The sphere of application of a tax incentive may be extended by way of a tax sparing clause in a tax treaty between a capital importing country and a capital exporting country.

Such clauses allow residents of the capital exporting country a credit against their domestic tax for profits or gains derived in the developing country in respect of which all or specified taxes are subject to exemption or reduction in the latter country.

The result resembles an offshore tax plan designed by the taxing government itself.

The failure of a capital exporting country to provide for tax sparing or some similar arrangement leads to a distortion of competition at the international level, since investors who are taxed on foreign income in their country of residence are at a disadvantage as compared with investors who are resident in countries giving full or partial exemptions for foreign source income, and also as compared with investors resident in the developing country itself.

A tax sparing arrangement is thus a concession offered by a capital exporting or investing country to ensure that an incentive offered by a developing country is effective. Without it, the incentive offered by the developing country may be nullified because it merely results in more tax being payable in the investing country.

Investment incentive programs, together with, or in the absence of, tax incentives, may well prove decisive in the choice of location of a project. Such programs are particularly attractive where substantial grants, interest-free or low-interest loans, factory sites, etc., are available in addition to tax incentives.

There are two areas where care should be exercised:
(1) the international measures that restrict the use of preferential tax regimes and tax havens; and
(2) the question as to whether the incentive is really beneficial.