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Tax treaties and foreign direct investment: a network approach

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Abstract

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 a computation algorithm to study the structure of tax-minimizing (direct or indirect) investment routes in the tax treaty network. The treaty shopping rate, defined as the difference between the foreign tax rates of the direct route and a tax-minimizing route, is about 3.66 percentage points on average. This paper also examines the relationship between FDI and the structure of tax-minimizing routes. Empirical results show that the existence of a tax-minimizing direct route is positively and significantly related to FDI. The inward FDI stock via a tax-minimizing direct route is about 2.14 times larger than the inward FDI stock via a direct route that is not tax-minimizing. By making a direct route tax-minimizing, countries can encourage FDI via the direct route and reduce treaty shopping.

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Notes

  1. Foreign “direct” investment from country i to country j requires that an investor in country i should play an active role by owning a significant proportion (e.g., at least 10%) of shares of a company in country j. Generally, FDI is distinguished from foreign “portfolio” investment that requires no minimum threshold on ownership. However, FDI can be made with indirect ownership structures using conduit companies in countries other than i and j. In this paper, the definition of indirect investment routes focuses on such indirect ownership structures.

  2. Louie and Rousslang (2008) also use a treaty dummy variable and find no significant treaty effect on the rate of return from FDI after controlling for the quality of governance in source countries. However, di Giovanni (2005) finds a positive treaty effect on cross-border mergers and acquisitions. For a survey of earlier studies, see Davies (2004).

  3. Weyzig (2013) uses Dutch data on special purpose entities and finds positive treaty effects on FDI. Blonigen et al. (2014) use the US BEA data on multinational company operations and find differential effects of tax treaties on foreign affiliate activities, depending on the use of differentiated inputs across industry sectors. They find positive treaty effects on foreign affiliate activities by firms in industries using more differentiated inputs.

  4. Given 70 countries, there are 4830 (\(=70 \times 69\)) pairs of residence and source countries. Here “residence” refers to a place where investors originally own their assets for investment and “source” refers to a place where investors earn income from their investment.

  5. de Mooij and Ederveen (2003) provide a survey of empirical studies. For recent studies, see Blonigen et al. (2007), Becker et al. (2012a), and Becker and Riedel (2012b). Conversely, Chisik and Davies (2004) study the effects of FDI on tax treaties by using a bargaining model and show that asymmetry in FDI stocks may result in higher tax treaty rates.

  6. For related studies, see Huizinga and Voget (2009) and Voget (2011). Dischinger and Riedel (2011) examine location decisions for intangible assets.

  7. Tax treaties also affect WHT rates on interest and royalties, which may influence cross-border investment in debt instruments and intellectual properties.

  8. Notably, until 2017, the United States maintained a foreign tax credit system with a high CIT rate. However, by the Tax Cuts and Jobs Act of 2017, it adopts an exemption system for foreign-source dividends.

  9. Barrios et al. (2012, Table 2) provide a tax rate matrix of 33 European countries. Johannesen (2012, Table 1) also presents a matrix of WHT rates on interest paid across 28 OECD countries.

  10. Accessed in July 2015 at dits.deloitte.com and taxsummaries.pwc.com.

  11. European Commission, Council Directive 2003/123/EC of 22 December 2003.

  12. This assumption may not be unrealistic. Mintz and Weichenrieder (2010, Table 4) find that only 0.2% of German multinational firms use cross-border investment routes (ownership chains) with three or more pass-through countries.

  13. In a pass-through country, CIT can be reduced by a favorable tax system for conduit entities, such as foreign equity-holding companies. According to van’t Riet and Lejour (2017, Table 4), the average effective CIT rate in pass-through (or conduit) countries is about 0.3%. In case (R), every pass-through country is assumed to impose CIT at the reduced rate of 1%. This rate is chosen as the smallest positive integer, and it is also greater than the estimate of 0.3%. As far as the reduced CIT rate is small and positive, the structure of tax-minimizing routes presented in this section remains qualitatively unchanged. However, in a special case when the reduced CIT rate is zero, tax-minimizing routes tend to pass through more countries with no WHT, because there is no additional cost of adding such a pass-through country into an indirect route. This special case is less realistic and not reported in this section.

  14. Note that the taxation of the residence country is not included in the definitions of foreign tax rate and tax-minimizing route. The absence of the residence country taxation may underestimate the magnitude of treaty shopping.

  15. For country j, the number in column “Direct route” is calculated as \(\sum _{i \ne j} \mathrm{DIRECT}_{{ ij}}\).

  16. For country j, the number in column “TSHOP” is \(\sum _{i \ne j} \mathrm{TSHOP}_{{ ij}}/(70-1)\).

  17. Each of the 70 countries, as a residence country, has tax-minimizing indirect routes to some source countries. Table 5 shows the results for the 20 countries whose outward FDI stock is greater than the inward stock according to the FDI data of the UNCTAD.

  18. For country i, the number in column “Direct route” is calculated as \(\sum _{j \ne i} \mathrm{DIRECT}_{{ ij}}\).

  19. For country i, the number in column “TSHOP” is \(\sum _{j \ne i} \mathrm{TSHOP}_{{ ij}}/(70-1)\).

  20. For country i, the number in column “PASS” is \(\sum _{j \ne i} \mathrm{PASS}_{{ ij}}\).

  21. Tax-minimizing indirect routes tend to pass through countries with WHT exemption and EU membership because entities in such countries can receive WHT-exempt dividends from other EU countries under the EU PSD, as mentioned in Sect. 2.2, and pay WHT-exempt dividends to any other countries under the WHT exemption rule.

  22. FDI into a country may depend on the FDI in proximate countries. To control for such spatial interdependence, Blonigen et al. (2007) use an autoregressive model of FDI with spatial lags and find significant spatial effects.

  23. According to UNCTAD (2009), inward FDI flows (and stocks) should be classified by the residence country of immediate foreign direct investors. For instance, if an American parent firm invests in a Chinese subsidiary firm through an intermediate subsidiary firm in Hong Kong, this investment is classified as the FDI from the United States to Hong Kong and as the FDI from Hong Kong to China.

  24. It often takes considerable time (e.g., 10 years) to negotiate and pass a tax treaty. Once in force, a tax treaty often lasts for a long period of time (e.g., 30 years) without any amendment. There are limited changes in tax treaties during the period between 2012 and 2015. However, if there are any, changes in tax treaties during the period may weaken the analysis in this section. Later, for a robustness check, I use the FDI data for year 2015 from an alternative source and find consistent results.

  25. Negative FDI may indicate reverse investment or disinvestment.

  26. Accessed at cepii.fr/CEPII/en/bdd_modele/bdd.asp.

  27. Accessed at ewf.uni-bayreuth.de/en/research/RTA-data.

  28. Accessed at unstats.un.org/unsd/snaama/dnlList.asp.

  29. For residence country \(i, \ln \mathrm{GDP}_{i}\) is calculated as \(\ln (\mathrm{GDP}_{i}+1)\), and similarly, for source country j.

  30. If \(\mathrm{SFTC}_{{ ij}}\) = 1, the direct route \(i \rightarrow j\) yields the same net-of-tax income as a tax-minimizing indirect route, and the investor may have no incentive to use an indirect route. Thus, one might expect a positive relationship between \(\mathrm{FDI}_{{ ij}}\) and \(\mathrm{SFTC}_{{ ij}}\). However, I could not find a clear relationship between the two variables. In Tables 11, 12, 13 and 14, the coefficients on \(\mathrm{SFTC}_{{ ij}}\) show mixed signs and become insignificant in most specifications.

  31. I find that \(\mathrm{DIRECT}_{{ ij}}\) and \(\mathrm{TSHOP}_{{ ij}}\) are strongly and negatively correlated with each other. The Pearson correlation coefficient between the two variables is about − 0.73, while the Spearman coefficient is − 0.96. To avoid issues related to multicollinearity, I do not use \(\mathrm{DIRECT}_{{ ij}}\) and \(\mathrm{TSHOP}_{{ ij}}\) together in the regressions.

  32. I admit the possibility that an unobserved factor can affect both FDI and the structure of tax-minimizing routes. For instance, if there is a cost of treaty negotiation for low tax rates, countries may incur the cost only when they expect large FDI. This can also explain the positive relationship between FDI and the existence of a tax-minimizing direct route. However, in this paper, I used the bilateral variables of Head et al. (2010) that describe the relationship between countries to control for unobserved factors, such as treaty negotiation process and cost. In this context, I believe that a potential endogeneity problem (due to unobserved factors) is minimized.

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Acknowledgements

Author would like to thank Ron Davies, Woo-Hyung Hong, Maarten van’t Riet, Hyun Young You, and two anonymous referees for insightful comments. An earlier draft of this paper was presented at IIPF 2016 Lake Tahoe, NTA 2016 Baltimore, and Vanderbilt University. Author appreciates comments from the participants.

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  1. Korea Institute of Public Finance, 336 Sicheong-daero, Sejong, 30147, South Korea

    Sunghoon Hong

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Appendices

Appendix A: Tables

Table 15 provides examples of tax-minimizing routes between selected pairs of home and source countries. According to the FDI data of the UNCTAD, the United States (US), Japan (JP), France (FR), Germany (DE), and the United Kingdom (GB) are the countries with the largest net outward FDI stock, and selected as home countries. China (CN), Mexico (MX), Indonesia (ID), Poland (PL), and Saudi Arabia (SA) are the countries with the largest net inward FDI stock, and selected as source countries. It is worthwhile to note that every tax-minimizing route passes through at most one country between the pairs of home and source countries in Table 15.

Table 16 provides the results of the OLS regressions with the FDI data from the CDIS. Overall, these results are consistent with those in Tables 11 and 12 based on the FDI data of the UNCTAD.

Table 15 Examples of tax-minimizing routes in case (R)
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Table 16 OLS estimation with FDI data from CDIS
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Appendix B: Network diagrams

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Tax-minimizing routes to Mexico (MX)

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Tax-minimizing routes to Indonesia (ID)

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Tax-minimizing routes to Poland (PL)

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Tax-minimizing routes to Saudi Arabia (SA)

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Tax-minimizing routes from Japan (JP)

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Tax-minimizing routes from France (FR)

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Tax-minimizing routes from Germany (DE)

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Fig. 10
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Tax-minimizing routes from the United Kingdom (GB)

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Hong, S. Tax treaties and foreign direct investment: a network approach. Int Tax Public Finance 25, 1277–1320 (2018). https://doi.org/10.1007/s10797-018-9489-0

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