Why the Dutch royalty tax is good to have – and should be even stricter

Then, out of a sudden, the Netherlands changed position and introduced a source tax on royalty payments. Is that generally a smart move?

First of all, how does profit shifting work? The first main strategy is known as debt shifting. A multinational’s affiliate replaces non-deductible equity by internal loans from a related affiliate in a low-tax country (e.g., a tax haven). Such a structure creates tax deductions in high-tax countries and causes little tax payments on received interest income in the tax haven. The second, and quantitatively much more important, strategy is to misprice intra-firm trade to shift profits from high- to low-tax affiliates. Such transfer pricing works particularly well for royalty payments that are the remuneration for the use of intangible assets. Overinvoicing such payments allows for shifting substantial profits to tax havens where the ultimate owners of the intangibles reside.

One way to target the latter transfer pricing is to impose source taxes on royalty payments. Source taxes have a bad reputation as they usually suffer from tax competition and cause substantial distortions. Nevertheless, a royalty tax regime for payments to black-listed countries became effective in the Netherlands in 2021. Is such regulation desirable? And will it be effective?

We theoretically explored these questions in a model that hosts both debt shifting and overcharging royalty payments to shift profits to a tax haven. The multinationals choose both their investment and their profit shifting to maximize their global after-tax profits. Their profit shifting is determined by balancing tax savings and costs related to coping with profit-shifting regulation.

Our results suggest that the policy is desirable and that all countries (except for the real tax havens) benefit. A first important insight is that debt shifting has some beneficial effects. It directly reduces the tax burden on marginal investment and fosters employment. In contrast, transfer pricing in intangibles is damaging because it does allow for shifting economic profits, while it does not foster firm investment (on the intensive margin). Hence, countries only loose from such transfer pricing. Therefore, it is optimal to eliminate it completely via a royalty tax that removes all tax advantages. Finally, the royalty tax also falls on the arm’s-length payment, and by that, it still taxes investment. The resulting economic distortion, however, can be compensated for by allowing for some (more) debt shifting.

In sum, the royalty tax is effective and should actually be extended to all royalty payments. At the same time, debt-shifting regulation should not become too strict to avoid investment and employment losses in the non-haven countries.