Article: Monday, 25 March 2024
We know too little about how international taxation affects the way that multinational corporations create new foreign affiliates to carry out cross-border economic activities. They have two options: corporate subsidiaries or non-corporate flow-throughs (the legal entities that pass income straight to owners, shareholders or investors). So investigating the factors that influence that choice is important because these are the activities that stimulate economic growth and development. But such corporations can also exploit differences between tax systems and shift income to low-tax jurisdictions. Responses to tax law changes, and whether the characteristics of new foreign affiliates vary according to the organisational form they take was researched by Dr Harald Amberger of WU Vienna, and Dr Saskia Kohlhase of Rotterdam School of Management, Erasmus University (RSM). What they found suggests that the choice can shape the future characteristics of investments abroad.
Dr Harald Amberger and Dr Saskia Kohlhase investigated the relationship between international taxation and the form of foreign direct investment chosen by multinationals. They used micro-level data on inbound foreign direct investment relations in Germany. “We found that a higher tax burden on income earned in a corporate subsidiary increases the probability that a foreign investment is conducted via a non-corporate flow-through, the sort of entity that passes income directly to stakeholders or shareholders,” explained Dr Kohlhase. “The tax effect matters less for firms engaging more in tax-motivated income shifting, and for whom limited liability and legal independence as non-tax benefits are important.”
The effect varies according to how important it is for the corporation to shift its income, the size of the subsidiary’s non-tax benefits of limited liability and legal independence, and the corporation’s local knowledge.
“Affiliate entities that were established as flow-throughs show a lower propensity for losses and are less profitable than affiliates that are established as subsidiaries."
“Altogether, our findings can be helpful for policymakers because they indicate the potential responses of multinational corporations to changes in tax laws. Our findings suggest that the form that corporations choose can shape the future characteristics of investments abroad."
The researchers carried out empirical analyses on foreign direct investment (FDI) relations between 2005–2013 using company-level data provided by the German Federal Bank, which told them which organisational form companies had chosen. This information is unavailable in conventional datasets. They looked at 2,175 decisions on the creation of new foreign affiliates made by investing entities located in 59 countries. These decisions accounted for more than 99 per cent of all inbound FDI relations in the MiDi database.
Dr Amberger and Dr Kohlhase showed that when there’s a higher tax burden on income earned in a corporate subsidiary, multinational corporations more often choose to use a non-corporate flow-through to enter a foreign market. They also found that the organisational form chosen affects the future characteristics of the newly established foreign affiliate.
“These findings highlight that the behaviour of multinational enterprises is affected by differences in the taxation of organisational forms,” commented Dr Kohlhase.
“Businesses should carefully consider the costs and benefits of their organisational forms. For example, because flow-through organisational forms don’t offer limited liability, our results suggest that foreign affiliates established as a flow-through have a lower probability of incurring a loss and exhibit lower profitability. If businesses don’t plan to set up intellectual property and loan contracts with the foreign affiliate, then they should consider choosing a flow-through organisational form for their cross-border investment.”
In documenting the economically meaningful effect of international taxation on how multinational corporations choose to organise their foreign affiliates, the researchers can suggest these decisions are sensitive to changes in tax law. Recent proposals to reform the international tax system with the OECD's BEPS Action plan or the Two-Pillar Solution consider withholding taxes as a way to combat tax-base erosion (OECD, 2013, 2021). “Our results indicate that to be effective, such policies must be implemented uniformly across all organisational forms,” they say.
Their findings were published in their paper, International taxation and the organizational form of foreign direct investment in the Journal of International Business Studies.
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Rotterdam School of Management, Erasmus University (RSM) is one of Europe’s top-ranked business schools. RSM provides ground-breaking research and education furthering excellence in all aspects of management and is based in the international port city of Rotterdam – a vital nexus of business, logistics and trade. RSM’s primary focus is on developing business leaders with international careers who can become a force for positive change by carrying their innovative mindset into a sustainable future. Our first-class range of bachelor, master, MBA, PhD and executive programmes encourage them to become to become critical, creative, caring and collaborative thinkers and doers.
