**4.1. Distortionary effects of corporate income tax**

As stressed by Cnossen and many others, even confined to the tax system of one country, the defects of the corporate income tax are numerous as it causes distortions of asset mix, capital allocation, financing and payout decisions, and the choice of organizational form [1, 34]. The main problem with capital taxation is that effective corporate tax and personal tax rates on investment returns vary depending on the choice of financing [35]. Investment can be made either through equity or debt. As a rule, debt finance is favored against equity finance because interest payments are deductible under most tax systems. The tax-favored status of debt discriminates against corporations that face difficulties in attracting debt [35]. Therefore, newly founded corporations have to sustain higher capital costs because of taxation than older, established corporations with either easier access to debt financing or sufficient retained profits to finance new investments.

The corporation's dividend policy produces yet another example of discrimination. Profits can be either distributed to shareholders as dividends or retained. When earnings are retained, the shareholders, instead of receiving dividends, benefit from an increase in the market value of the company. As a result of this bias in favor of retentions, equity funds may be locked in within certain companies rather than allocated between companies in the most efficient manner by financial markets [36]. Broadly, debt finance is favored against equity finance, and individual investors are discriminated relative to corporate investors. Therefore, differential tax rates and other tax structure features inherent to CIT distort investment decisions that should be based solely on economic costs and gains. Those features produce worldwide implications through the operations of multinationals.

#### **4.2. Tax avoidance**

the reforms undertaken by policy makers to adopt base-broadening, rate-reducing measures consistent with persisting reform recommendations to improve the efficiency, equity, and simplicity of the tax system [25]. Besides, reductions in statutory rates can also be explained as an attempt to minimize a country's vulnerability to the use of transfer pricing by multinational enterprises to move deductions to high-tax countries and receipts to low-tax countries [26]. This is consistent with tax avoidance problem caused by capital mobility and tax rate

**Figure 4.** Corporate Income Tax Revenue as percentage of GDP, OECD countries. Source: OECD (2017).

Since the 1980s, the relation between FDI and corporate taxation policy has been widely studied, and the pioneers in research have focused primarily on the FDI flows sensitivity to capital tax rate [3]. Despite abundant literature, the consensus on the effect of the corporate taxation on FDI in todays' globalized economies has not been reached. Some of the studies find no impact of tax reduction on FDI, but the other studies argue about the negative relationship

Hunady and Orviska examine EU countries (except Estonia due to the unavailability of certain data) in the period between 2004 and 2011 and find no statistically significant effect of statutory corporate tax rate on the flow of FDI [27]. Similarly, Kersan-Skabic using data on EU transition economies fails to find evidence that tax rates significantly affect the long-run elasticity of FDI [28]. Studies of Daniels and Egger based on data from the US and other OECD countries basically do not confirm a precise impact of tax rates on the long-run elasticity of

There exist even fewer studies which find any positive effect of corporate taxes on FDI. Herger finds that tax elasticity varies depending on the FDI strategy (with vertical FDI being in general more responsive) [31]. Salihu and Faria focus on emerging economies and they show that there is a positive relationship between FDI and the avoidance of corporate tax [32, 33]. Their research is based on Malaysian companies. The findings indicate that investors seek to avoid

The heterogeneity of empirical findings led to a need for concise and comprehensive review of the existing empirical evidence. In the meta-analysis undertaken by Feld and Heckemeyer,

differentials discussed in the following sections.

**3.2. Tax rates and foreign direct investment**

30 Taxes and Taxation Trends

between taxation policies and FDI gravity.

taxes in both host and parent countries.

foreign investment [29, 30].

As shown in **Figure 5**, OECD member states have widely diverging statutory CIT rates that may have externality effects on other member states. Statutory rates vary from 8.5% in Switzerland to 35% in the United States.

Different tax regimes have a direct bearing on tax avoidance. The main difference between tax evasion and tax avoidance is usually illegality of the former. Avoidance usually implies using and somewhat bending the tax laws in order to pay the least possible amount of taxes. It covers a broad range of behaviors. One example is to pay a tax professional to alert one to the deductibility of income earned from already undertaken activities. Another example is to change the legal form of a given behavior, such as reorganizing a business from one form of corporation to another, recharacterizing ordinary income as capital income or retiming the transaction to alter the tax year it falls under [37].

There are also hybrid instruments that can avoid taxation by being treated as debt in one

The empirical evidence is broadly consistent with these incentives. The reported profitability of multinational firms is inversely related to local tax rates, a relationship that is at least

equations for dividend, interest, and royalty payments by foreign subsidiaries to American parent companies and finds that high corporate tax rates in countries in which American subsidiaries are located are correlated with higher interest payments and lower dividend payout rates [22]. Patterns of reported profitability are consistent with other indicators of aggressive tax avoidance behavior. It is widely accepted that firms adjust prices used for within-firm transactions with the goal of reducing their total tax obligations. There is substantial evidence of tax-motivated transfer pricing in US trade prices. Multinational firms typically benefit by reducing prices charged by affiliates in high-tax prices for items and services provided to affiliates in low-tax countries [7, 38]. Prior research has found significant effects of tax rates in affiliate and parent countries on the profit shifting behavior of multinational entities; however, the magnitude of the effects varies. The results measured in semi-elasticities range from

The findings of the research based on the profit shifting behavior by US multinationals are supported by European evidence. Weichenrieder using data on German inbound and outbound FDI finds an empirical correlation between the home country tax rate of a parent and the net of tax profitability of its German affiliate that is consistent with profit shifting behavior. The result suggests that a 10% point increase in the parent's home country tax rate leads to roughly half a percentage point increase in the profitability of the German subsidiary [40]. Using a unique dataset containing detailed firm-level information on the parent companies and subsidiaries of European multinationals, Huizinga and Laeven build a model and empirically examine the extent of intra-European profit shifting by European multinationals. On average, they find a semi-elasticity of reported profits with respect to the top statutory tax rate of 1.3, while shifting costs are estimated to be 0.6% of the tax base. They come to the conclusion that international profit shifting leads to a substantial redistribution of national corporate tax revenues [41]. Evidence of income shifting in response to differences in corporate tax rates and the substantial loss of revenues from a unilateral increase in the corporate tax rate is also

supported by the research by using data on a large selection of OECD countries [42].

The exception to the findings that support the central message of the basic tax competition model is the paper by Han and Leach who develop a model in which competing governments offer financial incentives to induce individual firms to locate within their jurisdictions [43]. Equilibrium is described under three specifications of the supplementary taxes. There

Thin or hidden capitalization of a subsidiary arises when a foreign investor substitutes foreign debt capital for equity capital, particularly in cases where debt financing exhibits some of the characteristics of equity and the debt is owed to

Withholding rates on cross-border interest and royalty payments are (which vary by class of payer and payee and by the

financial instrument—in itself a source tax arbitrage) very low. (Cnossen, 2003)

, the pricing of

33

and other such methods. Grubert estimates separate

International Aspects of Corporate Income Taxes and Associated Distortions

http://dx.doi.org/10.5772/intechopen.74213

partly the consequence of tax-motivated debt financing (thin capitalization)<sup>3</sup>

jurisdiction and equity in another [8].

intrafirm transfers, royalty payments<sup>4</sup>

close to zero to well above one [39].

3

4

a related lender. (Shome, 1995)

**Figure 5.** Statutory corporate income tax rates of the OECD countries in 2017 (in %). Source: OECD, 2017.

International investors often have at their disposal numerous alternative methods of structuring and financing their investments, arranging transactions between related parties located in different countries and returning profits to investors. Sophisticated international tax avoidance typically entails reallocating taxable income from countries with high-tax rates to countries with low-tax rates and may also include the changing the timing of income recognition for tax purposes. Since interest, as a rule, is tax deductible while dividends are taxed, it is beneficial for the companies to use debt to finance foreign affiliates in high-tax countries and to use equity to finance affiliates in low-tax countries [8]. Another vehicle to reduce taxation of passive income is the use of hybrid entities or hybrid instruments that are treated differently in different jurisdictions. A new regulation has been introduced in the late 1990s in the USA with an intention to simplify questions of whether a firm was a corporation or a partnership. The application of the rule to foreign circumstances has led to a situation where an entity can be recognized as a corporation by one jurisdiction but not by another. For example, a US parent's subsidiary in a low-tax country can lend to its subsidiary in a high-tax country, with the interest deductible because the high-tax country recognizes the firm as a separate corporation. There are also hybrid instruments that can avoid taxation by being treated as debt in one jurisdiction and equity in another [8].

The empirical evidence is broadly consistent with these incentives. The reported profitability of multinational firms is inversely related to local tax rates, a relationship that is at least partly the consequence of tax-motivated debt financing (thin capitalization)<sup>3</sup> , the pricing of intrafirm transfers, royalty payments<sup>4</sup> and other such methods. Grubert estimates separate equations for dividend, interest, and royalty payments by foreign subsidiaries to American parent companies and finds that high corporate tax rates in countries in which American subsidiaries are located are correlated with higher interest payments and lower dividend payout rates [22]. Patterns of reported profitability are consistent with other indicators of aggressive tax avoidance behavior. It is widely accepted that firms adjust prices used for within-firm transactions with the goal of reducing their total tax obligations. There is substantial evidence of tax-motivated transfer pricing in US trade prices. Multinational firms typically benefit by reducing prices charged by affiliates in high-tax prices for items and services provided to affiliates in low-tax countries [7, 38]. Prior research has found significant effects of tax rates in affiliate and parent countries on the profit shifting behavior of multinational entities; however, the magnitude of the effects varies. The results measured in semi-elasticities range from close to zero to well above one [39].

The findings of the research based on the profit shifting behavior by US multinationals are supported by European evidence. Weichenrieder using data on German inbound and outbound FDI finds an empirical correlation between the home country tax rate of a parent and the net of tax profitability of its German affiliate that is consistent with profit shifting behavior. The result suggests that a 10% point increase in the parent's home country tax rate leads to roughly half a percentage point increase in the profitability of the German subsidiary [40]. Using a unique dataset containing detailed firm-level information on the parent companies and subsidiaries of European multinationals, Huizinga and Laeven build a model and empirically examine the extent of intra-European profit shifting by European multinationals. On average, they find a semi-elasticity of reported profits with respect to the top statutory tax rate of 1.3, while shifting costs are estimated to be 0.6% of the tax base. They come to the conclusion that international profit shifting leads to a substantial redistribution of national corporate tax revenues [41]. Evidence of income shifting in response to differences in corporate tax rates and the substantial loss of revenues from a unilateral increase in the corporate tax rate is also supported by the research by using data on a large selection of OECD countries [42].

International investors often have at their disposal numerous alternative methods of structuring and financing their investments, arranging transactions between related parties located in different countries and returning profits to investors. Sophisticated international tax avoidance typically entails reallocating taxable income from countries with high-tax rates to countries with low-tax rates and may also include the changing the timing of income recognition for tax purposes. Since interest, as a rule, is tax deductible while dividends are taxed, it is beneficial for the companies to use debt to finance foreign affiliates in high-tax countries and to use equity to finance affiliates in low-tax countries [8]. Another vehicle to reduce taxation of passive income is the use of hybrid entities or hybrid instruments that are treated differently in different jurisdictions. A new regulation has been introduced in the late 1990s in the USA with an intention to simplify questions of whether a firm was a corporation or a partnership. The application of the rule to foreign circumstances has led to a situation where an entity can be recognized as a corporation by one jurisdiction but not by another. For example, a US parent's subsidiary in a low-tax country can lend to its subsidiary in a high-tax country, with the interest deductible because the high-tax country recognizes the firm as a separate corporation.

**Figure 5.** Statutory corporate income tax rates of the OECD countries in 2017 (in %). Source: OECD, 2017.

32 Taxes and Taxation Trends

The exception to the findings that support the central message of the basic tax competition model is the paper by Han and Leach who develop a model in which competing governments offer financial incentives to induce individual firms to locate within their jurisdictions [43]. Equilibrium is described under three specifications of the supplementary taxes. There

<sup>3</sup> Thin or hidden capitalization of a subsidiary arises when a foreign investor substitutes foreign debt capital for equity capital, particularly in cases where debt financing exhibits some of the characteristics of equity and the debt is owed to a related lender. (Shome, 1995)

<sup>4</sup> Withholding rates on cross-border interest and royalty payments are (which vary by class of payer and payee and by the financial instrument—in itself a source tax arbitrage) very low. (Cnossen, 2003)

is no misallocation of capital under two of these specifications, and there might or might not be capital misallocation under the third. This result contrasts strongly with the basic tax competition model which finds that competition among governments almost always leads to inefficient allocation of resources.

and through avoidance techniques and quantify the revenue losses through the latter. In total, they estimate global revenue losses at around US\$650 billion annually, of which around onethird relate to developing countries. The concentration as a share of gross domestic product (GDP) is somewhat higher in developing countries compared to OECD economies [45].

International Aspects of Corporate Income Taxes and Associated Distortions

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35

Cobham and Gibson combine this finding with data on the relatively greater reliance on corporate tax revenue in developing countries to show that the estimated losses are around 2–3%

Applying a methodology developed by researchers at the International Monetary Fund to an improved dataset Cobhan and Jansky estimate revenue losses of around US\$500 billion per year globally [6]. Though the largest losses are suffered by rich economies such as the United States, relative losses are more intensive in lower-income countries. While any estimates of this intentionally hidden phenomenon are necessarily uncertain, the size of magnitude suggests that the economic development of countries may in some cases be substantially dam-

In country-specific research, Clausing using Bureau of Economic Analysis survey data on US multinational corporations during 1983–2012 finds that profit shifting is likely costing the US government between \$77 billion and \$111 billion in corporate tax revenue by 2012, and these revenue losses have increased substantially in recent years [7]. Those findings are corroborated by other researchers who estimate that the US tax losses from profit shifting of

However, accumulated losses are staggering. Recent estimates show that Fortune 500 corporations are avoiding up to \$767 billion in US federal income taxes by holding more than \$2.6 trillion of "permanently reinvested" profits offshore. In their latest annual financial reports, 29 of these corporations reveal that they have paid an income tax rate of 10% or less in countries where these profits are officially held, indicating that most of these profits are likely in

This might be viewed as evidence that lowering corporate tax rates is an effective tool against avoidance. Narrower studies, however, such as the studies by Cobham and Janský (2017) and Clausing [7] provide evidence that profit shifting has grown strongly even as effective tax rates have fallen. Cobham and Janský (2017) document effective tax rates for US-headquartered multinationals of 0–5% in the major misalignment jurisdictions to which most profit is shifted,

The survey of the literature in this chapter suggests that tax competition and related problems remain high on the agenda of policy makers as well as researchers. Since governments have the dual mission to attract investment into their jurisdiction and collect enough public revenue to provide public services, the tensions arise. In order to encourage FDI and other forms of investment, the governments offer tax incentives to potential investors. However, that often

of total tax revenue in OECD countries, but 6–13% in developing countries [46].

multinational firms may approach or even exceed \$100 billion per year [8].

compared to 15–20% in the USA and other economies on average [6].

aged by the activities of multinational companies.

offshore tax havens [47].

**5. Conclusions**

International tax avoidance is evidently a successful activity. Very little tax is paid on the foreign source income of US firms [8]. This has grave implications for domestic tax policy. "The international mobility of economic activity now dramatically reduces the ability to tax domestic income-producing activity too heavily. Indeed, the importance of this consideration raises the very real question of whether any longer exists such a thing as purely domestic tax policy" ([38] p. 319). It is really another way of saying that greater tax coordination between countries may be an answer to this international problem.
