Equilibrium audit strategies against tax treaty shopping

• Published date: 01 August 2019
• Author: Sunghoon Hong
• Date: 01 August 2019
• DOI: http://doi.org/10.1111/jpet.12371

Received: 9 March 2019

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Revised: 10 April 2019

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Accepted: 10 April 2019

DOI: 10.1111/jpet.12371

ORIGINAL ARTICLE

Equilibrium audit strategies against tax treaty

shopping

Sunghoon Hong

Korea Institute of Public Finance, Sejong,

South Korea

Correspondence

Sunghoon Hong, Korea Institute of

Public Finance, 336 Sicheong‐daero,

Sejong 30147, South Korea.

Email: sunghoonhong@kipf.re.kr;

sunghoon.s.hong@gmail.com

Abstract

This paper examines game‐theoretic models of tax treaty

shopping. An investor can choose a direct or indirect

investment route across countries to minimize tax. A tax

agency can audit the investor. The audit is costly but it

can give additional revenue to the tax agency. In

simultaneous‐move games, regardless of whether in-

complete information exists and whether a home

country allows foreign tax credits, there are mixed‐

strategy equilibria where the investor may choose tax‐

minimizing indirect routes and the tax agency may audit

the investor. This equilibrium random audit strategy

helps the tax agency raise revenue and reduce treaty

shopping. Comparative statics yields an implication

consistent with empirical evidence. However, if the

home country has a foreign tax credit system with a high

tax rate, or if the tax agency observes the investor’s

action in a sequential‐move game, the investor always

chooses the direct route, and no treaty shopping occurs

in equilibrium.

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INTRODUCTION

Tax treaty shopping, or simply treaty shopping, generally refers to the use of indirect investment

structures through countries with beneficial tax treaties.

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Multinational investors can remit

J Public Econ Theory. 2019;21:754–770.wileyonlinelibrary.com/journal/jpet754

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© 2019 Wiley Periodicals, Inc.

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For instance, a US multinational company, Corning, invested in a Korean manufacturer, Samsung Corning, through a Hungarian subsidiary, Corning Hungary

Data Services Kft., where “Kft.”is a form of a Limited Liability Company (LLC) in Hungary. According to the Korea–US tax treaty, withholding tax (WHT) rates

on dividends are set at 10% or 15% depending on percentages of shares. However, the Korea–Hungary tax treaty sets the minimum WHT rate at 5%, and in

Hungary, there is no WHT on dividends paid to nonresidents.

profits to their home countries through tax‐minimizing indirect routes. Treaty shopping is

considered to be an improper use of tax treaties, especially under the circumstances where

obtaining treaty benefits is one of the principal purposes of using indirect investment structures.

OECD (2015) emphasizes that treaty shopping is one of the most serious concerns regarding the

Base Erosion and Profit Shifting (BEPS) project.

In this paper, I develop game‐theoretic models of treaty shopping and study equilibrium

strategies of a tax agency and a multinational investor. The investor lives in a home country and

plans to invest in a source country. From this investment, the investor will earn dividend income

in the source country and remit her income to the home country. The investor intends to

minimize tax, that is, to maximize her net‐of‐tax income, by choosing an investment route from

home to source. The investor can choose a direct route or an indirect route, which may pass

through intermediate entities established in countries with beneficial tax treaties. Meanwhile, the

tax agency of the source country can choose to audit the investor to find out the investment route.

The audit is costly. If the audit reveals that the investor chose an indirect route, the tax agency

imposes a penalty tax. This situation can be viewed as a simultaneous‐move game.

In simultaneous‐move games, regardless of whether incomplete information exists and

whether the home country allows foreign tax credits, there are mixed‐strategy equilibria where

the tax agency audits the investor with positive probability and the investor chooses tax‐

minimizing indirect routes with positive probability. Comparative statics shows an interesting

implication about the relationship between foreign direct investment (FDI) and tax‐minimizing

direct routes, which is consistent with empirical evidence in Hong (2018).

If the penalty tax rate is high enough, the equilibrium random audit strategy helps the tax agency

increase revenue and decrease the probability of treaty shopping. When designing audit rules to

counter treaty shopping, tax agencies may consider using the equilibrium random audit strategy with

a high penalty tax rate. However, if the home country operates a foreign tax credit system with a

relatively high tax rate, or if the tax agency observes the investor’sactioninasequential‐move game,

the investor always chooses the direct route, and no treaty shopping occurs in equilibrium.

The contribution of this paper is threefold.

Broadly, this paper contributes to the economics of international taxation. In the literature, a

central theme has been tax competition between countries, which can choose tax rates, as well

as tax relief rules, such as foreign tax credit, deduction, and exemption systems.

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Another

important issue is to examine empirical relations between FDI and tax treaties. Blonigen and

Davies (2004) examine the effects of tax treaties on FDI stocks in the United States, and discover

substantial heterogeneity in treaty effects across countries. Hong (2018) and van’t Riet and

Lejour (2018) examine the structure of tax‐minimizing investment routes in tax treaty networks.

In addition, Hong (2018) finds a positive and significant relationship between FDI and tax‐

minimizing direct routes. Recently, increasing attention has been paid to international tax

policies regarding the BEPS project. Dharmapala (2014) provides a survey of empirical studies

to assess the magnitude of BEPS.

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Bloch and Demange (2018) analyze efficient taxation and

privacy protection on a monopolistic digital platform.

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In contrast, this paper analyzes the

effects of tax treaties, tax relief systems, and incomplete information on strategic interactions

between investors and tax agencies.

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For related studies, see Stöwhase (2013) and Eggert and Itaya (2014). Gauthier (2018) studies consumption tax competition in a trade model with home bias.

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Regarding specific BEPS actions, Johannesen (2016) studies tax avoidance with debt financing. Behrens, Peralt, and Picard (2014) examine transfer pricing

regulation.

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Kind and Koethenbuerger (2018) examine consumption taxes in a platform model.

HONG

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