Repatriation of Foreign Income and deferred taxes

One item affecting a number of company’s fourth quarter earnings releases is the tax effect of repatriating income held overseas by foreign subsidiaries. This provides an interesting discussion topic when covering deferred taxes. One provision in the big November 2004 tax bill (American Jobs Creation Act of 2004) was that companies could repatriate overseas profits at a rate of 5.25% (much lower than the normal 35%).

Previously the accounting for this item was based on what the company was expecting to do with the money.

• If a company was not expecting to repatriate the foreign profits and instead stated that it would permanently reinvest the foreign earnings it was not required to recognize any U.S. taxes on the profits. Usually companies would disclose the amount of permanently reinvested foreign earnings in the tax footnote. For example in its 2003 annual report Kellogg’s discloses the following:

At December 27, 2003, foreign subsidiary earnings of approximately $1.09 billion were considered permanently reinvested in those businesses. Accordingly, U.S. income taxes have not been provided on those earnings.

Companies that have not provided for taxes on their foreign earnings will recognize a tax expense (and tax liability) in the period they elect to repatriate foreign earnings. The amount of the tax expense will be 5.25% of the amount repatriated. In addition, these companies will have much higher effective tax rates in the period of the election. For an example of this take a look at Johnson and Johnson’s fourth quarter earning release.

• If a company has provided for U.S. taxes on its past foreign profits it set up a deferred tax liability (since the tax is not due until the actual profits are repatriated) equal to 35% of the foreign profits. If the company elects to repatriate the foreign income this period than it will result in a decrease in the deferred tax liability and an adjustment to the tax expense.

For an example of a company that had previously provided for U.S. taxes and is now able to get a benefit from the repatriation look at the earnings release of Autodesk.