Journal of Public Economics 68 (1998) 269290

Taxes and the division of foreign operating income

among royalties, interest, dividends and retained earnings
Harry Grubert*
U.S. Treasury Department, Room 5 l21, 1500 Pennsylvania Avenue, NW, Washington, DC 20220,
USA
Received 1 July 1995; received in revised form 1 June 1997; accepted 2 July 1997

Abstract
How do taxes influence the way U.S. corporations divide foreign affiliate operating
income among royalties, dividends, interest, and retained earnings? The paper goes beyond
previous work that focused largely on dividend repatriation behavior, and provides a
comprehensive analysis of the disposition of foreign subsidiary operating income. The
empirical results show that taxes have a large and statistically significant effect on the
composition of payments. Own tax prices discourage the payment of dividends, royalties
and interest. But dividend and other repatriation taxes do not increase retained earnings,
they only alter the composition of payments. The results are, therefore, consistent with a
generalized HartmanSinn model of the mature controlled foreign corporation that has
various alternative repatriation vehicles. Finally, this paper integrates the choice of
payments with income shifting among countries because the latter may be part of a low-tax
strategy for repatriations. In this general framework, conventional composite tax prices are
not appropriate because the response to a change in a composite tax price depends on which
components changed. 1998 Elsevier Science S.A.
Keywords: Dividends; Multinational corporations; Royalties; Tax prices
JEL classification: H32; H87; F23

1. Introduction
Almost all of the previous studies of multinational corporation (MNC) financial
*Tel.: 11 202 622 0465; fax: 11 202 622 2969; e-mail: harry.grubert@treas.sprint.com
0047-2727 / 98 / $19.00 1998 Elsevier Science S.A. All rights reserved.
PII S0047-2727( 97 )00077-7

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behavior focus exclusively on dividend repatriation behavior. Yet royalties and

license fees that U.S. based MNCs receive from foreign subsidiaries have become
increasingly important, amounting to 22% of total direct investment income in
1992. Moreover, dividends and royalties are only two payments among many
alternatives, so the role of taxes in foreign subsidiary or controlled foreign
corporation (CFC) financial policy can be understood only by taking a broader
look at the various ways in which a CFC can use its cash flow.1 To be more
precise about the various alternatives, consider true or undistorted pre-tax
operating income before payments of interest or royalties to related parties,
deductions for unrelated interest, and any artificial forms of income shifting. This
income can be divided among the following categories: (a) royalties, (b) payments
to affiliates for technical and other services, (c) interest payments both to its
affiliates and to third parties, (d) net retained earnings, (e) dividend repatriations,
(f) income shifted to or from other affiliates through commodity transactions and
other means, and (g) taxes.
Looking at several payments at the same time strengthens the analysis of each.
(The analogy, of course, is a system of consumer demand equations.) For example,
if a higher tax price on interest payments to the parent encourages royalty
payments, the substitutability of royalties and interest payments can be confirmed
from the role of the tax price of royalties in the interest equation. Similarly, a
broader analysis of the components of CFC operating income demonstrates that a
decision not to pay dividends is not the equivalent of a decision to retain more
earnings because income can be taken out of the company by other means. This
paper focuses explicitly on royalties, interest, dividends and retained earnings, but
it recognizes that total operating income itself can vary because of income shifting.
Income will be shifted not only to reduce the tax cost of current operations but
also to lower the cost of repatriations.
The more general analysis of CFC financial behavior contrasts with earlier work
(e.g., Altshuler et al., 1995) that focuses exclusively on dividend repatriations. The
paper also explores how Hartmans new view on the irrelevance of repatriation
taxes fits into this broader context? (Hartman, 1985).
Before proceeding, it is useful to summarize the relevant U.S. tax provisions.
The United States generally only taxes income from active business operations
abroad when it is repatriated. A credit is given for foreign income taxes paid,
including the underlying foreign corporate tax on direct dividends, but the credit is
limited to the U.S. tax on the income. A U.S. company is referred to as being in
excess credit if it has paid more foreign taxes than it can claim as credits. If
foreign taxes are less than the maximum of allowable credits, it is referred to as
being in excess limit. The tax credit limitation calculation is performed separately
1
A controlled foreign corporation, as defined in the U.S. Tax Code, is a foreign corporation more
than 50% of which is owned by U.S. shareholders. Shareholders for this purpose must own at least
10% of the equity. A MNC includes both the parent and one or more CFCs.

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271

for each type of income, or basket, in order to isolate active business income
from passive and other lightly taxed income. There are also anti-abuse provisions
that currently tax CFC passive income and the income from sales to related parties
routed through low-tax countries.
The more comprehensive analysis of CFC financial behavior demonstrates that
the conventional construction of composite tax prices for particular distributions is
inadequate because it is necessary to know the separate components of the tax
price. For example, suppose two CFCs have the same high tax price on dividends.
One has a parent in excess credit so the tax price on dividends reflects only the
high host country withholding tax. With excess foreign tax credits, the parent has
no residual U.S. tax liability on any marginal repatriations. The other CFC has a
parent in excess limit, and its dividend tax price is high because the host country
effective tax rate is low compared to the U.S. tax rate, resulting in a high residual
U.S. tax on dividends. These two companies with identical tax prices for dividend
payments (and identical tax prices for interest and other repatriations) might have
widely differing repatriation behavior. When a high withholding tax is the source
of the high repatriation tax, the CFC can respond by shifting income to another
foreign affiliate with lower withholding taxes. This strategy would provide no
benefit if the parent does not have excess credits. Accordingly, these two cases
should be distinguished in the econometric work.2
The empirical results, based on the 1990 U.S. Treasury corporate tax files,
indicate that the own tax prices always have a negative and significant effect on
dividends, interest and royalties. However, the fact that a higher tax price on
dividends discourages dividend distributions does not mean that there is an
equivalent increase in retained earnings. In fact, retained earnings do not go up at
all, suggesting that the company uses alternative ways for taking money out of a
CFC. Introducing the tax prices of alternatives into each payment equation has a
significant effect on the results. For example, including the tax prices of interest
and royalty payments in the dividend repatriation equation has a very important
effect on the coefficients for the dividend tax prices. The interest and royalty
equations suggest that they are substitutable forms of repatriating income.

2. Analytic background

2.1. The tax cost of various types of payments

Before discussing how introducing alternatives to dividend repatriation alters the
results of the HartmanSinn model of a foreign subsidiary, it is useful to review

Another way of expressing this point is that the tax price of payments (including income shifting) to
other foreign affiliates should be included in the equation.

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the determinants of the tax prices that enter into the model.3 Tax prices have been
discussed extensively in earlier work (Grubert and Mutti, 1991; Altshuler and
Newlon, 1993; among others). But let us summarize some of the basic considerations, with particular emphasis on royalties and their alternatives.
The tax cost of a payment depends on whether the parent is in an overall excess
foreign tax credit position in the relevant basket.4 If it is in an excess foreign tax
credit position, the tax consequences of paying an additional dollar of royalties,
rather than retaining the income, is w L 2 t S , where w L is the withholding rate on
royalties and t S is the foreign statutory tax rate. The royalty, being deductible,
reduces the foreign corporate tax by t S , but a withholding tax of w L has to be paid.
There is no additional U.S. tax liability because of excess credits. Note that the tax
price is likely to be negative because withholding rates on royalties are generally
lower than statutory tax rates. In this excess credit case, the tax cost of a dividend
compared to retention is w D , the foreign withholding tax rate on dividends. The
foreign corporate tax has already been paid and there is no residual U.S. tax.
If the parent does not have excess foreign tax credits, the credits that accompany
a distribution become relevant. The credit for the underlying foreign corporate tax
linked to a dividend depends on the foreign average effective tax rate t E , not t S .
The distinction is important in the empirical work because companies get a credit
only for foreign taxes actually paid on true equity income. It is common for t E to
be substantially less than t S because of accelerated depreciation, investment credits
and other incentives.
In this excess limit case, the tax cost of a marginal dividend instead of retention
is t US /(1 2 t E ) 2 t E /(1 2 t E ), where t US is the U.S. statutory tax rate.5 The
dividend is first grossed-up by the underlying foreign effective corporate tax rate,
then the U.S. tax is applied and the foreign tax credit on the grossed up dividend is
subtracted. The tax cost of a royalty payment instead of retention is t US 2 t S . (This
does not include the possible effect of an additional royalty on the credits for any
existing dividends, which is discussed below.) The foreign withholding tax rate on
royalties w L is not relevant because it is now fully creditable against the U.S. tax.
Note how a low foreign effective rate t E compared to t S affects the relative tax
costs of a royalty and a dividend in the excess limit case. Take a company paying
out no dividends or royalties that is deciding on how to repatriate a dollar of
pre-tax operating income. Paying it out as a deductible royalty will result in a tax
equal to t US , the U.S. statutory rate. Assuming no inframarginal dividends, the
3

An elegant presentation of this model can be found in Sinn (1993).

There is a look through for payments of CFC income to determine the basket for the income
received by the parent. For example, if the CFC earns only manufacturing income, all of its dividend
and royalty repatriations will be in the general active basket. Companies prefer royalties and interest
to be in the general active basket because they are more likely to have available excess credits there
originating from dividends.
5
We are abstracting from the interaction, discussed in Leechor and Mintz (1993), between CFC
investment and repatriation taxes when the host country provides investment incentives.
4

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273

total tax cost of distributing the same pre-tax amount as a dividend is t S 1 (1 2

t S )(t US /(1 2 t E ) 2 t E /(1 2 t E )). The extra dollar of equity income abroad triggers
an additional foreign tax of t S . That leaves (1 2 t S ) to be distributed as a dividend,
to which the dividend tax price in the previous paragraph applies. If t E , t S , the
value of the extra deduction abroad exceeds the potential credit on the dividend,
which depends on t E . If t E 5 t S , the same tax is paid irrespective of whether it is a
dividend or a royalty.
If t E , t S , the benefits of a switch to royalties on the margin decline as there are
more inframarginal dividends. The additional tax deduction of t S lowers the
average tax rate paid on the remaining net income and, therefore, the credit on
existing dividends. That is, the total foreign tax on net income is t 0 I 2 t S L, where I
is operating income before any deduction for royalties, L are royalties and t 0 is the
effective tax rate if no royalties are paid. t 0 , t S . Dividing through by I 2 L, net
income, shows that t E , and therefore the tax the price of dividends, depends on the
share of income paid out as royalties. Total (both U.S. and foreign) tax paid is
t 0 I 2 t S L 1 t US L 1 (P 2 L)(1 2 t S )t D (L), where P is total pre-tax income paid out
and t D , the tax price of dividends, is explicitly written as a function of L. This
shows that the marginal cost of royalties depends on P, total repatriations. If all
income is repatriated, the saving in foreign tax from the additional dollar of
royalties is exactly offset by the lower credits on the dividends. Because no
income is retained, all foreign taxes are credited currently and there is no benefit
from reducing them.

2.2. A simple model of CFC payments

The model addresses two issues. The first is the substitution between royalties
and dividends in response to differences in tax prices. The second is the validity of
the HartmanSinn result that repatriation taxes do not affect the capital stock of a
mature CFC in a world with alternative repatriation vehicles. In this second issue,
the focus is not on any particular type of repatriation, such as dividends, but total
repatriations and retained earnings.
We start with a two-period all-equity no-shifting model in the spirit of Hartman
and Sinn. To begin with, dividends are the only repatriation vehicle and then
royalties are introduced as an alternative. The CFC has a profit function f(K) in
each period where the return depends on the capital K employed. Capital does not
depreciate. The host country tax rate (both effective and statutory) is t F . There is a
positive repatriation tax t D , which is attributable to either the foreign withholding
tax if the parent has excess credits or a foreign effective rate below the U.S. rate if
the parent is in excess limit. All tax rates and the parents excess credit position
are unchanged over the two periods.
The parent injects an amount E of equity in the CFC at the beginning of the first
period. The CFC earns f(E) before tax during the first period, repatriates a
dividend D at the end of the first period, and retains f(E)(1 2 t F ) 2 D 5 R to be

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used in the second period. Finally, it repatriates the entire net worth of the CFC at
the end of the second period. The two decision variables are the initial equity
injection E and the amount R it retains after the first period.
The parents cash flows are 2E at the beginning of the first period, ( f(E)(1 2
t F ) 2 R)(1 2 t D ) at the end of the first period, and E 1 f(E 1 R)(1 2 t F )(1 2 t D ) 1
R(1 2 t D ) at the end of the second. The parent company has an after-corporationtax required rate of return on equity r. Taking the present value at the discount rate
and maximizing with respect to E and R leads to the following two optimizing
conditions:
f 9(E 1 R)(l 2 t F ) 5 r,

(1)

1 1 r(1 2 t D )
f 9(E)(1 2 t F )(1 2 t D ) 5 1 1 r 2 ]]]].
(1 1 r)

(2)

Condition (1), which determines the amount of capital in the second period,
reproduces the HartmanSinn result that capital in the mature state does not
depend on the repatriation tax t D . But it is necessary to note that we are implicitly
assuming that R, retentions after the first period, are non-negative, i.e. that the CFC
becomes mature after the first period. (It is as if we assumed that the first period
is long enough for first-period earnings to be sufficient to fund required new
investment for the second period.)
Condition (2), which determines the initial equity injection, indicates as
expected that the repatriation tax plays a role in this decision. The right-hand side
is also consistent with Sinns initial underinvestment effect, in which the parent
initially invests less than in a one period case (or in a non-deferral world) because
it wants to obtain the benefits of deferral until it reaches the target capital stock
in the mature state.
The HartmanSinn result that capital in the mature state is not affected by
repatriation taxes does not, of course, hold when t D is negative, as would be the
case if the parent is in excess limit for its worldwide foreign income but this
subsidiary has a foreign tax rate above the U.S. rate. If t D is negative, the CFC will
pay out all its income every period and reinject any amount of equity required to
finance an increase in K. If f(K) is unchanged over time, K will be constant in the
two periods with f 9(K)(1 2 t F )(1 2 t D ) 5 r. The equity is not trapped but
expelled.
Consider how the picture changes when royalties or license fees L are
introduced as an alternative to dividends. We first focus on royalties as a share of
total repatriations and the substitutability of different payments. It is helpful to
consider the excess credit and excess limit cases separately because the relative
advantages of a royalty and dividend will differ. Start with the parent always
having excess credits, in which case the tax price on dividends is the withholding
tax on dividends and the tax price on royalties is the foreign withholding tax on
royalties less the foreign statutory tax rate. As noted above, the tax price on

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275

royalties is likely to be negative. If there are no restrictions on the amount of

royalties that the company can pay in any period nor any restraints on the extent to
which they can vary from period to period, the company will choose the payment
with the lowest tax cost as the exclusive repatriation vehicle.
But the assumption of unrestricted royalties is unrealistic, because the amount of
royalties a CFC should pay presumably depends on the value of the intangibles it
has received from the parent, under general arms length principles. These
intangibles are reflected in the f(K) function. The role of transfer pricing rules can
be stated more formally by assuming that the norm for arms length royalties are
n percent of pre-tax operating earnings. If the CFC departs from this norm it risks
penalties by the home country (if royalties are less than n) or the host country (if
royalties are greater than n). In other words, it incurs non-creditable, nondeductible additional costs of C(nf(K) 2 L).
If the repatriation tax t L for royalties before additional penalties is negative, the
CFC will always pay royalties in excess of the norm, proceeding at least until the
marginal cost of royalties t L 1 C9(nf(K) 2 L) 5 0. If at this point, dividends are
still being paid, the CFC will increase royalties until C9 1 t L 5 t D , with the
marginal cost of royalties and dividends equated. (We assume an interior solution
with non-zero dividends.) An increase in t L , e.g. because of an increase in the
withholding rate on royalties, will reduce the share of royalties in total repatriations.
Consider now the case in which the parent never has excess foreign tax credits.
The previous section showed that if t E 5 t S , the tax prices on royalties and
dividends (before penalties) are equal because the value of the deduction for
royalties against foreign tax is the same as any credit on the same pre-tax income
distributed as a dividend. Royalties exactly at the norm will be paid to avoid any
penalties. If t E is not equal to t S (it is generally lower) and all operating income is
repatriated, the mix of royalties and dividends is also a matter of indifference,
because any corporate tax paid abroad will be fully creditable against U.S. tax
liability. Again, royalties at the norm will be paid. In these cases, there is no
incentive to substitute one payment for another because their tax prices are the
same.
If t E , t S and some operating income is retained, which would be a common
situation, the previous section demonstrated that, in the absence of penalties, a
royalty will be more advantageous than a dividend because the value of the
deduction abroad exceeds the loss in credits on the dividends. Royalties in excess
of the norm will be paid until the marginal cost of royalties including penalties
equals the marginal cost of dividends. An increase in the tax cost of dividends, e.g.
because of greater investment tax credits which lower t E while t S is fixed, will
increase the share of royalties in total repatriations.
The next issue is the general validity of the HartmanSinn result on the
irrelevance of repatriation taxes for the capital stock of a mature subsidiary in a
model with alternative repatriation methods. The HartmanSinn condition (1) in

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the dividends-only model above depended on t D , the tax price on dividends, being
constant over time. If the marginal cost of repatriations remain constant in a world
with more than one repatriation vehicle, then these generalized repatriations can
simply be substituted for dividends in the model and condition (1) will still hold.
The capital stock of the mature CFC will not depend on repatriation taxes even
though an increase in the cost of dividends relative to royalties will reduce
dividends in the mature state.
The above discussion of the determinants of tax prices and the least cost
condition for the choice of royalties and dividends shows that the requirement that
the marginal cost of repatriations remain constant over time (in a given tax regime)
will frequently be met. In the excess credit case, the tax price on dividends is
simply the (fixed) foreign withholding tax on dividends. The equality of the
margin cost of royalties (including penalties) and dividends will, therefore, always
take place at the same level of marginal costs as long as some dividends are paid.
Any distributions beyond this point will be in the form of constant cost dividends.
If the parent is in excess limit, t D is constant if t E 5 t S , because the credit rate on
dividends is not reduced if greater royalties are paid. In any case, the mix of
royalties and dividends do not affect repatriation costs. In this situation, it might
appear that the requirement to pay royalties would alter the eventual real
equilibrium because not all earnings can be trapped. For example, what if the
CFC always had to be paid a certain share of its operating income in royalties. The
issue in the mature state is whether it should reinvest any of its income net of
royalties now and repatriate the proceeds in the next period. The return is (1 2 t D )r
if the income is repatriated now and f 9(K)(1 2 t US ) if reinvested. The total tax rate
on next periods earnings is t US irrespective of what share is in the form of
royalties. Because (1 2 t US ) 5 (1 2 t F )(1 2 t D ), i.e. the total tax paid on the
dividends including the foreign corporate tax is the U.S. rate, condition (1) will
still hold. (The transition to the mature state may be different.)
The mix of royalties and dividends also do not affect repatriation costs even if t E
is not equal to t S as long as all operating earnings are repatriated, as they would be
in a pure HartmanSinn mature state. The subsidiary would, therefore, eventually
arrive at the HartmanSinn mature state with condition (1) holding.
But the marginal cost of repatriations may not be constant in all cases in a
model that goes beyond the strict requirements of the Sinn (1993) model, in which
f(K) is fixed over time and retained earnings are always zero in the mature state
when K has reached its target level. The model becomes more relevant if we
broaden the mature state to one in which increases in K are positive but they can
be financed entirely by retentions. That is, the production function f(K) is not
stationary over time and desired K increases over time for a given cost of capital.
Less than all operating income is paid out.
The previous section showed that if t E is less than t S in this situation and the
parent is in excess limit, the tax price of dividends depends on the amount of
royalties paid out and the marginal cost of royalties depends on the amount of

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277

dividends being repatriated. If changing expectations about the profitability of

investment change the amount of income retained, the marginal cost of repatriations, given by the equality of the marginal cost of dividends and royalties, can
vary over time. But, this variation may not be empirically significant because of
the specific way in which the credit on dividends is calculated under U.S. law. The
credit for corporate taxes paid is based on the pool of current income plus all
accumulated retained earnings and the taxes associated with them. This would tend
to smooth out changes in the tax price of dividends over time in a multi-period
model.
Summing up the results of this basic model, dividends, royalties and other
payments can be expected to be substitutes for given operating income if their
relative tax prices change. In contrast to the original dividends-only Hartman case,
dividends will be discouraged by higher dividend repatriation taxes, holding the
tax price of royalties constant. But also, if the marginal cost of repatriations is
positive, retained earnings will in many cases be unaffected by repatriation taxes
in the mature state because the marginal cost of repatriations (of all types) is
constant over time.
A negative repatriation tax can, of course, reduce retained earnings because
equity is continually reinjected after being paid out, as discussed above. If
royalties provide the opportunity for a negative repatriation tax where it would be
positive if dividends are the only repatriation vehicle, the real capital equilibrium
will be altered because some of the burden of the local tax rate will be offset.
In the examples so far, we have assumed that operating income (i.e., income
before deducting interest and royalties) is fixed for any given level of K. But if
there is income shifting from one country to another motivated by repatriation
taxes, then royalties and dividends may no longer be substitutes. The norm for
royalties can be expected to depend on the operating income that tax administrators observe. If higher dividend repatriation taxes or statutory tax rates cause
operating income to decline through the shifting of intangible income, then
royalties may decline as well, not increase. In other words, there is the equivalent
of an income and a substitution effect in the relationship between equity income
and royalties.
Interest paid to parents by CFCs is in some ways similar to royalties. In the case
of debt, the CFC is usually constrained by thin capitalization rules in the host
country that restrict the extent to which it can be capitalized with debt, which have
the same effect as arms length guidelines in the case of royalties and other types
of payments. But as Hines (1994) and Wilson (1994) point out, it may be
profitable for the CFC to repay its borrowing from the parent first because the
repayment of principal is not taxable, unlike a dividend or royalty distribution. The
implication is that if there is initial borrowing from the parent, repatriation costs
are not fixed over time until the initial debt injection has been repaid.
The opportunity for the CFC to invest in passive financial assets may also alter
the relative advantages of different payments in the generalized HartmanSinn

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model. Even though the income on the passive assets would be taxed currently
under the anti-abuse rules in the U.S. tax code, it may pay the company to invest
operating income in passive assets, rather than repatriating, because the passive
income would be earned on a larger base. Under some scenarios, the CFC may
accumulate passive assets for an indefinite period after the real capital stock has
reached its mature level. The availability of the passive asset alternatives for the
CFC may also change any transition to the mature real capital state. Because
CFCs have an asset they can switch to that is not subject to diminishing returns,
their initial underinvestment strategy may no longer be necessary (see Weichenrieder, 1995).

3. Data sources and the specification of the tax variables

3.1. Data sources

The linked 1990 files for the tax Forms 1120, 1118 and 5471 (compiled by the
Statistics of Income Division of the Internal Revenue Service) were the principal
data base for this study. Form 1120 is the basic corporate return and provides
information on the parents income, assets and other items such as research and
development expenditures that qualify for the R&D credit. Form 1118 contains the
foreign tax credit calculation, so it reports foreign source income, deductions, and
creditable foreign taxes. Form 5471 is an information return for each controlled
foreign corporation and gives its earnings and profits (E&P), assets, foreign taxes
paid or accrued and transactions with its parent and affiliates. E&P is defined in
the Internal Revenue Code and is an attempt to approximate book profits
undistorted by special deductions or allowances given as incentives by the host
government. It is the measure of net profits used in this paper. (Companies that
filed a 5471 but not an 1118, presumably because they did not claim a foreign tax
credit in 1990, were included in the basic file.)
The analysis was restricted to U.S. parents in goods production, including
mining, petroleum and manufacturing, where almost all U.S. R&D and, therefore,
royalties are concentrated. The CFC analysis was limited to the 7500 largest (in
terms of assets) because in 1990 the IRS only edited the Schedule M, which
reports intercorporate transactions such as royalties and interest, for this group.
After all the exclusions, we are left with about 3500 CFCs in the sample.
The category of payments used to construct the royalty variable is actually
referred to as rents, royalties and license fees, so that in principle it could include
rents for property leased from the parent, which might have tax prices different
from royalties. Two additional royalty variables were constructed to evaluate the
significance of the issue. First, the tax data give the parents deductions, including
depreciation, specifically for foreign rents and royalties received. Rents would
presumably bear a larger amount of these expenses. One variation scaled down

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279

rents and royalties paid by the CFC by the ratio of expenses to rents and royalties
reported by the parent. The second alternative used the gross royalties income
item from the first page of the Form 1120, the basic corporate tax return, where
rents are reported separately. This could include some domestic royalties, but
when the lesser of total royalties and foreign rents and royalties are computed
for each company, the total for the universe is very close to the total foreign
royalties received reported by the Commerce Department. This lesser of variable
was, therefore, substituted as a second variation. Neither alternative produced
results different from the unadjusted variable used in the tables.
The parent R&D variable, which is likely to be an important determinant of
royalties paid by CFCs, is based on the reported total qualified research for
purposes of the research credit available to U.S. companies. This has the advantage
of being restricted to R&D performed only in the United States. But sometimes it
is not reported on the tax return, presumably because no research credit is claimed.
When no qualified research is reported for the purposes of the credit and positive
R&D is reported for the company on Compustat, the Compustat data (with
adjustment), are used. (See Grubert and Slemrod, 1994, for the adjustment.) The
Compustat-based R&D observations may include some R&D performed abroad,
because the R&D reported on financial statements would be worldwide R&D, but
when they are excluded from the analysis the conclusions are not much different.
Some of the tax variables are derived from the tax return files themselves. These
include country average effective tax rates, total taxes paid as a percent of earnings
and profits. Statutory corporate tax rates as well as withholding rates on royalties,
interest, and dividends were taken from Corporate Taxes A Worldwide Summary
for 1990 published by Price Waterhouse (1990). In some cases judgment had to be
exercised, e.g. on the general availability of tax holiday rates in some countries. In
these cases, the decision on the appropriate statutory tax rate was in part based on
the country average effective rate.

3.2. Specification of the tax variables

3.2.1. Composite tax prices versus underlying components
In the more general view of CFC payments adopted in this paper, the
conventional construction of composite tax prices from the various components
described above is no longer adequate. Identifying the effect of a change in
particular tax price requires knowing why it changes. For some payments, the
identification of the effect of a change in the tax price is, in any case, based on
only one of the components even if conventional tax prices are used. In the excess
credit case, the tax price of royalties (compared to equity retention) is 2 t S 1 w L ,
and the tax price of interest payments is 2 t S 1 w i . In addition, the payments
equation would include the statutory tax rate, t S , itself as an independent variable
to reflect the marginal benefit of income shifting through other deductible
payments. Changes in the withholding tax rates on royalties and interest identify

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H. Grubert / Journal of Public Economics 68 (1998) 269 290

the own tax price responsiveness effects, not changes in t S which is common to all
deductible payments. In the empirical work, it will, therefore, be convenient to use
the withholding tax rates to identify the specific effect of increasing a tax price,
holding other tax prices constant, while retaining the statutory tax rate as a
separate variable. The own royalty and interest tax price coefficients are unchanged, but the source of the tax price change and the role of the statutory tax
rate are clarified.
As noted in the Introduction, the companys response to a higher tax price for
dividends will depend on what the source of the change is. If it is a high
withholding tax (which is relevant if the parent has excess tax credits) this may
lead to income shifting to other CFCs. If another CFC has a similar high dividend
tax price but it is due to a low effective tax rate in the host country and a parent in
excess limit, shifting income to another affiliate would not reduce repatriation
taxes because all foreign taxes are creditable. Another way of stating this point is
that the separate components of the dividend tax price have a different effect on
the price of routing income to other foreign affiliates; it is as if there were an
excluded variable in the payments equations. It is, therefore, necessary to
distinguish tax prices on dividends due to high withholding taxes from those due
to low effective tax rates.

3.2.2. Excess credit positions

The discussion above on tax prices indicated that the tax price of a particular
payment is critically dependent on whether the taxpayer is in an excess credit
position. However, introducing the taxpayers current excess credit position into
the computation of tax prices presents several problems. The most important is
that the companys observed position is the endogenous result of its financing and
payment decisions. Companies that have transferred valuable intangibles and
receive large royalties from abroad are less likely to be in an excess credit position
because the royalties are deductible from host country tax. They will have
correspondingly lower dividends that are the source of larger credits. Intangible
intensive companies may also have greater flexibility in locating in low-tax
jurisdictions. This endogeneity problem is evident when a measure of the
companys excess credits is put in as an independent variable in a royalty
regression along with other components of various tax prices. The coefficient is
negative, contrary to the expectation that being in excess credit creates a strong
incentive for deductible payments such as royalties.
Attempts to deal with the endogeneity problem were admittedly not very
successful. No valid instrument presented itself or seemed at all significant. One
possibility examined was to use the effective tax rate on dividends received by the
parent as an indication of potential excess credit positions, on the grounds that it
is less sensitive to the split of income between dividends and other types of
income such as royalties. But this was significant for royalties only (in some
tobits) and not other payments. It also required restricting the sample to include

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281

only companies that filed a Form 1118 and reported foreign dividends, which may
be a non-random subgroup.
Another problem with observed excess credit positions is that they can vary
over time. Capitalization and payment strategies are in part based on long run
expectations because there are probably constraints on the extent to which
royalties, interest and income reported can vary from year to year. The 1990 file
indicates that for 50% of active foreign income, the effective foreign tax rate is
within four percentage points of the excess-credit threshold, i.e, between 30 and
38%. The current years position may not be a good indication of long run
expectations. Indeed, companies may not have a clear picture themselves.
This problem of excess credit position expectations is addressed by including
both the excess credit tax price and the excess limit tax price as independent
variables. This implicitly assumes that companies are uncertain about their long
run credit position and recognize that there is some positive probability of being in
either excess credit or excess limit. These long run probabilities may, of course,
vary among companies (although it was difficult to identify any set of company
characteristics that determine the probability of being in excess credit), but this
would bias the estimated coefficients toward zero. Introducing excess limit and
excess credit tax prices separately also is consistent with the possibility emphasized above that the company will respond differently to a tax price depending on
its components.6
Note that the inclusion of withholding rates on royalties and interest and the
local statutory corporate rate implicitly captures both the excess limit and excess
credit tax prices on royalties and interest. For example, the excess credit tax price
on royalties is w L 2 t S and the excess limit price is t US 2 t S . The U.S. corporate
rate, t US , is constant in all observations and the other terms are variables in the
equations.

3.2.3. Permanent tax prices

The emphasis in this paper is on long run strategies. Altshuler et al. (1995) are
persuasive on the importance of distinguishing between permanent and transitory
tax prices for dividends. Accordingly, in the excess limit case where the issue
arises, the tax price of dividends is based on the country average effective tax rate,
not the companys own host country effective tax rate in 1990, which can change
from year to year and affect the timing of repatriations.
3.2.4. Calculating tax prices
In all cases, the tax price of a particular payment on the margin is measured
relative to retained earnings. The tax price of dividends in the excess credit case is
6
The discussion above of the different sources of a tax price would suggest using an excess credit
dummy interacted with the excess credit and excess limit prices. This proved less successful than
simply including the prices separately.

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H. Grubert / Journal of Public Economics 68 (1998) 269 290

the withholding tax rate on dividends, adjusted for the net benefits of a dividend to
U.S. investors under tax systems that integrate corporate and shareholder taxes.
This latter adjustment affects dividends from the United Kingdom, for example.
The withholding tax rate on royalties (and interest) was defined to include the
impact of nondeductibility that is imposed by a few host countries. For example, if
the statutory tax rate is 35% and royalties are not deductible from corporate
taxable income, the nondeductibility provision is the equivalent to a 35%
withholding rate on royalties that are deductible.

4. Results and comparison with previous work

4.1. Basic results

Table 1 presents the basic tobit and regression results for various types of
payments and retained earnings. The parents R&D and advertising expenses are
included as right-hand variables to indicate the value of intangibles provided to the
CFC by the parent. In each case, R&D and advertising expenditures are divided by
parent sales to express a measure of R&D and advertising intensity. These
measures of parent intangibles can be expected to be particularly important in
explaining royalty payments and, therefore, other types of payments as well
because they are all constrained by total operating income. R&D and advertising
intensity may also determine the amount of income a CFC retains to finance
investment in tangible capital.
The payments equations in Table 1 do not include E&P, the net profits measure,
as an explanatory variable because it reflects the choice of deductible repatriations
such as interest and royalties as well as other tax-induced strategies to reduce
equity income. In previous repatriation equations, such as those of Altshuler et al.
(1995), E&P is forced to play two roles, one related to the income elasticity of
dividends and the other to the effect of deductible repatriations on dividends. In
the latter role, the substitution among repatriation methods is captured indirectly
through the effect of deductible payments on E&P. But there is no reason why the
two sources of changes in E&P, basic profitability and the amount of deductible
repatriations, should have identical effects on dividends.
The endogenous nature of E&P is evident in the first row of Table 1, where the
regression shows that tax variables such as the excess credit dividend tax price, i.e.
the withholding tax rate on dividends, and the statutory tax rate have significant
negative effects because they increase the tax cost of equity income. The
withholding tax on interest has a significant positive effect, apparently because
deductible royalties become less advantageous. The second regression in Table 1
uses a more comprehensive definition of operating income as the independent
variable, including royalties and interest payments as well as E&P (after putting
them all on a comparable after-tax basis). The results are generally similar.

Table 1
Profitability and payment equations a (3467 CFCs)
R&D

Tax price on dividends

Withholding tax on

Excess
credit

Royalties

Excess
limit

Statutory tax rate

Interest

Potential undistorted
profitability

0.260
(2.93)

0.406
(6.91)

20.118
(4.25)

0.030
(1.16)

0.046
(1.18)

0.081
(2.08)

20.178
(5.26)

Sum of E&P,
royalties and interest

0.567
(4.64)

0.593
(7.29)

20.151
(3.92)

20.035
(1.00)

0.150
(2.80)

0.017
(0.32)

20.172
(3.68)

Payment equations
Dividends to U.S.
affiliates tobit

0.646
(4.16)

20.066
(0.60)

20.157
(3.08)

20.158
(3.55)

0.167
(2.42)

2034
(0.49)

20.252
(4.20)

0.443
(19.75)

All dividends tobit

0.528
(2.66)

20.036
(0.26)

20.264
(4.10)

20.009
(0.16)

0.139
(1.58)

20.074
(0.84)

20.151
(2.00)

0.796
(27.65)

Royalties tobit

0.425
(9.21)

0.093
(3.01)

20.031
(2.02)

20.061
(4.42)

20.083
(3.66)

0.039
(1.81)

20.044
(2.36)

0.086
(13.11)

Interest tobit

0.110
(3.87)

0.031
(1.67)

0.015
(1.70)

0.042
(4.95)

0.055
(4.24)

20.074
(5.32)

0.074
(6.51)

0.006
(1.43)

20.282
(3.27)

0.001
(0.02)

20.33
(1.21)

20.066
(0.26)

0.082
(2.18)

0.037
(0.98)

20.112
(3.41)

0.353
(29.62)

Retained earnings

H. Grubert / Journal of Public Economics 68 (1998) 269 290

Profitability equations
Earnings and profits

Advertising

N53467.
a
t values in parentheses.

283

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H. Grubert / Journal of Public Economics 68 (1998) 269 290

Even though profitability is endogenous and cannot be included as a variable

without adjustment, variations in undistorted profitability (or potential E&P)
can be expected to affect the level of various types of repatriations, and dividends
in particular. Therefore, the second regression on Table 1, based on expanded
income, is used to construct potential undistorted profitability by removing the
effect of country tax rates on operating income. It is added as an independent
variable in the payment equations.
Dividends to U.S. domestic affiliates is the principal dividend variable. But total
CFC dividends, including payments to related foreign shareholders and unrelated
minority shareholders, are also presented because they are the natural complement
to retained earnings, which are included as a separate way of using a CFCs
operating income. Royalties are those paid to domestic U.S. affiliates (the parent
and other controlled domestic companies). Interest payments also include payments to other controlled foreign affiliates because they are subject to current U.S.
tax under the anti-abuse rules. These are much greater than interest paid directly to
domestic affiliates and may reflect the use of financial affiliates in third countries.
Royalties, dividends, interest and retained earnings are not linearly dependent
because some transactions with affiliates that affect net income are not directly
observed. In all cases, the dependent variable is expressed in relation to total CFC
assets.
Let us look, first, at dividend repatriations to the United States. Both the excess
credit and excess limit tax prices for dividends have significant negative effects on
the ratio of dividends to CFC assets. The withholding tax rate on royalties has a
significant positive effect, as expected, because royalties are an alternative means
of repatriation. Interest payments seem a less important alternative, as the
withholding tax on interest has an insignificant (negative) coefficient. Finally, the
countrys statutory tax rate has a significant negative effect because it increases the
local tax cost of equity income.
But even though the tax prices of dividends discourage dividends, note the
retained earnings equation at the bottom of the table. High tax costs for dividends
do not increase retained earnings. In fact, the coefficients are negative although not
statistically significant. Higher dividend tax prices reduce dividend repatriations,
but that just means that income is repatriated (or shifted out of the CFC) by other
means. The results in Table 1 for the tax price of dividends are consistent with the
generalized HartmanSinn model discussed earlier. The tax price of dividend
repatriation discourages dividends, but they do not increase retained earnings.
Comparing the dividend equation and the profitability equations shows that a
reduction in local operating earnings is the primary way in which a high
withholding tax on dividends (the excess credit tax price) reduces dividend
distributions. As expected, this is not the case for a high excess limit tax prices on
dividends, which has insignificant coefficients in the profitability equations. As
noted above, shifting income out of countries with low effective tax rates, which
are the source of the high tax price in this case, provides no benefit.

H. Grubert / Journal of Public Economics 68 (1998) 269 290

285

The contrast between dividends to the United States and all dividends is
noteworthy. The excess limit tax price, which depends on the difference between
the U.S. tax rate and the local effective tax rate, is not significant for total
dividends. But the excess credit tax price, the withholding tax on dividends, is
highly significant. These withholding taxes may be more relevant because some of
the dividends may go to non-U.S. shareholders in a country that exempts foreign
dividends. For them, the repatriation tax is always simply the withholding tax.
In the retained earnings equation, the coefficient for the local statutory tax rate is
negative and significant. This may reflect the cases in which shifting income to
other affiliates provides a positive benefit and dominates other payment vehicles.
Equity could be reinjected by the affiliates to which the income has been shifted.
The positive coefficient for the withholding tax on royalties, which is significant at
the 5% level, seems inconsistent with the discussion above because the conditions
for the validity of the HartmanSinn model are met in the excess credit case where
the withholding taxes are relevant. The second row of Table 1 confirms that this is
an anomaly because the data seem to suggest that a higher withholding tax rate on
royalty payments increases total operating income, which is impossible on
conceptual grounds.
Turning now to interest payments, Table 1 shows that they respond in the
expected way to tax considerations. The withholding tax rate on interest has a
negative and highly significant effect. Conversely, the withholding tax rate on
royalties has the expected positive effect, indicating substitutability between
interest and royalties. The statutory tax rate also has a positive significant effect as
expected because it reduces the tax cost of deductible payments such as interest.
Finally, the tax price of dividends also indicates substitution between dividends
and interest, with the excess limit price highly significant and the excess credit
price of borderline significance.
Proceeding to consider royalties, we see in Table 1 that the withholding tax rate
on royalties has the expected significant negative effect. The withholding tax rate
on interest has a positive effect, consistent with the substitutability between
royalties and interest found in the interest equation, although the coefficient is only
of borderline statistical significance.
But the role of the tax variables associated with dividends and equity income
seems puzzling in the royalty equation. The dividend tax prices have a significant
negative effect, not positive as would be expected with substitutability between
dividends and royalties. In addition, the statutory tax rate also has a negative effect
even though it increases the tax benefits of deductible payments. This may suggest,
as mentioned above, that for some companies equity earnings and royalties are
complementary. If a low statutory tax rate encourages an inward shift of
intangible income, through commodity pricing, the company may feel compelled
to pay higher royalties as well. In other words, the income effect outweighs the
substitution effect between royalties and dividends.
This suggested complementarity between royalties and equity income is

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H. Grubert / Journal of Public Economics 68 (1998) 269 290

confirmed when an interaction between R&D (and advertising) and the statutory
tax rate is added to both the royalty and the E&P equation. (These are not shown
in the tables.) The interaction terms are intended to capture the possibility that
greater parent R&D and advertising increase the opportunities for shifting income
to low-tax countries. Further, if intangible income is shifted to low-tax countries,
do royalties increase as well? The coefficient for the R&Dtax interaction term is
negative and significant in both equations. (The advertisingtax interaction term is
negative and significant in the earnings equation but, while the coefficient is
negative in the royalties equation, it is only slightly larger than its standard error in
absolute value.) Intangible income is shifted to low-tax countries where it is
associated with larger royalties to the parent. The size of the R&Dtax interaction
coefficients in the royalty and earnings equations suggests that a lower tax rate
increases the effect of R&D on royalties by about a third as much as it increases
E&P, which seem plausible.
Table 1 shows that tax prices have a quantitatively significant effect on
behavior. At the mean of the independent variables, a one percentage point
increase in both of the dividend tax prices reduces dividends by 2.7%. The
elasticity of dividends with respect to a change in (1 2 t D ), the portion of the
dividend left after paying the repatriation tax, is thus greater than 2.

4.2. Comparison with Altshuler, Newlon and Randolph

The finding that the tax price of dividends reduces dividend repatriations, even
when using permanent components of the tax price such as country effective tax
rates and withholding rates, seems at variance with Altshuler, Newlon and
Randolph (1995) (hereafter referred to as ANR). They used dividend withholding
rates and average country dividend tax prices as instruments for the permanent tax
price on dividends and found no effect. There could be several explanations for
this difference in results. One is their not adding the tax price of other payments,
namely the withholding rates on royalties and interest and the statutory tax rate.
Another could be ANRs use of tax-distorted E&P as an explanatory variable.
Also, ANRs instruments for the permanent tax price on dividends are not quite
equivalent to the tax prices used in Table 1.
Table 2 attempts to resolve this issue. The first row repeats the dividends (to
the United States) tobit in Table 1 but without any tax prices for payments other
than dividends. The coefficients of the two dividend tax prices are much reduced
in absolute value and are now less than their standard errors. The ANR difference
from this paper, therefore, appears largely due to their not including the tax price
of the other payments. The second row in Table 2 reveals that the exclusion of the
statutory corporate rate, indicating the benefits of a deductible payment, is
particularly serious. When the statutory corporate rate is reintroduced, the excess
limit dividend tax price is still highly significant and the excess credit tax price is
of borderline significance. The statutory tax rate and the excess limit tax price,

Table 2
Alternative dividend equations a (all tobits)
Tax prices included

R&D

Advertising

Withholding tax on

Excess
credit

Excess
limit

Royalties

Dividend tax
prices only

0.638
(4.38)

0.068
(0.62)

2027
(0.67)

20.031
(0.98)

Statutory tax
rate added

0.644
(4.15)

20.071
(0.65)

20.071
(1.71)

20.152
(3.42)

Non-dividend tax prices

plus withholding tax
on dividends

0.675
(4.35)

20.062
(0.57)

20.131
(2.59)

Withholding tax on
dividends only

0.684
(4.40)

0.066
(0.60)

20.028
(0.71)

Non-dividend tax prices

plus country average
dividend tax price

0.589
(3.60)

0.008
(0.07)

Country average dividend

tax price only

0.590
(3.62)

0.010
(0.09)

20.770
(4.95)

0.045
(0.41)

Unadjusted E&P added

to basic dividend
equation in Table 1

Country average
divided tax price

Potential profitability

Earnings and
profits

0.447
(19.77)

0.143
(2.09)

20.008
(0.12)

0.228
(3.88)

0.466
(19.84)

20.102
(2.40)

0.444
(19.75)

0.477
(19.79)
0.058
(0.82)

20.083
(1.61)

Interest

Statutory
tax rate

20.190
(4.29)

0.118
(1.70)

0.042
(0.57)

20.063
(0.89)

0.130
(2.06)

0.137
(2.27)

20.182
(2.34)

0.432
(18.72)

20.038
(0.71)

0.433
(18.80)
0.602
(19.40)

H. Grubert / Journal of Public Economics 68 (1998) 269 290

Tax price on dividends

a
Number of observations same as in Table 1 except for rows 5 and 6, in which constructing the country average price on dividends reduced the number of
observations to 3227. t values in parentheses.

287

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H. Grubert / Journal of Public Economics 68 (1998) 269 290

which depends on the local effective tax rate, are highly correlated, so not
including the former has a large effect on the significance of the latter.
The same pattern reoccurs when an attempt is made to use dividend tax prices
identical to ANRs instruments.7 The third and fourth rows of Table 2 simply use
the country withholding rate on dividends, one of the instruments ANR employed.
It is significant in the third row when the other tax variables are included, but not
in the fourth when they are not. Similarly, the next two rows use a country average
dividend tax price along the lines of ANRs alternative instrument.8 It is again
significant in the presence of the other tax prices, but not by itself.
The last row of Table 2 shows that using unadjusted Earnings and Profits tends
to greatly reduce the significance of the withholding tax rate on dividends. As
indicated by the E&P equation in Table 1, high withholding taxes appear to
increase deductible payments, lowering E&P and capturing some of the role of the
dividend tax price.

4.3. Other independent variables used

Additional variables were added to the payments equations but with no notable
effect on the basic tax results. (These are not reported in the tables.) One was the
age of the CFC, computed from its date of incorporation. It was frequently
significant in itself. For example, age had a highly significant positive effect on
dividends to U.S. affiliates, but the two dividend tax price coefficients became
somewhat larger and more significant. Another variable added indicated the
parents alternative minimum tax (AMT) status. A company is subject to the AMT
if, when the AMT tax rate (20% in 1990) is applied to a specified expanded
income base, the resulting tax liability exceeds the regular tax. A company on the
AMT may have repatriation taxes different from other companies, but somewhat
surprisingly the AMT variable had very little statistical significance and did not
affect the role of the other variables.9
The component of the CFCs income that is taxed currently under the anti-abuse
rules even if not distributed was also added as an explanatory variable. This
includes passive income and income from sales routed through low-tax affiliates.
Because it is taxed currently, the residual U.S. tax price for repatriating it is zero.
(There may be foreign withholding taxes.) In the dividend equation, the coefficient
of this income on which U.S. tax cannot be deferred is positive and significant, but
7

Table 2 does not exactly replicate the ANR procedure, because they constructed a permanent tax
price using instrumental variables rather than simply including the instruments as regressors.
8
When the country average is used, the estimation is restricted to countries with more than 10
observations. The country average is almost significant at the 5% level when countries with more than
four observations are included.
9
Under the AMT rules, foreign tax credits cannot eliminate more than 90% of its total (including
domestic) U.S. tax liability, so it is conceivable that there is a residual U.S. tax under the AMT where
there would be none under the regular tax.

H. Grubert / Journal of Public Economics 68 (1998) 269 290

289

the coefficients of the tax price variables are virtually unaffected in size and
significance.

5. Summary and conclusions

Tax considerations have a significant impact on the composition of CFC
payments. In particular, the own tax price on interest, royalties and dividends are a
significant and large deterrent to the respective payments. Royalties and interest
payments also seem highly substitutable. But the negative effect of high dividend
tax prices on dividend distributions should not be interpreted as proving that
repatriation taxes affect total repatriations, only their composition. Dividend taxes
are not significant in increasing retained earnings, suggesting that companies use
alternative means for taking income out of the CFC. The difference from the
Altshuler et al. (1995) results on the (non) effect of taxes on dividend repatriations
is due to their not including the tax prices of alternative means for using a CFCs
cash flow in their estimation.
The relationship between royalties and dividends involves more than a simple
question of alternative ways of getting income out of a CFC. Lower dividend
withholding taxes and local tax rates attract greater operating income to the CFC,
which has the indirect effect of increasing royalties so that they are consistent with
the CFCs greater profitability. In other words, there appears to be a profitability
effect which can outweigh the substitution effect.
In addition to providing a comprehensive analysis of the disposition of CFC
operating income, this paper has expanded on earlier work in several ways. It
integrates the repatriation decision and the income shifting decision because
shifting income to a CFC with low tax and withholding rates may be part of a
low-tax strategy for repatriations. The paper also attempts to clarify the theory of
multinational corporations behavior by showing how it has to be adapted when a
comprehensive view of CFC payments is taken. It also demonstrates that the
conventional construction of tax prices is incomplete because knowing the
individual components of the tax prices is important in predicting MNC behavior.

Acknowledgements
I am grateful to Gordon Wilson and Paul Dobbins for providing me with the
linked data files in a convenient form, and to Don Rousslang, David Joulfaian,
Julie Collins, Douglas Shackleford and an anonymous referee for very helpful
comments on an earlier version of this paper. Nothing in this paper should be
construed as the views or policy of the U.S. Treasury Department.

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H. Grubert / Journal of Public Economics 68 (1998) 269 290

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