Companies that keep offshore earnings abroad to avoid high U.S. tax rates have a lot of explaining to do to satisfy not just tax authorities, but also the Securities and Exchange Commission.
The SEC has taken a keen interest lately in how fully and how consistently U.S.-listed companies describe their plans for reinvesting cash generated at overseas subsidiaries. Microsoft and Google, for example, have answered detailed queries from SEC staff over the past few months about their assertions that U.S. operations can be supported by U.S.-generated cash or debt while foreign earnings will remain offshore to be reinvested overseas. Both companies promised the SEC they would expand their disclosures in their filings to explain to investors how they are managing U.S. and foreign liquidity needs, as well as the tax effect of bringing foreign-earned cash into U.S. operations if they were eventually to do so.
Mark Shannon, an associate chief accountant in the SEC's Division of Corporation Finance, said at the recent Compliance Week 2011 conference that the staff is scouring all assertions about liquidity to assure companies are telling consistent stories about offshore versus domestic liquidity and the potential tax effect if any of those offshore earnings were to be repatriated (brought into the United States) to fund U.S. operations. Under U.S. tax rules, companies do not pay tax on foreign earnings until they are repatriated; if they are never repatriated, they are never taxed in the United States, which is notorious for slapping hefty tax rates on corporate earnings.
“Lately we've been asking a lot of questions about the impact of repatriation on liquidity,” Shannon said. “We've seen a number of companies with very low effective tax rates for their non-U.S. operations.” The SEC staff is looking for quantified disclosures describing the total amount of cash and short-term investments that are held in subsidiaries where companies assert that those amounts are permanently or indefinitely reinvested. The staff also is asking companies to quantify amounts attributable to countries with very low tax rates.
The goal is to give investors more information about where companies are holding cash and what tax and liquidity implications those holdings carry, Shannon said, especially when companies hold cash in countries with fragile political or financial issues. “We've gotten a lot of revised disclosures,” as a result of the inquiries, Shannon said.
MICROSOFT ANSWERS SEC
Below are Microsoft's responses to the Securities and Exchange Commission in regard to Microsoft's 10K and 10Q:
1. You indicate in your response to prior comment 2 that domestic cash flows from operations continue to be sufficient to fund operating activities and cash commitments for investing and financing activities. Tell us what consideration you gave to specifying the time period that you believe your domestic cash resources will be sufficient, including the short-term and long-term needs and sources of capital. Please refer to Financial Reporting Codification 501.03.a “Liquidity – Capital Resources.”
Response:
We acknowledge the Staff's comments, and in response, we will specify the time period that we believe our domestic cash resources will be sufficient, including the short-term and long-term needs and sources of capital. To do this we will disclose that we expect our domestic cash resources will continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future.
2. You indicate in response to prior comment 2 that borrowing funds domestically may be used to fund discretionary investing and financing activities, such as significant share repurchases. Tell us where this is identified in your liquidity discussion. In this regard, we note your discussion of other planned uses of capital on page 37 indicating that “existing cash, cash equivalents and
short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, debt repayment schedules, and share repurchases.” Furthermore, in view of that disclosure, you should provide the context and rationale for your prior issuances of long-term debt in fiscal years 2009 and 2010. Prior to fiscal year 2009, your long-term debt consisted primarily of tax contingencies and other tax liabilities and not long-term borrowings. Please refer to Financial Reporting Codification 501.02 “Prospective Information” and Section IV of SEC Release 33-8350, “Commission Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operations.”
Response:
With respect to the Staff's comment regarding identification in our liquidity discussion that we may borrow to fund discretionary investing and financing activities, we will prospectively enhance our disclosure, expanding from the disclosure in our Q1 FY11 10-Q. The enhanced language will disclose that while we currently do not have an intent nor foresee a need to repatriate funds, should we require more capital in the U.S. than is generated by our operations locally, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances to fund significant discretionary activities, such as acquisitions of businesses and share repurchases.
With respect to the Staff's comment regarding the context and rationale for our issuances of long-term debt, we issued the debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our superior credit rating and the low interest rate environment. In fiscal years 2009 and 2010, we issued $4.6 billion and $1.2 billion (net of repayments), respectively, of debt with maturities longer than 90 days. The proceeds of these issuances were used to partially fund discretionary business acquisitions and share repurchases, which totaled $10.2 billion and $11.5 billion in fiscal years 2009 and 2010, respectively. We anticipate that we will continue to have the ability to borrow funds domestically at reasonable interest rates. We propose that we include the foregoing information in our future filings.
3. In addition, regarding your response to prior comment 2, in order to provide context for the assets subject to repatriation, it appears that your disclosure should also address the nature and composition of such assets held in foreign subsidiaries including a description of the related market, settlement or other risk exposures and describe the nature of any limits or restrictions including your ability to use or access those assets to fund operations, domestically or otherwise. Refer to Financial Reporting Codification 501.03.a “Liquidity – Capital Resources” and Financial Reporting Codification 501.03.a.i. “Additional Guidance on Presentation of Liquidity and Capital Resources Disclosures.” Please provide us with your proposed disclosures addressing the foregoing concerns.
Response:
We acknowledge the Staff's comment and propose to add the following disclosure (in the context of our disclosure for the fiscal year ended June 30, 2010) to the financial condition section of our MD&A in future filings.
As of June 30, 2010, our consolidated liquid assets included $36.8 billion in cash and short-term investments and $7.8 billion in equity and other investments. Of these amounts, approximately $30 billion of cash and short-term investments were held by our foreign subsidiaries and were subject to material repatriation tax effects. The amount of cash and investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was approximately $150 million.
Our short-term investments held by our foreign subsidiaries consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are primarily U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. As of June 30, 2010, approximately 63% of foreign subsidiary short-term investments were invested in U.S. Government and Agency securities, approximately 14% were invested in corporate notes and bonds of U.S. companies, and 10% were invested in U.S. mortgage backed securities, all of which are denominated in U.S. dollars. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities.
4. We note your response to prior comment 3. It appears that the impact of changing the composition of your segments was material as compared to certain amounts previously reported. Specifically, we note the significant differences in revenue in the Windows & Window Live and Entertainment and Devices divisions. As such, please describe the nature of the changes in future filings.
Response:
We will describe the nature of the changes in future filings.
Source: Securities and Exchange Commission.
The SEC also is looking to assure companies have a good basis for avoiding a tax liability, says John Aksak, a managing director for tax consulting firm True Partners. According to Accounting Standards Codification Topic 740, Income Taxes, companies are required to book a deferred tax liability when they have offshore earnings that haven't been brought into the United States but will be at some point in the future. They can avoid booking that liability, however, if they assert that those foreign earnings are reinvested indefinitely in those foreign operations, with no need or likelihood of eventually repatriating them.
Quenching a Thirst
With companies facing strained liquidity as a result of economic and financial strife in recent quarters, the SEC wants companies to assure their disclosures reflect recent events, not just carry-forward boilerplate policies or objectives from prior reporting periods, Aksak says. “Companies are not supposed to accept everything is constant,” he explains. “To the extent circumstances have changes and there may be a need to have cash remitted to the United States, the SEC is saying to registrants and auditors, ‘We don't want you to take any of your past disclosures for granted.'”
April Little, director of tax accounting for Grant Thornton, says the SEC is looking beyond the tax-specific disclosures for evidence that the company means what it says when it asserts that foreign earnings will be held abroad. “How valid is that intent to reinvest?” she says. “They're looking at business decisions and overall strategy that might contradict that intent to reinvest.”
In addition to the focus on repatriation, the SEC also is looking carefully at deferred tax assets and whether companies may be clinging to false hope. A deferred tax asset is an asset that can be used to offset income tax expense in a future period; it represents a timing difference between accounting and tax reporting, and it reflects a company's expectation of income in a future period. Shannon said the SEC is looking for evidence that companies are operating under the same assumptions when carrying deferred tax assets as they are when, for example, making forecasts with analysts or booking asset impairments.
In addition to any scrutiny from the SEC, external auditors also have gotten toughon companies that carry deferred tax assets, says Chris Wright, managing director at consulting firm Protiviti. Both are pushing companies that have a history of accumulated losses, yet carry deferred tax assets based on an assumption that they will generate future taxable income. “They're looking to make sure if there's an assertion in the footnotes, that in other filings you're speaking the same language,” he says.
If, for example, companies express some uncertainty about their ability to earn future income, whether through the Management Discussion and Analysis, press releases, or conference calls with analysts, that likely would contradict the basis for carrying the deferred tax asset, Wright says. “The issue for companies is not to make sure their disclosures are in sync, but that the facts are in sync,” he says. “Inside the company, there should be a common understanding of expected or forecasted results among treasury, tax, and financial reporting staff, so that all the assumptions are the same.”
Inconsistencies in assumptions raise questions in the minds of SEC staff about whether companies are really looking at all the facts, Little says. “Are they really weighing the positive and negative evidence at the end of each reporting period?” she asks. When deciding what to do with a deferred tax asset carried forward from an earlier period, “some companies tend to bleed it out over time or leave it up there until there's a reason to release it.” The SEC is looking for a more thoughtful approach, she says.
The SEC scrutiny illustrates the importance of assuring tax and financial reporting staff members are providing careful documentation and working on it together, says Aksak. “This is not a decision that tax staff can make in a vacuum,” he says.
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