Royalty Taxation under Tax Competition and Profit Shifting

Abstract:

The increasing use of intellectual property as a means of shifting profits to jurisdictions with low tax rates or preferential tax regimes (so-called 'patent boxes') is a major challenge for the corporate tax base of medium- and high-tax countries. Based on a tax competition model enriched with capital-enhancing technology, royalty payments and profit shifting, our paper suggests a simple fix for this issue: Optimally set a withholding tax on (intra-firm) royalty payments equal to the corporate tax rate and deny any deductibility of royalties. As the tax applies to the full royalty payment, the problem of identifying the arm's-length component in a digital economy, highlighted in the OECD's BEPS report in Action 1, does not apply. Most importantly, the denial of royalty deductions is the Pareto-efficient solution under coordination and the unilaterally optimal policy under competition for mobile capital. In the latter case, a weakened thin capitalization rule is a crucial part of the policy package to avoid negative investment effects. Our results question the ban of royalty taxes in double tax treaties and the EU Interest and Royalty Directive.