Mitigating Double Taxation in an Open Economy

Transcription

1 Mitigating ouble Taxation in an Open Economy Tobias Linhe This version: February 2001 Abstract The interaction o various methos o mitigating economic an international ouble taxation o corporate source income is stuie within a stanar neoclassical moel o irm behavior. The main purpose is to etermine to what extent methos eective in mitigating economic ouble taxation in a close economy remain useul in an open economy where the irm s marginal investor is a oreigner. While a cut in the statutory corporate tax rate invariably reuces the cost o capital, the impact o the imputation an split rate systems is shown to epen on whether the creit or exemption metho is use in mitigating international ouble taxation, an the precise esign o these methos. Keywors: Corporate Taxation, ouble Taxation, Cost o Capital, Open Economy JEL classiication: G32, H25, H32 I am oblige to Jan Söersten or valuable iscussions an helpul comments. I am also thankul to Hovick Shahnazarian an seminar participants at the Ministry o Finance, Sween. epartment o Economics, Uppsala University, Box 513, S Uppsala, Sween. Tobias.Linhe@nek.uu.se. Phone: Fax:

2 1 Introuction The interaction o various methos o mitigating economic an international ouble taxation o corporate income is analyze in orer to unerstan how these interact in an open economy. The interaction is moele by letting a omestic subsiiary istribute iviens to a oreign parent corporation. O special interest is to inquire into how ierent methos eective in mitigating economic ouble taxation in a close economy remain useul, in the meaning o aecting the cost o capital, in an open economy where the marginal investor is a oreigner. The analysis is carrie out in a stanar neoclassical moel where the eects o the methos are evaluate base on the cost o capital. The economic ouble taxation (ET o corporate income reers to the act that income is irst taxe at the corporate level when it arises an then taxe a secon time at the shareholer level when it is istribute. Most o the countries within the European Union integrate the corporate an shareholer taxation an a variety o methos have been employe. Some o them are trivial in the sense that they amount to reuce one o the nominal tax rates involve, i.e. the corporate tax rate or the shareholers tax rates on iviens or capital gains, or allowing the corporations to accelerate epreciation allowances. Other methos are more complicate, such as the imputation system at the shareholer level, the split rate system an ivien euctions at the corporate level. In the EU Finlan, France, Germany, Italy an the Unite Kingom have a ull or partial imputation system. A couple o countries use special personal tax rates on iviens, e.g. Austria, Belgium, enmark an Greece. Sween uses a metho base on a tax-ree allocation o a raction o the corporate income. Outsie the EU, the Unite States stays with the so-calle classical system, where the corporate an shareholer taxes are not integrate, while Norway has an imputation system. The international ouble taxation (IT ollows also rom the act that the corporate income is taxe twice, but this time in ierent countries. There are two major methos use by the OEC countries to treat the international ouble taxation; the metho o tax exemption an the metho o tax creit. Even though most tax treaties between the OEC countries are base on the OEC Moel Convention 1 all treaties have special rules an ierent einitions 1 See e.g. Moel Tax Convention on Income an on Capital (OEC, 1996, which comments the articles in the Moel Convention. The comments on articles 23A an 23B iscuss the exemption an creit metho. 1

3 that aect the general methos o exemption an creit. Uner the tax exemption the oreign parent is allowe to exempt the iviens istribute rom the omestic subsiiary beore calculating its tax liability. Following countries use some orm o exemption: 2 Australia, Austria, Belgium, Canaa, enmark, Finlan, France, Germany, Luxembourg, the Netherlans, Sween an Switzerlan. 3 Accoring to the tax creit metho, the oreign parent is allowe to creit the amount o tax - corporate income tax an withholing tax - alreay pai by the subsiiary in the omestic country when iviens are istribute. The amount o tax pai in the subsiiary is creit against the amount o tax that woul have been pai by the parent i the income ha been generate in the oreign corporation. Hence, an aitional tax is impose on the oreign parent i the amount o tax pai in the omestic subsiiary is to low. The creit may be allowe on a worlwie basis (aggregate income rom all subsiiaries or on a source basis (country by country or type o income. Following countries allow the parent corporation to use the tax creit metho on a worlwie basis: 4 Icelan, Japan, the Unite States; an ollowing on a source basis: Greece, Irelan, Italy, New Zealan, Norway, Portugal, Spain, Turkey, an the Unite Kingom. Methos o mitigating ET have been analyze an iscusse in many ierent contexts over the years uner the assumption o a close economy. This paper ocuses on two o the most common techniques; the imputation system an the split rate system. When corporations are assume to operate in an open economy the methos o mitigating IT must also be consiere. The interaction between the imputation an the split rate systems on one han an the methos o tax exemption an tax creit on the other are analyze. Many technical aspects are surrouning these methos, but I will keep them in very general terms or simplicity. The characteristic o each metho an their interaction is nevertheless clearly illustrate. The terminology o a close economy an an open economy in this paper alls back on i a omestic or oreign investor equates the non-arbitrage conition that must hol or a capital market in equilibrium. 5 It says, in short, that the return rom investing in bons must be equal to the return rom investing in shares or the marginal shareholer. I the non-arbitrage 2 This is base on OEC (1991 an assumes a 100 percent ownership between the parent an the subsiiary corporation. 3 It may also be the case that a country, e.g. Sween, uses one o the methos in one treaty, while they use the other metho in another treaty. 4 Accoring to OEC (

4 conition hols or a omestic investor, i.e. the investor invests both in bons an shares, the marginal shareholer is omestic an the economy is enote close. An economy is sai to be open whenever the marginal shareholer is oreign, i.e. the oreign investor equates the non-arbitrage conition. 6 Boaway an Bruce (1992 argue that the methos o mitigating ET at the shareholer level (personal ivien tax creit in their moel woul have no eect in the open economy. The reason or this is that the ivien tax creit at the personal level is typical a resience base tax, implying that the oreign marginal shareholer is not inclue in the relie. The main point in evereux an Freeman (1995, who extene the paper o Boaway an Bruce, is that the eect o introucing any metho at the shareholer level in an open economy really epens on how the methos are esigne an i the marginal shareholer is omestic or oreign, which they illustrate in a very simple an stylize moel. I will exten the analysis o evereux an Freeman by explicitly eriving a moel or speciic methos o mitigating ET an IT an, thereby, have the possibility to analyze what etermine the cost o capital an how the methos interact. Following this chapter, the cost o capital an the methos o mitigating ET are erive in chapter 2 uner the assumption o an open economy. In chapter 3 the methos o mitigating IT are introuce in the moel. It contains urther the analysis o the interaction between the methos. Chapter 4 summarizes an conclues. 2 The cost o capital in an open economy 2.1 Introuction The cost o capital will be erive in a general moel illustrating the classical system, the imputation system an the split rate system. This kin o moel have been erive an iscusse in a close economy context, among others, by King (1974, Auerbach (1983 an Poterba an Summers (1985 in a iscrete time set up an by Bergström an Söersten (1981 in continues time. I will instea assume that the economy is open, implying that the marginal 5 The non-arbitrage conition will be ormulate algebraic in chapter 2, equation (7. 6 There is in principal nothing saying that the marginal shareholer coul not be omestic in an open economy. However, or simpliication o the terminology the term open is use as synonymous with oreign marginal shareholer an the term close synonymous with omestic marginal shareholer. 3

5 shareholer may be oreign. This is moele by letting a oreign corporation (the parent o its business through a wholly owne omestic corporation (the subsiiary that operates in an open economy. This implies that the marginal shareholer in the subsiiary automatically is oreign. 7 The subsiiary is perorming its business uner the omestic government s laws, tax coe an accounting rules. In other wors, the subsiiary is a true omestic corporation with a oreign owner. In eriving the subsiiary s cost o capital I will irst set up inancial an legal constraints that escribe the subsiiary together with constraints ue to the split rate an imputation systems. Out o the non-arbitrage conition that must hol in equilibrium or the parent s investment alternatives ollows the subsiiary s market value, which will be maximize with respect to the constraints. These steps are outline below an give the cost o capital uner two regimes, the retention regime an the new share issue regime Corporate constraints an the regimes The most unamental constraint is the cash low constraint that in principle restricts the amount o iviens that can be istribute; 9 F ( K + N = + I + T, (1 where ( FK is the prouction unction 10, I is gross investment an T is the amount o tax pai by the subsiiary. The amount o new share issues N is in terms o the oreign parent since only it can contribute with more capital, while F ( K,, I an T are in terms o the omestic subsiiary. The split rate system is a metho at the corporate level an, hence, it aects the cash low constraint (1. Accoring to the split rate system, see e.g. Söersten (1977, two ierent omestic tax rates exist on the subsiiary s income; ist i the income is istribute to the 7 It oes not matter or the iscussion i the corporation in the omestic country is a wholly owne subsiiary or not. It may very well be the case that the omestic corporation has both omestic an oreign owner, but the important thing is that the marginal shareholer is oreign. 8 The retention regime correspons with the ol, or traitional, view o ivien taxation an the new share issue regime correspons with the new view o ivien taxation. 9 ebts may be exclue rom the moel without any loss o generality. 10 The output price is set to unity implying that the prouction unction represents the subsiiary s gross earnings. The prouction unction is assume to exhibit positive but iminishing marginal prouct, F K > 0 an F KK < 0, which guarantees an optimal solution to the optimization problem. 4

6 parent an i the income is retaine in the subsiiary. The tax rate on istribute income is smaller than on retaine income since the purpose is to reuce the ET. It is eliminate totally when ist = 0. iviens are eine ater corporate tax implying that is the 1 ist istribute income beore omestic tax, which, in turn, means that ist 1 ist is the amount o tax the subsiiary pays on the istribute income. The amount o taxable income not istribute to the parent is retaine in the subsiiary, i.e. F( K δ K, where δ is 1 the economic epreciation rate o the capital stock. The tax liability in the subsiiary equals T = ist + F K K δ 1 ist 1 the sum o taxes, i.e. ( ist ist. The split rate system is moele by substituting the expression or T into the cash low constraint (1, which gives the subsiiary s buget constraint as; 1 = F K + N I + K 1 ist ( 1 ist ( ( δ. (2 Since the imputation system is a metho at the shareholer level it oes not aect the cash low within the subsiiary. An imputation system can be seen as the omestic government increases the amount o iviens istribute. I φ is the rate o imputation, the omestic government as 1 φ φ or every unit o income the subsiiary istributes. I is istribute, the omestic shareholers receive an amount, beore personal tax, o ; φ = φ =. (3 1 φ I the shareholers are allowe to creit the whole amount o the subsiiary s tax, i.e. φ =, the shareholers receive ull creit or the amount o tax pai by the subsiiary an, hence, the ET is eliminate. I φ is less than, the shareholers are only allowe to creit a raction o the corporate tax implying a reuce, but not eliminate, ouble taxation. 5

7 The subsiiary belongs to one o two regimes epening on how the marginal investment is inance. The buget constraint (2 can be rewritten as I RE N = +, where RE is the retaine earnings in the subsiiary. 11 Hence, the subsiiary has two sources o inancing at the margin; retaine earnings or new share issues. I will put a restriction on the amount o income istribute in orer to illustrate the two ierent regimes. Following Auerbach (1984 the corporations must istribute iviens an, at least, meet a minimum ivien payout ratio; ( 1 ist ( ( δ F K K. (4 The constraint says that the iviens may not all below a raction o the ater-tax income. The two ierent regimes are istinguishe epening on how the marginal investment is inance. In the retention regime, the iviens are greater than the ivien loor in (4. The subsiiary has the possibility to reuce the iviens, i.e. increase RE, an still meet the minimum payout ratio, implying that the marginal investment is inance with retaine earnings. In contrast, the marginal investment is inance with new share issues in the new share issue regime where the ivien constraint (4 is bining. This is because the amount o retaine earnings is exhauste an becomes ixe. Accoring to investment must be inance with new share issues. = +, the marginal ix I RE N The subsiiary is only allowe to istribute income to the parent through iviens. The parent is particularly not allowe to repurchase its own shares, moele as; N 0. (5 Further, the subsiiary is not allowe to accelerate the epreciation o the capital stock. This implies that the capital stock an the book capital stock are equal in the moel. As a result, it is only one equation o motion, which shows how the capital stock changes over time ue to investments an economic epreciation; K = I δ K. (6 11 The retaine earnings become ( 1 ( 1 RE = F K + δk. 1 ist 6

8 2.3 The cost o capital A capital market is in equilibrium when the marginal investor is inierent between an investment in bons at the rate i, with the return given on the let han sie, an shares, with the return given on the right han sie o the non-arbitrage conition; t ( 1 ( ( 0 i Vt = κ c V t N 0 t. (7 0 1 φ The marginal shareholer is assume to be the oreign parent corporation an not the shareholers o the parent, see e.g. Sinn (1993. In (7, V t is the value o the subsiiary, V 0 t is 0 t 0 the change in the value, an is the actual amount o iviens that woul have reache 1 φ omestic shareholers uner the imputation system accoring to (3; all at time t 0. But the marginal investor is a oreigner an the parameter κ captures the eect o ierent methos o mitigating IT an how these methos are esigne. 12 Since the oreign parent is the only owner o the subsiiary the marginal shareholer is automatically oreign, implying that the tax rates in the non-arbitrage conition (7 belongs to the oreign parent. oreign corporate tax rates on interest income an capital gains, respectively. an c are the Solving (7 orwar gives the market value o the subsiiary in the omestic country as; 1 i ( t t κ 0 1 c Vt = t N t e t. (8 t= t ( 1 ( 1 0 c φ V t equals the present value o the net cash low to the parent, i.e. ajuste iviens minus the capital contribution through new share issues. The problem o maximizing the market value o 12 When no metho is employe or mitigating IT the parameter becomes κ = 1, which is the most common 1 1 φ when the subsiiary interpretation in the literature. This implies that the parent receives ( ( istributes an the omestic government as φ ( 1 φ rate system is incorporate in through the buget constraint (2. accoring to the imputation system. Note that the split 7

9 the subsiiary given in (8 uner the constraints (2, (4, (5 an (6 is ormalize as (inex t is omitte; where Λ( = κ 1 i 1 c Max ( = Λ(,,,, ; t= t0 ( t t0 V K K K I N t e t, ( 1 c ( 1 φ N 1 ist + µ ( 1 ist F ( K + ( N I + δk 1 ( ( ( + η 1 ist F K δk + η NN + µ K I δk K. Assuming a steay state solution, the necessary an suicient irst orer conitions with respect to I, N, an K are given by; 13 I: N : : 1 ist µ µ K 0 + =, 1 1 ist 1+ µ ηn 0 + =, 1 κ µ η 0 φ + =, ( 1 c ( 1 1 µ η ist FK K µ K δ + i 1 c K: ( ( 1 ( 1 ist + η ( 1 ist δ + µ δ = 0 1. The cost o capital is the lowest acceptable rate o return on a new investment an is equate to the irst erivative o the prouction unction with respect to the capital stock, F K ( K. The cost o capital net o economic epreciation, i.e. ρ = F ( K δ, in the retention regime (RR an the new share issue regime (NSIR become; K 13 See appenix or etails. 8

10 an ρ ρ RR NSIR = ( 1 i ( 1 ( 1 c = ( 1 i ( 1 ( 1 ( 1 c + κ ( 1 ist (9 1. (10 1 φ From (9 it is clear that neither the imputation nor the split rate system aect the cost o capital in the retention regime. This is explaine by the act that any aitional cash low generate by the marginal investment in the subsiiary is istribute to the parent. It cannot be use to reuce the amount o the new share issues since it alreay equals zero. Hence, the less expensive source o inancing is alreay use, which implies that the cost o capital is unaecte. One can also conclue that the methos o mitigating IT, capture by κ, have no eect on the cost o capital in the omestic subsiiary. The intuition o this ining ollows also rom the act that the subsiiary alreay uses the less expensive source o inancing. The cost o capital is unaecte to whom, omestic or oreign, the iviens are istribute. A irst comparison o the costs in the two regimes, (9 an (10 makes it clear that the cost is not the same in all corporations. It epens on how the marginal investment is inance. A more comprehensive comparison is postpone to chapter 3 where κ is eine. A urther result concerns the eect o the omestic corporate tax rate,, in a small open economy. Apprehension has been raise that the omestic corporate tax rate plays no role in etermining the cost o capital in a omestic corporation (the subsiiary when the marginal shareholer is oreign (the parent. But, as shown in (9 an (10, this apprehension is wrong. The omestic corporate tax rate oes aect the cost in both the retention an the new share issue regime in open economies. Moreover, the result hols inepenent o which metho that is use or mitigating IT an how it is esigne. 3 The interaction between methos o mitigating ET an IT 3.1 Introuction I next ocus on the methos o mitigating IT; tax creit an tax exemption. The parameter κ will take ierent values epening on which metho that is use an how it is esigne. 9

11 Accoring to the non-arbitrage conition (7 the amount o iviens the oreign parent receives rom the omestic subsiiary is; = κ 1 φ. (11 When no metho is employe or mitigating IT the amount o iviens istribute rom the subsiiary to the parent will be taxe at the oreign corporate tax rate, implying that κ = 1. Ater eriving κ or the ierent methos ollows the analysis o how the methos o mitigating ET remains useul in an open economy. Out o the analysis ollows also what actors that etermine the cost o capital. 3.2 The methos or mitigating international ouble taxation i Tax Creit Uner the tax creit metho the parent is oere a creit or the amount o tax alreay pai by the subsiiary. Assume or the moment that the omestic corporate tax rate is to illustrate how the metho o tax creit works; the actor e. This is just e will be eine below. From the perspective o the parent corporation the amount o income generate in the subsiiary beore omestic tax is ψ = ( 1 φ e. 14 The tax liability woul be ψ i the income were generate in the oreign country. The parent then creits the omestic tax that has been pai by the subsiiary, which equals eψ. The net tax pai by the oreign parent then equals ( e ψ. The amount o iviens receive by the parent equals an, hence; 1 = 1 e 1 φ 15 1 κ = (12 1 e 14 Remember rom the non-arbitrage conition (7 that the oreign parent values the subsiiary base on an 1 φ. So, rom the parent s perspective the amount o income beore omestic amount o iviens equal to ( tax is ψ as in the main text, even though the actual income in the subsiiary beore omestic tax is ( 1 e. 10

12 in the tax creit metho accoring to ( The interesting parameter in (12 is the omestic eective corporate tax rate e. It takes ierent values epening on how the metho o tax creit is esigne. Two ierent scenarios may appear. In scenario 1 the oreign government takes into account that e is lower than the nominal when any metho is employe or mitigating ET. This is moele in various papers by using an average omestic corporate tax rate. 17 I will instea calculate an eective corporate tax rate. Note that the eective rate also consiers other ierences, besies the methos o mitigating ET, between the countries that the oreign government woul like to control or. In eriving 1 ist e note that the income generate in the subsiiary, rom its own perspective, is an the amount receive by the omestic shareholers is. The omestic 1 φ eective corporate tax rate can then be solve as; 18 ( 1 = e ist ist φ 1 φ. (13 Substituting (13 into (12 gives the relevant expression or κ in scenario 1 as; 19 ( 1 φ 1 κ = 1 ist. (14 15 ( 1 ( e = φ ψ 16 There is no withholing tax in the moel or simpliication o the expressions. Aing the withholing tax withholing κ = The general conclusions outline are the same. implies that ( ( e 17 Keen (1990, OEC (1991 an Hines (1994 are examples o where the average omestic corporate tax rate approach is use an iscusse. The average tax rate is basically calculate as the ratio o the amount o tax pai by the subsiiary in the omestic country over the subsiiary s taxable income rom the oreign parent s perspective. 18 ( 1 ist ( 1 e = ( 1 φ 19 I this expression is substitute into the non-arbitrage conition (7 the imputation parameter φ cancels an the amount o iviens is scale by ( 1 ( 1 ist, which is less than unity uner the tax creit metho an thereby correcting or the split rate system. Hence, the value o iviens is reuce when the oreign government controls or the methos o mitigating ET in the omestic country. 11

13 As an alternative, scenario 2, the omestic eective tax rate is set equal to the nominal rate, i.e. e =. This implies that the oreign government ignores the act that the omestic eective corporate tax rate is ierent rom the nominal ue to the methos o mitigating ET. From (12 the parameter κ in scenario 2 becomes; 1 κ =. (15 1 ii Tax Exemption In the secon metho o mitigating IT, the metho o tax exemption, iviens istribute rom the subsiiary to the parent are exempte rom tax as long as the corporate income is taxe omestically. Since is the amount o iviens ater omestic corporate tax, 1 φ iviens are not taxe in the oreign country, implying accoring to (11. = an, hence, κ = 1 1 φ 3.3 The interaction between the ierent methos All components or evaluating the cost o capital uner ierent methos have now been erive. Since the cost is unaecte o any metho o mitigating IT in the retention regime ocus is now solely on the new share issue regime. Hence, the benchmark equation rom which the cost o capital in the ierent cases can be erive is expression (10, which is rewritten here or clarity; ρ NSIR = ( ( ( c i κ ( 1 ist "" ""! 1 φ "" ""! ( 1 part part The cost o capital equals the ater tax return on the alternative investment grosse up by two parts. The raction ( 1 o the income is retaine in the subsiiary an thereore taxe at 12

14 the omestic tax rate an the oreign tax rate on capital gains. The raction o the income is istribute to the parent an the cost is, or that reason, aecte by the methos o mitigating ET an IT. Since the methos only aect the raction o the income that is istribute it is more convenient just to analyze this part. Table 1: The -part in the new share issue regime I II III IV No metho Tax creit, scenario 1 Tax creit, scenario 2 Tax exemption κ = 1 ( 1 φ 1 κ = 1 ist 1 κ = 1 κ = 1 The classical system = φ = 0 ist, The imputation system = φ > 0 ist, ( 1 ( 1 < ( 1 = ( 1? ( 1 ( ( 1 1 ( 1 φ < ( 1 1 < ( 1 φ? ( 1 ( 1 φ The split rate system < φ = 0 ist, ( 1 ( 1 ist < ( 1 < ( ( 1 1 ist? ( 1 ist Note: A higher -part implies a lower cost o capital. Column I in table 1 illustrates the ierent systems when no metho is employe or mitigating IT. As is clear rom the classical system the -part is taxe ully both by the oreign an the omestic country. This is to be compare to the cases where the imputation an split rate systems are employe, where the amount o omestic tax pai on the income is reuce, either by φ or ist, respectively. The -part increases an, as a result, the cost o capital ecreases. Hence, uner ull IT the eective methos in mitigating ET in a close economy remain useul in an open economy. The cost o capital is reuce uner the imputation an split rate systems. The -parts uner the metho o tax creit are in column II an III in table 1. When the oreign government corrects or the act that the omestic eective corporate tax rate is lower than the nominal (scenario 1, the -parts equal ( 1 uner all systems. This is seen in column II. The omestic tax rate or any share o it oes not show up implying that the IT is eectively eliminate. But, correcting or a lower eective omestic corporate tax rate makes, 13

15 o course, the methos o mitigating ET ineective. Some interesting special cases arise when the omestic country has employe an imputation system or a split rate system totally. When the split rate system is use to its maximum, = 0, it oes not matter i no metho or the tax creit metho (scenario 1 are employe or mitigating IT. The cost o capital is the same in both cases. The result reappears in the case the imputation rate parameter equals the omestic corporate tax rate, i.e. φ =. ist In column III o table 1 the oreign government ignores the act that uses instea e may be lower an when calculating the amount o tax creit (scenario 2. Compare to column II, the imputation an the split rate systems remain useul when the tax creit metho is employe. This implies that both the methos o mitigating ET an IT aect the cost. As a result the costs o capital become lower compare to the tax creit (scenario 1 an to the case when no metho is employe. The income rom the subsiiary becomes untaxe when the split rate system is use totally i the omestic an oreign tax rates are equal, =. The result reappears uner the imputation system in the case φ = =. As is clear rom column IV the -parts an, hence, the costs o capital are inepenent o the oreign tax rate when the metho o tax exemption is employe. This is because iviens are tax exempte. Compare to column I where no metho is employe, the -parts have become 1 ( 1 times larger. In the nature o the tax exemption metho lies that the oreign government accepts both the omestic tax rate an the ierent methos employe or mitigating ET. As a consequence, both the imputation an the split rate systems remain useul. Further, as long as < the tax exemption gives the highest measure o the -part, implying the lowest cost o capital. So ar the imputation an the split rate systems have been assume to cover both omestic an oreign shareholers. However, it is possible to esign any metho at the shareholer level to only cover omestic shareholer. I the imputation system only covers omestic shareholers, the oreign parent oes not beneit rom the metho. Uner the methos o tax creit an exemption the imputation parameter φ is set to zero, implying an increase cost o capital. 14

16 The istinction between ierent owner is not possible to o when a metho at the corporate level is employe, like the split rate system. 3.4 A comparison o the cost o capital in the two regimes Given the methos o mitigating ET an IT it is possible to compare the cost o capital in the retention an new share issue regime. This is one by rewriting the cost in the new share issue regime (10 in terms o counterpart in the retention regime (9. The relationship becomes; ρ NSIR = ρ RR ( 1 ( 1 c ( 1 ( 1 ( 1 c + κ ( 1 ist ( 1 φ 1 (16 By comparing the nominator an the enominator in (16 it is possible to set up constraints on the parameter to give a speciic relation between the costs o capital. Table 2 shows the constraints or the cost o capital to be higher in the new share issue regime. Table 2: Restrictions on the parameters or the cost o capital to be higher in the NSIR The classical system = φ = 0 ist, The imputation system = φ > 0 ist, The split rate system < φ = 0 ist, ist I II III IV No metho Tax creit, scenario 1 Tax creit, scenario 2 Tax exemption κ = 1 ( κ = 1 κ = φ κ = 1 1 > c ( c c > φ ( 1 c ( c > ( c c ( c c ( c c ist > > > ( c c > Not possible Not possible Not possible Not possible Not possible The stanar result in a close economy moel o a higher cost o capital in the new share issue regime uner the classical system reappears in this context only as a special case as is clear rom table 2. This is when no metho is employe or mitigating IT, see column I. In all other cases the parameter values are quite restrictive 20 or implying a higher cost o capital 20 A omestic corporate tax rate less than 21 percent when =. 35 an = 5 as an example. c. 15

17 in the new share issue regime, an not possible in 5 cases. The conclusion rom this comparison is that, given that any metho is employe or mitigating ET, the cost o capital is most likely higher in the retention regime compare to the new share issue regime. Hence, the eect o mitigating ET an IT more than oset the act that the subsiiary in the retention regime uses initial the less expensive source o inance at the margin. 3.5 The eect on the market value Uner the new share issue regime the market value or a subsiiary is reporte in (8. The amount o new share issues N is positive implying that it is not possible to raw any conclusions o how the market value changes ue to the methos o mitigating ET an IT. But, or a subsiiary in the retention regime the eect can be analyze. This is because the amount o new share issues equals zero at the margin, implying that the market value in (8 can be rewritten as; i 1 1 t t ist c t= t0 ( 0 κ 1 1 V = F ( K ( I δk e t 1 1 φ 1. (17 c The term κ 1 ist 1 1 φ c in (17 represents the capitalization eect that arises in the retention regime when ierent methos are employe or mitigating ET an IT. The eects are summarize in table 3. Table 3: The capitalization eect in the retention regime The classical system = φ = 0 ist, The imputation system = φ > 0 ist, The split rate system < φ = 0 ist, I II III IV No metho κ = 1 ( 1 ( 1 c ( 1 ( 1 ( 1 c ( 1 φ ( 1 ( 1 ist c Tax creit, scenario 1 ( 1 φ 1 κ = c c c 1 ist Tax creit, scenario 2 1 κ = 1 c ( 1 ( 1 c ( 1 φ ( 1 ( 1 ist ( 1 c ( 1 Tax exemption κ = 1 c ( 1 ( 1 c ( 1 φ ist c 16

18 From table 3 it is clear, by comparing column I with the rest, that the market value o the subsiiary increases when a metho is put to use or mitigating IT. Remember rom (9 that the methos o mitigating ET or IT have no eect on the cost o capital. Any attempt to increase the investment volume by ecreasing the cost o capital ails when the subsiiary inances the marginal investment with retaine earnings. The result is instea an increase market value. Given a speciic metho o mitigating IT the capitalization eect will epen on how the metho is esigne. Column I in table 3 illustrates that the methos o mitigating ET is capitalize in the market value when the income is taxe ully international. The capitalization eect implies that the market value increases uner the imputation an split rate systems, compare to the classical system. The result reappears in the tax creit metho when the omestic government ignores to ajust or a lower omestic eective tax rate (scenario 2, see column III. A quite surprising result appears uner the metho o tax creit (scenario 1 where the oreign government uses the eective tax rate when calculating the amount to creit. The imputation an the split rate systems are not capitalize in the market value as is clear rom column II. At the same time the cost o capital is unaecte since the subsiiary inances the marginal investment with retaine earnings. epening on the relative magnitue o the parameters the same conclusions appear uner the metho o tax exemption as well, see column IV. The question is then obvious; who beneit when methos o mitigating ET is introuce in these cases? The istribution o the tax liability between the subsiiary an the parent epens on which metho that is employe or mitigating ET uner the tax creit. 21 Following the erivations rom chapter 2 the amount o tax pai by the oreign parent on iviens becomes e T =. The eective corporate tax rate e takes ierent values epening on 1 e how the tax creit is esigne an which metho that is use or mitigating ET, but e < 17

19 always hols. The eect o a positive change in parent is negative. Hence, a reuce e on the amount o tax pai by the oreign e implies that the tax liability in the oreign parent rises while it is reuce in the subsiiary. The tax liability is in some way exporte rom the omestic subsiiary to the oreign parent. In summary, the amount o tax pai increases in the oreign country an ecreases in the omestic country, while the cost o capital in, an the market value o, the subsiiary in the omestic country are unchange. 4 Summary an conclusions In etermining the cost o capital in a omestic corporation (the subsiiary with a oreign marginal shareholer (the parent several actors must be consiere. The source o inance at the margin plays a crucial role. It is shown that or a corporation that inances the marginal investment with retaine earnings the cost o capital is unaecte both o methos o mitigating ET an IT. This is ully explaine by the act that the cost o capital is unaecte o any actors aecting the amount o istribute iviens. The eect is instea an exporte tax liability or capitalization o the market value. Hence, there is no meaning using any metho o mitigating neither ET nor IT i the motive is to mitigate the ouble taxation. On the other han, as long as the corporation inances the marginal investment with new share issues the methos o mitigating ET an IT o aect the cost o capital. The outcome epens on which metho that is use an how they are esigne. Besies the omestic corporate tax rate two methos o mitigating ET are analyze; the imputation an the split rate systems. The eect on the cost o capital epens on which metho that is use or mitigating IT. Uner the metho o tax exemption both the imputation an the split rate systems remains useul, in the meaning o aecting the cost o capital in an open economy. This is also the case uner the metho o tax creit as long as the oreign government oes not ajust the amount o tax to creit. But, i the oreign government ajusts the amount the methos no longer aect the cost o capital. The cost is lowest uner the tax exemption, given that the oreign corporate tax rate is larger than the omestic counterpart. It is urther shown that the cost o capital is higher in the retention regime than in the new share issue regime as long as any metho is use or mitigating the ET totally. 21 Since the oreign parent o not pay any tax on iviens uner tax exemption it is only interesting to ocus on 18

20 Even though the marginal shareholer is oreign the omestic corporate tax rate will always aect the cost o capital in a omestic corporation in an open economy. It oes not matter i the corporate income is taxe twice at the corporate level or i any metho is employe or mitigating IT. Further, the source o inancing the marginal investment oes not matter. the metho o tax creit. 19

21 Reerences Auerbach, A. J., 1983, Taxes, Corporate Financial Policy an the Cost o Capital, Journal o Economic Literature, Vol. XXI, September, pp Auerbach, A. J., 1984, Taxes, Firms Financial Policy an the Cost o Capital: An Empirical Analysis, Journal o Public Economics 23, pp Bergström, V. an Söersten, J., 1981, ouble Taxation an Corporate Capital Cost, in Eliasson, G. an Söersten, J. (es., Business Taxation, Finance an Firm Behavior, Proceeings o a Symposium at IUI, Stockholm, August 28-29, 1978, IUI Conerence Reports 1981:1, Almqvist & Wicksell International, Stockholm. Boaway, R. an Bruce, N., 1992, Problems with Integrating Corporate an Personal Income Taxes in an Open Economy, Journal o Public Economics 48, pp evereux, M. P. an Freeman, H., 1995, The Impact o Tax on Foreign irect Investment: Empirical Evience an the Implications or Tax Integration Schemes, International Tax an Public Finance 2, pp Hines Jr., J. R., 1994, Creit an eerral as international investment incentives, Journal o Public Economics 55, pp Keen, M. J., 1990, Corporation tax, oreign irect investment an the single market in Winters, L. A an Venables, A. J. (es., 1990, European integration: Trae an inustry, Cambrige University Press, Cambrige. King, M. A., 1974, Taxation an the Cost o Capital, Review o Economic Stuies 41, pp OEC, 1991, Taxing Proits in a Global Economy: omestic an International Issues, OEC Publications, Paris. OEC, 1996, Moel Tax Convention on Income an on Capital, conense version, OEC Committee on Fiscal Aairs. Poterba, J. an Summers, L., 1985, The Economic Eects on ivien Taxation, in Altman, E. an Subrahmanyam (es., 1985, Avances in Corporate Finance, Richar. Irwin. Sinn, H.-W., 1993, Taxation an the Birth o Foreign Subsiiaries in Long, -Ngo-Van (es, 1993, Trae, welare, an economic policies: Essays in honor o Murray C. Kemp., Stuies in International Trae Policy. Ann Arbor: University o Michigan Press. Söersten, J., 1977, Approaches to the Theory o Capital Cost: An Extension, Scaninavian journal o Economics, vol.79, no

22 Appenix: erivation o the cost o capital The objective unction: 1 i ( t t κ 0 1 c Vt = t N t e t (8 t= t ( 1 ( 1 0 c φ The constraints: 1 = F K + N I + K 1 ist ( 1 ist ( ( δ ( 1 ist ( ( δ F K K (4 N 0 (5 K = I δ K (6 (2 The problem to maximize: 1 i 1 c ( = Λ(,,,, ; t= t0 ( t t0 V K K K I N t e t where Λ( = κ ( 1 c ( 1 φ N 1 ist + µ ( 1 ist F ( K + ( N I + δk 1 ( 1 ( ( + η ist F K δk + η NN + µ K I δk K The irst orer conitions: Λ Λ Λ The conitions satisy = = = 0 an the Euler equation I N The assumption o a steay state solution implies that µ = 0. K ( Λ K Λ = 0. K t I: 1 ist µ + µ K =

23 N : : 1 ist 1+ µ ηn 0 + = 1 κ µ η 0 φ + = ( 1 c ( 1 1 µ η ist FK K µ K δ + i 1 c K: ( ( 1 ( 1 ist + η ( 1 ist δ + µ δ = 0 1 The retention regime (RR Uner the retention regime is ( 1 ist ( F( K δk > an N = 0 implying that the shaow values become η = 0 an η > 0. This gives ollowing irst orer conitions: N I ' : 1 ist µ K = µ 1 K' : F ( K K 1 1 ist µ K δ + i µ δ 1 c 1 = µ ( 1 ist The net cost o capital is then given rom I ' an K' as: ρ RR ( K = F δ = i ( 1 ( 1 c K (9 The new share issue regime (NSIR Uner the new share issue regime is ( 1 ist ( F( K δk = an N > 0 implying that the shaow values become η > 0 an η = 0. This implies that the irst orer conition can be rewritten as; N ' N : µ 1 = 1 ist 22

24 I ' : ' : 1 ist µ K = µ = 1 1 κ 1 κ η = µ = ( 1 ( 1 1 c φ ist ( 1 c ( 1 φ K' : F ( K K 1 1 ist µ K δ + i η ( 1 ist δ µ δ 1 c 1 = ( µ ηist The net cost o capital is then given rom N ', I ', ' an K' as: ρ NSIR K ( K = F δ = i ( 1 ( 1 ( 1 c + κ ( 1 ist 1 1 φ (10 23