handbook-tb

Hugh J. Ault and Brian J. ArnoldThe costs of tax incentives can be minimized if developingcountries follow best practices in designing, implementing, administeringand evaluating their tax incentive programmes.10.3 The role of tax sparingIf a company resident in a developed country makes a direct investmentin a developing country (that is to say, not through a domesticsubsidiary) that qualifies for a tax incentive in the form of a tax holiday,the tax given up by the developing country will be replaced by the taximposed by the developed country (assuming that it taxes the worldwideincome of its residents). As a result, the developing country’s taxholiday is ineffective because it provides no benefit to the non-residentinvestor. Instead of paying tax to the developing country and claiminga credit for that tax against the tax payable to the developed country,the investor pays tax only to the developed country. To avoid thisresult, many developing countries insist on “tax sparing” provisionsin their tax treaties with developed countries. Under these tax sparingprovisions, the developed country (the country in which the investoris resident) generally agrees to provide a credit for the tax that wouldhave been paid to the developing country (that is to say, the tax thatwas spared) in the absence of the tax incentive.The importance of tax sparing is sometimes exaggerated. Ingeneral, tax sparing is a problem only where a non-resident invests ina developing country directly in the form of a branch. If the investmentis made through a subsidiary established in the developing country,the residence country does not generally impose tax when profitsare earned by the subsidiary, and many developed countries exemptdividends from foreign subsidiaries. Even if the investment is made inbranch form, tax sparing is not a problem with respect to several developedcountries that exempt profits earned through a foreign branch.Tax sparing provisions in bilateral tax treaties are often subjectto abuse and may result in an unanticipated increase in the cost ofa developing country’s tax incentives without any increase in foreigninvestment.44