taxes and the clustering of foreign subsidiaries

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Taxes and the Clustering of Foreign Subsidiaries

Scott D. DyrengDuke University

Bradley P. LindseyCollege of William & Mary

Kevin S. MarkleDartmouth College

Douglas A. ShackelfordUniversity of North Carolina and NBER

February 2011

Preliminary and Incomplete

Please Do Not Cite Without the Authors Permission

Abstract

In this study we investigate the influence of taxes on the location of U.S. multinationals foreignsubsidiaries. Previous studies have assumed that location decisions are made independently. Wefind foreign subsidiaries cluster in a manner consistent with global tax avoidance. Specifically,we find that the certain pairs of foreign subsidiaries are more likely to include a tax haven thanwould be expected by chance. Similarly, we find that country pairs are more likely to have abilateral tax treaty and less likely to form as income and dividend withholding taxes between the

countries and with the U.S. parent increase.

We appreciate suggestions and comments from Mark Jackson, Richard Sansing, Bill Stewart, andworkshop participants at the American Accounting Association annual meeting and Duke University.


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1. Introduction

This paper tests the extent to which taxes affect the location of a foreign

subsidiary, conditional on the locations of the firms other foreign subsidiaries. Previous

studies show that taxes, among other factors, influence the foreign location decisions of

multinational firms (see Grubert and Mutti, 2000, Altshuler et al., 2001, Desai et al, 2004,

and a thorough review in Devereux, 2007, among many others). However, the prior

empirical literature, excepting Desai, Foley, and Hines (2006a), assumes that the location

decisions are independent of one another. For example, when Markle and Shackelford

(2011) estimate the impact of operating in a foreign country on a parents effective tax

rate, they assume that each countrys impact is independent from that of any other

country. However, if firms enter two (or more) countries because the pair provide tax

advantages that neither could achieve alone, then Markle and Shackelford (2011) and

other papers relying on independence potentially misstate the influence of individual

countries and understate the total effect of taxes on global operations.1

Broadening the analysis of multinational firms foreign country location decisions

from a unilateral setting to a multilateral framework better captures the global tax

avoidance options available to multinationals. Despite their tax disadvantages, high-tax

foreign jurisdictions often attract multinationals for a host of non-tax reasons, including

access to consumer, labor, and capital markets, which might be inaccessible without

operations in those countries. By pairing the high-tax country operations with an

1For example, Markle and Shackelford (2011) estimate that adding a German subsidiary to a firmsportfolio of foreign subsidiaries lowersthe global enterprises (accounting-based) effective tax rate by0.5%. From a unilateral perspective, this seems implausible since Germany is widely considered a high-taxcountry. However, if multinationals typically enter Germany, while simultaneously entering otherEuropean countries that are commonly associated with tax avoidance, e.g., Ireland, Switzerland, theNetherlands, Luxembourg, among others, then it is possible that unilateral estimates of the impact on globaleffective tax rates, which ignore the joint nature of the decision to expand into Germany, make indeed benegative or at least less positive than would be anticipated.


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appropriate low-tax foreign jurisdiction, e.g., a tax haven, a multinational might be able

to substantially mitigate the taxes collected by the high-tax country. If so, we should

observe predictable clustering patterns in the locations of multinational firms foreign

operations. An example of clustering based on geography is Desai, Foley, and Hines

(2006a), who find that economic activity in low-tax countries enhances economic activity

in nearby high-tax countries. Our study goes beyond geography to test whether tax-

motivated clusters can be observed along a host of factors, including tax havens, tax

treaties, and the interaction of parent-subsidiary and brother-sister income and dividend

withholding taxes.

Google nicely illustrates the clustering concept. According to aBloombergarticle

on October 21, 2010, Google, which operates in many high-tax countries, reduced its

total tax rate on foreign profits to 2.4%, saving $3.1 billion over the last three years. 2 The

article attributes this successful tax avoidance in large part to a transfer pricing technique

that routed company profits from high-tax jurisdictions through two low-tax Irish

subsidiaries, then to a Dutch subsidiary, and finally to a Bermuda entity that pays no tax.

2We are unable to verify the purported tax savings. The Bloomberg article states that Google Inc. cut itstaxes by $3.1 billion in the last three years using a technique that moves most of its foreign profits throughIreland and the Netherlands to Bermuda. We assume that the $3.1 billion figure comes from thecompanys rate reconciliation in the tax footnote of its Form 10-K because the dollar reduction for theForeign rate differential in the rate reconciliation for the 2007, 2008, and 2009 calendar years combinedis $3.1 billion. A negative figure in the rate reconciliation indicates a reduction in the GAAP effective taxrates from the arbitrary 35% starting point. However, it is quite a stretch to assert that an accounting figurein the rate reconciliation corresponds with the actual reduction in global cash taxes paid. In addition, the

companys filings provide no indication of the extent to which the $3.1 billion dollar reduction in the ratereconciliation relates to the Irish-Dutch-Bermudan technique discussed in the paper. The article goes on toassert that the technique helped reduce its overseas tax rate to 2.4percent We are unable to tie the2.4percent figure to the companys filings, although we assume that, as with the $3.1 billion figure, itcomes from some computation based on the companys GAAP-based accounting records. Because of thedifficulty in inferring actual tax payments from financial statement information (see Hanlon, 2003, andGraham et al. 2011, among others) we caution readers from placing excessive weight on these specificfigures. That said, from our casual review of the companys financial statements, it is clear that theaccounting-based effective tax rate for foreign operations is very small, consistent with the actual taxes paidon foreign operations being small as well.


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The Dutch subsidiary is needed to avoid an Irish withholding tax on the royalty payments

to a non-European Union member, Bermuda. By clustering the right set of countries (in

this case, Ireland, the Netherlands and Bermuda), Google avoids taxes that would

otherwise be levied on foreign profits in high-tax countries.3

This paper searches for the footprints of Google-like clusters by studying the

locations of U.S. operations around the world. Ideally, this study would evaluate the

entire portfolio of country choices that a firm facesthe three-country mix that Google

uses or even more complex clusters of foreign subsidiaries. However, tractability

prevents such a comprehensive investigation. Thus, we relegate our analysis to studying

pairs of countries. We recognize that by limiting the examination to pairs, we lose the

ability to identify triplets, such as Googles Irish-Dutch-Bermudan combination, and thus

potentially understate the importance of elaborate clusters.

Therefore, recognizing that this study should be viewed an initial foray into

understanding the role of taxes on clusters, we test whether foreign subsidiaries of U.S.

firms are located in pairs of countries in a manner consistent with tax incentives. We

examine a sample of 2,720 multinational firms domiciled in the United States at the end

of 2007. Using a proprietary text search program, we search Exhibit 21 of the firms

Form 10-K, which discloses the foreign countries in which the firm has material

operations. We then compute the percentage of U.S. firms in our sample that operate in

each foreign country. Using these percentages, we calculate the portion of U.S. firms that

3Google is not unique in its clustering exploits. TheBloombergarticle quotes Richard Murphy, director ofUK-based Tax Research LLP as stating that the Google technique is very common at the moment,particularly with companies with intellectual property. Murphy estimates that hundreds ofmultinationals are using some version of this clustering technique. The article adds that Facebook isconstructing a similar tax avoidance technique, which pairs Ireland and the Cayman Islands.


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would be expected to operate in any pair of countries, assuming that country locations

were randomly assigned. Next, we regress the difference between actual and expected

percentages on nontax determinants of foreign location clusters (e.g., trade and

geography) and various tax considerations. We find that the unexpected percentage

increases if one of the pair is a tax haven or the pair has a tax treaty, and it is decreasing

in the taxes levied on transactions between the pair and with the U.S. When we focus on

the largest positive unexpected percentages (indicative of pairs that far exceed

expectations), three countries commonly associated global tax avoidance (Singapore,

Hong Kong and the Netherlands) appear disproportionately. We interpret these findings

as consistent with foreign subsidiaries of American companies clustering in part to

mitigate their global tax liability.

This paper should interest scholars as they attempt to better understand how

multinationals arrange their affairs to lower their global tax liability. The results in this

paper suggest that clusters are an important multinational tax avoidance structure. In

addition, a better understanding of how and where multinational firms cluster their

foreign operations should interest policymakers worldwide as they seek to identify and

implement effective tax policies. The findings from this study are consistent with the

taxes collected in a country being not only a function of its tax law and enforcement but

also the tax laws and enforcement of every other country where the multinational firm

does business (or could do business) as well.

The paper proceeds as follows. Section two develops the hypotheses. Section

three outlines the research design. Section four details the sample selection and

descriptive statistics. Section five discusses the results. Section six concludes. The


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Appendix provides background information on the U.S. taxation of multinationals for

those readers with less expertise in the field.

2. Hypotheses Development

As discussed above, this paper examines the frequency of subsidiary pairs to

determine whether clusters of foreign subsidiaries can be explained in part by global tax

planning. If some U.S. firms consider global tax avoidance when they establish their

foreign operations, there are likely to be more subsidiaries in low-tax countries than in

high-tax countries. (By low-tax, we mean those countries whose own tax levies are

low, whose tax law lowers the taxes paid to other countries, and/or whose tax law lowers

the taxes levied on the parent when profits are repatriated.) If a disproportionate number

of subsidiaries domicile in countries that facilitate global tax mitigation, then we expect

to find pairs of low-tax countries are more prevalent, both because they provide low taxes

to their individual companies and also because they enable the multinational to lower

taxes throughout the enterprise.

This leads to the first hypothesis, stated in the alternative.

H1: The unexpected percentage of U.S. firms with material operations in bothCountry iand Countryjis decreasing in the statutory tax rates of iandj.

The second hypothesis concerns the attractiveness of tax havens in global tax

strategies. Besides lacking transparency in financial dealings and failing to share

information with other government and regulatory bodies, the low or zero tax rates of tax

havens also stimulate investment activities within their borders (Desai, et al 2006b).

With opportunities to use tax havens to shift profits out of high-tax foreign countries, we

predict that a foreign subsidiary pair will be more likely to occur if one of the countries is


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a tax haven. These haven pairings should be particularly attractive when the other partner

is located in a high-tax country. At the same time, as illustrated by the Google cluster,

multiple havens may be able to undertake tax avoidance strategies that would be

impossible with a single haven.

H2: The unexpected percentage of U.S. firms with material operations in bothCountry iand Countryjis higher when either iorj or both are tax havens.

Finally, the relationship between any two countries is governed by the negotiated

bilateral agreements in place. For tax purposes, these agreements take the form of tax

treaties and most are built on conventions established by the OECD. Provisions can vary

widely but generally relate to issues such as withholding tax rates on dividends and the

definition of income that is taxable by each of the countries. Because treaties generally

reduce trade frictions and signal a basic level of cooperation between the countries, we

predict that pairs of countries with bilateral tax treaties will be more likely to appear.

H3: The unexpected percentage of U.S. firms with material operations in bothCountry iand Countryjis higher when there is a bilateral tax treaty in

effect between iandj.

One reason that we might fail to find evidence that tax rates and the presence of a

tax haven or a tax treaty affect the location of foreign subsidiaries is that some

(potentially critical) tax assessments are privately negotiated. Multinationals and foreign

countries often negotiate private tax holidays and other tax rate incentives that can render

published statutory tax rates and other tax variables as meaningless indicators of the

actual taxes paid (Bond and Samuelson 1986). In fact, a high-tax country could serve (at

least temporarily) as a de facto tax haven for a given U.S. firm if the foreign country

grants a tax holiday or other similar tax concessions. While we know that private

arrangements exist, by definition we are unable to observe them and thus cannot assess


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whether the observable tax measures that we use are so fraught with error as to

undermine the power of our tests.

3. Research Design

To test these hypotheses, we regress the unexpected percentage of U.S. firms with

material operations in a subsidiary pair on tax and control variables. To develop the

dependent variable, we first consider a world with one home country and n foreign

countries. Under an assumption that countries are chosen independently,

, , , 1 , (1)

where represents country i, , represents the probability that a firm has

subsidiaries in both country iand countryj, and represents the probability that a

firm has a subsidiary in country i. Relaxing theindependence assumption, for any given

pair , , the following holds:

, , , 1 , (2)

where is an error term with unknown mean and variance.

By subtracting the expected frequency derived under the assumption that location

decisions are independent ( ) from the actual frequency of firms operating in

each country pair, we can calculate for each pair , . The object of this study is to

explain this unexpected percentage as a function of characteristics of the country pair.

, (3)

For each pair of countries, we calculate . We then use a linear equation to

ascertain the characteristics of country pairs that explain variation in the measure:

(4)


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_ _ 1 2

where

is the unexpected percentage of firms having material operations isboth country iand countryj.

_ is the mean of the withholding tax rate on dividends from country to the U.S. and the withholding tax rate on dividends from country

to the U.S., expressed as a percentage of $1 of pretax foreignincome.

_ is the mean of the residual U.S. income tax rate on income earnedin country and the residual U.S. income tax rate on incomeearned in country, expressed as a percentage of $1 of pretaxforeign income.

is the mean of the statutory corporate income tax rate in country and the statutory corporate income tax rate in country.

is the mean of the withholding tax rate on dividends paid fromcountry to countryand the withholding tax rate on dividendspaid from countryto country , expressed as a percentage of $1 ofpretax foreign income.

1 is an indicator variable equal to 1 if at least one of country andcountryare tax havens; 0 otherwise.

is an indicator variable equal to 1 if there is a bilateral tax treatybetween country and countryin effect; 0 otherwise.

2 is an indicator variable equal to 1 if both country and countryare in the Organisation for Economic Co-operation andDevelopment (OECD); 0 otherwise.

is the natural logarithm of the bilateral trade between country andcountry, in millions of U.S. dollars.

is an indicator variable equal to 1 if country and countryshare aborder; 0 otherwise.

is an indicator variable equal to 1 if country and countryhavethe same official language; 0 otherwise.

is the natural logarithm of the distance between the centers ofcommerce of country and country, in kilometers.

is an indicator variable equal to 1 if country and countryhavethe same majority religion; 0 otherwise.


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is an indicator variable equal to 1 if country and countryhavethe same legal origin; 0 otherwise.

These variables have been chosen to capture, 1) the tax characteristics of the pair,

2) the size of the economies of the countries in the pair, 3) the geographic proximity of

the pair, and 4) the cultural proximity of the pair. Grubert and Mutti (2000), Kogut and

Singh (1988), Blanco and Rogers (2008), and Barrios et al., (2010), among others, use

similar variables to capture these constructs.

4. Data and Sample Selection

To estimate equation (4), we first construct a sample of all U.S. incorporated

firms in 2007 in the Compustat database that have at least $10 million in total assets and a

CIK number.4 We use the CIK number to correctly match data from the Securities and

Exchange Commission website to the firm using a proprietary text search program.

Scanning Exhibit 21 on the website for all public U.S. firms, the program identifies all

foreign countries where the firm has material operations.

5

We drop all firms without

foreign operations and treat firms with multiple material operations in a foreign country

the same as firms with only one material operation in the country. Our final sample has

2,720 U.S. firms with foreign operations in 92 countries and 4,136 foreign-country

subsidiary pairs.

To determine the dependent variable in the regression (the unexpected percentage

of country-pairs), we begin by computing the percentage of U.S. firms that operate in

4We analyze 2007 data because that is the most recent year for which we have Comtaxs statutory tax rateand bilateral tax treaty data.5The outputted data have a small level of noise because of differences in reporting by firms. Additionally,while most disclosed material operations in foreign countries are incorporated subsidiaries, this is notalways the case.


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each of the 92 countries in our sample. Assuming independence in country choice, we

use these actual percentages to compute the expected percentage of US firms that would

operate in each foreign subsidiary pair of firms. The difference between actual and

expected is the unexpected percentage of country-pairs.6

Tax rates and treaty information are obtained from Comtax. Following Dyreng

and Lindsey (2009), havens are defined as countries that are listed on at least three of four

lists of tax havens reported at http://www.globalpolicy.orgon March 4, 2008. Bilateral

trade data are obtained from the STAN database on the OECD website. Information on

language religion, language, and legal origin are obtained from Andrei Shleifers website.

Table 1 reports the descriptive statistics for all regression variables included in

Equation (4). The unexpected percentage of firms in a foreign country pair (U_PCT), has

a positive mean (1.50% ) and median (0.69% ) value, consistent with some skewness in

the data attributable to the actual percentage of firms that operate in both countries in a

foreign subsidiary pair. 33% of foreign country subsidiary pairs include at least one

country in a tax haven, and 32% of foreign country subsidiary pairs have a bilateral tax

treaty between the two countries in the pair. 9% of subsidiary pairs include both

countries in the OECD. 13% speak a common official language. 20% share the same

majority religion. 31% have the same legal origin.

Table 2 presents both the Pearson and Spearman correlations among the

regression variables in Equation (4). As predicted, U_PCTis negatively correlated with

6For example, 18% of U.S. multinational firms in our sample have material operations in Ireland, and 32%have them in the Netherlands. Assuming independent foreign location choices, we would expect 5.8%(18%*32%) of U.S. multinational firms to operate in both Ireland and the Netherlands. We find that 12%of U.S. multinational firms in our sample have subsidiaries in both Ireland and the Netherlands. Thus, thedependent variable for Irish-Dutch pairs is 6.2% (12%-5.8%).


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all the tax measures, except the corporate statutory tax rates in the foreign countries

(HOSTTAX). As expected, the dependent variable is greater when the country-pair has a

tax treaty but uncorrelated if one of the pair is a tax haven. We turn next to the

multivariate analyses.

5. Results

5.1 Primary Findings

Table 3 reports the estimated regression coefficients for equation (4). The first

column of Table 3 reports the regression results with only the control variables. As

expected, all controls are positively correlated with the unexpected percentage of firms in

a subsidiary pair, except for legal origin (LEGOR). Looking across the columns, the

coefficient estimates of the control variables appear relatively stable and consistent as tax

variables are included in the various models; thus, we do not further discuss them.

Columns 2 through 8 of Table 3 introduce each tax variable separately. We focus

on the ninth column, which reports the results when all tax variables are included in the

regression.7 There, we find every tax variable is significant in the predicted direction,

consistent with taxes affecting foreign subsidiary clusters.

Consistent with H1, which predicts a negative relation between the unexpected

percentage and the statutory tax rates of the countries in the pair, we find negative

7PAR_EFFTAXis excluded from the full model becausePAR_EFFTAXis the sum of PAR_WH,HOSTTAX, and PAR_HOMETAX. On a different note, the variance inflation factors suggest thatmulticollinearity does not adversely affect the model.


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coefficients on PAR_WH, PAR_HOMETAX, HOSTTAX, andDIVWH.8 Their

coefficients imply that the unexpected percentages fall by:

0.41 percentage points with an interquartile range increase in PAR_WH (mean

dividend withholding rate between foreign subsidiaries and the U.S.);

0.71 percentage points with an interquartile range increase in PAR_HOMETAX

(mean residual U.S. corporate tax upon repatriation);

0.22 percentage points with an interquartile range increase inHOSTTAX(mean of

the subsidiary pairs corporate tax rates;

0.10 percentage points with an interquartile range increase in DIVWH (mean of

the subsidiary pairs dividend withholding rates).9

Consistent with H2, which predicts a positive relation between the unexpected

percentage and the presence of at least one tax haven in the pair, we find a positive

coefficient onHAVEN1. The coefficient implies that subsidiary pairs with at least one

tax haven have an unexpected percentage that is 0.56 percentage points larger.

Consistent with H3, which predicts a positive relation between the unexpected

percentage and the existence of a bilateral tax treaty, we find a positive coefficient on

TREATY. The coefficient implies that subsidiary pairs with a tax treaty have an

unexpected percentage that is coincidentally also 0.56 percentage points larger.

Together, the regression results in Table 3 provide compelling evidence that

corporate taxation in one foreign country affects a multinationals decision to operate in

8Inferences are unaffected when alternative measures of statutory rates are used, including the statutoryrates of both of the firms in the pairs and the spread between the rates. The robustness of the statutory ratesmeasures provide some confidence that the clusters are motivated by tax rate considerations.9Our text search program only identifies the material operations of U.S. firms and not the organizationalstructure of U.S. firms. Thus,DIVWHwould be relevant when one country in a subsidiary pair owns theother country but not when the U.S. firm owns both foreign subsidiaries directly.


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another foreign country. Clusters are more prevalent than would be expected when the

income and withholding tax rates of two countries are lower, when the pair includes a tax

haven, and when the duo enjoy a tax treaty. These findings are inconsistent with the

assumption of independence in foreign location decisions.

5.2. Supplemental Findings

Next, we focus on the most positive residuals from the first column in Table 3,

i.e., when only the control variables are included as explanatory variables. We look first

at the residuals (or conditional unexpected percentages) that are in the upper 5% of the

distribution. We then count the number of times that a country is included in the

subsidiary pair for the 206 pairs with the most positive residuals. The purpose of this

exercise is to identify those countries where foreign subsidiaries are found far more often

than would be expected. Our expectation is that (at least some of) these countries are

likely to be those most commonly used by U.S. multinationals to avoid global tax

liabilities.

We find that 38 of the 92 sample countries appear at least once and that six

countries (Brazil, India, Singapore, China, Hong Kong, and the Netherlands) appear at

least 20 times. Three of the six (Singapore, Hong Kong and the Netherlands) are either

low-tax countries (potentially tax havens) and/or often fingered as key players in global

tax avoidancethe very countries that we expected to detect.10 Three other countries

commonly mentioned among those that U.S. companies use to avoid taxes make the list

10While Hong Kong and the Netherlands are not technically identified as tax havens in our study, manysources do believe they should be classified as tax havens (Gravelle 2009).


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but are not at the top. They are Bermuda with 12 entries, Ireland with seven pairs, and

the Cayman Islands with six combinations.

The other three countries (Brazil, India, and China) represent high-growth,

emerging markets enjoying major investment inflows from the U.S. It is not surprising

that these countries are listed repeatedly among the most extreme pairs because their

current economic activity exceeds what would be predicted by the control variables in our

model, which exclude expectations of future economic activity. Future work will involve

fine-tuning the controls to screen for these emerging market countries.

Finally, we narrow the list of the most extreme 206 pairs to those 25 foreign-

country subsidiary pairs with the highest conditional unexpected percentages. Table 5

shows that all, but four, of the 25 pairs include the same six countries heading the list in

Table 4, providing further confirmation that these are the countries with the most extreme

values. Four of the 10 more extreme pairs involve Singapore paired with a high-tax

country: Germany, France, Japan, and Australia. One involves the Netherlands with a

high-tax country, France. These pairings are consistent with tax havens being

particularly useful when paired with a high-tax country. At the same time, the top 25 list

includes Singapore paired with both the Netherlands and Hong Kong. These pairs are

consistent with routing income through multiple tax avoidance locations along the lines

of the Google triplet, which involves three countries (Ireland, the Netherlands, and

Bermuda) that are commonly recognized as key tax avoidance countries. Future work

that extends our pair analysis to triplet or greater combinations might be better able to

identify these more complex clusters.


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6. Conclusion

A vast literature that spans a half-century has explored how taxes affect the

foreign location decisions of multinational firms. An implicit assumption throughout

those papers is that multinational firms make foreign location decisions unilaterally. The

transfer pricing literature documents that multinational firms shift profits from high-tax

countries to low-tax countries using a myriad of tax planning techniques. Our study

incorporates facets of both literatures into our research setting. Specifically, we relax the

assumption that firms foreign subsidiary locations decisions are independent and

investigate whether U.S. firms locate foreign subsidiaries in pairs of countries in a

predictable and coordinated fashion for tax reasons. The tax variables we usestatutory

tax rates of the subsidiary pair, the presence of at least one tax haven country in the

subsidiary pair, and the existence of a bilateral tax treaty between the subsidiary pair

countriesreflect the capacity for a U.S. firm that clusters foreign operations to shift

profits from a high-tax country to a low-tax country.

Policymakers around the globe are evaluating how tax policies both spur

economic growth while raising sufficient revenue to meet budget needs. Tax policies and

enforcement mechanisms that fail to account for multinational firms clustering foreign

operations for tax motivated reasons may suffer revenue shortfalls. After controlling for

tax and nontax factors related to unilateral foreign location decisions as well as nontax

factors in the subsidiary pair setting, we find that mean statutory tax rates, the presence of

a tax haven, and the existence of a bilateral treaty help to explain the clusters of U.S.

firms foreign subsidiaries that we observe.


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We close by reiterating an important caveat. For tractability, we study pairs of

countries. We recognize that more complex clusters exist. Indeed the most advanced tax

avoidance strategies likely involve a web of countries that enable firms to exploit the

inconsistencies in the treatment of income across countries and the idiosyncrasies in

every countrys tax law to shop for treaties and shift income to low-tax countries. By

limiting ourselves to pairs, we may be only glimpsing the intricacies of international tax

planning and understating the importance of clusters in tax avoidance. Nonetheless, we

find enough evidence in this simple analysis to suggest that multinationals consider their

portfolio of location options when expanding abroad.


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References

Altshuler, R., H. Grubert and T.S. Newlon, 2001. Has US investment abroad becomemore sensitive to tax rates? in J.R. Hines ed.International Taxation andMultinational Activity, Chicago: University of Chicago Press.

Barrios, Salvador, Harry Huizinga, Luc Laeven, and Gaetan Nicodeme, 2010.International taxation and multinational firm location decisions. TilburgUniversity working paper, March 19.

Blanco, Luisa and Cynthia Rogers, 2008. Competition between tax havens: Doesgeographic distribution matter? Pepperdine University working paper,November 11.

Bond, Eric and Larry Samuelson, 1986. Tax holidays as signals. American EconomicReview, 76, 820-826.

Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr., 2006a. Do tax havens diverteconomic activity? Economics Letters, 90, 219-224.

Desai, Mihir A., C. Fritz Foley, and James R. Hines Jr., 2006b. The demand for taxhaven operations. Journal of Public Economics, 90, 513-531.

Desai, M.A., C.F. Foley and J.R. Hines, 2004. Foreign direct investment in a world ofmultiple taxes,Journal of Public Economics 88, 2727-2744.

Devereux, Michael P., 2007. The impact of taxation on the location of capital, firms andprofit: A survey of empirical evidence, Oxford University Centre for BusinessTaxation working paper 07/02.

Dyreng, Scott and Bradley Lindsey, 2009. Using financial accounting data to examinethe effect of foreign operations located in tax havens and other countries on U.S.multinational firms' tax rates. Journal of Accounting Research, 47, 1283-1316.

Graham, John, Jana Raedy and Douglas Shackelford, 2011. Research in accounting forincome taxes. University of North Carolina working paper.

Gravelle, Jane, 2009. Tax Havens: International tax avoidance and evasion.Congressional Research Service working paper, July 9.

Grubert, Harry and John Mutti, 2000. Do taxes influence where U.S. corporationsinvest? National Tax Journal, 53, 825-839.

Hanlon, Michelle, 2003. What can we infer about a firms taxable income from itsfinancial statements?National Tax Journal, 56, 831-863.


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Kogut, Bruce and Harbir Singh, 1988. The effect of national culture on choice of entrymode.Journal of International Business Studies, 19, 411-432.

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Appendix

U.S. Taxation of Multinationals

When U.S. firms locate a subsidiary in a foreign country, the multinational firm

may be subject to a wide array of taxes. First, foreign subsidiaries must comply with the

corporate tax rules in the foreign or host country in which it operates, including paying

income taxes on any profits earned in the foreign jurisdiction. In addition, when

dividends are remitted by the foreign subsidiary to its owners (other higher-tier

subsidiaries or the multinational firm parent company), the foreign subsidiary may be

subject to a dividend withholding tax by the host country. After complying with all taxes

in the host country, the U.S. firm also may be subject to tax in the country of the higher-

tier subsidiary or parent company that receives the dividend. Whether and how dividend

income is taxed by the subsidiary or parent company that receives it depends on whether

the subsidiary or parent company country uses a worldwide or territorial system for

taxing foreign profits.

The United States uses a worldwide system (also known as a credit system) for

taxing the earnings of the foreign subsidiaries of its U.S. firms. The underlying premise

of the worldwide system is that the parent should pay the same amount of tax (the sum of

foreign and domestic) that would be paid if the income were earned domestically,

regardless of where the income is earned. Consider the case of a parent owning two

foreign subsidiaries, H and L, where Hs (Ls) tax rate is higher (lower) than the U.S.

statutory tax rate. When H pays a dividend to the parent, the parent does not pay any

domestic tax on the dividend since the amount of foreign tax on the income already

exceeds the amount of tax that would have been paid had the income been earned in the


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parent country. When L pays a dividend to the parent, the parent includes the income

(not the dividend) in its domestic taxable income. The parent then reduces its U.S. tax

payable by the amount of the foreign tax that was paid. At this point, the total amount of

tax paid on the foreign income is higher than what would have been paid if the income all

had been earned in the parent country (Ls was taxed at the parents rate, but Hs was

taxed at a rate higher than the parents). Cross-crediting allows the parent to reduce the

amount of domestic tax payable on the earnings of L by the amount by which the tax paid

in Hs country exceeds that which would have been paid if the income had been earned in

the parent country.

11

An important component of the worldwide system is that the parent is not liable

for U.S. tax on its foreign earnings until the dividend is received from the subsidiary. As

discussed by Desai et al. (2006b), this principle, commonly referred to as deferral, can

provide incentive for U.S. firms to use tax havens even when their average foreign tax

rate is lower than the U.S. corporate tax rate. If the dividend is paid by the foreign

subsidiary to a higher-tier foreign subsidiary owner that follows a worldwide system,

rules similar to the ones described about the United States would be followed including

the benefits of deferring any incremental tax until the dividend is received.

In contrast to the worldwide system of taxation, if the foreign subsidiary pays a

dividend to a higher-tier foreign subsidiary owner that follows a territorial tax system,

generally no incremental tax is paid on the foreign profits in the parent country when the

dividend is received. In some cases, countries that follow a territorial tax system place

restrictions on exempting the dividend from taxation if the foreign profits are earned in

tax havens or other low-tax jurisdictions to mitigate any potential abuses.

11Cross-crediting is limited to the amount of domestic tax paid on the earnings of L.


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Table 1 Descriptive Statistics

This table presents summary statistics of the regression variables. _is the unexpected percentage of firms in both iandj._is thandj. _is the expected percentage of firms in both iandj under an assumption of independence of choices._is the mean of from country to the U.S. and the withholding tax rate on dividends from country to the U.S., expressed as a percentage of $1 of pretax fomean of the total tax (foreign and domestic) rates paid on foreign income earned in iandjand repatriated to the parent, expressed as a perce

_is the mean of the residual U.S. income tax rate on income earned in country and the residual U.S. income tax rate on in

Variable Description MEAN STD MIN P

U_PCT Unexpected

Percentage

of

Firms

with

this

Pair 1.50 1.95 (0.06) 0

A_PCT ActualPercentageofFirmswiththisPair 2.32 3.47 0

E_PCT ExpectedPercentageofFirmswiththisPair 0.82 1.69 0.00 0

PAR_WH Meanoftwowithholdingratestopa rent 0.06 0.05 0

PAR_EFFTAX Meanoftwoefftaxratestopa rent 0.41 0.04 0.39 0

PAR_HOMETAX Meanoftwohometaxratestopa rent 0.13 0.09 0

HOSTTAX MeanofthetwoHOSTTAXratesinpa ir 0.24 0.07 0

DIVWH Meanofthetwodivwhratesinpa ir 0.06 0.05 0

HAVEN1 Atleastoneofthepa irisa TaxHaven 0.33 0.47

TREATY Thereis

atreaty

between

the

pa ir 0.32 0.47

OECD2 BothinPairareinOECD 0.09 0.29

TRADE LogofBilateralTrade (2.95) 3.59 (19.34) (5

CONTIG CountriesareContiguous 0.02 0.15

COMLANG CommonOfficial Language 0.13 0.33

DISTANCE LogofDistance 1.78 0.84 (2.03) 1

RELIGION BothCountriesHaveSameMajorityReligion 0.20 0.40

LEGOR EachCountryHa sSameLegalOrigin 0.31 0.46


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a percentage of $1 of pretax foreign income. is the mean of the statutory corporate income tax rate in country and the statutoryis the mean of the withholding tax rate on dividends paid from country to countryand the withholding tax rate on dividends paias a percentage of $1 of pretax foreign income. 1is an indicator variable equal to 1 if at least one of country and countryare taxindicator variable equal to 1 if there is a bilateral tax treaty between country and countryin effect; 0 otherwise. 2is an indicator vmembers of the OECD; 0 otherwise. is the natural logarithm of the bilateral trade between iandj, in millions of U.S. dollars.

iandjshare a border; 0 otherwise. is an indicator variable equal to 1 if iandjhave the same official language; 0 otherwise. distance between the centers of commerce of iandj, in kilometers. is an indicator variable equal to 1 if iandjhave the same man indicator variable equal to 1 if iandjhave the same legal origin; 0 otherwise.


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Table 2 Correlations

This table presents the Pearson (Spearman) correlations above (below) the diagonal of the regression variables. _is the unexpected pe

_is the mean of the withholding tax rate on dividends from country to the U.S. and the withholding tax rate on dividends from copercentage of $1 of pretax foreign income. _is the mean of the total tax (foreign and domestic) rates paid on foreign income eparent, expressed as a percentage of $1 of pretax foreign income. _is the mean of the residual U.S. income tax rate on incoU.S. income tax rate on income earned in country , expressed as a percentage of $1 of pretax foreign income. is the mean of thcountry and the statutory corporate income tax rate in country. is the mean of the withholding tax rate on dividends paid from cwithholding tax rate on dividends paid from countryto country , expressed as a percentage of $1 of pretax foreign income. 1is a

U_

PCT

PAR_

WH

PAR_

EFF

TAX

PAR_

HO

METAX

HOSTTAX

DIVWH

HAVEN1

TREATY

OECD2

TRADE

CONTIG

U_PCT 0.17* 0.21* 0 .1 9* 0 .1 9* 0.22* 0.04 0.45* 0.52* 0.56* 0.14

PAR_WH 0.24* 0.10* 0 .5 0* 0 .2 1* 0 .6 1* 0.09* 0.09* 0.05 0.09* 0.02

PAR_EFFTAX 0.36* 0.36* 0.37 0.10* 0.12* 0.13 0.20* 0.13* 0.11* 0.01

PAR_HOMETAX 0.11* 0.54* 0.03 0.81* 0 .2 8* 0 .3 4* 0.16* 0.13* 0.17* 0.00

HOSTTAX 0 .1 1* 0.2 0* 0 .24 * 0.80* 0.13* 0.31* 0.13* 0.11* 0.19* 0.00

DIVWH 0 .2 4* 0.6 3* 0 .31 * 0 .3 0* 0 .1 2* 0.02 0.33* 0.18* 0.16* 0.08

HAVEN1 0.02 0.13* 0.00 0.33* 0.29* 0.03 0.18* 0.08* 0.20* 0 .0 4

TREATY 0.40*

0.06*

0.21*

0 .1 3* 0 .1 1*

0.34*

0.18* 0.42* 0.52* 0.09

OECD2 0.39* 0.02 0.13* 0 .1 0* 0 .0 9* 0.20* 0.08* 0.42* 0.35* 0.11

TRADE 0.60* 0.08* 0.15* 0 .1 4* 0 .1 6* 0.20* 0.20* 0.56* 0.37* 0.20

CONTIG 0.11* 0.02 0.04 0.01 0.00 0.09* 0.04* 0.09* 0.11* 0.21*

COMLANG 0.03* 0.01 0.04 0 .0 7* 0 .0 8* 0 .0 6* 0 .1 3* 0.02 0.04* 0.00 0.15

DISTANCE 0 .0 4* 0.0 7* 0 .09 0 .1 3* 0 .1 2* 0 .2 0* 0.02 0.33* 0.20* 0.31* 0.23

RELIGION 0.08* 0.03 0.02 0.03 0.06* 0.00 0.06* 0.04* 0.06* 0.05* 0.15

LEGOR 0.01 0.03* 0.06* 0 .0 6* 0 .0 8* 0 .0 6* 0 .0 2 0.05* 0.04* 0.01 0.11


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one of country and countryare tax havens; 0 otherwise. is an indicator variable equal to 1 if there is a bilateral tax treaty betweotherwise. 2is an indicator variable equal to 1 if both iandjare members of the OECD; 0 otherwise. is the natural logarithmin millions of U.S. dollars. is an indicator variable equal to 1 if iandjshare a border; 0 otherwise. is an indicator variofficial language; 0 otherwise. is the natural logarithm of the distance between the centers of commerce of iandj, in kilometerequal to 1 if iandjhave the same majority religion; 0 otherwise. is an indicator variable equal to 1 if iandjhave the same legal ori

* indicates statistical significance at the 5percent level.


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Table 3 Main Results

_ _ 1 2

This table reports OLS estimates of Equation (4). Dependent variable is the unexpected percentage of firms in both iandj(_). _is the medividends from country to the U.S. and the withholding tax rate on dividends from country to the U.S., expressed as a percentage of $1 o

N 4,136 4,136 4,136 4,136 4,136 4,136

ADJRSQUARE 0.48

0.50

0.50

0.48

0.48

0.50

INTERCEPT 0.92** 1.16** 2.99** 0.98** 0.80** 1.11** 0

PAR_WH . 5.72** . . . .

PAR_EFFTAX . . 5.03** . . .

PAR_HOMETAX . . . 0.40 . .

HOSTTAX . . . . 0.56* .

DIVWH . . . . . 5.41**

HAVEN1 . . . . . . 0

TREATY . . . . . .

OECD2 2.80** 2.80** 2.72** 2.78** 2.79** 2.69** 2

TRADE 0.26** 0.26** 0.26** 0.26** 0.26** 0.26** 0

CONTIG 0.96** 1.01** 0.96** 0.96** 0.96** 0.99** 1

COMLANG 0.37** 0.36** 0.36** 0.37** 0.37** 0.35** 0

DISTANCE 0.57** 0.60** 0.56** 0.56** 0.56** 0.63** 0

RELIGION 0.24** 0.25** 0.25** 0.23** 0.23** 0.30** 0

LEGOR 0.09 0.06 0.07 0.09 0.09 0.13** 0

(6) (1) (2) (3) (4) (5)


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is the mean of the total tax (foreign and domestic) rates paid on foreign income earned in iandjand repatriated to the parent, expressed as a

income. _is the mean of the residual U.S. income tax rate on income earned in country and the residual U.S. income tax rexpressed as a percentage of $1 of pretax foreign income. is the mean of the statutory corporate income tax rate in country andin country. is the mean of the withholding tax rate on dividends paid from country to countryand the withholding tax rate on country , expressed as a percentage of $1 of pretax foreign income. 1is an indicator variable equal to 1 if at least one of country

otherwise. is an indicator variable equal to 1 if there is a bilateral tax treaty between country and countryin effect; 0 otherwiseto 1 if both iandjare members of the OECD; 0 otherwise. is the natural logarithm of the bilateral trade between iandj, in millionsindicator variable equal to 1 if iandjshare a border; 0 otherwise. is an indicator variable equal to 1 if iandjhave the same offiis the natural logarithm of the distance between the centers of commerce of iandj, in kilometers. is an indicator variable equal religion; 0 otherwise. is an indicator variable equal to 1 if iandjhave the same legal origin; 0 otherwise.

* and ** indicate statistical significance at the 5percent and 1percent levels, respectively.


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Table 4 Most frequent countries

This table reports the number of times each of the listed countries appears in a pair which is in the top 5percent ofcountry-pairs when sorted by the conditional unexpected percentage. To calculate conditional unexpected percentage,we estimate Equation (4) without the tax variables on the full sample. Pairijs Conditional unexpected percentage is theresidual of the country-pair that comes out of this regression.

2

The 38 countries listed are the only ones (of the 92 in the full sample) that appear in pairs in the top 5percent (206pairs) of this measure.

Country Numberoftimesinapair

intheTop5%

of

ConditionalUnexpectedPercentage

Inpercentageterms

(206pairsinTop5%)

Country Numberoftimesinapair

intheTop5%

of

ConditionalUnexpectedPercentage

Inpercentageterms

(206pairsinTop5%)

1 BRAZIL 31 15% 20 BELGIUM 9 4%

2 INDIA 27 13% 21 CANADA 9 4%

3 SINGAPORE 25 12% 22 UNITEDKINGDOM 9 4%

4 CHINA 23 11% 23 SOUTHKOREA 8 4%

5 HONGKONG 21 10% 24 IRELAND 7 3%

6 NETHERLANDS 20 10% 25 CAYMANISLANDS 6 3%

7 ITALY 19 9% 26 SOUTHAFRICA 6 3%

8 SPAIN 18 9% 27 POLAND 6 3%

9 FRANCE 17 8% 28 LUXEMBOURG 5 2%

10 AUSTRALIA 16 8% 29 CZECHREPUBLIC 3 1%

11 GERMANY 15 7% 30 HUNGARY 3 1%

12 MALAYSIA 15 7% 3 1 AUSTRIA 2 1%

13 THAILAND 14 7% 32 CHILE 2 1%

14 MEXICO 14 7% 33 NEWZEALAND 2 1%

15 BERMUDA 12 6% 34 BOLIVIA 1 0%

16 JAPAN 12 6% 3 5 NICARAGUA 1 0%

17 ARGENTINA 11 5% 36 COLOMBIA 1 0%

18 SWITZERLAND 10 5% 37 VENEZUELA 1 0%

19 SWEDEN 10 5% 38 DENMARK 1 0%


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Table 5 25 most frequent pairs

This table reports the 25 countries with the highest conditional unexpected percentages. To calculate conditionalunexpected percentage, we estimate Equation (4) without the tax variables on the full sample. Pairijs Conditionalunexpected percentage is the residual of the country-pair that comes out of this regression.

2

GERMANY FRANCE 8.6

CHINA JAPAN 7.2

GERMANY SINGAPORE 7.2

FRANCE SINGAPORE 7.1

JAPAN SINGAPORE 7.1

GERMANY ITALY 7.0

FRANCE NETHERLANDS 6.9

NETHERLANDS SINGAPORE 6.9

BRAZIL MEXICO 6.8

AUSTRALIA SINGAPORE 6.7

CHINA GERMANY 6.7

AUSTRALIA BRAZIL 6.5

CHINA FRANCE 6.5

FRANCE ITALY 6.4

BRAZIL ITALY 6.3

ITALY SINGAPORE 6.3

BRAZIL NETHERLANDS 6.3

SPAIN ITALY 6.2

INDIA SINGAPORE 6.1

HONGKONG S INGAPORE 6.1

BRAZIL SPAIN 6.1

GERMANY NETHERLANDS 6.1

GERMANY INDIA 6.0

CHINA SINGAPORE 6.0

HONGKONG JAPAN 6.0

Conditional

unexpected

percentage

taxes and the clustering of foreign subsidiaries

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