability to aggregate and parse all of one or more companies' XBRL filings, and present all of the individual quantitative and qualitative disclosures (over time) in a unified ("flattened") tabular format that can be more easily interpreted. While the specific XBRL tags used to disclose undistributed foreign profits, and the associated tax liabilities, can vary by company (making aggregation difficult), I was able to use the following tags:
Total Undistributed Earnings |
UNDISTRIBUTEDEARNINGSOFFOREIGNSUBSIDIARIES |
UNDISTRIBUTEDFOREIGNEARNINGS |
UNDISTRIBUTEDFOREIGNPROFITS |
CUMULATIVEAMOUNTOFUNDISTRIBUTEDINTERNATIONALEARNINGS |
Deferred Tax Liability From Undistributed Foreign Earnings |
DEFERREDTAXLIABILITIESUNDISTRIBUTEDFOREIGNEARNINGS |
DEFERREDTAXLIABILITYNOTRECOGNIZEDAMOUNTOFUNRECOGNIZEDDEFERREDTAXLIABILITYUNDISTRIBUTEDEARNINGSOFFOREIGNSUBSIDIARIES |
DEFERREDTAXLIABILITYNOTRECOGNIZEDFOREIGNEARNINGS |
DEFERREDINCOMETAXEXPENSEONUNDISTRIBUTEDEARNINGSNOTREINVESTEDAMOUNT |
INCOMETAXPOTENTIALREPATRIATIONOFFOREIGNEARNINGS |
Source: FinToolbox (upcoming product of Screener.co) |
to construct the table below:
Dow 30 Component | Annual Period End | Total Disclosed Undistributed Foreign Earnings | Deferred Tax Liability From Undistributed Foreign Earnings | XBRL Filing Source URL |
12/31/2013 | $9,700,000,000 | N/A | ||
12/31/2013 | (see text below) | N/A | ||
12/31/2013 | N/A | N/A | ||
12/31/2013 | $775,000,000 | $44,000,000 | ||
12/31/2013 | $17,000,000,000 | $90,000,000 | ||
12/31/2013 | $31,300,000,000* | N/A | ||
7/26/2014 | $52,700,000,000 | N/A | ||
12/31/2013 | $15,978,000,000 | N/A | ||
12/31/2013 | $47,000,000,000 | N/A | ||
12/31/2013 | $110,000,000 | N/A | ||
12/31/2013 | N/A | $4,060,000,000 | ||
2/2/2014 | $3,100,000,000 | N/A | ||
12/28/2013 | $20,000,000,000 | N/A | ||
12/31/2013 | $52,300,000,000 | N/A | ||
12/29/2013 | $50,900,000,000 | N/A | ||
12/31/2013 | $28,500,000,000 | $6,400,000,000 | ||
12/31/2013 | $16,100,000,000 | N/A | ||
12/31/2013 | $57,100,000,000 | $2,361,000,000 | ||
6/30/2014 | $92,900,000,000 | $30,740,000,000 | ||
5/31/2014 | $6,600,000,000 | $2,100,000,000 | ||
12/31/2013 | $69,000,000,000 | $19,399,000,000 | ||
6/30/2014 | N/A | $44,000,000,000 | ||
12/31/2013 | $30,600,000,000 | N/A | ||
12/31/2013 | $714,000,000 | N/A | ||
12/31/2013 | $25,000,000,000 | N/A | ||
12/31/2013 | $359,000,000 | N/A | ||
12/31/2013 | N/A | $2,100,000,000 | ||
9/30/2013 | $3,800,000,000 | $55,000,000 | ||
1/31/2014 | N/A | $21,400,000,000 | ||
9/28/2013 | $1,500,000,000 | $315,000,000 | ||
TOTAL | $633,036,000,000 | $133,064,000,000 | ||
* Chevron (CVX) did not tag its unremitted foreign earnings, but disclosed them in the INCOMETAXDISCLOSURETEXTBLOCK | ||||
Source: FinToolbox (upcoming product of Screener.co) | ||||
There are clearly missing values in this table (i.e. PG and WMT have very large deferred tax liabilities, but are listed as having N/A undistributed foreign earnings as the source of that liability). However, a subsequent review of the original SEC filings reveals that the N/A values are not present in the source documents. Furthermore, the extent to which these deferred liabilities are present in the GAAP financial statements varies. For example, Wal-Mart (WMT) lists the following disclosure in the "Unremitted Earnings" section of the INCOMETAXDISCLOSURETEXTBLOCK:
Unremitted Earnings
United States income taxes have not been provided on accumulated but undistributed earnings of the Company's international subsidiaries of approximately $21.4 billion and $19.2 billion as of January 31, 2014 and 2013, respectively, as the Company intends to permanently reinvest these amounts outside of the United States. However, if any portion were to be distributed, the related U.S. tax liability may be reduced by foreign income taxes paid on those earnings. Determination of the unrecognized deferred tax liability related to these undistributed earnings is not practicable because of the complexities with its hypothetical calculation. The Company provides deferred or current income taxes on earnings of international subsidiaries in the period that the Company determines it will remit those earnings.
From that disclosure, it appears that the $21.4 billion should have been tagged as total undistributed foreign earnings rather than the associated deferred tax liability. However, it also makes clear that any uncertain future liability associated with the unremitted earnings is not captured in the current GAAP financial statements. Procter & Gamble (PG) has a similar note in its most recent 10-K, which suggests its foreign earnings were similarly mischaracterized:
We have undistributed earnings of foreign subsidiaries of approximately $44.0 billion at June 30, 2014, for which deferred taxes have not been provided. Such earnings are considered indefinitely invested in the foreign subsidiaries. If such earnings were repatriated, additional tax expense may result. However, the calculation of the amount of deferred U.S. income tax on these earnings is not practicable because of the large number of assumptions necessary to compute the tax.
Goldman Sachs (GS) also has a problem with its XBRL not reflecting the full content of the note in its 10-K. Its full disclosure in its 10-K shows not only the $4.06 billion unrecognized deferred tax liability, but also the $22.54 billion of "reinvested earnings":
The firm permanently reinvests eligible earnings of certain foreign subsidiaries and, accordingly, does not accrue any U.S. income taxes that would arise if such earnings were repatriated. As of December 2013 and December 2012 this policy resulted in an unrecognized net deferred tax liability of $4.06 billion and $3.75 billion, respectively, attributable to reinvested earnings of $22.54 billion and $21.69 billion respectively.
With the aforementioned changes reflected, the above table, illustrating the problem of untaxed foreign earnings, would be even more shocking. It would reflect over $670 billion in accumulated untaxed foreign earnings from just the companies in the Dow 30 index. However, that doesn't tell the full Dow 30 story either, as American Express (AXP), which did not tag its quantified undistributed earnings, disclosed:
Results for all years primarily included tax benefits associated with the undistributed earnings of certain non-U.S. subsidiaries that were deemed to be reinvested indefinitely.
Even with a modest tax rate assumption, and taking into account the US Treasury's low cost of capital, the United States government would have been able to avoid incurring billions of dollars of borrowing costs had these foreign profits been subject to US taxes in the past. If these profits are "indefinitely re-invested" in foreign markets, as many of the companies intend, the cost to the US Treasury in foregone tax revenue, and the cost to the overall US economy from encouraging future investments to be made outside US borders, is enormous. If there is a change in tax policy, these "unaccrued" potential future liabilities are material to many of the companies in the list.
The problem of untaxed foreign earnings is not limited to the Dow 30, which likely represents only a modest percentage of the total untaxed foreign earnings on US-based multinational companies. The table below shows a similar analysis of four large-cap technology and biotech companies, which serve both US and international markets, and are not Dow 30 components.
Company | Annual Period End | Total Disclosed Undistributed Foreign Earnings | Deferred Tax Liability From Undistributed Foreign Earnings | XBRL Filing Source URL |
12/31/2013 | $25,500,000,000* | $9,100,000,000 | ||
12/31/2013 | $38,900,000,000 | N/A | ||
10/31/2013 | $38,200,000,000 | $7,469,000,000 | ||
5/31/2014 | $32,400,000,000 | $10,000,000,000 | ||
TOTAL | $135,000,000,000 | $26,569,000,000 | ||
* AMGN used a different tag: UNDISTRIBUTEDEARNINGSOFFOREIGNOPERATIONSONWHICHDOMESTICINCOMETAXNOTPROVIDED | ||||
Source: FinToolbox (upcoming product of Screener.co) | ||||
Even a market-wide analysis of US public companies would not fully capture the economic cost of current US tax policy. Private multinational companies, past borrowing costs that could have been avoided, and the opportunity cost from incentivizing foreign investments relative to domestic investments make the true cost of current tax policy impossible to measure.
The implications for policy makers are clear. The foreign earnings loophole in the US tax code costs the Treasury much-needed tax revenue while making it cheaper for companies to reinvest their foreign profits overseas rather than in the US. This directly costs US jobs by making the tax-adjusted cost of similarly compensated foreign employees cheaper than US employees.
Given the problems with the current tax code, it is hard to imagine that the status quo will persist indefinitely. US companies that have historically attained far lower tax rates than the statutory rate, by keeping profits overseas, may see future profits taxed to a greater extent. Investors who look at Net Income (or derived metrics that incorporate net income) should also pay attention to pre-tax metrics when valuing those businesses. For example, a conservative assumption to make when valuing such a business would be to apply a somewhat higher forward looking effective tax rate to pre-tax profits than the company has historically attained. Furthermore, the risk to companies with unaccrued potential deferred tax liabilities (from historical foreign earnings) should also be considered.
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