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A US professor has questioned whether FDI is always a benefit to developing countries given that companies can use sophisticated techniques to remove their profits or avoid tax. Philippa Maister reports.

The role of tax havens as intermediaries in global FDI and in multinational companies’ tax avoidance strategies is drawing increased scrutiny as the scale of national revenue losses in host countries becomes clearer. This is leading some economists to question whether some developing countries should even seek FDI.

A recent analysis by Thomas A Gresik, an economics professor at the University of Notre Dame in Indiana, has concluded that the answer may sometimes be ‘no’. Mr Gresik analysed the interplay of the roles of offshore tax havens, transfer pricing and the use of debt instead of equity to finance foreign subsidiaries in developing countries. He concluded that the result could make host countries worse off than they would be without FDI – a view he has acknowledged is at odds with that of most experts.

Unctad’s 2015 World Investment Report calculated that corporate profits shifted from developing economies total $450bn. This accounts for an estimated $100bn of annual tax revenue losses.

One way companies do this is ‘thin capitalisation’ – the use of a high proportion of debt (instead of equity) to finance a foreign subsidiary. Interest payments on debt – often loaned by a different subsidiary in a tax haven – are tax deductible in the host country, while dividend payments to equity holders are not.

The interest payments on the internal debt to the other subsidiary become a way for a multinational to take profits out of the host country. Many countries have rules that impose debt-to-equity ratios to limit the amount of debt that can be used and the interest that can be deducted from tax.

However, Mr Gresik said countries with low tax rates tend to allow more internal debt financing, and some have no thin capitalisation limits. Multinationals also commonly use transfer pricing to shift profit on intangibles such as intellectual property, royalties and licensing fees out of host countries to tax havens, as well as the mispricing of intra-company sales. 

“With weak transfer pricing enforcement and thin capitalisation rules, the multinational can shift all the taxable income out of the country to pay no taxes,” said Mr Gresik.

Raymond Baker, president of Global Financial Integrity, a Washington, DC-based research and advisory organisation, has advocated national legislation to make abusive transfer pricing illegal – something many countries lack. “To give it teeth, you would require the CEO of the local company to sign, on his annual financial report or tax return, a statement that quotes the law and says the company has abided by it,” said Mr Baker.

He agreed with Mr Gresik’s view that FDI can actually harm a country, especially if it does not produce significant employment. However, addressing the problem will not be easy.

As Unctad noted, in less developed countries, foreign affiliates contribute more than twice as much to government revenues through royalties on natural resources, tariffs, payroll taxes and other types of taxes and levies, than through corporate income taxes. Assessing the trade off would be something each country will have to examine.

This article is sourced from fDi Magazine
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