June 5, 2014 / 10:31 AM / 5 years ago

RPT-Fitch: Foreign Tax Exemption Can Disguise US Multinational Risks

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June 5 (Reuters) - (The following statement was released by the rating agency)

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. We address this in our ratings by evaluating the credit profile of both the domestic and consolidated entity and potentially taking rating action if these profiles become unbalanced.

Undistributed foreign earnings (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. Additionally, US accounting rules exempt corporates from having to recognise 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, crystallising a tax liability. These 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.

Our analysis of 40 large US multinational companies shows 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%. Applying a conservative haircut to FFO to account for US taxes on foreign earnings, FFO adjusted leverage for the sample rose by an average of 0.3x.

We address these potential distortions by evaluating the financial profile of both the foreign activities and the domestic business, which must pay returns to shareholders and debt holders purely from its domestic and received foreign earnings. A deteriorating domestic credit profile can lead to rating action. This was a factor in our revision of Coca-Cola’s Outlook to Negative from Stable in February.

For more details on our approach to UFEs and the impact they can have on credit metrics, see the report “Phantom Earnings: Offshore Accounts of US Multinationals Will Come Back to Haunt Investors”, published today on www.fitchratings.com.

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