# Tax treaties and foreign direct investment: a network approach

- 169 Downloads

## 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.

## Keywords

Tax treaty network Tax-minimizing route Treaty shopping rate Foreign direct investment## JEL Classification

F23 H25 H87## Notes

### 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.

## References

- Barrios, S., Huizinga, H., Laeven, L., & Nicodème, G. (2012). International taxation and multinational firm location decisions.
*Journal of Public Economics*,*96*(11–12), 946–958.CrossRefGoogle Scholar - Becker, J., Fuest, C., & Riedel, N. (2012). Corporate tax effects on the quality and quantity of FDI.
*European Economic Review*,*56*(8), 1495–1511.CrossRefGoogle Scholar - Becker, J., & Riedel, N. (2012). Cross-border tax effects on affiliate investment—Evidence from european multinationals.
*European Economic Review*,*56*(3), 436–450.CrossRefGoogle Scholar - Blonigen, B. A., & Davies, R. B. (2004). The effects of bilateral tax treaties on U.S. FDI activity.
*International Tax and Public Finance*,*11*(5), 601–622.CrossRefGoogle Scholar - Blonigen, B. A., Davies, R. B., Waddell, G. R., & Naughton, H. T. (2007). FDI in space: Spatial autoregressive relationships in foreign direct investment.
*European Economic Review*,*51*(5), 1303–1325.CrossRefGoogle Scholar - Blonigen, B. A., Oldenski, L., & Sly, N. (2014). The differential effects of bilateral tax treaties.
*American Economic Journal: Economic Policy*,*6*(2), 1–18.Google Scholar - Chisik, R., & Davies, R. B. (2004). Asymmetric FDI and tax-treaty bargaining: Theory and evidence.
*Journal of Public Economics*,*88*(6), 1119–1148.CrossRefGoogle Scholar - Davies, R. B. (2004). Tax treaties and foreign direct investment: Potential versus performance.
*International Tax and Public Finance*,*11*(6), 775–802.CrossRefGoogle Scholar - Davies, R. B., Norbäck, P.-J., & Tekin-Koru, A. (2009). The effect of tax treaties on multinational firms: New evidence from microdata.
*World Economy*,*32*(1), 77–110.CrossRefGoogle Scholar - de Mooij, R. A., & Ederveen, S. (2003). Taxation and foreign direct investment: A synthesis of empirical research.
*International Tax and Public Finance*,*10*(6), 673–693.CrossRefGoogle Scholar - di Giovanni, J. (2005). What drives capital flows? The case of cross-border M&A activity and financial deepening.
*Journal of International Economics*,*65*(1), 127–149.CrossRefGoogle Scholar - Dischinger, M., & Riedel, N. (2011). Corporate taxes and the location of intangible assets within multinational firms.
*Journal of Public Economics*,*95*(7–8), 691–707.CrossRefGoogle Scholar - Dyreng, S. D., Lindsey, B. P., Markle, K. S., & Shackelford, D. A. (2015). The effect of tax and nontax country characteristics on the global equity supply chains of U.S. multinationals.
*Journal of Accounting and Economics*,*59*(2–3), 182–202.CrossRefGoogle Scholar - Egger, P. H., & Larch, M. (2008). Interdependent preferential trade agreement memberships: An empirical analysis.
*Journal of International Economics*,*76*(2), 384–399.CrossRefGoogle Scholar - Head, K., Mayer, T., & Ries, J. (2010). The erosion of colonial trade linkages after independence.
*Journal of International Economics*,*81*(1), 1–14.CrossRefGoogle Scholar - Hong, S. (2014). Strategic treaty shopping. Working paper.Google Scholar
- Huizinga, H., & Voget, J. (2009). International taxation and the direction and volume of cross-border M&As.
*Journal of Finance*,*64*(3), 1217–1249.CrossRefGoogle Scholar - Johannesen, N. (2012). Optimal fiscal barriers to international economic integration in the presence of tax havens.
*Journal of Public Economics*,*96*(3–4), 400–416.CrossRefGoogle Scholar - Lewellen, K., & Robinson, L. (2013). Internal ownership structures of U.S. multinational firms. Working paper.Google Scholar
- Louie, H. J., & Rousslang, D. J. (2008). Host-country governance, tax treaties and US direct investment abroad.
*International Tax and Public Finance*,*15*(3), 256–273.CrossRefGoogle Scholar - Mintz, J. M., & Weichenrieder, A. J. (2010).
*The indirect side of direct investment*. Cambridge, MA: MIT Press.CrossRefGoogle Scholar - OECD. (2015).
*Preventing the granting of treaty benefits in inappropriate circumstances, Action 6—2015 final report, OECD/G20 Base Erosion and Profit Shifting Project*. OECD Publishing.Google Scholar - Silva, S., & Tenreyro, S. (2006). The log of gravity.
*Review of Economics and Statistics*,*88*(4), 641–658.CrossRefGoogle Scholar - UNCTAD. (2009).
*UNCTAD training manual on statistics for FDI and the operations of TNCs, Volume I, FDI Flows and Stocks*. United Nations Publication.Google Scholar - van’t Riet, M., & Lejour, A. (2017). Optimal tax routing: Network analysis of FDI diversion. Working paper.Google Scholar
- Voget, J. (2011). Relocation of headquarters and international taxation.
*Journal of Public Economics*,*95*(9–10), 1067–1081.CrossRefGoogle Scholar - Weyzig, F. (2013). Tax treaty shopping: Structural determinants of foreign direct investment routed through the Netherlands.
*International Tax and Public Finance*,*20*(6), 910–937.CrossRefGoogle Scholar