Foreign Investment

Tax Sparing Arrangement and Foreign Direct Investment

Governments in developing countries are attracting inbound Foreign Direct Investment (FDI) to ensure their economic development. In return for the benefit of FDI by multinational organizations, these governments offer tax holidays and tax incentives. The tax advantage generally arises due to the tax system and higher rate of taxes prevailing in the nation of origin. However, the lower tax paid in the source country reduces the subsidiary’s tax risk along with the tax credit accessible to the parent company in its domestic jurisdiction for the taxes paid abroad. Multinational Companies^[1] are concerned about the joint tax obligation of both governments. The purpose of benefiting from FDIs will be frustrated if a taxpayer has to pay taxes in the parent country on the income which has been exempt in the subsidiary country. So the tax-sparing arrangements are entered into where the contracting party to the tax treaty agrees to forego taxes that have been spared under the incentive program in the subsidiary country, in the parent country, either by exempting it from tax or by providing deemed credit for taxes not levied by the subsidiary country.

What are Tax Sparing Arrangements?

It is arrangements in the form of tax settlements where the nation of origin consents to furnish a subsidiary multinational company with a tax credit for taxes to be paid in the source country, by sparing or foregoing the tax to be paid in the source country. It happens due to a program of tax incentives provided by source country. It is a mechanism to ensure that the source country’s attempts to give tax incentives for attracting FDI does not depend on the parent country’s tax framework. In simple words, when a host country grants incentives to encourage FDI and the company investing is a resident of another country with which a tax treaty has been concluded, the resident country may give credit against its tax for the tax which the company would have paid if the tax had not to be spared under the provisions of tax incentives in the tax treaty. It is a special form of double taxation relief provided in tax treaties with developing countries.

How does Tax Sparing affect the Territorial vs. the Global Tax Systems?

The international Tax regimes are formed by a network of thousands of bilateral tax treaties entered into between countries. One of the major reasons for entering into a bilateral tax treaty is to avoid double taxation or double non-taxation of income earned in one jurisdiction by organizations of different jurisdictions. It is implemented by way of specific provisions in the tax treaties. One important element of tax sparing provision is that the tax credit allowed by the resident country to the MNC shall be deemed to include tax spared by the source country and tax paid in the source country. Tax sparing also involves the revenue losses for the resident country and benefits from tax holidays or tax incentives to the source country which chooses to attract FDI. In simpler words, tax sparing provides for losses for the resident country and gains for the source country. This brings forward a question as to why the resident country agrees to tax-sparing provisions. The answer to this is the extent to which the resident country provides other forms of aid to the source country, to that extent the source country can in principle reduce these other forms of aid when a tax sparing agreement is signed. Further, the transfer of revenue from the source to the residence country in a tax treaty is mitigated to some extent by introducing tax-sparing provisions. Some countries refuse to sign tax treaties if there is the absence of a tax sparing agreement in it. The inclination of developing countries towards tax-sparing provisions suggests that these agreements do matter in terms of attracting FDI.

Under Tax Sparing Arrangement, a source country introduces a tax holiday for an MNC based in a global resident country. The profit to the MNC arising from the tax holiday or tax incentive may be fully or partially annulled owing to the higher taxes in the resident country.  It is because the lower tax paid in the source country lowers the subsidiary’s tax liability as well as the tax credit available to the parent business in the resident country when the subsidiary pays a dividend to the parent. This offsets both active and passive income. This issue frustrates the entire purpose of FDI as MNCs are interested in combined tax liability. Therefore, the tax-sparing provisions are entered into to provide relief.

What is the effect of Tax Sparing Arrangement on FDI?

Fiscal Incentives provided by the host country concerning corporate tax rate and dividend withholding tax rate applied to an investor from a global tax system when applied to an investor from a global tax system simply lower the amount of foreign tax credit that can be claimed by an investor in the domestic country. Likewise, when a fiscal incentive regarding interest, royalty and withholding tax rates is applied to an investor from either the global tax system or the territorial tax system, it reduces the foreign tax credit, leaving the global tax paid static. To mitigate the above issues, tax-sparing provisions are entered into tax treaties. Tax-sparing provisions allow investors to obtain a foreign tax credit for taxes spared and not paid in the source country. Therefore, the foreign income that benefits from a tax incentive program in the source country is treated by the resident country as if it has been fully taxed in the source country.

Tax Sparing agreements are associated with up to 97% higher FDI. This percentage was obtained in the year following the entry into tax-sparing agreements with no effects from previous years. It has also been analyzed that in the absence of tax-sparing provisions in bilateral treaties, there has not been a significant rise in FDI. The result also suggests that tax-sparing provisions in tax treaties can be an important tool for attracting FDI.

Conclusion

The efforts of developing countries to attract multinational businesses by providing tax holidays and other tax incentives is frustrated by the tax systems of the multinational business’s domestic country. To prevent the source country’s tax incentive from being nullified by the resident country’s taxation, these provisions are included in the bilateral treaties. Almost all high-income-capital-exporting countries provide tax-sparing provisions for investments in developing countries. The effect of this is on the credits for withholding taxes and on interest and royalties which apply to both global as well as territorial jurisdictions. The relevance of these provisions has continuously increased. The growth of these provisions, therefore, becomes an important means to encourage FDI in developing countries.

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