"An important open question is the extent to which TRA'86 hampered the competitiveness of U.S. financial service firms who must compete for international market share with subsidiaries of firms from countries in which foreign-source income is exempt from taxation."

Until 1986 U.S. companies were allowed to defer U.S. taxes on active income earned in overseas subsidiaries until that income was repatriated to the parent corporation. The Tax Reform Act of 1986 (TRA '86) eliminated that deferral for active income earned in overseas financial subsidiaries, thereby subjecting financial services firms to harsher tax treatment than manufacturing firms. In The Effect of the Tax Reform Act of 1986 on the Location of Assets in Financial Services Firms (NBER Working Paper No. 7903), authors Rosanne Altshuler and R. Glenn Hubbard ask whether this change in the tax law affected the location of assets held in these firms. They find that before TRA '86, the location of assets held in financial subsidiaries was quite responsive to differences in host country tax rates across jurisdictions. After the tax changes went into effect, however, that responsiveness disappeared - differences in host county tax rates ceased to explain the distribution of assets held in financial services subsidiaries abroad.

Prior to the Revenue Act of 1962, U.S. multinational corporations were allowed to defer U.S. taxes on virtually all classes of foreign income generated in subsidiaries abroad. That legislation created the "anti-deferral" rules contained in Subpart F of the Tax Code. These rules impose accrual taxation on certain passive foreign income to reduce tax avoidance by multinational firms. The availability of deferral had made it attractive for firms to locate foreign subsidiaries in low-tax countries. Firms were able to avoid indefinitely the higher U.S. taxes on international income by retaining it abroad in low-tax countries.

Changes made in 1986 to the "anti-deferral" laws essentially eliminated deferral on active financial services income. These rule changes were not applied to other forms of active income (for example, manufacturing income), however. As a result, TRA '86 created an environment in which the tax incentive to locate operations in low-tax jurisdictions depends on the type of income the subsidiary is expected to generate. After TRA '86, there is still a tax advantage to locating manufacturing operations in low-tax countries since these operations generate active income that still enjoys deferral. However, this tax incentive was greatly diminished for subsidiaries that generate relatively large amounts of active financial services income.

For the financial services industry, the changes embedded in TRA '86 moved the U.S. tax system closer to one in which "capital export neutrality" is preserved for investments in low-tax countries. Capital export neutrality holds when investors pay the same level of taxes on investment projects regardless of where they are undertaken.

Using data from the tax returns of U.S. multinational corporations for 1984, 1992, and 1994, Altshuler and Hubbard examine how host country taxes affect the allocation of assets held abroad by financial services firms before and after the Act. In order to isolate the impact of the tax policy changes, the authors compare their results to numbers for the manufacturing industry, which was not affected by the same law changes. They find that companies no longer appear to base their location decisions concerning the assets of financial services subsidiaries on the tax rate of foreign countries.

Altshuler and Hubbard also note that an important open question is the extent to which TRA'86 hampered the competitiveness of U.S. financial service firms who must compete for international market share with subsidiaries of firms from countries in which foreign-source income is exempt from taxation.

-- Lucille Maistros


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