Taxes and the Clustering of Foreign Subsidiaries

Scott D. Dyreng
Duke University
Bradley P. Lindsey
College of William & Mary
Kevin S. Markle
Dartmouth College
Douglas A. Shackelford
University of North Carolina and NBER

February 2011
Preliminary and Incomplete
Please Do Not Cite Without the Authors Permission

Abstract
In this study we investigate the influence of taxes on the location of U.S. multinationals foreign
subsidiaries. Previous studies have assumed that location decisions are made independently. We
find foreign subsidiaries cluster in a manner consistent with global tax avoidance. Specifically,
we find that the certain pairs of foreign subsidiaries are more likely to include a tax haven than
would be expected by chance. Similarly, we find that country pairs are more likely to have a
bilateral tax treaty and less likely to form as income and dividend withholding taxes between the
countries and with the U.S. parent increase.

We appreciate suggestions and comments from Mark Jackson, Richard Sansing, Bill Stewart, and
workshop participants at the American Accounting Association annual meeting and Duke University.

1. Introduction
This paper tests the extent to which taxes affect the location of a foreign
subsidiary, conditional on the locations of the firms other foreign subsidiaries. Previous
studies show that taxes, among other factors, influence the foreign location decisions of
multinational firms (see Grubert and Mutti, 2000, Altshuler et al., 2001, Desai et al, 2004,
and a thorough review in Devereux, 2007, among many others). However, the prior
empirical literature, excepting Desai, Foley, and Hines (2006a), assumes that the location
decisions are independent of one another. For example, when Markle and Shackelford
(2011) estimate the impact of operating in a foreign country on a parents effective tax
rate, they assume that each countrys impact is independent from that of any other
country. However, if firms enter two (or more) countries because the pair provide tax
advantages that neither could achieve alone, then Markle and Shackelford (2011) and
other papers relying on independence potentially misstate the influence of individual
countries and understate the total effect of taxes on global operations.1
Broadening the analysis of multinational firms foreign country location decisions
from a unilateral setting to a multilateral framework better captures the global tax
avoidance options available to multinationals. Despite their tax disadvantages, high-tax
foreign jurisdictions often attract multinationals for a host of non-tax reasons, including
access to consumer, labor, and capital markets, which might be inaccessible without
operations in those countries. By pairing the high-tax country operations with an
1

For example, Markle and Shackelford (2011) estimate that adding a German subsidiary to a firms
portfolio of foreign subsidiaries lowers the global enterprises (accounting-based) effective tax rate by
0.5%. From a unilateral perspective, this seems implausible since Germany is widely considered a high-tax
country. However, if multinationals typically enter Germany, while simultaneously entering other
European countries that are commonly associated with tax avoidance, e.g., Ireland, Switzerland, the
Netherlands, Luxembourg, among others, then it is possible that unilateral estimates of the impact on global
effective tax rates, which ignore the joint nature of the decision to expand into Germany, make indeed be
negative or at least less positive than would be anticipated.

appropriate low-tax foreign jurisdiction, e.g., a tax haven, a multinational might be able
to substantially mitigate the taxes collected by the high-tax country. If so, we should
observe predictable clustering patterns in the locations of multinational firms foreign
operations. An example of clustering based on geography is Desai, Foley, and Hines
(2006a), who find that economic activity in low-tax countries enhances economic activity
in nearby high-tax countries. Our study goes beyond geography to test whether taxmotivated clusters can be observed along a host of factors, including tax havens, tax
treaties, and the interaction of parent-subsidiary and brother-sister income and dividend
withholding taxes.
Google nicely illustrates the clustering concept. According to a Bloomberg article
on October 21, 2010, Google, which operates in many high-tax countries, reduced its
total tax rate on foreign profits to 2.4%, saving $3.1 billion over the last three years.2 The
article attributes this successful tax avoidance in large part to a transfer pricing technique
that routed company profits from high-tax jurisdictions through two low-tax Irish
subsidiaries, then to a Dutch subsidiary, and finally to a Bermuda entity that pays no tax.

We are unable to verify the purported tax savings. The Bloomberg article states that Google Inc. cut its
taxes by $3.1 billion in the last three years using a technique that moves most of its foreign profits through
Ireland and the Netherlands to Bermuda. We assume that the $3.1 billion figure comes from the
companys rate reconciliation in the tax footnote of its Form 10-K because the dollar reduction for the
Foreign rate differential in the rate reconciliation for the 2007, 2008, and 2009 calendar years combined
is $3.1 billion. A negative figure in the rate reconciliation indicates a reduction in the GAAP effective tax
rates from the arbitrary 35% starting point. However, it is quite a stretch to assert that an accounting figure
in the rate reconciliation corresponds with the actual reduction in global cash taxes paid. In addition, the
companys filings provide no indication of the extent to which the $3.1 billion dollar reduction in the rate
reconciliation relates to the Irish-Dutch-Bermudan technique discussed in the paper. The article goes on to
assert that the technique helped reduce its overseas tax rate to 2.4percent We are unable to tie the
2.4percent figure to the companys filings, although we assume that, as with the $3.1 billion figure, it
comes from some computation based on the companys GAAP-based accounting records. Because of the
difficulty in inferring actual tax payments from financial statement information (see Hanlon, 2003, and
Graham et al. 2011, among others) we caution readers from placing excessive weight on these specific
figures. That said, from our casual review of the companys financial statements, it is clear that the
accounting-based effective tax rate for foreign operations is very small, consistent with the actual taxes paid
on foreign operations being small as well.

The Dutch subsidiary is needed to avoid an Irish withholding tax on the royalty payments
to a non-European Union member, Bermuda. By clustering the right set of countries (in
this case, Ireland, the Netherlands and Bermuda), Google avoids taxes that would
otherwise be levied on foreign profits in high-tax countries.3
This paper searches for the footprints of Google-like clusters by studying the
locations of U.S. operations around the world. Ideally, this study would evaluate the
entire portfolio of country choices that a firm facesthe three-country mix that Google
uses or even more complex clusters of foreign subsidiaries. However, tractability
prevents such a comprehensive investigation. Thus, we relegate our analysis to studying
pairs of countries. We recognize that by limiting the examination to pairs, we lose the
ability to identify triplets, such as Googles Irish-Dutch-Bermudan combination, and thus
potentially understate the importance of elaborate clusters.
Therefore, recognizing that this study should be viewed an initial foray into
understanding the role of taxes on clusters, we test whether foreign subsidiaries of U.S.
firms are located in pairs of countries in a manner consistent with tax incentives. We
examine a sample of 2,720 multinational firms domiciled in the United States at the end
of 2007. Using a proprietary text search program, we search Exhibit 21 of the firms
Form 10-K, which discloses the foreign countries in which the firm has material
operations. We then compute the percentage of U.S. firms in our sample that operate in
each foreign country. Using these percentages, we calculate the portion of U.S. firms that

Google is not unique in its clustering exploits. The Bloomberg article quotes Richard Murphy, director of
UK-based Tax Research LLP as stating that the Google technique is very common at the moment,
particularly with companies with intellectual property. Murphy estimates that hundreds of
multinationals are using some version of this clustering technique. The article adds that Facebook is
constructing a similar tax avoidance technique, which pairs Ireland and the Cayman Islands.

would be expected to operate in any pair of countries, assuming that country locations
were randomly assigned. Next, we regress the difference between actual and expected
percentages on nontax determinants of foreign location clusters (e.g., trade and
geography) and various tax considerations. We find that the unexpected percentage
increases if one of the pair is a tax haven or the pair has a tax treaty, and it is decreasing
in the taxes levied on transactions between the pair and with the U.S. When we focus on
the largest positive unexpected percentages (indicative of pairs that far exceed
expectations), three countries commonly associated global tax avoidance (Singapore,
Hong Kong and the Netherlands) appear disproportionately. We interpret these findings
as consistent with foreign subsidiaries of American companies clustering in part to
mitigate their global tax liability.
This paper should interest scholars as they attempt to better understand how
multinationals arrange their affairs to lower their global tax liability. The results in this
paper suggest that clusters are an important multinational tax avoidance structure. In
addition, a better understanding of how and where multinational firms cluster their
foreign operations should interest policymakers worldwide as they seek to identify and
implement effective tax policies. The findings from this study are consistent with the
taxes collected in a country being not only a function of its tax law and enforcement but
also the tax laws and enforcement of every other country where the multinational firm
does business (or could do business) as well.
The paper proceeds as follows. Section two develops the hypotheses. Section
three outlines the research design. Section four details the sample selection and
descriptive statistics. Section five discusses the results. Section six concludes. The

Appendix provides background information on the U.S. taxation of multinationals for

those readers with less expertise in the field.

2. Hypotheses Development
As discussed above, this paper examines the frequency of subsidiary pairs to
determine whether clusters of foreign subsidiaries can be explained in part by global tax
planning. If some U.S. firms consider global tax avoidance when they establish their
foreign operations, there are likely to be more subsidiaries in low-tax countries than in
high-tax countries. (By low-tax, we mean those countries whose own tax levies are
low, whose tax law lowers the taxes paid to other countries, and/or whose tax law lowers
the taxes levied on the parent when profits are repatriated.) If a disproportionate number
of subsidiaries domicile in countries that facilitate global tax mitigation, then we expect
to find pairs of low-tax countries are more prevalent, both because they provide low taxes
to their individual companies and also because they enable the multinational to lower
taxes throughout the enterprise.
This leads to the first hypothesis, stated in the alternative.
H1:

The unexpected percentage of U.S. firms with material operations in both

Country i and Country j is decreasing in the statutory tax rates of i and j.

The second hypothesis concerns the attractiveness of tax havens in global tax
strategies. Besides lacking transparency in financial dealings and failing to share
information with other government and regulatory bodies, the low or zero tax rates of tax
havens also stimulate investment activities within their borders (Desai, et al 2006b).
With opportunities to use tax havens to shift profits out of high-tax foreign countries, we
predict that a foreign subsidiary pair will be more likely to occur if one of the countries is

a tax haven. These haven pairings should be particularly attractive when the other partner
is located in a high-tax country. At the same time, as illustrated by the Google cluster,
multiple havens may be able to undertake tax avoidance strategies that would be
impossible with a single haven.
H2:

The unexpected percentage of U.S. firms with material operations in both

Country i and Country j is higher when either i or j or both are tax havens.

Finally, the relationship between any two countries is governed by the negotiated
bilateral agreements in place. For tax purposes, these agreements take the form of tax
treaties and most are built on conventions established by the OECD. Provisions can vary
widely but generally relate to issues such as withholding tax rates on dividends and the
definition of income that is taxable by each of the countries. Because treaties generally
reduce trade frictions and signal a basic level of cooperation between the countries, we
predict that pairs of countries with bilateral tax treaties will be more likely to appear.
H3:

The unexpected percentage of U.S. firms with material operations in both

Country i and Country j is higher when there is a bilateral tax treaty in
effect between i and j.

One reason that we might fail to find evidence that tax rates and the presence of a
tax haven or a tax treaty affect the location of foreign subsidiaries is that some
(potentially critical) tax assessments are privately negotiated. Multinationals and foreign
countries often negotiate private tax holidays and other tax rate incentives that can render
published statutory tax rates and other tax variables as meaningless indicators of the
actual taxes paid (Bond and Samuelson 1986). In fact, a high-tax country could serve (at
least temporarily) as a de facto tax haven for a given U.S. firm if the foreign country
grants a tax holiday or other similar tax concessions. While we know that private
arrangements exist, by definition we are unable to observe them and thus cannot assess

whether the observable tax measures that we use are so fraught with error as to
undermine the power of our tests.

3. Research Design
To test these hypotheses, we regress the unexpected percentage of U.S. firms with
material operations in a subsidiary pair on tax and control variables. To develop the
dependent variable, we first consider a world with one home country and n foreign
countries. Under an assumption that countries are chosen independently,
,
where

represents country i,

, , 1

(1)

represents the probability that a firm has

subsidiaries in both country i and country j, and

represents the probability that a

firm has a subsidiary in country i. Relaxing the independence assumption, for any given
pair , , the following holds:
,
where

, , 1

(2)

is an error term with unknown mean and variance.

By subtracting the expected frequency derived under the assumption that location

decisions are independent (

each country pair, we can calculate

) from the actual frequency of firms operating in

for each pair , . The object of this study is to

explain this unexpected percentage as a function of characteristics of the country pair.

,
For each pair of countries, we calculate

(3)

. We then use a linear equation to

ascertain the characteristics of country pairs that explain variation in the measure:
(4)

_
1

where
is the unexpected percentage of firms having material operations is
both country i and country j.
_

is the mean of the withholding tax rate on dividends from country

to the U.S. and the withholding tax rate on dividends from country
to the U.S., expressed as a percentage of $1 of pretax foreign
income.

is the mean of the residual U.S. income tax rate on income earned
in country and the residual U.S. income tax rate on income
earned in country , expressed as a percentage of $1 of pretax
foreign income.
is the mean of the statutory corporate income tax rate in country
and the statutory corporate income tax rate in country .
is the mean of the withholding tax rate on dividends paid from
country to country and the withholding tax rate on dividends
paid from country to country , expressed as a percentage of $1 of
pretax foreign income.
1

is an indicator variable equal to 1 if at least one of country and

country are tax havens; 0 otherwise.
is an indicator variable equal to 1 if there is a bilateral tax treaty
between country and country in effect; 0 otherwise.

is an indicator variable equal to 1 if both country and country

are in the Organisation for Economic Co-operation and
Development (OECD); 0 otherwise.
is the natural logarithm of the bilateral trade between country and
country , in millions of U.S. dollars.
is an indicator variable equal to 1 if country and country share a
border; 0 otherwise.
is an indicator variable equal to 1 if country and country have
the same official language; 0 otherwise.
is the natural logarithm of the distance between the centers of
commerce of country and country , in kilometers.
is an indicator variable equal to 1 if country and country have
the same majority religion; 0 otherwise.

is an indicator variable equal to 1 if country and country have

the same legal origin; 0 otherwise.
These variables have been chosen to capture, 1) the tax characteristics of the pair,
2) the size of the economies of the countries in the pair, 3) the geographic proximity of
the pair, and 4) the cultural proximity of the pair. Grubert and Mutti (2000), Kogut and
Singh (1988), Blanco and Rogers (2008), and Barrios et al., (2010), among others, use
similar variables to capture these constructs.

4. Data and Sample Selection

To estimate equation (4), we first construct a sample of all U.S. incorporated
firms in 2007 in the Compustat database that have at least $10 million in total assets and a
CIK number.4 We use the CIK number to correctly match data from the Securities and
Exchange Commission website to the firm using a proprietary text search program.
Scanning Exhibit 21 on the website for all public U.S. firms, the program identifies all
foreign countries where the firm has material operations.5 We drop all firms without
foreign operations and treat firms with multiple material operations in a foreign country
the same as firms with only one material operation in the country. Our final sample has
2,720 U.S. firms with foreign operations in 92 countries and 4,136 foreign-country
subsidiary pairs.
To determine the dependent variable in the regression (the unexpected percentage
of country-pairs), we begin by computing the percentage of U.S. firms that operate in

We analyze 2007 data because that is the most recent year for which we have Comtaxs statutory tax rate
and bilateral tax treaty data.
5
The outputted data have a small level of noise because of differences in reporting by firms. Additionally,
while most disclosed material operations in foreign countries are incorporated subsidiaries, this is not
always the case.

each of the 92 countries in our sample. Assuming independence in country choice, we

use these actual percentages to compute the expected percentage of US firms that would
operate in each foreign subsidiary pair of firms. The difference between actual and
expected is the unexpected percentage of country-pairs.6
Tax rates and treaty information are obtained from Comtax. Following Dyreng
and Lindsey (2009), havens are defined as countries that are listed on at least three of four
lists of tax havens reported at http://www.globalpolicy.org on March 4, 2008. Bilateral
trade data are obtained from the STAN database on the OECD website. Information on
language religion, language, and legal origin are obtained from Andrei Shleifers website.
Table 1 reports the descriptive statistics for all regression variables included in
Equation (4). The unexpected percentage of firms in a foreign country pair (U_PCT), has
a positive mean (1.50% ) and median (0.69% ) value, consistent with some skewness in
the data attributable to the actual percentage of firms that operate in both countries in a
foreign subsidiary pair. 33% of foreign country subsidiary pairs include at least one
country in a tax haven, and 32% of foreign country subsidiary pairs have a bilateral tax
treaty between the two countries in the pair. 9% of subsidiary pairs include both
countries in the OECD. 13% speak a common official language. 20% share the same
majority religion. 31% have the same legal origin.
Table 2 presents both the Pearson and Spearman correlations among the
regression variables in Equation (4). As predicted, U_PCT is negatively correlated with

For example, 18% of U.S. multinational firms in our sample have material operations in Ireland, and 32%
have them in the Netherlands. Assuming independent foreign location choices, we would expect 5.8%
(18%*32%) of U.S. multinational firms to operate in both Ireland and the Netherlands. We find that 12%
of U.S. multinational firms in our sample have subsidiaries in both Ireland and the Netherlands. Thus, the
dependent variable for Irish-Dutch pairs is 6.2% (12%-5.8%).

10

all the tax measures, except the corporate statutory tax rates in the foreign countries
(HOSTTAX). As expected, the dependent variable is greater when the country-pair has a
tax treaty but uncorrelated if one of the pair is a tax haven. We turn next to the
multivariate analyses.

5. Results
5.1 Primary Findings
Table 3 reports the estimated regression coefficients for equation (4). The first
column of Table 3 reports the regression results with only the control variables. As
expected, all controls are positively correlated with the unexpected percentage of firms in
a subsidiary pair, except for legal origin (LEGOR). Looking across the columns, the
coefficient estimates of the control variables appear relatively stable and consistent as tax
variables are included in the various models; thus, we do not further discuss them.
Columns 2 through 8 of Table 3 introduce each tax variable separately. We focus
on the ninth column, which reports the results when all tax variables are included in the
regression.7 There, we find every tax variable is significant in the predicted direction,
consistent with taxes affecting foreign subsidiary clusters.
Consistent with H1, which predicts a negative relation between the unexpected
percentage and the statutory tax rates of the countries in the pair, we find negative

PAR_EFFTAX is excluded from the full model because PAR_EFFTAX is the sum of PAR_WH,
HOSTTAX, and PAR_HOMETAX. On a different note, the variance inflation factors suggest that
multicollinearity does not adversely affect the model.

11

coefficients on PAR_WH, PAR_HOMETAX, HOSTTAX, and DIVWH.8 Their

coefficients imply that the unexpected percentages fall by:

0.41 percentage points with an interquartile range increase in PAR_WH (mean

dividend withholding rate between foreign subsidiaries and the U.S.);

0.71 percentage points with an interquartile range increase in PAR_HOMETAX

(mean residual U.S. corporate tax upon repatriation);

0.22 percentage points with an interquartile range increase in HOSTTAX (mean of

the subsidiary pairs corporate tax rates;

0.10 percentage points with an interquartile range increase in DIVWH (mean of

the subsidiary pairs dividend withholding rates).9
Consistent with H2, which predicts a positive relation between the unexpected

percentage and the presence of at least one tax haven in the pair, we find a positive
coefficient on HAVEN1. The coefficient implies that subsidiary pairs with at least one
tax haven have an unexpected percentage that is 0.56 percentage points larger.
Consistent with H3, which predicts a positive relation between the unexpected
percentage and the existence of a bilateral tax treaty, we find a positive coefficient on
TREATY. The coefficient implies that subsidiary pairs with a tax treaty have an
unexpected percentage that is coincidentally also 0.56 percentage points larger.
Together, the regression results in Table 3 provide compelling evidence that
corporate taxation in one foreign country affects a multinationals decision to operate in
8

Inferences are unaffected when alternative measures of statutory rates are used, including the statutory
rates of both of the firms in the pairs and the spread between the rates. The robustness of the statutory rates
measures provide some confidence that the clusters are motivated by tax rate considerations.
9
Our text search program only identifies the material operations of U.S. firms and not the organizational
structure of U.S. firms. Thus, DIVWH would be relevant when one country in a subsidiary pair owns the
other country but not when the U.S. firm owns both foreign subsidiaries directly.

12

another foreign country. Clusters are more prevalent than would be expected when the
income and withholding tax rates of two countries are lower, when the pair includes a tax
haven, and when the duo enjoy a tax treaty. These findings are inconsistent with the
assumption of independence in foreign location decisions.

5.2. Supplemental Findings

Next, we focus on the most positive residuals from the first column in Table 3,
i.e., when only the control variables are included as explanatory variables. We look first
at the residuals (or conditional unexpected percentages) that are in the upper 5% of the
distribution. We then count the number of times that a country is included in the
subsidiary pair for the 206 pairs with the most positive residuals. The purpose of this
exercise is to identify those countries where foreign subsidiaries are found far more often
than would be expected. Our expectation is that (at least some of) these countries are
likely to be those most commonly used by U.S. multinationals to avoid global tax
liabilities.
We find that 38 of the 92 sample countries appear at least once and that six
countries (Brazil, India, Singapore, China, Hong Kong, and the Netherlands) appear at
least 20 times. Three of the six (Singapore, Hong Kong and the Netherlands) are either
low-tax countries (potentially tax havens) and/or often fingered as key players in global
tax avoidancethe very countries that we expected to detect.10 Three other countries
commonly mentioned among those that U.S. companies use to avoid taxes make the list

10

While Hong Kong and the Netherlands are not technically identified as tax havens in our study, many
sources do believe they should be classified as tax havens (Gravelle 2009).

13

but are not at the top. They are Bermuda with 12 entries, Ireland with seven pairs, and
the Cayman Islands with six combinations.
The other three countries (Brazil, India, and China) represent high-growth,
emerging markets enjoying major investment inflows from the U.S. It is not surprising
that these countries are listed repeatedly among the most extreme pairs because their
current economic activity exceeds what would be predicted by the control variables in our
model, which exclude expectations of future economic activity. Future work will involve
fine-tuning the controls to screen for these emerging market countries.
Finally, we narrow the list of the most extreme 206 pairs to those 25 foreigncountry subsidiary pairs with the highest conditional unexpected percentages. Table 5
shows that all, but four, of the 25 pairs include the same six countries heading the list in
Table 4, providing further confirmation that these are the countries with the most extreme
values. Four of the 10 more extreme pairs involve Singapore paired with a high-tax
country: Germany, France, Japan, and Australia. One involves the Netherlands with a
high-tax country, France. These pairings are consistent with tax havens being
particularly useful when paired with a high-tax country. At the same time, the top 25 list
includes Singapore paired with both the Netherlands and Hong Kong. These pairs are
consistent with routing income through multiple tax avoidance locations along the lines
of the Google triplet, which involves three countries (Ireland, the Netherlands, and
Bermuda) that are commonly recognized as key tax avoidance countries. Future work
that extends our pair analysis to triplet or greater combinations might be better able to
identify these more complex clusters.

14

6. Conclusion
A vast literature that spans a half-century has explored how taxes affect the
foreign location decisions of multinational firms. An implicit assumption throughout
those papers is that multinational firms make foreign location decisions unilaterally. The
transfer pricing literature documents that multinational firms shift profits from high-tax
countries to low-tax countries using a myriad of tax planning techniques. Our study
incorporates facets of both literatures into our research setting. Specifically, we relax the
assumption that firms foreign subsidiary locations decisions are independent and
investigate whether U.S. firms locate foreign subsidiaries in pairs of countries in a
predictable and coordinated fashion for tax reasons. The tax variables we usestatutory
tax rates of the subsidiary pair, the presence of at least one tax haven country in the
subsidiary pair, and the existence of a bilateral tax treaty between the subsidiary pair
countriesreflect the capacity for a U.S. firm that clusters foreign operations to shift
profits from a high-tax country to a low-tax country.
Policymakers around the globe are evaluating how tax policies both spur
economic growth while raising sufficient revenue to meet budget needs. Tax policies and
enforcement mechanisms that fail to account for multinational firms clustering foreign
operations for tax motivated reasons may suffer revenue shortfalls. After controlling for
tax and nontax factors related to unilateral foreign location decisions as well as nontax
factors in the subsidiary pair setting, we find that mean statutory tax rates, the presence of
a tax haven, and the existence of a bilateral treaty help to explain the clusters of U.S.
firms foreign subsidiaries that we observe.

15

We close by reiterating an important caveat. For tractability, we study pairs of

countries. We recognize that more complex clusters exist. Indeed the most advanced tax
avoidance strategies likely involve a web of countries that enable firms to exploit the
inconsistencies in the treatment of income across countries and the idiosyncrasies in
every countrys tax law to shop for treaties and shift income to low-tax countries. By
limiting ourselves to pairs, we may be only glimpsing the intricacies of international tax
planning and understating the importance of clusters in tax avoidance. Nonetheless, we
find enough evidence in this simple analysis to suggest that multinationals consider their
portfolio of location options when expanding abroad.

16

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18

Appendix
U.S. Taxation of Multinationals
When U.S. firms locate a subsidiary in a foreign country, the multinational firm
may be subject to a wide array of taxes. First, foreign subsidiaries must comply with the
corporate tax rules in the foreign or host country in which it operates, including paying
income taxes on any profits earned in the foreign jurisdiction. In addition, when
dividends are remitted by the foreign subsidiary to its owners (other higher-tier
subsidiaries or the multinational firm parent company), the foreign subsidiary may be
subject to a dividend withholding tax by the host country. After complying with all taxes
in the host country, the U.S. firm also may be subject to tax in the country of the highertier subsidiary or parent company that receives the dividend. Whether and how dividend
income is taxed by the subsidiary or parent company that receives it depends on whether
the subsidiary or parent company country uses a worldwide or territorial system for
taxing foreign profits.
The United States uses a worldwide system (also known as a credit system) for
taxing the earnings of the foreign subsidiaries of its U.S. firms. The underlying premise
of the worldwide system is that the parent should pay the same amount of tax (the sum of
foreign and domestic) that would be paid if the income were earned domestically,
regardless of where the income is earned. Consider the case of a parent owning two
foreign subsidiaries, H and L, where Hs (Ls) tax rate is higher (lower) than the U.S.
statutory tax rate. When H pays a dividend to the parent, the parent does not pay any
domestic tax on the dividend since the amount of foreign tax on the income already
exceeds the amount of tax that would have been paid had the income been earned in the

19

parent country. When L pays a dividend to the parent, the parent includes the income
(not the dividend) in its domestic taxable income. The parent then reduces its U.S. tax
payable by the amount of the foreign tax that was paid. At this point, the total amount of
tax paid on the foreign income is higher than what would have been paid if the income all
had been earned in the parent country (Ls was taxed at the parents rate, but Hs was
taxed at a rate higher than the parents). Cross-crediting allows the parent to reduce the
amount of domestic tax payable on the earnings of L by the amount by which the tax paid
in Hs country exceeds that which would have been paid if the income had been earned in
the parent country.11
An important component of the worldwide system is that the parent is not liable
for U.S. tax on its foreign earnings until the dividend is received from the subsidiary. As
discussed by Desai et al. (2006b), this principle, commonly referred to as deferral, can
provide incentive for U.S. firms to use tax havens even when their average foreign tax
rate is lower than the U.S. corporate tax rate. If the dividend is paid by the foreign
subsidiary to a higher-tier foreign subsidiary owner that follows a worldwide system,
rules similar to the ones described about the United States would be followed including
the benefits of deferring any incremental tax until the dividend is received.
In contrast to the worldwide system of taxation, if the foreign subsidiary pays a
dividend to a higher-tier foreign subsidiary owner that follows a territorial tax system,
generally no incremental tax is paid on the foreign profits in the parent country when the
dividend is received. In some cases, countries that follow a territorial tax system place
restrictions on exempting the dividend from taxation if the foreign profits are earned in
tax havens or other low-tax jurisdictions to mitigate any potential abuses.
11

Cross-crediting is limited to the amount of domestic tax paid on the earnings of L.

20

Table 1 Descriptive Statistics

Variable

Description

MEAN

U_PCT

UnexpectedPercentageofFirmswiththisPair

1.50

A_PCT

ActualPercentageofFirmswiththisPair

E_PCT

ExpectedPercentageofFirmswiththisPair

PAR_WH

STD

MIN

P25

P50

P75

MAX

1.95

(0.06) 0.27

0.69

1.96

14.52

2.32

3.47

0.33

0.92

2.79

28.97

0.82

1.69

0.00

0.04

0.19

0.75

21.76

Meanoftwowithholdingratestoparent

0.06

0.05

0.03

0.05

0.08

0.28

PAR_EFFTAX

Meanoftwoefftaxratestoparent

0.41

0.04

0.39

0.39

0.39

0.40

0.72

PAR_HOMETAX

Meanoftwohometaxratestoparent

0.13

0.09

0.06

0.11

0.20

0.39

HOSTTAX

MeanofthetwoHOSTTAXratesinpair

0.24

0.07

0.20

0.25

0.30

0.39

DIVWH

Meanofthetwodivwhratesinpair

0.06

0.05

0.02

0.05

0.09

0.23

HAVEN1

AtleastoneofthepairisaTaxHaven

0.33

0.47

1.00

1.00

TREATY

Thereisatreatybetweenthepair

0.32

0.47

1.00

1.00

OECD2

BothinPairareinOECD

0.09

0.29

1.00

TRADE

LogofBilateralTrade

(2.95) 3.59

(19.34) (5.05) (2.58) (0.39) 5.59

CONTIG

CountriesareContiguous

0.02

0.15

1.00

COMLANG

CommonOfficialLanguage

0.13

0.33

1.00

DISTANCE

LogofDistance

1.78

0.84

(2.03) 1.32

2.04

2.37

2.98

RELIGION

BothCountriesHaveSameMajorityReligion

0.20

0.40

1.00

LEGOR

EachCountryHasSameLegalOrigin

0.31

0.46

1.00

1.00

This table presents summary statistics of the regression variables. _

is the unexpected percentage of firms in both i and j. _
is the actual percentage of firms in both i
and j. _
is the expected percentage of firms in both i and j under an assumption of independence of choices.
_
is the mean of the withholding tax rate on dividends
from country to the U.S. and the withholding tax rate on dividends from country to the U.S., expressed as a percentage of $1 of pretax foreign income.
_
is the
mean of the total tax (foreign and domestic) rates paid on foreign income earned in i and j and repatriated to the parent, expressed as a percentage of $1 of pretax foreign income.
_
is the mean of the residual U.S. income tax rate on income earned in country and the residual U.S. income tax rate on income earned in country , expressed as

21

a percentage of $1 of pretax foreign income.

is the mean of the statutory corporate income tax rate in country and the statutory corporate income tax rate in country .
is the mean of the withholding tax rate on dividends paid from country to country and the withholding tax rate on dividends paid from country to country , expressed
as a percentage of $1 of pretax foreign income.
1 is an indicator variable equal to 1 if at least one of country and country are tax havens; 0 otherwise.
is an
indicator variable equal to 1 if there is a bilateral tax treaty between country and country in effect; 0 otherwise.
2 is an indicator variable equal to 1 if both i and j are
members of the OECD; 0 otherwise.
is the natural logarithm of the bilateral trade between i and j, in millions of U.S. dollars.
is an indicator variable equal to 1 if
i and j share a border; 0 otherwise.
is an indicator variable equal to 1 if i and j have the same official language; 0 otherwise.
is the natural logarithm of the
distance between the centers of commerce of i and j, in kilometers.
is an indicator variable equal to 1 if i and j have the same majority religion; 0 otherwise.
is
an indicator variable equal to 1 if i and j have the same legal origin; 0 otherwise.

22

PAR_WH

0.24*

PAR_EFFTAX

0.36*

PAR_HOMETAX

0.11* 0.54* 0.03

HOSTTAX

0.11*

0.10* 0.50*
0.36*

0.37
0.24* 0.80*

0.63*

0.31* 0.30*

CONTIG

COMLANG

DISTANCE

0.52*

0.56*

0.14*

0.03

0.07*

0.21*

0.61* 0.09* 0.09* 0.05

0.10*

0.12*

0.13

0.00

0.11* 0.00

0.05*

0.02

0.01

0.03

0.06*

0.04* 0.13* 0.04

0.04*

0.11*

0.06*

0.12*

0.06*

0.07*

0.33* 0.18* 0.16* 0.08* 0.05*

0.25*

0.01

0.06*

0.06*

0.02

0.24*
0.02

TREATY

0.40* 0.06* 0.21* 0.13*

0.11* 0.34* 0.18*

OECD2

0.39* 0.02

0.13* 0.10*

0.09* 0.20* 0.08*

0.42*

TRADE

0.60* 0.08* 0.15* 0.14*

0.16* 0.20* 0.20*

0.56*

0.37*

CONTIG

0.11* 0.02

0.04

0.01

0.00

0.09*

0.11*

COMLANG

0.03* 0.01

0.04

0.07*

0.08* 0.06*

DISTANCE

0.04*

0.09

0.13*

0.12*

0.02

0.03

RELIGION
LEGOR

0.08* 0.03
0.01

0.03*

0.02

0.13*

HAVEN1

0.07*

0.12*

0.09* 0.02

DIVWH

0.13* 0.00

0.33* 0.29* 0.03

0.06* 0.06*

0.19*

0.00

0.18* 0.08* 0.20* 0.04*

0.09* 0.04*

0.42*

0.13* 0.02

0.20* 0.02

0.06* 0.00

0.06*

0.08* 0.06*

0.02

0.07* 0.01

0.20* 0.13* 0.11* 0.01

0.34* 0.16* 0.13* 0.17* 0.00

0.13* 0.31*

LEGOR

TRADE

0.45*

RELIGION

OECD2

0.19* 0.22* 0.04

0.81* 0.28*

0.20*

HAVEN1

DIVWH

HOSTTAX

PAR_HOMETAX

PAR_EFFTAX

0.17* 0.21* 0.19*

TREATY

U_PCT

PAR_WH

U_PCT

Table 2 Correlations

0.13* 0.03

0.52*

0.09* 0.02

0.36*

0.04* 0.05*

0.35*

0.11* 0.04* 0.28*

0.06* 0.04*

0.20* 0.01

0.05* 0.01

0.21*

0.04* 0.00

0.34*

0.15* 0.35*

0.15*

0.11*

0.11*

0.19*

0.38*

0.15*

0.33* 0.20* 0.31* 0.23* 0.09*

0.04*

0.06*

0.05*

0.05* 0.04* 0.01

0.15*

0.19* 0.16*

0.11*

0.38* 0.00

0.20* 0.04
0.24*
0.24*

This table presents the Pearson (Spearman) correlations above (below) the diagonal of the regression variables. _
is the unexpected percentage of firms in both i and j.
_
is the mean of the withholding tax rate on dividends from country to the U.S. and the withholding tax rate on dividends from country to the U.S., expressed as a
percentage of $1 of pretax foreign income.
_
is the mean of the total tax (foreign and domestic) rates paid on foreign income earned in i and j and repatriated to the
parent, expressed as a percentage of $1 of pretax foreign income.
_
is the mean of the residual U.S. income tax rate on income earned in country and the residual
U.S. income tax rate on income earned in country , expressed as a percentage of $1 of pretax foreign income.
is the mean of the statutory corporate income tax rate in
country and the statutory corporate income tax rate in country .
is the mean of the withholding tax rate on dividends paid from country to country and the
withholding tax rate on dividends paid from country to country , expressed as a percentage of $1 of pretax foreign income.
1 is an indicator variable equal to 1 if at least

23

one of country and country are tax havens; 0 otherwise.

is an indicator variable equal to 1 if there is a bilateral tax treaty between country and country in effect; 0
otherwise.
2 is an indicator variable equal to 1 if both i and j are members of the OECD; 0 otherwise.
is the natural logarithm of the bilateral trade between i and j,
in millions of U.S. dollars.
is an indicator variable equal to 1 if i and j share a border; 0 otherwise.
is an indicator variable equal to 1 if i and j have the same
official language; 0 otherwise.
is the natural logarithm of the distance between the centers of commerce of i and j, in kilometers.
is an indicator variable
equal to 1 if i and j have the same majority religion; 0 otherwise.
is an indicator variable equal to 1 if i and j have the same legal origin; 0 otherwise.
* indicates statistical significance at the 5percent level.

24

Table 3 Main Results

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

4,136

4,136

4,136

4,136

4,136

4,136

4,136

4,136

4,136

ADJRSQUARE

0.48

0.50

0.50

0.48

0.48

0.50

0.49

0.50

0.54

0.92**

1.16**

2.99**

0.98**

0.80**

1.11**

0.78**

0.49**

2.08**

PAR_WH

5.72**

8.37**

PAR_EFFTAX

5.03**

PAR_HOMETAX

5.04**

HOSTTAX

0.56*

2.19**

DIVWH

5.41**

1.39**

HAVEN1

0.40**

0.56**

TREATY

0.66**

0.56**

OECD2

2.80**

2.80**

2.72**

2.78**

2.79**

2.69**

2.82**

2.54**

2.44**

TRADE

0.26**

0.26**

0.26**

0.26**

0.26**

0.26**

0.27**

0.23**

0.23**

CONTIG

0.96**

1.01**

0.96**

0.96**

0.96**

0.99**

1.02**

1.11**

1.20**

COMLANG

0.37**

0.36**

0.36**

0.37**

0.37**

0.35**

0.30**

0.38**

0.22**

DISTANCE

0.57**

0.60**

0.56**

0.56**

0.56**

0.63**

0.59**

0.64**

0.63**

RELIGION

0.24**

0.25**

0.25**

0.23**

0.23**

0.30**

0.22**

0.26**

0.22**

INTERCEPT

LEGOR

0.09

0.06

0.40

0.07

0.09

0.09

0.13**

0.07

0.08

0.03

).
_
is the mean of the withholding tax rate on
This table reports OLS estimates of Equation (4). Dependent variable is the unexpected percentage of firms in both i and j( _
dividends from country to the U.S. and the withholding tax rate on dividends from country to the U.S., expressed as a percentage of $1 of pretax foreign income.
_

25

is the mean of the total tax (foreign and domestic) rates paid on foreign income earned in i and j and repatriated to the parent, expressed as a percentage of $1 of pretax foreign
income.
_
is the mean of the residual U.S. income tax rate on income earned in country and the residual U.S. income tax rate on income earned in country ,
expressed as a percentage of $1 of pretax foreign income.
is the mean of the statutory corporate income tax rate in country and the statutory corporate income tax rate
in country .
is the mean of the withholding tax rate on dividends paid from country to country and the withholding tax rate on dividends paid from country to
country , expressed as a percentage of $1 of pretax foreign income.
1 is an indicator variable equal to 1 if at least one of country and country are tax havens; 0
otherwise.
is an indicator variable equal to 1 if there is a bilateral tax treaty between country and country in effect; 0 otherwise.
2 is an indicator variable equal
to 1 if both i and j are members of the OECD; 0 otherwise.
is the natural logarithm of the bilateral trade between i and j, in millions of U.S. dollars.
is an
indicator variable equal to 1 if i and j share a border; 0 otherwise.
is an indicator variable equal to 1 if i and j have the same official language; 0 otherwise.
is the natural logarithm of the distance between the centers of commerce of i and j, in kilometers.
is an indicator variable equal to 1 if i and j have the same majority
religion; 0 otherwise.
is an indicator variable equal to 1 if i and j have the same legal origin; 0 otherwise.
* and ** indicate statistical significance at the 5percent and 1percent levels, respectively.

26

BRAZIL
INDIA
SINGAPORE
CHINA
HONGKONG
NETHERLANDS
ITALY
SPAIN
FRANCE
AUSTRALIA
GERMANY
MALAYSIA
THAILAND
MEXICO
BERMUDA
JAPAN
ARGENTINA
SWITZERLAND
SWEDEN

31
27
25
23
21
20
19
18
17
16
15
15
14
14
12
12
11
10
10

15%
13%
12%
11%
10%
10%
9%
9%
8%
8%
7%
7%
7%
7%
6%
6%
5%
5%
5%

BELGIUM
CANADA
UNITEDKINGDOM
SOUTHKOREA
IRELAND
CAYMANISLANDS
SOUTHAFRICA
POLAND
LUXEMBOURG
CZECHREPUBLIC
HUNGARY
AUSTRIA
CHILE
NEWZEALAND
BOLIVIA
NICARAGUA
COLOMBIA
VENEZUELA
DENMARK

9
9
9
8
7
6
6
6
5
3
3
2
2
2
1
1
1
1
1

(206pairsinTop5%)

Inpercentageterms

ConditionalUnexpectedPercentage

Country
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38

NumberoftimesinapairintheTop5%of

(206pairsinTop5%)

Inpercentageterms

Country
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19

ConditionalUnexpectedPercentage

NumberoftimesinapairintheTop5%of

Table 4 Most frequent countries

4%
4%
4%
4%
3%
3%
3%
3%
2%
1%
1%
1%
1%
1%
0%
0%
0%
0%
0%

This table reports the number of times each of the listed countries appears in a pair which is in the top 5percent of
country-pairs when sorted by the conditional unexpected percentage. To calculate conditional unexpected percentage,
we estimate Equation (4) without the tax variables on the full sample. Pair ijs Conditional unexpected percentage is the
residual of the country-pair that comes out of this regression.
2

The 38 countries listed are the only ones (of the 92 in the full sample) that appear in pairs in the top 5percent (206
pairs) of this measure.

27

GERMANY
CHINA
GERMANY
FRANCE
JAPAN
GERMANY
FRANCE
NETHERLANDS
BRAZIL
AUSTRALIA
CHINA
AUSTRALIA
CHINA
FRANCE
BRAZIL
ITALY
BRAZIL
SPAIN
INDIA
HONGKONG
BRAZIL
GERMANY
GERMANY
CHINA
HONGKONG

FRANCE
JAPAN
SINGAPORE
SINGAPORE
SINGAPORE
ITALY
NETHERLANDS
SINGAPORE
MEXICO
SINGAPORE
GERMANY
BRAZIL
FRANCE
ITALY
ITALY
SINGAPORE
NETHERLANDS
ITALY
SINGAPORE
SINGAPORE
SPAIN
NETHERLANDS
INDIA
SINGAPORE
JAPAN

percentage

unexpected

Conditional

Table 5 25 most frequent pairs

8.6
7.2
7.2
7.1
7.1
7.0
6.9
6.9
6.8
6.7
6.7
6.5
6.5
6.4
6.3
6.3
6.3
6.2
6.1
6.1
6.1
6.1
6.0
6.0
6.0

This table reports the 25 countries with the highest conditional unexpected percentages. To calculate conditional
unexpected percentage, we estimate Equation (4) without the tax variables on the full sample. Pair ijs Conditional
unexpected percentage is the residual of the country-pair that comes out of this regression.
2

28