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How Important are Tax Incentives to MNCs Today?

Aurobindo Ponniah IBFD Kuala Lumpur

Johor Bahru, Malaysia International Bureau of Fiscal Documentation - www.ibfd.org

Presentation Summary

1. Factors influencing FDI. 2. Do tax incentives influence MNC decisions? 3. The Iskandar Development Region. 4. FDI trends and tax incentives in selected Asian jurisdictions. 2

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Factors influencing FDI Factors influencing the flow of Foreign Direct Investment (FDI) may be segregated into two categories

Non-Tax Factors

Tax Factors

Economy wide Factors

Tax Legislation and Judicial Precedents

Government Policies

Tax Administration

Commercial Considerations

Cost of Compliance with Tax Laws


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Non-Tax Factors influencing FDI •

Economy wide factors Market, i.e. size, income levels, access to regional market -

Resources, i.e. natural resources, location


Competitiveness, i.e. labor availability, skills, supplier base

Government policies Macro policy, i.e. access to foreign sources, ease of remittances -

Commercial Considerations - MNCs Risk perception, i.e. country risk, based on political/macro/labor -


Encouragement to Private Enterprise, i.e. easy entry/exit policies, efficient financial markets Trade & Industry, i.e. trade strategy, ownership controls FDI policies, i.e. access to inputs, transparent & stable policies

Location, Sourcing, Integration, i.e. alliances, training, sourcing

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Tax Factors influencing FDI •

Tax policy and legislation Statutory corporate tax rate, Tax Incentive Schemes, Tax Treaty network, Transfer pricing, Depreciation allowances, Loss carry forward.

Tax administration Revenue Agency, Tax Inspection authority, Right to appeal, VAT

Compliance costs Time required and complexity of filing taxes, Stability of the taxation framework.


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What is an “Investment Incentive”? IBFD’s International Tax Glossary Financial and tax incentives [ ] used to attract local or foreign investment capital to certain activities or particular areas in a country. The incentives can be in the form grants, subsidies, interest-free loans, exemption from exchange control restrictions, and are frequently granted in a package with tax incentives. Tax incentives may include an investment allowance, or investment credit, special forms of depreciation allowance, such as free depreciation or accelerated depreciation. Investment incentives may also be granted to private individuals, but these are generally restricted to tax incentives. Examples can include an exemption from tax on interest on certain bonds, or on certain dividends ….., or a tax credit or deduction from income equal to a proportion of the acquisition cost of a qualifying investment.


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Relative Features of Various Tax Incentives Pros


Tax holidays

Relative low compliance & administrative costs

Only benefited to short-term & new investment Deny certain deductions Tax planning opportunities

Reduction of Corporate Tax Rates

Attractive for mobile investors Easy to administrate

Discriminate against other businesses Effects on debt finance and capital allowances Tax planning opportunities

Accelerated capital allowances

Helps with liquidity constraints

Advantages only with loss carry-forward provisions

Investment tax credits

Large impact on effective tax rate at lower revenue cost

Only targeted to new investment Large impact with short-lived assets

Reduced taxes on dividends and interest

Incentives for co-investment between domestic and foreign investors



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Purpose of Tax Incentives


Investment related growth of the economy

Regional development

Employment creation

Facilitation of Technology Transfer to the less developed economies

Export promotion and earning of foreign exchange

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Costs and Benefits What are the Benefits and Costs of Tax Incentives vis-à-vis FDI? Benefits • • • •

It is generally contended that every percentage point in reduction of the corporate tax rate augments FDI flows by 2%. Increase in FDI leads to investment related growth and is a means to make up for lack of domestic savings and capital. The countries view the incentives as a way to compensate for the other deficiencies. The global experience with the incentives has generally been more positive.

Costs • • •

The Incentives distort the tax system and make it discriminatory and more complicated. There is an economic cost associated for the country in the form of tax revenue forgone. The tax incentives become an avoidable cost if the target sectors would have attracted the investments any way.


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Should a country provide Tax Incentives?

• The majority view amongst theorist and international bodies is ‘No’. • Incentives are bad because they cause distortions, and are both ineffective and inefficient.


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Do Tax Incentives influence MNC decisions? • Does the conventional wisdom apply to MNCs today? • Recent studies show that incentives are playing a role in the investment decisions of MNCs, possibly because: – Tax incentives have become more generous; – As the competition field flattens (i.e. other barriers being removed), tax takes on an increasingly important role; – Globalisation has lead to international production/supply chains; and – Common markets, e.g. AFTA, customs areas, free trade agreements is blurring the boundaries between national markets.


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Do Tax Incentives influence MNC decisions? Important Research Findings: The results of various surveys and econometric analyses on the issue of correlation between the FDI and Tax Incentives, point to the following significant observations:



International investors are often highly mobile and can compare and take advantage of difference in tax rates among various jurisdictions. There is considerable evidence that tax considerations strongly influence the investment choices of the firms.


MNCs have at their disposal numerous alternative methods of structuring and financing their investments, arranging their transactions between related parties located in different countries in such a way that maximizes returns to the investors.


Impact of tax rates on investment decisions is generally higher on export-oriented companies than those seeking the domestic market or location-specific advantages.


The impact and the nature of incentive schemes may also differ if they apply to new or existing companies.


FDI financed by retained earnings is more strongly influenced by host country tax rates.


Government attaches far more importance to the tax incentives than the business community.


Most countries embark in a reform process that includes simultaneous actions on various facets of the economy, which makes it difficult to isolate the effects of taxation from the effects of other variables that are in turn correlated with tax rates.

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Iskandar Development Region (IDR) Focus of the Government The future vision of the government for IDR includes: 

Creating a well developed, internationally and internally integrated logistic system giving the region a high level of national and international accessibility.

Forming a strong base for vertically and horizontally integrated manufacturing and service clusters.

Attracting highly skilled managerial and professional foreign talent that would make it viable to have various international class social and educational, health, recreational and other facilities.


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Iskandar Development Region (IDR) Can Tax Incentives help bring the Foreign Investors The studies reveal that specific tax incentives generally work better than the incentives, which are more general in nature. The government can focus on a few specific sectors for growth and then devise the special type of incentives for • • •


Enterprises, to encourage them to set up businesses People employed in those businesses, for attracting talent from abroad (tax concessions can be given to the expatriates) Suppliers, to remove the other possible bottlenecks

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Lessons The Lessons from the Global Experience with Special Economic and Other Similar Tax Concessions Special Economic Zones can help in attracting FDI, but tax incentives per se cannot substitute the other important non-tax factors Tax Incentives are only of secondary importance and come into play only if the investment destination has passed the first test of other important criteria The government should keep in mind the economic and administrative cost associated with any tax holiday and should carefully examine how tax sensitive is the project to be promoted Transparency in tax administration is also equally important Government can try to customise its tax policy according to the needs of the IDR and devise the most cost effective approach of granting tax concessions


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Conclusion (Contd.) The Lessons from the Global Experience with Special Economic and Other Similar Tax Concessions The administration of incentives requires trained people and fairly developed accounting systems Tax holidays primarily benefit short term investments, where companies can change tax jurisdictions without much difficulty Tax incentives also tend to discriminate against existing businesses In the long run, this leads to erosion of tax base as people learn how to circumvent the tax liability There is a risk that the governments of the world will “race to the bottom” with competitive tax concessions, in their efforts in attracting higher amounts of FDI Care should be taken that the concessions should be within the WTO framework and compliant with the other regional economic partnership agreements signed by the government. 16

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FDI Trends and Tax Incentives in selected Asian Jurisdictions.


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FDI Trend – China 80,000 70,000

US $ Million

60,000 50,000 40,000 30,000 20,000 10,000 1980 1990 1995 1998 1999 2000 2001 2002 2003 2004 2005 Year


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Tax incentives – China

Tax Incentives offered: - General incentives, e.g.: a. Tax free distribution of profits to owners of FIEs after making contributions to certain local funds; b. A 40% refund of the state income tax paid if the profits are reinvested locally rather than repatriated; c. Duty-free import of raw materials if they are to be reexported. - Industry incentives (e.g. tax holidays)


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Tax incentives - China (cont’d)

Special zones with tax incentives: − − − − − −


Special Economical Zones (SEZ´s) Economical and technical development zones (ETDZ´s) Open coastal regions (COEZ´s) High-Tech Industrial Development Zones (HTIDZ´s) Bonded Zones Export Processing Zones

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FDI Trend – India

7,000 6,000

US $ Million

5,000 4,000 3,000 2,000 1,000 1980 1990 1995 1998 1999 2000 2001 2002 2003 2004 2005 Year


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Tax incentives – India

• Tax incentives offered: • • • • •

Infrastructure undertakings; New industrial undertakings; Hotel and tourism; Export income; and Plantations, etc.

• Generally, the incentives is for a given number of years and covers a % of profits.


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Tax incentives - India (Cont’d) Special Economic Zones (SEZs) Policy −

India recently passed its law on Special Economic Zones, offering extensive tax benefits among other measures making it much more efficient to do business in these demarcated zones.

The SEZ policy comprehensively covers all aspects of establishment, operation and fiscal oversight.

It is observed that the new SEZ law may have resulted in significant rise in applications both from foreign and domestic investors, but many of these proposed investments could be mere substitution of investments that would have otherwise taken place outside the SEZ area and thus involves an avoidable cost, in the form of foregone tax revenues.


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Comments - India


Historically, India laws have always offered a number of tax holidays and other incentives, which are generally focussed on development of a specific region, a specific industry, encouraging exports or any other economic goal of the government.

India saw a steep rise in FDI inflows after it liberalised its economy in 1991. A trend can be spotted that the flows of FDI are correlated more with its relaxing the exchange control laws and opening of its economy than with the tax incentives. Moreover, as the rise in FDI has coincided mostly with the reforms process taken by the governments, the effect of Tax Incentives is not very apparent and cannot be isolated.

Most of the FDI to India has been cornered by Technology Services and Telecommunications sectors. The reasons for this can be attributed as large pool of talent available at competitive rates and a fast growing domestic market respectively.

FDI flows in India are more correlated with the growth of Indian economy in general and the growth of specific sectors in particular.

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FDI Trend – Indonesia 6000 5000 4000 US $ Million

3000 2000 1000 0 -1000 -2000 -3000 -4000 -5000 1980 1990 1995 1998 1999 2000 2001 2002 2003 2004 2005 Year


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Tax incentives - Indonesia •

Early period switching from a nationalist investment regime to an open regime, 1967 – 1984 - Kind of tax incentives: 1. 1967-1969: Incentives for foreign & domestic investors, a five years tax holiday from corporate tax and from dividend withholding tax on those profits even if they were remitted later. (The corporate tax rate at that time was 60%) 2. 1970-1983 a. a basic tax holiday of 2 year was granted to all firms in priority sectors; b. an additional year granted if the firm invest in a project that save a significant foreign income, a risky or large project, non-java islands projects, or special priority projects. - Result: FDI in 1981 : between US$ 100 million to US$ 200 million FDI in 1982 : between US$ 200 million to US$ 220 million FDI in 1983 : US$ 300 million The FDI in Indonesia was increasing with the domination of the Japanese investments. Source: http://www.econ.hit-u.ac.jp/~ap3/apppfdi6/paper/INDONESIA.pdf


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Tax incentives - Indonesia (Cont’d) •

Reintroduction tax incentives through a more discrenationary process - Kind of tax incentives: 1. 1984 – 1994 Even though tax holidays was terminated in 1984, the corporate income tax rate was reduced to 35% from 45%. In addition, the bonded zone was introduced in 1986 and facilities (e.g. deferment of or exemption on import duty, excise, or VAT) were granted. - Result: FDI in 1984 : between US$ 200 million to US$ 220 million FDI from 1985 to 1988 : between US$ 300 million to US$ 580 million

Source: http://www.econ.hit-u.ac.jp/~ap3/apppfdi6/paper/INDONESIA.pdf


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Tax incentives - Indonesia (Cont’d) 2. 1995 – 2007 - the corporate income tax rate was reduced to 30%; - double depreciation rate in economic development zones or in priority sectors; - in 1999, tax holidays of up to 8 years were available for new projects in 22 categories of industries. This facility expires in 2007 and will not be extended; - loss carry forward extended to 10 years for companies in economic development zones or in priority sectors; and - import duty and VAT exemption granted for export enterprises located in the bonded zones, Batam island, Bintan & Karimun islands.

Source: www.pajak.go.id


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Tax incentives – Indonesia (Cont’d) Special Economic Zones (SEZs) Policy • exemption from VAT and income tax on the import of capital goods, raw materials and other equipment directly connected with production activity; • accelerated depreciation rates on buildings and other tangible or intangible assets; • carry-forward of losses for up to 10 years; and • a 50% reduction of withholding tax payable on dividends. 29

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FDI Trend – Singapore


US $ Million





1980 1990 1995 1998 1999 2000 2001 2002 2003 2004 2005 Year


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Tax incentives - Singapore

Tax incentives offered: − − − − − − − − − − −

Double tax deduction scheme; Global trader program; International marketing activities; Operational headquarter corporation (OHQ) incentive; International partners program; Regionalization finance scheme; Financial sector incentive scheme; Investment allowance incentive; Integrated industrial capital allowance incentive; Approved foreign loan scheme; and Research incentive scheme for companies.


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FDI Trend – Malaysia


US $ Million

5000 4000 3000 2000 1000 0 1980 1990 1995 1998 1999 2000 2001 2002 2003 2004 2005 Year


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Tax incentives - Malaysia

Tax incentives offered: − Pioneer status incentives; − Investment tax allowance which is applicable to manufacturing & high-tech companies, SMEs, and tourist development); − Reinvestment allowance; − Infrastructure allowance; − Investment allowance for service sector; − Operational headquarter companies incentives; − Labuan International Offshore Financial Center incentives; and − International procurement centre incentives. 33

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