TAX INCENTIVES OFFERED BY DEVELOPING COUNTRIES: ATTRACTING FOREIGN INVESTMENT OR CREATING DISASTER

TAX INCENTIVES OFFERED BY DEVELOPING COUNTRIES: ATTRACTING FOREIGN INVESTMENT OR CREATING DISASTER Andrés E. Bazó Electronic copy available at: http://ssrn.com/abstract=1319815

INTRODUCTION Developing country s economies constitute underdeveloped markets because domestic production is not efficient enough to improve the economy and to fulfill the needs of the population. For that reason, developing countries generally greatly depend on foreign investment in order to promote their local economy, increase market opportunities and provide better services for the local population. Generally speaking, investors from developed countries benefit from tax and non tax advantages developing countries offer to foreign investment. Underdeveloped markets, low product competition, cheap labor and currency exchange are usually advantage factors that attract foreign investors to developing countries. However, there are some situations that are not always positive or attractive for foreign investors to engage in business and commercial activities in developing countries. There are risks that have to be considered before deciding to invest in a developing country. Generally, developing countries are located in conflicted regions or the country itself presents different situations such as economic, political and/or social circumstances that may discourage foreign investors to open a line of business in these countries. Therefore developing countries must find ways to attract foreign investment that are good enough to outweigh the economic, political or social instabilities which can arise. Measures to reduce the negative influence of non tax issues are generally addressed through the implementation of a beneficial tax policy to foreign investors which may include tax incentives, tax holidays and tax sparing provisions. Electronic copy available at: http://ssrn.com/abstract=1319815

These are factors that investors take into account in order to make a decision on the location of foreign production and investment. Everyday these kinds of tax benefits from developing countries are becoming more and more important in the decision making process of foreign corporations. Sometimes, these tax policies create competition among developing countries in the hope of attracting foreign investment, but this can also lead to harmful tax competition causing distortions in the international context and negative economic consequences for developing countries. It is important to determine whether tax incentives and other tax benefits from developing countries constitute a beneficial policy for these countries or on the contrary create negative consequences for their economies while benefiting foreign investors and their home countries given that depending on the tax system used in each country, some sorts of income could be under taxed in developing countries and fully taxed on the residence country, making the economic effort from developing countries pointless.

I. TAX INCENTIVES IN DEVELOPING COUNTRIES Over the last decades, there has been great debate over whether tax incentives constitute beneficial tax policies for developing countries or only create a distortion on their economy that favors investors and their home countries instead of their own. The following analysis has been made in the hopes of coming to a conclusion as to whether they do more bad than good or whether they are a helpful economic stimulant. Almost every argument used to support or criticize the implementation of tax incentives, tax holidays and tax sparing provisions in developing countries is debatable and used from the other perspective in order to attack the same argument and use it in favor or against depending on the original argument perspective, the line between positive or negative is very small in the case of tax incentives and their consequences. That is why this discussion can sometimes be complicated. Because there is no model, developing countries do not have the guidance to implement a certain established system in order to achieve the economic goals these kinds of policies are intended to achieve, so most of the time the tax policies implemented in developing countries are based on trial and error. The problem, simply put, is that emerging economies do not have a model to rely on that demonstrates the efficient use of their tax systems to provide the critical ingredients for development, including increasing and retaining investment and at the same time increasing tax revenue. 1 Since the economy in developing countries is not strong enough to dictate its own rules, many times these countries are forced to implement tax policies, simply 1 BARKER, William B. An International Tax System For Emerging Economies, Tax Sparing, And Development: It Is All About Source! University of Pennsylvania Journal of International Law, Winter 2007 (29 U. Pa. J. Int l L. 349) page 8

because neighbor countries are doing so and their economy could be severely affected by these policies if they do not join the trend. Developed countries should get involved through the implementation of measures and tax policies focused to provide aid for developing countries in order to promote their economy and economic growth. In addition to positive aid, the U.N. Report calls on developed countries to remove trade barriers that adversely affect developing countries. 2 The United Nations suggests that additional source country measures should also be devised to encourage and facilitate investment flows to developing countries 3. Developing countries, as mentioned before, greatly depend on foreign direct investment (FDI) to promote their economies and domestic markets. Developing countries are always trying to attract foreign investment through the implementation of attractive tax policies and other tax measures because private international capital flows, particularly foreign direct investment, along with international financial stability, are vital complements to national and international development efforts. 4 Emerging economies are not self sustaining and foreign investment constitutes a large source of revenue since developing countries not only suffer from economic problems. The need for revenues in developing countries, however, goes far beyond social insurance. In some developing countries, revenues are needed to insure the very survival of organized government. In other, more stable developing countries, revenues are needed primarily to provide for adequate education (investment in human capital), 2 MCDANIEL, Paul R. The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis. The George Washington International Law Review, Volume 35, November 2, 2003, page 279 3 UNITED NATIONS, Report of the International Conference on Financing for Development, Monterrey, Mexico, 18-22 March, 2002, page 13 4 UNITED NATIONS, Report of the International Conference on Financing for Development, Monterrey, Mexico, 18-22 March, 2002, page 13

which many regard as the key to promoting development. 5 Developing countries have many economic problems that cannot be solved through domestic investment, foreign investment is truly needed to promote their economies, create new jobs, and build infrastructure projects and many other problems that are directly or indirectly improved by foreign investment. In today s global market, tax conditions are playing a greater role every day in determining the location of new businesses. Developed countries enterprises are looking for better tax conditions to place their investments. This situation could lead countries to engage in harmful tax competition against each other which may distort the international economic context. Sometimes, developing countries try to implement a tax policy good enough to make up for other domestic problems that may discourage foreign investment. Tax policies have to be established for the long run, a policy that is seen as temporary may have little effect to attract investments. 6 For developing countries the goal would be to implement tax policies that last in time in order to guarantee foreign business investment and secondly, they must achieve these policies without engaging in harmful tax competition with other developing countries. Before analyzing the tax and economic consequences of the various types of incentives used by developing countries to attract foreign investment, it is important to understand each type of incentives in order to reach a proper conclusion as to whether these kinds of tax measures are positive or negative for developing countries and their 5 AVI-YOHAH, Reuven S. Bridging the North/South Divide: International Redistribution and Tax Competition. Michigan Journal of International Law, Fall 2004 (26 Mich. J. Int l L. 371) page 5 6 VILLELA, Luiz and BARREIX, Alberto, Taxation and Investment Promotion, Inter-American Development Bank Department of Integration and Regional Programs, August 2002, page 5

economies. For Yoram Margalioth tax incentives are tax provisions that deviate from baseline provisions. If the baseline is the standard international or regional tax rate, or even the individual tax rate, then a low corporate rate qualifies as a tax incentive. If the motivation behind the low tax rate is attracting investment, then it is more appropriate to classify it as a tax incentive. 7 For Luiz Villela tax incentives can be profit or incomebased and focused to reward capital investment or labor-related expenditures. The tax benefits can be given in exchange for sales, job placement, value-added, import substitution or export targets, and Tax holidays as the most common form of tax incentives, under which new businesses are exempt from paying corporate income tax for a specified time period. 8 As for tax sparing provisions, William B. Barker defines them as a device used both by countries taxing worldwide income, which allow a foreign tax credit, as well as exemption countries, which allow a foreign tax credit for certain kinds of income (like dividends) that are not exempt. The object is to permit developing economies to reduce their income taxes under an incentive scheme for foreign taxpayers without having the residence country collect the spared tax. 9 Tax incentives are part of the tax system of developing countries and usually established by the Federal Government and Congress in order to grant foreign investors more attractive conditions to invest in their country. Developing countries must structure tax policies in a very effective way so that they attract foreign investment, but do not create a negative impact in the domestic economy and do not fall into a harmful tax 7 AVI-YONAH, Reuven and MARGALIOTH, Yoram, Taxation in Developing Countries: Some Recent Support and Challenges to the Conventional View. Virginia Tax Review, Summer 2007 (27 Va. Tax Rev. 1) page 9 8 VILLELA, Luiz and BARREIX, Alberto, Taxation and Investment Promotion, Inter-American Development Bank Department of Integration and Regional Programs, August 2002, page 2 9 BARKER, William B. An International Tax System For Emerging Economies, Tax Sparing, And Development: It Is All About Source! University of Pennsylvania Journal of International Law, Winter 2007 (29 U. Pa. J. Int l L. 349) page 6

competition situation against other developing countries. These incentives must be created under stable political circumstances in order to attract foreign investment and be analyzed under a specific structure which Luiz Villela 10 defines as the four stage planning a) design, b) concession, c) implementation, and d) compliance control. Although the tremendous international debate about the impact of tax incentives offered by developing countries these measures have to be analyzed independently in order to determine whether they have a negative or positive impact on the domestic economy of the emerging countries and on the international context as well. Some authors and even international organizations mention negative consequences of tax incentives provisions from developing countries to attract foreign investment, since their economies are not able to support themselves and beside economic issues, there are other problems like poverty, lack of education, inadequate health care, low employment, lack of infrastructure and corruption that need to be addressed by the local government in order to improve the welfare of the population before implementing tax incentives policies. These problems may be in some way solved by the influence of foreign investment but the question is whether tax incentives are the right approach to solve them or not. On the other hand, some argue that tax incentives are the best way to address these problems since foreign investment is attracted to invest because of their existence and would not engage in business activities in the country without them. Others argue that tax incentives are not the best approach to attract foreign investment and by implementing these measures, developing countries are distorting the tax and economic system of the country and that tax incentives never bring the expected consequences to 10 VILLELA, Luiz and BARREIX, Alberto, Taxation and Investment Promotion, Inter-American Development Bank Department of Integration and Regional Programs, August 2002, page 4

emerging economies because they sometimes create a negative impact on the region by creating harmful tax competition between similar countries which may distort the international economy.

II. IMPACT OF TAX INCENTIVES AND OTHER TAX PROVISIONS One of the major arguments in favor of tax incentives provisions from developing countries is that foreign investment may bring development and economic improvements to local economies. Foreign direct investment contributes toward financing sustained economic growth over the long term. It is especially important for its potential to transfer knowledge and technology, create jobs, boost overall productivity, enhance competitiveness and entrepreneurship, and ultimately eradicate poverty through economic growth and development. 11 Among other positive effects of tax incentives we find a reduction in poverty and general economic development. 12 Developing countries face many problems that cannot be addressed by the local government because of the lack of resources and corruption among the authorities, which leads third world countries to suffer economically and socially because of bad administrations and the need for more revenues to provide proper public services to the population. However, these kinds of tax policies are not always beneficial from a tax stand point, even though they favor the nation s economy through the creation of jobs, environmental investment, construction and infrastructure creating an overall improvement in the economy which may help to reduce poverty. A few years ago, tax issues were not determinant factors for businesses in order to decide whether to invest in a country or another. Some studies in the past showed that the statistically determinants of the location of investment are market size, labor 11 UNITED NATIONS, Report of the International Conference on Financing for Development, Monterrey, Mexico, 18-22 March, 2002, page 13 12 MCDANIEL, Paul R. The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis. The George Washington International Law Review, Volume 35, November 2, 2003, page 282

cost, infrastructure quality (a dominant factor with respect to developing countries), growth of industrialization, level of foreign investment, growing domestic markets, and stable international relations. 13 However, in more recent studies, tax issues are becoming a more determinant factor in the decision making process globalization has dramatically reduced the importance of these factors, and elevated the role of tax incentives play 14 and as a result of increasing economic integration, particularly regional trade agreements, tax incentives are becoming a decision factor of growing importance for FDI location. 15 These new arguments have driven developing countries to increase the implementation of tax incentives in order to attract more foreign investment. Tax incentive provisions are used by developing countries to provide foreign investors with beneficial situations both parties benefit from. Along with tax policies, developing countries governments may implement non tax measures, such as strong law compliance and other economic policies, in order to make the situation more attractive to the investors, since they have to guarantee the safety of the investment and the permanence of the policy during a long period of time. These measures may have a real and positive effect on the countries policies because they may lead to a stronger legal structure, creation a safer environment for the investment and more benefit from those investments. For Margalioth tax incentives, like any other market intervention, 13 MCDANIEL, Paul R. The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis. The George Washington International Law Review, Volume 35, November 2, 2003, page 280 14 MARGALIOTH, Yoram. Tax Competition, Foreign Direct Investments and Growth: Using the Tax System to Promote Developing Countries. Virginia Tax Review Vol. 23:157, October 2003, page 179 15 VILLELA, Luiz and BARREIX, Alberto, Taxation and Investment Promotion, Inter-American Development Bank Department of Integration and Regional Programs, August 2002, page 4

are justified if they correct market inefficiencies or generate positive externalities, and they require less action from developing countries governments. 16 General tax incentives may reduce the risk of corruption in developing countries since the policy is applied to all foreign investors without exemptions or special conditions. In developing countries, corruption constitutes a mayor problem for the administration and distribution of the country s revenue. Multinational enterprises are able to negotiate more favorable conditions for themselves with the local authorities. This situation may lead corrupted local authorities to take advantage of the multinational enterprises, and vice versa, in order to benefit from better conditions, so corruption may decide whether a tax or economic policy may be implemented or not. Through the application of well structured tax policies, corruption can be greatly reduced. Margalioth argues that Tax incentives, if carefully designed, are probably less vulnerable to corruption than most other available options. 17 Tax incentives may not always constitute a negative policy, but they require a tremendous effort from developing countries government not only to offer beneficial tax policies but to create a safe environment to protect existing investments and to attract future ones to their countries. In some cases, tax incentives are always good (assuming they are well designed to avoid manipulation), and no cost/benefit analysis is required. This happens when tax incentives satisfy two conditions: a) they attract FDI 16 MARGALIOTH, Yoram. Tax Competition, Foreign Direct Investments and Growth: Using the Tax System to Promote Developing Countries. Virginia Tax Review Vol. 23:157, October 2003, pages 180-181 17 MARGALIOTH, Yoram. Tax Competition, Foreign Direct Investments and Growth: Using the Tax System to Promote Developing Countries. Virginia Tax Review Vol. 23:157, October 2003, page 187

that otherwise would not have been made; and b) they do not involve a transfer of tax revenue from domestic taxpayers to foreign investors. 18 Harmful tax competition may be caused by the implementation of tax policies by developing countries to offer tax incentives and other tax benefits for foreign investors. Tax competition may be defined as the attempt to attract investment that might otherwise go elsewhere by offering a relatively attractive tax environment to investors, through the implementation of low tax rates and other favorable provisions in order to reduce the tax burden on foreign businesses. These measures are likely to create harmful tax competition and as an ultimate consequence, distort the international economic context. Tax competition as it exists today distorts decision making and results in an inefficient allocation of resources worldwide, but this is not the sole fault, nor even primarily fault, of emerging countries. 19 These tax measures are established by emerging countries governments in order to promote their economies and to improve the welfare of the population, but these measures create negative tax and economic circumstances in the international and domestic context, such as harmful tax competition, lower labor costs and the creation of tax havens. Developing countries that desire the benefits of foreign capital, the benefits of increasing employment, and the technological advancement it brings, are compelled today to grant concessions to foreign investors. This is a fact of modern economic life, and many developing countries perceive that they are helpless even though the harm that is being done can be enormous. 20 Harmful tax competition has become a major problem among developing 18 MARGALIOTH, Yoram. Tax Competition, Foreign Direct Investments and Growth: Using the Tax System to Promote Developing Countries. Virginia Tax Review Vol. 23:157, October 2003, pages 182 19 EASSON, Alex. Harmful Tax Competition: An Evaluation of the OECD Initiative, Tax Notes International 34, pages 1-2 20 BARKER, William B. An International Tax System For Emerging Economies, Tax Sparing, And Development: It Is All About Source! University of Pennsylvania Journal of International Law, Winter 2007 (29 U. Pa. J. Int l L. 349) page 8

countries, since they adopt tax policies in order to attract foreign investment but there are other areas that suffer from these actions, especially in their own countries. Globalization and tax competition lead to fiscal crises for countries that wish to continue to provide social insurance; at the same time, demographic factors and the increased income inequality, job insecurity, and income volatility that result from globalization render such social insurance all the more necessary. 21 Harmful tax competition has had many other consequences over the years since these kinds of policies not only affect the country which implements them, but usually they have an impact in the international tax and economic system which causes distortions because: tax competition makes it difficult to maintain stable government revenue; tax competition has led to the proliferation of production of tax havens; tax competition has driven effective tax rates down, and this competitions has made U.S. investment abroad more sensitive to tax rates; a developing country is likely to find itself forced to offer subsidies merely because other countries offer them, not because it would choose to do so on the basis of a cost-benefit analysis independent of tax competition; and also harmful tax practices, affect the location of financial and other service activities, erode the tax bases of other countries, distort trade and investment patterns and undermine the fairness, neutrality and broad social acceptance of tax systems generally. 22 Developing countries are competing against each other in order to provide better tax and economic situations for foreign investors but without a well established tax structure they bring negative effects to their own economies and to international commerce as well. 21 AVI-YONAH, Reuven, Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State, Harvard Law Review May 2000 (113 Harv. L. Rev. 1573) page 2 22 AVI-YONAH, Reuven, Globalization, Tax Competition, and the Fiscal Crisis of the Welfare State, Harvard Law Review May 2000 (113 Harv. L. Rev. 1573) pages 4,7,8,31,35

Developing countries grant tax incentives to foreign investment for many reasons among which, are international fear and pressure not to stay behind other countries. Many times, developing countries establish tax incentives without having the proper policy planning, so the design and implementation of the tax measure is not well structured. The need to collect more revenue from foreign investment is what drives these emerging economies to grant them anyway. These kinds of incentives may bring improvement and development to the domestic economy not because of revenue collection, but because foreign investment is helping to create jobs and build infrastructure which may lead to the conclusion that the incentives are working. This conclusion is not entirely correct because most of the time, tax incentives cause more revenue loss than revenue collection for the host country. However, developing countries often establish tax incentive provisions just to attract foreign investment and to be able to compete with other developing countries, so they grant the incentives without the certainty whether the incentive is beneficial or prejudicial for the local economy. By granting preferences and incentives, emerging economies give up a substantial portion of their tax base. IMF studies have documented that widespread tax exemptions have led to low tax ratios which are major fiscal factors in contributing to fiscal crises in emerging market economies. 23 Policies must be well designed and structured in order to fulfill the economic needs of the developing countries and improve the local economy while avoiding negative effects to the host country tax system. The major problem with tax incentives offered by developing countries is that these countries are making a great economic effort to attract foreign investment and by 23 BARKER, William B. An International Tax System For Emerging Economies, Tax Sparing, And Development: It Is All About Source! University of Pennsylvania Journal of International Law, Winter 2007 (29 U. Pa. J. Int l L. 349) page 8

granting the tax incentives they are renouncing the ability to collect revenues that are taxed by the residence country under the worldwide income system. Tax incentives constitute provisions that need to be designed under the international context because under the worldwide income system, the source country makes all the economic efforts and the residence country taxes all the foreign source income anyway. The current U.S. system prevents developing countries from offering tax incentives, such as tax holidays, to attract foreign direct investment (FDI) by U.S. multinational corporations. 24 In these cases, countries with a worldwide income system must offer tax sparing provisions to businesses conducting activities in developing countries in order not to take advantage of these emerging economies which are doing great economic efforts to attract foreign investment but the effort seems pointless if the residence country is collecting the revenues that the emerging countries were entitled to. The most notable consequence is that developing countries by granting tax incentives give away revenues through tax collection and there is no appreciable increase in the investment, so tax incentives are not as efficient as developing countries may expect. To illustrate the situation with tax incentives from developing countries with United States multinationals, Villela explains: The use of reduced corporate income tax rates is also observed in many countries as an incentive for investments in certain regions or sectors, yet tax holidays and reduced corporate income tax rates can be useless as incentives to attract FDI from countries like the U.S. that adopt the worldwide income approach to taxation. Under this system all the net revenues of American companies and their controlled foreign corporations (CFC s) are subject to U.S. taxation, although a 24 MCDANIEL, Paul R. The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis. The George Washington International Law Review, Volume 35, November 2, 2003, page 265

tax credit is provided to avoid double taxation. Therefore, if a host country provides a tax holiday or reduced taxation to an American CFC this would probably only result in additional tax revenue to the U.S. Treasury. 25 This example illustrates the multiple issues developing countries must analyze before considering the possibility of granting tax incentives and other tax benefits to foreign corporations. From the U.N. perspective, therefore, there is a dual responsibility for development: the developing country for its own economic, political and social order and recognition by developed countries that this order cannot be ordered by developing countries in isolation from the global forces that impact it. 26 There are other situations that are considered to have a negative impact on developing countries from the implementation of tax incentives and other tax measures to attract foreign investment, because these measures are costly and ineffective for the developing countries. As analyzed previously, the economic cost of tax incentives constitutes one of the major problems of these policies to attract foreign investment. For Margalioth and Avi-Yonah The most acute disadvantage of discretionary tax incentives, especially in developing countries, is that they are susceptible to corruption. In many countries, discretionary application of tax incentives is one of the most important contributors to corruption. 27 Tax incentives also distorts decision making, erodes the tax base, may lead governments to surrender the ability to tax domestic taxpayers to avoid discriminatory treatment and may bring with it negative non-tax/economic effects to the 25 VILLELA, Luiz and BARREIX, Alberto, Taxation and Investment Promotion, Inter-American Development Bank Department of Integration and Regional Programs, August 2002, page 3 26 MCDANIEL, Paul R. The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis. The George Washington International Law Review, Volume 35, November 2, 2003, page 277 27 AVI-YONAH, Reuven and MARGALIOTH, Yoram, Taxation in Developing Countries: Some Recent Support and Challenges to the Conventional View. Virginia Tax Review Summer 2007 (27 Va. Tax Rev. 1) page 9

host country. The negative impacts can include the creation of greater income inequality between individuals or regions in a developing country, environmental damage, erosion of the tax base, and crowding out the local capabilities. 28 Furthermore, International organizations categorically disapprove the implementation of tax incentives by developing countries to attract foreign investment, because their governments establish the incentives without measuring the consequences these measures could have in the domestic and international context, and as addressed previously, these policies generally have a negative impact of unmeasured proportions, and because they believe these measures create negative effects on their economies, create harmful tax competition between developing countries and need tax sparing provisions from developed countries in order to work as intended. When considering the implementation of tax incentives and other benefits to attract foreign investment, developing countries are using a persuasive technique to create a beneficial tax environment because most of the time, the non-tax aspects of the country do not offer any appealing circumstances for foreign investors. The U.N. Report suggests there are other important aspects that need to be considered before considering the implementation of tax incentives: A central challenge, therefore, is to create the necessary domestic and international conditions to facilitate direct investment flows, conducive to achieving national development priorities, to developing countries. To attract and enhance inflows of productive capital, countries need to continue their efforts to achieve a transparent, stable and predictable investment climate, with proper contract enforcement and respect for property rights, embedded in sound 28 MCDANIEL, Paul R. The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis. The George Washington International Law Review, Volume 35, November 2, 2003, page 282

macroeconomic policies and institutions that allow businesses, both domestic and international, to operate efficiently and profitably and with maximum development impact. Special efforts are required in priority areas such as economic policy and regulatory frameworks for promoting and protecting investments, including the areas of human resource development, avoidance of double taxation, corporate governance, accounting standards, and the promotion of a competitive environment. 29 There are many other issues developing countries must work on correcting before engaging in the implementation of tax incentives provisions which may lead to harmful tax competition policies and detrimental economic and tax measures that have been proven to affect the economy of the emerging country and in a negative way and distort the tax system. One conclusion that is relatively clear, however, is that tax incentives for FDI provide host country benefits only if the country has achieved minimum levels of human capital, stock, infrastructure, etc. 30 Political issues, education, health system, infrastructure, poverty and social conflicts constitute the main downsides of developing countries, and tax incentives would not make them disappear. That is why developing countries must address these issues under a safe tax and economic policy; it is the only way of promoting the local economy and to improving the welfare of the population. As a final consideration about the consequences of tax incentives, an analysis of the different tax systems around the world must be addressed since they may influence the implementation of these measures and the economic consequences for the host and residence country. The first and oldest system is the exemption system that 29 UNITED NATIONS, Report of the International Conference on Financing for Development, Monterrey, Mexico, 18-22 March, 2002, page 13 30 MCDANIEL, Paul R. The U.S. Tax Treatment of Foreign Source Income Earned in Developing Countries: A Policy Analysis. The George Washington International Law Review, Volume 35, November 2, 2003, page 283

recognizes only one basis for taxation- the source of the income. The second system is residence taxation, which taxes the worldwide income of residents of a country. 31 Under the exemption system, taxpayers engaging in activities in a developing country offering tax incentives such as tax holidays, may be in a situation where the source country is not taxing their revenues and, the residence country is not taxing their revenues either, which may result in double non-international taxation. This situation would imply that neither country would benefit from the tax incentives and the absolute beneficiary of the tax scheme would be the taxpayer since activities were not taxed by the source or the residence country. Under the residence system and by the application of the worldwide income system, developing countries offering tax incentives would not tax foreign investors in a conscious effort to attract investment, but since the residence country uses the worldwide income system, all the revenue is going to be taxed at the residence country. This approach may result in a useless economic effort from the developing country to attract foreign investment and the beneficiary of the tax structure would be the residence country with the worldwide income system in force. In this case, developing countries would have to reach an agreement with developed countries under worldwide income to implement tax sparing provisions for taxes not paid in developing countries that would otherwise be taxed by the developed country. Tax sparing is a device used both by countries taxing worldwide income, which allow a foreign tax credit, as well as exemption countries, which allow a foreign tax credit for certain kinds of income that are not exempt. 32 Since international cooperation is necessary to achieve 31 BARKER, William B. An International Tax System For Emerging Economies, Tax Sparing, And Development: It Is All About Source! University of Pennsylvania Journal of International Law, Winter 2007 (29 U. Pa. J. Int l L. 349) page 3 32 BARKER, William B. An International Tax System For Emerging Economies, Tax Sparing, And Development: It Is All About Source! University of Pennsylvania Journal of International Law, Winter 2007 (29 U. Pa. J. Int l L. 349) page 6

the development of emerging economies, developed countries should encourage economic and tax policies that help promote developing countries economies. Though the United States has considered tax sparing and other tax incentives for providing aid to emerging economies over the years, none have been adopted. For many years, however, tax sparing was adopted in the tax treaties between many developed and developing countries because it was considered a practical way to aid developing economies and it increased the competitive position of nations MNEs. 33 33 BARKER, William B. An International Tax System For Emerging Economies, Tax Sparing, And Development: It Is All About Source! University of Pennsylvania Journal of International Law, Winter 2007 (29 U. Pa. J. Int l L. 349) page 7

CONCLUSIONS International organizations are opposed to the implementation of tax incentives from developing countries to attract foreign investment because they claim there are multiple other factors that need to be addressed by developing countries governments in order to provide better services for their populations. Tax incentives usually provide non-tax benefits for developing countries because the investment creates new job sources, infrastructure and education, among others, but they also produce a negative effect in the domestic economy through the distortion of the tax and economic system which may lead the country to a worse situation. These beneficial tax policies are offered by developing countries to compensate for other negative factors present in the country/region so as to attract foreign investment despite them. Tax incentives are justified only if they attract more foreign investment than would otherwise not be attracted. Despite the fact that tax incentives are sometimes very attractive to investors, there are other factors that need to be addressed before implementing tax incentive provisions. Developing countries must first provide a safe investment climate; political and social stability; transparent, stable and predictable conditions; reduction of corruption; and a reliable legal structure and framework in order to provide guarantees to foreign investors along with other economic and tax benefits. Developing countries through the implementation of tax incentives distort domestic and international economy because they are trying to provide better conditions for foreign investors without the assistance of developed countries and other

international organizations, which generally leads them to implement the wrong policy. There is a need for international participation in order to provide guidance and aid to developing countries for the implementation of safe tax policies that really improve their situation. Harmful tax competition and many other negative consequences such as lower tax rates, the proliferation of tax havens, the erosion of the tax base and the distortion of the tax system in developing countries arise from the implementation of tax incentives and other benefits granted by developing countries to attract more foreign investment. Depending on the tax system used by developed countries (exemption or residence), tax incentives from developing countries may lead to a international double non-taxation or useless economic and tax sacrifices by the developing countries since developed countries under the worldwide income system would still tax the revenues exempted in the host country. Tax sparing provisions in the developed countries may be applied in these cases to offer economic aid. These kinds of provisions have been applied in the past through their inclusion on tax treaties around the world, although the U.S. has never applied these kinds of measures.