United nations of tax incentives

Common abuses of tax incentive regimes
Ongoing monitoring of investments is necessary not only to ensure 
continuing compliance with qualifying conditions but to detect tax 
avoidance or evasion. Tax avoidance presents greater difficulties, 
because countries have different attitudes as to what constitutes 
avoidance and what to do about it. For example, granting a tax holiday 
may be conditional upon an investor’s employing a given number of 
people. In some countries an investor could legitimately make up the 
qualifying number by hiring employees with minimal duties and at low 
wages. In other countries, that course of action might be considered an 
abuse of the legislation and result in the denial or withdrawal of the 
tax privilege.
Ten of the most common abuses associated with tax incentives, 
some of which are elaborated upon below, are:
(a) Existing firms transforming into new entities to qualify for 
incentives;
(b) Domestic firms restructuring as foreign investors;
(c) Engaging in transfer pricing schemes with related entities 
(sales, services, loans, royalties, management contracts);
(d) Churning investments or creating fictitious investments due 
to lack of recapture rules;
(e) Schemes to accelerate income or defer deductions at the end of 
a tax holiday period;
(f) Overvaluation of assets for depreciation, tax credit or 
other purpose;
(g) Employment and training credits, such as fictitious employees 
and fake training programmes;
(h) Leakages from export zones into the domestic economy;
(i) Regional investment incentives and enterprise zones diverting 
activities to outside the region or zone;
(j) Disguising non-qualifying activities or burying them in qual-
ifying activities.

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Part I: Theoretical Background
Round tripping
Round tripping, when one company sells an unused asset to another 
company under the agreement that it will buy it back for the same 
price, typically occurs in countries where tax incentives are restricted 
to foreign investors or to investments with a prescribed minimum 
percentage of foreign ownership. Domestic investors may seek to 
disguise their investments to qualify for those incentives by routing 
their investments through a wholly controlled foreign corporation. 
Similar practices have occurred in a number of countries with 
economies in transition, especially in connection with the privatization 
of State-owned firms in which the existing management has acquired 
ownership of the firm through the vehicle of an offshore company. 
Round tripping is not always undertaken in order to meet foreign 
ownership requirements; it may also be used to take advantage of 
favourable tax treaty provisions.
Double dipping
Many tax incentives, especially tax holidays, are restricted to new 
investors. In practice, such a restriction may be ineffective or 
counter-productive. An existing investor that plans to expand its 
activities will simply incorporate a subsidiary to continue the activity 
and the subsidiary will qualify for a new tax holiday. A different type of 
abuse occurs when a business is sold towards the end of the tax holiday 
period to a new investor who then claims a new tax holiday. Sometimes 
the “new” investor is related to the seller, although the relationship is 
concealed. A more satisfactory approach for policymakers may be to 
use investment allowances or credits, rather than tax holidays, so that 
new investments, rather than investors, qualify.