metadata: authors: 0: author: Balabushko,Oleksii
1: author: Beer,Sebastian
2: author: Loeprick,Jan
3: author: Pinto Vallada,Felipe
count: Ukraine
docna: 0: docna: The direct and indirect costs of tax treaty
            policy : evidence from Ukraine
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Social Policy,Legal Products,International Law,Judicial System Reform,Public Sector Economics,Legal Reform,Treaties,Financial Economics,Legislation,Regulatory Regimes,Public Finance Decentralization and
            Poverty Reduction
teratopic: Governance,Law and Development,Social Development,Public Sector Development,Macroeconomics and Economic Growth
abstracts: cdata!: This study combines macro and micro data
            to quantify the revenue effects of double tax treaties.
            First, drawing on administrative information, the study
            estimates the tax sensitivity of income flows (dividend,
            interest, and royalty payments) at an aggregate level. The
            analysis finds important direct revenue costs linked to
            treaty restrictions on taxing rights, especially for flows
            into a few major investment hubs. However, high elasticities
            of income flows also suggest that increases in withholding
            rates at the individual treaty partner level would not
            necessarily result in more revenue collection. Second, the
            study uses firm-level information to estimate the
            sensitivity of reported profitability to changes in the
            relevant treaty network. The analysis of the reported
            earnings of multinational enterprise affiliates in Ukraine
            suggests that the ownership structure and operations with
            affiliates in certain jurisdictions explain reported
            profitability, and should thus receive increased attention
            in risk assessment and transfer pricing audit activities.
geo_reg_key: 517208,517191,82689
repnme: repnme: The direct and indirect costs of tax treaty
            policy : evidence from Ukraine
display_title: The direct and indirect costs of tax
            treaty policy : evidence from Ukraine
listing_relative_url: /research/2017/02/27227133/direct-indirect-costs-tax-treaty-policy-evidence-ukraine
topicv3: Tax Law m1326225 1893,Treaties m1327063 1026,Taxation m1327615 1121,Beneficial Ownership m1327718 2079,Transfer Pricing m1504613 2526
publishtoextweb_dt: 2017-02-27T00:00:00Z
historic_topic: Governance,Law and Development,Social Development,Public Sector Development,Macroeconomics and Economic Growth
no_of_pages: 33
author_keys: 0: author_key: 644011
1: author_key: 1319768
2: author_key: 906063
3: author_key: 1441349
model_extractions: WPS7982 Policy Research Working Paper 7982 The Direct and Indirect Costs of Tax Treaty Policy

# Evidence from Ukraine

_Oleksii Balabushko Sebastian Beer Jan Loeprick Felipe Vallada_ Governance Global Practice Group February 2017
Policy Research Working Paper 7982

# **Abstract**

This study combines macro and micro data to quantify the revenue effects of double tax treaties. First, drawing on administrative information, the study estimates the tax sensitivity of income flows (dividend, interest, and royalty payments) at an aggregate level. The analysis finds important direct revenue costs linked to treaty restrictions on taxing rights, especially for flows into a few major investment hubs. However, high elasticities of income flows also suggest that increases in withholding rates at the individual treaty partner level would not necessarily result in more revenue collection. Second, the study uses firm-level information to estimate the sensitivity of reported profitability to changes in the relevant treaty network. The analysis of the reported earnings of multinational enterprise affiliates in Ukraine suggests that the ownership structure and operations with affiliates in certain jurisdictions explain reported profitability, and should thus receive increased attention in risk assessment and transfer pricing audit activities.

This paper is a product of the Governance Global Practice Group. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at obalabushko@ worldbank.org, sebastian.beer@oenb.at, jloeprick@worldbank.org, and Felipe.Vallada@wu.ac.at.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
The Direct and Indirect Costs of Tax Treaty Policy: Evidence from Ukraine Oleksii Balabushko<sup>a</sup> , Sebastian Beer<sup>b,c</sup> , Jan Loeprick<sup>a,c</sup> and Felipe Vallada<sup>c</sup> *

- a. World Bank Group, b. Oesterreichische Nationalbank, c. Vienna University of Business and Economics (WU)

**JEL codes** : F21, F23, H25, H26, H32

**Keywords** : Tax Treaty Policy, Transfer Pricing, Domestic Resource Mobilization, Ukraine

* We thank Eva Eberhartinger, Martin Zagler, Richard Stern, Marijn Verhoeven, Jonathan Leigh Pemberton, Sebastian James, Norbert Roller, Rajul Awasthi, and Adrian Fozzard for their helpful inputs and comments. We would also like to thank the Ukrainian State Fiscal Service and National Bank of Ukraine for guidance and support. The research was financed as part of the technical assistance work under the DFID Trust Fund financing Ukraine Governance Reform Program Technical Assistance
# **1. Introduction**

Double Tax Treaties (DTT) may contribute to investment and growth by avoiding double taxation and providing certainty in taxation rights, but they may also lead to considerable tax revenue losses. DTTs serve a range of purposes, including the limitation of countries’ taxing rights. They determine, for instance, how a country can or cannot tax foreign‐owned companies and payment flows. The treaty‐based allocation of taxing rights between capital receiving source countries and capital exporting residency countries has far reaching revenue implications. With more than 3,000 tax treaties in effect today, the global network is the foundation of the international tax architecture.<sup>1</sup> Presumed tax treaty benefits should include increases in trade and investment flows, increased investment certainty, tools to combat tax evasion, and strengthening of political relations between countries. These benefits come at a cost, typically reductions in applicable withholding tax rates and limitations on tax jurisdiction. In addition, recent international activities aimed at countering treaty abuse seek to address non negligible indirect costs linked to tax treaties, which are being used as part of aggressive tax planning strategies by companies and individuals.

Ukrainian treaties, as most tax treaties globally, are largely based on the OECD’s “Model Tax Convention on Income and on Capital”, which was initially published in 1963 and designed for countries with symmetric trade and investment relations. The UN has developed a similar model, first published in 1980, which aims to better capture interests of capital receiving developing (source) countries.<sup>2</sup> Both models are similar, based on the residency principle, and allocate exclusive taxation rights to residence countries for business profits, unless these are generated through a permanent establishment (PE) in the country. Regarding passive income, the models limit the primary taxing rights of source countries by introducing maximum rates.<sup>3</sup> In recent years the role of tax treaties has been re‐evaluated, most notably in the context of work led by the OECD aimed at avoiding or countering the abuse of tax treaty provisions.<sup>4</sup> For many countries, including Ukraine, a debate on tax treaty policy, however, needs to go beyond the avoidance of treaty abuse and involve a more structured analysis of what a desirable treaty network would look like. In practice, tax treaty policy has often been relatively neglected and not been subject to a proper analysis of cost and benefits. In light of a number of aggregate studies, associated costs may be substantial. UNCTAD (2015), for instance, estimates that 30 percent of global cross‐border corporate investment stocks have 1 For an introductory overview see: Owens, J. and Bennet, M., (2008) and Arnold, B. (2013).

2 UN (2011), Model Double Taxation Convention between Developed and Developing Countries. Daurer and Krever (2014) provide a more detailed discussion.

3 The UN model does not recommend specific rates. The OECD Model Convention proposes maximum withholding rates for dividends, differentiated for substantial (5%) and small ownership in in a company (15%), for interest payments at 10%, and royalties at 0%, thus effectively providing an exclusive taxing right for the resident country of the entity receiving royalty payments. The OECD suggests that the requirement for the lower dividend withholding rate applies to shareholders exceeding a 25% interest in the company paying the dividends.

4 In 2013, the BEPS plan was initiated by the OECD, with support of the G20 and international community. The acronym stands for Base Erosion and Profit Shifting and the BEPS package includes among others: model provisions to prevent treaty abuse; standardized Country‐by‐Country Reporting; a revitalized peer review process to address harmful tax practices; and an agreement on improving dispute resolution.

2
been routed through offshore hubs; the associated annual revenue losses for developing economies amount to approximately $100 billion. Improvement of treaty networks, including revisions of lopsided treaties, is an important policy area for developing countries (IMF 2014). A number of treaties were recently cancelled or subject to important revisions.<sup>5</sup> Treaty limitations on capital gains taxation and the cost of giving up or reducing withholding instruments, which can be interpreted as a ‘second line of defense’ for resource‐constrained administrations against international tax planning and profit shifting, played an important role in these revisions.

This paper proceeds as follows. In Section 2 we provide an overview of the Ukrainian treaty network, its effects on business activity, and its implications for government’s revenues. We then focus on the direct and indirect costs associated with reduced withholding tax rates on dividend, interest and royalty payments from Ukraine. Drawing on administrative information, we estimate the tax sensitivity of income flows at an aggregate level in section 3. Publicly available firm‐level information allows us to then estimate the sensitivity of reported profitability to changes in the treaty network in section 4. Section 5 concludes.

# **2. The Ukrainian Tax Treaty Network**

# **2.1 Role and development of Ukrainian tax treaties**

In Ukraine, international treaties are incorporated into domestic law.<sup>6</sup> The Ukrainian Tax Code and legislation on international treaties explicitly state that in case of conflict, rules established by international treaties approved by the Verkhovna Rada of Ukraine (Parliament) shall prevail over the rules of the Ukrainian Tax Code.<sup>7</sup> In practice, this means that international treaties entered into by Ukraine are hierarchically below the constitution but prevail over the Ukrainian Tax Code.

Ukraine has built a substantial treaty network, encompassing 66 double tax treaties (see Annex for the complete list). These treaties were negotiated with the partial objective of signaling an attractive business environment for potential investors during the transition since the 1990s. In addition, Ukraine still recognizes treaties of the USSR with Spain, Malaysia and Japan, which have not been renegotiated.<sup>8</sup> Foreign‐owned companies, while constituting a smaller share than in neighboring countries, still play an important economic role and are major actors in agribusiness, banking, consumer products, retail and telecommunication (OECD, 2015). However, a large portion of recorded foreign investment into Ukraine is likely the result of local funds being channeled and subsequently returned back to Ukraine in the form of direct investment (round‐tripping). This might explain the high share of investments originating from

> 5 Mongolia, for instance, cancelled DTT’s with Kuwait, Luxembourg, the Netherlands and UAE in 2012. See: Michielse, G. (2012).

> 6 The constitution does not provide explicit guidance on the hierarchy between laws, but prevails in case of conflict. International treaties that are in force, agreed to be binding by the Verkhovna Rada of Ukraine, are part of the national legislation of Ukraine.

> 7 Article 3.2 of the Ukrainian Tax Code.

> 8 Other DTT’s concluded before 1990 were subsequently revised.

3
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According to information obtained from the Central Bank, the share of dividends paid to portfolio investors remained on average below 5 percent of all dividend payments to Cyprus during the period from 2005 to 2015. Similarly, the shares of portfolio investments for the Netherlands, Russia, the UK, Austria, Switzerland, the US, France, and Germany and Sweden on average stood below 5%. Given differences in portfolio and non‐portfolio investor definitions across DTTs and the Central Bank classification<sup>21</sup> we assume that just about 80%<sup>22</sup> of dividend payments qualify for the non‐portfolio rates stipulated in treaty provisions.

# **3.2 Measuring the behavioral response to withholding rate changes**

We attempt to quantify behavioral responses to changes in withholding taxation by looking at historical variation in Ukrainian treaty provisions. This variation is limited and largely driven by new treaty formation,<sup>23</sup> leading to important imprecisions of our results as discussed further below.

Combining information on (limited) variations with administrative information on income flows, we estimate the magnitude of country‐specific dividend, royalty and interest payments, conditional on the structure of the withholding tax regime. To derive estimates on the impact of a partial tax reform, we assume that income flows with partner country i, denoted I(i), are functions of the entire set of withholding tax rates, {T(1),T(2),..T(n)}. Governmental income accruing from the taxation of capital transfers is thus given by ��∑���� T�i� I�i� . We are interested in the impact of a small change of tax rate T(k). Using the above notation, this reads: The first term represents the mechanical effect. Its magnitude is readily available by combining information on current capital transfers with the hypothesized reform, dT(k). The second term accounts for a behavioral response. Quantification of this indirect response requires estimates of the sensitivity of the tax base, dI(i). To arrive at these estimates, we assume that own‐ and cross‐price elasticities are different but constant across partner countries, so that a linearized version of income stream I(i) reads: Here, the first coefficient represents the own‐price semi‐elasticity: income streams to partner country i decrease by _a_ percent in response to a one percentage point increase in the withholding tax rate to partner country i. The second coefficient is given by (N‐1) times the cross‐price semi elasticity. In contrast to the own‐price elasticity, it is expected to take a positive sign due to substitution effects. The variable

> 21 Please note that the definitions of the Central Bank do not always correspond to the definition of the ownership threshold for the non‐portfolio investments specific in each treaty. In DTTs the rates differ between 10%, 20%, 25%, or 50%, depending on the specific provisions. For instance, the treaties with: Cyprus requires 20% shareholding; with Austria the requirement is 10%; while the UK requires at least 20% of the (direct or indirect) voting powers.

> 22 This estimate of 80% thus being fairly conservative, with the average of dividends to portfolio investors being below 5 percent of total payments.

> 23 During our sampling period, rates for the treaty with Cyprus were revised in 2012 and with Norway in 2008. New treaties were concluded with Iceland (2006), Jordan (2005), Libya (2008), Mexico (2012), Montenegro (2007) and Singapore (2007).

13
dl(k) = a*I(k)dT(k) dI(i) = b *I(i)dD(i) log y(itm) = c(m) + a(m) * T(itm) + b(m) * D(itm) + Time(mt) + e(itm) e(itm) = m(mi) + n(i) + v(itm)
|WHT rate of country $i$ -<br>1/r*WHT rate of other<br>countries||-2.33<br>(4.95)||-7.09*<br>(5.01)||-12.54***<br>(3.03)|
|---|---|---|---|---|---|---|
|Time effects|yes|yes|yes|yes|yes|yes|
|Country-specific SD|2.40|2.42|2.40|2.42|2.40|2.42|
|Measure-specific SD|2.08|2.07|1.26|1.35|0|0|
|Idiosyncratic SD|1.43|1.41|1.50|1.47|1.09|1.06|
|Observations|1550|1550|1550|1550|1550|1550|

Estimates on the covariance structure suggest that around 40 percent of the unexplained variation is related to partner‐country specific factors while a third is related to measure‐specific factors.<sup>25</sup> Although we incorporate this information in our estimation approach, the coefficients are estimated with major imprecision, likely owing to the limited variation in tax rates and multicollinearity. The observed magnitude of the estimates reported in columns (1), (3), and (5) is unconvincing. It suggests an increase in the overall tax base as a result of a country level increase in the withholding rate. We therefore introduce an additional restriction to enhance the plausibility of our estimates.

Specifically, we incorporate the assumption that an increase in any tax rate does not increase the overall tax base of the affected income measure. Intuitively, the overall tax base does not increase in response to policy changes if the (negative) own‐price elasticity exceeds the (positive) cross‐price elasticity ‐ the substitution effect. A sufficient condition for this requirement can be stated as the linear restriction _a+r*b=0_ , where r is the ratio of average capital transfers to other countries, relative to capital transfers to some country with the smallest such transfers.<sup>26</sup> We incorporate the restriction in columns (2), (4) and (6), by replacing the tax variables with a combined � rate, defined by ������� ∗������ , and using the ratios r(div)=1.58, r(int)=16.71 and r(roy)=1.60, ���� which are based on income flows in 2014. The implied own price semi‐elasticities are close in magnitude to own‐price elasticities estimated before. Cross‐price elasticities then follow from the restriction. We use these in the calculation of revenue effects in the following sub‐section.

# **3.3 Direct revenue effects of WHT rate reductions**

Our estimation results presented above suggest strong own‐ and cross‐tax elasticities, meaning that income flows with all partner countries respond to changes in the withholding tax rate with any one specific country. More specifically, we find that country‐specific income flows tend to decrease following an increase in the relevant withholding tax rate. This effect reduces the simple mechanical revenue gain

> 25 The measure‐specific error component in royalty outflows is estimated to be marginally negative. We thus restrict this component to zero in estimating other error components.

> 26 Using linearized income streams, the condition of no‐tax‐base‐increase in response to higher tax rates translates � into: ��∗������∗ ��� ∑��� �����������0 in the case of constant cross price elasticities. From this, the ∑��� ���� � sufficient condition _a+r*b=0_ follows with �� ~~.~~ We use a weighted average in our empirical application. ��� ����

15
one would expect from renegotiating a withholding rate at a higher level. The results also suggest that after withholding rates with a country increase, some of the income flows to this country are redirected to other countries. The share of flows that are redirected and the share that is discontinued thus shape the overall sensitivity of the withholding tax base and the efficiency of tax policy changes. Finally, these results suggest that the base of royalty payments and interest flows react strongly to any changes, while dividend flows are less sensitive. Accuracy and magnitude of revenue estimates based on these elasticities are, however, subject to a number of assumptions and need to be interpreted with caution.<sup>27</sup> Tables 2a and 2b below translate our findings into an estimate of revenue losses linked to reduced dividend payments for the five most important recipient countries. (Cyprus, Netherlands, Russia, Austria, and Switzerland). The tables differentiate the mechanical and behavioral effects described above and report the estimated potential revenue impact of partial reforms of the withholding tax structure based on 2012 and 2014 data. In each row we examine what would happen if the current treaty based withholding tax rate with a specific country was reset to the domestic level of 15%. The mechanical effect is presented in the column on “Direct Effect” and the column named “Total Effect” combines the mechanical and behavioral effects. The table indicates, for instance, that parents in the Netherlands received from Ukraine more than US$ 400 million in dividends in 2014. If the withholding tax rate had been reset to 15%, the mechanical increase in revenues would have been around US$ 60 million. However, a share of the flows would likely have been redirected. Our estimates indicate that roughly 80% of the initial increase would remain.

_Table 2a: Estimated revenue loss from reduced withholding on dividends (2014)_

|**Country**|**Flow in 2014**<br>**_Total non‐_**<br>**_portfolio_**<br>**_dividend flow_**<sup>**28**</sup><br>**_(Million USD)_**|**Differential**<br>**_of qualifying_**<br>**_rate with_**<br>**_standard_**<br>**_withholding_**|**Direct Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million USD)_**|**Total Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million USD)_**|**Efficiency**|
|---|---|---|---|---|---|
|**Cyprus**|175.95|0.10|17.59|14.49|0.82|
|**Netherlands**|416.40|0.10|41.64|34,14|0.82|
|**Russia**|71.44|0.10|7.14|6.01|0.84|
|**Austria**|77.03|0.10|7.70|6.46|0.84|
|**Switzerland**|73.79|0.10|7.38|6.20|0.84|
|**Mean**|162.92|0.10|16,29|13,46|0.83|

> 27 Most importantly, we impose a specific balance of own‐ and cross tax elasticities to ensure that our results are economically meaningful (we require that the aggregate tax base does not increase in response to an increase in any withholding tax rate).

> 28Assumed to be 80 % of total flow.

16
_Note: The table summarizes estimates of revenue losses from reduced dividend payments for the 5 most important recipient countries in 2014. The table presents an estimated revenue impact of resetting withholding tax rate with a specific country to the domestic level of 15%._ _Data Source: Central Bank_ In table 2b<sup>29</sup> we report estimated effects for the year 2012 to allow for a comparison of effects before the dramatic drop in dividend outflows as a result of ban on dividend repatriation following the currency shock in late 2014. Revenue implications in 2012 are more dramatic. However, the relative efficiency — the total effect as a share of the direct effect — is similar across both years, we estimate that roughly 80% of any mechanical increases would have ended up as additional government revenue.

_Table 2b: Estimated revenue loss from reduced withholding on dividends (2012)_

|**Country**|**Flow in 2014**<br>**_Total non‐_**<br>**_portfolio_**<br>**_dividend flow_**<sup>**30**</sup><br>**_(Million US$)_**|**Differential**<br>**_of qualifying_**<br>**_rate with_**<br>**_standard_**<br>**_withholding_**|**Direct Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million US$)_**|**Total Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million US$)_**|**Efficiency**|
|---|---|---|---|---|---|
|**Cyprus**|948.02|0.10|94.80|77.33|0.82|
|**Netherlands**|516.64|0.10|51,66|42,36|0.82|
|**Russia**|113.37|0.10|11.34|9.62|0.85|
|**Austria**|63.30|0.10|6.33|5.55|0.88|
|**Switzerland**|47.05|0.10|4.70|4.24|0.90|
|**Mean**|337.67|0.10|33,76|28,70|0.85|

_Data Source: Central Bank_ We repeat this exercise for the main recipients of interest flows and royalty payments in 2014, applying the same approach. Given that we cannot differentiate between flows potentially qualifying for a lower rate, we only refer to the higher standard rate stipulated in each treaty.

_Table 3: Estimated revenue loss from reduced withholding on interest (2014)_

|**Country**|**Flow in 2014**<br>**_Interest_** **_(Million_**<br>**_USD)_**|**Differential**<br>**_with standard_**<br>**_withholding_**|**Direct Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million USD)_**|**Total Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million USD)_**|**Efficiency**|
|---|---|---|---|---|---|
|**Cyprus**|613.65|0.13|79.77|21.72|0.27|

> 29 We also present tables for royalty and interest flows in 2012 in the Annex.

> 30Assumed to be 80 % of total flow.

17
|**Netherlands**|106.39|0.05|5.32|1.79|0.34|
|---|---|---|---|---|---|
|**Russia**|344.17|0.05|17.21|4.73|0.27|
|**Austria**|98.96|0.10|9.90|3.45|0.35|
|**UK**|480.80|0.15|72.12|20.14|0.28|
|**Mean**|328.79|0.10|36.86|10.36|0.30|

_Data Source: Central Bank_ _Table 4: Estimated revenue loss from reduced withholding on royalties (2014)_

|**Country**|**Flow in 2014**<br>**_Royalties_**<br>**_(Million USD)_**|**Differential**<br>**_with standard_**<br>**_withholding_**|**Direct Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million USD)_**|**Total Effect**<br>**_Tax revenue_**<br>**_foregone_**<br>**_Million USD)_**|**Efficiency**|
|---|---|---|---|---|---|
|**Cyprus**|62.77|0.05|3.14|0.02|0.01|
|**Russia**|40.09|0.05|2.00|0.39|0.20|
|**UK**|85.55|0.15|12.83|3.07|0.24|
|**Switzerland**|84.40|0.05|4.22|‐0.31|‐0.07|
|**US**|59.87|0.05|2.99|0.08|0.03|
|**Mean**|66.53|0.07|5.04|0.65|0.08|

_Data Source: Central Bank_ Our estimates suggest, for instance, that resetting the withholding tax rate on interest payments to Cypriot lenders could result in almost US$ 80 million in additional revenues. However, in the long run, financing would likely be restructured and originate from other countries and we estimate that only 27% of the initial increases of an isolated increase in the rate with a specific country would persist. For royalty payments, for which zero withholding rates are most common, this effect is even more pronounced. The ratio of total revenue increases as a share of mechanical effects is just 8% on average.

# **4. An investigation of indirect costs and treaty abuse**

Treaty based withholding rates likely affect government revenues both directly and indirectly. As presented above, the direct effect may be an increase in revenues due to a change in the applicable tax rate. Indirectly, a change in withholding tax rates may also change the costs of shifting income abroad 18
when using debt financing or charges for the use of intellectual property and disproportionate interest or royalty payments may decrease the reported pre‐tax profitability of MNE affiliates operating in Ukraine.

A growing body of evidence indicates that multinational enterprises (MNEs) exploit intra‐group transactions to reduce their corporate tax liability (Heckemeyer and Overesch, 2013, Beer and Loeprick 2015). These tax planning strategies often involve the cross‐border provision of intellectual property and intra‐group financing. By acquiring goods and services, tax‐deductible expenses of domestic entities can be inflated and earnings of affiliates can be increased. Given that the economic value of intellectual property, the appropriate magnitude of and remuneration for intra‐group lending, or the long term return on management services is often difficult to determine, these transactions can provide an opportunity to reallocate profit.

While reducing the domestic corporate tax base, interest‐, royalty‐, and service fee payments are also taxed domestically. Unless double tax treaties stipulate otherwise, withholding taxes of 15 percent are levied on the gross income payments to foreign entities, increasing the effective costs of intra‐group transactions and thus limiting the incentive to engage in tax arbitrage. Accordingly, withholding taxation can act as ‘a second line of defense’ in safeguarding the domestic tax base, especially when administrative capacity is limited or the scope of anti‐abuse provisions is narrowly defined.

In order to get a better indication of treaty related tax planning and potential profit‐shifting from Ukraine, we exploit information on group structures and performance indicators of more than 5,000 Ukrainian MNEs to examine profitability, and leverage ratios among Ukrainian MNEs. More specifically, we rely on available locational information on the MNE group structure to determine the relevant set of withholding tax rates for each firm in the sample to estimate the impact of withholding tax rates on reported firm level performance.

# **4.1 Data and sample description**

Our analysis in this section is based on Bureau van Dijk’s ORBIS database, offering administrative information for more than 50 million private and public companies globally. The data are collected by national institutions based on legal requirements and compiled and standardized by Bureau van Dijk. As of January 2016, ORBIS covers over 300,000 Ukrainian firms with unconsolidated accounts, providing balance sheet and profitability information for the years 2006 until 2014 as well as information on corporate group structures.<sup>31</sup> We consider firms to be a multinational enterprise if they either own, or if they are owned by, at least one foreign affiliate with a total ownership‐share of at least 20%. Following this definition, the majority of Ukrainian firms are not part of MNEs. We drop purely domestic firms from the sample. To avoid potential biases caused by influential and/or unusual observations, we perform a sequence of data cleaning steps. Specifically, we drop firms with unknown or excessive profitability level and 5% of the sample lying at the extremes of the distribution (in terms of profitability, size, or reported intensity on the use of intangible

> 31While a related information provider (Zephyr) allows tracing back recent mergers and acquisitions, there is little such information on Cypriot firms. Given that the majority of firms are affiliated to companies in Cyprus, the picture drawn by this analysis is static.

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assets). Finally, we limit the data set to firms with non‐negative sales and liabilities. Following these data cleaning steps, the baseline sample comprises 5,113 MNEs. Table 5 summarizes the sample selection.

# **Table 5: Sample Selection**

|**Step**|**Description**|**Firms in sample**|
|---|---|---|
|1|Downloaded from ORBIS|309,630|
|2|Drop domestic firms|5,333|
|3|Drop outliers|5,113|

_Source: ORBIS 2016 (January)_ For each MNE in the baseline sample, we record the number and location of affiliated companies and the location of its global ultimate owner. Around 90% of our sample is controlled from abroad. More than 20% of the firms in our sample are controlled from Cyprus. Other important locations of controlling shareholders' countries include Russia, Germany, the British Virgin Islands, USA, UK, Netherlands, Austria and Poland. We cannot clearly identify the global ultimate owner for roughly 15% of the sample because of shared ownership structures.

To further examine the impact of group structures, we assign each Ukrainian firm to at least one foreign country if either the controlling shareholders, or a controlled subsidiary, are located there. Over 30% of the sample exhibit a direct link to Cyprus (1,697 out of 5,312), either through a controlling shareholder or a controlled subsidiary. This number includes companies which are operating in Cyprus and Ukraine only (1,219 firms) and MNEs operating in more than two countries. The most frequent corporate group structures among the latter group include: Ukraine‐Cyprus‐Luxembourg (76 firms), Ukraine‐Cyprus‐British Virgin Islands (72 firms), and Ukraine‐Cyprus‐Netherlands (70 firms).<sup>32</sup> We do account for the details of these group structures when estimating the impact of withholding tax rates on firm‐level variables. Specifically, when a Ukrainian MNE is affiliated with companies in more than one country, we proxy for the effective withholding tax rate by taking the lowest of the tax rates applicable under the set of relevant double tax treaties.

Besides Cyprus, which seems to be part of most group structures, we find a high concentration of ownership links between Ukrainian MNEs and foreign entities in the following countries: Russia (435 firms), the Netherlands (402 firms), Great Britain (396 firms), Germany (371 firms), British Virgin Islands (333 firms), USA (256 firms), Poland (230 firms), Austria (229 firms), and Luxembourg (207 firms).

Figure 10 summarizes the relative importance of industries across Ukraine’s major partner countries. For each major partner country identified above, the circle size represents the share of firms operating in a

> 32 These figures do not differentiate the number of affiliated companies of a specific MNE in a country. The presence of one or multiple firms of the same corporate group in one foreign country is recorded as one direct relationship to this country.

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USA (+110%), Austrian real estate and financial firms (+110% and +210%), and the agricultural intensity of MNEs with affiliates in Luxembourg (+400%).

# **4.2 Empirical analysis**

We start our analysis from the premise that an MNE’s incentive to shift profits is inversely related to the level of withholding taxation. Where domestic withholding taxation applies to cross‐border interest‐, royalty‐, or service fee payments, the potential tax advantage of lower corporate income taxation abroad is reduced. Double taxation agreements thus likely affect reported firm profitability by altering the financial structure, the provision/use of intellectual property, or the use of internal services. We link group structure information with firm‐level variables to investigate this premise.

The following regression specification summarizes two related hypotheses: ������� ���������������������<sup>�</sup> ������������ The dependent variable y(it) varies over time t and firms i. It is either (a.) the return on assets (profit over tangible assets), or (b.) the leverage ratio (debt over tangible assets) of Ukrainian MNEs. The main explanatory variable, _withholding_ , is the relevant withholding tax rate which varies across observations in accordance with the location of affiliated companies.<sup>35</sup> We expect withholding taxation to exert a positive influence on firm profitability by reducing the incentive to shift profits abroad. Accordingly, the coefficient on the withholding tax rate should take a positive sign when using the return on assets as the dependent variable. The underlying mechanisms are twofold. First, withholding taxation on interest payments decreases the tax benefit of debt financing. For instance, by applying a high rate of withholding to interest payments to a related entity in a low tax jurisdiction, the return to shifting profits out of Ukraine decreases. We thus expect higher withholding taxation to impact the leverage ratio of MNEs in Ukraine negatively. The second mechanism works through the use of intellectual property. If royalty payments are taxed when crossing the border, the benefit of relocating profit using excessive royalty charges is reduced.

Ukraine’s withholding tax rates on royalty‐ and interest payments are highly correlated (around 0.8). To avoid multicollinearity, we use an average of these rates as an explanatory variable. Furthermore, to account for MNEs’ affiliation with several partner countries, we proxy for the relevant withholding tax rate by taking the minimum of the applicable tax rates. Limited variation in withholding tax rates between 2006 and 2014 limits our control for arbitrary correlation between unobserved effects at the firm level

> 35 Variation in withholding tax rates is limited thus complicating tests for reverse causality. Withholding tax rates, however, are less flexible and determined by the negotiators of two countries with competing interests on a range of policy objectives.

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and for our explanatory variables.<sup>36</sup> To reduce the potential of endogeneity, we include a range of control variables in X.<sup>37</sup>

# _Performance ratios and MNE links to partner countries_

We first examine the impact of DTTs graphically by depicting firm‐specific variables conditional on corporate group structures. Figures 11 and 12 below illustrate the average development of the return on assets and the leverage ratio of MNEs with an affiliate in a specific country (dark blue line) and a control group (light blue line) of comparable firms without a link to this country.

Selection of the control group is based on propensity score matching, with tangible asset‐, industry‐, and employee information used as explanatory variables. Firms in the experimental groups should thus not differ in these dimensions. However, while each firm in the “treatment“‐group owns a subsidiary (or is owned by a shareholder) in a specific country, firms in the control group are not affiliated with this country. More precisely, the values depicted are conditional means: they stem from MNEs of comparable size and similar industry composition but different ownership structures.<sup>38</sup> Red circles indicate significant deviations between the two groups in a given year.

> 36 We do, however, account for the characteristic error structure implied by equation 1 (i.e., the firm specific error component ���� ) and estimate the model via feasible GLS (random effects).

> 37 The vector includes a set of industry indicators, the logarithm of firm‐specific assets to control for the impact of size, the number of affiliated companies to control for group spill‐overs and a full set of time‐specific effects to account for macroeconomic shocks.

> 38 However, the graphs do not capture the influence of other variables, such as the impact of high debt levels on firm profitability.

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Group — Country-specific MNEs —— Matched Control
_Notes: Graph depicts average of firm‐specific variables (Return on Assets and Leverage Ratio) for MNEs with an ownership link to a specific country (dark blue line) and the average of these variables for matched MNEs without this link_ .

Data Source: ORBIS (2016) Noteworthy observations from Figures 11 and 12 include considerably lower reported profitability ratios of MNEs with Cypriot affiliates than in the control group. In 2009 and 2010, the difference with comparable firms is particularly remarkable and statistically significant. The development of the leverage ratio is presented in the second row and shows a moderate convergence between treatment and control group, as depicted in the third row.

Another interesting observation is that MNEs with an affiliate in Russia show no statistically significant differences in the return on assets in any given year. On average, however, the profitability figures seem to be slightly higher than the returns of comparable firms, particularly before 2010. The second row indicates that MNEs with a Russian affiliate are moderately leveraged. The first column in Figure 11 contrasts MNEs with affiliates in the British Virgin Islands with a matched control group. While profitability ratios seem to be particularly low, there are no significant deviations in any year.

To further analyze whether group structures impact firm‐specific variables, we estimate a series of regression specifications (see Tables 6a and b) where we include locational dummies in addition to controlling for industry composition and size. Aggregating over years supports the trends apparent in Figures 11 and 12: groups with affiliates in Cyprus exhibit significantly lower profitability ratios. On average, we find the return on assets to be 0.82 lower than the one of comparable firms without Cypriot affiliates. The difference is significant at the 1 percent level. The regression results also indicate that MNEs with affiliates in the UK (‐0.44) and the British Virgin Islands (‐1.42) exhibit significantly lower profitability ratios.

In contrast, we find MNEs with links to Poland, Germany, and the Netherlands to be more profitable than comparable firms of similar size, with significantly positive deviations of 0.83, 0.69, and 0.86, respectively. These findings seem to be partly driven by leverage ratios. Groups with affiliates in Cyprus and Luxembourg are also highly leveraged, while groups with direct relationships to Russia and Poland exhibit a lower ratio of liabilities to assets.

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_Table 6a: Profitability across partner countries_

|Random effects estima<br>Dependent variable: ret<br>Explanatoryvariables|tion<br>urn on assets||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
|Intercept|-1.322***<br>(0.373)|-1.653***<br>(0.379)|-1.517***<br>(0.371)|-1.506***<br>(0.371)|-1.556***<br>(0.371)|-1.472***<br>(0.371)|-1.594***<br>(0.375)|-1.579***<br>(0.372)|-1.535***<br>(0.371)|-1.535***<br>(0.371)|
|log(tangible assets)|0.359***|0.348***|0.341***|0.345***|0.343***|0.348***|0.344***|0.345***|0.343***|0.343***|
|Size of corporate|(0.070)<br>-0.003***|(0.069)<br>-0.003***|(0.069)<br>-0.004***|(0.069)<br>-0.003***|(0.069)<br>-0.003***|(0.069)<br>-0.003***|(0.069)<br>-0.003***|(0.069)<br>-0.003***|(0.069)<br>-0.003***|(0.069)<br>-0.003***|
|group|||||||||||
||(0.001)|(0.001)|(0.001)|(0.001)|(0.001)|(0.001)|(0.001)|(0.001)|(0.001)|(0.001)|
|log(employees)|0.109|0.095|0.092|0.097|0.101|0.096|0.096|0.101|0.099|0.098|
||(0.073)|(0.074)|(0.074)|(0.074)|(0.074)|(0.074)|(0.074)|(0.073)|(0.074)|(0.074)|
|CY|-0.823***<br>(0.180)||||||||||
|RU||0.532<br>(0.346)|||||||||
|NL|||0.860***<br>(0.320)||||||||
|GB||||-0.442*<br>(0.265)|||||||
|DE|||||0.694**<br>(0.334)||||||
|VG||||||-1.423***|||||
|||||||(0.337)|||||
|US|||||||0.651<br>(0.445)||||
|PL||||||||0.830**<br>(0.376)|||
|AT|||||||||0.293<br>(0.502)||
|LU||||||||||0.101<br>(0.336)|
|Obs|40064|40064|40064|40064|40064|40064|40064|40064|40064|40064|
|R2|0.013|0.012|0.012|0.012|0.012|0.012|0.012|0.012|0.012|0.012|

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# _Table 6b: Leverage across partner countries_

|Random effects estimation<br>Dependent variable: leverage<br>Explanatoryvariables|ratio||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
|Intercept|-0.003|0.003|0|-0.002|0|-0.001|-0.001|0|0|0|
||(0.007)|(0.007)|(0.007)|(0.007)|(0.007)|(0.007)|(0.007)|(0.007)|(0.007)|(0.007)|
|log(tangible assets)|-0.012***|-0.012***|-0.012***|-0.011***|-0.011***|-0.011***|-0.011***|-0.011***|-0.011***|-0.011***|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|Size of corporate|0.000**|0.000**|0.000*|0.000*|0.000**|0.000**|0.000**|0.000**|0.000**|0.000**|
|group|||||||||||
||(0.000)|(0.000)|(0.000)|(0.000)|(0.000)|(0.000)|(0.000)|(0.000)|(0.000)|(0.000)|
|log(employees)|0.014***|0.014***|0.014***|0.014***|0.014***|0.014***|0.014***|0.014***|0.014***|0.014***|
||(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|(0.002)|
|CY|0.008||||||||||
||(0.005)||||||||||
|RU||-0.015***|||||||||
|||(0.005)|||||||||
|NL|||0.026**<br>(0.012)||||||||
|GB||||0.021|||||||
|||||(0.016)|||||||
|DE|||||-0.008*||||||
||||||(0.005)||||||
|VG||||||0.013|||||
|||||||(0.012)|||||
|US|||||||0.008||||
||||||||(0.011)||||
|PL||||||||-0.013**|||
|||||||||(0.005)|||
|AT|||||||||0.005<br>(0.012)||
|LU||||||||||0.020**|
|||||||||||(0.009)|
|Obs|40254|40254|40254|40254|40254|40254|40254|40254|40254|40254|
|R|0.017|0.017|0.017|0.017|0.017|0.017|0.017|0.017|0.017|0.017|

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Table 7 presents our main results on the relationship between withholding tax rates and firm‐specific variables. More specifically, we test whether withholding tax rates drive the variation in profitability and leverage across MNEs with different ownership structures, documented above.

_Table 7: Impact of withholding on firm level variables_

|Random effects estimation|||||
|---|---|---|---|---|
|Dependent variable|Return on|assets|Leverage|ratio|
|Explanatory variables|(1)|(2)|(3)|(4)|
|Withholding tax|0.05***|0.04*|‐0.15***|‐0.19**|
||(0.02)|(0.02)|(0.08)|(0.08)|
|Log(tangible assets)|0.37 ***|0.39***|‐1.50***|‐1.50***|
||(0.07)|(0.07)|(0.17)|(0.17)|
|Log(employees)|0.07|0.07|0.68***|0.68***|
||(0.08)|(0.08)|(0.21)|(0.21)|
|Size of group|‐0.00***|‐0.00***|0.01*|0.01*|
||(0.00)|(0.00)|(0.00)|(0.00)|
|Country‐specific effects|‐|Yes|‐|Yes|
|Observations|40064|40064|40254|40254|
|Adj. R2|0.01|0.01|0.02|0.02|

The first column shows that withholding tax rates help explain reported profitability. Controlling for industry and year fixed effects, the amount of reported tangible assets, the number of employees, and MNEs’ group‐size, we find that a one percentage point increase in withholding taxation increases reported profitability by 5 percentage points. The impact is statistically significant at the 1% level. When additionally controlling for the presence of an affiliate in one of the most important partner countries (Cyprus, UK, Germany, Netherlands, Russia, Austria, Poland, Luxembourg), using a set of dummy variables, the estimated impact decreases only slightly in magnitude and remains significant at the 10% level, as shown in column 2. The observed effect thus also seems to be relevant outside the main partner countries.

In columns 3 and 4, we examine whether the observed correlation between withholding tax rates and firm profitability is driven by a change in leverage ratios. In line with our expectations, we find that higher withholding taxation decreases the leverage ratio significantly. More specifically, we find that a one percentage point increase in withholding taxation decreases the debt share by 19%.

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Withholding tax rates thus seem to be a determinant of reported profitability levels and the leverage of Ukrainian entities. However, the regression results indicate that the location of affiliated companies explains some residual variance, implying that the documented variation in firm profitability is not driven by withholding taxation alone. Specifically, after controlling for firm size, industry, macro‐shocks and withholding tax rates, we find that firms with an affiliate in either Cyprus or the British Virgin Islands are surprisingly unprofitable. The difference to comparable firms lies at 0.45 and 1.35, respectively, and is significant at the 10% and 1% level.<sup>39</sup> Similarly, the high profitability of MNEs with an affiliate in the Netherlands is not fully captured by withholding taxation or firm size.<sup>40</sup>

# **5. Conclusion**

To investigate the effect of reduced withholding tax rates on revenue collection in Ukraine, we combine administrative information on income flows and publically available firm level information. Our analysis of income flows suggests that there are important revenue losses linked to reduced withholding tax rates on dividend, interest and royalty payments. Combining information on historical variation in Ukrainian treaty provisions with administrative data we also find, however, that income flows to a specific country tend to decrease following an increase in the relevant withholding tax rate with the country. This effect reduces the simple mechanical revenue gain one can expect from renegotiating a withholding rate at a higher level. Furthermore, we investigate indirect costs of reduced withholding rates and find that the reported profits of Ukrainian multinationals are sensitive to withholding taxation, indirectly adding to total revenue losses. This effect is partly driven by differences in the use of debt financing. Group structures seem to impact the reported profitability of Ukrainian MNE affiliates.

Our findings point towards the importance of developing a comprehensive treaty policy approach to guide any future negotiations and/or revisions. This is particularly relevant with respect to the small number of major investment hubs (Cyprus, Netherlands, Switzerland, Luxembourg) accounting for a large share of income flows from Ukraine. A treaty can be beneficial where its benefits outweigh revenue losses. Consequently, further analysis of benefits should be done for the Ukrainian DTTs to see whether they measure up against the cost estimates in this paper. Notably, however, where investment activity is merely redirected via another country to take advantage of treaty benefits, but would have taken place irrespective of the treaty, revenue losses are not offset by any potential gains. The findings of this study suggest that further targeted enforcement may be needed to address such round‐tripping arrangements. Moreover, the analysis of reported MNE earnings suggests that the ownership structure and operations with affiliates in certain jurisdictions should receive increased attention in risk assessment and transfer pricing audit activities.

> 39 Effective final tax rates may explain some of the residual variance. However, we cannot reliably capture applicable tax rates given that jurisdiction may simply be used as a conduit.

> 40 For simplicity, the coefficient estimates on the locational dummies, reported in this paragraph, are not depicted in Table 2.

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At a more general level, our findings may motivate and provide input into a wider policy research agenda focused on a better understanding of costs and benefits of double tax treaties, with a particular emphasis on economies with asymmetric investment and income flows.

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