CHAPTER FIVE

5. INVESTMENT INCENTIVES
Introduction
Many developing and transition countries offer income tax incentives for investment. The
incentives are most often for direct investors as opposed to portfolio investors, relate to real
investment in productive activities rather than investment in financial assets, and are often directed
to foreign investors on the grounds that there is insufficient domestic capital for the desired level
of economic development and that international investment brings with it modern technology and
management techniques.

Countries sometimes introduce incentives to keep up with other countries in competing for
international investment. More rarely, tax incentives are introduced after other deficiencies in law
and administration are remedied and are directed to areas of economic activity that the country
wishes to develop.

5.1. Relationship Between Taxation and Investment

5.1.1. Tax and Non-tax Factors Affecting Investment
Investors often emphasize the relative unimportance of the tax system in investment decisions
compared with other considerations. Firms first examine a country’s basic economic and
institutional situation. While they are attracted to the potential markets in developing and transition
countries and the relatively low-cost labor, other considerations inhibit large-scale investment,
such as uncertainty in the policy stance of governments, political instability, and, in transition
economies, the rudimentary state of the legal framework for a market economy. Tax incentives on
their own cannot overcome these negative factors.

To prospective investors, the general features of the tax system (tax base, tax rates, etc.) are more
important than tax incentives. In transition countries, many tax laws contain provisions that are
held over from the regime that was used under the former socialist economy. These provisions
served purposes different from those of a market economy tax regime, for example, controlling
the enterprise’s budget rather than determining an appropriate tax base. From the point of view of
potential foreign investors, these provisions are unfamiliar and anomalous. They can cause the tax
base to diverge from market economy norms (especially in relation to depreciation, business
expenses, and loss carryovers) and impose taxation that is not consistent with reality from the point

1
of view of business investors. Furthermore, taxpayers expect to be able to predict the tax
consequences of their actions, which requires clear laws that are stable over time.

The administration of the law is as important as the law itself, and it is clear that tax administrations
in developing and transition countries often have difficulty coping with sophisticated investors,
whether in providing timely and consistent interpretations of the law or in enforcing the law
appropriately.

Investors may view both income and non-income taxes as potential problems. The latter are
payable even if no profits are made and often raise the cost of basic inputs. In particular, social
security taxes applied to the wages of expatriates in transition countries and border charges on the
importation of capital equipment in developing and transition countries are seen as obstacles to
investment.

5.1.2. Lack of Success of Investment Tax Incentives

The experience for developing and transition countries with tax incentives has been consistent
with that of the industrial countries. Tax incentives have not by and large been successful in
attracting investment, especially FDI. This underlines the conclusion that tax incentives cannot
overcome the other, more fundamental problems that inhibit investment.

Tax incentives introduce complexity into the tax system, because the rules themselves are complex
and because tax authorities react to the tax planning that inevitably results from their introduction
by putting into place anti avoidance measures. This complexity imposes costs on administrators
and taxpayers and increases the uncertainty of tax results. Uncertainty can deter the investment the
incentives are intended to attract. Moreover, the introduction of tax incentives creates a clientele
for their continuation and spread.

Why do countries enact tax incentives despite their drawbacks?

There are many factors.

1. Legislators may feel the need to do something to attract investment but may find it difficult
to address the chief reasons that discourage investment; tax incentives are at least
something over which they have control and which they can enact relatively easily and
quickly.

2
 2. Alternatives to tax incentives may also involve the expenditure of funds, and tax incentives
may be seen as a politically easier alternative, since subsidies involving expenditure may
undergo closer scrutiny as compared with other public expenditure needs. Further, some
countries may feel under pressure from multinational companies, which threaten to locate
investment elsewhere if they are not given concessions.
5.2. General Tax Incentives
5.2.1. Types of General Tax Incentives
Tax incentives can be grouped into a number of categories: tax holidays, investment allowances
and tax credits, timing differences, reduced tax rates, and free economic zones. Each type raises
different design and drafting issues.

A. Tax Holidays
A common form of tax incentive found in about half of developing countries is a "tax holiday"
which permits a new company to operate for a given number of years before paying
corporate income taxes. Companies may be required to meet certain conditions to qualify for a
holiday.
A tax holiday is a governmental incentive that temporarily reduces or eliminates taxes for
consumers or businesses. The objective of a tax holiday is to encourage economic activity and
foster growth. Tax holidays may also be offered to businesses as an investment incentive. There
is ongoing debate about whether the benefits of tax holidays justify their costs. Some states that
have offered sales tax holidays in the recent past have canceled them amid political opposition.
B. Investment Allowances and Tax Credits
What does investment allowance mean?
Another form of incentive, the investment allowance, permits investors to deduct from taxable
income a certain percentage of the cost of eligible assets in addition to depreciation
allowances. The total deductions thus may exceed the cost of an eligible asset over its lifetime
What is an investment tax credit?
Investment tax credits are basically a federal tax incentive for business investment. They let
individuals or businesses deduct a certain percentage of investment costs from their taxes. These
credits are in addition to normal allowances for depreciation. Examples of investment credit
are long-term loans, bonds or debentures.

3
 C. Timing Differences
Timing difference is a temporary differences between the reporting of a revenue or expense for
financial statements (books) and the reporting of the item for income tax purposes. For example,
it is common for companies to depreciate equipment on the financial statements over a ten-year
period using the straight-line method. However, for income tax purposes the company uses the
IRS's seven-year, accelerated depreciation method. Eventually, the total depreciation will be the
same; however, each year for ten years there will be differences due to the timing of the
depreciation.
A typical example is the current deduction of interest on an asset that is held for a period of time.
A significant net after-tax rate of return can be realized on an asset whose pretax return equals, but
does not exceed, the rate of interest on the funds borrowed for its purchase, simply because of the
mismatching of the deductions and the income. These technical timing differences can often be
more important than any explicit investment incentives for certain activities (e.g., in the case of
timber growing).
D. Tax Rate Reductions
General tax rate reductions can be provided for income from certain sources or to firms satisfying
certain criteria, for example, to small firms in manufacturing or agriculture. These reductions differ
from tax holidays because the tax liability of firms is not entirely eliminated, the benefit is extended
beyond new enterprises to include income from existing operations, and the benefit is not time
limited.
E. Administrative Discretion
Administrative Discretion: Entails the usage of a public officer's own judgment or intuition to
make decisions, especially, where the rules, regulations, and procedures appear grey or such usage
becomes imperative due to a context-dependent situation. A discretionary approach has a number
of potential advantages such as improving the cost-effectiveness of the program by improving its
targeting toward incremental investment.
5.2.2. Comparison of Incentives
General tax incentives can differ markedly in a number of important ways, in particular in terms
of the types of companies and activities that are likely to benefit from them, the time profile of the
revenue impact on the government for any given level of incentive, the difficulty of administration,
and the possibility of tax avoidance.

4
 1. Beneficiaries
Tax holidays are of greatest value to firms and projects that make substantial profits in the early
years of operation. Such enterprises are likely to be engaged in sectors such as trade, short-term
construction, and services. Most of the beneficiaries of the tax holidays have been small firms, for
example, real estate businesses, restaurants, and firms designed for short-term market exploitation,
such as trade and woodcutting.
Investment allowances, tax credits, and accelerated depreciation, in contrast, are specifically
targeted at capital investment. Their revenue cost is constrained by the amount of capital that the
firm is willing to put at risk. As such, they are of little benefit to the quick-profit types of firms
that can take best advantage of tax holidays. Tax allowances are of greatest benefit to firms with
income from existing operations. These firms can shelter a portion of such income from tax with
the incentives earned on the new investment.
General tax rate reductions differ from the other incentives in that they are not specifically directed
toward new activity. Income from both existing and new operations is eligible for the incentive.
Thus, when rate reductions are viewed as an incentive, they are less likely to be cost-effective than
incentives that are related to the amount of new investment.
2. Profile of Revenue Impact
The revenue impact of tax holidays and investment allowances is, in theory, tied to the degree of
new activity. Thus, the revenue impact is relatively small in the early years of the program and
grows over time as more firms become eligible. A general tax rate reduction, in contrast, has
significant up-front revenue costs because it applies to income from existing operations as well.
The pattern of revenue costs of accelerated depreciation is somewhat more complicated. Because
accelerated deductions confer a timing benefit only, the government incurs a higher level of up-
front cost to achieve the same incentive effect. The revenue cost actually falls over time, because
in future years the tax benefits from further new investments are partly offset by the reduced
deductions resulting from the acceleration of deductions on the old investments.
Tax incentives, particularly holidays, have contributed to this shortfall by providing opportunities
for firms to arrange their affairs to avoid paying taxes on income ordinarily subject to taxation.
3. Administration and Tax Avoidance
Auditing incentives provides an extra challenge to tax administrators, who must first verify that
the incentive has been applied correctly. Verification can be difficult if complex calculations are

5
involved. Second, administrators must ensure that the activity or firm actually qualifies for the
incentive. Third, tax officials must ensure that the amounts eligible for the incentive are correctly
reported, for example, that the value of a machine or service has been transferred at its fair market
value.

Tax holidays have been particularly susceptible to tax planning, much of which is especially
problematic for taxation authorities. The existence of a tax holiday introduces the possibility of
transferring profits from operations that do not qualify for the holiday to a firm that does.

Low tax rates for particular activities suffer from many of the transferring and targeting avoidance
problems that arise with tax holidays. For significant rate reductions, taxpayers will make
considerable efforts to shift income to the company with lower tax rates, for example, by shifting
debt within a corporate group. In addition, firms will attempt to characterize their activity as
qualifying for the incentive.

5.3. Special Purpose Tax Incentives

A serious disadvantage of offering tax incentives to attract investment is that, to the extent that
enterprises that would have invested in any event claim them, tax revenue is lost without any
corresponding benefit to the host country. These costs can, in theory, be reduced if means can be
found to target the incentives to particular desirable activities or to projects that would not have
occurred without the incentive.
One general problem with special incentives is that they inevitably lead to pressure for similar
treatment from other deserving sectors. This pressure is much more difficult to withstand once
some targeted incentives have been given. In a number of countries, both developing and
industrial, the incentives have spread over time to other activities, and removing the incentives
once the reason for them has gone has been difficult politically. While any one targeted incentive
may not involve a significant revenue cost, the total for all the resulting incentives can sharply
erode government revenues from the business sector.
The following discussion focuses on issues peculiar to special purpose incentives.
A. Regional Development
Regional development is a common objective of tax incentives in industrial countries
and elsewhere. Typically, investors in designated regions usually the more remote, economically
less-developed regions of a country or regions with high levels of unemployment receive tax

6
holidays, investment allowances, or accelerated depreciation. Experience demonstrates that
relatively little new activity is generated in the targeted region relative to the revenue cost. Insofar
as the incentives have any effect at all, the chief effect is to divert investment away from its
optimum location. The same types of transfer pricing and other avoidance transactions discussed
above also typically arise, particularly with firms whose operations are based both in the targeted
regions and elsewhere in the country.
B. Employment Creation
Incentives may be directed to promote the establishment of labor-intensive industries or the
employment of particular categories of workers, such as young persons, the disabled, or the long-
term unemployed. Many of the issues that arise with investment incentives, such as incentives
going to employment that would have occurred in any event, are also associated with employment
incentives. Moreover, incentives targeted to particular types of employment or increases in the
level of employment are subject to manipulation and administrative complexity.
C. Technology Transfer
Many countries have sought to attract investment that would bring in advanced technology, or
research and development activities, by granting tax incentives, usually with little success. It is
frequently difficult for tax authorities to determine when a particular technology qualifies as
“advanced” or “appropriate,” and difficult to define precisely what constitutes “research.” In most
cases, the investor is likely to be receiving a tax break for doing what it would have done in any
event, and it is the experience of many developing countries that technology that is introduced is
rarely “transferred” to the host country. Because of the generally unsatisfactory experience with
tax incentives in this area, a number of countries are turning to no fiscal inducements, such as the
establishment of Science Parks.
D. Export Promotion
Investment incentives are commonly provided in the form of tax holidays or special investment
allowances for firms designated as “export oriented.” They may be exempted from tax on a
proportion of their profits corresponding to the proportion that export sales bear to total sales, or
they may be allowed a generous deduction for expenditures aimed at export promotion. Some of
these policies have been successful in attracting foreign investment and have, at least in the short
term, had relatively little cost in terms of tax forgone, since much of the investment would not
have been attracted without tax exemptions.

7
 E. Free Trade or Export Processing Zones
Export processing zones (EPZs) are closely related to promoting export-oriented investment.
These zones, also called customs-free zones, duty-free zones, free trade zones, or special economic
zones, have over the past thirty years or so been established in more than fifty countries in all parts
of the globe, especially in developing and transition countries. The distinguishing feature of these
zones is that they provide a discrete environment in which enterprises (usually both foreign and
domestically owned) can import machinery, components, and raw materials free of customs duties
and other taxes for assembly, processing, or manufacture, with a view to exporting the finished
product. Normally, products from an EPZ sold on the domestic market are treated as imports and
are subject to import duties and taxes.
Exemption from customs duties and other taxes on importation is the essential feature of EPZs.
Such exemptions apply to materials and components that are imported and exported and are often
expanded to capital goods that firms use in the production process. Exemption from such taxes is
often one of the more important tax incentives offered to foreign investors because of the
immediate impact upon costs.

5.4. International Aspects of Tax Incentives

Some international issues have already been noted in the previous discussion, for example, transfer
pricing and fictive foreign investment. Where FDI is involved, however, international tax issues
are pervasive.

5.4.1. Incentives with an International Focus

1. Incentives for Foreign Investors
Incentives offered in many developing and transition countries are often tied to foreign investment.
These can take the form of special tax holidays under the income tax or special relief from customs
duties or turnover taxes. The incentives are sometimes directed at firms that are 100 percent owned
by foreigners and at other times offered to joint ventures, often with as little as 30 percent foreign
ownership.

The attraction for policymakers is that the targeting dramatically reduces the revenue costs of
offering the incentives. However, the question arises as to why it would be government policy to
favor foreign firms over domestic firms. The discrimination leads to resentment, which is likely to
reduce voluntary compliance with the tax system.

8
 2. Relief from Cross-Border Withholding Taxes
Among their measures to encourage FDI, many developing countries provide tax relief from
withholding taxes on certain interest and royalties and sometimes on dividends on foreign parent
companies’ investments in subsidiaries. The international chapter of this book explains how
interest and royalties can be used for profit stripping. Removal of cross-border withholding taxes
on these forms of income can increase the benefits from such tax planning. Such incentives can
also be subject to many of the forms of planning outlined above in relation to tax holidays, to
which they are closely related (often tax holidays for foreign direct investors and dividend
withholding tax relief are applied to the same project).

5.4.2. Tax Incentives and Relief from Double Taxation

To determine the tax treatment of FDI, it is necessary to look beyond the country where the activity
takes place (the source country). It is also necessary to consider the tax treatment in the country of
the foreign investor or parent company (the residence country). There are often further tax
consequences in the residence country on income that is earned and taxed in the source country.
This can lead to an interaction between the tax systems of the two jurisdictions that modifies the
impact of a tax incentive compared with what it would be in the source country alone.
1. Relief from Double Taxation in the Residence Country
An investment can take in a number of forms. The two basic methods are through a branch and
through a subsidiary. A branch is simply a division of the foreign company making the investment,
but it is not a separate legal entity. Accordingly, the branch’s profits are ordinarily taxed as they
are earned in the residence country under the principle of worldwide taxation. Investments can also
be channeled through a subsidiary, which is a separate legal entity, and whose income is usually
not included in the income of the foreign parent until it is repatriated as a dividend.

2. Tax Treaties and Tax Sparing

One method that avoids the problem of the residence country taxing away the benefit of a source-
country tax incentive is “tax sparing.” Under tax sparing, the residence country treats the income
remitted as if it had been fully taxed and had not benefited from the tax incentive. This method
ensures that the full benefit of the tax incentive goes to the investor and is not simply transferred
as tax revenue to the residence country. Tax-sparing is usually granted under tax treaties. It is
traditionally granted by industrial countries, which are most likely to be the residence country in

9
the flow of international investments, to developing countries, which are more likely to be source
countries. In more recent times, tax-sparing provisions have appeared in treaties concluded
between industrial and transition countries, and can also appear in treaties among developing and
transition countries.

The main role of tax-sparing provisions is to allow the source country to provide tax incentives
without the concern that it is simply transferring tax revenue to the other country and so can be
seen as preserving the sovereignty of the source country. This gives the source country more
freedom in designing its incentive regime. The fixed-relief method described below can go further
and act as an explicit subsidy or foreign aid program to the source country (or more specifically
for investors in that country), where credit is provided by the residence country for more tax than
is forgone by the source country.

3. International Double Non taxation

The assumption there is that international double non taxation is a bad thing that both the residence
and source countries should seek to prevent. From an economic perspective, double non taxation
favors international investment over domestic investment, which is generally not regarded as
desirable.
When a developing or transition country grants a tax incentive to a foreign investor and an
industrial country grants a tax-sparing credit in relation to that incentive, the outcome will often
be double non taxation of the income in question (in the source country because of the incentive
and in the residence country because of the tax-sparing credit). Here the countries are cooperating
to bring about a situation of double non taxation, rather than cooperating to prevent it. It is no
wonder in particular that taxpayers seek to exploit tax-sparing situations and in general that there
is a lack of clarity as to whether double non taxation is good or bad.
4. Tax Treaty Network
There are two broad groups of tax treaties that require a different policy perspective. The first
comprises treaties between countries in a region and countries outside the region that are
prospective sources of FDI. From the perspective of the foreign firm, a tax treaty establishes the
“rules of the game” for the interaction of the source-and residence country tax systems. From the
perspective of the taxing authority, it provides access to the exchange of information facilities that

10
would allow a better chance to police some of the cross-border tax avoidance schemes that firms
might employ.

The second group comprises treaties between countries within a region. Tax treaties among
countries within a region should be designed to facilitate flows of investment and trade within the
region reflecting historic close economic ties. Such treaties often result in provisions on
withholding taxes that are less stringent than in treaties with countries from outside the region.
They should also be used to allow closer administrative cooperation to help counteract regional
tax evasion. This difference in treaty policy within a region is well reflected, for example, in the
tax treaties of the Baltic countries (Estonia, Latvia, and Lithuania).

5.4.3. Tax Competition

Experience with tax incentives, particularly in Asia, suggests that, when so-called footloose
manufacturing plants for export are choosing the location for a new plant, they may be influenced
by tax incentives when they are comparing sites in different countries that are otherwise similar.
This influence may also occur when a firm targets a region for a strategic investment, but is
indifferent as to which country it operates from. For example, it may view any one national market
in the region to be inadequate for efficient production and may plan to supply the entire region
from one plant. Countries may therefore be tempted to try to attract these footloose export
industries.
Another reason that policymakers give for offering tax incentives is that they are necessary to
maintain their countries competitive position vis-à-vis neighboring countries. They may view
another country as having a natural advantage, such as location or raw materials that makes it more
attractive as a destination for foreign investment.
It is not necessary to rely on such economic efficiency arguments, however to see the potential
futility of tax competition. A country that views itself as competing for foreign investment will
respond to the tax incentives of another country by introducing some form of offsetting incentive.
In the end, the tax incentives offered by the two countries do nothing to alter the relative incentive
to invest between the two countries. The only result of the competition is that both countries
receive lower tax revenues. They would both be better off if they could agree not to compete.
The problem of tax competition is not confined to developing and transition countries. The
heightened tax competition among industrial countries in niche areas like headquarters and

11
offshore finance regimes has become an area of concern. Tax incentive regimes for foreign
investors in developing and transition countries also give rise to tax competition, not only among
these countries but also ultimately with domestic investment in industrial countries. There have
been some attempts to reduce tax competition among transition countries. International
cooperation in these areas is likely to increase in future years with a view to establishing a narrower
range of cases where international double non taxation is an acceptable policy.

12