Foreign Tax Exemption Can Disguise Multinational Risks

High levels of undistributed foreign earnings can flatter the post-tax earnings and credit metrics of US multinationals, potentially leading investors to underestimate the financial risk of an issuer, Fitch Ratings says.

The credit rating agency arrived at this conclusion after analyzing the financial statements of 40 large MNCs. It found that their undistributed foreign earnings (UFE) can have a significant impact on both earnings and credit metrics.

On average, the exemption from recording a tax liability on the difference between foreign and US tax rates boosted basic earnings per share by 18%. Earnings will thus be hit hard if the UFE are brought back to the US and the MNC will need to pay tax on it.

Deferred tax liabilities

UFE, the profits earned by foreign subsidiaries that have not been remitted back to the parent, are growing fast for many US multinationals.

While US corporations are taxed on worldwide earnings, this normally happens only when those overseas earnings are distributed to the US parent.

US accounting rules exempt corporates from having to recognize deferred tax liabilities on these earnings if they will be indefinitely reinvested abroad.

This means investors can underestimate credit risk because companies may not be able to access their entire reported cash balance without having to pay significant taxes.

There are several circumstances in which US multinationals may need to remit cash back to the US, crystallizing a tax liability. Situations include if the domestic business cannot support cash expenses including returns to shareholder and debt service or if debt maturities arise at a time when markets are shut and the debt cannot be refinanced.

A crackdown on the tax mitigation strategies many companies use could also lead to the creation of tax liabilities that did not previously need to be recorded.

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