Foreign Tax Rates Research Articles

Tax Treaties and Foreign Direct Investment: A Network Approach

Multinational investors often reduce tax on dividends by using indirect investment routes. This paper constructs a tax rate matrix to represent a real-world network of tax treaties between 70 countries and develops network algorithms to study the structure of tax-minimizing (direct or indirect) investment routes in the tax treaty network. The treaty shopping arbitrage rate, defined as the difference between the foreign tax rates of the direct route and a tax-minimizing route, is estimated to be about 3.57 percentage points on average. In bilateral FDI data, it appears that the average inward FDI stock via a tax-minimizing direct route is about 3.75 times larger than the average via a direct route that is not tax-minimizing. Empirical results confirm that the availability of a tax-minimizing direct route is positively and significantly related to FDI. By making a direct route tax-minimizing, countries can encourage FDI via the direct route and reduce the use of indirect routes through conduit countries.

Effective Rates of Corporation Tax in Ireland

This Technical Paper considers the effective tax rate on corporate profits in Ireland. It will be appreciated that this apparently straight-forward concept generates significant confusion. There is no single best measure of the effective tax rate and this Paper presents and examines eight different calculations for an effective tax rate on corporate profits in Ireland under three broad headings: using model companies; using official national statistics; and using company financial reports.The spread of estimates ranges from 2.2 per cent to 15.5 per cent for the most recent data available. Different approaches are relevant depending on the specific nature of the question being addressed. Some approaches are better at measuring the complexity and breadth of corporate tax. Other approaches are better at measuring the effective tax rate of companies. In attempting to assess the effective corporate tax rate that is applied to the aggregate total of corporate profits in Ireland, this Paper has concluded that the approach based on national aggregate statistics is the most suitable.The data from the Central Statistics Office and the Revenue Commissioners provide the best estimates of the effective rate of Irish Corporation Tax on the total profits that are subject to Irish tax but even within that there remains a choice of measures. This Paper has put forward the thesis that the measures based on Net Operating Surplus and Taxable Income best represent the effective Corporation Tax rate in Ireland.Much lower effective tax rates can be identified, notably the effective foreign tax rate for US-owned, Irish-incorporated companies, in the direct investment data produced by the Bureau of Economic Analysis. These show how MNCs can structure their activities to generate very low effective tax rates but it is not possible to achieve such low rates for profits earned in Ireland.The most appropriate effective tax rates identified in this Paper are below the headline 12.5 per cent rate and the reasons for this are the inclusion of foreign-source profits in the case of Taxable Income, and the exclusion of the interest cost of financing in the case of Net Operating Surplus. The impact of these factors is relatively small and the analysis presented here has shown that, since 2003, the effective Corporation Tax rates on Net Operating Surplus and Taxable Income have averaged 10.9 per cent and 10.7 per cent respectively.

Corporate Taxation and International Competition

Countries around the world continue to tax corporate income at significant rates despite downward pressures from international competition. Average statutory corporate income tax rates fell from 46 percent in 1982 to 33 percent in 1999, though tax bases simultaneously broadened, as a result of which average corporate tax collections actually rose from 2.1 percent of GDP in 1982 to 2.4 percent of GDP in 1999. Two pieces of evidence point to the possibility that mobile capital has received favorable tax treatment in recent years as a result of tax competition. The first is the experience of American multinational firms, whose average effective foreign tax rates fell from 43 percent in 1982 to 26 percent in 1999. The second is the cross-sectional pattern of tax rate-setting: small countries, facing elastic supplies of world capital, taxed corporate income at significantly lower rates than did larger countries in 1982. Corporate tax rates in 1999 did not substantially differ between small and large countries, implying that large countries set their tax rates in response to the same competitive pressures that small countries have always faced.

What Do Investors Infer About Future Cash Flows from Foreign Earnings for Firms with Low Average Foreign Tax Rates?

This study examines whether investors discount the foreign earnings of U.S. multinational corporations in anticipation of future repatriation taxes. Investor pricing of repatriation taxes has become increasingly important because of the decline in foreign statutory tax rates relative to the U.S. statutory tax rate over the past twenty years combined with the increasing significance of foreign income for U.S. multinationals. Recent comments by regulators suggest they believe current disclosures related to potential repatriation taxes on foreign earnings are insufficient. Consistent with investors pricing repatriation taxes, we observe a significant difference in the earnings response coefficient on changes in foreign earnings of firms with low versus high average foreign tax rates. We also conduct a series of tests to examine whether investor expectations about the likelihood of future repatriation taxes vary as a function of certain firm characteristics. We find no evidence investors differentiate between low foreign tax rate firms based on the likelihood of repatriation.

Impact of taxation on international transfer pricing and offshoring decisions

A multinational company may move production to a foreign country to take advantage of low manufacturing cost, and/or experience tax savings. Transfer prices play an important and strategic role on income shifting by multinational companies. In this paper, we construct a framework for optimal decision making in global supply chains with uncertain and price-dependent demand, propose methods to improve global supply chain parties’ performance, and explore schemes to integrate global supply chains. The optimal pricing and offshoring decisions are investigated for different situations where the low foreign production cost and low foreign tax rate exist or only one of them is available. The case of low foreign tax rate without the advantage of low foreign production cost provides the most interesting findings that partial offshoring dominates when a certain threshold is met. In addition, the double marginalization is examined in decentralized global supply chains similar to the mechanism in newsvendor problems. Due to the existence of the tax jurisdiction, the double marginalization cannot be completely eliminated by coordinating schemes. Finally, the traditional buy back contract is found to be unable to coordinate global supply chains, while a modified sales sharing contract can improve the performance of the global supply chain.

Financial Reporting versus Tax Incentives and Repatriation under the 2004 Tax Holiday

ABSTRACTWe analyze the repatriation behavior of U.S. multinational corporations under the tax holiday implemented as part of the American Jobs Creation Act of 2004. Our results suggest that tax incentives, as reflected in differences between firms' effective foreign tax rates, do not appear to be significant predictors of either participation in the tax holiday or the amounts repatriated by firms that chose to participate. In contrast, differences in financial reporting incentives were significant predictors of both participation in the holiday and the amounts repatriated. Not surprisingly, we find that firms appear to have chosen between repatriation of permanently versus temporarily deferred foreign earnings based on how the source of repatriation impacted their GAAP financial statements. Moreover, our results suggest that many firms chose to participate in the holiday only to the extent necessary to achieve financial reporting goals. Overall, our results suggest that financial reporting incentives appear to have been much more important to firms than tax savings in choosing whether and to what extent to participate in the holiday. Indeed, many firms appear to have viewed the act principally as an opportunity to manage reported GAAP income, rather than as an opportunity to reduce their U.S. tax costs.

Transfer Pricing and Sourcing Strategies for Multinational Firms

Taking advantage of low foreign tax rates using transfer pricing and taking advantage of low production costs using offshoring are two strategies multinational firms (MNFs) use to increase their profits. We identify an important trade-off that MNFs face in setting their transfer prices: the conflict between (i) the incentive role and (ii) the tax role played by the transfer price. For MNFs, we characterize transfer-pricing strategies that motivate divisional management to (i) make good sourcing decisions and (ii) take advantage of favorable tax rates. It is clear that using a dual transfer-pricing system, where one transfer price determines tax liability and the other transfer price determines management compensation will always achieve the first-best solution, but such an approach carries the burden of administrative and possibly punitive costs. In addition to finding the profit-maximizing sourcing and transfer-pricing policies for both single and dual transfer-pricing systems, we quantify the absolute and relative maximum inefficiency in terms of the after-tax MNF's profit change from using a single transfer-pricing system. We show that the highest relative loss is attained when the average outsourcing and offshoring costs, as well as the tax differential, are high. Using numerical experiments, we demonstrate that the absolute loss is attained when the outsourcing cost follows a symmetric distribution and the average outsourcing cost is approximately equal to the offshoring cost. We also extend our results to two practical variations of MNF structures: an MNF that faces operational constraints on its offshoring capacity and an MNF that uses compensation contracts linked to after-tax firm-wide profits. Insights from our analysis should help MNFs' managers identify when to use single and dual transfer-pricing systems.

A Model of the Cost of Income Shifting with an Application to Tax Planning and E-Commerce

This manuscript develops a model that incorporates income shifting into investments by U.S. multinationals in their foreign subsidiaries. The model demonstrates that, while there is always an incentive to shift income into the U.S. from high foreign tax rate subsidiaries, income shifting out of the U.S. to low tax rate countries occurs only when the required rate of return on foreign investments is low (repatriations are unlikely), i.e., it is not always optimal to shift to low-tax-rate countries. It also shows that the optimal amount of shifting relates to the interplay of costs and the tax rate differential. We apply the model to examine a setting where cross-sectional costs of income shifting likely vary based on the extent to which a firm is engaged in electronic commerce. Electronic commerce potentially alleviates costs by making it easier for firms to strategically locate sales among foreign jurisdictions, and to shift sales between domestic and foreign locations to benefit from the relative taxation of the two. Consistent with our theory, we find firms in industries with high levels of e-commerce have lower cash effective tax rates, and this effect is magnified for firms that are less likely to have taxable repatriations.

Are U.S. Multinational Corporations Becoming More Aggressive Income Shifters?

ABSTRACTThis paper examines income shifting of U.S. multinational companies over the past two decades. Domestic and foreign policy makers are increasingly concerned with the effect of income shifting on dwindling tax revenues, however, extant research on income shifting by U.S. multinational enterprises is mixed. We address the disconnect between the academic literature and the policy maker's perceptions by examining the extent of multijurisdictional income shifting by U.S. multinational companies. We directly address conflicting results in extant literature and show that using either multiperiod proxies or instrumental variables overcomes weaknesses of annual proxies in this setting. Our tests show that U.S. companies have become more active at shifting income out of the United States as the regulatory costs of shifting have changed. Holding tax rate differences between U.S. and foreign jurisdictions constant, our empirical estimates suggest that our sample of 380 corporations with low average foreign tax rates collectively shifts approximately $10 billion of additional income out of the United States annually during 2005–2009 relative to 1998–2002 due to varying regulatory costs of shifting.

How elastic are national corporate income tax bases in OECD countries? The role of domestic and foreign tax rates

Abstract To what extent do reductions in corporate income tax (CIT) rates attract foreign tax bases? What are the revenue implications of a unilateral tax reduction when tax bases are internationally mobile? These questions are explored using annual data from 17 OECD countries spanning the period 1982 to 2005. Controlling for fixed country effects, year effects, and country time trends, and subjecting our results to an extensive robustness analysis, we find (i) a country’s aggregate reported corporate profits are negatively and significantly affected by CIT rate reductions in neighbouring countries; (ii) a unilateral reduction in the domestic CIT rate results in lower domestic CIT revenues.

Home bias and cross border taxation

The relationship between cross border taxation and free float home bias is examined. This explicitly recognizes that insider shares are unavailable to foreigners. Other important explanations for home bias – information asymmetry, behavioural and governance issues – are controlled when examining the impact of cross border tax variables. In our sample of countries about sixty percent (eighty percent) withhold taxes on realized capital gains (dividends) of foreign investors and about thirty percent of the mature economies provide imputation of taxes paid on dividend income by domestic corporations. Dividend imputation is a statistically significant impediment to cross border equity flows. A tax credit variable for foreign taxes paid on dividends is constructed and found to be statistically significant in reducing home bias. A relatively high foreign tax rate that cannot be offset by tax credits is found to significantly increase home bias. These results hold for float adjusted home bias and traditional international portfolio home bias.

The Effect of Foreign Reinvestment and Financial Reporting Incentives on Cross‐Jurisdictional Income Shifting*

This paper investigates the influence of foreign reinvestment-related and financial reporting incentives on income shifting of U.S. multinational companies. While foreign and domestic policymakers are concerned with the effect of income shifting on dwindling tax revenues, to date no research has focused on the character of firms that are more aggressive income shifters. We provide insights on the role of cross-sectional variation in foreign reinvestment-related incentives and financial reporting incentives in income shifting; insights that are useful to policymakers, regulators, researchers and stakeholders. Using a comprehensive approach to estimate income shifting, we find evidence consistent with our argument that foreign reinvestment-related incentives affect a firm’s propensity to shift income when domestic tax rates exceed foreign tax rates, but not when foreign tax rates exceed domestic tax rates. We also find that firms with low foreign tax rates and incentives to manage income on their financial statements more actively shift income out of the U.S. than other firms. Finally, we estimate that firms with high reinvestment-related (financial reporting) incentives shift approximately $42 million ($43 million) of additional income per firm per year out of the U.S. relative to firms with low reinvestment-related (financial reporting) incentives.

Taxation of Firms with Unknown Mobility

We analyze the optimal tax choices of a revenue-maximizing government that levies taxes from firms of which the true degree of mobility is ex ante unknown. Differential tax treatment of immobile and mobile firms is ruled out, but the government may learn from the firms’ location responses to past tax rate changes. Firms, however, may anticipate this and adjust their choices accordingly. We derive all symmetric Bayesian equilibria with a focus on the (so far neglected) one where the government sets a tax rate that triggers partial migration but full revelation of the true number of mobile firms. We show that, if tax competition is fierce (i.e., relocation cost and foreign tax rates are low), expected tax rates and expected firm migration are higher if the degree of mobility is unknown. There is a positive value of learning, i.e. commitment on future tax rates cannot increase the government’s expected revenue. However, if the government can commit to a rule-based learning mechanism, i.e. credibly tie its future tax policy to present policy outcomes, it may obtain a Pareto improvement.

The Effect of Foreign Reinvestment and Financial Reporting Incentives on Cross-Jurisdictional Income Shifting

This paper investigates the influence of foreign reinvestment-related and financial reporting incentives on income shifting of U.S. multinational companies. While foreign and domestic policymakers are concerned with the effect of income shifting on dwindling tax revenues, to date no research has focused on the character of firms that are more aggressive income shifters. We provide insights on the role of cross-sectional variation in foreign reinvestment-related incentives and financial reporting incentives in income shifting; insights that are useful to policymakers, regulators, researchers and stakeholders. Using a comprehensive approach to estimate income shifting, we find evidence consistent with our argument that foreign reinvestment-related incentives affect a firm’s propensity to shift income when domestic tax rates exceed foreign tax rates, but not when foreign tax rates exceed domestic tax rates. We also find that firms with low foreign tax rates and incentives to manage income on their financial statements more actively shift income out of the U.S. than other firms. Finally, we estimate that firms with high reinvestment-related (financial reporting) incentives shift approximately $42 million ($43 million) of additional income per firm per year out of the U.S. relative to firms with low reinvestment-related (financial reporting) incentives.

Are U.S. Multinational Corporations Becoming More Aggressive Income Shifters?

This paper examines income shifting of U.S. multinational companies over the past two decades. Domestic and foreign policymakers are increasingly concerned with the effect of income shifting on dwindling tax revenues, however, extant research on income shifting by U.S. multinational enterprises is mixed. We address the disconnect between the academic literature and the policymaker’s perceptions by examining the extent of multijurisdictional income shifting by U.S. multinational companies. We directly address conflicting results in extant literature and show that using either multi-period proxies or instrumental variables overcome weaknesses of annual proxies in this setting. Our tests show that U.S. companies have become more active at shifting income out of the U.S. as the regulatory costs of shifting have changed. Holding tax rate differences between U.S. and foreign jurisdictions constant, our empirical estimates suggest that our sample of 380 corporations with low average foreign tax rates collectively shift approximately $10 billion of additional income out of the U.S. annually during 2005-2009 relative to 1998-2002 due to varying regulatory costs of shifting.

The Use of Tax Havens in Exemption Regimes

This paper analyzes the tax haven investment behavior of multinational firms from a country that exempts foreign income from taxation. High foreign tax rates generally encourage firms to invest in tax havens, though significant costs of reallocating taxable income dampen these incentives. The behavior of German manufacturing firms from 2002-2008 is consistent with this prediction: at the mean, one percentage point higher foreign tax rates are associated with three percentage point greater likelihoods of owning tax haven affiliates. This contrasts with earlier evidence for U.S. firms subject to home country taxation, which are more likely to invest in tax havens if they face lower foreign tax rates. Foreign tax rates appear to be unrelated to tax haven investments of German firms in service industries, possibly reflecting the difficulty they face in reallocating taxable income.

Multi-Jurisdictional Tax Incentives and the Location of Innovative Activities

Research and development (R&D) tax incentives offered by foreign countries and differences between U.S. and foreign tax rates provide opportunities that may affect the location of U.S. multinationals' innovative activities. Using firm-level patenting data to help identify the country-specific location of innovations from 1986 to 2000, I examine the relation between innovative activities performed in a foreign country and these tax incentives. I find evidence that the foreign percentage of innovative activities is associated with the attractiveness of foreign R&D tax incentives. In addition, the results suggest that firms in excess foreign tax credit positions decrease the amount of R&D activities in a foreign location with increased foreign tax rates, consistent with income shifting incentives. In contrast, I find that the firms in deficit foreign tax credit positions increase their foreign R&D activities with increasing foreign tax rates.

Foreign Investment and Taxation

The relationship between cross border taxation and free float home bias is examined. This explicitly recognizes that insider shares are unavailable to foreigners. Other important explanations for home bias - information asymmetry, behavioural and governance issues – are controlled when examining the impact of cross border tax variables. In our sample of countries about half (three-quarters) withhold taxes on realized capital gains (dividends) of foreign investors and about half of the mature economies provide imputation of taxes paid on dividend income by domestic corporations. A tax credit variable for foreign taxes paid is constructed and found to be statistically significant in reducing home bias. A foreign tax rate too high to be fully offset by tax credits is found to significantly increase home bias. Dividend imputation is a statistically significant impediment to cross border equity flows. The benefit of investor familiarity with foreign opportunities for reducing home bias is found to be mitigated by higher potential for foreign taxation of capital gains.

Using Financial Accounting Data to Examine the Effect of Foreign Operations Located in Tax Havens and Other Countries on U.S. Multinational Firms' Tax Rates

ABSTRACTThis paper investigates the effect tax havens and other foreign jurisdictions have on the income tax rates of multinational firms based in the United States. We develop a new regression methodology using financial accounting data to estimate the average worldwide, federal, and foreign tax rates on worldwide, federal, and foreign pretax book income for a large sample of U.S. firms with and without tax haven operations. We find that on average U.S. firms that disclosed material operations in at least one tax haven country have a worldwide tax burden on worldwide income that is approximately 1.5 percentage points lower than firms without operations in at least one tax haven country. Our results also show that U.S. firms face a 4.4% current federal tax rate on foreign income whether or not they have tax haven operations. Finally, we find that U.S. firms with operations in some tax haven countries have higher federal tax rates on foreign income than other firms. This result suggests that in some cases, tax haven operations may increase U.S. tax collections at the expense of foreign country tax collections.

Using Financial Accounting Data to Examine the Effect of Foreign Operations Located in Tax Havens and Other Countries on US Multinational Firms' Tax Rates

This paper investigates the effect tax havens and other foreign jurisdictions have on the income tax rates of multinational firms based in the United States. We develop a new regression methodology using financial accounting data to estimate the average worldwide, federal, and foreign tax rates on worldwide, federal, and foreign pre-tax income for a large sample of US firms with and without tax haven operations. We find that on average US firms that disclosed material operations in at least one tax haven country have a worldwide tax burden on worldwide income that is approximately 1.5 percentage points lower than firms without operations in at least one tax haven country. Our results also show that US firms face a 4.4 percent current federal tax rate on foreign income whether or not they have tax haven operations. Finally, we find that US firms with operations in some tax haven countries have higher federal tax rates on foreign income than other firms. This result suggests that in some cases, tax haven operations may increase US tax collections at the expense of foreign country tax collections.