Impact of international taxation on FDI location choice

Contents

1. Introduction

2. General tax factors affecting FDI
2.1. Corporate income tax rate
2.2. Indirect taxes
2.3. Transparency and complexity of tax systems

3. Tax incentives
3.1. Objectives of tax incentives towards FDI
3.2. Types of tax incentives
3.2.1. General tax rate reductions and non-income tax-based incentives
3.2.2. Loss carry-forwards
3.2.3. Tax holidays
3.2.4. Investment allowances and tax credits
3.2.5. Free Trade or Export Processing Zones
3.2.6. Tax competition and tax havens

4. Tax avoidance

5. Host country vs. Home country
5.1. Taxation of foreign-source income
5.2. Tax treaties

6. Conclusion

Appendix

Notes and further reading

1. Introduction

Foreign direct investment (FDI) can be seen as a purpose to obtain a lasting interest by an entity (“direct investor”) resident in one economy in an entity (“direct investment enterprise”) resident in an economy other than that of the investor.^[1] A lasting interest implicates an actual long-term relationship between the direct investor and the enterprise, in which the initial transaction between the two and all subsequent capital transactions are included.

The attraction of FDI is one of the main economic development activities of regional governments and development agencies, which make extensive use of marketing, promotion and investment incentives to influence foreign investors’ location decisions. Success in attracting FDI can potentially release many local development benefits. Providing an attractive location for foreign investments, countries may receive incremental investment capital, access to advanced management techniques and advanced production technologies, as well as many other benefits. To name some more: the development of international competition, employment creation and reduction of social or private disadvantage.

The consideration of multinational corporations (MNCs) to undertake FDI is influenced by various characteristics of the investment location or the host country (the investor’s country of residence is further referred to as “home country”). Market size of the host country and its infrastructure, reduction of operating costs, access to cheap raw materials, labour, and energy are the primary factors to attract FDI. If these factors are provided, foreign investors will next consider the taxation on returns in the host country, as well as in their home country.

This paper focuses on the impact of international taxation on FDI undertaken by MNCs. Thus tax revenues and costs of host or home countries connected with taxation and tax incentives are mostly not taken into account. The paper analyses the taxation influence on the FDI location choice under the assumption that FDI flows from firms in well-developed home countries to developing host countries. The aim is to emphasize the potential impact of the host country’s general tax factors, tax incentives, home country taxation and resulting international tax avoidance. The emphasis of taxation impact is put on all kinds of foreign investors, but principal importance is attached to highly mobile investors, like export-oriented and manufacturing firms.

2. General tax factors affecting FDI

As stated in the introductory remarks, there are various factors which affect the decision to invest in a country. Tax factors are not the most important ones to influence FDI flows, but they contribute without question a significant part to the attractiveness of investment and hence to the investment decision. In this section the focus is set on the host country tax factors affecting FDI.

2.1. Corporate income tax rate

The usual international range of corporate income tax is in average about 30 to 40 percent^[2]. However, it can also depend on the activity and the size of the company which is being levied taxes upon. For example, the UK, Canada, Japan and Switzerland levy reduced corporate tax rates on small and middle-sized firms, whereas a country like the Netherlands has a higher tax rate which is levied on earned profits only below a certain amount.^[3]

The corporate tax rate is important in establishing the overall tax burden, but as itself it is not the ultimate tax burden on a company’s activity. The effects of statutory actions which establish the tax base and actions taken by companies to decrease their tax burden are of similar importance. Tax planning and financial strategies of a firm include considerations about the host country’s corporate tax rate. As a matter of course, formidable differences in corporate tax rates affect the firms to transmit their benefits to low tax countries and their costs to higher tax countries. For instance, it is appealing to an investor to use debts in order to finance foreign subsidiaries in high tax countries and on the other hand use equities to finance those located in low tax countries. A higher corporate tax rate does not always lead to higher tax revenues for the host country, at least not from those companies who operate in several countries. Furthermore, the corporate tax rate can also affect a firm in some of its production decisions and could influence the occurrence of shut down situations in which the treatment of capital costs is no longer relevant for the production decision.

A high corporate tax rate can be a disadvantage for foreign investors, but it can also attract them. A country may provide for high mobility in form of developed infrastructure, access to public services and other factors financed through a high corporate tax rate. However, in practice, mobility provides the multinational investor with some kind of market power. This means that the threat of moving makes the government reduce its contribution to public goods and social transfers, and transfer the costs to less mobile tax bases which lack market power.

2.2. Indirect taxes

A host country’s income tax rate is one of the most important indicators of investment attractiveness. It can either be an incentive to attract FDI, or an incentive to stream FDI into the development of tax-avoiding strategies. Non-income or indirect tax factors are of the same importance to investors as the income tax factors, since there is a possibility that these taxes have to be paid even if there are no scored profits. Indirect taxes lead to increasing costs of basic input, also to an increased up-front risk of investment, or increased operating costs of the company. The most usual indirect taxes are, for instance, general taxes applied on investment goods, value-added tax (VAT), or social security taxes on wages and salaries.

Destination-based taxes such as VAT depress output of taxed versus untaxed goods by raising the cost of local sales, but do not influence the choice of input combinations or the desire to undertake FDI to facilitate intra-firm transactions.^[4] Indirect tax obligations are not functions of reported income and therefore don’t influence the MNC’s financing of its subsidiary or its decision of intra-firm transfers.

A high income tax rate facilitates the reallocation of a firm’s taxable profits towards low tax jurisdictions in order to substitute labour for capital, to reduce the scale of local business activity and also to reduce the capital intensity of any given level of business activity. In this way, increasing the total costs generally leads to the effect of production reduction and to the question whether the FDI is profitable at all. High indirect taxes may bring about additional costs (with a magnitude of their impact on FDI comparable to that of income taxes) discouraging economic activity, but not affecting the attractiveness of FDI connected with efforts to reallocate taxable income. Furthermore, one must take into account that in several countries foreign taxes which are levied on incomes of home firms abroad are governmentally credited, whereas foreign indirect taxes are not.^[5] Consequently, when higher direct and indirect taxes are imposed and reduce output, the effect of indirect taxes becomes stronger, since firms are not able to claim credits for indirect taxes in their home countries. On the other hand, as mentioned before, profit allocation and capital/labour ratios are largely unaffected by indirect taxes.^[6]

2.3. Transparency and complexity of tax systems

The transparency of the host country’s tax system and its simplicity can be a clear incentive for investors and should be taken into account during the investment consideration. General features of the tax system determine the tax burden of a firm, affect the firm’s organization of its operations, and therefore are of a certain importance. One contribution to the complexity of tax features can consist of, for instance, the tax incentives themselves. Incentives require definitions of the eligible activities: which investors are qualified for what kind of activities? Who are the beneficiaries for the incentives and who are not? The legislation must be sufficiently precise to allow the taxpayers to predict whether they are qualified for an incentive or not.

Accordingly, laws of the host country also contribute to the complexity of the tax system. For example, laws can be imprecise and vague, exacerbating the investment decision. Tax laws of many emerging countries may not have the provisions concerning investments which are natural to many Western countries.^[7] Thus when planning various complicated profit transactions, tax outcome is not always clear. The frequency of changing laws and introducing new ones makes it complicated and costly for both the host country’s tax administration and the foreign investor. Change in itself can be perceived as the most essential part of the complexity. In general, investors will be keen on knowing their exact ability to predict the tax consequences of investments and other decisions. This aspect tends to be of a bigger importance to long-term and capital intensive investments. Of course, the difficulties of administrating the laws also result in a worsened stability and transparency of law, where an incompetent law administration can impose costs anticipated by foreign companies. Consequently, companies will be encouraged to develop tax avoiding strategies, hence encouraging the host country tax administration to change the laws and again increase the complexity and costs. All in all, multinationals appear to attach greater importance to stability and simplicity in the tax system than to generous tax rebates, particularly in countries with great institutional and political risks^[8].

3. Tax incentives

Governments are promoting their countries as investment locations in order to achieve their development goals. For which they may make use of tax incentives as part of this promotion. However, potential investors often regard tax incentives as a secondary aspect of investment attractiveness, since they first take into account aspects like market size, access to raw materials and host country’s availability of skilled labour.^[9] In case these aspects are provided for, multinationals will take a closer look on taxation in their investment location. However, for foreign investors such as footloose, manufacturing-related or export-oriented investors, tax incentives can be a major factor in their investment location decision. These are companies that can quickly disappear from one jurisdiction to reappear in another, tending to invest in company founding rather than in existing companies and also avoiding investments relying on long-lived depreciable capital.^[10] Start-up companies will favour incentives that reduce their initial costs (material and equipment tax exemption), while expanding firms will favour profit-targeting tax incentives.

Among countries with similarly attractive provisions the importance of tax incentives may be more distinctive. Furthermore, governments can quickly and easily change the range and extent of the tax incentives they offer. However, changing other factors that influence the FDI location decision may be more time-consuming and difficult, or even beyond government control at all. For these reasons, investment experts, especially those assigned to investment promotion agencies, consider incentives as an important policy variable in their strategies to attract FDI for economic development.

3.1. Objectives of t ax incentives towards FDI

Tax incentives, as exceptions to the general tax regime, can be defined as any incentives that reduce the tax burden of enterprises in order to encourage them to invest in particular sectors or projects. The general purposes given by the introduction of tax incentives can be divided into the following five main groups.^[11]

I. Incentives to create employment. Various countries implement specific taxation incentives to facilitate growth and development of industry and employment in regional areas where there is a lack of competitive locational advantage. Subsidies are also provided to encourage the growth of business or industries in order to create employment or additional demand in slack areas.
II. Incentives for specific industries for social or private benefit. Many countries provide incentives in special industries or businesses which, they believe, have a private or a social benefit. For example, emerging countries would offer tax incentives which enable and alleviate research and development (R&D) inflows.
III. Incentives to foster transfer of technology. Following the mentioned R&D, countries with a lack of well-developed technology will be keen on supporting technology inflow. If a MNC is in need of an incentive to effectively apply local labour force and use local participation, a host country receives skills and support required for its development by means of provision of this incentive.
IV. Incentives to accelerate investment decisions. Facing times of low or static demand, governments provide certain incentives, such as accelerated depreciation allowances or investment credits, to promote investment decisions.
V. Incentives to facilitate international competitiveness. Tax incentives can be introduced to promote actions which reduce imports and generate exports, as an attempt to increase the international competitiveness or foreign reserves and reduce trade deficits of a host country.

3.2. Types of tax incentives

Most common taxation incentives, whose general features are described in this section, are loss carry-forwards, tax holidays, general tax rate reductions, non-income tax-based incentives, investment allowances and tax credits. These incentives may vary from country to country, different tax laws and economic performances provided. Further, export processing zones (EPZs), tax competition and “tax havens” can be also considered as tax incentives. Table 1 in the Appendix exemplifies some tax incentives towards FDI of six Asian countries.

3.2.1. General tax rate reductions and non-income tax-based incentives

General tax rate reductions are provided by governments to firms which fulfil special qualifications, or to income which streams from certain sources. The identification of the qualifying income is therefore of major importance. This incentive is not limited over time and includes new and already existing investment operations, whereas tax obligation of companies is not completely erased. Firms apply for this incentive on the assumption that they belong to the required type of investors (e.g. small businesses) defined in the incentive rules, as well as to certain type of income which is measured through defined calculations. If such rules are complex and unclear, they often stimulate companies to manipulate their income, streaming costs and revenues to increase the profits.

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^[1] OECD, “OECD Benchmark Definition Of Foreign Direct Investment, Third edition”, OECD 1996, p. 7

^[2] Centre for co-operation with the economies in transition, “Taxation and foreign direct investment”, OECD 1995, p. 24

^[3] OECD Documents, “Taxation and investment flows: An exchange of experiences between the OECD and the Dynamic Asian Economies”, OECD 1994, p. 2736

^[4] Desai, M. A. et al., „Foreign direct investment in a world of multiple taxes“, Journal of Public Economics 88 (2004), p. 36

^[5] For example: USA. Ibid., p. 2740

^[6] Ibid., p. 2740

^[7] Centre for co-operation with the economies in transition, “Taxation and foreign direct investment”, OECD 1995, p. 22

^[8] Morisset, J., “Tax incentives”, Public Policy For The Private Sector, Note Nr. 253, 2003, p. 4

^[9] UNCTAD, “Tax Incentives and Foreign Direct Investment. A global survey”, UN, New York and Geneva 2000, p. 11

^[10] Morisset, J., et al., “How Tax Policy and Incentives Affect Foreign Direct Investment, A review”, Policy Research Working Paper 2509, 2000, p. 13

^[11] OECD Documents, “Taxation and investment flows: An exchange of experiences between the OECD and the Dynamic Asian Economies”, OECD 1994, p. 55