International Taxation and Initial Foreign Entries

To stay competitive, U.S. firms look towards expansion. In this expansion process, U.S. firms analyze a variety of factors ranging from market size and demographics to location. Research shows that foreign taxes affect foreign direct investment (FDI); however, other research indicates that many companies are not taking the necessary tax planning steps. Using a combination of a survey and secondary data, I analyzed the effect of statutory tax rates on firms’ initial entries – where (to which country), how (using which entry modes), and when (how soon after firm founding). Results suggest that statutory tax rates have different effects for different internationalization decisions. I do not find an influence of tax rates on when firms internationalize for the first time, and, contrary to prior research, I do not find an effect of tax rates on how firms make their initial entry (mode of entry). Interestingly, tax rates appear to influence where firms make their first entry, yet the effect may be an artifact of other factors rather than the direct influence of statutory tax rates. Taken together, my results suggest that firms internationalizing for the first time may not be properly considering tax rates. This has important implications for internationalization theory, for tax professionals, and for internationalizing entrepreneurs. INTERNATIONAL TAXATION AND INITIAL FOREIGN ENTRIES 6 International Taxation and Initial Foreign Entries Introduction/Literature Review In a global business environment, U.S. firms look towards expansion as a way to stay competitive in the market place. When deciding where to expand, U.S. firms analyze a variety of factors ranging from market size and demographics to location. For example, research shows that multinational firms “are not only concerned by the size of the host domestic market, but also by its density, i.e. the concentration of domestic demand around the main productive centers” (B’Enassy-Qu’er’e, Fontagn’e and Lahr’Eche-R’Evil, 2005, p.585). However, to be successful when expanding internationally, companies should also take taxation effects into consideration due to the effects taxation has on a firm’s profitability. In order to understand the importance of taxation, it is beneficial to have a general understanding of the U.S. tax system. The U.S. tax code labels corporations that have been incorporated in the United States as U.S. persons, which allows the U.S. to gain tax jurisdiction on world-wide income. In order to aid the tax burden on U.S. corporations and citizens, the U.S. tax system allows a foreign tax credit or a tax deferral. A foreign tax credit permits a deduction in the U.S. corporate tax liability by reducing the tax liability by the foreign taxes paid. A tax deferral grants “American-owned foreign affiliates that are separately incorporated as subsidiaries in foreign countries” the option of waiting to pay U.S. taxes on income earned until the money is repatriated (Desai & Hines, 2001, p.5). However, income earned by “unincorporated foreign businesses, such as those of American-owned branch banks in other countries, are taxed immediately by the United States” (Desai & Hines, 2001, p. 5). Proper tax planning allows a company or corporation to retain a larger percentage of its after tax profits, which enables the business to utilize that money and reinvest, provide dividends to shareholders, INTERNATIONAL TAXATION AND INITIAL FOREIGN ENTRIES 7 or reduce debt. In short, a lack of tax planning can lead to double taxation and missed tax deductions that negatively impact a firm’s resources and profitability. Although the United States government considers organizations incorporated in the United States as U.S. persons, the United States taxes individuals and corporations at two different rates. Therefore, if corporations do take tax rates into consideration when planning international entry, they would utilize corporate tax rates as set by the United States for operations within the U.S. and tax rates set by foreign nations for operations abroad. These tax rates are the rates that are stated within the tax law, also known as statutory tax rates. Given the importance of corporate structure for taxation when entering an international market, it is not surprising that academic research demonstrates that taxation influences the mode of entry in a new market. Hebous, Ruf, and Weichenrieder (2011) find that tax differences influence the choice of greenfield investments, where a corporation builds a new venture from the ground up, versus mergers and acquisitions (M&A), where the corporation joins in a venture with another company, when entering foreign markets. They state that “there are reasons to expect that the location decision of greenfield investments are significantly more elastic to international taxation than M&A investments” (Hebous et al., 2011, p.818). Their study found that “an increase in the statutory corporate income tax rate of 10 percent reduces the probability of choosing a country to host a greenfield investment by about 6.4 percent. M&A investments, however, are less sensitive to differences in international tax rates as indicated by a tax elasticity of -2.8 percent” (Hebous, et al., 2011, p. 834). These findings conclude that “greenfield investments are more deterred in high tax states than are M&A” (Hebous, et al., 2011, p.819); thus firms are less likely to start a new facility in high tax countries. INTERNATIONAL TAXATION AND INITIAL FOREIGN ENTRIES 8 Further, other literature explains that “while the effective marginal and average tax rates prove insignificant, the statutory tax rate shows a significant negative impact” on the likelihood of investing in a particular country (Buettner and Ruf, 2007, p. 159). A statutory tax rate is the tax rate that the corporations pay on their corporate income; while the effective marginal tax and average tax rates refers to the percentage of taxes a corporation pays in relation to its profits. In their research, B’Enassy-Qu’er’e, Fontagn’e and Lahr’Eche-R’Evil (2005) concluded that “there is an asymmetry in the impact of tax differentials on foreign direct investment (FDI): while lower tax rates in the recipient countries fail to significantly attract foreign investment, higher tax rates tend to discourage new FDI inflows” (p. 598). “Empirical evidence shows that multinational firms (MNF thereafter) do react to tax incentives, be they embedded in tax rules (which avoid double taxation problems through credit or exemption schemes) or tax rates” (B’Enassy-Qu’er’e, et al., 2005, p. 584). Additionally, Kneller and McGowan (2011) studied 17 European countries and found “ that a reduction of the corporate tax rate from the median (30.04%) to the first quartile (27.57%) implies a . 088 percentage point increase in the entry rate, whereas for the same sized reduction from the third quartile (33.44) to the median, entry increases by . 027 percentage points” (p. 6-7). In sum, although the literature provides many examples on the effects of tax rates on certain entry modes (e.g., foreign direct investment), the extant literature remains relatively silent regarding other entry modes such as partnerships and exporting as well as whether the tax rate influences the choice of country or if the foreign direct investment was the firm’s first international move. This suggests that it is an open question if firms really do consider tax rates when making their first move internationally. Tax professionals support the idea that companies may be failing to properly plan for tax consequences when expanding internationally. For example, Goulet (2011), a tax professional in INTERNATIONAL TAXATION AND INITIAL FOREIGN ENTRIES 9 NYC with more than 25 years of accounting experience and a focus on emerging growth companies and entrepreneurs, explains the implications of failing to comprehend tax consequences: “when start-ups aspire to go global, they often overlook the impact that international tax structures and offshore operations will ultimately have on their operations and on their investors” (p. 4). She questions the importance that companies place on taxation when expanding internationally and foreshadows some of the consequences: “it is possible to restructure an existing business structure but it can be very expensive and the result will seldom be optimal,” (Goulet, 2011, p.8). Although this type of restructuring is an option, it is a difficult one that a company would like to avoid, if possible. Goulet (2011) further explains that startups’ attitudes towards taxation results from their inexperience with internationalizing. In line with this argument, Johanson and Vahlne (1990) explain that in companies “two kinds of knowledge are distinguished: objective knowledge which can be taught, and experiential knowledge which can only be acquired through personal experience” (p. 12). This suggests that the lack of experiential knowledge may play a role in why firms may or may not consider tax rates when commencing internationalization. As noted above, these findings further lead me to question whether or not companies are actually considering tax implications when preparing for their international future. Thesis Statement (Research Question) Based on the literature and professional opinions outlined above, taxation has an important effect on foreign direct investment and location choice and that companies may not be considering international taxation as much as they should. This information leads to the research question for this thesis: INTERNATIONAL TAXATION AND INITIAL FOREIGN ENTRIES 10 Do firms internationalizing for the first time consider statutory tax rates? If so, to what extent are they considering them? Hypotheses Development There are three inter-related decisions that entrepreneurs must make when expanding internationally: where to expand (market selection), when to expand (timing), and how to expand (entry mode) (cf. Shra