The effect of the Tax Reform Act of 1986 on the capital structure of foreign subsidiaries.

Abstract

The Tax Reform Act of 1986 made significant changes to the foreign tax laws. The rule changes make it easier for U.S. multinationals to be in an excess foreign tax credit position and alter the way they allocate interest expense between domestic and foreign source income. As a result, there are incentives for U.S. multinationals to increase the debt levels of their foreign subsidiaries. This dissertation examines whether foreign subsidiaries of U.S. multinationals: (1) have increased the use of debt (relative to equity) in response to the Tax Reform Act of 1986, and (2) have made location (in a high-tax versus low-tax country) a more important variable in financing decisions after 1986. A large sample of foreign subsidiaries of U.S. multinationals, which represents forty four percent of the Fortune 500, is used for testing the hypotheses of the dissertation. A second large sample of foreign subsidiaries of non-U.S. multinationals is used as a control and as a basis of comparison. The results indicate that foreign subsidiaries of U.S. multinationals have significantly increased the use of debt (relative to equity) in the years after 1986. This increase in debt is shown to be positively associated with the foreign tax credit characteristics of the U.S. parent, such as the U.S. parent's ratio of foreign assets to worldwide assets and their foreign tax credit position. During this same time period foreign subsidiaries of non-U.S. multinationals have slightly decreased the use of debt. The results also indicate that the location of the foreign subsidiary of the U.S. multinational has a different effect on its financing behavior after 1986. After 1986, foreign subsidiaries of U.S. multinationals located in high-tax countries have made a significant shift towards debt, while foreign subsidiaries of U.S. multinationals located in low-tax countries have made a significant shift towards equity.