Summary

Under the current U.S. tax rules, non-U.S. earnings are generally not subject to U.S. tax until the earnings are repatriated. FASB Accounting Standards Codification® 740, Income Taxes, provides an exception to the requirement to recognize deferred taxes on undistributed earnings of foreign subsidiaries and foreign joint ventures if the related undistributed earnings are, or will be, indefinitely invested in the foreign entity. Numerous practice issues arise in applying this guidance, one of which is determining whether the earnings of a foreign subsidiary or foreign joint venture are essentially permanently reinvested, a determination that is especially difficult in times of economic uncertainty.

This bulletin addresses common practice issues related to the income tax implications of earnings in foreign subsidiaries.

A. Income tax accounting for undistributed foreign earnings

With limited exceptions, FASB Accounting Standards Codification® 740-10-25, Income Taxes, requires entities to recognize a deferred tax liability or asset for the estimated future tax effects attributable to temporary differences and carryforwards. One exception to that requirement is undistributed earnings of foreign subsidiaries and foreign joint ventures that are, or will be, indefinitely invested in the foreign entity. Numerous practice issues arise in applying this guidance, one of which is determining whether the earnings of a foreign subsidiary or joint venture are indefinitely invested in the foreign entity, a determination that is especially difficult in times of economic uncertainty, which can result in changes in estimated liquidity needs.

A parent entity will often indefinitely invest the earnings of a foreign subsidiary, which results in a difference between the book carrying amount of the investment and the tax basis in the stock of the subsidiary (also known as the "outside basis" difference). Although the book carrying amount of the investment is increased by the subsidiary's earnings included in the parent's net income, the tax basis remains unchanged, unless the subsidiary is consolidated in the parent's U.S. federal tax return. Additionally, there may be other basis differences resulting from, among other items, business combinations and cumulative translation adjustments. Although this NDS primarily addresses the temporary differences related to undistributed earnings, a parent entity is required to recognize a deferred tax liability for the entire outside basis difference of its investment in a foreign subsidiary, unless it qualifies for the exception in ASC 740-30-25-18, Other Considerations or Special Areas.

Since the exception to the requirement to provide a deferred tax liability applies only to investments in foreign (and not domestic) subsidiaries, an entity must first determine which subsidiaries qualify for the exception. This assessment is made using a bottom-up approach by reviewing the relationship with the investee's immediate investor. Accordingly, an intermediate parent could be required to recognize a deferred tax liability in its separate financial statements for a domestic subsidiary, even though the ultimate parent can support its assertion that the foreign earnings will not be repatriated.

ASC 740-30-25-3 states that there is a presumption that all undistributed earnings of a subsidiary will be transferred to the parent entity and that an entity must have specific, definite plans to overcome this presumption. Further, ASC 740-30-25-17 includes guidance on the evidence needed for a parent entity to assert that undistributed earnings are invested indefinitely. Examples of evidence to substantiate the parent entity's representation of the indefinite postponement of remittances from a subsidiary include the following:

  • Experience of the entities
  • Long- and short-term forecasted cash flow needs in the parent company and the foreign subsidiary, including reasons why excess earnings and cash flows are not needed by the parent or another subsidiary
  • History of dividends or other repatriation events, including amounts deemed to be dividends under U.S. tax rules
  • Restrictions on the remittance of earnings under a subsidiary's loan agreement or local regulations
  • Tax consequences of a decision to reinvest or remit excess earnings

An entity must demonstrate both the intent and the ability to reinvest the foreign subsidiary's earnings indefinitely. The evidence should include positive cash flows from domestic operations and sufficient working capital and liquidity, including the availability of debt or equity markets, to provide for its domestic needs.

Management should document its plans for reinvestment, including the evidence it uses to substantiate a representation of the indefinite postponement of remittances from a subsidiary. It is possible that some foreign subsidiaries could meet the indefinite reversal criterion while others do not.

The indefinite reinvestment exception applies only to the outside basis difference of a foreign investment. Deferred taxes should always be applied to basis differences of a foreign subsidiary's underlying assets and liabilities (called "inside basis differences").

B. Changes in reinvestment assertion

If it becomes apparent that some or all of the undistributed earnings of a subsidiary will be remitted in the foreseeable future and income taxes have not been recognized by the parent entity, income taxes should be accrued as current period expense in the period the determination changes. Likewise, if it becomes apparent that some or all of the undistributed earnings of a subsidiary for which income taxes have been accrued will not be remitted in the foreseeable future, an entity should adjust current period income tax expense.

Determining recognized versus nonrecognized subsequent events

In some situations, management's plans for reinvesting undistributed earnings may change after the balance sheet date and before the financial statements are either issued (for public entities) or available to be issued (for nonpublic entities). In those circumstances, management must apply judgment to determine whether the change in management's assertion is a recognized or a nonrecognized subsequent event.

In making that determination, management should evaluate the factors that influenced its decision to change its plans for reinvesting the undistributed earnings. For example, the change in assertion may be seen as a nonrecognized subsequent event if (a) specific events occur after the balance sheet date that cause conditions that existed at the balance sheet date to change significantly, and (b) management uses that information in making its decision on reinvesting foreign earnings. Conversely, if information about events occurring before the balance sheet date comes to light after the balance sheet date and that information causes a change in management's assertion regarding the repatriation of foreign earnings, the change in intent may be considered a recognized subsequent event.

Partial reinvestment

An entity may plan to remit only a portion of a subsidiary's undistributed earnings. Under ASC 740-30-25-18, a deferred tax liability is not recognized for undistributed earnings in a foreign subsidiary that is "essentially permanent in duration." As a result, an entity is permitted to recognize a deferred tax liability on only the portion of earnings to be remitted. Management's plan regarding undistributed earnings, therefore, is not an all or nothing decision.

Example: Partial reinvestment

Entity A has an investment in a wholly owned subsidiary, Entity B, in a foreign jurisdiction. The outside basis difference is $1,000,000, which relates entirely to the undistributed earnings of Entity B. Historically, Entity A has concluded based on the available evidence that there will be no need to remit any portion of the undistributed earnings of Entity B in the foreseeable future. As a result, Entity A has not recognized a deferred tax liability for the basis difference.

In the current year, Entity B has net income of $200,000 and declares a $200,000 dividend. Entity A would evaluate whether there are changes in facts or circumstances that indicate the assertion of indefinite reinvestment of Entity B's undistributed earnings is no longer appropriate.

For example, if the dividend was declared because of projected shortfalls in meeting Entity A's working capital requirements during the coming year, that fact might indicate that Entity A can no longer support an assertion that all or a portion of Entity B's earnings are permanently reinvested.

C. Disclosures

Under ASC 740, an entity must disclose when a deferred tax liability has not been recognized for an investment in a foreign subsidiary because the earnings of that subsidiary are indefinitely reinvested. In addition, the gross amount of the temporary difference for which deferred taxes have not been provided must also be disclosed. If it is not practicable to determine the amount of the unrecognized deferred tax liability, an entity must also disclose that fact.

The SEC staff has indicated that registrants need enhanced liquidity disclosures if a significant amount of cash and short-term investments reside overseas, including an assertion, if true, that such cash is permanently reinvested in those foreign entities. Specifically, the SEC staff looks for the following three disclosures:

  • The amount of cash and short-term investments held by foreign subsidiaries not available to fund domestic operations unless repatriated
  • A statement indicating that the registrant would need to accrue and pay taxes on repatriated funds
  • A statement, if true, that the registrant does not intend to repatriate those funds

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.