Effects of an Equalization Tax on Multinational Investments and Transfer Pricing

Cost of Capital for Cross-Border Investment: The Fallacy of Estonia as a Tax Haven

“…Case (iv) assumes that dividends are taxed as earned income at a rate of 0.52, their average marginal tax rate in recent years according to statistics by the National Board of Taxes and that the effective tax rate on capital gains equals 0.29, which is also the rate of imputation. 19 The assumption that the parent company pays equalization tax, though this is avoidable by investing foreign-source profits in the home country (Kari and Ylä-Liedenpohja 2005), is relevant for the purpose of calculating the foreign-country cost of capital because the homecountry optimal investment plan is such that the owners of the parent are indifferent between the immediate distribution of repatriated foreign profits and reinvesting them in the home country (Weichenrieder 1998, 460). 20 The derivation of a benchmark project for this owner category is beyond the scope of this paper due to the complexity of the issue.…”

“…One is profit-shifting using transfer pricing. Kari and Ylä-Liedenpohja (2005) derive a condition for transfer pricing from a foreign subsidiary to a parent company under the imputation system. 24 Applied to the case of a Finnish parent and an Estonian subsidiary, the condition reads as where u is the rate of the equalization tax paid by the parent.…”

“…6 In the case of portfolio dividends an additional withholding tax is levied by Estonia, as allowed by bilateral tax treaties. 7 Equalization tax, however, is different from other dividend taxes because it is avoidable by the parent by transforming foreign profits via home-country investments or via transfer pricing into home-country taxed profits which are distributable without equalization tax (Kari and Ylä-Liedenpohja 2005). Equalization tax may thus change the parent's investment incentives while not affecting those of its foreign subsidiary…”

Formal Integration: FDI and trade in Europe

“…In the case of portfolio dividends an additional withholding tax is levied by Estonia, as allowed by bilateral tax treaties.7 Equalization tax, however, is different from other dividend taxes because it is avoidable by the parent by transforming foreign profits via home-country investments or via transfer pricing into home-country taxed profits which are distributable without equalization tax(Kari and Ylä-Liedenpohja 2005). Equalization tax may thus change the parent's investment incentives while not affecting those of its foreign subsidiary8 Arbitrage equilibrium between dividend income and capital gains implies for the opportunity cost of home country retained profits γ h =(1τ d )/(1τ g ) where τ d is the rate of dividend tax and τ g the rate of capital gains tax for a representative investor.9 If interest expenses are deductible, τb f =0 holds, and if they are not,τb f equals the statutory τ f .…”

“…Case (iii) relies on the most recent evidence about the Helsinki Stock Exchange byVilkman (2002) and also corresponds to their theoretical values after the Finnish tax reform from 2005 onward. Case (iv) assumes that dividends are taxed as earned income at a rate of 0.52, their average marginal tax rate in recent years according to statistics by the National Board of Taxes and that the effective tax rate on capital gains equals 0.29, which is also the rate of imputation.19 The assumption that the parent company pays equalization tax, though this is avoidable by investing foreign-source profits in the home country(Kari and Ylä-Liedenpohja 2005), is relevant for the purpose of calculating the foreign-country cost of capital because the homecountry optimal investment plan is such that the owners of the parent are indifferent between the immediate distribution of repatriated foreign profits and reinvesting them in the home country(Weichenrieder 1998, 460).20 The derivation of a benchmark project for this owner category is beyond the scope of this paper due to the complexity of the issue. In the case of the subsidiary cost of capital this owner category is more straightforward to analyse because the reinvestment of foreign country profits does not increase the net asset value of the parent company, the basis of splitting dividends into capital and earned income.21 The entries in the first row are MRR h = ρ E θ (1-τ h )p from formula (1).22 From (1) the entries of intra-marginal profits are MRR R h =.ρ E γ h/ θ (1-τ h )p.…”