A tax break for U.S. financial services companies that operate overseas fell victim to the Washington budget drama on Monday.

President Clinton, in the first test of the line-item veto authority that Congress granted last year, voided a provision in the balanced budget act that would have allowed U.S. banks, finance companies, insurers, and securities firms to defer taxes on income earned by offshore units.

The Treasury Department estimated the exemption would cost taxpayers $317 million over five years.

"This is a real shocker," said a senior official at a New York bank with a large international presence. "Most people involved thought this was pretty well understood and that Treasury's concerns with it were laid aside."

The President, however, called the tax break "inappropriate," adding that it would "allow financial services companies to shield income in foreign tax havens to avoid all U.S. taxes."

The President's surprise decision hauled the banking industry into what is expected to be a protracted court battle over the constitutionality of the line-item veto-a power intended to enable the White House to eliminate pork from tax and spending bills.

President Clinton, who signed the budget bill last Tuesday, told a press conference Wednesday that he expected to invoke the line-item veto, but did not yet know which items he would kill. The banking provision was one of three he struck.

The veto drew fire from industry officials and Capitol Hill.

"For our banks with foreign operations this was an important provision and we are very disappointed it was cut," said Donna Fisher, director of tax and accounting at the American Bankers Association.

A lobbyist for a large New York bank said the tax break would have helped U.S.-based financial service companies compete globally. "It was a major step forward in rationalizing U.S. tax policy and bringing it into step with trade policy," he said.

"The issue is one of fairness," agreed Jack Dolan, a spokesman for the American Council of Life Insurers. "U.S. insurers are taxed 24% higher than non-U.S. firms are taxed on investment gains in foreign countries."

The provision would have deferred taxes on foreign income until the profits were returned to the parent company here. Financial companies were allowed to defer taxes in this manner until 1986, when Congress banned the practice because it feared corporations were abusing the law.

To ensure the new tax break only was used by legitimate financial institutions, the measure would have required companies to satisfy three technical tests involving how a company earned its income. The White House apparently did not consider the tests rigid enough to deter fraud.

Senate Majority Leader Trent Lott, R.-Miss., had championed the one-year pilot program, saying financial companies needed the special treatment to compete with foreign banks that enjoy similar tax treatment at home.

After Congress returns from recess on Sept. 2, lawmakers will have 30 days overturn the veto.

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