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Taxation of Unknown Beneficial Owners: Treaty Shopping with Incomplete Information

This paper examines treaty shopping in a game-theoretic model with incomplete information. An investor has private information about her country of residence and chooses a direct or indirect investment route across national borders to minimize tax. A tax agency has private information about its audit cost and decides whether to audit the investor. An audit is costly but it can generate additional revenue for the tax agency. If the audit reveals that the investor chose an indirect route, the tax agency imposes a penalty tax on the investor. In this model there is a Bayesian Nash equilibrium where the tax agency of a low cost type audits the investor with positive probability and the investor of a country with tax-minimizing indirect routes chooses such indirect routes with positive probability. I calculate the decrease in the tax agency's expected payoff due to indirect routing, i.e., treaty shopping, and show the payoff dominance of the equilibrium random audit to the mandatory audit. Under foreign tax credit systems in residence countries with relatively high tax rates, there is an equilibrium where the investor chooses the direct route regardless of her type. Treaty shopping can be prevented in equilibrium.