Azémar and Dharmapala on Tax Sparing and Foreign Aid

Céline Azémar  and Dhammika Dharmapala recently posted "Tax Sparing, FDI, and Foreign Aid: Evidence from Territorial Tax Reforms," of interest. Tax sparing refers to the intentional exemption of income from tax by two countries working cooperatively. The idea of tax sparing is to ensure that tax incentives granted to investors by source countries are not “cancelled out” by income taxation in the residence country. This is typically accomplished by ensuring that the residence country gives credit for the amount of tax that would have normally been paid to the source country, instead of a reduced (or eliminated) amount that was actually paid according to an incentive scheme. In other words, tax sparing is treaty-based double nontaxation.

Here is an example of tax sparing from Article 21 of the 1993 tax treaty between Indonesia and the United Kingdom,:

For the purposes of paragraph (1) of this Article, the term “Indonesian tax payable” shall be deemed to include any amount which would have been payable as Indonesian tax for any year but for an exemption or reduction of tax granted for the year….”    

In this type of provision, an amount of tax would be credited by the taxpayer’s home country (presumably the UK) in accordance with the standard double tax relief provisions of the treaty even though not ultimately paid to the source country (presumably Indonesia).

If the residence country does not tax foreign income (i.e., is an exemption or territorial system as the UK is now), tax sparing would be pointless since the incentive in the source country accomplishes the desired result of nontaxation unilaterally. Yet this paper finds a surprising result: tax sparing increases FDI even after a treaty partner switches to a territorial system.

Here is the abstract:

The governments of many developing countries seek to attract inbound foreign direct investment (FDI) through the use of tax incentives for multinational corporations (MNCs). The effectiveness of these tax incentives depends crucially on MNCs' residence country tax regime, especially where the residence country imposes worldwide taxation on foreign income. Tax sparing provisions are included in many bilateral tax treaties to prevent host country tax incentives being nullified by residence country taxation. 

We analyse the impact of tax sparing provisions using panel data on bilateral FDI stocks from 23 OECD countries in 113 developing and transition economies over the period 2002-2012, coding tax sparing provisions in all bilateral tax treaties among these countries. We find that tax sparing agreements are associated with 30 percent to 123 percent higher FDI. The estimated effect is concentrated in the year that tax sparing comes into force and the subsequent years, with no effects in prior years, and is thus consistent with a causal interpretation. 

Four countries - Norway in 2004, and the U.K., Japan, and New Zealand in 2009 - enacted tax reforms that moved them from worldwide to territorial taxation, potentially changing the value of their preexisting tax sparing agreements. However, there is no detectable effect of these reforms on bilateral FDI in tax sparing countries, relative to nonsparing countries. 

These results are consistent with tax sparing being an important determinant of FDI in developing countries for MNCs from both worldwide and territorial home countries. We also find that these territorial reforms are associated with increases in certain forms of bilateral foreign aid from residence countries to sparing countries, relative to nonsparing countries. This suggests that tax sparing and foreign aid may function as substitutes.

The link to foreign aid is intriguing: it looks like compensation for the loss of a benefit. The OECD's Action Plans to counter BEPS are specifically designed to eliminate benefits like those created by tax sparing provisions. Is BEPS the end of tax sparing? If so, will BEPS also result in increased foreign aid?