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Exploring the world's phantom FDI: Luxembourg, Ireland well-known tax havens destinations

Ireland and the Netherlands are preferred destinations for multinationals operating in Europe.

, ET Bureau|
Updated: Sep 11, 2019, 10.51 AM IST
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Luxembourg City, Grund, bridge over Alzette river_iStock
View of Luxembourg City, Grund, bridge over Alzette river.
Imagine a country where everyone is a millionaire. Luxembourg is, at least on paper, one such place. According to official statistics, the alpine nation - which is home to around 600,000 people - hosts as much as USD 4 trillion in foreign direct investment (FDI), much more than India’s GDP of USD 2.7 trillion. Back of the envelope calculations show that investors’ apparent bullishness on Luxembourg’s economy translates into FDI of USD 6.6 million per person.

However, a recent study by researchers at the University of Copenhagen and the International Monetary Fund (IMF) has found that a large chunk of the funds that changes hands across borders as FDI is “phantom capital,” meant to reduce companies’ tax liabilities rather than financing domestic businesses that stimulate job growth and result in brick-and-mortar investments. The study, which comes at a time when governments are cracking the whip on corporate tax avoidance, reveals that around 40 per cent of worldwide FDI – totalling USD 15 trillion – was phantom capital, or wealth funnelled through “empty corporate shells” having “no real business activities”.

The IMF defines foreign investment as cross-border financial investments made between firms belonging to the same multinational group. Such capital flows, if used to drive growth, can be beneficial to both companies as well as host countries. But instead of spurring production, companies exploit low corporate tax regimes in some countries to carry out “holding activities, conduct intrafirm financing, or manage intangible assets,” the study found. Innovative tax engineering on the part of multinationals results in a trimming their global tax bills, distorting FDI statistics, and depriving developing countries of tax on profits earned by MNCs in their markets.

Reaching new heights
Reaching new heights

A few well known tax havens are the destination for the majority of the world’s phantom FDI. Luxembourg and the Netherlands cumulatively account for nearly half such capital flows. Havens like Mauritius, Hong Kong SAR, Bermuda, the British Virgin Island, Singapore, Cayman Islands, Ireland and Switzerland are other low-tax jurisdictions favoured by corporations. They are able to attract investment on account of sweetheart deals and low effective corporate tax, helping companies dodge tax in other countries with which these havens have ratified double taxation avoidance treaties.

Despite the low levels of tax in such countries, shell companies of large corporations contribute to the local economy by paying substantial registration and incorporation fees, as well as spending on tax advisory, financial and legal services to facilitate their operations. For Caribbean nations, which are largely dependent on tourism, these ancillary services account for the lion’s share of their GDP. Ireland and the Netherlands are the preferred destinations for multinationals operating in Europe, lending to creative nicknames like “double Irish with a Dutch sandwich”.

Source: ‘The Missing Profits of Nations’, Thomas R. Tørsløv, Ludvig S. Wier, Gabriel Zucman
Source: ‘The Missing Profits of Nations’, Thomas R. Tørsløv, Ludvig S. Wier, Gabriel Zucman

The corporate tax rate in Ireland was lowered significantly from 50 per cent in the 1980s to 12.5 per cent today, leading to wide-ranging changes to the economy. Dublin ranks among the most expensive cities in the world, and is the European base of Apple Inc. Such lucrative deals with corporations are helpful to tax havens, but starve foreign treasuries of taxes due them as the profits would have been accrued in their jurisdictions. In the intervening years, many countries have slashed their corporate tax rates, from around 40 per cent in 1990 to 25 per cent in 2017, in a quest to drive greater investment and avoid losing out to tax havens.

Governments across the world have wised up to the threat of tax avoidance through the amendment of bilateral tax treaties, and also working towards a multilateral consensus on the subject through initiatives like the G20 Base Erosion and Profit Shifting (BEPS), and the automatic exchange of financial information including bank details within the Common Reporting Standard (CRS). The lack of financial checks, combined with the existence of legal loopholes contributed to phantom FDI rising from around 30 per cent to almost 40 per cent of global FDI during the course of the past decade.

American Dream, Taxman's nightmare
Source: Federal Reserve Bank of St. Luis, World Bank

Moreover, global GDP has not kept pace with FDI flows since the recession of 2008, indicating that economic growth may be becoming disconnected with corporate profits. This is point is illustrated by analysing data pertaining to companies headquartered in the United States – home to a large number of multinational corporations. According to data collated by the Federal Reserve Bank of St. Luis, corporate profits after tax as a percentage of the gross domestic product of the U.S. fell from 11.24 per cent in 2012 to 8.95 per cent in 2018. Incidentally, the market capitalisation of listed companies in the U.S. increased 163 per cent from USD 11.59 trillion in 2008 to USD 30.436 trillion in 2018, as per World Bank data. Corporate revenues have also correspondingly increased in the past decade.

Source: ‘The Missing Profits of Nations’, Thomas R. Tørsløv, Ludvig S. Wier, Gabriel Zucman
Source: ‘The Missing Profits of Nations’, Thomas R. Tørsløv, Ludvig S. Wier, Gabriel Zucman

Investments in shell companies based abroad could explain this disparity, as stock valuations and revenue are tied to performance and sales in the global market, giving multinationals a chance to save on tax back home, and also in countries they do business in, by setting up intermediaries in low tax jurisdictions. The World Bank-University of Copenhagen study, unsurprisingly, found a direct correlation with a country’s exposure to phantom FDI with its domestic corporate tax structure. In spite of extremely low corporate taxes, havens have profited considerably from attracting phantom FDI. In 2015, the GDP of Ireland grew by 26 per cent, owing to relocation of intellectual property rights by some corporations.

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