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Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.2, March 2010 287 Empirical Analysis of International Tax Treaties and Foreign Direct Investment ∗ Taro Ohno Economist, Policy Research Institute, Ministry of Finance of Japan Abstract The author conducted an empirical analysis as to how the tax treaties Japan executed influenced Japan’s foreign direct investments (covering 13 Asian countries between 1981 and 2003). The result shows that among the tax treaties that Japan executed in the recent 20 years, newly concluded treaties had a statistically significant long-term positive effects on the investment scale, while tax treaties revised during the same period showed no significant effects on investment scale. The author also verified the indirect effects of the tax treaties that Japan executed with another country on Japan’s investments in a third country, and found no statistically significant effects in the cases of both newly concluded treaties and revised treaties (at least in the short-term). Keyword: International Taxation, International Tax Treaty, Foreign Direct Investment JEL classification: F23, H25, H32 I. Introduction The importance of tax treaties has been increasing day by day against the background of a rise in international investment activity. Tax treaties are defined as coordination between sovereign nations, first in order to eliminate international double taxation and second to prevent international tax avoidance. A tax treaty is normally executed between two sovereign nations. In this article, the author empirically verifies the effect of tax treaties on foreign direct investments. ∗ In writing this article, the author would like to express appreciation to all of the following people for their valuable advice: Mr. Masayuki Goto (Ministry of Finance), Mr. Motohiro Sato (Hitotsubashi University), Mr. Masayoshi Hayashi (Hitotsubashi University), Ms. Satoko Maekawa (Kansai University), and Mr. Tamon Yamada (Keio University). The author is solely responsible for the content of this article. Opinions expressed in this article have nothing to do with any statement issued by the Ministry of Finance or the Policy Research Institute. Lastly, this article is based on a study first reported in the Ohno(2009), ‘Sozei Jouyaku to Kaigai Chokusetsu Toushi no Jisshou Bunseki’, Financial Review, Vol.94, pp.172-190 (in Japanese). 288 T. Ohno / Public Policy Review The rise of international investment activity has raised taxation issues in two respects. The first involves the occurrence of international double taxation and the second involves the prevalence of international tax avoidance. This article will look into these issues one at a time. First, the right of taxation is a sovereign right and therefore is basically exercised based on the discretion of each nation. Therefore, every nation often imposes tax on the domestic source income of foreign corporations and nonresidents, not to mention on the worldwide income of domestic corporations and residents. However, this has created a problem. For instance, when a multinational corporation gains an income from its production activity at a plant it established in a foreign country, a tax is levied on the corporation first in the income-source country (source taxation). In addition, if the corporation remits the income to its head office in the home country and is levied a tax (residence taxation), it constitutes a double taxation on the same income (occurrence of international double taxation). Since such double taxation may hinder international investment activity, many countries have concluded tax treaties in a bid to solve the problem. Second, the internationalization of investment makes it more difficult for tax authorities to capture income. For instance, a government may want to levy tax on all income from around the world from the standpoint of fairness, but it is often more difficult to capture foreign source income than to capture domestic source income. For this reason, if the government takes no measures, investors may be prompted to avoid tax (prevalence of international tax avoidance). Because this is a problem common to many countries, countries have cooperated with one another to resolve the issue by concluding tax treaties. Tax treaties have two objectives, first to eliminate international double taxation and second to prevent international tax avoidance. A tax treaty can influence foreign direct investment in two possible ways. From the viewpoint of the first objective, tax treaties contribute to an increase in foreign direct investments because they reduce harm of investments by eliminating international double taxation. On the other hand, from the viewpoint of the second objective, tax treaties may contribute to a reduction in the investment scale, because they discourage international tax avoidance. In light of this nature of tax treaties, does the tax treaty actually influence foreign direct investment? If it does, which of the effects above would be relatively greater? The objective of this article is to empirically find the answer to these questions. Here, I would like to explain the features of this article, while referring to existing studies. In the last 20 years or so, many studies have been made on the effects of taxation (in particular, the tax rate) on foreign direct investment, 1 and in more recent years, the effects of tax treaties on foreign direct investment have come to be examined. Blonigen and Davies (2000, 2004) studied the effects of new tax treaties on U.S. outbound and inbound foreign direct investments. The study found that executing new tax treaties reduced U.S. direct foreign investment and concluded that tax treaties contribute largely to prevent international tax avoidance. Davies (2003) also examined the effect of the revision of tax treaties on U.S. outbound and inbound foreign direct investments, reaching the conclusion that the revision of tax treaties does not have an impact on foreign direct investment. In recent empirical analyses, whether or not 1 Among survey reports concerning these types of studies are those by Gordon and Hines (2002), and de Mooij and Ederveen (2003). Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.2, March 2010 289 there was a conclusion of tax treaties has come to be added to explanatory variables. In his analysis of cross-border M&As, di Giovanni (2005) showed that the conclusion of a tax treaty increases foreign direct investment. Stein and Daude (2007), in their analysis of 17 OECD countries’ foreign direct investments in 58 countries, showed that the conclusion of a tax treaty also increases foreign direct investment. On the other hand, Louie and Rousslang (2008) showed that the conclusion of a tax treaty does not influence foreign direct investments by U.S. corporations. Meanwhile, in Japan, although several studies have been made on the relationship between the tax rate and foreign direct investment, 2 the effects of tax treaties on foreign direct investment have yet to be verified. Incidentally, Hines (2001), Hotei (2006), and Azemar et al (2007) focused on Japan’s "tax sparing credit system", which is a provision of tax treaties, and examined its effect on foreign direct investment. Based on the above, the features of this article are set out in order as follows. First, this article verifies the effects of the tax treaties that Japan has executed (newly executed or revised) on foreign direct investment by Japan. So far, no study has been made to verify the effects of tax treaties executed by Japan. When studying the effect of taxation factors on investment, it is also important to take into account factors other than the tax rate. For instance, it is important to take into account such factors as avoidance of double taxation, exchanges of information among tax authorities, transfer pricing taxation, and treaty shopping. They are measures that should be covered by a tax treaty. In this sense, tax treaties form an important element of taxation factors and it is meaningful to verify their effects. Second, this article verifies the long-term and short-term effects of both newly executed treaties and revised treaties. Existing studies on tax treaties focus only on the long-term effects in the case of newly executed treaties and on short-term effects in the case of revised treaties. However, there are no logical reasons to assume that newly executed treaties have only long-term effects, while the revised treaties have only short-term effects, leaving a need for improvement of those studies in the future. Third, this article adopted the "dynamic panel-data estimation" (system GMM estimator). Among already existing studies on tax treaties, none have adopted the dynamic panel-data estimation. However, it is important to consider the previous year’s level of foreign direct investment, because it is natural to assume that it significantly influences the following year’s level. Also, when verifying the effects of the tax treaties, endogeneity (arising from simultaneity) is a concern, but the dynamic panel estimation makes it possible to deal with this issue as well. The specific target of this article is Japan’s outbound foreign direct investment (in 13 Asian countries in 1981 through 2003). Tajika, Ohno, and Hotei (2007) looked at the recent trends concerning Japan’s outbound foreign direct investments by using statistical indicators, such as the "Balance of Payments Statistics" of the Ministry of Finance and the "Basic Survey of Overseas Business Activities" of the Ministry of Economy, Trade and Industry. They found that Asia accounted for the highest percentage in 2 Among such studies are those by Hidaka and Maeda (1994), Chong (1996), Fukao and Yue (1997), and Maekawa (2005). These studies can be positioned as part of a series of “factor analyses of foreign direct investment” including the tax rate as a factor. Among other studies on “factor analysis of foreign direct investment” (not including the tax rate) are those by Tokunaga and Ishii (1995), Urata (1996), Fukao (1996), Fukao and Chong (1996), and Wakasugi (1997). 290 T. Ohno / Public Policy Review terms of the amount of income on foreign direct investment returned to Japan from abroad. With Japanese corporations’ business activities abroad steadily increasing, the ratio of profits to sales of Japanese corporations operating in Asia is higher than those of their counterparts operating in the U.S., Europe or other regions. In addition, in terms of the ratio of retained earnings gained by local subsidiaries, the ratio of such earnings remaining in Asia is smaller than those remaining in other regions, meaning the amount of earnings remitted to Japanese head offices from Asia is larger than those from other regions. This suggests that Asia has become an important direct investment destination for Japanese corporations. In view of the above, this article focuses its analysis on Asian countries. The result shows that among the tax treaties that Japan has executed in the last 20 years, newly concluded treaties had statistically significant long-term positive effects on the scale of investment, while tax treaties revised during the same period showed no significant effects on such scale. The author also verified the indirect effects of the tax treaties that Japan executed with other countries on Japan’s investments in third countries, and found no statistically significant effects in the case of both newly concluded treaties and revised treaties (at least in the short-term). The structure of this article is as follows. Section 2 puts in order the concept of the functions of tax treaties and their effects on foreign direct investments, focusing on the contents of the tax treaties that Japan has actually concluded. Based on this, Section 3 estimates the effects of the tax treaties that Japan has executed on foreign direct investment by Japan. Lastly, in Section 4, the author presents a conclusion based on the results of the analysis. II. Tax Treaty II.1. Objective, Direction and Function of Tax Treaties A tax treaty is concluded between two countries. So far, Japan has concluded 45 tax treaties with 56 countries (as of December 2008). 3 Japan’s tax treaty network covers more than 90% of the country’s foreign direct investment (in terms of accumulated value). Although the contents of tax treaties vary from one tax treaty to another, they have a lot in common, as most of them are based on the OECD Model Tax Convention. Let’s take a look at the objective, direction and function of tax treaties. 3 The reason for the number of countries being larger than the number of treaties is that the treaties concluded with the former Soviet Union and Czechoslovakia have been maintained by the countries that came into being after the breakup of the two countries. Also, the treaty concluded with the U.K. has been inherited by Fiji. Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.2, March 2010 291 Table 1: Japan’s Tax Treaty Network (45 treaties, 56 countries) Western Europe (15) Eastern Europe/former Soviet Union (17) Asia (12) Africa/Middle East (5) Oceania (3) North America/Central and South America (4) Ireland U.K. Italy Austria Netherlands Switzerland Sweden Spain Denmark Germany Norway Finland France Belgium Luxemburg Slovakia (b) Czech (b) Hungary Bulgaria Poland Rumania Azerbaijan (a) Armenia (a) Ukraine (a) Uzbekistan (a) Kirghiz (a) Georgia (a) Tajikistan (a) Turkmenistan (a) Belarus (a) Moldavia (a) Russia (a) India Indonesia South Korea Singapore Sri Lanka Thailand China (c) Pakistan Bangladesh Philippines Vietnam Malaysia Israel Egypt Zambia Turkey South Africa Australia New Zealand Fiji (d) U.S. Canada Brazil Mexico (Source) Ministry of Finance website (Note 1) As of December 2008 (Note 2) a: The treaty concluded with the former Soviet Union has been inherited. b: The treaty concluded with former Czechoslovakia has been inherited. c: Not applied to Hong Kong and Macao d: The original treaty with the U.K. has been inherited. <Objective of tax treaty> The objectives of tax treaties are as follows. (1) Elimination of international double taxation (2) Prevention of international tax avoidance In order to achieve these objectives, various provisions are provided in tax treaties, which will be described in the <Function of tax treaties> section. <Direction of tax treaty> The following two points can be cited as the direction of tax treaties. (1) Basically, they aim at allocating taxation rights, mainly residence taxation. (2) However, they allow source taxation in some tax bases, as source taxation has its own merit. 292 T. Ohno / Public Policy Review Problems of international double taxation mainly occur when both contracting countries of a tax treaty impose tax on the same income. Therefore, if both parties agree to adopt either source taxation or residence taxation, the problem of double taxation can be solved. Then, the question arises as to which taxation—residence or source taxation—the two parties should adopt, and tax treaties mainly offer the above mentioned directions. Before explaining the reasons behind the directions, let’s take a look at the good points and bad points of residence taxation and source taxation. One of the good points of residence taxation is that it can ensure the fairness of taxation and the efficiency of investment. From the standpoint of fairness, it is desirable for a government to impose a tax on the worldwide income of domestic corporations and residents. It is also desirable from the standpoint of efficiency, since it ensures the neutrality (capital export neutrality) of investment by imposing the same tax rate on similar income wherever an investment is made. On the other hand, one of the bad points of residence taxation is that it is difficult to capture foreign income. From the standpoint of fairness, the government wants to impose a tax on the worldwide income of domestic corporations and residents. However, capturing their foreign source income is often more difficult than capturing their domestic source income. By contrast, one of the good points of source taxation is that it is easy to capture income and, therefore, taxation cost is relatively low. This is because source taxation covers only domestic source income. This point is the exact opposite of the bad point of residence taxation. However, the bad points of source taxation are that the fairness of taxation and the efficiency of investment are not always ensured. Since source taxation does not cover foreign income, the fairness of taxation on a worldwide level cannot be achieved. Moreover, since each country has tax autonomy, the tax rate applied to similar income normally differs from one country to another under source taxation. In other words, there is no guarantee that the same tax rate will be applied. In this sense, the neutrality of investment (capital export neutrality) is not ensured and, therefore, source taxation is not desirable also from the standpoint of efficiency. This point is the exact opposite of the good point of residence taxation. Therefore, tax treaties are moving in the direction of attaching relative importance to the good points of residence taxation but also of partially allowing source taxation to cover the bad points of residence taxation. 4 4 This direction is in line with the “OECD Model Tax Convention” and is reflected mainly in tax treaties concluded between advanced countries. In the case of advanced countries, since their capital exports are relatively large, giving more priority to residence taxation is in the interest of the governments in question. In the case of developing countries, however, since their capital imports are often larger than their capital exports, giving more priority to residence taxation is not in their best interests. Rather, they want to expand the scope of application of source taxation. Therefore, when a tax treaty is signed between an advanced country and a developing country, or between developing countries, the scope of application of source taxation is often wider under such a treaty than under the OECD Model Tax Convention. Japan also takes this point into account when it concludes a tax treaty with a developing country, while basing it on the OECD Model Tax Convention. Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.2, March 2010 293 <Functions of tax treaty> Here, I would like to discuss the functions of tax treaties and their effects on investment. A tax treaty has the following five functions: 5 (1) Allocation of tax jurisdictions (Positive effect on investment) (2) Adjustment of double taxation (Positive effect on investment) (3) Prevention of international tax avoidance (Negative effect on investment) (4) Resolution of international tax issues (Positive effect on investment) (5) Economic cooperation for developing countries (Positive effect on investment) (1) Allocation of tax jurisdictions (Positive effect on investment) In tax treaties, the allocation of tax jurisdictions on individual income is coordinated between two sovereign nations. Specifically, the two sovereign nations decide whether to adopt residence taxation or source taxation depending on the nature of individual income. For instance: • With regard to "international traffic income," both countries adopt residence taxation • With regard to "real estate income," both countries adopt source taxation These efforts are expected to contribute to the reduction and prevention of the risk of double taxation for investors and, as a result, have a positive effect on investment activity. Incidentally, in the cases of certain incomes, tax jurisdictions are not thoroughly allocated and both residence taxation and source taxation are allowed on an exceptional basis. For instance: • "Business income" basically falls under residence taxation. However, when there is a permanent facility, source taxation may be applied within the scope of the income imputed to the facility. • "Investment income (dividends, interest, royalties, etc.)" also basically falls under residence taxation, but source taxation may be applied. The efforts are basically seen as residence taxation but also take the good points of source taxation (ease of capturing income) into account. (2) Adjustment of double taxation (Positive effect on investment) As described above, in the case of certain incomes, the tax jurisdictions are not thoroughly allocated and both residence taxation and source taxation are in place. This may cause the problem of double taxation. Therefore, remedial measures are taken, such as setting: 5 The method of classifying the functions is based on Tax Treaty Study Group (1997). 294 T. Ohno / Public Policy Review • "double taxation relief" (the "foreign tax credit system" in the case of Japan) • limiting the tax rates of source taxation (limited rate of taxation or reduced tax rate) on "investment income (dividends, interest, royalties, etc.)." These efforts are considered to have contributed to the elimination or reduction of double taxation for investors and, therefore, have a positive effect on investment activity. However, in the case of the Japanese foreign tax credit system, it should be kept in mind that since the system is applicable even before a treaty is concluded, it does not exert any new effect after the treaty is concluded. (3) Prevention of international tax avoidance (Negative effect on investment) Tax treaties are also measures to cope with international tax avoidance. The following are examples of such measures: • Measures for transfer pricing (stipulating that transfer pricing is not to be allowed under a "specified affiliated company provision") • "Exchanges of information" (increasing the capture of foreign source income) between the tax authorities of the two countries involved • "Mutual assistance in tax recovery" between the tax authorities of the two countries involved (cooperation to recover tax when a person not covered by the treaty is enjoying the benefits of the treaty) In recent years, other measures have been established to prevent tax avoidance, such as: the "limitation of benefits provision" (in 2004, following the new Japan-U.S. tax treaty), which enables the strict screening of persons eligible for the benefits of the treaty beforehand; the "silent partnership agreement provision" (in 2006, following the new Japan-U.K. tax treaty), which stipulates source taxation on income arising from a silent partnership agreement; and the "anti-conduit provision" and the "anti-abuse provision" (in 2007, following the new Japan-France tax treaty), both focused on the forms and objectives of transactions to limit treaty benefits on investment income. These efforts are expected to contribute to the reduction of tax avoidance and, as a result, have a negative effect on the size of investment (although a question remains as to the quality of investment, in the sense that it is nonproductive activity). (4) Resolution of international tax issues (Positive effect on investment) Tax treaties also provide measures to solve problems that were not assumed at the time of the conclusion of the treaties, including: • mutual agreement procedures for the tax authorities of the two countries involved (government responses in the case of an occurrence of double taxation not stipulated in the treaty) Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.6, No.2, March 2010 295 Incidentally, in the case of double taxation arising from transfer pricing taxation, many treaties have a separate stipulation on coordination through mutual agreement (correlative adjustment provision). They also set a time limit for the correction of transfer pricing and stipulate that the transfer pricing problems of more than 7 years will not be taken up (time limitation on correction). These efforts are expected to contribute to the elimination or reduction of risk uncertainties for investors and, therefore, have a positive effect on investment activity. (5) Economic cooperation for developing countries (Positive effect on investment) When a tax treaty is concluded between an advanced country and a developing country, measures for economic cooperation for the benefit of the developing country are sometimes added to the treaty. Among examples of such measures is: • The "tax sparing credit system" A tax sparing credit system has been incorporated in some of the tax treaties that Japan has executed so far. Since the system directly eases investors’ tax burden, it is expected to have a positive effect on investment activity. The above reveals that tax treaties perform more than one function at a time. As noted above, the objectives of tax treaties are the elimination of international double taxation and the prevention of international tax avoidance. Function (1): allocation of tax jurisdictions, function (2): coordination of double taxation, and function (4): resolution of international tax issues are designed to realize the former objective, while function (3): elimination of international tax avoidance is to realize the latter objective. (Function (5): economic cooperation for developing countries can be viewed more or less as an exceptional measure.) Since the former has a positive effect and the latter has a negative effect on investment, the conclusion of a tax treaty can have both positive and negative effects on investment as a result. II.2. Main points of recent treaty revision It’s not that a full set of the tax treaty functions has been in place since tax treaties began to be concluded in around 1955. The contents of tax treaties have been added, modified and refined in tandem with changes in the economic environment over time. (In other words, the contents of newly concluded tax treaties are more refined than those of previous treaties.) Since tax treaties concluded in the past tend to become obsolete as time passes, leading to double taxation and tax avoidance, it is always necessary to revise such treaties. 296 T. Ohno / Public Policy Review Here, the author would like to organize the main points addressed in the revision of treaties in recent years (from 1981 to around 2003). The following are the main points of revision in accordance with the classification used in the <Functions of tax treaties> described above. (1) Allocation of tax jurisdictions (positive effect on investment) • Creation of "real estate income," "capital gain," and "other income" provisions • Revision of the contents of the "international traffic income" provision. (2) Adjustment of double taxation (positive effect on investment) • Lowering the limited rate of taxation on "investment income" (3) Prevention of international tax avoidance (negative effect on investment) • Establishment of a "mutual assistance" provision (from around 1992) (4) Resolution of international tax issues (positive effect on investment) • Establishment of a "correlative adjustment provision" (from around 1999) • Establishment of a "time limitation for correction (concerning transfer price)" (from around 1999) (5) Economic cooperation benefiting developing countries (positive effect on investment) • Establishment of a "tax sparing credit system" (but on a temporary basis since around 1991) The above shows that in recent revisions, contents have been added or modified in all of the five tax treaty functions. Therefore, treaty revision may have both positive and negative effects on investment. Lastly, the author would like to confirm the flow of tax treaty conclusion and revision by Japan. Table 2 is a list of years in which Japan concluded or revised tax treaties with other countries since 1981. Treaty revision is classified into two types: total revision and partial revision. However, there is no clear distinction between the two. They are only classified so in response to the announcement by the Ministry of Finance. Basically, the difference seems to be in the number of items. In terms of the effect of revision on investment, there is no particular reason to believe there is a difference between total revision and partial revision. The effect of revision depends on the contents of revision. . tax treaties. Tax treaties have two objectives, first to eliminate international double taxation and second to prevent international tax avoidance. A tax. of tax treaties are the elimination of international double taxation and the prevention of international tax avoidance. Function (1): allocation of tax