THE IMPACT OF THE TAX REFORM ACT OF 1986 ON THE INTERNATIONAL COMPETITIVENESS OF SERVICE INDUSTRIES
^ , Biblíofeca San Puctto Uico
Thomas Horst
Deloitte Haskins & Sells
William R. Cline
January 1988
This report was preparad for the Coalition of Service Industries, Washington, D.C. by Thomas Horst and William R. Cline.
The Coalition of Service Industries, established in 1982, is the oniy national organization representing the interests of the U.S. service sector. Its members are among the largest service corporations in the United States, and include:
American Express Company
American Intemational Group
ARA Services, Inc.
Arthur Andersen & Company
Bechtel Group, Inc.
Beneficia! Corporation
Chase Manhattan Bank, N.A.
Chubb Corporation
Citicorp/Citibank
Coopers & Lybrand
Interpubiic Group of Cos.
Marsh & McLennan, Inc.
Peat Marwick Main & Co.
Sea-Land Corporation
Additionally, the following companies participated in the study: Akin Gump. Strauss Hauer & Feid, Continental Corporation, Dun & Bradstreet Corporation, The First Boston Corporation, Johnson & Higgins and Cigna Corporation. ^
^^aístradón
About the Authors
Thomas Horst, a director in the Washington, D.C. office of Deloitte Haskins & Seíls holds a Ph.D. in economics. A former faculty member of Harvard University from 1977 to 1981 he served as Director of the U.S. Treasury Departmenfs intemational tax staff which was responsible for economic analysis of intemational tax issues. Dr. Horst is the author of numerous books and articles on intemational economics and taxation.
William R. Cline is Sénior Fellow at the Institute for Intemational Economics, Washington, D.C. He holds a Ph.D. in economics from Yaie University. He was for mer^ assistant professor at Princeton University, a Ford Foundation visiting professor at the Brazilian Planning Ministry and University of Sao Paulo, Deputy Director for rade and Development Research at the U.S. Treasury, and Sénior Fellow at th'b Brookings Institution. He is the author of numerous books and articles on intemational finance and foreign trade. He participated in this study in a personal capacity, and views expressed herein should not be attributed to the Institute for Intemational Economics.
Part I
Part III
Appendix A
Appendix B
Appendix C
Appendix D
Appendix E
Appendix F
Appendix G
Appendix H
List of Tablea.
Executive Summary.
laxes and U.S. Competitiveness in the Services industries: Overview
Impact of Tax Reform Act on Rate of Return and Comparison to Foreign Tax Systems
The Impact of Tax Changes on U.S. Services Exports and Foreign Affiliate Salea
Footnotes to International Tax Survey
Advertising Agencies
Commercial Banking
Investment
Banking
Insurance
Ocean Shipping
Tax Impact Formulas
A Demand-Supply Model of Services Exports
Table Number Title
Impact of 1986 Act on Ocean Shipping - U.S. Corporation/U.S. Flag
Impact of 1986 Act on Ocean Shipping - Foreign Subsidiary/Foreign Flag
Impact of 1986 Act on Marginal Tax Ratas.
This Repon evaluates the impact of the Tax Reform Act of 1986 en the international competitiveness of U.S.-based service industries. Part I summarizes the resuits of the overall study.
Part II describes U.S. taxation of service companies' foreign income before and after the 1986 Act and compares U.S. taxation with that in eleven other countries Japan, the United Kingdom, West Germany, Switzerland, the Netherlands, France, Belgium, Sweden, Denmark, Cañada and Hong Kong -- that are heme base to the overwhelming majority of U.S. companies'foreign competitors.
Part II .of the Report aiso quantifies the impact of the 1986 Act on the amount five service industries -- advertising, commercial banking, investment banking, insurance, and ocean shipping -- must charge foreign customers in order to derive the same after-tax profit as those companies would have earned under prior U.S. tax law. These quantitative estimates reflect not oniy the 1986 Act changes in the tax treatment of foreign income ^er but aiso the generally applicable tax rate reduction and base broadening provisions, including the repeal of the bad-debt reserve deduction for large banks, the discounting of loss reserves of property and casualty insurance companies, the deceleration in tax depreciation and the repeal of the investment credit. That quantitative analysis concludes that the 1986 Act had a significant adverse competitive impact on:
Cross-border lending subject to foreign withholding tax of 5 percent or more; Interest and other investment income earned by foreign banking, insurance and other financial service subsidiaries subject to low foreign effective tax rates;
Premiums and other income received by foreign subsidiaries for insurinq
U.S. orthird-country risks;
Srtipping income, whether earned directly by a U.S. corporation or through a foreign subsidiary.
In particular, the calculations indícate that U.S. banks would have had to increase mterest rates and fees for banking services by an average of 3.5% to offset the increased tax burden, and their foreign affiliates by approximately 1%. U.S. producers of shipping services would have had to increase prices by 12% to offset the increased burden; and their foreign flag affiliates, by 4%. International affiliates of U.S. insurance firms would have had to increase prices by 6% to offset the in creased tax burden. The effects are more modest or mixed for advertising invest ment banking, and U.S. resident insurers.
The acíivity and employment effecís from these tax changas may be calculated by applying the pnce changas to "elasticity" measures, which show the sensitivity of foreign demand to price. Each sector is classified as low, intermediate, or high elasticity, and specific elasticity valúes in each class are basad on the émpirical literature for traded goods. This approach yields the estímate that for the five sectors combinad, the tax changes under the 1986 Act may be expected to reduce service exports by a total of $1.7 billion annually (almost 10 percent of their export base), and to reduce eamings of foreign affiliates by $1.9 billion annually.
Apphcation of the labor coefficients to these estimates indicates that the tax changes may be expected to reduce service export employment by a total of approximaíely 15,000 direct jobs. The bulk of this reduction occurs in banking (10,000 jobs) and shipping (6,500 jobs). There are net small, offsetting gains in emolovment in the other sectors.
In general, these categories of service income eamed by U.S.-based companies were competitively disadvantaged not oniy by comparison to pre-1986 U.S. tax law, but aiso by comparison to comparable income eamed by foreign-based service companies. Alíhough the U.S. corporate tax rate has moved from the higher to the lower end of the intemational corporate tax rate spectrum, the base-broadeninq provisions of 1986 Act, particularly the repeal of banks' bad-debt reserve deducíion and the discounting of property and casualty insurance reserves, have generally not een adoptad outside the United States. Even if other countries amúlate the United States in reducing tax ratas and broadening the tax base, U.S.-based companies will continué to be competitively disadvantaged as long as the U.S. treatment of foreign income is more restrictive than that of other countries.
The principal polK^ iroplication of these findings is that in its refinements to the
^ Congress should merge the two tracks of tax and trade policy and consider measures to reverse or offset the negativa effects for U.S. service
ment^^tn
ents to U.S. competitiveness are costiy at a time of acute need for export expan sión and increased foreign earnings to help service the growing U.S. external debt
Moreover emp oymem in service sector exports warrants atteníon in addHton to me more traditional policy focus on manufacturing and agricultural export jobs.
I. Taxes and U.S. Competitiveness in the Services Industries: Overview
It is increasingíy recognized that exports of services are important to the international economic position of the United States. One of the least studied aspects of U S competitiveness IS the Influence of the tax structure. This overview summarizes an empirical analysis of the impact of taxes, and in particular the Tax Reform Act of 1986 on the abihty of U.S. service sector firms to compete internationally. Parí II of this studv
eTe«s" employment
Importance of Trade in Services
The large U.S. external déficit and mushrooming foreign debt place a hiah imhl J affiliates to reduce ihe imbalance and meet payments on the external debt. The service industries have a hITa rim^° United States as a comparativa advantage in important service sectors. Several require human capital, and experience from a large domeslic market, all areas of U.S. strength. The natural ünkage of many service seoTor aotivities to the foreign operations of multinational manufacturing corporations is another basis for sucoess in the sector. poicuions is an
The rJnn confirin U.S. oomparative advantage in the service industries lone e,f """f Assessment has estimated that in 1984 ex p of services (excluding capital income) amounted to $77 billion or one-third the valué of merchandise exports. The trade surplus in services was $14 billion a ^hlrn contrast to the large déficit in merchandise trade in that year. Moreover U S foreicn affihates in service industries earned $92 billion in 1984, which exceeded the'amount earned in the United States by affiliates of foreign firms by $21 billion.
Services trade is an important source of employment as well as exoortc; Tone nt a™, seolTs aftourism bInkL ing (Pan m tabirir^Thirsfir'"^''^"^''"® software, and enginee?-
■ I . . ' '® study estímales that there are 870 000 U S iobs rtírortiu invoived m senrioe sector exports, aimost 60 peroent as high as he numier o?S jobs in the production of manufactured exports.
surh affiliates play a special role in several service sectors Often t mes^'e a:%rn fena'l'rr
scuroing to^e^L' ~
to firms from othGr countriGS. In somG casGS such Iossgs can jGopardizG tha shara cf U.S. firms avan within tha U.S. markat, as soma larQG multinational cliants saakto placa businass giobally with a singla firm and cannot do so if it is not presant in kay foraign markats.
U.S. trada nagotiators hava racognizad tha importanca of tha sarvicas sactors by strassing tha naad to ramova barriars to trada in sarvicas through nagotiations in tha Uruguay Round of multilataral trada nagotiations. Ironically, whila trada policy has accordad a high priority to opportunitias for sarvica axports, U.S. tax policy has procaadad along a saparate track and appears to hava raised naw obstadas to American compatitivaness.
Tha Tax Raform Act of 1986 and Compatitivanass
Tha Tax Raform Act of 1986 raducad tax ratas (from a basic máximum rata of 46 percent to 34 parcent for corporations) whila broadening tha tax basa by limiting daductions and preferances. The Act aiso eliminated or restricted credits and imposed a naw Alternativa Mínimum Tax. Although the reform applied the same principie of reducing ratas whila broadening the base for both corporate and personal income taxes, by dasign tha 1986 Act shiftad tha income tax burden away from individuáis and toward corporations. As a rasult, for corporations in the aggregate, incraasad taxas from a broadar basa excaadad tax raductions from lowar ratas.
Within tha corporata sactor, tha Act had varying affacts among diffarant in dustrias. in tha waka of the Act, analysts widely noted, for example, that capital in tensiva sectors tended to be disadvantagad relativa to less capital intensiva sactors, such as tha sarvicas industrias, by virtua of tha genaral langthaning of dapraciation schadulas and the rapeal of the investment credit. However, this diagnosis was accurata oniy for compañías compating solaly in tha domastic markat. Compañías compating in foraign markats wara confrontad by naw problems in the form of tightaned limitations on the "U.S. foraign tax credit and a significant expansión of the typas of foraign subsidiary income taxabla to U.S. parant corporations whathar or not such incoma was ramittad as a dividand. In addition, a numbar of industry-spacific provisions of tha 1986 Act craatad naw tax liabilitias for thosa spacific industrias that wara mora significant than tha basa-broadaning changas affacting all corporata taxpayars.
Part I! of this raport analyzes in graatar detail the spacific changas enactad by the Tax Raform Act of 1986. In summary, under prior law, cartain typas of foraign incoma earnad through controllad foraign subsidiarias were subjact to immadiata U.S.
taxation, notwithstanding the general provisión that suoh income is taxable in the United States oniy upon repatriation. The 1986 Act significantly expended the range of income subject to current taxation. Included for the first time were:
- dividend and interest earnings of banking, insurance, and other financia! subsidiarias aven though suoh earnings are derivad from the bona fide conduct of an active foreign business;
- securities gains on proprietary accounts;
- underwriting income in connection with the insurance of risks in any third countriesand
- al! shipping income, regardiess of whether reinvested in shipping assets.
The expansión of current taxation to these broad new categories of income will create significantly higher current tax liabilities for firms presently earning suoh income through subsidiarias.
In addition to expanding the scope of foreign subsidiary income subject to current U.S. taxation, the 1986 Act aiso restricted significantly the ability of U.S. corporations to claim a credit for all foreign taxes paid by requiring that the foreign tax credit limit be calculated separately for a number of different income "baskets". Although prior law had aiso required the segregation of certain types of foreign-source income, this segregation was significantly expanded by the 1986 Act. This change will greatly reduce the ability of U.S. firms to combine high and low-tax foreign income, and thus to claim credits for foreign taxes imposed at rates in excess of the U.S. rate. When com binad with the new, lower U.S. tax rates, this revisión will often result in a substantially increased tax burden on U.S. firms doing business abroad.
A similar result is achieved by the third significant change in this area, namely, new rules for the allocation of interest and other expenses against foreign versus domestic income. The effect of the 1986 Act changas will be to require the allocation of additional acense against foreign source income, reducing foreign-source taxable income and thereby reducing further the limit on the foreign tax credit that can be claimed.
Other provisions of the 1986 Act, although not directed explicitly at foreign earn ings, also had adverse effects on the international competitiveness of certain service industries. The reduction of accelerated depreciation, the elimination of the investment tax credit, and the new Alternativa Mínimum Tax were burdensome changas for the capital intensiva containerized shipping industry. The elimination of the deduction for bad debt reserves penalized foreign lending by the U.S. banking industry, and the discounting of loss reserves hurí foreign underwriting by U.S. insurers.
As a result of these provisions, the assessment that service-sector industries generally benefitted from the 1986 Act is reversed for companies engaged in interna tional commerce. Because many of the Tax Reform Act's provisions are industry
spedfic in their application, its impact on the competitiva footing of American businesses must be analyzed on an industry-by-industry basis. This overview summarizes such an evaluation for five specific industries. First, however, we turn to a comparison of U.S. vs. foreign tax practicas in this area.
Comparativa International Tax Structure
In addition to examining how the 1986 Tax Reform Act reallocated tax liabilities among U.S. taxpayers, it is important to compare the relative tax burdens imposed on foreign-based service companies with that imposed on U.S.-based companies before and afterthe 1986 Act.
Parí II of this study provides a detailed analysis comparing U.S. and foreign tax systems. As Table 1 in Part II shows, the United States and about half of its principal trading partners adhere to a "global" tax system. That is, corporations are taxed on their woridwide earnings, and a tax credit for foreign taxes paid is allowed. In contrast, the remaining half of America's principal trading partners tax corporations on a "ter ritorial" basis under which oniy income attributable to domestic activities are subject to the national income tax. Companies based in countries which tax income on a territorial basis thus avoid any home-country tax on by earning income through foreign branches and subsidiarias. Whether this divergence implies a competitiva advantage depends upon the degree to which that foreign income is taxed in the country in which it arises.
The formal similarity of the U.S. and foreign "global" tax systems masks, however, important differences in such features as the degree to which limitations on foreign tax credits are a major concern and in the operation of provisions taxing the unremitted income of foreign subsidiaries. As Table 1 Indicates, many (but by no means all) countries do have provisions for taxing such unremitted income. Oniy the United States, however, goes so far as to tax interest earnings of foreign banking and other financial subsidiaries and third-country insurance underwriting income. Similarly, all countries with global income taxation have a foreign tax credit system. In some cases, such as Japan, the foreign tax credit limit is calculated on an overall basis, as opposed to the United States' basket-type approach. Even in countries in which the foreign tax credit limit is on a per country basis, the foreign rules generally are applied in such a way as to allow our foreign competitors to claim full credit for the foreign taxes they pay. Thus, the binding limits on foreign tax credits enacted in 1986 will generally impose a tax burden on U.S.-based service companies that their foreign competitors do not bear.
Although precise comparisons require a case-by-case analysis, it appears safe to say that foreign countries are generally no more stringent, and usually less stringent, than is the United States in the taxation of foreign source income of domestic corporations.
With respect to general provisions of foreign tax systems, comparisons are difficult to draw. Even with respect to seemingly straightforward features, such as tax rates, considerable compiexity is introduced by provisions in foreign tax codes which reduce corporate tax on earnings distributed to domestic shareholders and/or which permit those shareholders to claim credit for corporate taxes paid with respect to distrib uted profits. However, it does appear that the U.S basic income tax rate, which formerly was among the highest, is now lower than that of most foreign competitors. On the other hand, other countries appear to have narrower tax bases, as illustrated by their typical lack of requirements for loss reserve discounting by insurance companies and their more generous deductions for bad debts. More broadly, because the aggregate effect of the 1986 Act was to increase total U.S. corporate tax even though tax rates declined, it is clearly misleading to use the tax rates alone as the guide to international comparison of tax burdens. A more detailed discussion of these issues is contained in Part I!.
Impact of the 1986 Act: Estimates
The effect of tax changes under the 1986 Act on U.S. competitiveness may be measured by calculating the price increase required for a U.S. firm to maintain the same rate of return on investment as before, when the tax burden increases, or the price reduction the firm can grant with no change in rate of return, in instances of lower tax burden. The net change in taxation depends on the trade-off between the 12-point reduction in the corporate income tax rate and the base-broadening changes, including extensión of Subpart F treatment to interest, insurance (including investment), and shipping income, new restrictions on the foreign tax credit, and others summárized above.
The change in price may be translated into estimated change in sales and employment. As developed in Appendix H, the responsiveness (elasticity) of sales volume to price is imputed to each of the five sectors examined on a basis of the broad range of past statistical estimates for trade and a judgmental classification of the sector as price-sensitive or not. The price change applied to the elasticity yields the estimated change in sales quantiíy. Application of labor coefficients shows the number of U S jobs involved.
The analysis shows a wide variation among sectors for the net impact of the 1986 Act on tax burden. Within each sector, the effects are calculated separately for export activity from a U.S. base and for sales by U.S. subsidiarias and affiliates located abroad (with U.S. employment estimates only for exports).
Although aggregate figures must be viewed with considerable caution because of the substantial variation among the sectors, the overall estimates show that for advertising, banking, insurance, investment banking, and shipping, changes under the 1986 Act may be expected to reduce exports by $1.7 billion annually (9 percent of the export
With respect to banks' fee and other (non-high-withholding tax) interest income, thG changG in thG compGtitivG footing of a U.S. bank dGpands upon thG foraign tax rata it facGS, thG applicability of U.S.tax to such incomG if Garnad through a foraign subsidiar/, and whathar tha bank is in an gxcgss cradit or axoass limitation situation. In ganara!, banks wara advantagad by tha 1986 Act to tha axtant thay earn incoma through branchas(not subsidiarias) in low tax foraign countrias (or in a situation of axoass cradit limitation). On tha othar hand, a subsidiar/ of a U.S. bank oparating in a foraign country with a favorabia tax systam (a.g., Switzarland) and ramitting a smali proportion of its profits would, as a rasult of tha axpandad scopa of U.S. taxabia incoma, find itsalf sevaraiy disadvantagad by tha 1986 Act, both in comparison to tha pra-1986 U.S. situation and in comparison to its foraign compatitors (racaíl that no othar country taxas a foraign banking subsidiary's intarast incoma).
ECONOMIC IMPACT - Tha rastrictions placad by tha 1986 Act on U.S. tax cradits for high foraign withhoiding faxes on crossbordar landing would raise tha prica of this U.S. bank activity raquirad to kaap raturn constant by an astimatad 4.3 parcant (from a typical intarast rata of 8.5 parcant to 8.9 parcant par annum). In contrast, for faa-basad sarvicas tha naw law actual!/ reduces taxas by an amount permitting a prica declina of 1.4 parcant for U.S.-basad activity. Tha weightad averaga prica impact for banking sarvica axports is an incraasa of 3.5 parcant. In viaw of tha high prica sansitivity of damand, this incraasa may ba axpactad to causa a declina of 10.5 parcant in tha voluma of bank sarvica axports, for a loss of $682 million annually (and 9,820 axportralatad jobs).
For banking sarvicas providad by foraign affiliatas of U.S. banks, tha prica changas that would neutraliza tha affacts of tha 1986 Act on rata of raturn ara, again, a 4.3 parcant incraasa for cross-bordar landing and a 0.5 parcant raduction for local currancy landing and faa-basad sarvicas. Tha weightad avaraga prica incraasa of 0.7 parcant translatas into ravenua losses of $137 million (2.4 parcant of tha total). Thasa astimatas imply that tha 1986 Act had a substantially negativa affact on an industry airaady hardpressed by intarnational compatition.
Insuranca
MARKET ENVIRONMENT ~ U.S. firms provida fira, property, casualty, marina, and product liability insuranca to covar not oniy tha oparations of U.S. multinational firms abroad but aiso foraign nationals. üfa insuranca companias ara aiso activa whara antry is parmittad. Sophisticatad financia! and insuranca instrumenta davalopad in tha United Statas can provida a "tachnologicár adga in tha compatition. For national accounts, compatition is primarily with tha national firms in aach respectiva markat. For global accounts of multinational firms, compatition is from a limitad numbar of larga firms, primarily thosa from tha Unitad Kingdom, Garmany, Franca and Switzarland. Japan has aiso bacoma activa, in tha area of late. Raputation of tha firm is important, as wall as prica.
Some 50 large insurance companies domínate U.S. activity abroad. Typically insurance companies operating abroad are torced by foreign regulations to conduct operatíons through branches or subsidiarles located in the country. Measures that place a disadvantage on foreign subsidiarles or affiliates thus tend to result In a ioss of business rather than reallocation of the business to an export base.
In 1984 U.S. insurance firms eamed an estimated $6.5 biiiion in premiums net of claims paid and reinsurance passed to third parties, for insurance provided foreign customers from U.S. offices. In addition, U.S.-owned foreign branches and subsidiarles earned some $12 billion. Approximately 26,000 U.S. jobs were associated with exports of insurance services.
TAX CHANGES - The property and casualty insurance industry was adversely affected by severa! provisions in the 1986 Act. On the purely domestic front, U.S. firms must henceforth discount for the time valué of money the additions to reserves for losses and Ioss adjustment expenses payable in future years. They were disallowed a deduction for a portion of additions to unéarned premium reserves and torced to recapture a portion of existing unearned premium reserves. AIso, 15 percent of the interest from state and municipal obligations and of the deductible portion of dividends received, tax free under prior law. has become fully taxable. These will substantially broaden'the base of insurance company taxable income.
In addition, the 1986 Act extended the reach of Subpart F, which faxes curreníly certain unremitted income of controlled foreign subsidiarles, to two new major sources of foreign insurance income: U.S. third country underwriting income, and investment income generally. As a result of these changes, insurance subsidiarles earning income in foreign countries with low effective tax rafes and remitting oniy small portions of this income to the United States will be significantly disadvantaged by the 1986 Act. Other subsidiarles and branches of the U.S. parent, will be less disadvantaged relative to prior law.
The extensión of Subpart F to large parts of U.S. insurance companies' foreign income places them at a significant disadvantage vis-a-vis insurance companies in foreign countries, none of whom impose such faxes.
ECONOMIC EFFECTS -- The estimates of Part II find that for U.S.-based exports of property and casualty insurance services, the effect of the 1986 Act is to reduce the tax burden by an amount that would permit a reduction in price by 3.0 percent. For foreign subsidiarles and affiliates, the estimated impact of the Act is to raise faxes by an amount requiring an increase of price by 6.0 percent to keep the rafe of return constant. Application of an intermedíate price sensitivity of demand to these changes yields the estimates that the new tax law increased prospectiva insurance service exports by 3.8 percent or $245.7 million, but reduced earnings of foreign affiliates by 5.3 percent or bv $641.1 million. '
The losses in foreign affiliate sales thus far outweigh prospective gains from insurance service exports. As noted, the in si^ nature of the bulk of the foreign affiliate activity means that the losses are unlikely to be recaptured through reallocation of the business to exports.
Investment Banking
MARKET ENVIRONMENT - Investment banking services include the traditional underwriting of securities as they come to market, trading for the firm's own account, commissions on securities transactions, and fee-based advisory work. The principal international competitors include firms from the United Kingdom, Germany, Switzerland, and Japan.
Competition is keen and price sensitivity high on underwriting, where spreads tend to be thin, and sales commissions, where cut-rate brokerages have made inroads. For specialized advisory work (including on mergers and acquisitions) the firm's reputation is a more dominant factor.
The international market is expected to grow more rapidly than the domestic market. Foreign revenue is already substantial, with investment banking service ex ports of $1.75 billion in 1984 and earnings by foreign subsidiaries and affiliates at $7.7 billion. The employment associated with exports may be estimated at some 25,000 jobs.
TAX CHANGES - The investment banking industry was adversely affected by the application of Subpart F rules to securities gains on proprietary accounts and interest and dividends derived in the active conduct of a trade or business, and aiso by the foreign tax credit limitation rules. Although the reduction in the U.S. tax rate appears to have provided some benefit, the newly revised Subpart F rules offset this benefit.
Income earned by providing services through U.S. branches may be more advantageously treated, provided (a big proviso) that foreign withholding taxes can be avoided (i.e. "many foreign countries impose high withholding taxes on advisory services income). income earned through foreign branches and subsidiaries in hightax countries was clearly disadvantaged by the expense allocation and other changes in the U.S. foreign tax credit limit.
Countries where investment banking firms do major business (i.e. Japan, United Kingdom, Ganada, Australia, and Switzerland) have income taxes equal to or substantially higher than the current U.S., rate. The income of a foreign affiliate whose ownership is between 10 percent and 50 percent (often due to regulatory constraints) cannot be included in the financial services basket. Therefore this income will be subject to its own sepárate limitation. In addition, if the investment banking firm or its foreign affiliate receives high withholding tax income, this income will fall into another sepárate basket, increasing the likelihood that the company will end up in a foreign tax credit limitation position.
In general, U.S. investment banks will be helped vis-a-vis their foreign competiíors by the lower U.S. rates, but will be hurt by the more restrictive foreign tax credit iimitation provisions. Their disadvantage vis-a-vis countries with territorial taxation (and henee zero tax rates on foreign source income) will remain in place in lew tax third countries.
ECONOMIC EFFECTS - The net effects of the 1986 act have been to leave the tax borden for both export and foreign affiliate activities of the investment banking industry almost unchanged. As indicated in Section III, the price changes required to offset the net tax effects are relatively low because of the specialized nature of the industry. As a result, estimated changes in exports and foreign affiliate sales are minimal.
MARKET ENVIRONMENT
~ Two features domínate U.S competitiveness in ocean shipping services. First, the United States holds only a. small share of the market; U.S.-flag carriers account for only 15 percent of the "liner" (primarily containerized) cargo in U.S. imports and exports (excluding protected coastal trade), and for bulk cargo the share is much smaller. Even taking into account the fact that a significant portion of bulk cargo is carried by U.S. subsidiarles flying foreign "flags of convenience", the U.S. market share is small. Second, the great bulk of international shipping takes place in a nearly tax-free environment. Subsidiarles operating out of tax-haven bases (such as Liberia) provide an easy vehicle for low-tax operations by firms from other countries, and low-tax competition is also stiff from various East Asian newly industrializing countries (NlCs).
U.S. flag ship operators are able to compete in the face of such unfavorable circumstances largely because the move toward containerization has shifted advantage toward countries with strong capital and technological bases. In the actual construction of ships, however, comparativa advantage lies more with countries possessing rela tively low-wage labor, as the process is labor intensive.
In the past, U.S. policy has combinad tax and subsidy programe to enable the shipping industry to compete more successfuliy in view of national security objectives. These incentives have eroded ovar time, however, especially with the 1986 Act. One past benefit was the Capital Construction Fund provisión of 1970 legislation. Firms could defertaxes on income usad to purchase ships built in the United States, but after U.S. shipyard construction subsidies terminated in 1982 this benefit became of little use as ships were generally purchased from other sources. U.S.-flag carriers have received operating subsidies to offset the higher cost of American crews, but the Reagan Administration has cut back these subsidies as well.
The move toward deregulation under the Shipping Act of 1984 has meant that price and quality competition within the international "liner conference sysíem" has
intensified. All of these factors, combined with a relativa oversuppiy of ships, have meant a squeeze on earnings in the Industry in recent years.
Ocean shipping nonetheless still buiks larga in U.S. export and foreign subsidiary activities. Export earnings (U.S.-flag carriers) in 1984 amounted to $3.6 billion, while revenues of affiliates (fiag of convenience) amounted to $9.3 billion. Soma 18,000 U.S. jobs may be attributed to the formar, export activity.
TAX CHANGES -- Both the U.S.-flag and foreign flag operations of U.S. ocean shipping corporations were adversely affected by the 1986 Tax Reform Act. Lengthening of depreciation lives, the repeal of the investment tax credit and enactment of the Alterna tiva Minimum Tax in this capital intensiva industry will substantially increase the ratas that would be charged in order to preserve the after-tax rata of return or, more likely, reduce the after-tax return on shipping investments.
Foreign flag operations, which did not benefit from accelerated depreciation and investment credits under pre-1986 law, are less adversely affected. Still, however, the repeal of the provisión that allov/ed foreign shipping subsidiaries to defer U.S. tax by reinvesting their profits in shipping assets will lead to a substantial increase in the U.S. tax burden. This change will aiso put U.S.-owned shipping affiliates at a disadvantage vis-a-vis foreign-owned ship owners, because other countries uniformiy permit foreign shipping subsidiaries to defer domestic tax by reinvesting their profits.
ECONOMIC EFFECTS ~ The heavy impact of repeal of deceleration of ACRS depreciation, the investment tax credit and the Alternative Minimum Tax mean that U.S.-flag ocean shipping bears an additional tax burden from the new law that would require a 12 percent price increase to permit an unchanged rate of return. For foreign flag subsidiaries of U.S. shipping companies, the repeal of the Subpart F exclusión of reinvested shipping profits reinvested in shipping assets means that the tax burden will rise by an amount requiring a 4 percent price increase to maintain the rate of return.
These price increases transíate into large percentage declines of activity because of the relatively high sensitivity of demand in what is a "commodity" type of service with keen competition. Part III estimates the cutback in shipping service exports that may be expected from the new tax law at 36 percent, or $1.3 billion, and the reduction in foreign affiliate revenue at 12 percent, or$1.1 billion. Some 23,000 jobs could be lost as the result of the reduction in shipping service exports (U.S.-flag carriers). Thus, an industry already under severe competitive pressure faces serious new obstacles from the changes of the Tax Reform Act of 1986.
Conclusión
Two principal patterns emerge from the sectoral studies. First, overa!! the 1986 Act has imposed a new obstada to the competitiveness of U.S. service sector exports and sales by foreign affiliates. This burden is untimely in view of the imperativa of reducing the massive U.S. trade déficit and net foreign indebtedness. Second, it is apparent that the adverse effects can be highiy concentrated by sector. Among the sectors examinad, banking and shipping account for the greatest losses. The adverse effects are aiso large in insurance. These results suggest the need for a review of U.S. tax policy that takes account of the impact on U.S. internationa! competitiveness in general and takes particular cara to avoid concentrated damage to the ability of important individual service sectors to compete internationally.
II. Impact of Tax Reform Act on Rate of Return and Comparison to Foreign Tax Systems
Introduction
The Tax Reform Act of 1986 made far-reaching changas in the U.S. tax system. Broadly speaking, the cveraií tax burden was shifted from individuáis to corporations. Although the máximum rata of the regular tax on corporate income was cut from 46 percent to 40 percent for 1987 and 34 percent for later years, the overall corporate tax burden was increased through a series of provisions broadening the measure of gross income, limiting deductions, repealing or restricting tax credits, and enacting a new Alternativa Minimum Tax (AMT). The 1986 Act aiso sharply limitad the general deferral of U.S. tax on retained earnings of U.S.-controlled foreign subsidiarias and imposed several new restrictions on the U.S. foreign tax credit.
This Report evaluates the impact of the 1986 Act on the international competitiveness of U.S.-based service companies. Service companies, like manufacturera, are heterogeneous -- they include providers of personal and business services (e.g., advertising, accounting, law), financial services (e.g., banking, insurance), transportation (e.g., airlines, ocean shipping) and other types of services. Many service companies have developed over the years substantial businesses outside the United States, often initially in response to the overseas expansión of their primary U.S. clients" businesses While U.S.-based service companies often enjoy certain advantages by virtue of their familiarity with the needs and operations of U.S.-based multinational corporations, they must Overeóme the disadvantages of operating in a foreign economic and legal environment, often in competition with established local and third-country rivals. U.S.-based service companies concern for their international competitiveness generally and the impact of U.S. taxation on that competitiveness in particular is every bit as immediate and real as the concern of U.S.-based manufacturers.
To describe the impact of the 1986 Act on the international competitiveness of U.S. service companies, we have examined not oniy the foreign-income provisions of the 1986 Act, but aiso general and industry-specific provisions having significant impact on service companies' international competitiveness. In both areas, we have compared and contrastad U.S. tax treatment with that of Japan, the United Kingdom, West Germany, Switzerland, the Netherlands, Franca, Belgium. Sweden, Denmark, Cañada and Hong Kong, the eleven countries that are heme base for most major competitors of U.S.-based service companies.
Global versus Territorial income Taxation
United States
The United States taxes income earned by U.S. corporations from all sources, including income earned by foreign branches, dividends received from foreign sub sidiarias and in certain instances the unremitted profits of foreign subsidiarias. To prevent the double taxation of income from foreign sources, U.S. corporations can claim a credit dollar-for-dollar against their U.S. tax for foreign income taxes. The U.S. foreign tax credit is limitad, however, to the U.S. tax attributable to foreign-source taxable income or, if a corporation has a domestic loss, to the total U.S. tax liability. The 1986 Act retained the general principies of taxing woridwide income and eliminating international double taxation through a foreign tax credit, but made substantial changas in the practical appiication of those principles.i/
Foreign Countries
At obvious risk of oversimplification, we have summarized the essential features of the eleven foreign countries' tax systems in Table 11-1. (Appendix A contains exten siva footnotes to this table.) Our survey was basad on English-language descriptions of foreign countries tax systems supplemented by materials and information provided by overseas offices of Deloitte Haskins & Sells. Under their statutory law, six of those countries - Japan, the United Kingdom, West Germany, Sweden, Denmark and Cañada -- aiso tax their multinationals' woridwide income and eliminate international double taxation through a foreign tax credit. (West Germany, Ganada, and,to a lesser
1/ In addition to the changas described below, the 1986 Act provided that profit or loss of foreign branches and subsidiarles wiil generaily be translated into U.S. dollars using a profit-and-loss method, ratherthan a net worth method. In a hyper-inflationary economy, the profit-and-loss method incorporales the pureiy inflationary gains and losses reflectad in local currency prices and interest ratas, whereas the net-worth method does not. Although a net worth method may apparently be eiected by taxpayers. the legislativa history of the 1986 Act states that a taxpayer electing the net worth method for one qualified business unit (e.g., a branch in a hyper-inflationary country) might be required to eiect it for all qualified business units (including branches operating in countries with low to modérala inflation ratas). If such a requirement were imposed, U.S. corporations would have to choose between paying the U.S. tax on purely inflationary gains in hyper-inflationary countries or contending in all foreign countries with largely erratic foreign currency translation gains and losses of the sort which usad to arise for financial reporting purposes under Financial Accounting Standards Board Statement No. 8.
extent, Sweden exempts certain types of foreign income from domestic taxation when a tax treaty applies.)
By contrast, Switzerland, the Netherlands, Belgium, Franca, and Hong Kong generally have "territonal" tax systems under which business profits attributable to a domestic branch are subject to domestic tax, but profits attributable to a foreign branch and dividends received from a foreign subsidiary of a domestic corporation are gener ally exempt from domestic tax. Unless a tax treaty applies, countries with territorial tax systems generally allow a deduction from income, but not a credit against tax, for foreign tax withheid from foreign-source income (e.g., interest) earned by a head office or other domestic branch. Thus, territorial tax systems implicitly provide a strong tax incentive to earn foreign income through foreign branches and subsidiarles.
Income Earned Through Foreign Subsidiarles
United States
Prior to the 1986 Act, income earned by foreign subsidiarles of U.S. corporations generally was not taxed until dividends were remitted to U.S. shareholders. However, U.S. shareholders who separately or collectively "controlled" a foreign corporation were taxed to the extent the foreign subsidiary either had tainted ("Subpart F") income or were deemed to have remitted income by investing in tainted U.S. assets (e.g., a loan by a foreign subsidiary to its U.S. parent). Under pre-19B6 tax law, tainted Subpart F income was limited to:
- Certain passive foreign personal holding company income:
- Foreign base company sales income (i.e., sales income from property purchased from, or soid to, a relatad party in another country);
- Foreign base company service income (i.e., income from services performed in a third country for a relatad party);
- income from the insurance of U.S. risks;
- Shipping income, but oniy to the extent such income was not reinvested in shipping assets (as most such income was).
The 1986 Act significantly expended the types of passive income currently taxable to its U.S. shareholders. For example, gains on commodities, securities and foreign currency transactions are generally taxable unless specified trade-or-business tests are met. Securities gains of a regular dealer are excluded from Subpart F income. More significant for U.S.-based service companies, the 1986 Act provided for current taxation of:
- Dividends and interest earned by foreign banking, insurance and other financial service subsidiarias, aven whan such incoma is racaivad from unraiatad parsons and in tha activa conduct of a bona fida businass by I tha foraign subsidiary;
- Sacurity, foraign currancy and commodity gains not quaiifying for tha trada-or-business axcaptions (a.g., sacurity gains on invastmants hald for a daalar's own account);
- Incoma attributabla to tha issuing of any insuranca or annuity contract in connaction with risks in any country (not just tha Unitad Statas) othar than tha country in v\/hich tha insurar was craatad pr organizad: and
- Shipping incoma, aven if reinvasted in shipping assets.
Foreign Countrias
As shown in Tabla 11-1, four of tha tan foraign countrias includad in our survay ~ Switzarland, tha Natharlands, Balgium, and Hong Kong -- hava territorial tax systems under which dividends from wholly-ownad foraign subsidiarias ara ganerally axampt from tax aven when remittad and hava not anactad any provisions comparable to tha U.S. Subpart F rules. Two countrias - Swadan and Danmark - hava global tax sys tems and tax dividends from wholly-ownad foraign subsidiarias, but hava not anactad provisions comparable to tha U.S. Subpart F rules. Tha ramaining five countrias Japan, tha Unitad Kingdom, Wast Garmany, Franca and Cañada ~ hava anactad Subpart F-type provisions, but ganarally do not tax incoma derivad from bona fide banking, insurance, shipping or othar businassas whan racaivad from unraiatad par sons. Thus, tha typas of incoma includad in Subpart F by tha 1986 Act would not be taxabla to a parant corporation in any of tha elevan countrias includad in our survay.
Deamad-Paid Cradit
Unitad Statas
U.S. corporations may claim a foraign tax cradit for incoma taxas paid to foraign govarnmant by tha corporation itsalf (including its foraign branchas) and a daamad-paid cradit for incoma taxas paid by its foraign subsidiarias with raspact to thosa profits that ara aithar paid out as a dividand or ara taxabla as Subpart F incoma. Prior to tha 1986 Act, for daamad-paid cradit purposas, dividends paid aftar tha first sixty days of a yaar or within tha first sixty days of tha following yaar wara traatad as paid first out of that yaaris profits and than out of tha pravious yaars' profits undar a last-in-first-out (LIFO) ordering rula. Through careful yaar-to-yaar timing of foraign incoma tax and dividand payments, U.S. corporations could oftan maximiza tha daamad-paid foreign tax availabla for cradit relativa to dividand incoma and tharaby minimiza any residual U.S. tax.
r .cnL repealed the 60-day rule with the resuit that dividends paid in the first 60 days of a year are deemed to be paid from that year's profits. not the precedino year-s profits. Moreover. a forelgn subsidiary's post-1986 profits and income taxes wil! m cumulative. multi-year pools (sepárate pools are maintained for each oreign tax credit limitation category, as described below). Taken together these w- opportunities and thereby reduce the amount of deemed-paid credit available for those U.S. corporations with foreign subsidiarias «"«"^«ons in their
Foreign Countries
Of the five countries which próvida a deemed-paid foreign tax credit or an equivalent system, Japan and Denmark generally apply an annual vintage-account approach similar to the pre-1987 U.S. system. Subsidiarias of U.K. and West Germán natTTp to any particular ordering rule and can generally desig- nate the source or the year of the profits to be distributed. Profits subject to a high remeted bJp r" distributed. and lightiy taxed profits retained. Dividen^ received by a Canadian corporation from a foreign subsidiary are generally exempt from Canadian tax if the subsidiary is carrying on a business in a country wi h lich Cañada has. or is negotiating. a tax treaty. Other dividends are subject io Canadian tpv h ^
credit^cY ?f
essentially the same tax effect as a deemed-paid Hi!t h + 5 r f ^'"^^Se-account method. Dividends are deemed to be wh rh fi.rth exempt(treaty-country) surplus and second out of taxable surplus which further minimizas any chance that Canadian tax will be imposed. '
deemed-paid foreign tax credit. so absent a tax treatv exemptmg a foreign subsidiary's dividend from Swedish tax the dividend would hp potentially subject to economic double taxation. In addition. benmaXs Seemed-opid credit is limitad to dividends declarad at the shareholders annual meetinq from the LeXVs'íhe u's'deeme2°®'d"°^ dividends. Apart from these two tivrthPrt^l ; credit rules under the 1986 Act appear more restric- tive than those in foreign countries with comparable tax systems.
The foreign tax credit is generally limitad to the U.S tax attributable tn fnrpinn source taxable income, which equals foreign-source gross i coa tes r^a ed e "
Si ,1% olaTT' incide no. en; d rectly allocable ítems (e.g., depreciation of property used by a foreiqn branchl bis aiso a em ^ta share o. general and administratL expensas Sest e^inSS!
Prior to the 1986 Act, U.S. corporations were generally subject to an overa!! ümitation under which the tota! foreign tax credit was limited to the U.S. tax on overa!! foreign-source taxable income. Under an overall limitation, excess foreign tax with respect to a high-foreign tax category of income (e.g., interest income subject to a high foreign withholding tax and against which no deductions are aüowed) couid effectiveiy be offset against the U.S. tax on a second, low-foreign-tax category of foreign-source taxabie income ~ a phenomenon referred to as foreign tax credit "averaging."
The 1986 Act required that the foreign tax credit be calculated separateiy forthe foüowing "baskets" of foreign-source income:
- Interest, dividends, rents, royalties and other specified types of passive income;
- High-withho!ding-tax interest income;
- Financia! services income;
- Shipping income;
- Dividends received from each non-U.S.-controüed foreign subsidiary;
- Ai! other foreign income.
Specia! "iook through" rules generally require U.S. corporations to aüocate Subpart F income and dividends, interest, rents and royalties received from a controüed foreign subsidiary to the appropriate basket based on the nature of the subsidiary's underlying income out of which the dividend was paid or from which the interest, rent or royalty was deducted. The intended and certain effect of these rules is to curtai! foreign tax credit "averaging" by U.S. corporations.
In addition, the 1986 Act tightened the rules for allocating and apportioning interest and other expenses by requiring inter alia that interest and certain other ex penses incurred by affiliated U.S. corporations be apportioned based on the consolidated group's assets, ratherthan the sepárate assets or gross income of the corporation incurring the expense. Prior to the 1986 Act, U.S. corporations could minimize the impact of the interest allocation rules by shifting interest-bearing debt to an affiliate. Under the new Act, by allocating additional U.S. expense against those baskets of foreign income for which the foreign tax available for credit exceeds the limitation, the foreign tax credit is reduced and U.S. tax is increased.
Foreiqn Countries
As noted above, six of the eleven countries surveyed have a global tax/foreign tax credit system. Of those six countries, oniy Japan has an overall foreign tax credit limitatlon under which excess foreign taxes from one source can be offset against domestic (Japanese) tax on income from a low-tax foreign source. Three countries West Germany, Denmark and Cañada - apply a per-country limitation, and one -- the United Kingdom -- applies a per-item-of-income foreign tax credit limitation. Five of the six countries thus appearto limit foreign tax credit "averaging" in a fashion similar to that under the separate-basket approach instituted by the 1986 Act.
The degree of restrictiveness of the foreign provisions is often ameliorated, however, by other provisions in their laws. For example,the United Kingdom applies its foreign tax credit limitation separately with respect to each item of income (e.g., income from a particular sale), thereby apparently denying a U.K. corporation the ábility to "average" foreign taxes with respect to separata items of income from the same country of the same generic type. However, in appiying the foreign tax credit limitation, U.K. corporations.can elect the order in which various items of income and expense are taken into account. By taking high-foreign-tax items of income into account last, a U.K. corporation can avoid allocating any expense against that item of income, with the result that the foreign tax credit limitation equals the rate of U.K. tax applied to the amount of gross foreign income. U.K. corporations can aiso achieve substantial foreign tax credit "averaging" by interposing a foreign holding company between the U.K. parent corporation and its foreign operating companies. Because the U.K. does not have "look through" rules comparable to those enacted by the United States in 1986, the foreign holding company can combine high- and low-tax foreign income and dis tribute blended dividends to its U.K. parent. (With respect to bank lending, the flexibility of U.K. practico has been limitad by the U.K. Finance Act of 1987, which limits U.K. banks' credit for foreign withholding taxes on cross-border loan interest to the U.K. tax on such interest net of the financial cost of funding those loans. As under prior U.K. law, foreign withholding taxes in excess of 15 percent of the gross income are deductible, but not creditable. Where the cost of funding the loan is not readily ascertainable, the cost will be basad on LIBOR or soma other "just and reasonable" measure. Priorlaw treatment of loans outstanding on April 1, 1987 will be continuad for two years. Apart from potential differences in the amount of interest expense allocated against foreign source income, then, the primary differences between the U.S. and U.K. treat ment are: (1) the U.K. limitation is calculated for each cross-border loan separately and (2) U.S. banks, but not U.K. banks, are required to allocate or apportion other expenses and losses, such as G&A or bad loan write-offs, against such income.)
To take a less extreme case, West Germany appears to apply a per-country limitation and applies look through" rules to dividends received from foreign subsidiaries. However, as explained more fully below, West Germany has a spiit-rate tax
syst6rn und6r which rGtainGd Garnings ara taxGd at a 56 parcant rata and distributad aarnings at a 36 parcant rata. For purposas of appiying its foraign tax cradit limitation. foraign-sourca incoma tha Garman tax on which may ba offsat by a foraign tax cradit is daamad to ba distributad last and thus daamad to ba subjact to tha 56 parcant rata to tha extant that any incoma is taxad at that rata.
Datarmining tha axtant to which foraign countrias raquira Intarast and othar expansa to ba allocatad against foraign-sourca taxabie incoma was not simple bacausa foraign countrias' rulas in this araa are not as fully articulated as tha U.S. rulas ara. Most countrias in principia raquira at laast soma intarast expansa to ba allocatad against foraign-sourca incoma: no othar country appaars to apply tha intarast allocation raquiramants to tha consolidatad group takan as a whole, rathar than aach numbar saparataly.
In ordar to gain a battar imprassion of tha trua stringancy of othar countrias foraign-tax cradit limitation rulas, wa askad intarnational tax spacialists in tha ovarseas offices of Daloitta Haskins & Salís whathar tha foraign tax cradit limitation rulas wara a major concern of multinational corporations basad in that country, or whathar multinational corporations can ordinarily claim a full cradit for foraign taxas availabla for cradit. Tha ráspense was surprisingly uniform: tha foraign tax cradit limitation was not a major concern for most foraign-basad multinational corporations, full cradit could ganarally ba claimad for foraign incoma taxas. So whila a superficial analysis would indícate that tha 1986 changas in tha foraign tax cradit limitation rulas brought tha U.S. rulas into lina with thosa in othar countrias, on closar examination tha 1986 Act appaars to hava rastrictad U.S. corporations' usa of foraign tax cradit mora tightiy than foraign compatitors' tax systams do.
Tax Traatias
Tax traatias raprasant bilateral agraamants batwaan two countrias undar which, among othar things, ona traaty partnar eliminates its taxátion of spacifiad types of incoma arising'in that first country and earned by rasidants of tha sacond country (a.g., tha withholding tax on intarast) in axchange for tha othar traaty partnar's raciprocating with raspact to comparable incoma earnad by rasidants of tha first country. Tax traatias aiso ganarally provida for tha elimination of intarnational doubla taxation through aithar tax axamption or a foraign tax cradit by tha country of rasidanca. For countrias othar than tha Unitad Statas, tax traatias oftan provida foraign tax cradits and tax axamptions unavailabla undar domastic statutory law.
Tablas 11-2 and 11-3 summariza withholding tax ratas on intarast and dividends, raspactivaly, undar various countrias' statutory law and undar its bilateral tax traatias. Whara no bilateral tax traaty applias, or whara tha tax traaty rata axcaads tha statutory rata, incoma would be taxad at tha statutory tax rata. By raading across tha rows of thasa Tablas, ona can compara tha withholding tax ratas applied to dividends and
&
Interest on debts smnired by nortgag., on real «atat. and interest on convertible bonds + incone bonds are subject to 25* withholding tax,
mte^'nl^LrJ"""T" convertible bond, and on incoo» bonds.
Fifteen percant if recexvabl.. collateralized by real estáte located in Italy withholding on re»ittance after withholding of incoae tax. Zaro for loans approved by central banh itnnoiaing May not yet be ratified.
Nine perc^t for loan intarast granted for eore than thre. years by a foreign financial institución in ordar to finance investaents. I^wer rata if recipient financial institución is registered with the Treasury Departaent. Interese on foreign loans exeopt or partially exMpt:
Repaynwnt Period (Including Moratoriua)
MAXIMUM AND DEEMED WIIHHOLDIMG TAX RAIES UNDER BILATERAL TAX TREAIIES ON DIVIDENDS PAIE BY RESIDDÍTS OF DEVQiOPQ) AND DEVELOPING COUNTRIES 10 BANKS XN DEVELOPED COUNIRIES
DEVELOPO & DEVIXOPING STAIÜTORY
COUNTRY WIIHHOLDING
RESIDENCE OF TAX RAE BORRDWER IN
Zero rata until 1989 undar naw Traaty.
Five percent of siá of diridand and 1/2 dividand tax cradic.
Dividands in axcasa o£ 12X par aiutun on a 3-yaar novlng aTaraga of tha actual ragistarad iitrastaant ara alao subjact ta "supplmantary taxas" at ratas froa W) to 60X.
Lasa ioX cradit prorldad eorporation has paid Cha first catagory incoaa tax.
u(A unlasa taxad at a rata no lowar than 28X in tha racipianta' country.
Lowar rata appliaa only if racipiant country doaa not tax, or próvidas tax cradit cradit or othar raliaf.
interest, respectively. received by U.S. corporations to the withholding tax rates applied to comparable income received by otherdeveioped country corporations.
Generaiiy speaking, with respect to dividends and interest having their source in other developed countries, U.S. corporations pay withholding taxes at rates comparable to, or lower than, those for corporations based in other developed countries. With respect to dividends and interest having their source in other developing countries, U.S. investors, unlike their foreign competitors, are often paying withholding tax at the higher statutory tax rate ratherthan a lower treaty rate.
The limited number of U.S. tax treaties with developing countries refleots the U.S. policy opposition to "tax sparing" provisions under which the United States would give a credit for taxes which the developing country might otherwise have imposed, but were spared to attract additional investment. Other developed countries, by contrast, have generaiiy been willing either to exempt income derived from developing countries from home-country tax or to give foreign tax credit for amounts in excess of income taxes actually paid. The result, as noted above, is that U.S. corporations are often subject to the higher statutory withholding tax rates on interest and dividends from developing countries, not the lower tax treaty rates that their foreign competitors often enjoy.
General Tax Provisions
United States
In order to evalúate the impact of the U.S. tax system on companies with foreign operations, it is important to look not oniy at provisions pertaining specifically to foreign income and taxes, but aiso to general provisions that apply to foreign as well as domestic income. Foreign income, like domestic income, benefited significantly from the reduction in the máximum rate of the regular corporate income tax from 46 percent to 34 percent effective July 1, 1987(a blended rate of approximately 40 percent applies to calendar year 1987). This rate reduction considered in isolation will result in a substantial tax saving for U.S.-based service companies, and its effect must be weighed against the base broadening measures described above and below in assessing the impact of the 1986 Act on U.S. companies' international competitiveness.
The Accelerated Cost Recovery System (ACRS) was modified to create addi tional classes of depreciadle property, to reclassify some property to new classes having a longer useful life and to apply a more accelerated depreciation method to short-lived property. Property used predominately outside the United States continúes to be depreciated over a longer life than domestic property, and the use of accelerated depreciation for such property was replaced by straight-line depreciation. The regular investment credit was repealed for property (other than grandfathered "transition property )placed in service after 1985. Moreover,the amount of investment credit
To assure that ai! corporations earning more than de minimis income for financia! reporting purposes wiil pay some tax, Congress aiso enacted in 1986 the Alternativa Minimum Tax (AMT). The AMT generaily equals 20 percent of alternativa minimum taxable income, whioh is calculated by restating regular taxable income (taking account of the new base-broadening rules) to include oertain AMT adjustments and preferences and then adding 50 percent of any remaining differenoe between tentativa AMT income and adjusted book income. For example, AMT taxable" income is adjusted by the amount of the differenoe between regular depreciation and less accelerated "alterna tiva" depreciation. Up to 90 percent of the AMT can generaily be offset by the foreign tax credit, but not by othertax credits (a limitad exception is available for the investment credit claimed with respect to "transition" property or carried ovar from years prior to 1986).
The 1986 Act also repealed or modified oertain deductions and other provisions for specific service industries. Commercial banks have traditionally been allowed a deduction for the net addition to a bad-debt reserve, which is the liability for bad debts which have not been specifically identified as such, but which the bank projects it will suffer basad on its past experience with similar debts and other factors. Under prior law, a formularly deduction basad on a bad-debt reserve equal to 0.6 percent of eligible loans was scheduled to expire at the end of 1987, leaving only an alternativa "actual experience" method. Under that latter method, the bad-debt reserve was computad by multiplying the bank's outstanding loans at the end of the year by a fraction, the numerator of which was the sum of the bank's oharge-offs for actual bad debts for the ourrent and five preceding taxable years, and the denominator of which was the sum of the loans outstanding atthe olese of each of those years.
The 1986 Act repealed the bad-debt reserve deduction for "larga" banks (generaily those with assets in excess of $500 million), with the result that bad-debt losses cannot be deducted until specific loans are determinad to be partially or totally worthless. Moreover, such banks must recapture (i.e., include in taxable income) ratably ovar the four years 1987-90 the accumulated bad-debt reserve outstanding at the end of 1987.
The 1986 Act also made significant changas in the taxation of insurance companies. In the case of life-insurance compañías, the special deduction equal to 20 percent of a life-insurance company's taxable income, which reduced the máximum effective rata of Federal tax from 46 percent to 36.8 percent, was repealed for years after 1986. Thus,the effective rate of tax for life insurance compañías for calendar year 1987 will increase from 36.8 percent to approximately 40 percent before declining to 34 percent for years after 1987. For mutual life insurance companies only, the deduction
for policyholder dividends was reduced by a formulary "differential earnings amount" to achieve an historical 55-45 balance in the tax burden of mutual versus stock Ufe insurance companies and to offset the competitive advantage mutual Ufe insurance compa ñías were allegad to have on account of the deductibiilty of policyholder, but not stockholder, dividends.
The 1986 Act aiso overhauled the taxatlon of property and casualty Insurance companies to provide that:
The deductlon for losses Incurred was reduced by an amount to reflect a time-value of money adjustment for the difference between the time the pollcy Is In effect and the loss Is Initlally accrued and the time It Is expected to be pald;
- The deductlon for losses Incurred was further reduced by 15 percent of tax-exempt Interest plus the deductible portion of dividends recelved from unaffillated corporatlons;
- In Ileu of capitalizing pollcy acquisitlon costs (e.g., agents' commlsslons), property and casualty Insurance companies are currently taxable on 20 percent of the amount which would otherwlse be added to their unearned premium reserve (l.e., premium recelpts whIch would otherwlse be capitallzed and restored to Income ratably over the period the Insurance pollcy was In effect):
Note that these changas generally apply not oniy In determining the taxable meóme of a U.S. corporation (including Its forelgn branches). but aiso In calculating u pail F income and, for deemed-paid forelgn tax credlt purposes, the profits out of which dividends are pald. The Subpart F Income of a forelgn banking subsidlary would generally be calculated without deductlon for any bad-debt reserves, and that of an insurance subsidiary by discounting Its loss reserves and expensing 20 percent of the addition to its unearned premium reserve. Thus. the general base-broadening measures and the Subpart F income measures have greater combinad effect than the sum of the effects ojthe two provislons taken separately.
Forelgn Countrles
1 1 •*
forelgn countrles' máximum corporate Income tax ratas to that ¡n the United States is complicated for those countrles whIch partially or fully Intégrate corporate-level and shareholder-level taxes to relieve the double taxatlon of corporate profits distributed as dividends. in West Germany and Japan, a reduced rate of cor porate tax apphes to distributed profits, so the weighted-average rate of corporate tax decrease as the portion of profits distributed to shareholders Increases. Moreover
^he United KIngdom, France, Belgium, Denmark, and Cañada allow domestic shareholders to claim credit for parí (and. In the case of West Germany, all) corporate-level tax imposed on the profit out of which the dividend was
paid. If that part of the corporate tax is considerad to be the equivalent of a shareholder-level tax for which the corporation is the withholdinQ agent, rather than to be a corporate-level tax, the weighted-average rate of corporate tax rate in all those countries would be further reduced.
With this in mind, Tabie 11-1 indicates that two countries - Sweden and Denmark" had corporate tax rates of 56-58 percent and 50 percent, respectiveiy, higher than even the 46 percent U.S. rate under pre-1986 law.2/ Assuming that 50 percent of before-tax profits are earmarked for corporate-level tax, the weighted average Japanese, Germán and Canadian corporate tax rates appears to be comparable to the prior-Iaw U.S. rate of 46 percent, and the French, Belgian, and Netherlands cor porate rates are 2-3 percentage points less than the oíd 46 percent rate. The United Kingdom rate of 35 percent would be comparable to the 34 percent U.S. rate that carne into effect on July 1, 1987.3/ Switzerland generally applies somewhat lower rates of tax than the new 34 percent U.S. rate, while the rate in Hong Kong is substantially lower than the U.S. rate.
In summary, foreign countries tax corporate income at widely varying weighted average effective tax rates. The 46 percent rate under prior U.S. law was a comparatively high rate, but not as high as the rates in Sweden or Denmark. The 34 percent rate under current U.S. law is certainly below average, but not as low as the rates in Switzerland or Hong Kong.
We also sought to compare the United States rules with respect to banks' baddebt reserves and the discounting of loss reserves of property and casualty insurance companies with comparable provisions in foreign countries. In sum, Japan, West Germany, Switzerland, the Netherlands, France, Sweden, Denmark and Cañada all allow their banks some form of a bad-debt reserve deduction, whereas the United Kingdom, Belgium and Hong Kong do not. None of the eleven foreign countries included in our survey required property and casualty insurance companies to discount losses incurred, but not paid, in the current year. In short, the 1986 elimination of U.S. bad debt reserve and the discounting of property and casualty insurance company provisions will impose U.S. tax burdens that with limited exception have no counterpart in foreign countries' tax systems.
2/ Tabie 1 refiects federal or national income taxes, but generally not income taxes imposed by subfederal or sub-national jurisdictions except in those cases where such taxes are automatically imposed on income earned through foreign branches of domestic corporations (e.g., the Japanese Inhabitants tax). The application of sub-federal or sub-national taxes to foreign source income (e.g., through the inclusión of foreign subsidiaries in a unitary group, the income of which is subject to apportionment in determining a state's taxable income) is an extremely complex question and beyond the scope of this survey.
3/ If corporate taxes for which individual shareholders claim credit are excluded from corporate-level tax, the effective rate of the Japanese, French, U.K., Canadian and particularly the Germán effective tax rates would be reduced further.
Impact on Competitiveness
To assess the impact cf the 1986 Act on the Internationa! competitiveness of U.S. based service industries, one must weigh the tax savings from the 12 percentage point reduction in the corporate income tax rate against the additional U.S. tax resulting from the extensión of Subpart F to interest, insurance and shipping income, the new restrictions on the foreign tax credit limitation, the modifications in the deemed-paid credit rules, and the various base-broadening changes. Necessarily, the impact will vary from industry to industry depending on the rate at which foreign income is taxed in its source country, the incidence of the Subpart F,foreign tax credit limitation rules, and possibly other factors.
Because across-the-board generalizations are diíficult to make, we have sought to assess the impact on a typical investments or activities within a given industry. In performing this analysis, we focused on five service industries -- advertising, commercial banking, investment banking, insurance underwriting, and ocean shipping -- all of which have substantial operations outside the United States and which we believe represent a fair cross section of the service industry. Details of our analyses are set forth in Appendices B-F of this Report and are oniy summarized here.
We have measured the impact of the 1986 Act on international competitiveness by the percentage increase (or decrease) in the amount which U.S.-based companies would have to charge foreign clients for various types of services in orderto achieve the same after-tax profit as they would have achieved under pre-1986 U.S. tax law. As analyzed more fully in Part II of this Report, whether a U.S.-based company could increase its price by that amount without alienating or losing its clients depends, of course, on how competitivo foreign markets for its services are. At one extreme are the highiy specialized services (e.g., merger and acquisition advice) where well-heeled clients may care less about the cost and more about the quality of the service they receive. At the other extreme are the "commodity" services where international com petitiva condjtions may preclude even a 1 percent increase in the charge for the service (e.g., increasing an interest rate charged to a foreign borrower from 10.0 to 10.1 percent per annum). Thus, depending on the context, a 1 percent increase in price may have limited impact on a business or may be sufficient to price a U.S. company out of a hiahiv competitiva market.
Advertising Services
Companies providing personal services ~ that is, services performed by individu áis - have historically been subject to relatively high effective income tax ratas in most countries. At least with respect to their U.S. income, advertising agencies benefitted significantly from the reduction in the corporate rate from 46 percent to 34 percent. Given cultural differences among countries, U.S. advertising agencies can rarely serve foreign clients (including foreign subsidiarias of U.S.-based multinationals) effectively
from the United States or from some low-tax third-country location. Thus, even under prior U.S. law, U.S.-based advertising agencies typically paid foreign taxes equal to or in excess of their foreign tax credit limitation and derived iittie or no benefit from the deferrai of U.S. tax earned through a foreign subsidiary. As a consequence, the reduction of the U.S. rate from 46 percent to 34 percent will result primariiy in foreign tax avaiiable for credit in excess of the U.S. limitation with iittie or no U.S. tax saving.
In the case of a U.S.-based advertising agency serving foreign clients through foreign subsidiaries, we estimate that fees charged to foreign clients would be increased by 1 percent to maintain the same incremental after-tax profit as obtained under pre-1986 law. This result contrasts sharply with an estimated 6 percentage point decrease ín the fee the advertising agency would have to charge if it could serve foreign clients from its U.S. offices without incurring significant foreign taxes in the process. Given the nature of the advertising business however, serving foreign clients from the United States rarely makes good business sense.
Because foreign-based advertising agencies are generally able to claim full domestic credit for foreign taxes paid, the 1986 Act burdened U.S.-based advertising agencies not oniy in comparison to prior U.S. law, but also in comparison with their foreign competitors.
Commercia! Banking
High-Withholdinq Tax Interest
Interest on cross-border loans is often subject to withholding tax at rates of 5 percent to 25 percent (or more). Because withholding taxes are imposed on gross interest - that is, no deduction is allowed for interest and other costs of making the loan "such taxes often exceed the U.S. tax attributable to the r^ income from such loans. Traditionally, U.S. banks and other lenders were able to offset the excess foreign withholding ta)f against the U.S. tax on other, low-tax foreign-source income. Subject to rules "grandfathering" certain outstanding loans, the 1986 Act precludes such foreign tax credit "averaging" in the future by subjecting high-withholding-tax interest to a separata foreign tax credit limitation.
In addition to the separata foreign tax credit limitation for high-withholding-tax interest, crossborder lending also suffered from the requirement that additional interest and other expenses be apportioned against foreign-source income in computing the foreign tax credit limitation and the repeal of the bad-debt-reserve deduction. In the numerical example described at length in Appendix C,the rate of interest charged on a cross-border loan would have to be increased from 8.5 percent per annum to 9.2 percent per annum, an increase of 8 percent.
Foreign banks basad in countries with foreign tax credit systems by statute (e.g., Japan and the United Kingdom) or by treaty often do not appear to face similar restric-
tions on foreign tax credit averaging and thus will enjoy a significant, tax-based competi tiva advantage ovar U.S. banks. Moraovar, as notad abova, tha Unitad Statas has a mora limitad natwork of tax traatias with daveloping countrias than do othar davalopad counthas, so U.S. banks may ba subjact to foraign withholding tax at highar ratas than ara thair foraign compatitors.
Othar Commarciai Banking incoma
U.S.-basad commarciai banks earn foraign source income othar than highwithholding tax intarast. Soma of this othar income will be subjact to ralativaly high ratas of foraign tax at sourca (a.g., profits from branches and dividands from sub sidiarias locatad in various high-tax foraign countrias), wharaas othar foraign incoma may aithar ba axampt from foraign tax or sourcad in countrias with comparativaly low ratas of tax (a.g., Switzarland and Hong Kong).
Tha impact of tha 1986 Act on othar foraign incoma of commarciai banks dapands on tha complax intarplay of savaral factors: (1) tha rata of foraign tax on such incoma, (2) whathar or not such incoma was aarnad through a foraign branch or a foraign subsidiary,(3) if aarnad through a foraign subsidiary, whathar incoma is intarast or similar incoma taxabla under tha extended Subpart F rulas or raprasants feas for sarvicas or othar incoma exciudad from Subpart F, and (4) whathar tha bank will hava foraign tax availabla for cradit with raspact to its financial sarvicas incoma graatar or lass than tha U.S. limitation with raspact to such incoma.
Tha principal "winnars" undar tha 1986 Act wara thosa catagorias of incoma aarnad through foraign or domastic branches and subjact aithar to low ratas of foraign tax or, providing tha U.S. bank has axcass foraign tax cradit limitation, to a high rata of foraign tax. Dapanding on tha spacific circumstancas, a U.S. bank could reduce its feas or othar chargas by up to 2 parcant with raspact to such incoma. Nota that with raspact to low-tax incoma, U.S. banks will gain competitiva advantage with raspact to foraign banks subjact to domastic tax on such incoma and narrow, but not eliminata, tha com petitiva disadvantaga vis a vis banks from countrias which imposa tax at a lowar rata or exampt such incoma from domastic taxation.
Tha obvious "losar" from tha 1986 Act was tha foraign subsidiary oparating in a low-tax foraign country, remitting littia or nona of its profits to tha Unitad Statas, and earning intarast and othar income subjact to tha expandad Subpart F rulas. In such a casa, tha sama aftar-tax profit margin could be attainad oniy if intarast or othar incoma could ba raisad by approximataly 5 parcant (a.g., incraasing tha avaraga intarast rata from 10.0 parcant to 10.5 parcant). Bacausa no othar country saaks to tax comparable foraign banking subsidiary incoma if derivad from unralatad partias, U.S.-basad banks will ba at a claar competitiva disadvantaga with raspact to such incoma.
Investment Banking
Our analysis of investment banking leads to essentiaily the same conclusions as that for commercial banking income other than high-withhoiding tax interest. The chief benefit is the reduced U.S. tax rate. Offsetting this is a broader application of Subpart F. Investment banking is fee income oriented, so the impact of Subpart F is generally not great, although dividends, interest and other gains on assets held for the investment banking affiliate's own account would, for the first time, come under Subpart F. Because profit margins as a percentage of gross income tend to be higher in investment banking than in commercial banking, however, the impact of the tax savings from the U.S. corporate rate is relatively larger for investment banking than for commercial banking.
On the whole, we estimate that the benefits to investment banking firms of the corporate rate reduction outweighed the harm that was inflicted by the extensión of the Subpart F rules and the changes in the foreign tax credit limitation rules. In the case of income earned though foreign branches or subsidiarias, the net effect would be, we estimate, to allow fee reductions in the neighborhood of 1 percent. Larger reductions of 3-4 percent would be possible for investment banking services rendered from U.S. offices, providing significaní foreign withholding faxes can be avoided. As in the case of commercial banking, significant U.S. tax burden was imposed on high-withholding-tax interest investment bankers earn on debt securities held for their own account and on any interest and other income earned through foreign subsidiarias.
Whether or not U.S. investment banks enjoy a competitiva advantage ovar foreign banks on account of the rate reduction depends on whether such income would be currently taxable to the foreign investment bank and, if so, at what rate. Where such income is taxable at a relatively high rate (e.g., Japan), U.S. banks have gained an advantage. Where income is taxed at a rate lower than, or comparable to, that in the United States (e.g., the United Kingdom and Switzerland, respectively), the prior-law competitiva disadvantage of U.S. banks has been reduced or eliminated. Where such income is earned through a foreign branch exempt from domestic tax under a country's statutory law or by tax treaty, foreign-based banks would continué to have a significant competitiva advantage vis-á~vis U.S. banks.
Insurance
The insurance industry was particularly hard hit by the extensión of Subpart F to premiums and other income from insuring third-country risks and to interest, dividends, and other income from the investment of insurance reserves (including those relating to same-country risks). Moreover, in calculating the amount of Subpart F income, U.S. property and casualty insurance compañías must apply the domestic rules relating to the discounting of loss reserves, the 20 percent disallowance of additions to the unearned premium reserves and other general base-broadening rules. Similarly, in
calculating Subpart F income, U.S. life insurance companies must base their reserves on U.S.-based mortality and morbidity statistics and U.S. reserve-investment-yieid assumptions.
Based on the numerical examples in Appendix E, we calcúlate that a U.S.-owned property and casualty insurance subsidiary would on average have to increase its premium by 6.5 percent to obtain the same atter-tax profit ¡t would have obtained under prior U.S. tax law. Because no other country taxes comparable income earned by its insurance companies' foreign subsidiaries, the additional U.S. tax resulting from the 1986 Act puts U.S. insurance companies at a disadvantage with respect to such income.
Ocean shipping consists of two distinct segments, both of which were severely impacted by the 1986 Act, but for different reasons. U.S. maritime laws require that certain types of shipping be undertaken by U.S. corporations (or other U S entities) using vesseis registered (or "flagged") in the United States. The income of U.S. ship owners is taxable when earned, but qualified for the accelerated depreciation and the investment credit under pre-1986 law. Because of the declaration of ACRS deprecia tion and the repeal of the investment credit, we estimate that for a shipowner able to fully utilize prior-law deductions and credits the cost of U.S.-flag ocean shipping could be increased by as much as 12 percent. The impact would be less to the extent the U.S. shipowner was operating at a loss and was torced to defer its tax savings from accelerated depreciation and the investment credit.
Foreign-flag shipping has traditionally been undertaken by U.S. shipping compa nies through foreign subsidiaries, which avoided prior-law Subpart F taxation by reinvesting profits in shipping assets, which was easily done in this highiy capital intensiva industry. The repeal of the Subpart F exclusión for reinvested shipping profits would require, we esrimate, a 4 percent increase in shipping rates. Given the substantial foreign competition in this industry, none of which are subject to comparable Subpart F taxation, the impact on international competitiveness appears severe,to say the least.
III. The Impact of Tax Changas on US Services Exports and Foreign Affiliate Sales
The Policv Settiní
The United States faces a severe problem of external adjustment Because of an excessively strong dollar in the early I980s, as well as ah Uhusuaí^arge 03^0° foreign resources to bndge the gap between domestio resouroe use and availabilitv spurred by large fiscal déficits,the United States has shifted from an externalSon o^ approximate balance in 1980 to a trade déficit of $166 biiiion in 1986 (and a current account déficit of $139 biiiion, or 3.3 percent of Gross Nationai Produm)' t couW take two years or more for the recent decline of the doiiar to bring a substantiai turnaround fis"caMef¡c¡tT" tiepreciation may be necessary (in addition to correction of th¿
intern Of large déficits has abruptiy turned the United States inte a net ternational debtor country. From a creditor position of $150 biiiion at its peak in 1981 the countiy s net position on international investments turned to indebtedness of $264 biiiion at the end of 1986, and the excess of liabiiities over assets ¡srBiv tr,.«i nsing to at ieast $500 biiiion and conceivably as high as $1 triiiion by thl earit I990s' inchirio T'® "■^"s'ormation are oniy dimiy perceived as yet 1/ They couid rs^:rrgrwT.rn=bie^^inrsre,rs;:ii¿f.¿s rSicrrtts,rrururrner::;grdU:tm's forefgné'rs"^ Americans, who wiii no iongerowe nationai debt "tothemseives" butto
to review both the policy context of trade in services and the available data describing its features and dimensions.
In recent years U.S. ofíicials have stressed the importance of the service sector to U.S. exporta. Monetary authorities pressed hard for liberalization of the Japanese financial market and access of U.S.firma to participation in it. Trade officiala inaiated on inclusión of the services sector in the multilateral trade negotiations of the recently launched Uruguay Round, over considerable opposition from some countries (India and Brazil in particular). The centrality of services reflecta the perception that these sectors are dynamic and that the United States possesses the factors of production -- skilled manpower, capital, and the presence of a robust domestic market and experience in the sectors -- conducive to "comparativo advantage" in services.
There is clear evidence on the dynamism of the services sector. Table 1 indicates growth over the first six years of this decade in major sen/ice sectors in comparison with major sectors of manufactured goods. It is evident that oniy the "sunrise" goods sectors (such as computers) managed to perform as well as services, while traditional manufactured goods and agriculture lagged far behind.
The evidence is less clear on the comparativo advantage of the United States in services trade. Indeed, oven the base of information on trade in services is fragmentary. in terms of the balance in external accounts, it is well known that for many years the United States has had a surplus on "services," but that bread category includes both factor services (interest and dividend income from investments abroad) and the non-factor services that usually are referred to when considering potential servicesector activity as an area for expanding U.S. competition abroad.
Balance of payments statistics have been less than firm in capturing non-factor services transactions. For goods, the statistics can rely on customs data with thousands of detailed categories. But services traditionally have been the residual portion of the balance of payments, in which tens rather than thousands of categories attempt to capture the transactions that do not fit neatly elsewhere. Inadequate separation of services activities from goods sales to which they are linked has been one of several sources of weakness in standard data.
The Congressional Office of Technology Assessment has recently compiled a special study on trade in services.5/ The OTA analysts built upon existing Commerce
5/ U.S. Congress, Office of Technology Assessment, Trade in Services: Exports and Foreiqn Revenues (Washington: OTA, 1986).
Department data through reference to company reporta in the industry, interviews, data from cther government agencies, and the financia! press. Table 2 reports the' OTA estimates of U.S. exports and foreign affiliate sales of services for 1984. (Note that the figures of Table 2 apply the average between the low and high ends of the rangas reportad by OTA, which in the aggregate are 12 percent below and above the midpoint, respectively, for services exports.) The Table aiso indicates the Commerce Department's most recent estimates, which are relatad to balance of payments statistics with respect to exports of services (that is, direct sales abroad by U.S. firms), and are drawn from surveys of foreign investment with respect to sales of majority-owned foreion affiliates (MOFAs).
As indicated in the Table, direct exports of non-factor services in 1984 were estimated by OTA at $77 billion, and on the basis of the Commerce data were at least $49 billion. Considering that total U.S. merchandise exports were oniy $217 billion in 1986, these estimates indícate that non-factor service exports add between one-fourth and one-third to the earnings available from exports of goods alone.
In addition, as indicated in the Table, foreign affiliates earn between $58 billion (Commerce) and $92 billion annually (OTA). In both sets of estimates, foreign affiliate sales exceed direct exports. Based on the disparity between export volumes and the magnitüde of foreign affiliate sales, some authors have stressed that the salience of services in recent trade negotiations really reflects the importance to U.S. service firms of the right of establishment for direct investment in foreign markets rather than traditional negotiation for export opportunities.6/ While the magnitüde of affiliate sales is clearly consistent with a strong interest in this objective, the estimates in Table 2 are aiso consistent with interest in direct exports. Indeed, if "retailing" is excluded from the OTA estimate for foreign affiliate sales, it is actually smaller than the estimate for direct exports.
^ The fact that affiliate sales are nonetheless at least as important as exports highlights the point that in terms of international competition and market penetration by U^S. firms, direct exports are oniy a part of the overall picture. While the importance of affiliate sales in overall market penetration is relatively well known with respect to goods w n®' "Intemational Competition in Services," National Bureau of Economic Research by U.S. Multinational Firms, (Cambndge, Mass.: Nationai Bureau of Economic Research, 1986). Note anH T services, such as investment banking large-voiume contributors to services exports as tourism and even shipping, on grounds that it is the new areas that have been given the most attention in the trade negotiations
a. Total expenditure on advertising
b. Loans outstanding
c. Valué of new construction put in place d. Premiums
e. Contribution to GNP
f. 1981
g. 1982
h. 1984
i. 1985
Source: Department of Commerce, 1987 Industrial Outlook,
e.
(for example, in transactions with Japan, where the bilateral U.S. déficit including affiliate sales is far smaller than the bilateral trade déficit),?/ it is noteworthy that the same phenomenon is present in services, and perhaps to a larger degree.
In the dimensión of contribution to net earnings of foreign exchange, however, exports dominate foreign affiliate sales. On the assumption that perhaps 15 percent of foreign sales remain after foreign taxes, labor, and other costs,then on the basis of the OTA estímate sales by affiliates contribute approximately $14 billion annually to the net U.S. foreign exchange position, a major contribution but oniy about one-fifth of the foreign exchange earnings from service exports.
Several of the categories reportad in Tabla 2 warrant clarification. The largest export categories are transportation, travel (foreign tourist expenses in the United States), banking, insurance, construction, and licensing (including royalties and Tícense feas).
In insurance, activity is measured in the OTA estimates by premiums net of claims paid and reinsurance passed on to third partías. In the absence of reliable data on claims paid internationally, the estimates apply typical ratios from domestic industry experience. An important part of insurance company earnings comes from interest and dividends on assets, but is excluded from the estimates here because it is factor income.
Retail and wholesale trade are problematic in that estimates must be based on trade margins rather than total sales. The OTA data include a large estímate for retailing earnings of affiliates ($25 billion), which by itself accounts for the great bulk of the difference between the OTA and Commerce estimates for affiliates (as the Commerce data exelude this sector). In contrast, the Commerce estimates attempt to capture services that are "bundled" with sales of goods, as indicated in the final set of sectors (for example,"manufacturing").
It should be stressed that trade in services is conceptually different from trade in goods in that the classic movement of goods across borders is not necessarily, or even usually, present. The exporting of services may involve movement of the service from the United States to the foreign market (for example, an insurance policy soid from a home office to a foreign customer); movement of the foreign consumer for use of the service in the United States (as in the case of tourism, educational services, and fees
7/ C. Fred Bergsten and Wiiüam R. Cline, The United States-Japan Economic Probiem (Washington: Instituía for international Economics, 1985), p. 108.
earned from foreign carriers in U.S. ports); and even transaction in the no-man's land between nations, as in ocean shipping.
Nonetheiess, the conceptual basis for the service export ís similar to that for goods exports: foreign persons or firms make purchases from U.S. firms or persons of services that require the mobilization of labor, capital, and human capital resources for the production of the activity in question. The directions of the flows of production and (conversely) payments define the "export," rather than the geographical location of the transaction.
There are other important paralleis between service and goods exports. One of the more intriguing emerges from the case studies developed below. In several sectors, the principal competition of a U.S. firm in a foreign country tends to be the national firms of that country, with competition from large international firms from third countries oniy secondary. This pattern is analogous to the position of a goods exporten The first competition an exportar faces in a foreign country will be the national firms that have brand allegiance and local infrastructure within that country. The competition from third-country international firms in that national market typically will be secondary.e/
The OTA ñas preparad estimates of U.S. imports of non-factor services and U S sales by affiliates of foreign firms, comparable to its estimates of U.S. service exports and affiliate sales to foreigners. The central estimates are that in 1984 the United States importad $56.7 billion in non-factor services and in 1983 purchased $71 6 billion from U.S. affiliates of foreign firms.9/ The United States thus had a surplus of $14 billion m direct services trade, and a surplus of $20.8 billion on sales of affiliates. That the United States ran sizeable surpluses in the service sector in 1983-84 even as the balance on merchandise trade was plunging into deep déficit suggests that the bread perception that the United States has a comparativa advantage in services is not misplaced.io/ In turn, the view that services are an important area of U.S. comparativa advantage underscores the importance of ensuring that U.S. competitiveness in these sectors is not eroded by new impediments, tax orotherwise.
altematlve sources of competition ~ host country national firms and third-country international firms - correspond to the altematlve statistical procedures of calculating trade-welqhted real exchange rata or olher oompellliverrass indaxas on a bilateral or multilateral Oasis,respe^riy.)
9/ OTA,Trade In Services. p. 42.
10/ For just exports and Imports of services, the surplus of $14 billion amounted to 11 percent of total turnover (exF^rts plus imports). If the merchandise trade account had performed as well in 1984 merchandise trade would have been in surplus by $61 billion instead of in déficit by $123 billion.'
Because of its importance In the determination of trade policy, employment is of special Interest in a review of U.S. services exporte. It Is possible to use the service expon data of Table 2 In comblnatlon wlth estimates of sectoral labor coefficlents to estímate the number of U.S.jobs assoclated wlth service exporte.
Table 3 presente estimates of the dollar valué of sales revenue per worker In several of the principal services sectors. The estimates for "exporte" are obtalned from U.S. Department of Commerce data on groes revenue and number of employees In each service sector In 1984. It Is assumed that the labor coefficlents for service exporte are the same as those that apply to the entire service sector, domestic and export. For comparison,the Table reports estimates of sales revenue per employee In MOFAs wlth U.S. párente,from Commerce Department surveys.
For the ten sectors In which labor coefficlents may be estimated for the Unlted States, the most labor Intensivo (lowest sales revenue per worker) Is travel services (tourism). The least labor Intensiva Is Insurance, although for this sector the revenue measure, premiums,tends to be overstated In comparison wlth most activities. Thus, a more typical service sector wlll have revenue equal to bllllngs for services rendered (or, In manufacturing, gross sales, equal to valué added plus the valué of Intermedíate Inputs). In contrast, Insurance premiums are a mixture of placement of funds for Investment, on one hand, and payment for actuarial, accounting, marketing, and related professional services, on the other. The "capital placement component of the premium enlarges the measured revenue relativa to required labor for selling, accounting, and so forth. The other sectors tend to have labor coefficients wlthln a relatively narrow range (some $50,000 to $70,000 per worker), wlth telecommunlcatlons the other exception of high revenue per worker (as would be expected In view of the highiy capital Intensiva nature of the sector).11/
11/ Transportation is another capitai-intensive sector. The figure contained in the U.S. Department of Commerce source listed in Table 3(Industrial Outlook) is oniy $41,275 per job. However, this estímate refers to "contribution to GNP" (in ocean transportation), a much narrower concept than total revenue. The estimates here apply instead a ratio of $200,000 revenue per worker, calculated from the annual reports of the largest U.S.-flag shipper, Sea-Land Corporation, which had gross revenue of $T6 biiiion and employment of 8,000 in 1985. Sea-Land Corporation, Annual Report 1985, p. 14, and CSX Corpora tion, Financia! Supplement to the 1986 Annual Report, p. 65. Note that the higher estímate used here is closer to the revenue per worker figure for foreign affiliates than to the Commerce Department "contribution to GNP"figure.
Table III-3
Revenue Per Job, 1984 (dollars)
a. Estimated as 15 percent standard fee share of gross spendinq on advertising. ^ ^
b. Premiums, Life and Casualty companies.
c. "Finance except banking".
d. Ocean transport.
e. Transportation, communication and public utilities exceot petroleum. ^
f. Hotels.
Sources; rjs Department of Commerce; 1987 US Industrial Outlook (Washington: Department of Commerce, 1987); Irving B. Kravis and Robert E. Lipsey, "Production and Trade in Services by US Multinational Firms" (Cambridge, Mass: National Bureau of Economic Research, Dec. 28, 1986), .Table A; Office of Technology Assessment, Trade in .Serv_i£e£, p. 53; and annual reports of Sea-Land Oorporation, 1985 and 1986.
Table 4 applies these labor coefficients to estímate the number of workers involved in the production of U.S. service exporte. For many of the sectors, direct estimates of the labor coefficient are unavailable, and the Table merely applies the median coefficient from the ten sectors with estimates in Table 2.
For constnjction and licensing, a special adjustment reduces the employment estímate to one-fourth of the level based on the labor coefficient approach. By its nature, construction abroad tends to empioy local personnel even though the business is booked out of U.S. offices. At the same time, some U.S. employees will be located on foreign construction sites, and some overhead employment at headquarters will be attributable to foreign operations. The estímate is thus collapsed to one-fourth of the magnitude based on the U.S. labor coefficient, but not forced to zero. The corresponding reductiqn of the employment estímate for licensing reflects the fact that revenue in this sector is primarily royalties. Although it might seem that royalties generate no employment at all, in fact they are payments for U.S. technology that has required employment in research and development. While that employment was in the past, there is current R&D employment creating technology that will generate royalties in the future, and complete suppression of the employment estímate for this sector would be an understatement. A "high" alternativa estímate retains the labor-coefficient method for these two sectors.
The results of Table 4 indícate that approximately 900,000 U.S. workers are employed in exports of non-factor services (and over 1 million in the "high" alternative estímate). Approximately one-fourth of the total is found in the sector of travel services (tourism), the consequence of its relatively larga share in the dollar volume of service exports and its high labor intensity. The second largest sectoral employment is in banking. Other large-employment sectors for service exports include construction, licensing (although here there may be overstatement because royalty and license fees typically would generate less employment than implied by the median labor coefficient), transportation (which could well understate employment by the use of the very high "affiliate" labor coefficient in preference to the U.S. "GNP contribution" coefficient), software, and education.
There are some caveats about these estimates. Clearly the data are fragüe, perhaps especially labor coefficients for sectors with conceptually problematical "revenue" (banking, insurance). Moreover, in terms of U.S. trade and tax policy, some sectors are less relevant than others. Educational services, for example, are not the subject of Uruguay Round negotiations, ñor are they germane for tax policy (in view of the sector's taxexempt status). The same may be said for tourism (travel) with respect to trade negotiations (although not necessarily with respect to tax policy, considering
Table III-4
Estimated Employment Associated with US Exports of Services, 1984 (number of jobs)
Accounting
Advertising
Construction
Data Processing
Education
Engineering
Franchising
Health
Information
Insurance
Investment banking, bcokerage
Leasing
Legal
Licensing
Management, consulting
Motion Pictures
Software
Telecommunications
Transportation
Travel
Miscellaneous
Banking
Total
a. Applies median labor coefficient.
(1,030,464)'=
c! coefficient:, see text.
d. Applies estimated labor coefficient of $40,000 based on average salary in higher eduction ($32,000).
e. Applies labor coefficient for data processing.
f. Applies labor coefficient for banking.
g. Applies labor coefficient for foreign affiliates.
Source: Tables 1-3.
that lengthening of depreciation life - for example -- could substantially affect costs in the hotel sector and abiiity of U.S. tourist services to compete).
Despite these qualifications, the broad picture that emerges here is that the services sector is indeed one worthy of considerable poiicy attention. In fact, a comparison with manufacturing yieids the striking resuit that direct empioyment in exports of services is 60 percent as larga as direct empioyment in exports of manufactures. Specifically, in 1985 there were 1.5 million direct jobs in the manufacturing sector associated with manufacturad exports,12/ compared with 907,002 estimated here for direct jobs in service sector exports.
The findings here are somewhat at odds with the qualitative conclusión in a recent study by the Congressional Office of Technology Assessment that "Relatively few American jobs depend directly on trade in services."i3/ The OTA's 400-page study contains no quantitative estimates on empioyment associated with services exports, but instead appears to reach its qualitative conclusión on general grounds such as the fact that "U.S.-based service firms do more overseas business through foreign affiliates than through direct exporting ... [because] the need to produce services at the point of consumption limits growth prospecte for exports, in contrast to goods, which can be shipped and stored."
It is curious that the OTA reaches the conclusión of limited empioyment in serwice exports, considering that the estimates in the present study apply the OTA's own estimates of service exports. While it is true that these exports are smaller than foreign affiliate sales, they are not radically smaller and compared to overall exports they are relatively large in valué, as reviewed above (and in Table 2). Moreover, while it is true that some services must be produced in the lócale of their consumption (such as construction), others clearly can be produced in the heme country (crossborder loans preparad in and booked out of New York, for example). Even where a major portion of the production process must occur abroad, there are typically relatad componente of production that remain in home offices as overhead operations attributable to the foreign sales,
12/ U.S. Department of Commerce, Intemational Trade Administration, Contribution of Exports to U.S. Empioyment (Washington: Department of Commerce, March 1986), p. 21. Note that when indirect empioyment in intermediate inputs is included, manufacturad exports generated 4.0 million jobs, and all exports, 5.5 million. However, the appropriate figure for comparison with the direct sen/ice export jobs estimated here is the direct empioyment measure.
13/ U.S. Congress, Office of Technology Assessment, Intemational Competition in Services: Bankinq, Buildinq, Software, Know-How (Washington: OTA, July 1987), p. 5; aiso see Alian Murray, "Services are 25% of Total U.S. Exports but They Create Few Jobs, Study Says," Wall Street Journal, July 2, 1987, p. 6.
Overall, the profüe of services exports developed here ¡ndicates that they are of considerable importance. They account for an export valué of nearly $80 billion annually, or about one-third of total merchandise exports and approximately half the valué of manufactured exports.i4/ They represent employment that is nearly two-thirds the level of direct employment associated with manufactured exports, even though it is typically the manufacturing sector rather than services that receives primary attention in the formuiation of U.S.trade policy.
The Sample Sectorsis/
This study examines the impact of tax policy on U.S. service sector exports and foreign affiliate sales through case studies of five sectors. The tax changes affecting these sectors have been examinad in Part I. The analysis below translates these tax changes into estimates of trade and employment effects. It is first useful, however to review the natura of extemal sector activities of the sample sectors.
ADVERTISING -- Certain featutes domínate international competition in the advertising sector. The industry is relatively concentrated, with a handful of larga firms accounting for the bulk of business that is international, as opposed to domestic. The industry has traditional pricing" rules. In particular, it has been standard practice in the industry to charge 15 percent of the total advertising expenditure (billing) for the services of the advertising agency. There has been some shift toward specific feas for discreta serv ices m recent years, and some tendency toward an industry-wide squeeze on the traditional 15 percent charge. Nonetheless, this percentage pricing structure remains dominant, and it has implications for competition because it suggests that as costs risa the firm must vary quality or some other dimensión rather than directly increase the pnce as in a merchandise product. Another peculiar feature of the industry is that its clients in each product sector tend to pressure the agency in question not to have other accounts in the same sector that are competitors of the client firm.
Much of the international activity of advertising firms has been generated by the demand of U.S. advertising firms' traditional domestio clients as these client firms expended their operations abroad. Thus,the service industry has followed the multina-
amounted to $153.7 billion. OECD. Foreian Trade bv nnmmnHiti«c 1985, Schedule C (París: OECD,1987), SITO Categories 5 through 9. '
conside^ed^^''''°" interviews with selected firms in each of the service sectors
tionals in the goods industries as they have set up estabiishments abroad. Advertising firms active abroad typicaliy will have two other classes of ciients in addition to their multinationai U.S. ciients: large accounts that entertain competition from al! of the major internationa! advertising firms, and strictiy local accounts within the foreign country in question. The principal competitors of U.S. firms in the international market include firms from Japan, the United Kingdom, and France. However, the principal competition in each foreign country is from the national firms of that country, rather than from inter national chains.
Delivery of services through foreign affiliates as opposed to U.S. offices depends in part on restrictions in the country in question. Some, for example, require that an advertisement actually be produced within the country. As indicated in Table 2,the bulk of sales is through foreign affiliates rather than U.S. offices.
Today televisión accounts for the great bulk of advertising expenditure. An important implication for foreign activity is that future growth could be large, because in many countries governments are just now privatizing the televisión industry and private sector advertising should grow rapidly with this transition.
On the spectrum of price sensitivity of demand (an important issue for the calculations below), the advertising industry is in an intermedíate position. While its services are clearly "product differentiated" in that brand reputation has an important influence, the industry has faced intense competition (as indicated by the pressure on the traditional 15 percent fee). With respect to ability to expand services at a given cost ("supply elastidty," another element in the subsequent calculations), the industry is moderately flexible but probably not at the extreme of ability to provide unlimited expansión of services without increased unit cost (in view of the specialized nature of the service and limited number of firms). Thus, a limitad number of outstanding artists or advertising concept leaders are in constant demand by existing agencies, and to some extent increased demand will bid up the rents of these specific factors rather than generate additional advertising output.
BANKING"The foreign activities of U.S. banks include crossborder loans (for example, to Latín América). They aiso include a wide ranga of other functions, such as the management of cash accounts and pensión funds, advising corporations, leasing, and off-balance-sheet financial operations (such as repurchase obligations and currency and interest rata swap operations).
Increasingly the industry has been pushed toward more innovative activities than traditional lending, as corporations with strong credit-ratings have been able to go to the
market on their own and obtain funds as cheaply as through banking intermediaries (the "securitization" of financing that was previously in the form of loans). This same dynamic is a major reason for the ¡ndustry's keen interest in expanding Its activities into areas previously associated with investment banking and other financiaí services but to a considerable extent off limits to banking since the Glass-Steagall Act of the I930s, which sought to divorce banking from other sectors to avoid excesses that were seen to have contribüted to the Depression (although the compartmentalization appears less natural in today's broad move toward economic deregulation). The financiaí service areas of banking are fee-based. in contrast to interest rate earnings on traditional loans (that is, the spread above interest cost).
A salient feature of international banking is the large role played by regulation. particularly of U.S. banks. A reoent study by the Congressional Office of Technology Assessment notes among its principal findings that The maze of U.S. banking regulations ... exerts wide-ranging impacts on the international competitiveness of the U.S. financiaí services industry."i6/ One reason for the presence of U.S. affiliates abroad is that in some key centers there is much less regulation than in the United States on the fields in which banks may opérate. While the Glass-Steagall Act prevente U.S.-based banks from underwriting securities. for example, a subsidiary incorporated in Switzerland is free to enter such activities. This.divergent regulatory environment means that domestic offices and foreign subsidiarias are not simple substitutes. In a range of activities, the home office would be unable to enter markets served by the bank's foreign subsidiary. Accordingly, an increased tax burden on foreign affiliate activities may displace U.S. banks from the relevant market, rather than cause replacement of subsidiary activity by home office operations.
International banking is highiy competitivo. In London, the Bhtish and Japanese banks are seen as the primary competitors with U.S. banks. In other centers the pnncipal competition typically will be from banks of the country in question. Noniheess. for a specialized product (such as an interest rate swap),the principal competition for a major U.S. bank could be another large U.S. bank that is a leading provider of such services. ^ ^
D I. foreign operations depends on each country's regulations. anks tend to prefer branches, but in some countries are oniy allowed to opérate hrough subsidiarios because of the country's desire to be in regulatory control A few large banks have large operations in "looal franchise" banking in foreign countries: that
Technology Assessment. International Competition in ServiceR- R;,nHnn Buildmo, Software, Know-how tWashiníTtnn- OTA, 1987), p. 82. ^
is, networks with branch offices through the country in question that provide local cúrrency lending to prívate sector clients. These operations are typically structured as subsidiarles.
The Office of Technology Assessment notes that at the end of 1984, 163 U.S. banks operated 905 foreign branches, 523 Internationa! Banking Faciüties (IBFs), and 146 Edge Act corporations with 138 branches. The IBF is an entity physically located in the United States but with special advantages for Internationa! activity (in particular, freedom from domestic reserve requirements), while the Edge Act corporation is permitted to take deposits and make loans across state ünes if related to internationa! transactions. In addition, 133 U.S. banks had foreign affiliates or subsidiarles, and U.S. interests had 10 percent or more equity in 822 foreign banks.i7/
The OTA estimates that banks based in the United States earned $5.5 billion in net interest income from foreigners in 1984 (of which $3.8 billion was by IBFs) and $1 billion in other income (fee-based). The foreign subsidiaríes, affiliates, and branches of U.S. banks earned $3 billion in net interest income and $2.7 billion in other income, placing total foreign earnings at $12.2 billion.18/ The OTA calculations for interest consider not the ful! amount of interest on loans outstanding but, appropriately, oniy the "spread" of the loan rate over borrowing costs.
It should be kept in mind that although much attention has focused on the exposure of large banks to debtor countries in the Third Worid, the bulk of their loans are placed in the industrial countries.ie/ Tax and other economic influences thus remain highiy relevant to their activities, even though for a subset of loans to developing coun tries their lending activities may be based for an interím period more on the need to particípate on a pro-rata share in coordinated lending organized in conjunction with internationa! official institutions and debtor country governments than on near-term profit potential.
17/ OTA,Trade in Services. p. 56.
18/ Ibid, pp. 56-57.
19/ Thus, at the end of 1986 the exposure of al! U.S. banks to Latin América was $79 billion, while their exposure to industrial countries was $130 billion, for crossborder loans. In addition, the banks held $117 billion in local cúrrency loans by offices in foreign countries, and these loans probably were primarily in the industrial countries. Federal Financial Institutions Examination Council, Country Exposure Lending Survey: December 1986(Washington: FFIEC, April 24,1987).
U.S. banks have faced growing international competition, especially from Japanese banks. Among the largest 500 banks in the worid, U.S. banks accounted for 42 percent of total assets and Japanese banks for oniy 17 percent in 1970 By 1985 the positions had reversad, as the asset share of U.S. banks had declined to 18 percent and that of Japanese banks had risen to 29 percent. U.S. banks were aiso losing ground to those from other nations, whose aggregate share had risen from 41 percent in 1970 to 53 percent by 1985.20/ The decline of the dollar since 1985 has undoubtedly eroded the U.S. share further (as domestic U.S. assets denominated in dollars have declinad relativa to domestic yen assets of Japanese banks. for example). New tax or other impediments to U.S. competitiveness tend to aggravate an already deterioratinq relativa U.S. position in this industry.
INSURANCE - U.S. sales of insurance abroad include first the coverage provided to U.S. multinationaj corporations on their direct investment overseas. Fire, propertv casualty, marine, and product liability insurance are all examples. In add'ition U s' insurers compete in the foreign countries' markets for insurance purchased by natíonals of the country The sophisticated financial and insurance instrumente that have been developed in the United States provide a basis for competition in this market on a basis of what may be viewed as technological advantage. Ufe insurance companies are aiso active abroad, despite difficulty of entry into certain countries.
u/h
0^ the industry's foreign operations is relatively concentrated United States, oniy some 50 are active abroad. In some cases the activity is by U Stnn^ i H regulations require that transactions be conducted by branches, subsidiarias, and affiliates located in the country. In some areas, such as fire insurance (and in Utin América, in particular), it is often illegal for natíonals to purchase insurance from abroad. Sanctions range from non-deductiUlity of prerniums for t^ purposes to imprisonment. In such cases the firm cannot shift from thé affii-fltp I ^ burdens reduce its ability to compete through the affihate. Instead,the firm may simply have to withdraw from the market in question.
Foreign markets differ according to the presence or absence of governmentta°riff ma w Germany, Japan, and many developing countries are tanff rnarkets, while in the United Kingdom and the Netherlands pnces may be set Lch more freely In tariff markets, competition shifts toward advertising, impmved se^e and speo,ai,zed products rather than price reduction. Pricing aleo vafes by induS^
20/ OTA, International Competition in Servíces. p. 86.
group. In lite insurance, the presence of actuarial statistics means pricing closely íollows established standards; but in property and casualty insurance, especialiy on iarge projects, pricing is much more intuitive. While demand may be expected to respond to price in those markets that are non-tariff, non-price factors are aiso important. Reputation is a major consideration (for example, in promptness of payment of ciaims).
Competing foreign firms divide into two dominant categories. For insurance sales to nationals of the country in question, the competition is usualiy from national firms (for example, a French insurance company for sales in France). For sales of global coverage to multinational companies, the competition is typically from a limited number of Iarge firms primarily from the United Kingdom, Germany, France, and Switzerland.
INVESTMENT BANKING
-- The traditional activity of investment banking is the underwriting of new financial securities. As firms issue shares or bonds, the investment banking firm managing the issue gives advice on the proper price and stands ready to purchase some of the issue for its own account temporarily in order to "make a market" for the security. Such purchases typically are soid off into the market subsequentiy. In addition to underwriting, investment banking firms have major earnings from three other principal sources; trading fortheir own accounts; advisory work (including mergers and acquisitions); and commissions from securities transactions (especialiy Iarge for those firms that are major brokerages as well).
Price sensitivity of demand varíes among these principal product lines. Under writing is highiy price sensitive; the firm earns its income from quoting a specific spread between the interest rate to the corporation and that paid by bond purchasers (for example), and there are narrow limits within which reputation of the firm can permit widening of the spread. Trading (which for some firms includes commodities) is highiy price sensitive by definition, because it involves transactions at the market price for well-defined and homogeneous assets. Commissions are aiso relatively price sensitive, especialiy in view of rising competition from cut-rate brokerage services in recent years. Oniy the area of corporate advisory work has relatively low price sensitivity of demand. A firm considerad to be outstanding in mergers and acquisitions, for example, is likely to be able to set its price for its services within a relatively wide ranga, and is not necessarily likely to obtain more business through major price cuts.
Competition in international markets is present from major foreign firms (with the ñames of principal players displayed on the "tombstones" reporting major issues iri the financial press). Principal competitors include firms from the United Kingdom,
In the past, foreign activities tended to be conducted through branch offices. The tightening of foreign regulation has caused a shift of organization toward foreign subsidiaries.
SHIPPING - Ocean shipping is the final sector in the sampie of service indus tries examined in detail in this study. It is a subcategory of "transportation" as listed in Tabies 1 through 4. Specifically, on the basis of Department of Commerce data, ocean shipping accounts for 19.6 percent of balance of payments receipts (exports) in transportation services (the other major corhponents being air passenger fares, 17 9 percent, air freight, 3.6 percent; air and water port services to foreign carriers 55 4 percent; and other, 3.6 percent).
Shipping has experienced major change in both technoíogy and poiicy environment In recent years. Technologicaily, the industry has shifted heavily toward containerized shipping. Containerization has reduced the number of ships required for a given voiume of cargo because of the more rapid turnaround time in loading and unloading. it has aiso further raised capital costs and made the industry highiy capital intensiva. o / r
The major change in the poiicy environment has been the frend toward increased competition. The Reagan Administration sponsored legislation in 1984 that introduced much greater price competition into the international "linar conference" system. Changas in the Shipping Act of 1984 have required improved cost efficiency and quality of service on the part of all competing linar carriers, regardiess of nationality "Procompetitive" regulation and relativa oversupply of ships have combinad in recent years to place a severa earnings squeeze on the industry.
Much of international shipping takes place under the flags of nations that have minimal taxation. For U.S. firms, there has been a balance of incentives in the past that has involved a trade-off on the decisión to shift to subsidiary organization using such foreign flags, with access to U.S. shipping subsidies under certain conditions being the incentive to remain under U.S. flag operation.
The industry is highiy competitiva, and the service is largely of the "commoditv" natura (standardized), with soma exceptions such as refrigerated service. Major foreion competitors include linas basad in Japan, Korea, Taiwan, and Hong Kong, as well as European linas on the Atlantic. The East Asian NICs have tended to be the oricesetters with low ratas in recent years.
Estimated Impact of Tax Changas
Appendix H develops a simple suppiy-demand modal for the purpose of estimatInQ the impact of changas under the 1986 tax law on U.S. earnings from exports and foreign affiliate sales of services, and the corresponding impact on U.S. employment in service sector exports. The first step in the estimation process is to calcúlate the percentage by which the price wouid have to rise to compénsate for the higher tax burden resüiting from the new law (as developed in Part I). This increase is then applied to specific features of the particular sector to determine changas in activity leváis and employment.
In the simplest case, in which supply is treated as "infinitely elastic" (with increased supply avalladle at unlimited quantities at the existing price), the percentage changa in activity equals the percentage changa in price multiplied by the "price elasticity of demand" (which reflecte the responsiveness of foreign demand to the price charged by U.S. firms). The percentage changa in activity is applied to the base valué of export (or affiliate) earnings to determine the changa in earnings from abroad. Similarly, the percentage changa in activity is applied to the base estímate of employ ment in the service export, to determine the number of export jobs lost as the consequence of the increased tax burden.
In a slightiy more complicated case, the supply elasticity is considered to be less than infinitely elastic. There is an "upward sloping supply curve" such that higher price is required to cali forth larger quantity of supply. By the same token, if the quantity supplied declines, there is some reduction in unit cost. In this case, the equilibrium price after the market adjusts is higher than the price before imposition of the additional tax burden, but not by the full amount of that increment (because U.S. firms partially adjust by cost savings as they move to a lower-quantity position on the supply curve). Similarly, the equilibrium quantity after adjustment is at an intermedíate point between the original level and the level that would have resultad if the price charged had risen by the full amount of the initial (tax-imposed) amount.
The calculations require estimates of the price elasticity of supply and demand for each service sector. The empirical literature does not contain such estimates for services, but many estimates have been prepared for goods. The approach here is to determine qualitatively for each sector whether the respective elasticities are high, intermedíate, or low, and then to refer to the profile of elasticity estimates found in the econometric literature on trade in goods for appropriate leveis of elasticities in each class.
Considering trade elasticities summarized at the level of twenty-one broad commodity groupings from a broad survey of statistical estimates for merchandise imports of Europa and Japan, the following elasticity valúes are found.2i/ High import elasticities based on the top 20 percent of estimates averaged 2.06. Intermedíate elasticities based on median estímate valúes were 1,26. Low import elasticities based on the bottom 20 percent of estimates averaged 0.60. (The elasticity is negativa in sign, and indicates -- for exampie -- that a 1 percent increase in pnce causes a 0.6 percentage reduction in quantity purchased.)
Tabla 5 reports the calculations of the impact of changes in the 1986 tax iaw based on the modal set forth in Appendix H and the estimates of sales and employment presentad in Tablas 2 and 4 above. Note that for shipping, the trade, employment, and affiliate sales estimates are based on the fraction of the corresponding estimates for the whole transportation sector comprised by ocean shipping alone.22/
The Tabla indicates the supply elasticity assumption used for the sector. As discussed in Appendix H, in most cases the supply of service exports from U.S.-based firms is set at infinity (horizontal supply curve), with the exception of investment banking in view of its more specialized services. The supply elasticity for forelgn affiliates is placed lower, at a valué of 3, for advertising and insurance, and still lower (1.5) for the more specialized investment banking. However, the infinite supply elasticity assump tion IS maintained for shipping aven from foreign affiliates, in view of the considerable foreign-flag presence among U.S. carriers.
Similarly, for each sample sector a price elasticity of foreign demand is selected on the basis of the qualitative review of demand conditions and the particular valúes assigned to high, intermedíate, and low elasticity, as discussed above. Advertising and insurance are assigned intermedíate price elasticities of demand (1.26). Given their "commodity" nature, banking and shipping are assigned high price elasticities of demand. The high elasticity range for merchandise exports is placed at 2.06 (as dis cussed above). However, qualitative review of the banking and shipping service sectors indicates an extremely high responsiveness of demand to price. Accordingly, the
21/ Wniiam R. Cline, Nobotu Kawanabe, T. Kronsjo. and Thomas Williams. Trade Neootiations in the Tokyo Round. A Quantrtative Assessment(Washington: Brookings Institution, 1978), p. 58.
2^ For ex^rts, these fractions are discussed above. For foreign affiliate sales, it is assumed that the OTA figure for transportation may be divided between air and ocean shipping solely, considering that the applicable to exports (air passenger service and port services) are not applicable to o eign affiliate sales. The división of affiliate sales between air and ocean freight is set in proportion to their shares in direct exports. k
price elasticity for these sectors is set at 3.0. The investment banking sector is assigned a.low price elasticity of demand (0.6) in view of its more specialized nature.
Note that both the advertising sector, where a fíat percentage of billing fee is customary, and the insurance sector, where the "tarifí" countries have highiy regulated rates, are treated under the same suppiy-demand mode! as the other sectors where more flexible pricing is the norm. The interpretation here is that advertising and insur ance firms adjust the quality of their service to carry out an effective change in the price of the constant-quality service, and that this adjustment is comparable to a change in price for an unchanged service.
Table 5 reports the initial price impact of the change in tax burden, as calculated in section I, The final portion of the Table reports the estimated resulting changes in sales, employment, and final price.23/ As indicated, the increased tax burden under the 1986 tax law implies losses of $682 million annually in banking for exports and $137 million for affiliate sales;$641 million annually in insurance earnings by foreign affiliates; and $1.3 billion for exports of ocean shipping firms and $1.1 billion for sales of their
23/ The price increases required in commercial banking are calculated as follows. For cross-border iending, the increment is 5 percent;for other income (primariiy fee-based activities), the new law actually reduces taxes by an amount permitting a reduction of price by 1.4 percent for U.S. exports and 0.5 percent for foreign subsidiaries. The crossborder Iending impact must be further adjusted to take account of the fact that ioans to central governments (but not state firms) in Latin América typicaliy are exempt from withhoiding tax. Loans to central governments are perhaps 30 percent of the total to Latin América (which. in turn, accounts for 29 percent of total U.S. bank loans to foreign borrowers). For crossborder loans exempt from withhoiding tax, the impact of the 1986 Act was to reduce cost by 2.9 percem rather than increase it. Taking these factors into consideration, the overall impact of the act on crossterder loans was to raise cost by 4.3 percent (for example, raising the interest rate to the borrower from 8.5 percent to 8.9 percent per annum).
As indicated in the text, for home offices of U.S. banks the división between interest and nonmterest income from foreigners in 1984 was in the proportions of 85 percent and 15 percent, respectively Thus, the weighted average price impact of the 1986 Act for banking exports was an increase of 35 percent. For foreign subsidiaries, affiliates, and branches, 53 percent of income was interest and 47 percent fee-based. Considering that significant crossborder Iending is booked out of subsidiaries tocated in third coumnes (such as U.S. loans to Brazil through offices in the United Kingdom) or through branch offices in the borrowing country, it is assumed that one-half of the interest income of MOFAs and branches was of the crossborder Iending type and thus facing the 4.3 percent average price increase imposed by changes in the 1986 Act. The remainder of MOFA interest income, and all of their fee-based o' act'vity lor which the impact of the act was to permit a price reduction of 0.5 percent. The resulting weighted average price increase for MOFAs is an increase of O 8 percent.
foreign affiliates. The only sectors in which the new law effectively reduced the tax burden (because lower rates outweighed a broader base, more limited foreign tax credits, and restrictions on deferral) were exports in advertising and in insurance, and both exports and MOFA sales in investment banking services. The expected impact in these sectors is an increase of annual exports by $11 miilion in advertising,$246 million in insurance, and $27 million in investment banking: and increased MOFA sales of $33 million in investment banking. For the five sectors combined, the valué of service exports declines by $1.7 billion annually, or 9 percent of the export base, while earnings by foreign affiliates decline by $1.9'billion annually (5 percent).
The estimates for employment indícate job losses amounting to 14,770 for the five sectors. The losses occur in banking (approximately 10,000 jobs) and shipping (nearly 6,500 jobs lost). The small gains in employment in some of the other sectors do littie to modérate this loss of service export jobs. TheTarge losses In banking and shipping are consistent with perceptions in the industries that the new tax provisions have had a sharply negativa effect on the ability of U.S. firms to compete abroad. in terms of dollar valúes, the larga losses in insurance sales by foreign affiliates are aiso prominent.
Policy Implications
The analysis of this study suggests that the service sector has a major contribution to make toward the resolution of the serious probiem of external déficits and indebtedness faced by the United States, and that moreover service sector exports próvida a considerable amount of employment (estimated at 907,002 direct jobs). The analysis aiso indicates that for at least the five larga service sectors examined in the sample considerad, the tax law of 1986 had a generally adverse impact that will cause significant reductions in exports (and export employment) as well as activity of foreign affiliates (and thus foreign profits that can help deal with the management of America's foreign debt).
Tax policy must balance a larga number of political and economic concerns. In economic terms, when tax rates are cut as in the 1986 law, it is necessary to find offsetting revenue from somewhere. In the broad sweep of measures designad to find this revenue, the law generated significant adverse impacts on services exports and affiliate earnings. It is by no means olear that this outcome was consistent with the needs of the nation on a separata policy track -- dealing with the larga external déficit. The results of this study suggest that as policymakers review and refina the new structure of U.S. taxation, they should merge the two tracks of fiscal and international economic policy to
ensure that they are not working at cross purposes. Such a review would seem ükely to come to the conclusión that a reversal of, or adjustment for, many of the adverse effects of the new law on service sector exports and foreign affiüate activitles would be appropriate.
APPENDIX A Footnotes to International Tax Survey
(General notes are provided beiow for each üne of the Table, and are identifled by line number. Specific answers that require more detall than can be shown In the Table are marked with an asterisk. These country-specific footnotes are grouped by country and identifled by line number.)
GENERAL FOOTNOTES:
1. Global tax systems are intended to tax the woridwide income of a domestic corporation, generally with some provisión to avoid double-taxation of income earned and taxed abroad. Systems identifled as territorial either do not claim the right to tax woridwide income, or are administered in a way that effectively taxes oniy domestic source income.
2. Foreign branch income is explicitly subject to tax under a global tax system. Under a territorial system foreign branch income would generally be explicitly exempted. although the exemption might have to be applied for and granted bv tax authorities. ^
3. A statutory foreign tax credit provides, as part of the regular tax system, a credit against domestic taxes for taxes paid to foreign countries. If the foreign tax credit is statutory its availability is not dependent on the existence of a tax treaty with the foreiqn government.
4. Some countries normally negotiate tax treaties which provide for exemption of foreign source income from domestic taxation. In these cases a foreign tax credit would be redundant. Countnes may aiso provide for foreign tax credits in tax treaties with countries that favor the credit method, even though their normal treatment effectively exempts foreign-source income.
5. Under global systems the income of foreign subsidiarles is normally subject to IS distributed to the parent as a dividend. Under a territorial system dividends from foreign subsidiarles are generally exempted, either in whole or in part.
6. Sonie countries normally negotiate tax treaties that provide for the exemption of dividends of foreign subsidiaries in treaty countries from domestic tax.
7. Countries which provide a statutory foreign tax credit for foreign taxes paid on income of foreign branches generally provide íhe same credit for taxes paid on dividends received from foreign affiliates.
8. Treaty results generally do not differ unless income from treaty countries is exempt from domestic taxation.
9. The deemed paid credit is a foreign tax credit for income taxes paid to foreign governments by foreign affiliates on the income from which these affiliates pay dividends to the domestic parent.
10. Treaty results generally do not differ unless income from treaty countries is exempt from domestic taxation.
11. Where a deemed paid foreign tax credit is allowed, the determinaron of the actual profits out of which the dividend that gives rise to the credit was paid has potential tax consequences. This is because effective tax rates, especially on profits measured under accounting principies, are likely to vary from yearto year.
12. If the entry in this line is yes the country has some explicit "anti-tax haven" provisions in its tax laws. In many cases these provisions apply oniy or primarily to passive income.
13. The United States (after TRA 86) is the oniy country surveyed which specifically applies its anti-tax haven provisions to the earnings of foreign banking subsidiarias of domestic corporations.
14. No country surveyed applies its anti-tax haven provisions to income earned by foreign subsidiarias of domestic corporations from insuring nationals of the countries in which the subsidiarias are located.
15. The United States is the oniy country surveyed which specifically applies its anti-tax haven provisions to the income earned by foreign subsidiarias of domestic corporations from insuring parent country nationals.
16. The United States (after TRA 86)is the oniy country surveyed which specifically applies its anti-tax haven provisions to the income earned by foreign subsidiarias of domestic corporations from insuring third country nationals.
17. The United States (after TRA 86)is the oniy country surveyed which specifically applies its anti-tax haven provisions to the income earned by foreign subsidiaries of domestic corporations from shipping.
18. If a country provides a foreign tax credit, the limitations on the use of the credit may have llttie or no effect on the tax reiief provided by the credit (no), may be of con cern to some taxpayers but not a major source of concern to most (some), or may be a major concern to most taxpayers (most).
19. The theoretical limitation on the use of a foreign tax credit may be the domestic tax owed on that income (overall), the domestic tax owed on income from each country separately (per country), the domestic tax owed on income of each of several major types (per basket), orthe domestic tax owed on income from each separata transaction or activity (per item).
20. The foreign tax credit limitation may be less binding in practica than in theory, if holding compañías or other techniques can be usad to changa the characterization of income.
21. When interest earned abroad is directly or indirectly associated with deductible interest paid by the domestic corporation, a country's tax law may or may not require án allocation of interest deductions to the foreign source interest (which would reduce the foreign tax credit limitation). If no allocation is required, so that the foreign tax credit limitation is basad on the gross interest income, and the full interest deduction can be taken against domestic taxable income, the entry is "no". If an allocation is required oniy when the domestic debt is directly associated with the foreign interest the entry is "traced". If an overall formula is usad to allocate all interest paid between foreign and domestic interest income the entry is "formula".
22. The United States (after TRA 86) is the oniy country surveyed which requires allocation against foreign interest income aven if the associated deductible interest is paid by an affiliate of the domestic parent, rather than by the parent itself.
23. The rata shown in this lina is the máximum rata applicable to income from foreign activities. Subnational income taxes have been included if they are levied directly on the same base as the national tax, or if there are other reasons to believe that foreign source income will be subject to them. Taxes not specifically identified as income taxes may aiso be included if they are levied on the same base as the income tax.
9. íf the U.S. corporation owns 10 percent or more of the foreign corporation.
11. The dividends for which the deemed paid credit was calculated were assumed to have been paid first out of the most recent year's Income.
17. The U.S. tax on shipping income earned through a controlled foreign corpora tion could be deferred by reinvesting in qualified shipping assets.
19. An overa!! ümitation prevented use of foreign tax credits to reduce tax on domestic source income. A sepárate ümitation was applied for passive interest and dividend income, and another sepárate ümitation for income from oil and gas extraction.
21. The required aüocation could be based, at the taxpayer's cholee, on either gross income or asset valuation.
23. In addition to the máximum 46 percent federal corporate tax rate, domestic corporate income may be subject to state corporate income taxes if the corporation does business in the District of Columbia or any of the 45 states (46 for banks) that levy corporate income taxes. State corporate rates can range as high as 15 percent (District of Columbia), but are deductible on the federal return. It is assumed that the types of foreign source income this survey is primariiy concerned with would generally not be effectively subject to state corporate tax.
27. The deduction was the amount necessary to bring the bad debt reserve to an appropriate level under either the "bank experience method" or the "percentage of eligible loans method".
9. If thé U.S. corporation owns 10 percent or more of the foreign corporation.
11. After 1986, dividends for which the deemed paid credit ¡s calculated are assumed to have been paid first out of the post-1986 pool of earnings and profits.
19. TRA 86 created sepárate limitations for Income from different sources: 1) passive income; 2) interest subject to high withhoiding tax; 3)financia! services income; 4)shipping income; 5) dividends from each sepárate noncontrolled corporation of which the taxpayer owns at least 10 percent, but less than 50 percent; 6) dividends from DISCs and former DiSCs; 7) taxable income attributable to foreign trade income; 8) distributions from-FSCs or former FSCs; and 10) income not classified in one of the other categories.
21. and 22. The required allocation must be based on asset valuation.
23. In addition to the máximum 34 percent federal corporate tax rate, domestic corporate income may be subject to state corporate income taxes if the corporation does business in the District of Columbia or any of the 45 states (46 for banks) that levy corporate income taxes. State corporate rates can range as high as 15 percent (District of Columbia), but are deductible on the federal return. It is assumed that the types of foreign source income this survey is primarily concerned with will not generally be subject to state corporate tax. For tax years which include July 1, 1987, the máximum statutory rate is a weighted average of 46 percent for the period before 1/1/87 and 34 percent thereafter.
27. After 1987 (after 1986 for large banks) the deduction will be the amount necessary to bring the bad debt reserve to an appropriate leve! under the "bank experience method". Under the bank experience method the máximum ending reserve balance is determined by the ratio of actual bad debts for the current and five preceding years to the total amount of loans outstanding at the cióse of each of those years.
9. If the foreign subsidiary was not established to avoid Japanese taxes and the domestic parent has held at least 25 percent ownership for at least 6 months.
10. Under treaties with the U.S. and Australia the ownership requirement is reduced to 10 percent.
12. If a corporation owns 10 percent or more of the total stock of a foreign sub sidiary in a country or area designated as a tax haven and more than 50 percent of that subsidiary's stock is owned by domestic corporations and residents, the undistributed income of the subsidiary may be taxed directly to the parent in proportion to its owner ship. To avoid this provisión the subsidiary must use a fixed facility to conduct business in the country of its main office, must manage and control its own business in that country, and, for the kinds of service business this survey is concerned with, must conduct its business mainly with unrelated persons.
15. If the majority of the subsidiary's business deait with parent country risks the subpart F rules would appiy.
19. The overall limitation is based on the ratio of income from foreign sources to total income subject to tax.
20. In practica, some of the foreign source income included in the limitation numerator may not be included in the denominator.
21. For banking the required allocation is based on the ratio of average foreign loan balances to the sum of total liabilities and the excess of paid in capital over fixed assets.
23. The máximum federal corporate income tax is 43.3 percent. The municipal inhabitants tax is a máximum of 14.7 percent of the national income tax and the prefec toral inhabitants tax is a máximum of 6 percent of the national tax. Thus the máximum rate is 43.3 + .147*43.3 + .06*43.3, or 52.3 percent. (The locally levied enterprise tax has aiso been described as an income tax, but foreign source income is speciíically exempted.)
24. The máximum federal corporate income tax on income distributed as dividends is 33.3 percent. With the two inhabitants taxes the máximum rate is 33.3 + 33.3*(.147+.06), or40.2 percent.
25. The credit for dividends allows taxpayers to deduct 10 percent of net dividend income (after interest expenses incurred to acquire securities) from taxable income. If taxable ¡ncome before this deduction exceeds 10 million yen, however, oniy a 5 percent deduction is allowed for net dividend income in excess of 10 million yen of taxable income (with dividend ¡ncome counted last). Instead of this "credit", taxpayers may, under some circumstances, choose to have their dividends taxed separately from other income at a fíat rate of 35 percent (20 percent if no more than 100,000 yen are received annually from one corporation.)
27. Banks are allowed to deduct up to 0.3 percent of outstandings at the end of the accounting period (businesses other than banking and insurance are allowed larger percentages). The taxpayer may choose the experience method instead of the fixed percentage.
9. If the U.K.. corporation owns at least 10 percent of the voting power of the foreign corporation.
11. If the dividend is paid for a speclfic period the accounting profits of that period determine the deemed paid credit. If the dividend is paid out of specified profits those are the relevant profits. Otherwise, profits for the last accounting period ended before the dividend was paid are relevant.
12. The Controiled Foreign Company (CFC) legislation of 1984 established three tests which take into account both the type of activity and whether the business is "genuine". Passive investment income retained by a foreign subsidiary is more likely to be taxed to the parent than active trading income, but any kind of service income might be caught.
14-16. As long as more than 50 percent of a foreign subsidiary's premium income is derived from unconnected third parties the Controiled Foreign Company legislation would not appiy.
19. Income is allocated on a source by source basis. Determination of sources is complicated, but as a rule of thumb, sepárate investments, even in the same country, should be regarded as separata sources.
20. The theoretical limitations can be avoided by inserting an off-shore holding company between the foreign subsidiarles and the parent so that all receipts and credits come from the same source. This is a fairly frequent practice. Recent legislation has had the effect of imposing a separata limitation for interest income on cross-border loans. Sea text for discussion.
23. The 35 percent rate first applied to the tax year ended fyiarch 31, 1987. The rate was 40 percent for the year ended March 31, 1986, and 45 percent for the year ended March 31, 1985.
25. A UK resident non-corporate shareholder is taxable on the gross dividend (dividend plus Advance Corporation Tax of 29/73rds) paid by the company, but receives a tax credit equal to the tax.
26. Currently an ¡nsurance company does not have to discount loss reserves fortax purposes. However, the UK Inland Revenue are exploring the argument that discounting can be imposed under the general tax iaw relating to the accountabiilty of reserves. A test case may be taken soon.
WESTGERMANY
12. Base company income of controlled foreign corporations that is subject to low level foreign taxation is attributed to domestic shareholders on a pro rata basis. A foreign subsidiary is a controlled foreign corporation if more than 50 percent of its shares or voting power are owned by domestic taxpayers or persons subject to domestic tax. The level of foreign taxation is defined as low if the rate is below 30 percent.
13. Controlled foreign corporation rules do not apply if the bank maintains offices to transact its business.
14-16. Controlled foreign corporation rules do not apply if the insurance company maintains offices to transact its business.
17. Controlled foreign corporation rules do not apply if the shipping subsidiary does business with unrelated persons and without assistance from related persons.
18. Past outbound investment was not strong enough to generate high leveis of foreign tax credits. In the future there may be more concern about limitations.
23. In 1990 the máximum rate will drop to 50 percent.
25. The shareholder is liable for income tax on the gross dividend (dividend received plus the 36 percent corporate tax paid), but receives a tax credit equal to the corporate tax paid.
26. There is an increasing tendency for discounting .to be considered appropriate, but it is not yet required, or done in practice.
27. Specific percentages are allowed for debts of different types. The bad debt reserve for tax purposes may not exceed the reserve for accounting purposes.
2. For corporations with permanent establishments abroad, total domestic taxes are reduced by the proportion of total income that is attributed to those establishments Before this reduction, 5 to 35 percent of total income may be deemed derived from the principal domestic office and therefore not subject to the proportional reduction.
5. In general, dividends received from wholly-owned foreign subsidiarles are subject to tax, but the total tax is reduced by the ratio of net dividends (after nonrecoverable foreign withholding taxes)to total net income. This treatment may result in higher domestic taxes under progressive rates than total exemption, but if all income were foreign source dividends, there would be no domestic tax.
8. Some tax treaties provide for a foreign tax credit, but since the income will already have been reduced by the method described above, the FTC is not likelv to be significant.
19. Where, as the result of a specific tax treaty, there is a foreign tax credit, the i^mitation rules apply separately to interest and dividend income, and to royalty income f the Swiss taxpayer is a "domiciliary company" paying oniy federal income taxes on toreign source income,the máximum credit is one third of the otherwise avalladle credit.
21. Interest expenses incurred by the domestic corporation will be apportioned against its foreign source income by the underiying asset valúes.
Pw . P® percent. However, the 26 Cantons, which assess the federal tax, have rates of their own that are generally at least twice the federal rate. There are aiso communal corporate taxes that are generally assessed with the cantonal taxes Taxes at each level are deductible at the federal level, and often at the lower leveis too, so over time the effective rate is lower than the combined statutory rates (a 45 percent statutory combined rate is estimated to equal about a 31 percent effective
Ihl® f 7 . and lower level taxes are not always as broad as the federal tax base, but it appears reasonable to assume that any foreign source meóme subject to the federal tax would aiso be subject to other levels.
26. There is no specific tax legislation or regulation regarding the tax treatment of capability to analyse reserves, and should accept the results of direct legislation and eguiation of insurance. However, insurance regulators base reserve requirements on
the discounted present valué of expected futura expenses, so tax deductions based on these official reserves are not believed to be overstated.
27. Differs by Canten. Geneva and Vaud allow up to 8 percent of total loans.
2. Income of a foreign branch is subject to domestic tax. However, if a treaty is in place or the foreign source income is effectively subject to tax in the country in which it is earned, tax relief is granted by exemption. Generally the exemption is calculated as the ratio of foreign to woridwide income times the Netherlands corporate tax.
5. Dividends.from foreign subsidiarias are not subject to domestic tax as long asthe parent is not an investment company, the parent owns at least 5 percent of the subsidiary (or less if its participation is connected with its business or serves the public interest), and the subsidiary is subject to a foreign national profit tax.
21. In the application of the exemption method to próvida relief for foreign taxes interest expense incurred by the domestic corporation will reduce foreign source income to the extent that there is a olear relationship between the interest expense and the foreign income.
27. The amount of the reserve for tax purposes is basad on the bank's best estimate of its probable losses.
5. Dividends from a domestic or foreign subsidiary are 95 percent exempt from corporate tax. (The 5 percent included in taxable income is attributed to expenses and charges.)
12. If a corporation cwns at least 25 percent of a company established in a tax haven, its net profit from those operations is subject to domestic tax at the parent corporation's rate, regardiess of type. The parent corporation's tax haven net profit is proportional to its ownership interests in the tax haven operation. in order to avoid this treatment a corporation wouid have to prove that its foreign subsidiary was earning income soiely by doing business in the tax haven country.
23. Currently the top rate is 45 percent. Beginning in 1988 it will be 42 percent.
25. Domestic sharehoiders receive a credit against tax equai to 50 percent of the dividends distributed, and must include the amount of the credit in taxable income.
1. In theory the basic tax system is global, but with reduced rates for forelgn source Income.
2. Forelgn branch income is subject to domestic taxation, but the rate is reduced to 25 percent of the regular corporate tax rate if the income has been subject to foreign tax provisions (whether or not any tax was paid).
4. The typical tax treaty exempts income from a permanent establishment in a treaty country from Belgian tax.
5. Dividends from a foreign subsidiary are subject to domestic tax, but the 95 percent intercorporate dividend exemption (90 percent for holding compa'nies) means that oniy 5 percent(10 percent) is actually taxed. If shares have not been held through the entire accounting period no exemption is allowed.
9. In the case of a permanent investment (shares held for the full taxable year) a deemed paid foreign tax credit of 5 percent (regardiess of actual foreign faxes paid) is allowed, and the reported dividend paid is grossed up by the credit. For dividends on shares held less than a year (non-permanent investments) the deemed paid foreign tax credit is 15 percent, and the reported dividend is not grossed up.
12. While there are no "Subpart P provisions, a transfer to companies located in tax havens of shares, securities, patents, or trademarks can be disregarded by the tax authorities when the transfer does not constitute a genuine business transaction, or the consideration received does not generate sufficient taxable income.
19. Deemed paid foreign tax credits are completely creditable against total income faxes. The 5 percent credit for income from permanent investments is refundable if it exceeds total tax liability.
In general corporate profits paid out in dividends are taxed at the regular cor porate rate. However, no corporate tax is imposed on dividends paid by companies set up (or on dividends attributable to capital increases) in 1982 or 1983 up to 13 oercent of paid up capital. ^
25. Provided certain investment conditions are met, a credit is available for domestic individual stockholders receiving dividends from domestic corporations. Beginning 1/1/88 the credit will be 50 percent of the net dividend received (after deduction of a 25 percent withholding tax). Currently the credit rate is 54.5 percent oí the net dividend received, or 40.9 percent of the grossed up dividend (.545 * (1-.25)= .409).
27. A bank cannot deduct for tax purposes any reserve for hsks that are not specificaliy identified.
3. Some oider treaties próvida for foreign tax credits. Sweden is now negotlating treaties under which foreign faxes are deductible expenses.
5. In the absence of a treaty, dividends from foreign subsidiarias are generally taxabie uniess an exemption has been granted. An exemption can be obtained if the income is taxed abroad either ín the same way or at the same rata (at least 30 percent) as in Sweden.
The statutory foreign tax credit is available oniy in the absence of a treaty.
23. The basic corporate tax rata is 52 percent. in addition there is a "profit sharing" tax of 20 percent on "real", inflation adjusted profits, which is deductible in the following year, and is estimated to have an effective rata on nominal profits of 4-6 peroent.
5. Dividends from a foreign subsidiary are not subject to domestic tax, provided the Danish company owned at least 25 percent of the share capital during the parenfs entire accounting year in which the dividend is distributed, and the income was taxed under an approved foreign tax system. Generaliy approval is supposed to require that the effective rate be at least 35 percent and the dividend not be deductibie from foreign taxable income. if the foreign tax system does not qualify the company may appiy for a refund of foreign taxes paid.
11. To be eligible for the deemed paid credit the dividend must have been declared at the annuai stockholders' meeting in the year foilowing the year it is earned. (if in come is retained in the subsidiary afterthat meeting it will not be eligible for the credit.) As a result, the distributed profit pool is always from the year before the parent's tax year.
12. No specific tax provisions exist, however, tax authorities may correct for income misallocations under the arm's-length principie.
19. Generaliy the limitation is both per country and per type of income (dividends, royalties, etc.). The limitation on the deemed paid credit is calculated separately for each subsidiary, and is determined both by the effective domestic tax rate on the sub sidiary in the year the profits are earned and the effective tax rate on the parent in the year the dividend is paid.
25. Domestic non-corporate shareholders are entitled to a tax credit equal to 25 percent of dividends received and must include the credit in taxable income.
27. in principie banks are allowed to choose between a block reserve provisión of 3 percent of oufstandings, or an individualizad provisión of up to 5 percent of outstandings, with estimates of losses for each debt. The Bank Supervisión Service requires individualizad provisión for bad debts, however, so in practica there is no difference between bad debt reserves for book and tax purposes.
5. Dividends from a foreign affiliate (more than 10 percent ownership)that are paid cut of income derivad from carrying on an active business in a country with which Ganada has or is negotiating a treaty, or that are subject to comparable taxation, are defined as exempt surplus, and are not subject to domestic tax.
7. Withholding taxes on dividends of exempt surplus are not creditable. Dividends paid out of "taxable surplus" — defined as income from an active business in a country with which Ganada dees not have a tax treaty, foreign accrual property income, dividends from taxable surplus of another foreign affiliate, and certain intercompany charges -- are allowed a deduction for withholding tax and underiying foreign tax that produces the same result as a foreign tax credit. Dividends from "pre-acquisition surplus", income that is neither exempt ñor taxable surplus, are not included in taxable income, and are not allowed a foreign tax credit.
9. See note to line 7.
11. Dividends are assumed to be paid first out of exempt surplus.
18. Most foreign source dividends are from exempt surplus. The remainder is generally from low tax rate countries.
20. The characterization of specific items of foreign source income as exempt, taxable, or pre-acquisition would not be changed by the insertion of a holding company between the domestic parent and second-tier foreign subsidiaries. However, if oniy a portion of profits was paid out in dividends, passing those profits through a holding company could increase the portion of dividends paid that was classified as exempt. If some dividends were classified as taxable and there was taxable surplus from both high and low tax countries, passing these dividends through a holding company would allow the pooling of the taxable surplus and associated foreign tax credits, which could in crease the tax savings resulting from the credits.
23. The basis máximum federal rate for 1986 is 46 percent. For income earned within Ganada the federal rate is reduced by 10 percentage points to partiy offset provincial taxes, which average about 14 percent. Income eamed outside of Ganada would not be taxed by the provinces, and is not eligible for the federal abatement. As a result of a provisión in the budget of February 1987, the máximum federal rate applied to foreign source income declined from 46 percent in 1986 to 45 percent in 1987, and
will decline to 44 percent in 1988, and 43 percent in 1989. A 3 percent surtax en fed eral tax iiabiüty increases the effectlve máximum federal rafe to 47.38 percent in 1986, 46.35 percent in 1987, 45.32 percent in 1988, and 44.29 percent in 1989. The proposed income tax reform announced June 18, 1987 would lowerthese rates further, but has not been included in this comparison because it has not yet been passed.
25. The individual shareholder's taxable Income includes dividends received grossed up by one third, and the individual receives a tax credit equal to the gross up (22.22 percent against federal taxes, the rest against provincial taxes). Through 1986 the gross up and credit were 50 percent.
A reasonable deduction is allowed for a reserve for doubtful debts.
APPENDIX B: ADVERTISING AGENCIES
Companies providing business services to domestic ciients, such as advertising agencies, benefitted significantly from the corporate tax rate reduction from 46 percent to 34 percent and, as a general rule, were oniy marginally affected by the various base-broadening measures, such as the new prohibitions on cash-basis accounting, and by the alternative minimum tax.
Advertising agencies serving foreign ciients, as much or more than other providers of business services, must be located within the same countries in which their ciients are operating. From a business perspective, advertising ciients can rarely be served from a U.S. office or an affiliate located in a distant, low-tax jurisdiction. Consequently, U.S. advertising agencies' foreign income is typically earned through foreign affiliates subject to high rates of foreign tax. In addition to bearing the full burden of the foreign country's corporate income tax, such income would typically be subject to a foreign branch profits tax or a foreign dividend withholding tax, respectively. Thus, even under prior law, U.S. based advertising agencies typically paid foreign income taxes at least approximating their U.S. foreign tax credit limitation and derivad littie or no benefit from the deferral of U.S. tax earned through a foreign subsidiary.
Because U.S.-based advertising companies had under prior law paid foreign taxes approximating the limitation on the U.S. foreign tax credit, the reduction in the corporate tax rate from 46 percent to 34 percent had no benefit with respect to foreignsource income. By virtue of their high foreign taxes, advertising agencies were effectively exempt from additional U.S. tax on foreign income under prior law and had incen tive to find low-tax foreign income in order to absorb excess foreign tax credits generated by their overseas agencies.
The impact of the 1986 Act is illustrated in Table B-1. We have assumed that the advertising agency has high-tax foreign operating income subject to corporate tax at a 37 percent rate plus dividend withholding tax at a 10 percent rate. We have assumed that 50 percent of afíer-tax foreign operating income is remitted and subject to U.S. tax.
The assumed tax treatment under prior U.S. tax law is shown on Unes 12 t rough 26. Some U.S. expenses (interest, general and administrativa) would have been allocated against overall foreign income in calculating the foreign source taxable meóme. Under the assumptions we have made,the U.S. advertising agency generated enough low-tax foreign source income to absorb all foreign tax available for credit leaving it with a small U.S. tax in excess of its foreign tax credit.
Tax under the 1986 Act ¡s calculated on Unes 27 through 41. As the Table shows,the lower U.S. tax rate results in excess foreign tax credits offsetting the benefit of the U.S. rate reduction, and essentially no change in the overali effectíve tax rate.
For purposes of determining the impact on intemational competitiveness it is useful to evalúate not only the Impact of the 1986 Act on ai! categories of foreign income taken together, but aiso on the marginal tax rate with respect to different types of income. Appendix G sets forth marginal tax rates formulas which can be applied to different types of income according to the rate at which it was taxed by foreign governments, the proportion of subsidiary profits paid out as a dividend, and so forth The calculation is summarized in Table B-2. In appiying these formulas to the advertising industry, we have assumed that under prior law U.S. advertising agencies were able to generate enough iow-tax foreign-source income to avoid having an overali excess of foreign tax avalladle for Credit, but that given the rate reduction. such agencies will certainly pay excess foreign tax relativa to the limitation under current U.S. law.
Under those assumptions and using the same tax rates, etc. as shown in Table B-1 we conclude that U.S. advertising agencies would be able to reduce fees charged by foreign subsidiarles by a fraction of 1 percent to maintain the same incremental profit rtiargin af^er foreign and U.S. income tax. Were it feasible to serve foreign clients through U.S. offices and to pay foreign withholding tax at an average rate of, say 5 percent of gross meóme, fees could be reduced by about 3 percent. But given the commercial impracticality of serving foreign advertising clients from U.S. offices the latter is an unlikely scenario. '
The taxation of comparable income earned by a multinational corporation based on the eleven countnes included in our survey would not be appreciably different from U.S. taxation under pre-1986 Act tax law. The measurement of an advertising agency's meóme and expense is relatively straightforward and does not differ significantly from count^ to country Because advertising agencies' foreign affiliates' income is typically subject to relatively high rates of local tax, countries like the United States which tax such meóme, but allow a foreign tax credit against that tax, impose littie or no additional tax, which IS-the economic equivalent of exempting such income. As noted in the text countnes (e.g., the United Kingdom) which appear to apply their foreign tax credit
fnTl olT respect to different categories of income often allow significant foreign tax credit averaging" by not appiying "look through" rules to dividends received from foreign holding companies. '«v-civeu
TABLE B-2
RATES:
Subsidiary Before-Tax Profit Margin
Subsidiary Dividend Payout Rate
Subpart F Inclusión Rate
Foreign Country Income Tax Rate for Subsidiary Foreign Country Dividend Withholding Tax Rate
Foreign Branch Before-Tax Profit Margin
U.S. expense apportionment rate
Foreign Country Income Tax Rate for Branch Ratio of
APPENDIX C: COMMERCIAL BANKING
To analyze the impact of the 1986 Act on commerdal banks, we have distinguished high-withholding-tax interest from other foreign source income. Table C-1 below illustrates the impact pf the 1986 Act on a commerdal bank's portfolio of highwithholding-tax crossborder loans, which was subject to a separata foreign tax credit limitation by the 1986 Act. Unes 1-5 set forth our assumptions about that 0.3 percent of loans outstanding at the start of a year stop paying interest or principal during the year. Unes 6-8 reflect our assumption that 95 percent of the funding for the loan is obtained from deposite having an annual interest cost of 7 percent, and the remaining 5 percent of the loan is funded with the bank's own capital. Unes 9 through 12 show the gross interest income calculated at a rate of 8.5 percent per annum before the assumed 15 percent foreign withholding tax is imposed.
Unes 13-25 summarize the way in which the income, expense, and losses might be recordad for book purposes. Specifically, we have assumed that in this instance the bank projects accurately the fraction of the initial loan portfolio which will not be repaid in due course (aven though it may pay interest for some period of time) and establishes a bad debt reserve at the end of the first year for the full amount of the losses inherent in its initial loan portfolio. However, oniy 50 percent of loans which cease paying inter est and principal during a year are actually charged off during that year, with the re maining 50 percent of such loans being charged dff in the first following year.v
Unes 26-47 show how U.S. tax would have been computed under prior tax law. Specifically, Unes 26-33 show the accrual of interest income, including interest receivable on loans which have stopped paying interest, but have not as yet been written off. Unes 34-37 show the calculation of bad debt expense under the bank-experience method. Note that we have assumed that the bank-experience method would allow the bank to establish a bad-debt reserve equal to 0.3 percent of outstanding loans - i.e. this loan portfolio has the same bad-debt risk as the bank has traditionally experienced.'
OQ xn e><pense, taxable income, and tax before credit are shown on Unes u calculating the foreign tax credit on Unes 41-45, we have shown the portion of the bariks overall foreign tax credit limitation attributable to income from this loan portfolio alone. Note that we have assumed that interest expense apportioned against
y This representafion of banks' recognition of bad debts oversimplifies actual experience A more exteüd ^ ® borrower initialty proposes, and a bank reluctantly agraes, to thi ÍÍS fh h l payments and to reschedule principal repayments with the result that the bank continúes to accrue interest income aven though it may not have actually re- ceived intere^ payments from the borrower. The main point which we are seeking to capture ^belt wTh and Iha aSTha"?g"e-rofapr¿S^^
foreign source income equals oniy 80 percent of the incremental interest expense of funding the loan. Under the interest apportionment rules prescribed in Regulation 1.861-8, the interest expense charged for foreign-tax credit limitation would reflect the bank's averaqe interest cost of funds (including low-interest or interest-free deposits), not its incremental cost of funds. Assuming the bank has some other low-foreign-tax income, credit for the 15 percent foreign withholding tax could be claimed in fui), even when the foreign tax available for credit for these particular loans exceed the foreign tax credit limitation with respect to this source of income alone.
Une 46 shows the incremental U.S. tax after credit, which is generally negative because the foreign tax credit exceeds the incremental U.S. tax before credit. Une 47 shows the bank's cash flow after its own debt service and after taxes - the cash flow of the bank's equity holders. As a result of all the assumptions described above, the internal rate of return to that cash flow is 16.7 percent per annum.
The effect of the 1986 Act is assessed in Unes 48-61. The key differences reflected in our calculations are: (1) the deduction for bad debts is limited to specific loan charge-offs with no bad-debt reserve deduction (Une 51);(2) U.S tax is assessed at the rate of 34 percent, not 46 percent (Une 54); (3) the amount of interest apportioned against foreign interest income was assumed to increase from 80 to 90 percent of the incremental interest cost (Une 56); and (4) the foreign tax credit is limited to the U.S. tax attributable to the high-withholding-tax interest considered separately, not overall foreign source income (Une 59).
As a result of the changed tax treatment, the internal rate of return for the cash flow to equity holders is reduced from 16.7 percent to 8.8 percent. To achieve the same internal rate of return as was obtained under prior law, the interest rate charged to borrowers would have to be increased from 8.5 percent to 8.9 percent, a proportionate increase of 5 percent.
The comparison of the U.S. tax rules to those in other counthes will vary according to whether other countries have global/credit tax systems or exemption systems. For those countries which allow a foreign tax credit by statute or by treaty and do not effectively limit the credit to the domestic tax attributable to high-withhbiding-tax interest income (e.g., Japan), the net domestic tax burden would be essentially equivalent to that under prior U.S. tax law under the overall foreign tax credit limitation. For those countries which exempt such income from taxation (e.g., Switzerland), the tax treatment would be essentially equivalent to the effective exemption under the 1986 Act.
The impact of the 1986 Act on commercial banks' foreign income other than that from high-withholding-tax interest can be computed using the formulas set forth in Appendix G. Table C-2 shows the price changes which will preserve the after-tax return on foreign source income other than high-withholding-tax interest generated by a foreign subsidiary, a foreign branch of a U.S. office, and a U.S. based office, respectively. In each case, we assumed a 10 percent before-tax profit margin. The foreign
EFFECTIVE TAX RATES: COMMERCIAL BANKING INCOME OTHER THAN LENDING
nSUB p d t w-div
nBRANCH a t+b
nU.S. wl
EFFECTIVE TAX RATES
U.S.
IMPACT ON GROSS INCOME
FOREIGN
Subsidiary Before-Tax Profit Margin
Subsidiary Dividend Payout Rate
Subpart F Inclusión Rate
Foreign Country Income Tax Rate for Sub. Por. Cnty. Dividend withholding Tax Rate
Foreign Branch Before-Tax Profit Margin
U.S. expense apportionment rate For. Country Income Tax Rate for Branch
Ratio of profit before tax to gross inc. For. cnty. other inc. withhold. tax rate
Oíd U.S. Tax Rate New U.S. Tax Rate
subsidiary is assumad to pay out 25 parcant of its nat aarnings as dividands, and 50 parcant of its incoma is assumad to ba Subpart F incoma. The foraign country is assumad to tax incoma at a 25 parcant rata, and aiso to imposa a 10 parcant withholding tax on dividand paymants.
Tha foraign branch is assumad to faca a combinad foraign incoma and branch profits tax rata of 50 parcant, with 2 parcant of its axpansas apportioned against foraign sourca incoma. Incoma of tha U.S. company othar than dividands is aiso assumad to ba subjact to an avaraga withholding rata of 2 parcant.
Wa aiso assuma that undar prior law U.S. banks wara abla to ganarata anough low-tax foraign sourca incoma to avoid having an overairexcass of foraign tax avaiiabla for cradit, but that givan tha rata raduction and tha changas in tha foraign tax cradit limitation, approximataly haif of banking foraign sourca incoma will faca foraign tax in excass of tha cradit limit aftartha 1986 Act.
Tha rasulting prica changas raquirad to prasarva aftar-tax incoma for foraign sourca incoma othar than high-withholding-tax intarast aarnad by a U.S. corporation, a foraign branch, and a foraign subsidiary ara -1.36 parcant, -.63 parcant, and -.24 par cant raspactivaly. A simpla avaraga of tha lattar two figuras of -.50 parcant is usad for ai! foraign affiliatas.
Wa than avaraga thasa prica changa parcantagas with tha 7.9 parcant prica incraasa raquirad to kaap constant tha aftar-tax raturn on orossbordar ianding to highwithholding-tax countrias, saparataly for a U.S. corporation and for foraign affiliatas. As waights wa usa tha sharas of incoma raprasantad by intarast vs. othar incoma, saparataly maasurad for U.S. corporations and foraign affiliatas.
Whathar U.S. banks hava a compatitiva advantaga or disadvantaga vis-a-vis foraign banks with raspact to foraign incoma othar than high-withholding-tax intarast has no simpla answar. To tha axtant foraign countrias are subjacting comparable incoma to tax at highar ratas than tha naw U.S. 34 parcant rata, U.S. banks will hava gainad an ádvantaga vis-a-vis thosa banks but not vis-a-vis foraign banks whosa foraign incoma is aithar axampt from tax or taxabla at a lowar rata. And against any advantaga attributabla to tha rata raduction must ba offset tha additional U.S. tax on account of tha broadanad Subpart F rulas.
APPENDIXD: INVESTMENT BANKING
Broadly speaking, investment banking differs from commercial banking in that investment bankers put their own money (including borrowed funds) at risk oniy for limited periods of time (e.g., in underwriting a new security issue). Investment banking consists of various actívities, such as undenvriting new security issues, security brckerage and trading, advising ccrpcrate clients en mergers and acquisiticns, and finance adviscry wcrk.
Wlth respect te fereign eperatiens, the mest significant changes affecting invest ment bankers generally was the repeal cf the prior law exclusión from Subpart F income of dividends and interest earned by ccntrciled fereign subsidiaries en their trading portfolios and in the interest allocation rules relating te the fereign tax credit limitation. U.S. investnient bankers which had taken minority positions in fereign companies (e.g.", First Boston's minority interest in Credit Suisse) were aiso penalizad by the previsión subjecting dividends received en such investments te a fereign tax credit limitation.
The impact of the 1986 Act en the fereign eperatiens of a U.S. investment bank ing firm is illustrated in Table D-1. For completeness, the investment bank is assumed te earn fereign source income through a fereign subsidiary, a fereign branch, and directly from a U.S. office. Unes 1-11 describe that earned from a fereign subsidiary located in a fereign country imposing a 50 percent rate of tax en profits and a 5 percent rate of tax en remitted dividends.1/
In order te take advantage of the pre-1986 Act deferral of income earned through fereign subsidiaries, the subsidiary is assumed te remit oniy 25 percent of its after-tax earnings.
Unes 12-16 show income earned through a fereign branch subject te a total (income plus branch profits) rate of fereign tax of 50 percent. Unes 17-20 show fereign income earned directly by a U.S. office (e.g.,for the performance of investment advisory services) and subject te a 5 percent fereign withholding tax.
Unes 21-28 show the U.S. tax under the pre-1986 Act law. In short, U.S. taxable income includes the dividend from the fereign subsidiary grossed up by the amount of the underiying fereign tax, the fereign branch profit before tax, and the pretax fereign income less allocable expenses of the U.S. office. In computing the fereign tax credit limitation (Unes 34-38), we have subtracted not oniy the directly allocable expenses shown at Une 25, but aiso a proportionate share of general and administrativa ex penses shown at Une 35. Our analysis assumes that the formar, directly allocable
1/ Subsidiary profits and dividends paid to U.S. shareholders might actually be taxed at significantiy higher or significantiy lower rates of tax. The rafes shown here are intended to represent average rafes not typical rates. ^
expenses would not have been incurred but for the activity giving rise to the foreign income, but the latter, apportioned U.S. expenses would have been incurred in any event. Note that we have assumed that in the aggregate the U.S. tax on foreign source income exceeded by a considerable margin the foreign tax, so that the foreign tax credit limitation was not binding.
Unes 45-54 show U.S. tax under the 1986 Act. it is assumed that all of the income is financial services income and subject to a single foreign tax credit limitation. The key differences between prior and present tax law in this instance are as follows. First, part of the foreign subsidiary's income may consist of interest or dividends which, even though attributable to a foreign investment banking business, are taxable under Subpart F - see Unes 46-47 for the taxable income effect and Unes 55-58 for the deemed-paid tax effect. If the Subpart F income less related expenses exceeds the dividend grossed up to include the underiying tax, the excess will be added to taxable income under the new law.2/
Second, the U.S. tax rata was reduced to 34 percent ~ see Une 53. Third, the amount of U.S. expense apportioned against foreign source income has been increased, a changa which has an impact oniy if the foreign tax credit limitation is binding (as it may well be on account of the rata reduction from 46 percent to 34 percent).
The impact of the 1986 Act on investment banks' foreign income other than that from high-withholding-tax interest can be computad using the formulas set forth in Appendix G. Table D-2 shows the price changes which will preserve the after-tax return on foreign source income generated by a foreign subsidiary, a foreign branch of a U.S. office, and a U.S based office, respectively. In each case, we assumed a 20 percent before-tax profit margin. The foreign subsidiary is assumed to pay out 25 percent of its net earnings as dividends, and 25 percent of its income is assumed to be Subpart F income. The foreign country is assumed to tax income at a rate of 50 percent, and aiso to impose a 5 percent withholding tax on dividend payments.
The foreign branch is assumed to face a combinad foreign income and branch profits tax rate of 50 percent, with 5 percent of its expenses apportioned against foreign source income. Income of the U.S. company other than dividends is aiso assumed to be subject to an average withholding of 2 percent.
We aiso assume that under prior law U.S. investment banks were able to genér ate enough low tax foreign source income to avoid having an overall excess of foreign tax available for credit, but that given the rate reduction and the changes in the foreign
21 Strictly speaking, the Subpart F income is taxable, and the grossed-up dividend is excludabte as previously taxed income to the extent it does not exceed Subpart F income, so the addítional taxable income is the excess of the Subpart F income over the grossed-up dividend.
nSUB P d t w-div
nBRANCH 1 a t+b
nU.S. wl
EFFECTIVE TAX RATES
FOREIGN SUBSIDIARY
Subsidiary Before-Tax Profit Margin
Subsidiary Dividend Payout Rate
Subpart F Inclusión Rate
For. Country Inc. Tax Rate for Sub. For. Cnty. Div. withholding Tax Rate
For. Branch Before-Tax Profit Margin
U.S. Expense Apportionment Rate For. Cnty. Inc. Tax Rate for Branch
Ratio of Prof. Bef. Tax to Gross Inc For. Cnty. Other Income With. Tax Ra
Oíd U.S. Tax Rate New U.S. Tax Rate Excess Excess Foreign LirnitTax ation Average
IMPACT ON GROSS INCOME
a/ This column reflects simple averages of the preceding two, and dees not necessarily reflect the consequences for any specific bank.
tax credit limitation, approximately half of investment banking foreign source ¡ncome will face foreign tax in excess of the foreign credit limit afterthe 1986 Act.
The resulting price changes required to preserve after-tax income for foreign source income earned by a US corporation, a foreign branch, and a foreign subsidiary are -3.6 percent, -1.10 percent, and +.06 percent respectively. The latter two figures average to just under minus one-haif of 1 percent; -1.0 percent is used for al! foreign affiiiates.
Just as it is difficult to generaliza about the impact of the 1986 Act on investment banks, so too are comparisons difficult between Ü.S. investment banks versus their foreign competitors generally. investment banks in high-tax countries (e.g., Japan) that eliminate international doubie taxation through a foreign tax credit mechanism bear essentially the same tax burden as did Ü.S. investment banks under prior law, and thus will be at a competitiva advantage vis-a-vis Ü.S. investment banks with respect to those activities that generate income burdened by the 1986 Act (e.g., interest and dividends subject to the broadened Subpart F rules). Investment banks in moderate-tax countries (e.g., the United Kingdom) that eliminate international doubie taxation through a foreign tax credit mechanism lost their competitive advantage with respect to low-tax foreign income subject to domestic tax, but gained a new advantage with respect to those types of income burdened by the 1986 Act (e.g., interest and dividends subject to Subpart F income).
Foreign-based investment banks earning income through foreign branches and subsidiarias exempt from domestic tax by statute (e.g., Switzerland, the Netherlands, France, Hong Kong) or by treaty (e.g.. Cañada and West Germany) generally enjoy a competitive advantage with respect to activities generating low-foreign-tax income and which are taxable to Ü.S. investment banks because they are earned by a foreign branch or are subject to the Subpart F income. Such foreign-based investment banks, if subject to a high rate of domestic tax (e.g., West Germany) would be at a competitive disadvantage with respect to: (1) low-foreign-tax income éarned directly by a domestic office and thereby subject to domestic tax, and (2) in cases where no foreign tax credit is available (e.g, income derived by domestic offices from non-treaty countries).
I. In General
Insurance companies are taxed under special rules set forth in Subchapter L (Sectlons 801-846) of the internal Revenue Code. Because most readers are probably unfamiliar with those provisions, which were heavily amended in 1984 and in 1986, a brief explanation of insurance taxation follows.
An "insurance company" taxable under Subchapter L means a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracta or the reinsuring of risks underwritten by insurance companies. Insurance companies are subdivided into "life insurance companies" and all other insurance companies (i.e., property and casualty (P&C)insurance companies).
A life insurance company is an insurance company engaged in the business of issuing life insurance and annuity contracta or noncancellable contracta of health and accident insurance providing that the sum of its life insurance reserves plus its unearned premiums and unpaid losses on noncancellable life, health or accident policies comprise more than 50 percent of its total reserves.
The insurance industry consista of both conventional stock insurance companies and mutual insurance companies. A mutual insurance company has no shareholders and is legally owned by its policyholders. fvlutual insurance companies usually issue policies which under certain circumstances pay dividends to policyholders. Dividendpaying policies are aiso issued by stock insurance companies, particularly in workers' compensation and life insurance linea.
As a general rule, affiliated life insurance corporations can join each other in filing a consolidated tax return, but cannot join a consolidated return that includes affiliated non-life insurance corporations and/or non-insurance corporations. An affiliated group may elect to include all life insurance affiliates that have been members of the affiliated group for thé preceding five years. However, the amount of a net operating loss of non-life insurance affiliates that can be offset against the taxable income of life insur ance affiliates is limited to 35 percent of the net operating loss of the former or 35 percent of the taxable income of the latter, whichever is less.
II. Regulatory and Financial Accounting
Virtually all insurance companies are regulated by the various states in which they do business and must file annual statements conforming to standards promulgated by the National Association of Insurance Commissioners (NAIG). Because the computation of an insurance company's taxable income is generally based on the NAIC report, understanding the insurance regulatory accounting is a prerequisite to understanding insurance company taxation.
In ¡nsurance company accounting, total operating income or loss equals the sum of underwriting gain or loss plus net Investment gain or loss. Underwriting gain or loss represents the company's premium income earned during the year less its policy acquisition costs, loss and loss adjustment expenses incurred (whether paid or estimated), and Its operating expenses. Net investment gain or loss equals the return on its invested assets plus capital gains and losses, minus investment expenses.
1. Property and Casualty Insurance
A property and casualty insurance company typically charges and receives a premium payment before the period of time the insurance is in effect. Consequently, premiums are first credited to an unearned premium account, a liability on the insurance company's balance sheet representing its obligation to reimburse insured losses. Premium income is then earned and the unearned premium balance reduced ratably over the period in which the insurance is in forcé. Although often a straight-line pattern of income recognition would apply, in certain cases where the coverage provided is not uniform over the coverage period (e.g., insurance of warranty risks) premium income may be accrued based on a time profile reflecting the varying coverage provided.
Policy acquisition costs, such as commissions paid to insurance agents, must be expensed for regulatory purposes even though they would be capitalized and amortizad over the coverage period for financial reporting purposes. At the same time premium income is earned and the unearned premium account is reduced, a property and casualty insurance company (but not a life insurance company) accrues the loss and loss adjustment expense it expects to incur on account of the risk insured. As time passes and insurance claims and loss-adjustment expenses are paid, the insurance company charges those payments to the loss reserve, rather than to current income. However, the amount of reserves provided may have to be adjusted to reflect revised loss projections, in which case current income will be impacted. That is to say, for regulatory and financial reporting purposes, the total loss and loss-adjustment expense incurred in a year is measured by losses and loss adjustment expenses paid plus the increase (or minus the decrease) in loss reserves during the year.
In some property and casualty insurance product lines (e.g., fire insurance) most claims are paid out within ene or two years of the period the insurance was in effect. In other insurance lines (e.g., medical malpractice insurance), several years and even decades may pass before losses can be fully determined and claims paid. Even if an insurance company could forecast with certainty its ultimate losses and time for their payment, it would stiil have a considerable period of time during which it would be holding and investing its loss reserves. An insurance company thus aiso faces the risk that the return on its investments will be less than it forecast at the time it set its policy premium.
2. Lífe Insurance
The primary statutory accounting difference between life insurance and a property and casualty Insurance is that on a whole life policy, a life insurance company would initially accrue a liability equal to the net present valué of the amount to be paid upen the death of the insured. A discount rate, mortality table, and other assumptions necessary to calcúlate a minimum required reserve would generally be determined by a state regulatory commission. Over the life of the policy, the life insurance company would increase its reserve to reflect the increase in the net present valué on account of the reduction of time remaining in the life of the insured. Thus. in life insurance com pany accounting, reserves for future payments to beneficiarles are discounted to reflect the time valué of money, whereas in P&C insurance company accounting, reserves are not discounted (because the loss has already occurred, even though the amount to be paid may not be paid for several years). This difference in practice presumably reflecte he rnuch greater certainty in life insurance both with respect to the magnitude of the loss (which IS defined by the life insurance policy) and the timing of the loss (which is actuarially highiy predictable).
III. Taxation
Propertv and Casualtv Insurannfi
Prior to the 1986 Act, a property and casualty insurance company's taxable meóme was ciosely relatad to regulatory book income, the primary differences being: ? interest on indebtedness of state and local govern- ments.(2)the dividends received deduction,(3) mutual property and casualty insurance companies were erititled to a special "Protection Against Loss"(PAL)account deduction equal to the sum of 1 percent of underwriting losses plus 25 percent of statutory underwriting meóme (phjs certain other losses). In general, PAL deductions were restored to axable meóme after five years, thereby effecting a deferral of a portion of underwriting meóme of up to five years. uci wmmg
The 1986 Act made four significant changas in the tax treatment of property and casualty insurance companies. ^ ^
Íh
Premium Starting in 1987, P&C insurance companies ust reduce by 20 percent the deduction from gross income for the increase in the unearned premium reserve. This adjustment has the same effect as capitalizing an equivalen amourit of policy acquisition costs (e.g., sales commissions) and amortizing tho^P rntf? h insurance policy is in effect, rather than allowing those costs to be expensad when they are incurred. In addition, 20 percent of the
.
unsarnGd prGmium rGSGrvG outstanding at tha and of 1986 must ba includad in taxabla incoma ratably overthe six yaar interval 1987-92.
2. Proration of Tax Exampt Intarest The deduction for losses incurrad is reduced by 15 parcant of tha sum of tha insurance company's tax-exempt intarest plus tha daductibla portion of dividands racaivad from unaffiüatad corporations (which, as notad abova, was reducad from 85 percent to 80 percent for dividands received after 1986).
The 15 percent disaliowance applies \with respact to otharwisa tax-axampt intarest and dividands received with respact to bonds and stocks, respactivaly, acquirad aftar August 7,1986. Note that the 15 percent disaliowance generally does not apply to the deduction equal to 100 percent of dividends received from affiliated corporations. However, that deduction is disallowed to the extent that such dividands ara paid out of an affiliata's tax-exempt interest or dividend income.
3. Discountinq of Loss Reservas Tha deduction for lossas incurrad is aiso reducad to raflact a tima-valua-of-monay adjustmant for the difference between the time a loss is accruad and tha time that loss is expected to be paid. The time-value-of-money adjust mant is basad on tha P&C insurance industry's overall historical loss paymant axparienca classifiad by major insurance linas (e.g., automobila insurance, fira insurance, etc.) or, if an insurance company so elects, its own historical loss-payment experiance for an insurance lina. Projectad loss paymants are generally discountad at tha avaraga of tha applicabla Federal mid-tarm intarest ratee for the 60-month period immadiataly pracading tha calendar yaar to which tha discounting first applies. Once a serias of discount factors has first been applied to loss reserve for an accident year (i.e., the year in which the incidant occurs that gives risa to the unpaid loss) for a line of insurance business, that serias continuas to be applied in futura years without furthar adjustmant for changas in loss-paymant experiance or intarest ratas.
The discounting methodology first applies for 1987, and insurance companias are not required to include in taxable income the differential between the undiscounted loss reserve ks of the end of 1986 and the discountad loss reserve - the differential batwaan tha amount of loss expansa daducted in pravious years and the amount which would have been daducted had the discounting provisions been in effect for past years. The so-called "fresh start" results in insurance companias' receiving a one-time examption from tax for the differential between the undiscounted and the discountad loss reservas. However, the "fresh start" amount is added in full to the corporations' earnings and profits for 1987.
The 1986 Act aiso repealed the special deduction for mutual property and casualty insurance companias' additions to the PAL account.
2. Ufe Insurance
As noted above, because of the greater predictability of the size and timing of loss under life-insurance policies, life insurance companies, unlike property and casualty insurance companies, have traditionaily accrued reserves based on timevalue-of-money concepts. The taxation of üfe insurance companies was overhauied substantially in 1984 to provide that life insurance companies wouid be subject to corporate tax on their underwriting and invesíment income. Uniform mortality, investmení yieid, and other standards were prescribed for purposes of computing'the tax deductlon for additions to life-insurance reserves. While life insurance companies generally expense policy acquisition costs for tax and regulatory book purposes, a first-year term method of computing life insurance reserves that offsets the effect' of expensing policy acquisition costs may be elected. Although disadvantageous for tax purposes, by avoiding a reportad loss for regulatory purposes, this election allows a life insurance company to preserve its capacity to undenvrite additional insurance.
To mitigate the effect of various provisions of the 1984 reforms, life insurance companies were allowed a special deduction equal to 20 percent of its tentativo taxable income, which reduced the máximum effective rate of corporate tax from 46 percent to 36.8 percent. This special deduction was repealed in 1986 for years after 1986, so in effect the máximum rate of tax on life insurance company income went from 36.8 percent for 1986 to 40 percent for 1987(on account of the blended rate) and 34 percent for later years.
The 1986 Act aiso provided that deduction by mutual insurance companies for policyholder dividends would be reduced by a "differential earnings amount" to achieve an historical 55-45 "segment balance" in the tax burden between mutual versus stock life insurance companies and to offset the competitive advantage mutual life insurance companies were alleged to have on account of the deductibility of policyholder, but not shareholder, dividends.i/ The "differential earnings amount" is computad by appiying a differential earnings rate which generally reflects the difference between the average earnings rate of larga stock life insurance companies and that of all mutual life insur ance companies,to mutual insurance companies' average equity base.
h,.t th^ disallowance of policyholder dividends appiies to mutual P&C insurance companies e Treasu^ Department is required by Congress to issue a report before January 1 1989 as to Tomn^- ^ P® required. The special deduction for mutual P&C insurance companies additions to PAL accounts was repealed in 1986.
56
64
TAXABLE INCOHE
65 Toul Prsaiia Incoas
66 Policy Acquisitson Coses
67 Lossss Incurrsd
68 UndscvriClng Gsin (Loss)
69 Cuh At SLare
70 ToLsl InTsscaanc Incoas
71 Currcnc Tusbla Incoas (Loss)
72 ToLil Taubls Incoas (Losa)
73 Tuibls Incoas
74 Loss CuryfoTvard
75 U.S. Tu Bafors CrsdiC
76 Poreign Tu Paid 6 Ossasd Paid
77 U.S. Tu Aftsr Crsdlt
78 Total Tu Paid
79 Aftsr-Tu Cuh Plow '
80 OmilatiTs Cash Flow
3. Foreiqn Income
The 1986 Act subjects to current U.S. tax most income earned by a foreign insurance subsidiary. First, income of controlled foreign corporations from the insurance of risks other than those in which the CFC is organized ("same country" risks) are now subject to current U.S. tax, whereas oniy income from the insurance of U.S. risks were subject to current U.S. tax under prior iaw. Second, even when a CFC is insuring same country risks, income from investment of unearned premiums and reserves is now taxable currently to its U.S. shareholders, whereas under prior Iaw, insurance company investment income was not taxable currently if such investments were ordinary and necessary for the proper conduct of its insurance business. Thus,the oniy portion of an insurance CFC's income which continúes to be tax deferred is the underwriting gain, ¡f any,from insuring same-country risks.
In determining the amount of a CFC's income currently taxable to its U.S. shareholders, U.S. not foreign tax accounting principies are applied. Thus, in calculating Subpart F insurance income, 20 percent of a property and casualty insurance subsidiary's increase in unearned premiums is disallowed, and loss reserves must be discounted based on loss and loss-expense payment histories of U.S., not competing foreign, insurance companies.
In general, insurance income, including same-country underwriting gains and income from the investment of its unearned premiums and reserves, is included with other financial services income for foreign-tax-credit-limitation purposes. üke other corporations, interest income subject to foreign withholding tax at a rate of 5 percent or more will be subject to a separata foreign tax credit limitation, as will any non-insurance income.
IV. Impact of the 1986 Act
Table E-1 evaluates the impact of the 1986 Act on income earned by a property and casualty insurance company through a controlled foreign subsidiary. ünes 1-6 show how premiums are first added to uneamed premium income and amortizad over the assumed two-year interval the policy is in effect. Unes 7-9 show policy acquisition costs, which would aiso be amortizad forfinancial reporting purposes, but expensad for regulatory and tax purposes. Unes 10-18 show the projected loss and loss reserves for each of the two years the policy is in effect. The projected loss payment percentages (34.3 percent in the current year, 26.7 percent in the second year, etc.) are based on the discount factors in the Composite Schedule P insurance lina, sea below.
<•1
<•5
51 PraBlua Incona Accruad
52 Total Pranlua Incona
53 Taz Projaccad Loia
54 Cmlatlaa Taz Projacead Losa
55
57
58
59 Incraaza
60 Taz Daducelon
61
62
63 Incraaza
64 Taz Oadiicelon lAXABLE INCOME
65 Total Pranlia Incona
66 Pollcy Acquisieion Ooitz
67 Loiiai Incurrad
68 Undacvrleing Galn (Lozi)
69 Casti At Start
70 Total Inaaseaane Incona
71 Ourrane Tazabla Incona (Uozc)
72 Total Tazabla Incona (Loza)
73 Tazabla Incona
74 Lozz Carryfocvard
75 U.S. Taz Bafora Oradle
76 Foraign Taz Paid & Daanad Pald
77 U.S. Taz Afear Oradle
78 Total Taz Pald
79 Afear-Taz Caah Flow'
80 CUaulaelra Oazli Flow
We have assumed that with total underwriting losses and expenses over the life of the poücy of $1,000, the insurance company wouid charge a premium of $1,000 and thus have no underwriting gain or loss over the life of the policy.
Unes 27-40 show the calculation of foreign income tax, which for convenience we assumed was similar to U.S. tax law prior to the 1986 Act. Foreign tax is assumed to be assessed at the rate of 15 percent. Dividends, which are assumed to equal 25 percent of after-tax profits, are subject to a 7.5 percent withholding tax.
Unes 41-48 show U.S. tax under prior tax law, total tax paid, and after-tax cash flow. Taking account of the investment income earned at a rate of 9 percent per annum on the accumulated after-tax cash flow, the insurance company's cumulative profit after finally adjusting all losses ~ its reward for putting its capital at risk ~ is positiva.
Unes 49-80 shows its U.S. tax under the 1986 Act. Unes 49-52 reflect the disallowance of 20 percent of the addition to the unearned premium reserve, and Unes 53-64 show the discounting of loss payments and loss adjustment expenses. The discount rate of 7.2 percent per annum is that applicable to losses accrued in 1987.
Unes 65-80 show the calculation of U.S. tax on the assumption that all of the foreign subsidiary's insurance income is taxable under Subpart F. (Note, incidentally, that because underwriting expenses and losses exoeed premium income for the policies in question, limiting Subpart F income to investment income oniy, as is done with respect to "same country" risks, could in certain oiroumstances result in the insurance company s paying more, not less, U.S. tax.) Lines 49-52 show how under the 1986 Act the insurance subsidiary would have to include in income 20 percent of the amount which would otherwise be added to the unearned premium reserve.
Unes 53-56 develop the loss reserve discount percentages based on the appli cable 7.20 percent discount rate and the loss payment rates for the Composite Schedule P insurance line, as speoified in the IRS Rev. Proc. 87-34 applicable to calendar year 1987. Unes 57-64 apply those discount percentages to derive the tax deduction for losses and loss adjustment expenses under the 1986 Act.
Unes 65-80 show the calculation of taxable Subpart F income, U.S. tax before and after the foreign tax credit, and the after-tax cash flow. In calculating the cash avalladle for investment in each year (Une 69), we have subtracted U.S. as well as foreign tax, atthough U.S. tax would be payadle by the U.S. parent, not its foreiqn subsidiary. ^
The impact of the 1986 Act is most accurately assessed by comparing the cumu lative cash flow before and after the 1986 Act- Une 48 and 80, respectively. To offset
fully the effect of the 1986 Act, the insurance company would have to increase its premium by 6.5 percent.2/
Tabla E-2 shows the impact of the 1986 Act on Insurance wrítten directly by a foreign branch or U.S office. A key difference between the results shown there and those in Tabla E-1 is that the initial losses incurred under prior law could be offset against other U.S. taxable income, which results in a substantial front-end tax saving. In addition, we have assumed that 25 percent of the insurance company's investment portfolio is invested in tax-exempt securities and subject to the 15 percent disallowance under the 1986 Act(Une 81).
Under the assumptions made in Tabla E-2, the benefit of the reduction in the corporate rata from 46 percent to 34 percent more than offsets the various basebroadening measures applicable to the property and casualty insurance industry, and a property and casualty insurance company writing policies abroad directly from its U.S. office or through a branch could preserve its after-tax retum while actually lowering its pnce slightiy.
Underwriting through a branch or a U.S. office is distinctly less important in intemational insurance than are operations through subsidiarles (largely because of foreign government regulation). With respect to the more significant subsidiaries, U.S. insurance companies were disadvantaged as a result of the 1986 Act. Under realistic assumptions about the economic environment and loss experience of the industry, underwriters would have to raise prices approximately six percent to preserve a constant after tax return.
2/ The same effect on premium would be obtained if tt were assumed that dividends were distributed, but no additional U.S. tax was paid because the insurance company had a domestic source loss against which it could offset its foreign source income.
APPENDIX F: OCEAN SHIPPING
In General
Ocean shipping is a capital-intensive industry. Under prior law,the Investment credit and most accelerated AGRS depreciation were not available for property used predominately outside the United States. However, vesseis documented under the laws of the United States and operated in the toreign or domestic commerce of the United States qualified as 5-Year ACRS property and for the investment credit at the ful! 10 percent rate, as did containers used in the transportation of property to or from the United States and other water-transportation equipment. Under the Tax Reform Act of 1986, eligible U.S. containers and vesseis wouid generally be 5-Year and 10-Year property, respectively, and be depreciated using a 200 percent-declining-balancemethod-switching-to-straight-line method under the regular(as opposed to alternativa minimum)tax provisions. Other industry capital would generally be 15-Year property depreciated using a 150 percent-declining-balance-switching-to-straight-line method. The investment credit was repealed for all types of property by the 1986 Act; investment credits available with respect to "transition property" orcarried forward from years before 1987 are reduced by 17.5 percent for 1987 and 35 percent for years after 1987.
Under prior law, property used predominately outside the United States - which included vesseis and containers other than those described in the preceding paragraph "was depreciated using a 200 percent-declining-baíance-method-switching-tostraight-line method based on the class life of the property,6 years for containers, 18 years for vesseis and 20 years for other water transportation equipment. Under the 1986 Act, property used outside the United States continúes to be depreciated over its class life, but using the straight-line, ratherthan an accelerated, method of depreciation.
Like other capital-intensive industries, ocean shipping may be impacted more by the imposition of the Altemative Minimum Tax than by the changes in the regular income tax. AMT income is based on "alternativo depreciation"- the system described above for calculating regular tax depreciation for property used predominately outside the United States. AMT income aiso includes amounts contributed to, and earnings on, a Merchant Marine Capital Constmction Fund that are deductible in calculating regular taxable income. Perhaps most significantly, the amount of net operating losses incurred in recent years when the shipping industry was depressed that can be carried forward cannot reduce the AMT by more than 90 percent, which dilutes the economic valué of the NOL carryover.
II. Foreign Provisions of the 1986 Act
Severa!foreign provisions of the 1986 Act impacted U.S.-controIIed ocean shipping. First and most important, the U.S. tax on shipping income earned through controlied foreign corporations can no longer be deferred by reinvesting those earnings in qualified shipping assets. Second,the rule for determining whether income is foreign or domestic source was changad from one based on the number of days a ship spent within U.S. territorial waters (in the case of bare-boat charters) or according to where expenses were sourced (time-charters)to one under which 50 percent of income from transportation to or from the United States is U.S. source, which effectively increased the portion of total income which is domestic source and reduced that which is foreign source. This is important for foreign tax credit purposes. Third,the foreign tax credit limitation will be applied separately to ocean shipping and other transportation income (aircraft shipping income),thereby eliminating U.S. corporations' ability to apply excess foreign taxes from other foreign activities against the U.S.tax on ocean or aircraft shipping income. Fourth, the amount of interest expense which must be apportioned against various categories of foreign source income will probably be increased by the expense allocation rules.
III. Evaluation of Impact
The impact of the 1986 Act on.U.S.-based ocean shipping companies is evaluated in Table F-1 for U.S.-flag ships owned by a U.S. corporation and Table F-2 for foreign-flag shlps owned by foreign subsidiaries of U.S. corporation. Unes 1-4 of Table F-1 project the underiying economice of a U.S. corporation investing $100 in a U.S. flag ship. Gross income (Une 2) has been set by trial-and-error procedure at a leve! that generates an after-tax, after-debt-service cash flow having an interna! rate of return of approximately 17 percent per annum — see Une 35. Shipping income is assumed to be subject to foreign tax averaging 1 percent of gross shipping income. Operating costs (Une 3)are assumed to trend upward over time as the ship ages and operating and maintenance costs increase.
Unes 6-9 réstate the underiying economic amounts in current accounts based on a projected inflation rate of 4 percent per annum (Une 5). Unes 10-13 show the book valué of the shipping asset assuming 25-year straight-line depreciation. Unes 14-17 show debt and debt-service costs on the assumption that the ship would be financed 65 percent with long-term debt, and that the associated interest cost would be 11 percent per annum. Unes 18-19 show book net income and cash flow before U.S. income tax; Une 20 shows the 4.8 percent interna! rate of retum to the before-U.S.-tax cash flow shown on Une 19.
IBHf(2: IWWI OF IW TflI RfrOW flCT Oí 1966 W OCfOH SHIPTING ■ ÍÜKIEH aBSIDIARY/FOICia» FIM
im CnMMIC R69WPTI(K aieíom im? oaiM p«uicii»6
1 Nn Invnlatnl I'I7 I)
2 6rM% Incoa* 1*17 •!
3 Forti|n T«i ('17 11
k Optrtiinf Cotll (ft7 II
CURfOn tOiM PfflJECTKM
5 Inflition Indfi
b Mm InwslKnk
7 Grott Incoa*
I Fonrifn lai
9 Opfr«tin| CoiU
MfHI 9cn
II Grosi Invrtlatnl - COY
11 looli Deprvciitlon
12 AccuiuUltd DtpraclallM
13 Hrt InvHtamt * EOV
Xi1 Pié KBT SERVIS
14 OuUk*ndÍn| D*bl - EQY
15 Inttmi Eip*m*
IG Oitnf* In Principal
17 IoIjI Dtbl Sfrvict
28 Inlirnil lili of litiir* 17.8*
PIIOR lAI LAU
28 Gro» InraM
21 OpiTilitif Coili
22 DipriclilíM litll
23 II Viar DDI SL - *
24 ll-Yitr DM-SL DipncUtion
25 Inliml [ipifoi
24 Profll Ilion lii
27 Fanl|n Til
21 Curnnl Prolil Aflir Fonl|n lia
29 Cirrifil Pnlil liit Ciiryovir
31 loM Cirriid Onr
31 Oivilfod
32 Dmtd Pili Cndit
33 Grcniid IJf Itcow
34 lii kion Cndit
35 Foni|n Tii Cndit
34 U.S. Til Altir Cndit
37 Cith Flw Aflir US. lii
31 Intirnil liti
Unes 21-33 calcúlate net U.S. tax under prior tax law. The investment is assumed to qualify for the 10 percent investment credit and, after a 5 percent basis reduction, for 5-Year ACRS depreciation. We have assumed that the shipping company would have sufficient taxable income from other sources to claim all deductions and credits in the first year they were available. Une 34 shows the cash flow after debt service,foreign and U.S. taxes. As noted above,the level of gross income shown on Une 2 was calculated so as to yieid an internal rate of return to that cash flow of approximately 17 percent per annum (Une 35). The result that the internal rate of return for the after-ü.S.-tax cash flow is higher than that for the before-Ü.S.-tax cash flow reflects the significant benefit of accelerated depreciation and the investment credit under prior tax law.
Unes 36-45 show the regular U.S.tax under the 1986 Act. Without the invest ment credit and with less accelerated depreciation, the internal rate of return to the after-regular-tax cash flow (Une 46)would be reduced to 7.2 percent per annum Unes 48-55 show the comparable results under the new AMT on the assumption that the shipping income has sufficient AMT income to absorb any AMT loss generated by this investment. Une 56 shows the after-AMT net cash flow, which yields an infernal rate of return of 5.6 percent per annum.
If the U.S. shipping company could increase its gross income(Une 2 and 7), it would, of course, generate net cash flows with higher internal rafes of return. To obtain approximately the same internal rate of return after the regular tax computad under the 1986 Act as it obtained under prior tax law, gross income would have to be increased by approximately 9 percent. To obtain the same internal rate of return after the AMT, gross income would have to be increased by approximately 12 percent.
Table F-2 analyzes the impact of the 1986 Act on shipping income earned by a foreign subsidiary from investment in a foreign flag ship and paralleis Table F-1 described above. Unes 20-38 evalúate the U.S. tax under prior law. It is assumed that the foreign subsidiary repatriates and pays U.S.tax on 25 percent of its after-tax profif the remaining 75 percent is reinvested in shipping assets and under prior law exempted from U.S. taxation as Subpart F income. (Of course,to the extent that a company repatriated less than 25 percent of profits before 1986,the impact of the loss of deferral imphed by the 1986 Act would be correspondingly more severe.)
Unes 39-49 evalúate U.S. tax under the 1986 Act and incorpórate the slower depreciation (contrast Unes 42 and 43 with Unes 23 and 24, respectively). More significantly, all profits are taxable to the U.S. shareholders because the exclusión for shipping profits reinvested in shipping assets was repealed. To obtain the same 16.9 percent internal rate of return to cash flow after debt service,foreign and U.S. tax as was obtained under prior law, gross income would have to be increased by 4 percent.
1986 nCT
39 Gtms Incoa*'
18 Oparjiinf CotU
41 Dcprcicilion Snii*
42 nilcriuliv* bprtcittio* - t
43 fllUrnitivf Dtpraciit ion
44 Inltml Eipcnt*
45 EaiabI* Supparl F Incoa*
46 lii kior* Crtdil
41 For«i|n Iti Cradil
48 Rc|uUr lai Altor Crarfil
49 CoBh Floa AFIcr U.B. lia
58 Inlcrnal Ral* of Itlurn
Comparison to Foreign Countries
As indicated in the main body of the text, no other country seeks to tax the unrapatriatad profits of a foreign shipping subsidiary. Assuming U.S.-controlied shipping subsidiaries had no shortage of eligible shipping assets in which they could reinvest retained profits, prior to the 1986 Act U.S.companies would have been competitiva with foreign competitors whose home countries taxed repatriated dividends at ratas comparable to the 46 percent rata under prior law. All such companies would have been at a competitiva disadvantage with respect to foreign competitors whose home countries either taxed at a lower rata or exempted such dividends from tax aven upon remittance. Thus,the 1986 Act put U.S. firms at a competitiva disadvantage with respect to all foreign competitors.
This Appendix derives effective tax rate formulas used ¡n the previous Appendices and referred to in the text to determine the Impact of the 1986 Act. These formu las assume that the U.S. corporation under prior tax law was not significantly affected by Subpart F and through reasonable tax planning could claim full U.S credit for any foreign income taxes paid (that is, its foreign tax available for credit did not exceed its foreign tax credit limitation).
The two columns in table G-1 show how effective tax rates vary according to whether foreign tax available for credit is more or less than the foreign tax credit limita tion under the 1986 Act. (In each case it is assumed that foreign tax was less than the credit limit prior to the 1986 Act.) That is to say,the reduction in the corporate rate from 46 percent to 34 percent, the introduction of new categories of income subject to sepá rate foreign tax credit limitations, and the changes in the interest and other expense allocation rules may have lowered the foreign tax credit limitation sufficiently to put U.S. corporations into an excess foreign tax position. However, the extensión of Subpart F to new categories of low-tax foreign income would tend to keep the U.S. corporation in an excess-limitation position.
The formula on Line 1 of Table G-1 indicates that the effective tax rate on income earned through a foreign subsidiary under prior law representad a weighted average of the U.S. and foreign tax rates, the weights being determinad by the portion of after-tax profits remitted to U.S. shareholders.
The formula in the first column on Line 2 shows that if the corporation pays foreign tax in excess of its limitation under the 1986 Act, its effective tax rate equals the sum of three elements:(1)the foreign income tax rate,(2)the foreign withholding tax on dividends paid out of after-tax profits, and (3) the additional U.S. tax resulting from additional U.S. expense apportioned against foreign source income.
The formula in the second column on Line 2 is a weighted average of U.S. and foreign tax ratas similar to that on Line 1, the two differences being that the U.S. rate has been reduced from 46 perent to 34 percent and the relativa weight given to the two rates reflects the broadening of the Subpart F rules.
Jí® formulas on Line 3 measure the impact of the 1986 Act on income earned through foreign subsidiarias and equal the corresponding formula on Line 2 minus that on íjne 1.
. . on Line 4, 5 and 6 apply to foreign branches rather than foreign subsidiarias and are otherwise comparable to the formulas on Unes 1, 2 and 3, respectively. A foreign branch may be subject to a foreign branch profits tax in addition to the
Foreign Tax MORE THAN Foreign Tax Credit Limitation (1986 Act)
Foreign Tax LESS THAN Foreign Tax Credit Limitation (1986 Act)
= Subsidiary's dividend payout ratio (i.e., ratio of dividend to after-tax profit);
= Greater of: (1) ratio of subsidiary's Subpart F taxable income under 1986 Act to its before-tax profits, and (2) its dividend payout ratio, £;
= Foreign country income tax rate;
5 = Foreign country dividend withholding tax rate;
= Ratio of additional U.S. expense apportioned against foreign-source taxable income;
= Foreign country income plus branch-profits tax rate;
= Ratio of net income before tax to gross income;
j. = Foreign country withholding tax rate for gross income earned directly by U.S. office.
regular foreign income tax, and its profits are taxable in the United States. whether or not remited. As indicated on Une 5, if the corporation has excess foreign tax avaliable for credit, the rate of U.S. tax has no impact on the marginal tax rate.
The formulas on Unes 7,8 and 9 describe foreign income earned through a U.S. office, rather than a foreign branch or subsidiary. The formulas reflect the assumption that such Income wil be subject to foreign tax based on gross, rather than net, income. Accordingly, the rate of the foreign withholding tax must be divided by the ratio of before-tax net income to gross income in order to make it comparable to a tax expressed as a percentage of net income.
The impact of a change in an effective tax rate on the gross income the corpora tion would have to eam in order to attain the same after-tax net income it earned under prior law can be expressed as follows:
Impact on Gross Income =[n Delta]/[1-T] where:
n = Ratio of before-tax net Income to gross income under prior law
Delta = Increase in effective tax rate per Unes 3,6 or 9
T* = Current law effective tax rate as shown on Unes 2, Sor8
For example, if net income was 10 percent of gross income, the prior law effective tax rate was 20 percent, and the current law effective tax rate was 34 percent the imoact on gross income would be;
[(.1)(.34-.2)]/[1-.34] = .014/.68 =.021 or approximately 2 percent.
The general derivation is as follows:
t(old)= before Tax Reform marginal effective tax rate;
t(new)= after Tax Reform marginal effective tax rate;
n(old) = before Tax Reform pre-tax profit margin, expressed as a percent of before Tax etorm gross income. The corresponding after-tax profit margin is n(old) * (l-t(old));
n(new) = after Tax Reform pre-tax profit margin, also expressed as a percent of before Tax Reform gross income. The corresponding after-tax profit margin is n(new)* (l-t(new)):
g(new)= after Tax Reform gross income, expressed as a percent of before Tax Reform gross income.
In order to preserve the after tax rate of return, it must be the case that;
n(old)'(1 - t(old)) = n(new)* (1 - t(new)) or
n(new)= n(old)'(1 - t(old))/(1 - t(new)).
The corresponding gross income, expressed as a percent of before Tax Reform gross income, is:
The term on the R.H.S. of this last equation represents the percent by which the price must rise to preserve the after-tax real rate of return.
A Demand-Supply Model of Services Exports
The calculations of the impact of a higher tax burden on US exports of services, and on sales abroad by forelgn affiliates. are based on a simple demand and supply model of the market for each service. There are two basic cases. In the simpler, there is unlimited supply avalladle at a given price (horizontal supply curve). The new tax boosts this price to a higher plateau. The quantity demanded falls back to a lower level at the higher price. This is the case of "infinite supply elasticity." The alternative case deals with "finite supply elasticity," in which there is an upward-sloping supply curve.
Infinite Supply Elasticity
Figure A-1 depicts the first case. Before the new tax, the supply of US services facing the foreign market is available in unlimited quantities at price Pj,. The supply curve, SqSq, is horizontal at this price. After imposition of the new tax, the increased cost requires firms to raise their price to the new supply curve, S.S., aiso horizontal The amount of the tax is "t". ' ^
The demand curve, DD, tells the quantity of the service import from the United States ("Q" axis) that foreigners demand at any given price ("P" axis), and is downward sloping because they will buy more at lower prices.i/ The original market equilibrium occurs at point Eq, where the quantity demanded as shown by DD equals the quantity supplied as shown by SqSq (that is, where the demand and supply curves intersect). The original price is Pq and the original quantity Qq. After imposition of the tax, the new equilibrium is at E.|, where the price is P.| and the quantity purchased has declinad to
The output and employment effects in the-first case (infinite supply elasticity) are calculated as follows.
1) q = pf
where q refers to quantity, p refers to price, the tilde( )refers to proportionate changa and "f" is the price elasticity of demand. That is. it is the natura of the demand curve
1/ The slope of the demand curve is flatter, and thus quantity demanded more responsive to price than for the entire market for the service in the country in question, because of the scope for substitutina home- and third-country services for the U.S. service as the U.S. price rises. At the same time, the demand curve is not simply horizontal of the going price (infinite elasticity of demand) because services are sufficiently non-homogeneous that factors such as company reputation and quality make a difference, and the quantity.of the import from the United States does not fall to zero just because of a modest increase in the U.S. price.
(inelastic - almost vertical -- or elastic -- relatively horizontal) that determines whether the change in quantity Is large or small when the price rises as the consequence of highertaxes.
The absolute change in services soid abroad (Q') equals:
2) Q- = qQo
as the result of the proportionate change applied to the original quantity. The corresponding absolute change in employment involved in production for services exports (N') is:
3) N'= 5Nq
where Nq is the original level of employment associated with this production.
This first, infinite supply elasticity model is appropriate for many exports of serv ices from US-based firms. Usually these exports will be a small fraction of total domestic production of the service, and thus their availability can be expended over a wide range (relativa to the export base) vwith minimal increase in supplier price, if any (henee the horizontal supply curve).
Finita Supply Elasticity
Some service sectors may be sufficiently specialized, or their relativa weight of exports so large, that an increasing price is likely to be required to cali forth significant increases in the quantity exportad, in these cases there is a "finita supply elasticity", causing an upward-sloping supply curve, in addition, this case is likely to domínate among sales of foreign affiliates of US firms, simply because for the affiliate (MOFA,for Majority Owned Foreign Affiliate), the entirety of production is being sold to the foreign market (rather than just a modest fraction of output as in the case of exports of services from the U.S. base). A given percentage increase in the foreign market for the MOFA will mean an equivalent percentage increase in the MOFA's full output, whereas a given percentage increase in the exports of a U.S.-based service sector will constitute a much smaller percentage of total U.S. production (home-based) of that service, considering that exports usually will be oniy a modest fraction of total domestic output. With the increment in output being large relative to existing production, it becomes unlikely that the full increase can be obtained with no change in price (horizontal supply curve).
Figure A-2 shows the case of finite supply elasticity. The supply curve, SqSq, is upward sloping. A relatively steep slope would indícate inelastic supply: a relatively fíat
slope, elastic supply.2/ The original market equiiibrium occurs at E.. where the demand curve(DD)íntersects the supply curve (SqSq). with quantity Qq and price Pq.
Impositlon of the new tax ralses costs and torces the firms to cut back the quan tity supplied at any given price. The supply curve thus shifts backward to the left(where each specific price is associated wlth a lower quantity). to S.S.. At the original equi iibrium, the effect of the new tax is to raise the price the firms must charge by T,the vertical distance between the two supply curves.
The new market equiiibrium in the finite supply elasticity case involvés a feedback process in which, after the initial increase in price, the cutback of demand reduces not oniy output volume but aiso output price (moving downward to the left along the new supply curve), until at the final equiiibrium of supply and demand the new price is somewhat lower than the full increment caused by the tax plus the original price, and the new quantity supplied is somewhat higherthan would have occurred if the price had settied at the full valué of the original price plus the new tax.
That is, the original price (P ) plus the tax (t) equals P, on the diagram. The intersection of this price with the oemand curve would be at point "A", where output would be much lower than before. But because the reduction in output permits a reduction in unit cost - moving backward along the supply curve -- there is some offset to the new tax. The new equiiibrium then occurs at point E., where price is P and quantity Q Equiiibrium price is thus intermediate between the original price ani that price plus the tax, and equiiibrium output is intermediate between original output and the level that would have resulted if the final price had risen to the full amount of the onginal price plus the tax.
This case is estimated using the following model. On the side of supply,
1) Qo = aP®
where Q refers to production, subscript O refers to the original supply curve, superscript s refers to supply, the constant "a" is a scaling factor, P ¡s the market price, and "e" is the pnce elasticity of supply. This equation indicates that as price rises, output ex pande, With the percentage rise in output for a one-percent increase in price being given by the exponent "e". a a
On the demand side.
21 The "price elasticity" refers to the percentage change in quantity for a one-percent change in price.
DEVELOPED & DEVELOPING STAIUTORY COÜNTRY WITHHOLDING
RESIDDíCE OF TAX RAJE BORROWER IN *
Interese on debts secnred by oortgages on real estáte and interest on convertible bonds + income bonds are subject to 25X withholding ta*.
Only interest on debts secured by onrtgages on real estáte on convertible bonds and on income bonds.
Fifteen percent if receivablea collateralized by real estáte located in Italy.
Forty percent withholding of income tax, 20* reoittanca ta* withholding on remittance after withholding of income ta*. Zero for loana approved by central banJt.
Hay not yet be ratified.
Nine percent for loan interest granted for more than three years by a foreign financia! institución in order to financa investswnts.
Lower rate if recipient financia! institución is registered with the Treasury Departmcnt.
Interese on foreign loans exeapt or partially exempt:
Repayment Period (Including Moratorium)
rABLE II-3: maXIMUM and deehed withholding tax raies undek bilateral tax treaties on dividends paid by RESIDENTS OF DEVELOPED AND DEVELOPING COUNTRIES TO BANKS IN DEVELOPED COUNTRIES DEVELOPED & DEVELOPING
CÜUNTRY WITHHOLDING
RESIDENCE OF TAX RATE
BORROWER IN
Zero race until 1989' under new Treaty. Five percent of sum of dividend and 1/2 dividend tax credit. Dividends in excess of 12\ per annua on a 3-year noving average of Che actual registered invesciDonC are also subjecc Co "supplenentary Caxes" at ratea from UO to 60\. Less 10\ credit provided corporación has paid Che first category incooe tax. UCfii unless taxed at a rata no lower than 28X in Che recipienta' countxy. r®te applies only if recipient country doea not Cax« or próvidas t-«v credit credit or other relief.
2) D = bP'
where D ¡s the quantity demanded, b is a scaling factor, P is market price, and the exponent T ¡s the price elasticity of demand (defined as a negativa number).
Equilibrium occurs where the quantity demanded equais the quantity supplied. Equations 1) and 2) may thus be set equal to each other,for;
3) Q« — D, aP® =bP^
The origina! market equilibrium may be obtained by solving for P;
4) P.=[b/a]{1/(e-f)}
where subscript O refers to the original equilibrium.
Now consider the impact of a tax increase. First, it is necessary to specify the changa in the supply curve. From the standpoint of the firm, if the tax efíectively siphons off the fraction T of the market price, for any given market price "P" the firm will behave as if it only perceived a price of P(l-t). Accordingiy, the supply curve (original equation 1) may be rewritten as;
5) Q® = a[P(1-tf
The demand'curve remains unchanged, al
6) D = bP^
Setting equations 5) and 6) equal to equate the quantity supplied with that demanded,the new market equilibrium occurs at:
7) Q® = D; a[P(1-t)]® = bP^
Solving for P from equation 7:
8) P^®'^U[b/a](1-t)"
9)
where subscript "1" for price refers to the new equilibrium.
The ratio of the new price to the cid price is obtained by dividing equation 9) by the previous equation 4):
4) P^/PQ =(l-t)í'®^(®'^^^
As (1-t) is less than unity and the final exponent is a negativo number. the ratio of P to Pq is greater than unity (that is, the fui! expression is the reciproca! of a fraction taken to a positiva power). Thus,the equilibrium price increases afterthe tax, as expected.
The equilibrium output after the tax is (applying the new supply curve, equation 1', to the new equilibrium price):
