Finance Development, September 2019, Vol. 56, No. 3 PDF version
According 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 $4 trillion in FDI comes out to $6.6 million
a person. FDI of this size hardly reflects 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 FDI brings
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 intrafirm financing, or manage intangible
assets—often to minimize multinationals’ global tax bill. Such financial
and tax engineering blurs traditional FDI statistics and makes it difficult
to understand genuine economic integration.
‘Double Irish with a Dutch sandwich’
Better data are needed to understand where, by whom, and why $40 trillion
in FDI is being channeled around the world. Combining the Organisation for
Economic Co-operation and Development’s detailed FDI data with the global
coverage of the IMF’s Coordinated Direct Investment Survey, a new study
(Damgaard, Elkjaer, and Johannesen, forthcoming) creates a global network
that maps all bilateral investment relationships—disentangling phantom FDI
from genuine FDI.
Interestingly, a few well-known tax havens host the vast majority of the
world’s phantom FDI. 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 percent of all phantom investments.
Why and how does this handful of tax havens attract so much phantom FDI? 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 of GDP, alongside tourism.
In Ireland, the corporate tax rate has been lowered substantially from 50
percent in the 1980s to 12.5 percent 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 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 percent in 1990 to about 25 percent in 2017, indicating a race to
the bottom and pointing to a need for international coordination.
Globally, phantom investments amount to an astonishing $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 FDI. In
less than a decade, phantom FDI has climbed from about 30 percent to almost
40 percent of global FDI (see chart). This growth is unique to FDI.
According to Lane and Milesi-Ferretti (2018), FDI positions have grown
faster than world GDP since the global financial crisis, whereas
cross-border positions in portfolio instruments and other investments have
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 percent of total FDI.
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.
Better data for better policies
Globalization 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 FDI figures in tax havens.
Prominent cases include Irish GDP growth of 26 percent 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 globalized 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 globalization 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 unaddressed.
However, this seems to be changing with emerging widespread agreement on
the need for significant reforms. Indeed, this year the IMF put forward
various alternatives for a revised international tax architecture, ranging
from minimum taxes to allocation of taxing rights to destination economies.
No matter which road policymakers choose, one fact remains clear:
international cooperation is the key to dealing with taxation in today’s
globalized economic environment.
The views expressed here are those of the authors; they do not
necessarily reflect the views of the institutions with which they are
Damgaard, Jannick, Thomas Elkjaer, and Niels Johannesen. Forthcoming. “What
Is Real and What Is Not in the Global FDI Network?” IMF Working Paper,
International Monetary Fund, Washington, DC.
Lane, Philip R., and Gian Maria Milesi-Ferretti. 2018. “The External Wealth
of Nations Revisited: International Financial Integration in the Aftermath
of the Global Financial Crisis.” IMF Economic Review 66 (1):
ART: ISTOCK / SLALOMP; FILBORG; SUESSE; SLAVICA
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.