Taxation of International Investment and Accounting Valuation

This paper develops a model of a firm's foreign investment decisions and characterizes its optimal investment and repatriation strategies. It explicitly models the uncertain arrival of tax holidays and the effects of possible future holidays on the firm's decisions. Because the foreign subsidiary has reached the optimal level of operating assets, the firm will either immediately repatriate earnings, permanently reinvest earnings in financial assets held by the subsidiary, or invest earnings in financial assets until a tax holiday arrives, then repatriate earnings during the tax holiday. The paper derives the theoretical relation between the level of a foreign subsidiary's permanently reinvested earnings as reported in the income tax footnote and the value of the subsidiary to the parent. It shows that earnings reinvested in financial assets are discounted due to either the U.S. tax due on their repatriation or the opportunity cost associated with delaying that repatriation. The opportunity cost arises to the extent the rate at which investors discount riskless after-tax cash flows exceeds the after-domestic-tax interest rate. Finally, the paper shows the effects of a temporary tax holiday on firm value. The arrival of a tax holiday increases firm value if the subsidiary accumulates financial assets and repatriates them at a tax holiday. The increase in firm value is proportional to the financial assets held by the subsidiary when the tax holiday arrives, and reflects the difference between the opportunity cost of investing in financial assets and the tax rate on repatriations made during the tax holiday.