Offshore Corporate Profits Pose Hidden Risks

As they pile up in cash accounts, undistributed foreign profits are inflating U.S. multinationals’ valuations and making companies appear less leveraged.

Undistributed foreign earnings (UFE) — foreign profits earned by overseas subsidiaries that have not, at least not yet, been remitted back to the U.S. parent — are a good deal for U.S. multinationals. Too good, says Fitch Ratings in a report released Thursday, because investors are forgetting about an important aspect of this corporate cash building up overseas.

The growing profits earned by U.S. companies in foreign jurisdictions are in many cases sitting subsidiaries’ bank accounts and are being rolled up into the parent company’s consolidated balance sheet, boosting overall reported cash balances. But many investors and creditors are forgetting are that these cash balances in most cases have strings attached; namely, the hefty tax on them owed to the United States if the funds are remitted back to the parent, says Fitch.

So, while creditors include the cash in leverage calculations and investors count UFE in their valuation models, “the cash held in foreign subsidiaries may not be fully available to remunerate shareholders, or repay debt issued elsewhere in the group,” says Fitch.

A sample of 40 large, nonfinancial multinational corporates studied by Fitch had on average had $28 billion of UFE, having added an average $3.1 billion in UFE in the last reporting year. Microsoft, for example, had $76 billion stashed in foreign jurisdictions as of the end of 2013.

While companies pay local taxes on the profits when they earn them, they don’t have to pay the incremental U.S. tax due until the earnings are distributed back to the U.S. parent. In addition, U.S. accounting rules exempt the recognition of deferred tax liabilities on foreign earnings if they are intended to be “indefinitely reinvested” outside the United States, which many companies claim. So multinationals are not recognizing a deferred tax liability on these profits and no tax deduction is being made from reported earnings in the income statement.

“[The accounting] standard provides a way for companies to report higher than ‘normal’ post-tax earnings,” Fitch says in its report. “As a result, investors may then ascribe a higher value to the company and perceive better credit metrics and therefore lower credit risk to the company, discounting perhaps that accessing these foreign earnings could come at a significant tax cost.”