The market reaction to the forgiveness of deferred taxes due to the repeal of the domestic international sales corporation: expectations regarding subsequent export related tax incentives

International Journal of Business Research, Jan, 2008 by Sid Howard Credle, Sharad Maheshwari, Jacob Angima

ABSTRACT

This study addresses two issues regarding the Deficit Reduction ACT of 1984 (DRA) which was signed July 1984, replacing the Domestic International Sales Corporation (DISC) with the Foreign Sales Corporation (FSC). The change resulted in wealth adjustments for DISC exporter since accumulated unpaid taxes on the DISC were forgiven. The first is whether the DISC repeal affected the values of DISC's operators. The second is whether alternative accounting methods resulted in different values across firms during news releases regarding DISC repeal. The investigation of these issues is accomplished by (1) measuring the contemporaneous association between changes in firm security prices and news releases about DISC repeal, and (2) comparing the reaction due to tax announcements of firms that had/had not provided taxes on accumulated DISC income to isolate the accounting method choice effect. The results indicate that the DISC-related announcements conveyed significant negative news to exporters. However, on average security price changes of firms moved in the same direction and the choice of accounting method did not result in an unequal impairment of firm value. It is expected that the subsequent market reaction to the repeal of tax incentives of the Foreign Sales Corporation and the Extraterritorial Exclusion Act will be similar.

Keywords: Deferred Taxes, Foreign Sales Corporation, Extraterritorial Exclusion Act, Domestic International Sales Corporation.

1. INTRODUCTION

Since the Domestic International Sales Corporation was created and later repealed in 1984, two additional foreign tax exempt vehicles have been created and have also experienced hostilities from foreign members of the General Agreement on Tariffs and Trade (GATT) and later its replacement the World Trade Association (WTO). The Foreign Sales Corporation (FSC) created in 1984, replaced the DISC and was subsequently ruled illegal in 1997. In November 2000, the FSC was repealed and replaced with the Extraterritorial Exclusion Act (ETI). The WTO ruled against the ETI in 2002, and the US replaced the ETI with the newly created American Jobs Creation Act in 2004 to be phased in during 2006.

With such a turbulent history for export incentives it is instructive to revisit the primary structured export incentive to shed light on the prospects of subsequent export incentives noted above. In this paper we revisit the period prior to and including the repeal of the DISC to serve as a guide regarding the expected market reaction to the subsequent repeals. The DISC analysis is examined in this document. The market reaction to the repeal of the FSC, and the ETI will be examined in subsequent research works.

This study examines the effect on the stock market performance of US exporters due to tax and financial accounting policy changes associated with the enactment of the Deficit Reduction Act of 1984 (DRA), which included the Tax Reform Act of 1984 (TRA). The DRA was signed into law on July 18, 1984. The most significant provision of the TRA was the repeal of the controversial Domestic International Sales Corporation (DISC), the forgiveness of deferred DISC taxes, and the replacement of the DISC with the Foreign Sales Corporation (FSC). TRA Section 805(b) forgave approximately $13 billion in taxes attributable to the DISC structure. Following the DRA, the Financial Accounting Standards Board (FASB) issued Technical Bulletin 84-2 (T.B. 84-2), requiring firms that had previously provided taxes on deferred DISC income to disclose the full earnings effect to the tax law change in their first quarterly or annual report issued after July, 31, 1984. Firms that had not provided deferred taxes prior to the TRA, received the benefit of the forgiveness of an undisclosed potential tax liability.

This study addresses two issues associated with the DISC repeal and the required disclosures by FASB. The first is whether the repeal, the replacements FSC provisions, and the forgiveness of taxes on deferred DISC income affected the share values of firms operating DISCs. This issue is referred to as the tax announcement effect. Second, since exporters could account for the taxes on DISC income according to alternative financial accounting methods, it is possible that share value adjustments across firms may differ at the date of important news releases regarding DISC repeal. This issue is referred to as the accounting method effect. The investigation of these issues is accomplished in two steps: (1) measuring the contemporaneous association between changes in firm security prices and news releases about the DISC repeal, tax forgiveness, and FSC replacement to capture the tax announcement effect, and (2) comparing the observed reaction due to these announcements of firms that had or had not provided taxes on DISC income to isolate the accounting method effect.

2. LITERATURE REVIEW

A number of researchers have used an "event study" methodology to study wealth effects due to mandatory accounting policy or tax law changes. Extant examples include Bathke [1985], Shaw [1985], Harrison's [1977], and Gupta [1995]. The method effect comparison explores the possibility that investors were initially biased in their assessment of DISC firm value. Prior to DISC repeal, investors of affected firms may not have had an accurate basis for cross-firm comparisons. For financial reporting purposes firms accounted for taxes on deferred DISC income in one of two ways. Some firms provided taxes on this income, assuming the amounts would be distributed as future dividends. Others did not recognize tax expenses by assuming amounts would be permanently reinvested in export-related activities. The two accounting methods result in different tax expense and payable amounts. Providing firms reported a larger tax expense and deferred tax liability than non-providing firms, ceteris paribus. By not providing taxes on DISC income, non-providing firms had greater exposure in the event that DISC income taxes were not forgiven. Hence, a primary issue of this paper is whether investors were capable of unraveling a controversial tax provision, while sorting firms and the associated benefits by the accounting method used.