• What Your Auditor May Want to Know About APB 23 Representations and Section 965 Repatriation
  • January 14, 2005
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • A much-discussed area of the American Jobs Creation Act of 2004 is the new temporary dividends received deduction in new Section 965. New Section 965 permits a corporation that is a U.S. shareholder of a controlled foreign corporation a one-time election, for one of two tax years to be chosen by the U.S. shareholder, to repatriate selected extraordinary cash dividends from the controlled foreign corporation. If the election is made, a taxpayer will be taxed on the basis of an 85 percent dividends received deduction, subject to certain limitations and requirements. The IRS is working on guidance regarding the deduction, including the definition of cash dividend. Because of the uncertainty surrounding qualification for the election, many U.S. corporations have put off the analysis required to take advantage of it until the Treasury issues further guidance.

    In the meantime, reporting company auditors are beginning to question their U.S. shareholder clients about their plans to repatriate the funds. As a result, the U.S. shareholder may need to record the tax liability associated with the repatriation in the company's financial statements under APB Opinion Number 23, Accounting for Income Taxes (APB 23).1 APB 23 is a default position that assumes a U.S. shareholder's foreign earnings are repatriated to the United States. This is a subjective test, and if it becomes apparent that some or all of the undistributed earnings will be remitted to the United States in the foreseeable future, a reporting company may need to record an income tax liability equal to the expected taxes that will be incurred upon the repatriation.

    Paragraph 31 of APB 23 does, however, provide an indefinite reinvestment exception. To qualify for it, the U.S. shareholder needs to provide evidence of specific plans for reinvestment of the undistributed earnings.

    APB 23, Paragraph 8 establishes six critical factors to evaluate whether the foreign earnings qualify for the indefinite reinvestment plan:

    1. financial requirements of the U.S. shareholder
    2. financial requirements of the controlled foreign corporation
    3. operational and fiscal objectives of the parent company, long-term and short-term
    4. remittance restrictions imposed by governments
    5. remittance restrictions imposed by lease or financing agreements of the subsidiary
    6. tax consequences of the remittance.

    Lack of the information necessary to calculate the tax liability is not a viable reason for excluding the deferred tax liability from the balance sheet, although the tax consequences of including the dividend is a factor for qualifying for the exception.

    To qualify, reporting companies need to document their position with specific examples that satisfy the factors outlined in APB 23. This documentation may include items such as past experience, planned foreign mergers and acquisitions, and overall needs for the undistributed earnings to stay offshore. Satisfactory documentation must reflect a viable plan and rebut the presumption on repatriation.

    Because the indefinite reinvestment exception is subjective, some external auditors have begun to question the validity of past representations because the enactment of new Section 965 has changed the facts and circumstances of companies that previously qualified for the indefinite deferral. In light of these circumstances, a company may be required to accrue the projected residual tax consequences of a planned Section 965 repatriation when it becomes apparent that profits will be repatriated under Section 965.

    The Financial Accounting Standards Board (FASB) issued proposed guidance November 15 addressing this issue in FSP FAS 109-b, which is effective immediately. FASB concluded that a company should be allowed time beyond the financial reporting period of enactment to evaluate the effect of this new provision on its plan for reinvestment or repatriation of foreign earnings for purposes of applying Statement 109, due to the need for legislative clarification on some of the provisions in Section 965. The position paper also provides guidance about disclosures for companies that may have started the evaluation process of whether to repatriate the dividends under the new provision.

    The Pepper Perspective

    In light of the proposed FASB statement, reporting companies that intend to keep the funds offshore indefinitely need to properly document their reasoning and support for this position so that it can be provided to their external auditors for review. Reporting companies that have begun evaluating the provision, but have not made a final decision, should prepare a schedule of the status of its repatriation plans and show a range of "reasonably possible" remittances and income tax effects under the disclosure rules. Reporting companies that have evaluated whether or not to repatriate funds need to disclose the tax liability impact in their financial statements. If the evaluation is completed after year end and before the release of the financial statements, the reporting company also may be required by their external auditor to issue pro forma financial statements taking into account the repatriation.

    1 FASB Statement No. 109, Accounting for Income Taxes, left intact the provisions of APB 23 that relate to the accounting treatment for unremitted earnings of a foreign investment.