Article: Tuesday, 11 February 2020
International taxation is an ongoing concern of policy makers around the world. Current international taxation rules allocate taxing rights to the country where companies report their profits. For profits repatriated from foreign subsidiaries, either a worldwide tax system or a territorial tax system applies. New research of Dr Jochen Pierk from Erasmus School of Economics and Dr Saskia Kohlhase of Rotterdam School of Management, Erasmus University (RSM) shows that a worldwide tax system reduces the incentives of multinational corporations (MNCs) to engage in tax management in their foreign subsidiaries. This implies that multinationals subject to a worldwide tax system face competitive disadvantages compared to competitors from countries with a territorial tax system.
Under a worldwide tax system, firms pay taxes on their domestic income and repatriated foreign income. In a territorial tax system, repatriated foreign income is exempt from taxation. The study investigated the tax management behaviour of foreign subsidiaries owned by a parent company located in a country that either has a worldwide or a territorial tax system (hereafter, worldwide-parent subsidiary versus territorial-parent subsidiary).
The researchers wanted to answer the question whether, and if so to what extent, tax systems influence MNCs to engage in tax management in their foreign subsidiaries. Dr Kohlhase: “Answering this question is important as many countries have introduced a territorial tax system since 2000 to attract investments. In addition, foreign direct investments (FDI) of MNCs headquartered in countries with a worldwide tax system may be disadvantaged compared to investments of MNCs headquartered in countries with a territorial tax system because of the taxes that apply to dividend repatriations under a worldwide tax system.”
Dr Kohlhase and Dr Pierk studied the tax management behaviour of worldwide-parent and territorial-parent subsidiaries by investigating the switch of Japan and the UK from a worldwide to a territorial tax system in 2009. Their sample consisted of 39,496 subsidiary–year observations in 19 European countries.
“Our analysis showed that Japanese- and UK-owned subsidiaries reduced their effective tax rates depending on different control groups, between 1.2 and 3.5 percentage points after switching to territorial tax system.
We provide evidence on the magnitude by which tax management in foreign subsidiaries increases after the switch to a territorial system,” Dr Kohlhase said.
The main finding of the paper is that worldwide-parent subsidiaries have a lower incentive to engage in tax management. So, MNCs subject to a worldwide tax system face competitive disadvantages compared to competitors from countries with a territorial tax system when conducting cross border investments.
Understanding whether tax management in foreign subsidiaries is less prevalent if the parent is located in a country with a worldwide tax system is important to policymakers around the world for two reasons.
First, in 2017, 41 countries still applied a worldwide tax system for foreign source dividends. Excluding the USA, the eight largest economies that applied a worldwide tax system in 2017 were China, India, Brazil, South Korea, Mexico, Indonesia, Argentina, and Taiwan.
Second, with the passing of the Tax Cuts and Jobs Act (TCJA) in 2017, the USA switched to a territorial tax system for specific types of foreign source income (TCJA , 2017), which implies that US MNCs now have more incentives to devise strategies to manage taxes in their foreign subsidiaries.
Taxing MNCs based on their worldwide profits is associated with a reduced profitability of their foreign subsidiaries, because worldwide-parent subsidiaries engage less in tax management than territorial-parent subsidiaries. This can not only have consequences when repatriating foreign profits, but also for investment and reinvestments decision of foreign subsidiaries abroad.
Switching from a worldwide to a territorial tax system lowers the effective tax rates in the foreign affiliates which may in turn incentivize firms to invest more in those affiliates. Also, the change to a territorial tax system might impact the optimal financing structure of MNCs and their affiliates as a decrease in the effective tax rates impacts the debt shield.
The results of the study suggest that following the switch of the US to a territorial tax system for certain types of income (TCJA 2017), foreign subsidiaries of US MNCs will likely engage in more tax management. This will especially affect countries with a high number of US foreign direct investments, as more tax management of US MNCs in foreign subsidiaries generates less tax revenue in the subsidiary country. The reduced tax revenues of US-owned subsidiaries are especially relevant for countries with a high ratio of US FDI such as Canada that exhibited US FDI of US$474 billion or 45.2 per cent of all inward FDI in 2016 (Statistics Canada, 2017).
These results are informative for countries that still operate a worldwide tax system or recently switched to a territorial tax system, and for countries with a large volume of foreign direct investments from countries that recently switched to territorial tax system. As tax laws vary, the costs and opportunities to reduce taxes in the respective affiliate countries differ from country to country. As respective laws and regulations are often only available in the local language, the researchers encourage local researchers and policymakers to conduct thorough investigations into country-specific tax legislation.
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