Why do countries combine the exemption system for the taxation of foreign profits with domestic double taxation relief?

Clemens Fuest and Bernd Huber

Munich Reprints in Economics from University of Munich, Department of Economics

Abstract: Many European countries exempt foreign profits from domestic corporate taxation. At the shareholder level, however, all corporate profits are taxed, and double taxation relief is granted only for domestic corporate taxes. This paper attempts to rationalize this tax policy. In the presence of double taxation agreements which exempt foreign profits from domestic corporate taxation, countries may use shareholder taxes to tax these profits. The disadvantage of shareholder taxes is that they create incentives to sell domestic firms to foreigners. But double taxation relief for domestic profits may preserve domestic ownership. Our results imply that national dividend tax policies may be a factor contributing to the empirically observed home bias in investment.

Date: 2004
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Published in Journal of International Economics 1 62(2004): pp. 219-231

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