NYU Tax Policy Colloquium of January 21, 2010

This past Thursday, we discussed Kim Brooks' recently published paper, "Tax Sparing: A Needed Incentive for Foreign Investment in Low-Income Countries, or an Unnecessary Revenue Sacrifice?"

A bit of background may help here, as the term "tax sparing" is generally known only to international tax cognoscenti. To illustrate with an example taken from the paper, suppose Mongolia generally has a 25 percent tax rate, and that the U.S. and Canada have 35 percent rates and impose full worldwide taxation on resident companies, without deferral although with foreign tax credits. A U.S. or Canadian company that earns $100 in Mongolia will pay $25 of tax to the Mongolian government, and $10 of tax (net of the foreign tax credit) to its own home government.

Mongolia then decides that it would like to offer targeted tax incentives, in the form of paying zero tax rather than 25%, for specified new inbound investments. The incentive it would like to offer is targeted in two senses: by investment, as it only applies to activity in the mining sector, and by investor, as it only applies to nonresident (such as U.S. and Canadian) companies. For purposes of the rule, a wholly owned domestic subsidiary of a foreign company qualifies as foreign.

Unfortunately for Mongolia, given the structure of the U.S. and Canadian tax systems (which, in this hypothetical, do not offer deferral), the incentive would not offer any net benefit whatsoever to U.S. and Canadian firms. They would still pay $35 of tax overall, only now it would be 0 to Mongolia and $35 to the home government, rather than 25-10. (In the real world setting where foreign source income of subsidiaries can be deferred for domestic purposes, this does not entirely hold, but the prospect of a repatriation tax still reduces, while not eliminating, the firm's intended benefit from the Mongolian tax incentive.

Mongolia therefore asks the US and Canada to agree to a "tax sparing" clause in their tax treaties. Such a clause commits the signatories to count the source country taxes that WOULD have been paid, but for the targeted tax incentive, as if they actually had been paid. Hence, with a tax sparing clause, a firm investing in Mongolian operations would still be able to claim a $25 foreign tax credit back home, despite actually paying zero, and thus would remain taxable at home only on the $10 residual.

As it happens, Canada (along with the U.K. and Australia) has agreed to tax sparing rules in numerous treaties, whereas the US never has. Back in the late 1950s, the U.S. negotiated such a treaty with Pakistan, but the Senate rejected the tax sparing clause after hearing what was evidently stem-binding oratory from Stanley Surrey. Naturally enough given his general views, Surrey hated tax sparing, which contradicted his preference for fuller worldwide taxation of US companies' outbound investment, and also struck him as perverting the logic of the foreign tax credit rules (by offering credits for taxes that weren't actually paid).

Kim's paper makes two main arguments: that developing countries such as Mongolia shouldn't offer the sorts of targeted tax incentives that tax sparing treaty clauses, and that developed countries such as the US and Canada, where they continue to tax resident firms' worldwide income, should not agree to tax sparing, both because the underlying practice of granting incentives is bad business for the treaty counter-parties that they evidently want to help, and for other reasons of good tax policy (e.g., advancing a policy of capital export neutrality).

I very much like the paper, but quarrel with several points in the analysis. First, whereas the paper is somewhat hostile to tax competition, I'd argue that tax competition between developing countries (such as Mongolia) on the one hand and developed countries (such as the US and Canada) generally is good for the former group. Hence, if targeted incentives are an effective form of tax competition, developing countries may have good reason to use them.

Second, targeting by investor (such as by offering "ring-fenced" tax benefits that are only available to outside multinationals) can benefit developing countries, although I share Kim's general skepticism about incentives that are targeted by investment (such as by being limited to the mining sector).

Third, countries like the US may have good reason, from their own tax policy standpoint, to agree to tax sparing deals. The deals tend both to move the home country's residence-based international tax system in the direction of being an exemption rather than a worldwide system, and to induce resident companies to want to avoid foreign taxes, which is generally in the resident country's self interest. That is, shouldn't the US prefer that US companies (with US shareholders) can benefit after US tax from paying zero rather than $25 per $100 of earnings to the Mongolian government.

As for the Surrey view that granting foreign tax credits for taxes not paid is a perversion of the credit system, I would say, in effect: It's a good thing to pervert the already perverse (so to speak - I am not making a more general philosophical statement about life here). It is perverse, from the standpoint of national self-interest, to make one's taxpayers wholly non-cost conscious with respect to foreign taxes paid. Thus, even if the overall tax burden on outbound investment remained constant (e.g., due to an offsetting rate increase on foreign source income), it would be a good thing to allow foreign tax credits for taxes NOT paid. Only in the Bizarro World of foreign tax credits, in which who gets a given dollar is treated as irrelevant even though in the real world it obviously matters, would tax sparing look so counter-intuitive.

To be sure, this still offers no defense for limiting credits for foreign taxes not actually paid to cases where a targeted incentive did the job, rather than, say, a general rate reduction. Whether Mongolia should prefer targeted or general rate cuts, it's unclear why the US, via tax sparing clauses that apply only to special incentives, should seek to steer it one way rather than the other.