Tax sparing agreements, territorial tax reforms, and foreign direct investment

Abstract

The governments of many developing countries seek to attract inbound foreign direct investment (FDI) through the use of tax incentives for multinational corporations (MNCs). The effectiveness of these tax incentives depends crucially on MNCs' residence country tax regime, especially where the residence country imposes worldwide taxation on foreign income. Tax sparing provisions are included in many bilateral tax treaties to prevent host country tax incentives being nullified by residence country taxation. We analyse the impact of tax sparing provisions using panel data on bilateral FDI stocks from 23 OECD countries in 113 developing and transition economies over the period 2002–2012, coding tax sparing provisions in all bilateral tax treaties among these countries. We find that tax sparing agreements are associated with up to 97 % higher FDI. The estimated effect is concentrated in the year following the entry into force of tax sparing agreements, with no effects in prior years, and is thus consistent with a causal interpretation. Four countries – Norway in 2004, and the U.K., Japan, and New Zealand in 2009 – enacted tax reforms that moved them from worldwide to territorial taxation, potentially changing the value of their pre-existing tax sparing agreements. However, there is no detectable effect of these reforms on bilateral FDI in tax sparing countries, relative to nonsparing countries. These results are consistent with tax sparing being an important determinant of FDI in developing countries for MNCs from both worldwide and territorial home countries.