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OCR for page 69
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OCR for page 70
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
OCR for page 71
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
OCR for page 72
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"
OCR for page 73
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."
OCR for page 74
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
Representative terms from entire chapter:
revenue code
