Incentive Effects of Foreign Tax Credits on Multinational Corporations Rosanne Altshuler* & Paolo Fulghieri**

INCENTIVE EFFECTS OF FOREIGN TAX CREDITS ON MULTINATIONAL CORPORATIONS ROSANNE ALTSHULER* & PAOLO FULGHIERI**

Abstract - The United States tax code al- tax credit system which allows multina- lows multinational corporations to credit tionals to credit tax payments to foreign tax payments made to foreign treasuries treasuries against their United States tax against domestic tax obligations, up to obligations on international income.’ To their United States tax liability on foreign- prevent multinationals from using the source income. If foreign tax payments foreign tax credit to reduce tax liabilities exceed the United States tax liability on on domestic income, the credit is limited foreign-source income, the corporation is to the United States tax liability on said to be in excess credits. We study how foreign-source income. Corporations that the incentives for investment abroad do not receive full credits for taxes paid through foreign subsidiaries change as abroad are said to be in “excess cred- parent corporations transit into and out its.” This paper considers how invest- of excess credits. We also examine how ment incentives change as multinational the presence of foreign tax credit carry- corporations switch into and out of ex- forwards affects tax-related investment cess credit positions. incentives. United States tax policy toward foreign- source income has traditionally at- tempted to provide United States inves- tors with capital export neutrality.2 Un- INTRODUCTION der this tax doctrine, income should be taxed at the same rate in the home American multinationals are taxed on country whether it is derived from for- the basis of their worldwide income. eign or domestic investment.3 The for- This “residence” approach creates the eign tax credit preserves capital export potential for the double taxation of neutrality by refunding the taxes that foreign-source income. For this reason, United States multinationals pay abroad. the United States has adopted a foreign On the other hand, since the credit is limited, United States taxes will distort *Department of Economics, Rutgers University, New Bruns- the Investment choices of corporations wick, NJ 08903 **Graduate School of Business. Columbia Unlverslty, New with excess credits. Capital export neu- York, NY 10027 trality is violated for this group of corpo-

349 rations, since an investment in a country tcven before TRA ‘86, there was evidence with a low corporate tax rate will be that a significant proportion of United more attractive than a similar investment States multlnational corporations trans- in the United States or a high corporate ited into and out of excess credit posi- tax rate country. Capital export neutral- tions. Allshuler and Newlon (1993) ity is further compromised by the defer- (hereafter, A&N) used a sample of ral advantages avarlable on income IJnited States corporate tax returns to earned through foreign subsidiaries, develop iestimates of the extent to which which is not subjelct to United States multination c:orporations switched for- taxation until it is remitted to United eign tax credit states during the 1980s. States parerlls.4 This feature of the tax Their estimates are calculated for three code enhances the attractiveness of low time periods: 1980-2, 1982-4, and tax locatiors for all United States multi- 1984-6. During each of these time pe- nationals regardless of foreign tax credit riods,, more than one-third of parent positions.’ corporatronc switched credit states, and this proportron increased over time to al- The logic presenteNd above was chal- most one-half in the 1984-6 sample.8 lenged in a seminal article by David This paper (analyzes the investment in- Hartman. By taking into account future centives of these corporations. as well as current United States tax liabilities on repatriated ealrnings, Hartman We Ipresent the simplest model neces- (1985) showed that under a credit and sary to derive our results. Following deferral tax system the Ihome country tax Hartman (1985), we consider the source rate on foreign-source income is irrele- of both curr’ent and future funds for vant to investment decisions of foreign marginal foreign investment.” We discuss subsidiaries if investment is financed by how domestic and fore,ign taxes impact subsidiary retained earnings6 Hartman’s the (marginal) investment decision rules work demonstrates that In this case for an all-equity financed foreign subsid- credit and deferral systems do not pro- iary. Unlike prevrous work, we consider vide capital export neutrality but instead parent corporations that control subsid- yield capital import neutrality: United iaries in Inore than one foreign locatron States and host country domestic rnves and that transit into anld out of excess tors are influenced by the same ‘set of credits. If foreign tax credit positions corporate tax parameters. change over time, we find that the Hart- rnan result does not obtain and rneither Although this benchmark result charac- capital import nor capital export neutral- terizes steady-state investment incen- ity holds.” Marginal investment deci- tives, the model does not consider how sions are dependent on the credit posi- domestic and foreign taxes impact in- tion of parents, the financial policy of vestment decisions in settings in which the subsidiary, and both domestic and foreign tax credit positrons of multina- foreign tax rates. We also show that tionals change over time. This case is parent corporations that switch foreign particularly relevant after the passage of tax credrt positions face an opportunrty the Tax Reform Act of 1986 (hereafter, cost of capital that may be higher or TRA ‘86) which lowered the corporate lower, dependrng on the location of tax rate from 46 percent to 34 percent subsdiary investment, tihan that faced by and consequently iincreased the likeli- subsidiaries with parents that remain in hood that lJnited States multinationals the same credit state. will find themselves with excess foreign tax credits.’ Since the ernphasis of our analysis is on I INCENTIVE EFFECTS OF FOREIGN TAX CREDITS the effects of the foreign tax credit limi- of the subsidiary investment to the par- tation, we also investigate the impact of ent corporation will depend on the foreign tax credit carryforwards on in- United States taxation of dividend repa- vestment incentives. Under current law, triations. The first part of this section excess foreign tax credits can be carried discusses the tax consequences of divi- back for two years and forward for five dend remittances. The second part pre- years to offset United States tax liabilities sents an analysis of the required rate of on foreign-source income. We find that return for subsidiary investment projects allowing multinational corporations to taking repatriation taxes into account. claim foreign tax credit carryforwards may decrease or increase the opportu- The Tax Consequences of Dividend nity cost of foreign investment. This is Remittances interesting given the expected post-TRA United States multinationals must pay ‘86 increase in the number of multina- taxes on both domestic and foreign- tionals with excess credits and in light of source income. However, the United recent proposals to extend the carryover States allows credits for foreign taxes period for the foreign tax credit.” paid directly on income as it is received The remainder of the paper is organized by the parent corporation (direct credits) as follows. First, we briefly discuss the and for foreign income taxes paid on United States tax treatment of foreign- the income out of which a distribution is source income and describe our model made to the parent corporation (deemed of investment behavior. We then present paid or indirect credits). The deemed decision rules, derived from our model, paid credit available for a dividend distri- for marginal investment of subsidiaries bution is calculated by first grossing up with parents in different financing and the drvidend repatriation by the foreign foreign tax credit regimes. Following tax deemed paid on that dividend.13 The this, we examine the impact of foreign grossed up dividend in period t can be tax credit carryforwards on investment written as Di/(l - T’), where Or repre- incentives. The last section of the paper sents the dividend remittance from a offers some concluding remarks. subsidiary operating in host country i and T’ represents the corporate tax rate THE MARGINAL INVESTMENT DECISION in host country i.14 The United States tax RULE liability before foreign tax credits is TD’J (1 - #), where T is the United States In this section, we analyze the invest- corporate tax rate. The credit potentially ment decision faced by a multinational available on the dividend remittance is with investment opportunities in a sub- equal to the sum of the deemed paid sidiary located in a foreign country. For credit on the distribution, ~‘Di/(l - T-‘), simplicity, we will assume that the sub- and the direct credit for withholding tax sidiary is wholly owned by the United at rate t’ paid to country i on the divi- States parent corporation and that in- dend remittance, t’D:.” vestment projects at both the parent and subsidiary level are completely eq- As discussed in the Introduction, the uity financed.” In this case, investment amount of credit available on the divi- in the subsidiary may come either at the dend remittance is limited to the United expense of a foregone dividend repatria- States tax payable on foreign-source in- tion or through an equity transfer from come. Corporations are in excess credits the parent company. A consequence of if foreign tax payments exceed the limi- this financing scheme is that the value tation.16 Corporations for which the limi-

351 tation is not binding receive full credits come by (7’ -- ~)/(l - 7’). Alternatively, for taxes pafd abroad and are said to be dividencl remittances from subsidiaries in “excess limitatilon” or “deficit cred- located in low tax couhtries to parents its.” in excess limitation have an after-tax value of less than one,” Deferring repa- The foreign tax credit limit operates to triations from low tax countries is an at- some extent on an overall basis. Under tractive strategy for parents in this situa- current tax law, excess credits accruing tion. from one source of foreign Income can often be used to offset United States tax The Required Rate of Return on on foreign income from another Subsidiary Investment Projects source.17 This averaging can occ:ur when United States parent corporations receive We assume that the investment projects simultaneous dividend remittances from of foreign subsidiaries are chosen so as subsidiaries in high tax rate and low tax to rnaximize the wealth of parent com- rate countries. Averaging can also occur pany stockholders.” This means that at between different types of foreign- any given time period, the objective of source income and across time through the firm is to choose an investment plan foreign tax credit carryforwards. In this maximizing the after-tax, cum-dividend section, we take the first type of averag- market value of the shares of the parent ing into account. The next section con- company. Auerbach (11979) shows that siders averaging across time. under these assumptions, the required rate of return on a marginal investment Allowing simultaneous dividend remit- (the “cost of capital”) will depend on its tances from subsidiaries located in high marginal1 source of funds at the time in- tax rate and low tax rate countries will vestment is made and1 in all future pe- impact the after-fax value of dividends.‘* riods in which the project has a positive Let k: represent the value of one dollar payoff. This implies thbt if the marginal of dividend repatlriations after home and source of funds for the parent company host country taxes. Firms in excess cred- in the current and in all future dates is its pay no home Icountry taxes on divi- retained earnings, the appropriate rate dend repatriations, and therefore a dol- to discount after-corporate-tax cash flow lar of dividends is subject only to IS R = p/( 1 -- TJ, where p is the dis- withholding taxes in the host country. count rate on tax-free income and 76 is For these firms, k: is equal to 1 - t’. On the accrual equivalent tax rate on capit, the other hand, a multinational in excess gains.” limitation must pay home country taxes on grossed up dividend repatriations but To simplify the exposition, we will as- receives a full credit on withholding sume that the subsidiary has access to taxes, and thus k: = (1 - d/(1 - T’).” investment projects w/th the following cash flow pattern. A droject undertaken Note that repatriations from subsidiaries by subsidiary i at, say,# t = 0, requires an located in high tax countries to parents initial investment of 1. After that, in in excess limitation reduce United States every future period, t == 1, . ., IX, the tax liabilities on foreign-source Income project will require a ffixed level I of rein- through averaging. In this situation, the vestment and will provide a gross return after-tax value of one dollar of dividends of i’ + F,(I), with F:(l) > 0 and f’;(l) < exceeds one, since by repatriating divi- 0. We will also assume that the United dends, the parent decreases its United States and host countries allow full de- States tax liability on foreign-source in- duc:tions for these investment expendi- I INCENTIVE EFFECTS OF FOREIGN TAX CREDITS tures against the gross income earned and ki = k' for all t = 1, . . ., 00.~’ In this one period later.23 Under these assump- case, the share value of the parent com- tions, a project requiring an initial invest- pany is maximized when the present dis- ment level of / will generate, after host counted value of the marginal product country taxes, a net cash flow equal to of investment, after all corporate taxes, (1 - +)F,(/) in every future period. is set equal to the current after-tax cost of a marginal investment; that is, when The profitability of an investment project the return on the marginal investment, will depend on its impact on the after- f:(l), satisfies: tax cash flow of the parent company. This, in turn, will depend on the source of financing for the subsidiary and on the foreign tax credit position of the (1 - T')F: - = kbhb + 1 - A;. parent company.24 To simplify the expo- (k'p' + ' - "I R sition, we will assume that at the time the project is initiated, a fraction A; of As long as dividend repatriation policies investment in subsidiary i is financed by and credit states are stationary (p’ = AL retained earnings and the residual frac- and k' = kb), the Hartman result obtains tion 1 - hb is financed by equity trans- since the marginal condition for invest- fers from the parent company. Similarly, ment becomes we assume that in all future periods, investment projects in the subsidiary are financed for a fraction & by retained earnings and for the residual fraction -=(l - m 1 1 - pi by equity transfers. Under these R ' assumptions, an initial investment of a dollar will decrease dividend repatriations The tax system provides capital import by A;, decreasing the parent’s after-tax neutrality in the sense that investment is cash flow by k&lb, and will require an affected only by the host country corpo- increase of equity transfers by 1 - AL. rate tax rate and not by the home coun- Therefore, the total effective cost to the try corporate tax rate. Marginal invest- parent company of one dollar of investment decisions are not impacted by ment will be k& + 1 - Ah. In a similar United States taxes due upon repatria- way, at all future dates, a dollar of in- tion, because these taxes reduce the op- come from the project, after host coun- portunity cost of investment and the try taxes, will increase dividend repatria- present discounted value of the return tions by pi and will allow the parent to to investment by the same amount, decrease equity transfers to the subsid- since credit positions are constant over iary by 1 - &. The value to the parent time for these companies.26 However, if company of one dollar of project cash credit positions change, the United flow is then k:F: + 1 - &. States taxes due upon repatriation will reduce the opportunity cost and return We may now discuss the expression for to investment by different amounts and the minimum required rate of return on capital import neutrality will not obtain. investment in a subsidiary. For simplicity, we will assume here that the parent In what follows, we discuss the opportu- credit state and the financing regimes of nity cost of capital for parent corpora- the subsidiary are stationary for all pe- tions in two credit regimes that are de- riods after the one in which the initial fined by the credit position in the year investment is made; that is, & = p’, in which investment takes place and in

353 the following years. The first group of Into expression 1, the tnarginal condition parents are In excess lirnitation when on investment becomes marginal investment is initialized, transit to an excess credit position in the next q period, and remain in this regime for all (1 - ?)(‘I - T’)F: 1 - 7 future periods. The second group con- -~---_ = v tains parents that are in excess credits R 1 - 7” when marginal investment is initialized, transit out of the credit constrained state In c#Dntrast to the stationary credit rein the next period, and remain in excess gime, both the home gnd host country limitation for every future period. tax rates alfect the m;lrginal investment decision. Since earnings are repatriated These cases are interesting since there whi’le the parent is in excess credits, are several reasons why parent compa- withholding taxes are pot creditable and nies may anticipate a clhange in credit reduce the marginal bknefit to invest- positions. Multinationals may switch ment. The marginal c&t of investment is credit states as a result of changes in the after-tax value of qhe foregone dollar statutory United States or host country of clividend repatriatiohs while in excess tax rates or because of revisions in the limitation, which depehds on whether tax law, such as those governing the av- the investment is made in a high or low eraging of foreign-source income. An tax country. anticipated switch may also be due to For investments located in high tax sub- adjustments of re,patnation strategies. In sidiaries, the rnarginal icost of investment the remainder of this section, we study is greater than one dolllar because the how investment incentives are affected additional investment expenditure in- by such anticipated changes In credit duclps a dividend paynient that reduces positions. the credit available to the parent. Since Following Hartman (1985), we examine the marginal cost of investment in- the cost of capital for subsidiaries in two crezlses and the margival benefit de- financing positions that we identify as creases, the cost of capital in this regime mature and immature. At the margin, a is increased relative to’the stationary mature subsidiary finances current and credit regime. All else equal, investment future investment through retained earn- in high tax countries is less attractive for ings (p’ = hl, := 1). On the contrary, parent corporations that expect to current investment in an immature sub- transit into excess credit positions than sidiary is financed through equity trans- for those that expect tlo stay in excess fers (AL = 0). In the future, immature limitation. subsidiaries may be financed through re- Alternatively, the cost of capital for a tained earnings (CL’ = l), continued eq- marginal investment iq a low tax country uity transfers (p’ .= 0), or some combi- may be lower for this case relative to nation of the two1 (1 :> p’ :> 0). the stationary case. Now the after-tax Mature Subsidiar,ies cost of investment is less than one, since additional Investment Ian a lovv tax sub- Consider a subsidiary initially in excess sidiary reduces the current tax liabilities limitation that transits to excess credits of the parent. If withhiolding taxes are in the period immediately following the sufficiently low, (1 - T)/( 1 - 7’) <: (1 - marginal investment. By substituting the t’), the cost of capital will fall relative to appropriate values of p,‘, AL, k’, and k;, the stationary case. I INCENTIVE EFFECTS OF FOREIGN TAX CREDITS

Now consider the case in which parents incentives. To start, as Hartman (1985) invest while in excess credits but transit and others have pointed out, the current out of this state in the next period. The United States tax system does not pro- marginal condition on investment is: vide capital export neutrality to all United States multinationals. In addition, we find that parent companies that anticipate changing credit positions face -=(1 - dC , _ t,, different costs of capital than those that R do not. An anticipated switch to excess credits makes investments in low tax Since the initial investment occurs when countries more attractive and invest- the parent is in excess credits, the op- ments in high tax countries less attrac- portunity cost of one dollar of invest- tive than they are when credit states are ment is 1 - t’. However, in all future stationary. The opposite is true when periods, the parent is in excess limitation parents transit into excess limitation po- and thus the effective tax rate on the in- sitions. come from the project is the domestic tax rate T. Note that capital import neu- These results are similar to those found trality does not hold and capital export in the literature on net operating losses neutrality only obtains when withholding (NOLs). Domestic corporations that are tax rates are zero. always taxpaying face different costs of capital (and different effective marginal In this credit regime, the cost of capital tax rates) than those that are not tax- is higher than in the stationary case if (1 paying in some years as a result of - $)(I - t’) > (1 - T). To see this, NOLs.*’ Consequently, the investment compare this case to one in which the incentives of domestic corporations de- parent company is always in excess cred- pend on whether they switch into and its. Since both parents are in excess out of taxpaying periods. The same is credits when the project is initialized, the true of multinationals that transit in and effective after-tax cost of current invest- out of excess credit states. In our case, ment is the same in the two cases. If investment in some countries is more at- the parent is in excess credits also in the tractive (all else equal) than in others, future, income from the project will be depending on foreign tax credit posi- effectively taxed at 7’ and will face with- tions In the next section, we study the holding taxes t’. If, on the other hand, investment incentives of immature sub- the parent is in excess limitation in the sidianes that switch both credit positions future, the effective tax rate will be the and financing regimes. statutory home country rate T. If T’ exceeds 7, the return on investment is lmma ture Subsidiaries taxed at a lower rate than in the sta- If subsidiary investment is continually fi- tionary excess credit case, and therefore, nanced through equity transfers investments in high tax rate countries throughout the life of the project, the are more attractive. By a similar argu- cost of capital IS given by expression 2. ment, investment in projects located in Capital import neutrality holds and the low tax countries (with sufficiently low withholding tax rates) face a higher cost marginal condition for investment is in- of capital than in the stationary case. dependent of the foreign tax credit position of the parent since dividend repatri- Combining the results of these cases ations never occur. However, this result gives us a complex picture of investment may not hold for immature subsidiaries that mature and finance future projects all future financing is atcomplished through retained earnings. through retained earnings (p’ = 1). Consider an Immature subsidiary that fl- Alternatively, if the parent is in excess nances a fraction ‘I - r-(,’ of future in- credits in all future periods, we have the vestment projects with retained earnings. following marginal investment rule: Since equity transfers are the initial source of funds for a marginal invest- . ment, the effective cost of funds is inde- 13 (1 - /.L?‘)( 1 -- T’)F: , pendent of the credit position of the ----- = parent. As a result, there are only two h possible cost of capital expressions that are functions only of future credit posi- Withholding taxes on remittances are tions. This means that parents that not offset by foreign ta~x credits, and the switch into excess credit positions from opportunity cost of funds is adjusted to excess limitation face the same invest- include tlhis tax cost. C pital import neu- ment incentives as those that are contin- trality obtains if withho t ding taxes are uously in excess credits. And parents 7ero. that transit to excess limitation from ex- A comparison of expreqsions 5 and 6 cess credits face the same cost of capital shows that a subsidiary~ located in a high as those that are continuously in excess tax country will have a #lower cost of limitation. capital if the parent company is in ex- The required rate of return on subsidiary cess limitation rather than in excess investment for a corporation in excess credits in all future periiods. If withhold- limitation in all future periods is given by ing taxes are sufficiently low, the opposite is true for a subsidiary located in a low tax country. These results apply to all parents regardless of whether they (1 -. ($7 + (1 - p')Ty)F: 1 ---:= . switch credit regimes. As was true of R the mature subsidiary case, investment incentives vary across n+ultinationats in Since initial investrnent is financed different credit. positionis. Whether these through equity transfers, the effective results are desirable froim a policy per- cost to the parent of one dollar of cur- spective is an open qu&tion. rent investment is exactly one dollar. Furthermore, only a fraction J.L’ of the FOREIGN TAX CREDIT future earnings from the project are re- CARRYFORWARDS AND patriated and, with the parent in excess INVE:STMENT INCENTIVES limitation, are effectively taxed at the United States tax rate. The remainder, By lowering the top statutory rate on 1 - p’, is retained in the host country corporate income, TRA ‘86 may have and taxed at the local rate. The effective placed a17 increased number of multina- corporate tax rate is an average of home tional corporations in eFcess credit posi- and host country tax rates weighted by tions.28 These corporations may generate the payout ratio ,u’. Note that an equiva- foreign tax credit carrytorwards, which lent expression wais obtained in Horst currently expire after five years. The (1977) but without explicit reference to most receni figures on the empirical sig- a tax capitalization framework. Note also nificance of foreign tax, credit carryfor- that capital export neutrality obtains if wards may be found in A&N. Of the $4 I INCENTIVE EFFECTS OF FOREIGN TAX CREDITS billion worth of foreign tax credit carryforwards reported by firms in their sample in 1986, A&N estimate that 40 per- t’ + 8’ = (I + R)-r [ 51 cent were claimed in that year. Although the fraction of carryforwards that are r-i claimed after the Act may differ from -&I + c p’(1 - 7y: this figure, it is of interest to study how t=1 1 the ability to claim credit carryforwards affects the investment incentives of mul- The term K’ is the equivalent of the fac- tinational corporations.*’ tor k’ but is modified to account for the fact that the parent company is in ex- In this section, we consider the case of a cess credits for t < T and switches to subsidiary with a parent in excess credits in the period in which marginal invest- the excess limitation regime at T. This ment occurs that remains in excess cred- term is the weighted average of the val- its for T - I years. At year T, the parent ues that k’ would take in the excess switches to excess limitation and claims credit and excess limitation regimes, all of the credit carryforwards available where the weighting factors depend on at that moment. The difference between the discount rate R and the date T of the previous analysis and this one is that the switch. the impact of the marginal investment The term 8’ measures the impact of on the market value of equity must now marginal investment on the present include the effect on the cumulative tax value of cumulated net foreign tax cred- credit that is claimed in period T. This is its that will be claimed by the parent analogous to taking into account the company at time T. The first term of 8’ impact of investment on tax loss carry- is the discount factor. The second term forwards in the NOL case.3o measures the total value of foreign tax Following a procedure similar to the one credit carryforwards generated by one leading to expression I, it may be dollar of dividends. Note that if the sub- shown that the marginal condition for sidiary is in a high tax country, the value investment in a subsidiary is3’ of this term is always positive. If the subsidiary is in a low tax country, the q term can be positive or negative, and it (K’p’+ I - $)(I- T’F:+ e, is always negative if the withholding tax R rate is zero. The last term in 8’ measures = (1 - t’)h; + I - A&, the cumulated change in dividend payments between periods 0 and T - I due to the marginal investment and is made up of two components. The first component, --A& represents the de- =1-T I crease in dividend repatriations due to +C-- the marginal investment, while the sec- t=r I - ~‘(1 + R)’ ond component represents the cumulated increase in dividend repatriations generated by the marginal investment. I I-T Expression 7 combines these terms and +-- (I + R)‘-’ 1 - T’ generalizes the cost of capital to the case of corporations that are able to and claim credit carryforwards before they expire. It requires that the present value in turn depend on the ,interest rate and of the perpetual sitream of after-tax in- all the tax parameters ffecting the cost come generated by the marginal project of capital. However, if he discount rate plus the present value 8’ of the foreign R is sufficiently low, th I F: that solves tax credit available at year T be equal to expression ‘7 will tend o be low as well, the after-tax cost of the marginal proj- and the third term in ,’ ’ is likely to be ect. Since in the absence of a carryfor- negative. This means that an additional ward system, 8’ = 0, by comparing investment will decrease the cumulated expressions 7 and 1, it can immediately dividend repatriated between t = 0 and be seen that the sign of 8’ will deter- t = T - 1. This negative third term re- mine whether allowing parent corpora. verses the results discu’sed above in the tions to claim carryforwards will de- immature subsidiary ca e. If the subsid- crease or increase the cost of capital for iary is located in a hig b tax country, the a subsidiary investment. middle term of 8’ is p sitive. Therefore, the decrease in divide ds due to the Consider first an investrnent by an im- new project will reduc 9 the total value mature subsidiary. In this case, the entire of the credit carryforwbrds that (are amount of investment is financed by an available to the parent~company when it equity transfer, anId therefore AL = 0. eventually switches to the excess limita- The sign of 8’ now depends on the sign tion state. ,4s a result, ‘the abrlity to of the middle term. This sign is positive claim carryflorwards in the future in- if the subsidiary is located in a high tax creases the opportunit’ cost of current Y country, and therefore 8’ > 0. Hence, Investment, increasing ~the cost of capital allowing the parent to use credit carry- to the parent company. A similar argu- forwards increases after-tax profits and ment, but in the oppo ite direction, ap- consequently decreases the cost of capi- plies to mature subsidi I ries in low tax tal. This result may be reversed if the countries with sufficiently low withhold- subsidiary is located in a low tax coun- ing taxes. try. If withholding taxes are sufficiently low, so that t’ + (T’ -- ~)(l - $1 < 0, In summary, allowing parent companies then 8’ < 0 and the presence of a carry- to claim carryforwards in the future has forward system will increase the cost of opposite effec:ts on investment incentives capital. This result depends on the fact of subsidiaries located tin high tax coun- that the additional1 dividend repatriations tries and those located in IOW tax coun- from a marginal project located in a low tries (if withholding taxes are sufficiently tax country while the parent is in excess low‘). Claiming carryforwards rnay in- credits will absorb credits. This will re- crease (decrease) the cost of capital of duce the value of the total carryforwards subsidiaries located in ihigh (low) tax that the parent is able to claim when it countries, If they are mature, and de- eventually switches to excess limitation, crease (increase) the cost if they are im- decreasing in this way the marginal ben- mature. efits of investment. Conclusions In the case of mature subsidraries, it is difficult to unambiguously sign 0 for a Taxes affect both the cost and the bene- given project. The sign of the third term fit of investing in foreign subsidiaries. In in expression 9 depends on the propor- this model, the cost of investing a dollar tion of the project’s cash flow that is abroad for a mature subsidiary is the paid out in the first T -- 1 years. Since value of the foregone Idollar of dividend F: must satisfy condition 7, this sign will repatriations and the benefit is the after- I INCENTIVE EFFECTS OF FOREIGN TAX CREDITS tax present discounted value of the Capital export neutrality therefore results in stream of returns generated by the mar- the most efficient allocation of worldwide income. ginal investment. If credit positions and Multinational corporations may invest abroad dividend policies of parents and subsid- through branches or subsidiaries. Unlike sub- iaries are stationary, taxes due upon re- sidiaries, branches are not separately incorpo- patriation will decrease the benefit and rated in foreign countries and are taxed when the cost of foreign investment by equal income is earned. Since the emphasis of this work is on the interaction between deferral amounts and the Hartman result will ob- and the foreign tax credit, we ignore invest- tain. The assumption that credit posi- ment in foreign branches and concentrate in- tions are stationary may not adequately stead on subsrdiary investment. reflect the experience of United States In 1962, Congress enacted the Subpart F pro- multinational corporations, however. For visions, which restrict deferral on certain types example, TRA ‘86 may have forced a of unrepatriated income. Under Subpart F, income that arises from a subsidiary’s passive substantial set of parents into excess ownership of assets is denied deferral and credit positions. These parents may taxed immediately. Income earned from the eventually switch back into excess limita- conduct of a business is generally not subject tion positions. We have shown that to the Subpart F provisions and is allowed deferral. when credit positions change, both Alworth (1988) extends this approach to con- United States and foreign tax parameters sider a spectrum of financing policies. impact marginal investment decisions. Other provisions included in TRA ‘86, such as Furthermore, whether investment abroad the increase in the number of separate limita- is more or less costly than in the station- tion baskets for the purpose of the foreign ary credit position case depends on the tax credit, are likely to place United States location of marginal investment and multinationals in excess credits. whether parents switch from excess The authors also report that at least 37 percent of assets and 41 percent of foreign- credit positions to excess limitation posi- source income were associated with multina- tions or vice versa. Whereas one set of tionals that switched credit positions. parent corporations may find it attractive Thts approach is analogous to the “tax capi- to invest in a low tax country, for exam- talization” or “new view” of how taxes affect ple, another set will be indifferent be- decisions made by firms or shareholders de- veloped by Auerbach (1979), Bradford (1981). tween investing abroad or in the United and King (1977). Jun (1987) presents a similar States. This makes it difficult to predict model to ours but does not explicitly model how the investment, financing, and loca- parent foreign tax credit positions. tion choices of United States multina- Recent work by Keen (1990), Leechor and tional corporations will respond to tax Mrntz (1993), and Hines (1992) has also fo- regime changes. cused on the conditions under which the Hartman result obtains. Keen introduces the ENDNOTES integration of goods markets to the analysis and finds that this breaks the Hartman propo- We would like to thank Michael Adler, Glenn sition. Leechor and Mintz show that tax bases Hubbard, Joel Slemrod, and three anonymous across countries, adjusted for inflation, must referees for very helpful comments at various be proportional for the Hartman result to stages of our work. We claim responsibility hold. Hines derives a similar result but does for all errors. Paolo Fulghieri gratefully ac- not take inflation into account. knowledges financial support from the Faculty The Foreign Income Tax Rationalizatron and Research Fund of the Graduate School of Simplification Act of 1992 (H.R. 5270) would Business of Columbia University. extend the carryback period on foreign tax ’ Foreign tax credits are available for income credits from two to three years and the carry- and related taxes paid to foreign treasuries. forward period from five to fifteen years. ’ See Hufbauer (1992) for an excellent presen- These extensions would make the carryover tation of the history of United States interna- periods available for foreign tax credits identi- tional tax policy. cal to those available for tax loss carryovers. ‘J The financing of foreign Investment may In- ents receiving dividends in their sample volve a complrcated flow of funds between received them from both high and low tax parent corporations and foreign subsidiaries subsidiaries srmultaneously\ and these parents For example, subsidiaries rnay be financed accounted for almost 94 percent of dividend through retained earnings, equity transfers remittances. from the parent, intercompany loans, or local ” These formulas ignore foreign tax credit carry- borrowing. Similarly, investment funds chan- forwards which may also ichange the neled from the parent may be raised by re- after-tax value of dividends. For example, the taining earnings, new share issues, or debt. In after-tax value of a dividend repatriation may an earlier version of this paper (Altshuler and increase tf foreign tax credit carryforwards can Fulghieri, 1990), we derive the cost of capital be claimed In the future. As mentioned for projects that are financed with both eq- above, we examine the effect of these carry- uity and debt forwards on investment incentives in the next l3 For tax years beginning in 1987, the amount section. of foreign tax credit associated with a divi- “’ A&N estrmare that in 1986, about 51 percent dend payment is based on the accumulated of dividend payments in their sample had af- value of earnings and profits. Taking this law ter-tax values of less than ‘one, 13 percent change into account would complrcate the had after-tax values of one, and 36 percent analysis without altering the qualitative re- had after-tax values that exceeded one. sults. I’ We assulne here that all of the stockholders l4 This expression assumes th.at both the United in the parent corporation bre United States States and the host country use the same tax resildents. base definition. As mentioned in endnote 10, j2 Capital gains are taxed on realization, not on papers by Hines (19!32) and Leechor and accrual. The rate TG represents the expected Mintz (1993) have shown that differences in value of the tax liability associated with a cap- tax base definitions across home and host ital gain accruing today. countries may affect investment decisions. In Allowing for depreciation ,over a longer period this model, we focus on how credit positions of time would complicateIthe analysis without impact investment decisions, ignoring the dis- changing our qualitative results. tortions caused by differences in tax base def- “4 Since we consider the coslt of caoital for a initions. “marginal” tnvestment pr ject, we take the l5 We have assumed that host countries use credit St&e of the parent Pcompany as given. classical corporate tax rate systems. As a re- In CI mote general setting,1 the credit state of sult, the only host country tax consequence of the parent company will depend on the inter- a dividend remittance is the withholdrng tax action of Its financing and investment decr- liability generated. sions, green the cash-flow available in every ” A firm is considered to be in an excess credit subsidiary. This more artiqulated optimizat’on position if, after carrybacks, foreign tax pay- problem must account for the impact of ments exceed the limitatlon. changes of credit states on the cost of capi- ‘I Different types of foreign income are placed tal, as examined in this paper in separate foreign tax credit baskets. Averag- .” Our analysis could be extended to the case in ing IS not permitted across foreign tax credit which flilancial policies and credit regimes are baskets. However, averaging is permitted not stationary in the future. In the next sec- across different income types within baskets. tion, we present an examlple in which a credit We concentrate on income placed in the ac- regime :#wrtch occurs at al date T > 1. tive income basket, which includes dvrdends, .“’ This result I’; due to the fact that equity is interest, rents, and royalty payments. See “trapped” In the foreign subsidiary, since it A&N for a more detailed discusslon of averag- must be repatriated in the current period or ing and estimates of the extent to whrch in the future. This is equivalent to the argu- United States multinational corporations use ment made for domestic Jcorporationr under averaging to reduce tax liabilities on overseas the “new view” of dividelnd taxation income. ” See, for example, Auerbach (1983), Altshuler ” Assuming that a parent corporation controls and Aucrbach (1990), and Mintz (1988) both high and low tax subsidraries IS not un- ” Other pl+ov’i;rons in TRA ‘$6, such as changes realistic. For example, almost 75 percent of In the foreign tax credit basket systern, may A&N’s sample of United States parer’t corpo- also increase the percentage of multinationals rations owned both high and low tax subsid- in ‘excess credits. Unfortunately, tax return iaries in 1986. About 54 percent of the par- data on the credit positiolns of Unrted States

360 INCENTIVE EFFECTS OF FOREIGN TAX CREDITS

multinationals after 1986 are not available Auerbach, Alan 1. “Wealth Maximization and yet. A recent paper by Hines (1993) provides the Cost of Capital ” Quarter/y Journal of Eco- some evidence from Compustat on the for- nom/c5 93 (1979): 433-46. eign tax credit positions of United States cor- Auerbach, Alan 1. “Corporate Taxation in the porations during the late 1980s. He con- United States.” Brookings Papers on Economic structed a sample of 116 United States parent Activity 2 (1983): 451-505. corporations that in every year from 1987 to Auerbach, Alan 1. “The Dynamic Effects of Tax 1989 (1) reported both domestic and foreign Law Asymmetries.” Review of Economic Studies income and sales, (2) reported research ex- 53 (1986): 205-25. penditures, and (3) were not involved in a major merger. Of the 116 firms, he estimates Bradford, David. “The Incidence and Allocation that only 21 were continuously in excess limi- Effects of a Tax on Corporate Distributions.” tation over the time period under consider- Journal of Public Economics 15 (198 1) : l-22. ation. This suggests a large set of United Hartman, David. “Tax Policy and Foreign Direct States parent corporations may have gener- Investment.” Journal of Public Economics 26 ated foreign tax credit carryforwards after (1985): 107-21 TRA ‘86. Hines, James R. “Credit and Deferral as Interna- Similar work has analyzed the effect of tax tional Investment Incentives.” NBER Working Pa- loss and investment tax credit carryforwards per No. 4191. Cambridge, MA: National Bureau on investment incentives. For example, see of Economic Research, 1992. Auerbach (1986) or Altshuler and Auerbach Hines, James R. “The Sensitivity of R&D to Deli- (1990). cate Tax Changes: The Behavior of United States See Auerbach (1986) for an analysis of invest- Multrnationals in the 1980s.” In Studies in Inter- ment incentives in the presence of tax loss national Taxation, edited by Albert0 Giovannini, carryforwards. Glenn Hubbard, and Joel Slemrod, 149-187. Chicago: University of Chicago Press, 1993. See Altshuler and Fulghieri (1990) for a full Horst, Thomas. “American Taxation of Multina- derivation of these expressions. tional Firms.” American Economic Rewew 67 (1977): 376-89 REFERENCES Hufbauer, Gary. U.S. Taxation of International Altshuler, Rosanne and Alan J. Auerbach. Income: Blueprint for Reform. Washington, D.C. : “The Significance of Tax Law Asymmetries: An Institute for International Economics, 1992. Empirical Investigation.” Quarterly Journal of Jun, Joosung. 1987. “Taxation, International In- Economics 105 (1990): 61-86. vestment and Financing Sources.” Cambridge, Altshuler, Rosanne and Paolo Fulghieri. “ln- MA: Harvard Unrversity. Mimeo. centive Effects of Foreign Tax Credits on Multi- Keen, Michael. July 1990. Corporate Tax, For- nationals.” Working Paper No. 478. New York: eign Direct Investment and the Single Market. Columbia University Department of Economics, University of Essex. Mimeo. 1990. King, Mervyn. Public Policy and the Corpora- Altshuler, Rosanne and T. Scott Newlon. tion. London: Chapman and Hall, 1977. “The Effects of United States Tax Policy on the Leechor, Chad and Jack Mintz. “On the Taxa- Income Repatriation Patterns of U.S. Multina- tion of Multinational Corporate Investment when tional Corporations.” In Studies in international the Deferral Method is Used by the Capital Ex- Taxation, edited by Albert0 Giovannini, Glenn porting Country.” Journal of Public Economics Hubbard, and Joel Slemrod, 77-l 15. Chicago: 57 (1993): 75-96. University of Chicago Press, 1993. Mintz, Jack. “An Empirical Estimate of Corpo- Alwotth, Julian. The Financial, investment and rate Tax Refundability and Effective Rates.” Taxation Decisions of Multinationals. Oxford, UK: Quarter/y Journal of Economics 703 (1988): Basil Blackwell, 1988. 225-31.