JANNICK DAMGAARD, THOMAS ELKJAER and NIELS JOHANNESENACCORDING to official statistics, Luxembourg, a country of 600 000 people, hosts as much foreign direct investment (FDI) as the United States, and much more than China. Luxembourg’s US$4 trillion in foreign direct investments comes out to US$6,6 million a person.
Investments of this size hardly reflect brick-and-mortar investments in the minuscule Luxembourg economy. So, is something amiss with official statistics, or is something else at play?
FDI is often an important driver for genuine international economic integration, stimulating growth and job creation, and boosting productivity through transfers of capital, skills and technology. Therefore, many countries have policies to attract more of it.
However, not all of these investments bring capital in service of productivity gains. In practice, FDI is defined as cross-border financial investments between firms belonging to the same multinational group, and much of it is phantom in nature — investments that pass through empty corporate shells.
These shells, also called special purpose entities, have no real business activities. Rather, they carry out holding activities, conduct intra-firm financing, or manage intangible assets—often to minimise multinationals’ global tax bill.
Such financial and tax engineering blurs traditional foreign direct investment statistics, and makes it difficult to understand genuine economic integration.
Better data is needed to understand where, by whom, and why US$40 trillion in FDI is being channeled around the world. Combining the Organisation for Economic Cooperation and Development’s detailed FDI data with the global coverage of the IMF’s coordinated direct investment survey, a new study creates a global network which maps all bilateral investment relationships— disentangling phantom investments from the genuine.
Interestingly, a few well-known tax havens host the vast majority of the world’s phantom investments. Luxembourg and The Netherlands host nearly half. And when you add Hong Kong SAR, the British Virgin Islands, Bermuda, Singapore, the Cayman Islands, Switzerland, Ireland, and Mauritius to the list, these 10 economies host more than 85% of all phantom investments.
Why and how does this handful of tax havens attract so much phantom investments? In some cases, it is a deliberate policy strategy to lure as much foreign investment as possible by offering lucrative benefits—such as very low or zero effective corporate tax rates.
Even if the empty corporate shells have no or few employees in the host economy and do not pay corporate taxes, they still contribute to the local economy by buying tax advisory, accounting, and other financial services, as well as by paying registration and incorporation fees. For the tax havens in the Caribbean, these services account for the main share of gross domestic product, alongside tourism.
In Ireland, the corporate tax rate has been lowered substantially from 50% in the 1980s to 12,5% today. In addition, some multinationals take advantage of loopholes in Irish law by using innovative tax engineering techniques with creative nicknames like “double Irish with a Dutch sandwich,” which involves transfers of profits between subsidiaries in Ireland and The Netherlands with tax havens in the Caribbean as the typical final destination.
These tactics achieve even lower tax rates, or avoid taxes altogether. Despite the tax cuts, Ireland’s revenues from corporate taxes have gone up as a share of GDP because the tax base has grown significantly, in large part from massive inflows of foreign investment.
This strategy may be helpful to Ireland, but it erodes the tax bases in other economies. The global average corporate tax rate was cut from 40% in 1990 to about 25% in 2017, indicating a race to the bottom, and pointing to a need for international coordination.
Globally, phantom investments amount to an astonishing US$15 trillion, or the combined annual GDP of economic powerhouses China and Germany. And despite targeted international attempts to curb tax avoidance—most notably the G20 base erosion and profit shifting (BEPS) initiative and the automatic exchange of bank account information within the Common Reporting Standard (CRS)—phantom FDI keeps soaring, outpacing the growth of genuine investments.
In less than a decade, phantom invesments have climbed from about 30% to almost 40% of global FDI. This growth is unique to foreign direct investments, having grown faster than world GDP since the global financial crisis, whereas cross-border positions in portfolio instruments and other investments have not.
While phantom FDI is largely hosted by a few tax havens, virtually all economies—advanced, emerging market, and low-income and developing—are exposed to the phenomenon. Most economies invest heavily in empty corporate shells abroad and receive substantial investments from such entities, with averages across all income groups exceeding 25% of total foreign investments.
Investments in foreign empty shells could indicate that domestically controlled multinationals engage in tax avoidance. Similarly, investments received from foreign empty shells suggest that foreign-controlled multinationals try to avoid paying taxes in the host economy.
Unsurprisingly, an economy’s exposure to phantom FDI increases with the corporate tax rate.
Globalisation creates new challenges for macroeconomic statistics. Today, a multinational company can use financial engineering to shift large sums of money across the globe, easily relocate highly profitable intangible assets, or sell digital services from tax havens without having a physical presence.
These phenomena can hugely impact traditional macroeconomic statistics—for example, inflating GDP and actual foreign investment figures in tax havens.
Prominent cases include Irish GDP growth of 26% in 2015, following some multinationals’ relocation of intellectual property rights to Ireland, and Luxembourg’s status as one of the world’s largest FDI hosts. To get better data on a globalised world, economic statistics also need to adapt.
The new global FDI network is useful to identify which economies host phantom investments and their counterparts, and it gives a clearer understanding of globalisation patterns. Such data offer greater insight to analysts, and can guide policymakers in their attempt to address international tax competition.
The taxation agenda has gained traction among the G20 economies in recent years. The BEPS and CRS initiatives are examples of the international community’s efforts to tackle weaknesses in the century-old tax design, but the issues of tax competition and taxing rights remain largely unattended to.
However, this seems to be changing, with emerging widespread agreement on the need for significant reforms.
* This article was adopted from the International Monetary Fund’s finance and development write-up for September 2019.
