The Tax Burden on Cross-Border Investment: Company Strategies and Country Responses

We look at the tax burden on direct investment from three perspectives. The first section illustrates how the recognition of company tax planning and of the importance of intellectual property affects measures of effective tax rates. It also discusses the methodological issues that arise, such as to which subsidiary the benefits of a multicountry strategy should be attributed. The simulations emphasize the importance of the share of royalties in crossborder income, and of tax planning strategies such as the shifting of debt to high-tax locations. At the same time, evidence on actual company behavior is necessary to limit the range of possible tax avoidance strategies. Otherwise, the effective tax burden on cross-border investment would virtually disappear. Even then, the range of possible estimates is large. The simulations also show how home governments can respond to some types of tax planning by, for example, requiring that parent interest expense be allocated to foreign income. The second section supplements the hypothetical calculations by evaluating the determinants of the actual effective tax rate on overall U.S. manufacturing investment abroad. Among the various components are the location of assets, the location of debt, other forms of income shifting, the share of royalties, and home government repatriation taxes. The results are generally consistent with the simulations in the first section. Somewhat surprisingly, real assets seem more mobile than tax bases, confirming the constraints on tax avoidance. The first two sections demonstrate that it is not the more ‘obvious’ features of a tax system, such as whether foreign dividends are taxed or exempt, that are important, but provisions that govern the taxation of royalties, the use of tax haven finance subsidiaries, and the allocation of parent interest expenses to foreign income. The third section introduces host government behavior to see how they tax different types of companies.

Repatriation Taxes, Repatriation Strategies and Multinational Financial Policy

Several investment-repatriation strategies are added to the standard model of a multinational in which an affiliate is located in a low-tax country and is limited to two alternatives: repatriating taxable dividends to the parent or investing in its own real operations. In our model, affiliates can invest in passive assets, which the parent can borrow against, or in related affiliates which can be used as vehicles for tax-favored repatriations. We show analytically how the availability of alternative strategies can effect real investment throughout the worldwide corporation. We use firm level data for U.S. multinationals to test for the importance of alternative strategies. The evidence is generally consistent with the theory, particularly the strategies using related affiliates.

The Three Parties in the Race to the Bottom: Host Governments, Home Governments and Multinational Companies

Most studies of tax competition and the race to the bottom focus on potential host countries competing for mobile capital, neglecting the role of corporate tax planning and of home governments that facilitate this planning. This neglect in part reflects the narrow view frequently taken of the policy instruments that countries have available in tax competition. But high-tax host governments can, for example, permit income to be shifted out to tax havens as a way of attracting mobile companies. Home countries will cooperate in this shift if their companies’ gain is greater than any reduction in the domestic tax base. We use various types of U.S. data, including firm level tax files, to identify the role of the three parties (host governments, home governments and MNCs) in the evolution of tax burdens on U.S. companies abroad from 1992 to 2002. This period is of particular interest because the United States introduced regulations in 1997 that greatly simplified the use of more aggressive tax planning techniques. The evidence indicates that from 1992 to 1998 the decline in effective tax rates on U.S. companies was driven largely by host governments defending their market share. But after 1998, tax avoidance behavior seems much more important. One indication is that effective tax rates on U.S. companies had a much weaker link with local statutory tax rates. After 1997, the new regulations motivated a very large growth in intercompany payments and a parallel growth of holding company income abroad. We attempt to estimate how many of these payments were deductible in the host country, and conclude that by 2002 the companies were saving about $7.0 billion per year by using the more aggressive planning strategies. This amounts to about 4 percent of companies’ foreign direct investment income and about 15 percent of their foreign tax burden.

The Tax Burden on Cross-Border Investment: Company Strategies and Country Responses

We look at the tax burden on direct investment from three perspectives. The first section illustrates how the recognition of company tax planning and of the importance of intellectual property affects measures of effective tax rates. It also discusses the methodological issues that arise, such as to which subsidiary the benefits of a multicountry strategy should be attributed. The simulations emphasize the importance of the share of royalties in crossborder income, and of tax planning strategies such as the shifting of debt to high-tax locations. At the same time, evidence on actual company behavior is necessary to limit the range of possible tax avoidance strategies. Otherwise, the effective tax burden on cross-border investment would virtually disappear. Even then, the range of possible estimates is large. The simulations also show how home governments can respond to some types of tax planning by, for example, requiring that parent interest expense be allocated to foreign income. The second section supplements the hypothetical calculations by evaluating the determinants of the actual effective tax rate on overall U.S. manufacturing investment abroad. Among the various components are the location of assets, the location of debt, other forms of income shifting, the share of royalties, and home government repatriation taxes. The results are generally consistent with the simulations in the first section. Somewhat surprisingly, real assets seem more mobile than tax bases, confirming the constraints on tax avoidance. The first two sections demonstrate that it is not the more obvious' features of a tax system, such as whether foreign dividends are taxed or exempt, that are important, but provisions that govern the taxation of royalties, the use of tax haven finance subsidiaries, and the allocation of parent interest expenses to foreign income. The third section introduces host government behavior to see how they tax different types of companies

The Effect of Taxes on Royalties and the Migration of Intangible Assets Abroad

Migration of intangible assets from the United States to foreign countries has become easier due to the ability of U.S. firms to create hybrid entities in their affiliates abroad and to reach favorable cost sharing agreements with them. This strategy was particularly encouraged by the U.S. adoption of "check-the-box" regulations in 1997. Rather than receive royalties from affiliates abroad, US parent firms have an incentive to retain abroad in low-tax countries a greater share of the return to their US R&D. Evidence from several sources for years that span the 1997 policy change indicate a significant response by US corporations in utilizing this strategy. BEA data indicate affiliate earnings and profits grew more rapidly than royalty payments to US parents. Payments to U.S. parents for technical services rose even faster, as would be called for under cost sharing agreements. Regression analysis of affiliate data shows that parent R&D was a more important determinant of royalty payments to U.S. parents than it was for affiliate earnings and profits in 1996, but by 2002 it played a larger role in earnings and profits than in royalties. Cost sharing payments from affiliates in Ireland and from pure tax havens (Bermuda, the Cayman Islands, and Luxembourg) are particularly significant, both economically and statistically.