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INDUSI ON INTERNA 7 PERS IMP} ANAL CTIVES rOF X RULES

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5 Impact of Tax Incentives on the Location of Investment: A Corporate Perspective PETER E. NUGENT Merck & Co., Inc. MAGNITUDE AND DURATION OF TAX INCENTIVES A multinational's decision to locate an investment in a particular country is generally based on all relevant economic, operational, and financial factors. Taxa- tion is only one of these factors. The tremendous impact of section 936 of the Internal Revenue Code on the economy of Puerto Rico is clear evidence that a substantial tax benefit can dramatically influence the location of investment. The impact of more modest tax incentives is far more difficult to assess. I have never seen a minor tax benefit tip the scale in a major investment decision. Uncertainty about future tax law changes discounts the value of favor- able tax regimes, often to the point that the perceived tax cost differential be- tween locations is overwhelmed by the intuitive preferences of operating man- agement. A tax incentive under constant threat of repeal or one that will expire unless extended by legislation must be far greater than a permanent incentive if it is to have the same influence on corporate decision making. LOCATION OF RESEARCH AND DEVELOPMENT Recent developments in communication and information technology have made the geographic dispersal of R&D activities substantially more feasible than it was just 10 years ago. E-mail, teleconferencing, and electronic global informa- tion repositories have facilitated the management and coordination of R&D projects at great distances. Thus, geographic proximity, which used to be a domi- nant factor in decisions to locate R&D, has diminished in importance As a conse- quence, tax considerations have increased in relative importance. 71

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5 Impact of Tax Incentives on the Location of Investment: A Corporate Perspective PETER E. NUGENT Merck & Co., Inc. MAGNITUDE AND DURATION OF TAX INCENTIVES A multinational's decision to locate an investment in a particular country is generally based on all relevant economic, operational, and financial factors. Taxa- tion is only one of these factors. The tremendous impact of section 936 of the Internal Revenue Code on the economy of Puerto Rico is clear evidence that a substantial tax benefit can dramatically influence the location of investment. The impact of more modest tax incentives is far more difficult to assess. I have never seen a minor tax benefit tip the scale in a major investment decision. Uncertainty about future tax law changes discounts the value of favor- able tax regimes, often to the point that the perceived tax cost differential be- tween locations is overwhelmed by the intuitive preferences of operating man- agement. A tax incentive under constant threat of repeal or one that will expire unless extended by legislation must be far greater than a permanent incentive if it is to have the same influence on corporate decision making. LOCATION OF RESEARCH AND DEVELOPMENT Recent developments in communication and information technology have made the geographic dispersal of R&D activities substantially more feasible than it was just 10 years ago. E-mail, teleconferencing, and electronic global informa- tion repositories have facilitated the management and coordination of R&D projects at great distances. Thus, geographic proximity, which used to be a domi- nant factor in decisions to locate R&D, has diminished in importance As a conse- quence, tax considerations have increased in relative importance. 71

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72 BORDERLINE CASE There is a spectrum of R&D location decisions. At one end is the decision to locate a major capital investment in a new world-class basic research facility. At the other end is the decision to locate more routine research activities. Often this type of activity is a recurring component of a broad class of R&D projects. In many cases, these activities can be assigned readily to any one of a number of proficient internal or external facilities. The first type of decision has far-reaching consequences and will be gov- erned by a long-term assessment of productivity drivers, such as the ability to recruit top scientific talent, the estimated capital investment, and projected oper- ating costs. This decision may also be influenced by collateral business objec- tives such as enhancement of the company's presence in an important market. In certain cases, the long-term political and economic stability of the country will be an issue. When making a choice between developed countries, tax is often a relatively unimportant factor in this type of decision. The second type of decision is generally a simple matter of cost, quality, and delivery date and may also involve conventional staffing and resource allocation considerations. It is at this end of the spectrum that R&D activities become relatively portable and more readily influenced by tax incentives. A tax incentive that influences decisions of the first type will usually have a greater and more lasting effect on the economy. Trying to influence these deci- sions with minor, temporary tax incentives is just wishful thinking. On the other hand, a U.S. multinational in a perpetual excess foreign tax credit position might very well locate a new world-class basic research facility outside the United States to avoid the unfavorable consequences of Treasury Department Regulations sec- tion 861-17 (allocation and apportionment of research and experimental expendi- tures)~. The adverse consequences of the 861-8 regime for a U.S. multinational with a substantial foreign presence are rarely minor, and accordingly, the com- pany's forecast of its foreign tax credit position is likely to be the critical factor in evaluating the cost of a U.S. location. CONSEQUENCES OF COMPLEXITY Tax incentives and disincentives for investment are often unintentional. The international provisions of the U.S. Internal Revenue Code have become so com- plex that the architects who regularly patch up this structure may fail to perceive the behavioral consequences of new layers of complexity. The enactment and repeal of section 956A of the Internal Revenue Code, an anti-deferral provision, is one example. Another, less obvious, example is section 904(g). This provision of the Internal Revenue Code was originally intended to curtail the use of a for iThe allocation and apportionment of research and experimental expenditures were formerly gov- erned by Treasury Department Regulations section 861-8 and the issues arising under these regula- tions continue to be identified by references to "861-8"

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IMPACT OF TAX INCENTIVES ON THE LOCATION OF INVESTMENT 73 eign subsidiary to shift the source of income from domestic to foreign, thereby increasing the capacity of the U.S. parent to credit foreign taxes. Under section 904(g) if 10 percent or more of the earnings of a foreign subsidiary are derived from sources within the United States, a ratable portion of dividends paid by the subsidiary is treated as domestic source income. The apparent motivation for the enactment of section 904(g) was to shut down schemes involving portable in- come in tax havens. In its current form, however, it applies broadly to all sorts of income no matter how legitimately or heavily taxed by foreign governments. Unintended consequences arise when a foreign subsidiary operating in a high- tax country discovers and develops a blockbuster product through its own R&D program. The income from global exploitation of this product may dwarf the level of income historically reported by the subsidiary. Given the relative impor- tance of the U.S. market, it is assumed for purposes of this example that if the subsidiary were to license the manufacture of the product in the United States to its U.S. parent (even for U.S. market requirements only), the U.S. source royalty income received by the subsidiary would exceed 10 percent of its earnings. If the U.S. parent is in an excess foreign tax credit position, there will be a double tax on the U.S. source royalty paid to the subsidiary once when the subsidiary pays tax in its home country and again in the United States when the subsidiary' s earnings are distributed to the U.S. parent. There are various ways to solve this problem but none of them involves manufacturing in the United States. So for this company there are two disincentives to invest in the United States a disincentive to locate R&D in the United States under the 861-8 regime and later, when its overseas R&D generates a product, a disincentive to manufacture the product in the United States. Carrying on research in a foreign subsidiary is not a tax abuse, and neither is the payment of a royalty to the foreign owner of a U.S. patent. These are normal business activities caught in a web of tax provisions so complex that in some cases, no one can confidently predict the economic behavior that will result from the latest attempt to "plug a leak."

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6 The Virtual Global Electronic Economy ROBERT N. MATTSON IBM Corporation Global business enterprises in the next century will be borderless organiza- tions built around information networks, flexible work forces, and webs of strate- gic alliances. In this environment, current U.S. tax policy on international invest- ment is outmoded. Economic conditions have changed dramatically since the U.S. tax rules controlling international operations were adopted 35 years ago. The U.S. economy's percentage of the world gross domestic product (GDP) is half of what it was 30 years ago. U.S. exports of high-technology goods relative to those of other OECD (Organization for Economic Cooperation and Develop- ment) member countries dropped by 40 percent during this period. U.S. outward direct investment in 1960 was five times inward investment, today, the flows are about equal (Hufbauer, 1992, Table 1.1~. Before we can analyze the impact of U.S. tax policy on international invest- ment, it is necessary to understand three major fundamental changes in the global business environment (1) globalization, (2) quantum leaps in technology, and (3) the emergence of a new set of technologically skilled nations. Unfortunately, none of these changes has ever been considered in the numerous recent piecemeal changes in U.S. tax law affecting international business. GLOBALIZATION Businesses no longer can focus solely on geographical borders. Many large global companies have increasingly integrated their regional business activities. It is not uncommon that they conduct their businesses at a Pan-European, Pan- American (especially after NAFTA [the North American Free Trade Agreementi), or Pan-Asian level. 75