Research Phase 5        Tax policy in an uncertain world

1   Profit allocation & business restructuring

The Allocation of Profits and the OECD Approach to Business Restructuring
Christopher Heady

The allocation of the profits of multi-national groups between their member companies for tax purposes has important impacts on both
the corporate tax revenues of the countries in which these groups operate and the taxes paid by the groups. The current international
tax system allocates these profits using separate accounting, based on the “arms length principle”. However, this approach has been
criticised at both a practical level and a conceptual level, and many of these criticisms have been highlighted by recent trends in
business restructuring.

In this context, the purpose of this paper is to analyse the economic consequences of the arms length principle and to illustrate the
issues raised in this analysis with elements of the OECD approach to the transfer-pricing aspects of business restructuring. The
paper argues that the arms length principle achieves a reasonably fair allocation of tax base between countries and promotes the
important efficiency principle of ownership neutrality, especially now that most OECD countries use the exemption method to relieve
international double taxation. However, in the absence of tax harmonisation, it does not ensure that capital is allocated efficiently
between countries. The main difficulties with the arms length principle arise in the context of intangible property and intra-group
services, issues that arise commonly in the restructuring of multi-national companies. Particular additional problems that arise in
restructuring are the compensation of subsidiaries for lost profit opportunities and the treatment of risk. The paper concludes that,
while the arms length principle is far from perfect, many of its difficulties would also arise in some form under formulary apportionment
(the most widely supported alternative). It is only more radical reforms of international corporate taxation that can solve these problems,
but they would fundamentally alter the allocation of tax bases between countries.


2   FDI and corporate tax

Foreign direct investment and corporate income taxation under legal uncertainty
Martin Zagler

This paper analyzes the effects of legal uncertainty in the application of double tax agreements on foreign direct investment in
developing economies. Despite the fact that we would suppose that the existence of a double tax agreement should encourage foreign
direct investment, the literature is surprisingly inconclusive and more often than not finds a negative or insignificant relationship. We
explain this stylized fact by taking legal uncertainty into account. We will study a general equilibrium model of foreign investors who
consider investing in a profitable developing market. Uncertainty arises due to uncertainty about the application of tax treaties. The entry
decision will be undertaken strategically, taking the behavior of other market participants into account. Depending on the industry
structure, firms may decide to enter until economic rents are zero in the low tax scenario. Companies that compete with each other may
underbid each other, speculating that legal uncertainty resolves in their favor. This will lead to a race to the bottom between foreign
direct investors and harmful competition. A double tax agreement with a high degree of legal uncertainty can therefore be worse for the
host company (and the involved firms) than a fully implemented agreement or no agreement at all.


3   Taxation and the financial crisis

Taxation and the financial crisis
Julian Alworth and Giampaolo Arachi

This paper is divided into two broad sections. The first examines those elements of the tax system that may have contributed to the
crisis. It suggests that there are a number of weaknesses in existing arrangements, some of which have long been known (such as
the propensity for tax systems to encourage leverage) while others (such as the excessive reliance on the financial sector and its
ephemeral earnings for tax revenue projections) have only become apparent with the benefit of hindsight. The discussion is organized
around the tax treatment of households (in particular the deductibility of mortgage interest), non-financial corporate entities (leverage)
and financial institutions.

The second part of the paper is more tentative; it discusses policy initiatives in respect of the financial sector that are currently being
aired. These policy initiatives have been organized under three broad (and often overlapping) headings: (i) special taxes on the
financial sector to recover the costs incurred for the bailout; (ii) the use of taxes to correct for distortions (particularly of systemic
character) resulting from the safety net which applies to the financial sector; (iii) reforms in the taxation of the financial sector which
have been highlighted by the crisis (VAT on financial services, the interaction with accounting and regulatory definitions of income, anti-
avoidance measures in particular with respect to tax arbitrage).


4   Taxes and cross-border acquisitions

How do taxes affect cross-border acquisitions?
Wiji Arulampalam, Michael Devereux & Federica Liberini

This paper uses firm-level data to investigate the impact of taxes on the location of mergers and acquisitions. Our theoretical
framework suggests that there are many ways in which tax can influence such M&A activity. For example, it is possible that a higher tax
rate in the country of the target company could make an acquisition of the tax more likely, less likely, or have no effect at all. Another
possibility is that the difference between the home and host country tax rates has an effect. We combine financial and ownership data
from a large number of companies in the ORBIS database for 2005 with domestic and cross-border acquisitions in the ZEPHYR
database between 2006 and 2008. We estimate a model in which acquiring companies choose in which country to acquire a target
company. The results suggest that the predominant effect is that a higher tax rate in the target country has a negative impact on the
probability of an acquisition in that country.


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