Inequality and Fiscal Policy
Chapter

Chapter 10. International Corporate Tax Spillovers and Redistributive Policies in Developing Countries

Author(s):
Benedict Clements, Ruud Mooij, Sanjeev Gupta, and Michael Keen
Published Date:
September 2015
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Author(s)
Ruud de Mooij, Thornton Matheson and Roberto Schatan 

Introduction

Mobilizing domestic resources is recognized to be one of the key factors in meeting the development objectives of low-income countries, including reducing poverty and inequality (see, for example, Chapter 4). Financing social programs and comprehensive redistributive policies, as well as public investment in infrastructure, education, and health care, depend in the first place on an adequate taxation system capable of generating sufficient resources. Frequently, international businesses constitute a key group of taxpayers in developing countries and therefore are an important source of revenue.

At the same time, another essential element for development and poverty reduction in developing countries is a healthy business climate, capable of attracting foreign direct investment (FDI). FDI is critical for developing countries to become integrated into the global economy and to speed up productivity and income growth. Empirical evidence consistently shows positive correlations between FDI and economic growth in developing countries—although causality remains a contentious issue in this research. And although taxation is perhaps not the main factor weighing on multinational corporations’ FDI decisions, evidence suggests it does matter significantly (de Mooij and Ederveen 2008). Excessive levels of taxation on international businesses, even if aimed at maximizing domestic resource mobilization, can dissuade foreign investors and hamper development.

Thus, there is an important trade-off between mobilizing domestic resources from international business and creating an attractive investment climate for FDI. Both are important for addressing poverty and reducing inequality, but the goals of attracting FDI and funding social development programs may clash, so pushing too hard for one may undo the other. Finding the right balance is a key challenge for all countries, but particularly so for developing countries for two reasons. First, revenue mobilization in developing countries typically relies more heavily on corporate income taxes (CIT) than it does in advanced countries (Figure 10.1)—and a relatively large part of these CIT revenues in developing countries often comes from multinationals. Second, international spillovers from global corporate tax practices are likely to weigh especially heavily on developing countries. For example, the very low tax burden imposed by some tax haven countries enables multinationals seeking to reduce their global tax liabilities to engage in tax planning, causing base erosion and profit shifting away from both developed and developing countries. Developing countries are particularly susceptible to this form of base erosion, however, due to their more limited administrative capacity.

Figure 10.1Corporate Income Tax Revenue as a Share of Total Revenue by Country Income Group

(Percent)

Source: IMF staff estimates.

Note: Total tax revenue excluding social contributions (data on which are incomplete); resource-rich countries are excluded because of divergences in the reporting of taxes on natural resources. Figure shows medians, with countries ranked by income per capita each year and divided into four equal-sized groups.

Spillovers to developing countries raise two important policy issues: (1) the international tax rules adopted elsewhere (including in advanced countries), which determine the magnitude of spillovers to developing countries; and (2) the tax rules set by developing countries themselves to cope with spillovers. This chapter focuses on the first issue: the rules of the international tax architecture that influence the revenue-raising ability of developing countries. Advanced economies have an important responsibility with regard to this issue. This chapter does not address the second issue in any detail, other than to note that developing countries should try to design policies that strike a proper balance between protecting their tax base and maintaining a competitive business climate. For instance, well-designed anti-avoidance measures can be critical to securing a reasonable revenue take from multinationals. International guidelines for anti-avoidance measures are currently being discussed under the Base Erosion and Profit Shifting initiative of the Group of 20 and Organisation for Economic Co-operation and Development (OECD).

In discussing spillovers from the international tax architecture, this chapter focuses on three issues that are particularly relevant for revenue mobilization in developing countries:

  • Territoriality versus worldwide taxation. The system for avoiding international double taxation adopted by major capital-exporting countries (mostly advanced economies) can provide incentives for net capital-importing countries (mostly developing countries) to engage in tax competition.

  • Bilateral tax treaties (BTTs). Although aimed at attracting FDI, treaties often reallocate taxation of foreign investment income from the host country to the home country by, for example, lowering withholding tax rates on dividends, interest, and royalties. This treatment reduces revenues in developing countries, which are usually net capital importers.

  • Separate accounting with arm’s-length pricing versus consolidation with formulary apportionment. The current international tax system allocates taxable income of a multinational on the basis of separate accounts of subsidiaries in each country, with intracompany transactions valued on the basis of “arm’s-length” pricing. An alternative principle—currently applied only within countries with subnational business taxes to allocate tax bases across localities—would be to consolidate multinational profits and divide them among jurisdictions according to factors such as the share of domestic sales, payroll, assets, and employment in each country.

The rest of this chapter is organized as follows: First, the current international tax architecture and its associated spillovers are discussed. Then the three design features outlined above and their implications for developing countries are explored in more detail.

Taxation of Multinational Enterprises

Current Practice and Key Concepts

The current international corporate income tax framework that defines and divides the international corporate tax base has evolved during the past century with little explicit coordination, other than through bilateral treaties that govern only a subset of relevant matters.1 Taxing rights are based on identifying, on the one hand, the source of profits and, on the other hand, the residence of corporate taxpayers.

  • Source refers—very loosely—to where investment is made and income generated, and is traditionally determined largely by the physical presence of labor, capital, or both. Certain thresholds of contact (proxies for the creation of value)—said to create a permanent establishment—must be met for a foreign-resident company to become liable to pay tax to the country deemed the source of profit.

  • Residence means the place where the company receiving the income is deemed to have its primary location, with common tests for this being where the company is incorporated (applicable, for example, in the United States) or from where it is effectively managed (in most other countries).

Double taxation, that is, taxation by both source and residence countries, is typically avoided. Under territorial taxation, tax on business profits is levied only in the source country. By contrast, assertion in domestic law of the right to tax profits from any geographic source based on a company’s domestic residence is generally referred to as worldwide taxation. In that case, double taxation is avoided by the residence country’s granting to the company a foreign tax credit for income and withholding taxes paid in the source country. Foreign tax credits can be offered either in domestic law or in applicable bilateral tax treaties, or both. The result is that the residence country tax is limited to the excess of its effective tax rate over that of the source country.

A key issue in assessing any international tax arrangement is how it divides the rights to tax between source and residence countries. The allocation of rights is especially important for developing countries, because flows for them are commonly very asymmetric: with some exceptions (such as China), they are usually source countries—that is, the recipients of capital inflows—not investors in business activities outside their borders. The current architecture allocates taxing rights to the source country through rules regarding permanent establishments, so might seem to favor source countries. Looking deeper, however, the network of bilateral double taxation treaties based on the OECD model2 significantly constrains the source country’s rights.

The determination of source itself relies on the allocation of earnings to particular entities within corporate groups. The core allocation rule for this purpose is the arm’s-length principle of valuing transactions within multinationals at the prices that would be agreed to by unrelated parties—which, given current guidelines, leaves considerable scope for manipulation by multinationals to shift their tax bases away from high-tax (often source) countries. At issue here are deeper notions as to the fair international allocation of income tax revenue and powers across countries. Arrangements that seem to contradict broad perceptions of fairness, even if those are imperfectly articulated, may increasingly give rise to unilateral domestic measures to change them, with a consequent risk that uncoordinated defensive measures will even further undermine the coherence of the international tax system.

The allocation of income between residence and source countries is further complicated by the widespread use of conduit entities—notably, financing subsidiaries—in low-tax (or no-tax) jurisdictions. Multinationals often use these entities, in conjunction with various provisions of national tax codes and tax treaties, to strip income out of both residence and source countries.

Spillovers

The current architecture as just outlined gives rise to spillovers—the impact that one jurisdiction’s tax rules or practices have on others not party to the underlying decisions. Fiscal externalities of this kind can arise from many aspects of national tax systems, but the focus in this chapter is on cross-border effects arising through taxation at the corporate level.

  • The corporate tax base may be affected as taxable profits in any one geographical location change to reflect both real responses (through investment and the like) and profit-shifting responses (loosely speaking, alterations of where profits are booked only for tax purposes). This channel, holding constant the tax policy of the affected country, is referred to as base spillovers.

  • Corporate tax rates may also be affected, since the best response to reduced foreign tax rates abroad may be to reduce national tax rates, too. These strategic spillovers—tax competition in its broadest sense—are often accused of creating a race to the bottom that lowers the global CIT take.

The effects of base and strategic spillovers are closely related. Decisions about the location of real activities, for instance, may be influenced by the associated opportunities for profit shifting. Spillovers can also arise from several aspects of national tax policies. Most obviously, they can arise from differences in headline statutory CIT rates, since these rates create incentives to shift taxable profits between countries. The decline in CIT rates across the globe since 1980 may thus be a manifestation of strategic spillovers (Figure 10.2), along with more narrowly defined preferential regimes that offer targeted tax incentives to attract FDI or particular types of income (such as royalties).

Figure 10.2Corporate Income Tax Rates, 1980–2013

(Percent)

Source: IMF staff estimates.

Note: Figure shows medians, with countries ranked by income per capita each year and divided into four equal-sized groups.

The form and severity of spillovers depend on the structure of the international tax framework. For instance, the tax rate levied in source countries would not matter for corporate decisions under a pure system of worldwide taxation in which such income was fully subject to tax, without deferral, by the residence country.3 The company would then simply pay the residence country rate on all its earnings, wherever they arose. Addressing spillover problems thus inevitably raises issues concerning not just particular tax arbitrage opportunities under current arrangements, but the wider architecture itself.

The effects of spillovers are not zero sum, but can create a collective inefficiency—and national interests can diverge sharply. This situation is clearest in relation to profit shifting, that is, moving taxable income from a high-tax jurisdiction to a low-tax one to reduce total tax payments. Since the company’s purpose in doing so is to reduce its total tax payments, the collective revenue of the countries affected must fall, but revenue in the low-tax country will likely increase (provided that its tax rate is above zero). Similar effects arise more broadly from factors other than such straight income-shifting techniques. Noncooperative policymaking in the presence of externalities can result in outcomes that, from the collective perspective, are inefficient but from which some countries or jurisdictions nonetheless gain.

Recent evidence for a large number of countries suggests that both base and strategic spillovers are important (IMF 2014; Crivelli, de Mooij, and Keen, forthcoming). In particular, a reduction in the CIT rate in other countries is found to exert a significant and large impact on a country’s own tax base, both through real capital and profit-shifting effects. Moreover, tax reductions in one set of countries are found to induce a significant same-way strategic reaction in other countries, exemplifying the process of tax competition. Both spillovers are also found to be considerably larger for developing countries than for advanced economies. Hence, international tax design in advanced economies as well as in tax havens will have a noticeably greater impact on tax revenue in developing countries than elsewhere. This finding warrants analysis of the key international tax design considerations from the perspective of developing countries.

Key issues for developing countries

The Trend toward Territoriality

Worldwide taxation was once predominant among capital-exporting countries. Under these rules, dividends distributed by foreign corporate subsidiaries are subject to CIT in the home country. CIT and withholding taxes paid in the host country are at least deductible against home-country tax liability, but more often a full tax credit is granted.4 The home-country tax liability on “active” income5 is generally deferred until the foreign earnings are repatriated, allowing them to accumulate offshore without this additional layer of taxation. Foreign subsidiaries of parent companies in high-tax worldwide jurisdictions may thus have an incentive to reinvest rather than repatriate earnings, even if the pretax rate of return in the host country is lower than that in the home country.

Most OECD countries have moved their systems closer to territorial taxation principles, under which active earnings distributed by foreign subsidiaries are exempt from home-country taxation.6 Since the 1980s, 17 OECD countries—including, in 2009, the United Kingdom, Japan, and New Zealand—have altered their international tax regimes to adopt territoriality as the main principle.7 Territorial tax systems now account for roughly twice as much outbound FDI as worldwide systems (Table 10.1).8 The major policy considerations driving the trend toward territoriality are the desire to avoid discouraging domestic multinationals from repatriating foreign earnings or encouraging them to reincorporate in lower-tax jurisdictions, and to level the playing field for them when they bid for assets in foreign markets.

Table 10.1Outward Foreign Direct Investment Stock by Tax Regime, 2012
CountryYear of

Adoption
Outward Foreign

Direct Investment

Stock (million US$)
Percent of Global

Foreign Direct

Investment Stock
Percent of

Domestic GDP
Territorial systems
United Kingdom20091,808,1677.774
Germany20011,547,1856.646
France19791,496,7956.357
Hong Kong SAR1,309,8495.6509
Switzerland19401,129,3764.8177
Japan20091,054,9284.518
Belgium19621,037,7824.4214
Netherlands1914975,5524.1126
Canada1951715,0533.040
Spain2000627,2122.746
Italy1990565,0852.428
Australia1991424,4501.827
British Virgin Islands433,5881.847,335
Singapore401,4261.7148
Sweden2003406,8511.778
Denmark1992229,4701.074
Austria1972215,3640.954
Norway2004216,0830.943
Luxembourg1968171,4680.7301
Finland1920142,3130.657
Cayman Islands108,0300.53,306
Total15,207,68663.7
Worldwide systems
United States5,191,1162233
China509,0012.26
Russia413,1591.821
Ireland357,6261.5171
Brazil232,8481.010
Taiwan Province of China226,0931.047
Korea196,4100.817
Mexico137,6840.612
India118,1670.56
Total7,636,35831.4
Sources: PricewaterhouseCoopers; UNCTA Dstat.Note: Blank spaces in the “Year of Adoption” column indicate that the year of adoption is not known.

The additional layer of home-country taxation under a worldwide system tends to equalize the tax burden on outbound investment across host countries with different tax rates: earnings from low-tax countries are subject to a higher tax upon repatriation than earnings from higher-tax countries, which generate more foreign tax credits. This system protects host countries from international tax competition. Furthermore, when a country that is a major capital exporter operates a worldwide tax system, its FDI recipients can set their CIT rates at or just below that country’s CIT rate without undermining their attractiveness as investment locations. When capital exporters adopt territoriality, however, this layer of protection is stripped off, exposing host countries to additional pressure to cut their CIT, their withholding tax rates, or both.

Empirical evidence indicates that the choice between worldwide and territorial systems has a significant effect on cross-border investment patterns. Matheson, Perry, and Veung (2013) find evidence consistent with territoriality’s spurring tax competition by making multinationals more sensitive to host-country tax rates: in a country-level bilateral panel regression of outward FDI from the United Kingdom, the coefficient on host-country tax rates becomes more negative after adoption of territoriality in 2009. There is also evidence that territoriality increases earnings repatriation: adoption of territoriality by the United Kingdom and Japan resulted in an immediate surge in dividend repatriation in both countries (Egger and others 2012; Hasegawa and Kiyota 2013). It remains to be seen whether these dividend surges were temporary or whether territoriality results in a permanently higher level of repatriation.

Increased dividend repatriation may result in a lower level of FDI by multinationals headquartered in jurisdictions adopting territoriality.9 However, a reduction in effective tax rates may also spur outbound investment. For example, Smart (2011) shows that conclusion of a tax treaty providing for territorial taxation increased Canadian FDI in the treaty partner by an average of 79 percent.10 Shifting to territoriality may also spur outward investment by increasing the competitiveness of domestic companies in bidding for foreign assets.11 The economic benefit of leveling the playing field among international bidders is that it ensures that assets fall into the hands of the owner most likely to maximize their productivity.

Tax Treaties

Another aspect of international taxation that may erode developing countries’ corporate tax revenues is negotiation of bilateral tax treaties (BTTs). Developing countries are increasingly negotiating BTTs, primarily with OECD countries but also among themselves (Figure 10.3). Tax treaties usually reallocate taxing rights over foreign investment income from the host country to the home country, chiefly by lowering withholding tax (WHT) rates on cross-border financial distributions such as dividends, interest, and royalties (Table 10.2). Since developing countries are usually net capital importers with little if any outbound investment, they stand to lose significant revenue from the lower WHTs negotiated in tax treaties. For example, it has been estimated that Dutch treaties cost their developing-country treaty counterparts at least €770 million in revenue each year, while U.S. tax treaties cost their developing-country counterparts at least $1.7 billion.12

Figure 10.3Growth of Bilateral Tax Treaties and Tax Information Exchange Agreements

Source: International Bulletin for Financial Documentation tax research platform (www.ibfd.org).

Note: BTT = bilateral tax treaty; OECD = Organisation for Economic Co-operation and Development; TIEA = tax information exchange agreement.

Table 10.2Domestic Law versus Treaty Withholding Tax Rates, 2011
DividendsParticipating

Dividends
InterestRoyalties
Income LevelDomestic Law Withholding Tax RatesNumber of

Countries
All Countries15.99.115.915.7151
High Income17.78.915.314.645
Non-OECD6.45.79.89.314
Upper Middle Income13.511.916.716.346
Lower Middle Income13.812.616.317.035
Low Income13.010.616.216.825
Income LevelTreaty Withholding Tax RatesAverage

Number of

Treaties
All Countries12.57.89.19.031
High Income12.06.98.18.060
Non-OECD7.94.97.98.032
Upper Middle Income11.58.010.810.131
Lower Middle Income12.79.811.010.723
Low Income12.49.912.310.08
Source: IBFD database.

The chief motivation for developing countries to negotiate tax treaties is the belief that BTTs stimulate inward investment. If treaties create enough net new foreign investment to offset their costs in lowered revenue on existing investments and treaty negotiation costs, then the treaties could be worthwhile. However, existing evidence on treaty costs and benefits for developing countries is at best inconclusive.

Tax treaties typically have a number of different provisions that could either stimulate or suppress foreign investment. In addition to lowering WHT rates, BTTs ensure foreign investors of fair tax treatment on par with domestic firms, provide for adjudication in case of disputes, and alleviate double taxation by coordinating definitions of the corporate tax base and ensuring foreign tax credits. Although these factors could stimulate investment, treaties also provide for the bilateral exchange of information between tax authorities, which, if effective, could increase the effective tax rate on inbound investment. BTTs are also quite costly to negotiate, requiring high levels of legal expertise and other expenses, so countries with limited resources are well advised to weigh their costs and benefits carefully.

To date, studies of the impact of BTTs on FDI show mixed results. Four studies using bilateral country-level data for developed countries find either no impact from treaty presence or a negative one (Blonigen and Davies 2004, 2005; Egger and others 2006; Louis and Rousslang 2008). Two studies find some positive impact for certain subsets of countries (Millimet and Kumas 2007; Neumayer 2007), and two studies of data sets including developing countries show a positive impact of treaties on FDI (Di Giovanni 2005; Barthel, Busse, and Neumayer 2009). Studies using firm-level data find that treaties have a positive effect on entry, though not on marginal activity (Davies, Norback, and Tekin-Koru 2009; Egger and Merlo 2011). Use of micro-data alleviates concerns about reverse causality, since BTT negotiation may be driven by past investment activity.

The above studies all represent the influence of tax treaties using a dummy variable, so the positive and negative effects of tax treaties on FDI cannot be distinguished. A study by Blonigen, Oldenski, and Sly (2011) attempts to separate positive and negative treaty effects by interacting the treaty dummy with industry effects, capturing the extent to which firms in a particular sector are likely to experience increased taxes due to information exchange.13 The authors find that presence of a tax treaty increases average foreign affiliate sales by 45 percent, while the interacted term capturing information exchange reduces them by 28 percent. The authors also find that presence of a BTT roughly doubles the entry rate of new foreign affiliates.

There are as yet no empirical studies of the revenue impact of tax information exchange agreements (TIEAs), which have exploded in popularity since the global economic and financial crisis (Figure 10.3). These stand-alone agreements contain the same information-exchange language included in modern tax treaties but without the other provisions.14Blonigen, Oldenski, and Sly’s (2011) finding suggests that multinationals do expect TIEAs to increase their tax burden, but whether they effectively enhance revenues is still undocumented. Given developing countries’ limited administrative capacity, it is particularly unclear whether TIEAs will help them mobilize revenue from multinational enterprises.

Countries operating worldwide regimes may offer tax sparing to their treaty partners, under which multinationals benefiting from host-country tax incentives receive tax credits for the taxes they would have paid in the absence of those incentives. Japan traditionally offered these terms to many of its Asian treaty partners—and China still does—whereas the United States does not. Empirical evidence supports the effectiveness of tax-sparing agreements in stimulating FDI,15 although this benefit is probably offset by the complications and distortions that tax incentives introduce (along with lower revenues). If the trend toward territoriality among capital exporters continues, tax sparing will likely wane in importance.

Research clearly shows that FDI responds negatively to tax rates (de Mooij and Ederveen 2008). However, reduced WHT rates may not significantly lower the overall tax burden on FDI: although many countries now exempt corporate foreign earnings (that is, dividends from foreign subsidiaries in which the parent holds a minimum ownership stake), most still subject portfolio dividends as well as interest and royalties to domestic income tax, usually allowing a tax credit for foreign income taxes paid (including WHTs). Thus, unless the home-country tax rates are less than those of the host country, treaty reduction of WHTs may only redistribute tax revenues from host to home country without reducing them. Studies of the impact of WHTs on FDI, which do not control for other treaty factors, indicate that they do influence FDI flows as well as financing (Egger and others 2006, 2009; Barrios and others 2012;Huizinga, Laeven, and Nicodeme 2008; Arena and Roper 2010).

Comparison of domestic law and tax treaty WHTs for countries with different income levels shows that the higher cost of reducing WHT rates for developing countries affects BTT provisions (Table 10.2). Richer countries, on average, set higher WHT rates on dividends in their domestic law and reduce them significantly by treaty. They also tend to offer significant tax relief for participating dividends in their domestic law. (A notable exception to this pattern is non-OECD high-income countries, many of which are low-tax conduit jurisdictions or oil-rich countries with very low domestic law WHTs.) By contrast, lower-income countries tend to set more moderate WHT rates on dividends in their domestic laws but do not reduce them as much, either for participating dividends or for tax treaties. Because they are more reliant on CIT revenue (and have weaker PIT revenue) than are wealthier countries, developing countries may be less concerned about double taxation of dividends.

Whereas high-income countries, on average, set WHTs on interest and royalties—which, unlike dividends, are deductible for CIT purposes—at the same level as dividend WHTs, developing countries are likely to set these rates higher than dividend WHTs. This policy likely reflects their concern about the use of interest and royalty payments for transfer pricing, either cross border or into untaxed sectors of the economy (such as free trade zones). Given these countries’ generally weaker tax administrations, interest and royalty WHTs perform an important function in protecting their corporate tax bases. However, their rates are often substantially reduced by tax treaty, especially for royalties, indicating a need for caution in treaty negotiation.

Empirical studies show that treaty WHTs are indeed influenced by the income levels of the negotiants, as well as by the size of their economies and the level and asymmetry of FDI flows. Chisik and Davies (2004) and Rixen and Schwarz (2009) show that domestic law rates, which form the starting point for negotiation, relate positively to treaty WHT rates. Bilateral FDI flows are also important: because net capital importers stand to lose from lower WHT rates, treaties between countries with asymmetrical FDI flows usually reduce rates less than treaties between symmetric countries. Similarly, since larger markets are likely to attract more investment, negotiated rates correlate negatively with the aggregate GDP of each partner, and WHT rates are increasing in the difference between signatories’ GDP levels.

The need for caution in treaty negotiation is compounded by the practice of treaty shopping, whereby investor countries channel funds to a host country through an entity established in a third country with which the host country has a highly favorable tax treaty. Though a country may negotiate many treaties, the majority of its inward investment often flows through just a small number of treaty partners—usually those with very low WHT rates and an otherwise advantageous tax and regulatory regime. In this manner, a treaty with one country can effectively become a “treaty with the world.” Limitation of benefit clauses, such as those included in U.S. treaties, deny treaty benefits to entities that lack substantial economic or ownership ties to the treaty jurisdiction. These may offer some protection against this practice; however, most developing countries will have neither the bargaining power to impose such clauses nor the administrative capacity to enforce them.

Formulary Apportionment

The shortcomings of the current international framework for taxing corporate income and increasing public awareness of the cross-border leakage of corporate tax revenue have led to widespread calls for fundamental international corporate tax reform. Therefore, some observers have pressed for an approach in which a multinational enterprise’s tax base is established on a unitary basis—that is, consolidated across the entire corporate group—and this base is allocated across jurisdictions by formula, according to varying combinations of the shares of sales, assets, payroll, or employees located in each. In the view of some, formulary apportionment can be especially attractive for developing countries because capacity limitations currently leave them particularly vulnerable to profit shifting.

The primary appeal of unitary taxation is that it dispenses with the need to value intragroup transactions, and so eliminates direct opportunities to shift profits through transfer pricing and other devices. And, by then allocating the base using proxies to substantial activities, it may align tax payments more closely with economic fundamentals.16 The use of formulary apportionment to allocate the tax base across jurisdictions is long established at the subnational level, and the European Commission has also proposed a Common Consolidated Corporate Tax Base for the European Union. This suggests that formulary apportionment has at least some merit in taxing firms operating across highly integrated economies.17

Significant issues arise, however, in relation to the weights used in the formula, which will determine the new allocation of the tax base across jurisdictions.18 Rough estimates can be made, for instance, of the impact for some countries of reallocating the taxable income of U.S. multinationals using the factors commonly discussed: sales, assets, payroll, and employees (Figure 10.4). These estimates point to large and systematic redistributive effects on tax bases: advanced economies generally gain tax base regardless of the factor used, while conduit countries lose base; developing countries gain base only if head-count employment is heavily weighted.

Figure 10.4Reallocation of Taxable Income of U.S. Multinational Enterprises, Using Alternative Factors

(Percentage change)

Source: IMF staff calculations based on U.S. Department of Commerce, Bureau of Economic Analysis, data.

Note: The figure shows the weighted averages for three country groups, using current taxable income as weights.

Precise definitions in determining the weights are critical, however. For instance, whether sales are measured on a destination basis (that is, by residence of the purchaser) or an origin basis (residence of the seller) matters greatly, as does whether they include or—more in the spirit of the unitary approach, but further from accounting practice—exclude sales to other members of the corporate group. Moreover, valuation and avoidance issues still exist under formulary apportionment, for example, with respect to the valuation of assets.

Also, spillovers will not disappear under formulary apportionment. This method would simply present firms with different real and profit-shifting opportunities compared with the current system: these opportunities would focus on the factors entering the apportionment rule rather than on local profitability and intragroup transactions. For example, if assets are used as the basis for the apportionment, there is an incentive to locate assets in low-tax jurisdictions. This creates evident scope for production inefficiency. The incentive to attract whatever factors are given high weight in the formula could be strong under formulary apportionment, since the revenue gain from attracting such factors is not from a marginal increase in some local tax base—as it is under territoriality—but from being allocated a greater share of the group’s overall profit. Tax competition can, for this reason, become even more severe than under territorial taxation.

Practical issues make formulary apportionment less simple than it may seem. A definition of the corporate group is required, for instance, and current forms of income allocation will remain necessary (with all the problems that now entails) if formulary apportionment applies only up to some water’s edge. Distinct forms of distortion can also arise, potentially providing artificial incentives to merge or spin off. Whether these difficulties are greater than those under present arrangements is unclear, but they are certainly not trivial.

Whatever its merits in principle, prospects for adoption of international formulary apportionment seem remote. A substantial legal and institutional infrastructure has been built around current arrangements, so that movement toward international formulary apportionment would likely involve considerable disruption.

Conclusion

Mobilizing domestic revenue to address inequality concerns in developing countries requires that tax systems be designed to strike the right balance between raising revenue from multinational corporations and creating an attractive investment climate. Managing this trade-off is a challenging task, especially in light of spillovers from international corporate tax design, which appear to be particularly relevant for developing countries.

Substantial international coordination to address spillovers from international taxation has proved difficult to achieve. Some see little if any case for coordination, for political reasons. However, even if all agreed that spillovers cause collective harm, identifying and securing agreement on appropriate measures of coordination is likely to be highly problematic. This set of circumstances largely leaves countries to design their own policies under the given international architecture.

Because of spillovers, developing country governments’ ability to effectively raise revenue from multinational corporations depends, apart from their own tax rules, on the international rules adopted by advanced countries. This chapter explores three such issues and the spillovers they create for developing countries: the choice between worldwide and territorial taxation in advanced countries, the design of BTTs concluded with developing countries, and the choice between separate accounting with arm’s-length pricing versus unitary taxation with formulary apportionment.

The international trend among major capital-exporting countries to move from worldwide to territorial taxation systems has been found to exacerbate tax competition among capital importers, imposing downward pressure on CIT rates and bases. This tax competition particularly harms developing countries because they are usually capital importers and depend more heavily on CIT revenues than do richer countries.

BTTs provide benefits to investors, such as lower WHT rates, tax base harmonization, certainty about basic fiscal principles, and protection against double taxation. However, the empirical evidence about whether BTTs stimulate investment in developing countries is ambiguous. Moreover, treaty negotiation carries high costs in both government resources and forgone revenue, especially from reduction or elimination of WHTs. For these reasons, developing countries should approach treaty negotiation with extreme caution.

The proposal for formulary apportionment might address some spillovers under current arrangements, including spillovers to developing countries. However, such a system has its own difficulties, involves significant risk of distortion, and may not benefit developing countries. Although prospects for widespread adoption of formulary apportionment are remote, new approaches might nevertheless be introduced incrementally where the current arm’s-length approach is particularly problematic.

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This chapter draws heavily on IMF 2014.

These bilateral treaties are informed by guidelines produced by the OECD and, with somewhat less impact, the United Nations. Some regional agreements also have considerable effect, notably in the European Union, where directives and decisions of the Court of Justice reflecting the principle of nondiscrimination among member states have a major impact.

The United Nations model allocates somewhat more rights to the source country by, for instance, not prescribing maximum withholding tax rates and providing for source taxation of royalties. Lennard (2009), Lennard and Yaffar (2012), and Lang and Owens (2014) elaborate on the differences between the two models.

This assumes that the tax rate in the residence country is equal to or higher than that of the source country.

Depending on “pooling” rules, excess credits may be used to offset other foreign taxes paid.

Generally, active income excludes dividends, interest, rents, royalties, and sales commissions or margins from companies in which the parent does not have at least some minimum ownership stake, often 10 percent.

However, even under territoriality distributions of financial flows other than dividends, such as interest and royalties, are subject to taxation in the home country, usually with a credit for foreign withholding taxes paid. So-called portfolio dividends from minority shareholdings are usually also subject to home-country taxation.

The distinction between worldwide and territorial taxation is not always pure; for example, Canada’s domestic law prescribes a worldwide system but exempts foreign dividends through bilateral tax treaties; Germany subjects 5 percent of dividend repatriations to domestic CIT to offset domestic CIT deductions taken to generate foreign income; and countries with worldwide taxation often permit deferral of domestic tax on foreign earnings until those earnings are distributed back to the parent company.

The use of conduit entities in low-tax jurisdictions, which are usually territorial, undoubtedly produces some double counting of these flows.

Egger and others (2012) find a reduction in outward investment by British parent companies and a rise in the efficiency of their foreign affiliates beginning in 2009. The measure of efficiency is the sales-to-fixed-assets ratio.

However, this result does not control for the possibility that FDI to nontreaty countries was rechanneled through treaty countries to avoid repatriation tax.

Investigating the impact of the United Kingdom’s and Japan’s conversions to territoriality, Feld and others (2013) show that the shift increased Japan’s foreign acquisitions by almost 32 percent and the United Kingdom’s by almost 4 percent. The greater impact in Japan is due to its higher CIT rate. If the United States were to adopt territoriality while maintaining its current CIT rate, the authors estimate that its foreign acquisitions would rise by 17 percent.

McGauran (2013) and estimates of the authors (which take into account dividends and interest only).

The authors use the percentage of industry inputs that are homogeneous goods with readily ascertainable arm’s-length prices as a proxy for vulnerability to audit resulting from tax information exchange.

Several theory papers model countries’ decisions to engage in information exchange; Keen and Ligthart (2006) summarize this literature and review the political economy of information exchange.

Both Hines (1998) and Azemar and Delios (2007) find that tax-sparing provisions have a positive impact on Japanese outward FDI flows. Similarly, Davies, Norback, and Tekin-Koru (2009), studying Swedish firm-level data, show that inclusion of a tax-sparing agreement in a BTT increases affiliate production, sales, and exports (though not entry).

See several papers produced by the International Centre for Tax and Development (www.ictd.ac), including, notably, Durst 2013.

In various forms, formulary apportionment is used at the subnational level in Canada, Germany, Japan, Switzerland, and the United States.

A separate set of questions concerns the impact on aggregate revenue; unitary taxation in itself tends to reduce this impact, since consolidation allows greater offset of losses in one part of a corporate group against profits in others (Devereux and Loretz 2008).

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