1. Extracts from Research Proposal
Taxation, Transfer Pricing and Multinational Firm Investment Location
Decisions
Submitted in Partial Fulfilment of the Requirements of MSc – Business and Management Research, Henley
School of Business
Junaid Mirza
April 11, 2014

2. Junaid Mirza
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Page 1
Contents
1 Introduction..................................................................................................................................................................... 2
2 Brief Overview of International Business Theory..................................................................................................... 4
3 Review of Literature on Taxation and Investment Location Decisions ................................................................ 6
3.1 Identifying Relevant Literature...................................................................................................................... 6
3.2 Methodological Approaches Used................................................................................................................ 6
3.3 Review of Relevant Literature: Taxation as a Predictor of Investment Location Decisions............... 8
3.3.1 Geographic Focus of Empirical Studies........................................................................................................ 8
3.3.2 Disaggregated Data Availability ...................................................................................................................... 9
3.3.3 Measures of Investment ................................................................................................................................... 9
3.3.4 Measure of Taxation ......................................................................................................................................... 9
3.3.5 Impact of Tax System.....................................................................................................................................10
3.3.6 Home and Host Country Taxation...............................................................................................................10
3.3.7 Impact of Bilateral Tax Treaties....................................................................................................................11
3.3.8 Impact of Capital Structure............................................................................................................................11
3.3.9 Impact of Tax Havens....................................................................................................................................11
3.3.10 Role of Transfer Pricing ............................................................................................................................12
3.4 Review of Relevant Literature: Other Predictors of Investment Location Decisions........................ 13
3.5 Gaps and Opportunities for Future Research........................................................................................... 14
References................................................................................................................................................................................16

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1 Introduction
The recent economic downturn and deficit challenges have focused political debate on revenue generation, and
specifically corporate taxation, making international tax reform one of the most important areas of discussion on
public policy.1 The Occupy movement, an international protest movement that first gained prominence in 2011
for its protests against the alleged corporate greed on Wall Street, has consistently pointed to the relatively low
tax rates paid by large corporations as a prime reason for growing inequality and gap between the rich and the
poor in the US and elsewhere around the world. In a recent paper on base erosion and profit shifting, OECD
(2013) highlights what it considers the low share of corporate taxation in overall governmental revenues, at less
than ten percent. Mandated by the Group of Eight (“G8”), Organisation for Economic Co-operation and
Development (“OECD”) has expended a significant amount of effort over the last year in proposing
recommendations for fixing what it describes as loopholes and gaps in the international tax system. The work
done by OECD over the last year has been unprecedented in its scope, multilateral buy-in and the speed at
which it is forging ahead to plug gaps that purportedly result in base erosion and profit shifting.
Despite the political pressures to increase corporate tax rates, or otherwise remove incentives that allow
multinational enterprises (“MNEs”) to legally reduce their tax burden, the preponderance of academic literature
shows inward foreign direct investment (“FDI”) reacting positively to reduction in tax rates. This is perhaps the
reason that, at a unilateral level, many developed economies continue to create tax incentives for MNEs that
would attract FDI (Norman 2014). The competition for greater inward FDI using taxation has been a long-
standing policy tool at the disposal of governments, and one that has raised fears of a ‘race to the bottom’
between countries (OECD 2008). Despite this, the political and academic debate on the topic has been relatively
new. Historically, the differences in tax rates between countries were relatively low and the capital mobility of
MNEs was limited due to tariffs, capital and currency controls, visa and immigration restrictions and the high
cost of travel. As Genschel & Schwarz (2011) contend, deep economic integration and increased globalization
has reduced the mobility barriers previously faced by MNEs, which has in turn encouraged government to
increasingly use taxation as one relatively simple tool at their disposal to attract inward FDI in an increasingly
competitive global market.
While increasing equality and fairness are laudable goals for a tax system, increasing the tax burden of MNEs
may result in the unintended consequence of lower inward FDI. Before attempting to increase corporate tax
revenues through higher tax rates, governments must better understand the impact of any tax policy initiatives
on the behaviour of MNEs. Failure to do so may result in further erosion of corporate tax base and reduction of
tax revenues in a world where capital is more mobile than ever before. For example, an MNE with a
sophisticated tax and transfer pricing department may be able to legally structure its affairs in a manner that
1 For example, in the May 2011 federal election in Canada, both the Liberal Party of Canada and the New Democratic Party
pledged to cancel the future corporate tax cuts announced by the ruling Conservative Party. Similarly in the United States of
America (“US”) successive budget proposals by President Obama have focused on the need for tax reform and more
recently, in February 2014, Chairman of the House Committee on Ways and Means (US), David Camp, released a detailed
proposal for tax reform in the US, with most of it focused on corporate tax reform relevant to multinational firms engaged
in cross-border activity.

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lessen the impact of tax rate increases by a government so long as there are disparities between rates of taxation
between countries. At the same time, a less sophisticated MNE may be incentivized by tax rate increases to pay
greater attention to deploying legal tax and transfer pricing structures, resulting in greater profit shifting and
insulation from future tax rate changes. Existing literature studying the relationship between FDI and taxation
shows that despite the attention paid to profit shifting by MNEs, the role of tax and transfer pricing
sophistication of an MNE as a determinant of investment location decisions has not been adequately explored
and significant gaps remain in our understanding of it in informing investment location decisions. Without
further developing our understanding of how MNEs make investment location decisions, impact taxation has on
these decisions, and the options at an MNE’s disposal to move capital, resources and income from one
jurisdiction to another, attempts at combating base erosion and profit shifting through increased taxation of
MNEs may actually expedite such base erosion and profit shifting.

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2 Brief Overview of International Business Theory
In assessing taxation as a determinant of investment location decisions, it is appropriate to first develop an
understanding of the nature of an MNE. The two main theories that are proposed for internationalizations of
firms are the internalization theory and the evolutionary theory (Verbeke 2003).
The theoretical framework for the modern understanding of a firm can be traced back to Coase (1937), who
proposes that a firm exists because it is able to realize cost efficiencies by internalizing certain functions. This is
often referred to as the internalization theory, and its focus has primarily been on minimization of transaction
costs (Verbeke 2003). Hymer (1960), generally considered one of the first major attempts to explain the
internationalization of a firm, found two major determinants of FDI: removal of competition and firm-specific
advantages (Horaguchi & Toyne 1990). The model proposed by Hymer (1960) was extended in Hymer (1968),
where Coasian analysis was used to explain why an MNE may choose to control its foreign activities, instead of
relying on independent parties under an export model (Dunning 2009). The internalization theory was further
developed by Buckley & Casson (1976), and became one the major theories of MNEs (Calvet 1981). Around the
same time, the Uppsala model of international expansion was proposed by Johanson & Vahlne (1977), along the
same lines as Hymer (1960), contending that advantages of operating in new and foreign markets should be
balances against the risks of doing business in a foreign market.
The classical transaction costs model was further advanced by Williamson (1981), proposing that under the
efficient-markets hypothesis a firm that chooses to internalize its internationalization, rather than exporting or
licensing, does so to economize the transaction costs (Anderson & Gatignon (1986), Oviatt & McDougall
(2004)). Similarly, the internationalization theory proposed by Rugman (1980: 376) “explains that the MNE
develops an internal market in response to an externality.” Dunning (1980, 1988) is a significant attempt in
translating the general framework of transaction costs economics into a theory of international trade, proposing
the eclectic paradigm on international production. Dunning (1980, 1988) posits three factors, namely ownership,
locational and internalization advantages (the “OLI” model), to explain why a firm may choose to form an
international subsidiary. A recent overview of developments in the theory of the multinational firm by Rugman
et al. (2011) shows the continued relevance of the ideas proposed by Dunning (1980, 1988) and Williamson
(1981). The theoretical framework for internalizing of activities forms the basis of much of the empirical work
done to understand the location decisions of multinational firms.
There has been an increasing focus on the role of managerial decision-making in investment location decisions.
Kogut & Zander (1993) propose an evolutionary theory of the MNE, as an alternate to the internalization
theory, that focuses on value-creation and knowledge production that is the key to MNEs existence and
expansion. This view of an MNE suggests the role of managerial behaviour and aggressiveness in informing
location decisions. Kogut & Zander (1993) also argued that the internalization theory is focused on protection of
existing advantages (the O-factor in Dunning (1980, 1988)) but not sufficiently concerned with the creation of
new knowledge (Verbeke 2003). Kogut & Zander (1993) dismiss cost opportunism as the primary motivation for

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internalization (Safarian 2003). Buckley et al. (2007) show that managers use basic economic factors as screening
criteria, but also rely on perceptions of cultural similarities, language and other biases that the decision-makers
may not be explicitly aware of. Schotter & Beamish (2013) adds to the analysis of Buckley et al. (2007) and finds
that managerial decision making is significantly influenced by the “hassle” of traveling and other biases based on
personal experience. This shows that there is a role of bounded-rationality and managerial biases in investment
location decisions that cannot be fully explained by using financial and economic data, and lends support to use
of agglomeration effects (Goerzen et al. (2013), Baldwin & Krugman (2004), Brülhart et al. (2012), Bobonis &
Shatz (2007)) and gravity models (Kleinert & Toubal (2010), Mutti & Grubert (2004), Rao (2010), Disdier &
Head (2008)) in future empirical research on the topic.

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3 Review of Literature on Taxation and Investment Location
Decisions
This section provides an overview of the approach taken to identify relevant literature on taxation as a predictor
of investment location decisions, discusses the relevant methodological approaches used in literature, and
provides a brief summary of literature categorized into key subject areas expected to influence the design of the
research project.
3.1 Identifying Relevant Literature
The relevant literature was identified using a broad database search, a review of bibliographies in identified
literature and a search by specific authors. The identified literature was prioritized for review based on inclusion
and exclusion criteria expected to provide a broad understanding of the research undertaken to-date and to help
identify key gaps that may be addressed through future research.
The initial search for relevant literature was undertaken using the EBSCO – Business Source Complete database.
A full-text search was conducted using Boolean logic: (foreign direct investment OR fdi OR location decision
OR investment decision) AND (tax OR taxation OR transfer pricing) AND (multinational OR international OR
mne OR mnc). The search results were further limited to articles published in peer reviewed journals, with ‘full
text’ and ‘references available.’ This resulted in an initial set of 183 articles. Based on a review of the titles and
abstracts, 74 articles were selected as relevant.
A review of the bibliographies of the 74 articles resulted in the identification of a further 301 articles, including
books, trade journals and unpublished working papers and identified authors who have written extensively on
the topic. A broad search was undertaken in the IDEAS database, through Google Scholar and on the website of
selected journals to identify other articles by these authors to identify a further 78 articles, for a total of 562.
Articles were then selected for further study in three categories. First, articles with the highest citation counts
were reviewed to develop an understanding of the topics relevant to the hypothesis. Second, literature surveys
and meta-studies were reviewed to identify key findings and gaps. Lastly, recent literature and literature related to
transfer pricing was reviewed to further investigate areas relevant to the hypothesis. These categories and the
literature reviewed are discussed in more detail in this section.
3.2 Methodological Approaches Used
The literature identified utilizes two primary methodological approaches. A majority of the studies are empirical,
grounded in financial data, with a smaller number focused on behavioural aspects of managerial decision-making.
This section provides a brief overview of the two approaches.
The hypothesis lends itself well to empirical analysis due to the availability of financial data. Beginning with
Hartman (1984, 1985), a number of empirical studies have been undertaken with taxation as an independent
variable on the right-hand side of the equation and investment as a dependent variable on the left-hand side,

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with significantly variable results. Feld & Heckemeyer (2011), based on a review of 45 studies, identify mean
semi-elasticities of investment ranging from -1.3 to 9.8.2 The overall mean semi-elasticity of 3.4, based on 704
estimates, and a standard deviation of 5.2, is consistent with DeMooij & Ederveen (2003, 2008).
In the earliest studies on the subject, Hartman (1984, 1985) uses a time series analysis on the aggregate FDI
inflow into the United States over the years 1965 to 1979, regressed on relative after-tax rates or return, transfers
of funds and reinvestment of retained earnings, finding that a tax cut would result in a 0.5 percent decrease in
transfers from abroad and a 1.5 percent decrease in reinvestment of retained earnings. Boskin & Gale (1987)
expands this analysis to years 1956 to 1984, with a slightly modified definition of after-tax rate of return, finding
consistent results. Young (1988) further extends the analysis by adding a lagged dependent variable and again
finding results that are consistent with earlier studies.
An early study by Grubert & Mutti (1991) uses cross-sectional aggregate data on affiliates of US MNEs in 33
foreign countries, demonstrating a negative influence of taxation on investment. Grubert & Mutti (1991) find
that high taxes corresponded with shifting of income into low tax jurisdictions.
A popular technique since the late 1990s, the first identified study employing panel data is Bartik (1985).
Incidentally, this is also one of the first studies to look at firm-specific data by considering the impact of taxation
and other factors on manufacturing plant births in the US in years 1974 and 1978. Bartik (1985) uses a
conditional Logit model on microeconomic company data to “contradict the [then] common view that state and
local taxes … exert no influence on business location patterns.” More recently, Stöwhase (2005), Buettner & Ruf
(2007) and Buettner & Wamser (2009) also utilize firm-level panel data from German MNEs. Consistent with
earlier studies using firm-level panel data (Devereux & Griffith (1998), Devereux & Lockwood (2006)), both
studies find that EATR did have an impact on a German MNE’s investment location decisions. A majority of
empirical studies demonstrate negative impact of taxation on FDI flows, investment decisions and location
decisions regardless of the empirical testing model used. However, the large variation in results suggests it may
not be appropriate to solely rely on empirical methods. An investigation of behavioural responses to taxation
may provide additional guidance that a purely empirical analysis may overlook.
The agency dilemma—motivating the agent to act in the best interests of the principal—has long been
acknowledged as one of the reasons for results contradictory to economic theory. While there is a much long
tradition of studying behavioural considerations of location investment decisions, as discussed above and
presented by Kogut & Singh (1988), Kogut & Zander (1993), Buckley et al. (2007), Boeh & Beamish (2012) and
others, behavioural considerations with respect to taxation have not been studied in similar depth. Slemrod
(2001) is among the first to propose a theoretical model accounting for behavioural considerations in an MNE’s
response to taxation. Slemrod & Yitzhaki (2002) further consider the behavioural responses in the context of tax
2 This is to say that a one percent increase in taxation results in a range of 9.8 percent reduction in foreign investment to 1.3
percent increase in foreign investment.

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evasion3 to argue that such responses result in an agent arriving at a result that deviates from the optimal tax
structure. Buckley et al. (2007) and Schotter & Beamish (2013) show that managerial decision making is
significantly influenced by the “hassle” of traveling and other biases based on personal experience; however, the
hassle of dealing with a difficult tax administration is not specifically considered. Rosenboim et al. (2008) is the
only study identified in this review to test behavioural biases on decision-making processes of agents with respect
to taxation. Based on responses to a 20-question questionnaire from 102 MBA students, Rosenboim et al. (2008:
605) finds that agents tend to “make decisions in a way that sometimes contradicts the expected utility theory.”
For the purposes of this review, Rosenboim et al. (2008) raises the possibility that variations in the empirical
literature on responsiveness of investment decisions to taxation may be at least partially explainable through
consideration of behavioural biases.
3.3 Review of Relevant Literature: Taxation as a Predictor of Investment Location
Decisions
The hypothesis focuses on taxation as a determinant of investment location decisions given increasing tax and
transfer pricing sophistication of MNEs. The literature reviewed shows the negative impact of taxation on
investment and an increasing tax and transfer pricing sophistication of MNEs. This section categorizes the
reviewed literature into key topical areas, provides a brief overview of the literature, identifies shortcomings of
existing studies and presents relevant considerations for the research proposal.
3.3.1 Geographic Focus of Empirical Studies
A vast majority of the empirical studies reviewed are based on financial data from the US and German MNEs,
with a small number of studies using Japanese and Canadian data. The earliest studies were all based on the US
data (for example, Bartik (1985), Papke (1991), Devereux & Griffith (1998), Grubert & Mutti (2000), Devereux
& Lockwood (2006)) due to the greater availability of data in the US from public filings. Over the last decade,
this changed as Germany introduced greater public disclosure requirements on its MNEs, providing researchers
with previously unavailable data (Stöwhase (2002), Buettner (2002), Bénassy-Quéré et al. (2005), Buettner & Ruf
(2007) and Buettner & Wamser (2009)). Azémar & Corcos (2009) uses data from Japanese MNEs to test a model
of international capital allocations based on degree of control an MNE is able to exhibit (i.e., depending on
whether the counterparty is a controlled subsidiary or a joint-venture). A handful of Canadian studies have
focused on testing tax sensitivity of FDI between Canadian provinces (Ferede & Dahlby (2012), Mintz & Smart
(2004)) and impact of the North American Free Trade Agreement (“NAFTA”) on Canada-US location decisions
(Feinberg & Keane 2001).
Overall, the impact of taxation on Canadian MNEs investment location decisions has not been well studied in
the available literature. Nor has there been a direct study of impact of tax rate changes on inward FDI to Canada.
3 It should be noted that tax evasion refers to evading taxes that are legally due through incorrect tax filings and other
activities that may be considered fraudulent. There is a relatively significant body of literature that deals with tax evasion;
however, it is not considered directly relevant to the primary area research for the purposes of this review.

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This lack of studies is surprising given the sharp decreases in Canadian corporate tax rates over the last decade
and the political debate that these tax cuts have generated.4
3.3.2 Disaggregated Data Availability
As described by Rugman et al. (2011), the earliest studies on the research topic were done by international
economists interested in national competitiveness and using country-level data on trade and FDI. After Hymer
(1960), in the 1970s, the focus shifted to FDI by MNEs, and by 1980s it shifted to investment behaviour at the
subsidiary level. From an empirical perspective, use of bilateral trade flows at a country-level remained the
preferred level of data aggregation for testing the impact of taxation due to constraints on availability of data
(Hartman (1984), Boskin & Gale (1987), Young (1988)). Feld & Heckemeyer (2011) found that these studies
resulted in systematically larger effects of taxes on FDI than later studies at a higher level of disaggregation.
Aggregate data is considered a poor predictor of investment location decisions because it is not possible to take
into account multiple choices an MNE may have had in making its decision (Devereux & Lockwood 2006).
Disaggregation at the subsidiary-level is found to be difficult due to data limitations. However, European-based
subsidiary-level data has become more available recently, resulting in a number of studies based on German
MNEs (Stöwhase (2002), Buettner (2002), Bénassy-Quéré et al. (2005), Buettner & Ruf (2007) and Buettner &
Wamser (2009)).
3.3.3 Measures of Investment
Hebous et al. (2010) and Becker & Fuest (2011a) built on the existing literature on the impact of taxation on
investment location decisions by introducing the categorization of investment between mergers and acquisition
(“M&A”) and greenfield investments. Both studies found that investments pertaining to M&A were less
sensitive to taxation than greenfield investments. That is to say, where a firm was seeking to start a new
operation, instead of acquiring an existing operation, it was more concerned with the differences in tax rates
between jurisdictions. Such differences in tax rates appeared to matter less where acquisition of an existing
business was concerned.
The results of Hebous et al. (2010) and Becker & Fuest (2011a) are similar to those of Altshuler (1995), Klassen
& Laplante (2011) and Markle (2012), who found that reinvestment of earnings is less sensitive to tax rate than
new investment into a jurisdiction. For both reinvestment and M&A, an existing operation is likely to understate
the impact of taxation on investment location decisions and ability to bifurcate the dataset to distinguish between
existing operations and new operations is expected to provide more robust results.
3.3.4 Measure of Taxation
In considering the impact of taxation on investment location decisions, it is critical to select a reliable measure of
taxation. Some of the variability in the empirical literature may be attributable to the differences in measures of
taxation. Hartman (1984, 1985), used historical average tax rates to match tax rates with income reflecting the
4 It should be noted that a recent study by Beugelsdijk & Mudambi (2013) argues that in an increasingly globalized,
borderless world, using country as a unit of analysis is mistaken and a larger geographic space (e.g., regions) should be
considered instead. This has not been investigated further for the purposes of this research proposal but will be studied in
more detail over the course of the research project.

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actual cost of taxation on investment (Feld & Heckemeyer 2011). However, investment decisions are more likely
to be made based on anticipated future tax rates without the benefit of hindsight.
Devereux & Griffith (2003) developed a measure of forward-looking effective average tax rates (“EATR”). In
developing their ex ante measure of EATR, Devereux & Griffith (2003) use a weighted average of effective
marginal tax rate (“EMTR”) and an adjusted statutory tax rate. While widespread in use, the measure is not
universally adopted. Smart (2010) prefers using the statutory corporate tax rates while Ferede & Dahlby (2012)
use the weighted average of contemporaneous and one-year lagged corporate income tax rates, weighted by
distance. The use of distance was also proposed by Devereux et al. (2008), arguing that a country is likely to be
more responsive to the tax changes by neighbouring countries than those by countries that are not in close
geographic proximity.
Slemrod (1990) was among the first to argue that EMTR be used instead of EATR, given that investment
decisions are likely to be based on marginal taxation and not the average taxation. The use of EMTR over EATR
as a predictor of investment location decisions was questioned by Buettner & Ruf (2007: 51), who found that the
EMTR has “no predictive power for location decisions.” Devereux & Griffith (1998) may have bridged the gap
between the two sides by arguing that while the investment location decision is based on EATR, the size of the
investment given the location decision is dependent on EMTR.
The above demonstrates that the literature has not yet settled on a precise measure of taxation. A reliable
investigation of the hypothesis would require evaluating the available measures of taxation and adequately
understanding the chosen measure’s impact on the empirical analysis.
3.3.5 Impact of Tax System
There are two primary types of tax systems in use globally. The exemption system, used in Canada, exempts the
income of a subsidiary from taxation in the home country under certain conditions (typically, as long as the
income is taxed in another jurisdiction). Therefore, where the home country’s tax rates are higher than the home
country, the overall effective tax rate is reduced. By contrast, the credit system, used in the US, provides a credit
in the home country for taxes already paid in the host country but otherwise applies taxation on worldwide
income. The credit system results in effective tax rates that are no lower than the tax rate in the home country.
The type of tax system in the home country has been shown by Bénassy-Quéré et al. (2003), Bénassy-Quéré et al.
(2005) and Barrios et al. (2012) to be a relevant predictor of investment location decisions.
Given that the research project is focused on investment location decisions of Canadian MNEs, the data used in
the project will pertain only to those firms that have the exemption system as the home country tax system.
Therefore, the type of tax system is not expected to have any bearing on the results of the research project.
3.3.6 Home and Host Country Taxation
The early literature was almost exclusively focused on host country taxation. Slemrod (1990) first highlighted the
theoretical shortcomings of not considering home country taxation. Markle (2010) showed that MNEs subject to
an exemption-based regime, where the income of the subsidiaries taxed in the host country is not taxed in the

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home country, shift 3.5 times as much income to low-tax jurisdictions than those subject to a credit-based
regime, where the home country imposes taxation on worldwide income. Weichenrieder (2009) showed that a 10
percent increase in home country taxation in the case of Germany resulted in a 0.5 percent increase in the
German affiliates’ profitability, demonstrating that ignoring home country taxation may result in an incomplete
understanding of the impact of taxation on investment decisions. Other studies have looked at the relative
impact of host and home country taxation. For example, based on data from years 1999 to 2003 for 906 MNEs
from 33 European countries, and 3,094 subsidiaries, Barrios et al. (2012) show that home country taxation is at
least as important as the host country taxation as a determinant of investment decisions. Therefore, a reliable
investigation of the hypothesis is expected to require the inclusion of both the host and the home country tax
measures.
3.3.7 Impact of Bilateral Tax Treaties
BTTs are signed between countries to reduce the instance of double taxation and to establish a common
understanding of how various tax-related circumstances are to be handled. Using macro level aggregate
investment data from Canada, Smart (2010) found the incidence of a treaty resulted in an increase in outbound
FDI of 79% where dividends from treaty partner countries were exempt from domestic taxation in Canada. This
result is consistent with a firm-level analysis of Swedish MNEs by Davies et al. (2009) showing that a treaty
increased the probability of a Swedish MNE having an affiliate in a given country. Accounting for the impact of
BTTs is, therefore, considered important in determining the tax elasticity of investment.
3.3.8 Impact of Capital Structure
A number of studies have provided evidence that the capital structure of the firm is significantly affected by
taxation. Jog & Tang (2001) show that an increase in Canadian corporate tax rate vis-à-vis the US resulted in
increasing debt in the capital structure of Canadian affiliates of foreign multinationals. Jog & Tang (2001)
hypothesise that a later decrease in the Canadian corporate tax rate may have been to discourage the interest
shield being created by excessive use of debt. In the context of the US, Dyreng & Markle (2012) point out the
use of debt in the capital structure by US MNEs for cross-jurisdictional income shifting. Desai et al. (2005)
shows that a 10 percent increase in tax rates is associated with 2.8 percent higher debt-to-asset ratios for the US-
owned affiliates.
Given that much of the empirical literature reviewed on the impact of taxation explicitly excluded the impact of
capital structure from the analysis due to data availability issues (Azémar & Corcos 2009), an analysis accounting
for the use of debt and under-capitalization strategies is expected to be more robust.
3.3.9 Impact of Tax Havens
A tax haven is a country with a highly favourable tax regime, characterized by minimal tax rates and nearly non-
existent enforcement activities by tax authorities. A number of studies have looked at the impact of tax havens
and found consistent results. For example, Gumpert et al. (2011) found, based on 2002 to 2008 financial data
from German MNEs, that a one percent increase in tax rates is likely to result in three percent greater likelihood
that the MNE would own affiliates in tax havens. Dyreng & Markle (2012) uses public filings data of US MNEs

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to find that US corporations are increasing their overall usage of tax havens. Krautheim & Schmidt-Eisenlohr
(2011) found that larger MNEs are more likely to use a tax haven jurisdiction than smaller MNEs.
Halperin & Srinidhi (2010) and Dyreng & Lindsey (2009) show that MNEs with operations in tax haven
countries, reducing income and hence taxes paid in the home country. Dyreng & Lindsey (2009), specifically,
found that the global tax burden of MNEs with at least one tax haven operation were 1.5% lower than the
MNEs that had no tax haven operations. Similarly, Hong (2010) found that having operations in tax haven
countries resulted in a significantly negative impact on taxable income of the Canadian MNE in Canada.
Based on the literature reviewed, presence of tax haven operations is expected to be a key variable of interest in
understanding the impact of taxation on investment location decisions.
3.3.10 Role of Transfer Pricing
The literature reviewed largely ignored both the impact of a firm’s transfer pricing practices and a country’s
transfer pricing regulations and enforcement environment on the tax elasticity of an MNE’s investment location
decisions. An early, well cited study, by Grubert & Mutti (1991) refers to transfer pricing in its title but makes no
other direct reference to the term. Future authors citing Grubert & Mutti (1991) pre-suppose that income
shifting referred to in the paper was accomplished through transfer pricing. Such passing references to transfer
pricing are commonplace in the literature reviewed.
Klassen & Laplante (2012) uses a sample of 380 US-based MNEs with average foreign tax rates lower than the
US statutory tax rate over the periods 1988 to 1992 and 2005 to 2009. They find that the US-based MNEs
shifted approximately $10 billion more income annually from the US over the 2005 to 2009 period than they did
in the earlier period. The authors contend that given this upward trend in income shifting coincides with an
increase in transfer pricing regulation and enforcement by foreign countries, it demonstrates the impact of
transfer pricing on FDI flows. The authors did not consider whether the MNEs in the later period are more
adept at structuring their international operations in a tax advantageous manner than those in the earlier period.
Azémar & Corcos (2009) focus on abusive transfer pricing as a determinant of FDI flows. Based on a sample of
3,614 Japanese affiliates in 49 developing countries, they observe a greater semi-elasticity between investment
and statutory tax rates in the case of wholly-owned subsidiaries of Japanese MNEs than the joint ventures
formed by the same MNEs with unrelated parties. Azémar & Corcos (2009) find that the income of joint
ventures was less sensitive to tax rates than the income of wholly-owned subsidiaries, suggesting to them
evidence of “abusive transfer pricing” in the case of wholly-owned subsidiaries. The authors did not, however,
control for non-tax reasons for a joint venture’s income to be higher than a wholly-owned subsidiary. Koh &
Venkatraman (1991) point out four reasons for why a joint venture is formed: (a) economies of scale; (b) access
to complementary assets; (c) cost or risk sharing; and (d) shaping the scope and basis for competition. Each of
these reasons is expected to be economically advantageous for the joint venture members. Therefore, a joint
venture may have a higher expectation of profits than a wholly-owned subsidiary for reasons unrelated to

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taxation. The analysis presented by Azémar & Corcos (2009) can be refined by including a proxy for a firm’s
transfer pricing sophistication to isolate the impact of transfer pricing on differences in profitability, if any.
3.3.10.1 Tax Authority Aggressiveness
One of the reasons tax havens are popular investment destinations is the tax lax enforcement environment.
Therefore, one would expect that a highly aggressive tax enforcement environment is likely to be negatively
correlated with investments (Hanlon & Heitzman 2010). However, this has not been widely tested in the
literature. The most relevant case of using tax or transfer pricing aggressiveness risk at the country-level is from
an unpublished manuscript, Mescall (2011), where a proprietary survey of transfer pricing professionals from
two accounting firms was carried out to develop a country-specific transfer pricing risk model. This model was
used to demonstrate that purchase price of companies is negatively correlated with transfer pricing risk faced by
the target. However, Mescall (2011) did not use the country-specific transfer pricing risk model to assess its
impact on investment location decisions.
Desai et al. (2007) uses the tax enforcement crackdown data from Russia as a proxy for tax authority
aggressiveness in studying the impact of strong corporate governance, showing the greater tax authority
enforcement results in reduces tax evasion activity by MNEs. Guedhami & Pittman (2008) developed a measure
of monitoring by Internal Revenue Service (“IRS”, the US tax authority) to show results that are largely
consistent with Desai et al. (2007), finding that cost of debt for private firms decreases with stronger IRS
monitoring, resulting from reduced information asymmetries between controlling shareholder and other
minority investors.
In non-empirical research, Plesner-Rossing (2013) undertook a case study of an organization and found that
while the MNE was interested in minimizing tax burden, it was not willing to risk reputational risk from tax
authority action to achieve that goal.
3.3.10.2 Taxpayer Sophistication
Desai et al. (2007) is the only paper identified in literature to tie impact of taxation to taxpayer’s sophistications.
Desai et al. (2007) focuses on the corporate governance framework of the MNE to show that the income of a
more sophisticated taxpayer (from a corporate governance perspective) is less sensitive to tax rate changes. This
is to say that strong corporate governance limits tax evasion in the case of tax rate increases. While informative,
this research proposal is focused on corporate governance and sophistication of an MNE, especially the tax
department of the MNE, and its impact on the investment location decisions of the MNE. This area has not be
explored in the literature reviewed.
3.4 Review of Relevant Literature: Other Predictors of Investment Location Decisions
The economically relevant non-tax determinants of investment location decisions were reviewed from the
synthesis of empirical literature provided by Blonigen (2005). The factors provided included exchange rate
effects, quality of institutions, trade protection regimes and trade effects. Each of these is expected to form

15. Junaid Mirza
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control variables when designing the empirical model to test the hypothesis. In addition, Blonigen (2005)
identified taxation as a significant determinant of FDI, which is the focus of this review.
3.5 Gaps and Opportunities for Future Research
There are a number of potential gaps in the existing research, and hence opportunities for future research. In the
case of empirical studies, these gaps and opportunities relate either to a continuing refinement of methodology,
or limitations placed by availability of data. This section provides a brief overview of the gaps and opportunities
as they relate to the hypothesis.
First, a significant number of empirical studies are based on aggregate data, disregarding firm-specific factors.
Feld & Heckemeyer (2011: 233) found that “studies based on aggregate data report systematically larger semi-
elasticities than firm-level analyses.” Increasing availability of data has resulted in a greater number of studies
using firm-level financial data, while data availability constraints continue to apply to subsidiary-level data except
where the authors had access to confidential company data (Devereux & Maffini 2007). An analysis based on the
subsidiary-level financial data is expected to be more robust than those using aggregate or firm-level data.
Second, the lack of availability of firm-level data has also resulted in researchers largely limiting themselves to
US, German and Japanese MNEs. The relatively small set of countries for which studies have been conducted
means the results are not necessarily generalizable. Given that the hypothesis is proposed to be tested from a
Canadian perspective, it is significant that none of the studies identified in this review were based on firm-level
Canadian data. It is expected that a study based on Canadian MNE financial data would be considered a
welcome addition to the literature.
Third, opportunities remain to investigate the impact of transfer pricing rules, tax authority aggressiveness and
MNE’s tax department sophistication on the investment location decisions of MNEs. Transfer pricing is the
mechanism by which an MNE allocates income to its various subsidiaries. The most commonly used pricing
mechanism is the arm’s length principle (“ALP”). Adopted by a significant number of world governments, the
basic appeal of the ALP is its theoretical simplicity and its purported neutrality. However, the ALP is less
straightforward in implementation, if only because Coase (1937), Dunning (1980), and others have argued that a
firm chooses to internalize its internationalization due to advantages it may enjoy over other participants in the
marketplace. By extension, one may argue that to arrive at an ALP by using the market mechanisms in the
context of an MNE’s intercompany transactions is inherently subjective and controversial. Despite increased
government and media scrutiny of income shifting by MNEs, the impact of MNEs’ transfer pricing practices is
not well explored in the literature. It is expected that the variability in the results of empirical studies may be
partially explained by controlling for tax and transfer pricing sophistication of MNEs, and the regulatory and
enforcement environment they face. The country-specific transfer pricing risk model developed by Mescall
(2011), or a similar alternate model, is expected to be informative in refining the existing results on taxation and
investment location decisions.

16. Junaid Mirza
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Lastly, the identified literature is predominantly empirical and ignores behavioural considerations in managerial
decision-making. The hypothesis is also expected to take into account the actual practices of MNEs in an
attempt to better understand the variability in the results of empirical studies. As shown by Schotter & Beamish
(2013) and Buckley et al. (2007), managers may make decisions based on biases and personal conveniences
instead of using sound business and financial metrics exclusively. Given that an agent or a manager may have
different motivations than the principal or a shareholder, and is influenced by personal biases, the role of
bounded rationality may explain some of the variability in the empirical results.

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