Withholding Taxes and Foreign Portfolio Investment
WHU – Otto Beisheim School of Management
Norwegian School of Economics and LMU Munich
This draft: March 2020
We examine the role of withholding taxes on foreign portfolio
investment (FPI) using data on U.S. mutual fund holdings and on
bilateral FPI. Exploiting variation in withholding tax rates for 38
investor countries and 115 issuer countries over 2008–2015, we find
that, conversely to the intended design of the international tax system,
withholding taxes adversely affect FPI. We show that this is due to
compliance frictions in claiming foreign tax credits. We further provide
evidence that frictions in claiming foreign tax credits are reflected in
lower stock returns in the setting of American Depositary Receipts.
Keywords: Foreign portfolio investment, withholding taxes, shareholder taxation, home bias
JEL codes: D25; G11; G25; H20; H24
We gratefully acknowledge helpful comments from Harald Amberger, Dan Amiram, Tobias Bornemann, Alex
Edwards, Jesse van der Geest, Kevin Markle, Maximilian Müller, Terry Shevlin, Siew Hong Teoh, Ryan Wilson,
Chenqi Zhu, and seminar participants at the University of California, Irvine, WHU – Otto Beisheim School of
Management, and the University of Tuebingen.
With globalization, the removal of trade barriers, and global economic integration, capital markets
are also becoming integrated across borders. In addition to firms directly investing via subsidiaries
abroad—foreign direct investment (FDI)—individual and institutional investors are increasingly
investing in shares of foreign companies. Globally, such foreign portfolio investment (FPI)
witnessed enormous growth, from USD 5 trillion in 2001 to USD 22 trillion in 2015 (12.3% of the
global financial wealth, or 32% of the global market capitalization).1 FPI is an important source of
financing for firms seeking capital to invest and, thus, for economic growth. According to
international portfolio theory (e.g., Adler and Dumas 1983), costs such as withholding taxes on
foreign dividends can theoretically reduce foreign investment (e.g., Cooper and Kaplanis 1986,
1994). On paper, the cross-border taxation of dividends via domestic dividend taxes and foreign
withholding taxes is therefore designed in a capital export–neutral way, which means that the
location of FPI is independent of taxation: Double tax agreements (DTAs) ensure that the
withholding tax rate in the foreign country (where the firm is located) is below the dividend tax
rate in the home country (where the investor is located).2 Since foreign withholding tax payments
are usually fully credited against the domestic dividend tax, they would be rendered irrelevant.
Therefore, cross-border equity investments and individual portfolio decisions should not be
affected by withholding taxes.
However, this irrelevance of withholding taxes for FPI is based on the assumption that
investors claim credits for the foreign withholding tax. In this paper, we challenge this view and
1 Source: Coordinated Portfolio Investment Survey (CPIS), International Monetary Fund (IMF). According to data
from Credit Suisse (Global Wealth Databook 2019), global financial wealth was USD 175.4 trillion in 2015. The
World Federation of Exchanges reports a global market capitalization of USD 67 trillion in 2015.
2 The very few cases with a withholding tax above the final dividend tax 0 F comprise mainly investments from tax havens,
where dividends are usually not tax exempt (e.g., Cayman Islands or Bermuda).
examine the effect of compliance frictions in claiming foreign tax credits on FPI. A significant
part of the tax credit—the difference between the withholding tax rate in the respective DTA and
the standard withholding tax in the foreign country—must be actively claimed from foreign tax
authorities, increasing the costs associated with cross-border investments. Anecdotal evidence
suggests substantial compliance issues in this process due to extensive reporting requirements,
lengthy processes, and fees.3 To date, the academic literature on FPI lacks an understanding of this
issue and its consequences.4 We fill this void by showing that compliance hurdles in claiming
foreign withholding tax credits have adverse effects on FPI. In short, although withholding taxes
on dividends should not matter for FPI, since they are designed in a capital export–neutral way,
withholding taxes can affect FPI due to compliance frictions in claiming foreign tax credits.
We build a large data set of dividend withholding tax rates for bilateral combinations of 38
investor countries and 115 issuer countries over the period 2008–2015, taking into account DTAs.
We obtain information on dividend tax rates in the investor’s home country to calculate the country
pair–specific effective dividend tax rate on cross-border FPI, assuming the credit is granted. A
novel aspect of our paper is the computation of what we call the withholding tax overpayment that
the investor must claim from the tax authorities of the foreign country. The withholding tax
overpayment is the difference between the actual tax rate withheld in the foreign country, which
is usually the same for all foreign investors, and the tax rate that is applicable under an effective
DTA for that particular country pair. The important insight highlighted in our paper is that claiming
back the withholding tax overpayment often comes at a high compliance cost. To summarize,
3 For example, the media (e.g., Lodge 2010), policy makers (e.g., European Commission 2016), think tanks (e.g.,
Næss-Schmidt et al. 2012), and investors (e.g., European Federation of Investors 2011) have been alerted that
withholding taxes are burdensome because of compliance issues.
4 For instance, Chan et al. (2005), Ammer et al. (2012), and Amiram and Frank (2016) study the effects of withholding
or dividend taxes on FPI, but do not consider compliance frictions.
while the effective dividend tax rate captures tax payments assuming that shareholders are granted
the full tax credit, our withholding tax overpayment variable isolates the compliance hurdle in the
cross-border withholding tax credit system for individual investors.
Our empirical analysis is based on data from two sources. First, we obtain information on
bilateral equity FPI holdings from the IMF’s Coordinated Portfolio Investment Survey (CPIS) over
the period 2008–2015. Second, we obtain foreign portfolio holdings for individual investors and
securities from the Form 13F filings of U.S. institutional investors with the U.S. Securities and
Exchange Commission (SEC).
In our bilateral tests, we exploit the variation in effective dividend taxes and withholding tax
overpayments in a generalized difference-in-differences design, using FPI as the dependent
variable. The level of withholding tax overpayment can change when DTAs change or when issuer
countries reform their withholding tax systems. We observe 616 bilateral changes (383 increases
and 233 decreases) in withholding tax overpayments in our sample. Most of these are driven by
changes in unilateral withholding tax rates, which reduces the likelihood of the changes in our
main independent variable being a response to (the lack of) country pair–specific FPI. We then
compare the FPI for a given country pair experiencing a change in withholding tax overpayment
to another country pair from either the same issuer or the same holder country, but without a change
in withholding tax overpayments (first difference) around the change in withholding tax
overpayment (second difference). The identification approach absorbs any issuer country–year as
well as investor country–year–specific and any time-invariant country pair–specific characteristics
to account for nontax characteristics driving bilateral FPI.
Our main results indeed indicate an economically large effect of compliance hurdles on FPI.
For an average country pair, a one percentage point decrease in withholding tax overpayments in
terms of cross-border dividends paid increases the investor country FPI to the issuer country by
2.3%, or USD 186 million.5 Note that the overall FPI in a particular issuer country is the sum of
FPI from all investor countries, such that the overall effect of reducing withholding tax
overpayments for an individual country is likely to be substantial. Consistent with this effect being
driven by dividend payments, we find a stronger tax effect of withholding tax overpayments on
FPI when companies in the foreign country have higher dividend payout ratios. This effect is robust
to the inclusion or exclusion of additional country pair–specific control variables, as well as to t