The push for a corporate tax holiday to encourage repatriation of an estimated $2.1 trillion in foreign profits seems to have gained traction again, thanks to a recent proposal from former President Bill Clinton, but such an idea could provide multinational companies with the incentive for earnings manipulation, according to a new study.

Clinton suggested earlier this month granting U.S. multinationals a tax holiday on their repatriated profits as long as they used a portion of the repatriated funds to buy bonds to rebuild the nation's infrastructure. The idea has drawn support from both sides of the aisle in Congress.

What impact such measures would have on the national economy remains an open question, but a similar tax holiday in 2004 that temporarily reduced the tax on repatriated funds by 85 percent but had no infrastructure-bond mandate gave far less boost to the economy and the national job market than its supporters had predicted, instead increasing shareholder dividends and spurring corporate stock buybacks.

New research provides further reasons to be suspicious of a tax holiday on repatriated corporate profits. A study in the current issue of The Journal of the American Taxation Association, published by the American Accounting Association, suggests that most multinationals shunned the 2004 tax holiday altogether, while those that took advantage of it did so mainly to manipulate earnings.

In the words of the study, “On average, firms do not appear to have repatriated more than necessary to meet analysts’ expectations, suggesting that many firms...viewed the tax holiday as an opportunity to manage their reported earnings rather than to save U.S. income taxes.”

Strongly supporting this conclusion was the lack of any significant relationship between participation in the holiday and tax levels in the countries where multinationals’ subsidiaries were located, even though under normal circumstances the lower the foreign rate, the bigger the U.S. tax bite in repatriation. As the study noted, “Firms with the lowest foreign effective tax rates stood to benefit the most from participation in the tax holiday; yet, the relation between this variable and...tax-holiday capacity utilization is statistically indistinguishable from zero.”

“Not only did manipulating the earnings numbers matter more than taxes—it mattered a whole lot more," said Robert C. Ricketts, an accounting professor at Texas Tech University, who carried out the study with Michaele Morrow, an assistant accounting professor at Suffolk University. “And it’s the easiest thing in the world to do. You don't have to move any cash around; it’s all a matter of telling the auditor what you intend to do.”

“We started out with the idea of investigating how the companies used the money,” Ricketts added. “What surprised us was how many didn't repatriate at all. Of 596 multinationals in the our sample that reported foreign pretax earnings in the years around the tax holiday, only 246 repatriated funds—and then only 44 percent of the full amount that they were entitled to repatriate.”

To explain these low rates, Morrow and Ricketts cited two principal factors. They found “some support that firms with relatively higher growth in foreign earnings, a proxy for foreign investment opportunities, were significantly less likely to participate in the tax holiday.”

Stronger still was evidence that “the excess of the holiday limitation over the amount needed by the firm to exactly match its reported earnings with analyst forecasts [was] negatively and significantly associated with the ratio of actual repatriation dividends to the maximum allowable under the tax holiday...In other words, the more a firm's capacity to repatriate foreign earnings under the tax holiday exceeded the amount it needed to meet its financial reporting incentives, the less of that capacity the firm actually utilized.”

Participating companies manipulated earnings by two means. To raise their reported earnings to meet or beat analysts’ forecasts, they took advantage of a tax deferral provision of the Tax Code. This enables multinationals to defer paying U.S. tax on foreign subsidiaries’ profits not yet paid to the parent company, for which a deferred tax liability is entered on the parent corporation's financial statements.

For example, a U.S. multinational that paid a 20 percent tax on profits in the country where an affiliate is located (15 percent below the U.S. corporate rate) and deferred paying the additional amount to the IRS could use the tax holiday to reduce that 15 percent liability to 5.25 percent, thereby boosting its bottom line. For example, the technology company Radisys reduced its 2005 income-tax expense by eight cents a share, enabling it to meet analysts’ earnings forecasts exactly.

In contrast, other multinationals chose to manage their reported earnings downward so as not to exceed analysts’ forecasts and, presumably, to facilitate reporting earnings growth in a subsequent period. These companies took advantage of a rule promulgated by the Financial Accounting Standards Board that permits firms to omit from their financial statements entirely, except in footnotes, that any taxes at all are owed to Washington on foreign subsidiaries’ profits, something they are able to do by declaring their intention to permanently reinvest these earnings abroad.

Some companies used the tax holiday to reverse these declarations, making these permanently reinvested earnings taxable (though at the tax holiday rate of 5.25 percent) so as to reduce reported earnings. Breakfast cereal maker Kellogg, for example, repatriated $1.1 billion in PREs, enabling it to lower its earnings per share from $2.41 to $2.36, just above analyst forecasts of $2.35.

Most popular of all was to combine the two maneuvers. “A firm with high levels of PRE but no deferred-tax liability associated with foreign operations...could repatriate relatively more under the holiday, but the effect of the repatriation dividend on reported GAAP income would be overwhelmingly negative,” wrote the researchers. “In contrast, a firm with high levels of both PRE and [foreign-engendered] deferred-tax liability [would have] much greater ability to control the net effect on reported income.”

Despite finding that financial reporting concerns outweighed tax considerations in driving repatriation a decade ago, Morrow acknowledges that taxes can sometimes be an overriding factor in determining corporate strategy, citing the current swirl of news about the efforts of Pfizer and other U.S. companies to shift their headquarters to low-tax jurisdictions abroad and congressional proposals to thwart such inversions. Pfizer recently abandoned its bid to acquire AstraZeneca, however.

“It certainly appears that Pfizer is among the most tax-sensitive U.S. multinationals,” said Morrow. “Interestingly, it was the firm that repatriated the largest dividend, $37 billion, in the 2004-05 holiday. But that degree of repatriation was a far cry from what was typical at the time or what probably will turn out to be typical if a holiday is instituted again.”

The study, “Financial Reporting versus Tax Incentives and Repatriation under the 2004 Tax Holiday,” appears in the spring issue of The Journal of the American Taxation Association, published twice a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research and practice.