Taxation of Foreign Income of Financial Service Companies
The following is an excerpt from a study, “Taxation of Foreign Income of Financial Service Companies,” presented by Thomas Horst at a June 26, 1997, forum sponsored by the ACCF Center for Policy Research (the complete proceedings of this forum are available by contacting the Center). The Center underwrote this research to further the debate on the foreign income provisions of the U.S. tax code and the implications of these provisions for the competitiveness of U.S. firms in world markets. The Taxpayer Relief Act of 1997 (H.R. 2014) included a provision designed to ameliorate the disadvantage faced by U.S. financial service firms compared to their international competitors. This provision, the exemption from foreign personal holding company income under Subpart F for active financing income, was selected for line-item veto by President Clinton on August 11, 1997.
The Impact of the U.S. Tax Code on Financial Service Firms’ Competitiveness
This study explains why America’s increasingly important financial service sector firms face much higher tax rates on foreign source income than do their international competitors when operating in a third country such as Taiwan. A twelve-country analysis shows that U.S. insurance firms are taxed at a rate of 35 percent on income earned abroad compared to 14.3 percent for French-, Swiss-, or Belgian-owned firms. To clarify, a U.S. subsidiary is taxed at an assumed rate of 14.3 percent on income earned in a country such as Taiwan, and then the U.S. parent company is taxed at an additional 20.7 percent on the foreign source investment income-whether it is repatriated or not-for a total of 35 percent. As a result, U.S. firms face tax rates that are as much as 145 percent higher than those paid by their competitors on income earned in the same third country (see Figure 1). As a consequence of their more favorable tax codes, foreign financial service firms can offer products at lower prices than can U.S. firms, thereby giving them a competitive advantage in world markets.
[Figure 1: International Comparison of Tax Rates on Foreign Income Earned by Insurance Companies Operating in a Third Country
(By country of residence of parent company)]
1. “Parent” means residence country income tax on parent company.
2. “Subsidiary” means local income tax on foreign subsidiary.
Reasons U.S. Firms Are Disadvantaged
The Tax Reform Act of 1986 significantly increased the tax burden on the business income of the various U.S. service industries primarily through the following changes to the Subpart F and foreign tax credit provisions of the code.
- Subpart F and DeferralThe procedure of taxing income earned by a foreign subsidiary only once a dividend is remitted to the U.S. parent company is referred to as “deferral.” In the early 1960s, the U.S. Treasury Department, concerned about tax haven operations and transfer pricing abuses, proposed to eliminate deferral by taxing all foreign subsidiaries’ profits when they were earned. To make a long story short, the U.S. Congress rejected the proposal and enacted instead the “Subpart F” provisions that eliminated deferral only for the types of income that were easily shifted to tax havens (e.g., passive investment income, third-country sales and service income, and income from insuring U.S. risks). The application of Subpart F was extended in 1976 to international shipping income that was not reinvested in shipping assets and in 1983 to oil-related income. The Tax Reform Act of 1986 extended significantly the scope of Subpart F and imposed new limitations on the foreign tax credit. The Subpart F changes affected not only passive income, but also business income of various service industries, including:–Dividends and interest earned by foreign banking, insurance, and other financial service subsidiaries, even when such income was received from unrelated persons and in the active conduct of a bona fide business of a foreign subsidiary;
–Income attributable to the issuing of any insurance or annuity contract in connection with risks in any country other than the country in which the foreign subsidiary was created or organized; and
–Shipping income, even when reinvested in shipping assets.
- Foreign Tax CreditThe United States has long been a strong supporter of eliminating artificial restrictions on international trade and investment. To encourage U.S. companies to invest their capital where it will yield the highest return, the United States gives U.S. companies a credit against U.S. tax for not only the foreign country’s withholding tax on dividends, but also the foreign country’s income tax on the local subsidiary’s profit out of which the dividend was paid. The U.S. foreign tax credit is limited, however, to the U.S. tax on a U.S. company’s foreign income. That is to say, a U.S. company cannot use the foreign tax credit to avoid U.S. tax on the company’s domestic income.The effect of this system depends on the combined rate of foreign tax on profits remitted as dividends in comparison to the marginal U.S. tax rate. If the combined rate of foreign tax exceeds the U.S. tax rate of 35 percent, no net U.S. tax is imposed, so the overall tax rate is whatever the foreign country imposes. If the combined rate of foreign tax is less than the U.S. tax rate of 35 percent, the U.S. tax net of the foreign tax credit brings the overall tax rate up to the U.S. rate of 35 percent.
Because the U.S. foreign tax credit is limited to the U.S. tax on that income, a critical issue is whether foreign income from different sources that has been subject to foreign tax at different rates can be combined. To take a simple example, suppose a U.S. company’s German subsidiary earned $100 and paid $40 of German tax, while its Hong Kong subsidiary earned $50 and paid $10 of Hong Kong tax. If the U.S. foreign tax credit limitation was calculated for each category of foreign income separately, the U.S. company would have no net U.S. tax liability on its dividend from Germany, but would owe an additional $7.50 of U.S. tax on its dividend from Hong Kong. If the two categories of income can be combined, the U.S. company’s net U.S. tax liability would be reduced from $7.50 to $2.50. This latter result is referred to as “foreign tax credit averaging.” As a practical matter, most U.S. companies were not unduly concerned by the foreign tax credit limitation.
The Tax Reform Act of 1986 restricted the foreign tax credit limitation in two ways. First, the limitation was reduced directly by increasing the amount of interest and other expense that was allocated to foreign income. Second, rather than applying the limitation to overall foreign-source income, the 1986 Act required the foreign tax credit limitation be calculated separately for different “baskets” of foreign income, such as passive income, including interest, dividends, rents, and royalties; high­p;withholding-tax interest income; financial services income; shipping income; dividends received from each non­p;U.S.-controlled foreign subsidiary; and all other foreign income.
As explained above, if the limitation is calculated separately for a type of income subject to high foreign tax, the foreign tax in excess of the limitation in one “basket” cannot be applied against the U.S. tax on a “basket” of income subject to low foreign tax, so the net U.S. tax on overall foreign income is increased.
- Our Competitors Tax Foreign Source Income More LightlyFour of the eleven foreign countries included in our survey-Switzerland, the Netherlands, Belgium, and Hong Kong-have territorial tax systems under which dividends from wholly owned foreign subsidiaries are generally exempt from tax even when remitted and have not enacted any provisions comparable to the U.S. Subpart F rules. The remaining seven countries-Japan, the United Kingdom, Germany, France, Denmark, Sweden, and Canada-have enacted or tightened Subpart F-type provisions over the past decade. However, none of these seven countries tax interest or dividend income derived from bona fide banking, insurance, or other businesses when such income is received from unrelated persons. Thus, the bona fide business income included in Subpart F for U.S.-based financial service companies would generally not be taxable to a parent corporation in any of the eleven foreign countries included in this survey until that income was distributed, resulting in lower taxes than U.S. firms must pay (see again Figure 1).
Until 1986, financial service subsidiaries were exempted from the Subpart F inclusion for interest and other investment income. This exemption was premised on the notion that investment income is an integral part of the business profits of a financial service company. Because investment income often exceeds the total business profit of a financial service company, the Tax Reform Act of 1986 resulted in the profits of U.S.-owned financial service subsidiaries being taxed at U.S. rates under U.S. rules for calculating taxable income.
It is hard to imagine any tax policy justification for this result. To compete in foreign countries, financial service companies must typically establish local offices staffed by local employees. Exporting U.S. jobs is generally not an option and thus not an issue. Investment income of financial service companies arises in the normal course of their business and, because of local regulatory requirements, cannot normally be diverted to tax haven companies, or, for that matter, the U.S. parent company.
The result is at variance not only with the deferral of U.S. tax on the business income of U.S.-owned subsidiaries of manufacturing and other nonfinancial corporations, but also the deferral or exemption for financial service subsidiaries of parent companies based in the eleven other countries surveyed. Because of the Subpart F rules, U.S.-owned financial service subsidiaries are at a clear competitive disadvantage vis-a-vis their competitors.