CES Lecture Series. Tax Avoidance in Multinationals: The Case of Debt Shifting. Dirk Schindler (Norwegian School of Economics)

Transcription

1 CES Lecture Series Tax Avoidance in Multinationals: The Case of Debt Shifting Dirk Schindler (Norwegian School of Economics) Lecture 1: Background and Theory of Debt Shifting

2 What are we talking about? Tax avoidance (tax planning/tax engineering) use tax legislation to minimize tax payments tax planning can be done domestically or as arbitrage activity across states exploiting differences in tax codes what firms think is legal tax planning may be considered tax evasion by tax authorities grey area where unclear what is legal or not CES Lecture: The Case of Debt Shifting 2 Lecture 1: Background and Theory

3 Multinational companies affiliate(s) in at least one other country face international differences in tax rates profitable to shift income to low-tax countries various strategies to reduce global tax burden CES Lecture: The Case of Debt Shifting 3 Lecture 1: Background and Theory

4 Debt shifting fundamental asymmetry in corporate tax law: equity costs fully taxed interest expenses on debt tax deductible debt tax shield (simplest version: t i r D i ) strategically exploiting international allocation of debt across affiliates maximizes tax savings (international) debt shifting CES Lecture: The Case of Debt Shifting 4 Lecture 1: Background and Theory

5 The avoidance of taxes is the only intellectual pursuit that carries any reward. (John Maynard Keynes) CES Lecture: The Case of Debt Shifting 5 Lecture 1: Background and Theory

6 1 Stylized Facts Multinational companies World-wide growth rates (per annum) between 1985 and 1999 (Navaretti/Venables, 2004) (real) GDP: 2,5% / exports: 5,6% / FDI: 18% multinationals exponentially gaining importance one-third of global trade being trade within MNCs (Antràs, 2003) 40% of total US trade flows in 2008 being intra-firm exports and imports (Egger/Seidel, 2011) CES Lecture: The Case of Debt Shifting 6 Lecture 1: Background and Theory

7 Table 1.2: Top 10 countries with highest ratio of FDI flows as percentage of GDP ( ) Rank Country FDI Outflow (%) FDI Inflow (%) Sum of In- and Outflows (%) 1 Luxembourg Hong Kong (China) Singapore Iceland The Netherlands Belgium Ireland Lesotho Switzerland Bulgaria Sources: Mintz/Weichenrieder, 2010, based on IMF Statistics CES Lecture: The Case of Debt Shifting 7 Lecture 1: Background and Theory

8 Tax avoidance: Recent public incidents No taxes by global MNCs (e.g., Apple 1.9%, Google 2.5% on non-us profits) Starbuck s UK without tax payments in 14 out of last 15 years (Reuters/Bergin, 2012) Case study on Apple by US senate (Subcommittee Memorandum, 2013): Apple most egregious offender (Sen. John McCain) Apple sought the Holy Grail of tax avoidance (Sen. Carl Levin) CES Lecture: The Case of Debt Shifting 8 Lecture 1: Background and Theory

9 Tax avoidance Better access to tax-planning in multinationals Profit shifting in multinationals late-breaking political concern (OECD, UN-committee on tax havens) growing field in public finance In academia relevance well-known: Grubert/Mutti (1991, REaS), Hines/Rice (1994, QJE) Two main strategies (abusive) transfer pricing international debt shifting CES Lecture: The Case of Debt Shifting 9 Lecture 1: Background and Theory

10 2 Background: Tax-avoidance Strategies (Abusive) Transfer pricing Stylized facts Pak and Zdanowicz (2001): amounts to 18% of total reported US-corporate profits total volume 44.6 billion US-$ Bernard et al. (2006): total volume up to 33 billion US-$ Bartelsman and Beetsma (2003): reduces gain in revenue from tax increase by 65% - 87% CES Lecture: The Case of Debt Shifting 10 Lecture 1: Background and Theory

11 Main idea Over-/Underinvoicing intangibles, franchise fees, intermediates Shifting profits to low-tax affiliates Problem Transfer pricing disputed (illegal): concealment costs in hiding Transfer pricing in intermediate goods (prod. factors): potential distortion costs (depending on concealment costs) Transfer pricing in intangibles/fix costs potentially cheaper CES Lecture: The Case of Debt Shifting 11 Lecture 1: Background and Theory

12 CES Lecture: The Case of Debt Shifting 12 Lecture 1: Background and Theory

13 CES Lecture: The Case of Debt Shifting 13 Lecture 1: Background and Theory

14 International debt shifting Main idea: claim tax deductions in high tax countries External debt: loans from capital market load high-tax affiliates with external debt reduce external debt in low-tax affiliates maximize tax savings for given overall bankruptcy costs Internal debt: lending among related affiliates generate tax deductions in high tax affiliates declare interest income from internal debt in lowest-taxed affiliate utilize tax differential for tax savings CES Lecture: The Case of Debt Shifting 14 Lecture 1: Background and Theory

15 Table 1.3: Conduit entities of German MNC with positive net lending by country (2006) Country Lending to affiliated companies Number of conduit Statutory less liabilites (in Mio. euro) entities tax rate USA 53, UK 3, Switzerland France The Netherlands Belgium 2, Austria South Africa Luxembourg 1, Ireland Spain Sweden Canada Italy ,3725 Cayman Islands 4, Malta Sources: Ruf/Weichenrieder, 2012, MiDi database CES Lecture: The Case of Debt Shifting 15 Lecture 1: Background and Theory

16 Example: Statoil internal bank: coordination center in Mechelen/Belg. (since 1989) serving 130 affiliates worldwide / profit of 400 Mio. euro (2012) official aim: optimizing treasuring (NOT taxation) CES Lecture: The Case of Debt Shifting 16 Lecture 1: Background and Theory

17 Example: Statoil internal bank: coordination center in Mechelen/Belg. (since 1989) serving 130 affiliates worldwide / profit of 400 Mio. euro (2012) official aim: optimizing treasuring (NOT taxation) Coordination center in Belgium (until 2010) corporate tax base: costs minus wage and capital costs no tax burden on profits from interest received effective tax rate de facto zero Coordination-center regime replaced by Notional Interest Deductions (Belgian variant of ACE system) Internal banking no vehicle for tax planning and profit shifting? CES Lecture: The Case of Debt Shifting 17 Lecture 1: Background and Theory

18 Table 1.3: Conduit entities of German MNC with positive net lending by country (2006) Country Lending to affiliated companies Number of conduit Statutory less liabilites (in Mio. euro) entities tax rate USA 53, UK 3, Switzerland France The Netherlands Belgium 2, Austria South Africa Luxembourg 1, Ireland Spain Sweden Canada Italy ,3725 Cayman Islands 4, Malta Sources: Ruf/Weichenrieder, 2012, MiDi database CES Lecture: The Case of Debt Shifting 18 Lecture 1: Background and Theory

19 2.1 Questions: Economic Point of View How does tax-driven debt shifting work? How is a tax-efficient multinational structured? How large are the effects (e.g., on debt-to-asset ratio, on tax revenue)? What can be done to curb tax planning? CES Lecture: The Case of Debt Shifting 19 Lecture 1: Background and Theory

20 2.2 Questions: Finance Point of View How does (international) taxation affect firms value? What characterizes the optimal capital structure? In which sense are multinationals special? CES Lecture: The Case of Debt Shifting 20 Lecture 1: Background and Theory

21 3 Tax-efficient Capital Structures in Multinationals See Møen et al. (2011), Schindler and Schjelderup (2012) Distinctive features of multinational firms: facing international tax-rate differentials use of internal debt for tax reasons ability to shift (external and internal) debt across affiliates Improved capacities for tax avoidance CES Lecture: The Case of Debt Shifting 21 Lecture 1: Background and Theory

22 3.1 Model Price-taking multinational firm (henceforth: MNC) Production of homogenous good in i affiliates/countries Production function: x i = F(K i,l i ) Production factors: real capital K i, labor L i Decreasing marginal productivities in each factor CES Lecture: The Case of Debt Shifting 22 Lecture 1: Background and Theory

23 Small country assumption / well-functioning capital markets Constant rental cost of capital per unit r > 0 Tax-exemption principle dividends received from affiliates tax-free see, for example, Parent-Subsidiary directive of EU rare exception having no tax-exemption: USA Location of headquarters of MNC does not matter CES Lecture: The Case of Debt Shifting 23 Lecture 1: Background and Theory

24 Financing of investments in country i: E i = equity D E i = external debt (non-related third parties) D I i = internal debt (from other affiliates within MNC) CES Lecture: The Case of Debt Shifting 24 Lecture 1: Background and Theory

25 Leverage ratio in affiliate i: b i b E i +b I i external leverage: b E i D E i /K i internal leverage: b I i DI i /K i Internal lending constraint: r Di I = b I i r K i = 0 i i total sum of internal loans is zero CES Lecture: The Case of Debt Shifting 25 Lecture 1: Background and Theory

26 Affiliate-specific costs of debt External debt (cf. corp. finance lit.): U-shaped cost function C E (b E i ) Benefits: Capital market monitors firm / Reduction in moral hazard (e.g., limiting empire-building) Costs: Bankruptcy costs / Debt overhang Optimal leverage (in absence of taxation): b Internal debt: convex concealment costs C I (b I i ) Hiring tax experts (lawyers...) Avoiding thin cap rules and CFC taxation CES Lecture: The Case of Debt Shifting 26 Lecture 1: Background and Theory

27 Costs of debt fundamentally differing Internal debt de facto tax-preferred equity Assumption 3.1. External credit markets are assumed to be perfect except for the debt tax shield and financial distress costs. The cost function related to borrowing external and internal debt in affiliate i is additively separable, C(b E i,bi i ) = CE (b E i )+CI (b I i ), and exhibits C E (b E i ) > 0 with C E (b E i ) > 0, C E (b E i ) > 0, if b E i b, C E (b E i ) < 0, C E (b E i ) > 0, if b E i < b, C I (b I i) > 0 with C I (b I i) > 0, C I (b I i) > 0, if b I i > 0, C I (b I i) = 0 with C I (b I i) = 0, if b I i 0. CES Lecture: The Case of Debt Shifting 27 Lecture 1: Background and Theory

28 Overall bankruptcy costs on parent level MNC (partly) guarantees debt of affiliates Bankruptcy costs at parent level Costs depending on firm-wide leverage b f = ide i i K i Costs C f convex in firm-wide leverage CES Lecture: The Case of Debt Shifting 28 Lecture 1: Background and Theory

29 Profit equations Economic profit in affiliate i: π e i = F(K i,l i ) w L i [ r +C E (b E i )+C I (b I i) ] K i (3.1) Taxable profit in affiliate i (cost of equity not deductable) π t i = F(K i,l i ) w L i r [D E i +D I i] [C E (b E i )+C I (b I i)] K i (3.2) Affiliate s after-tax profit π i = π e i t i π t i = (1 t i ) [F(K i,l i ) w L i ] r K i } {{ } =V U i + t i r [D E i +D I i] (1 t i )[C E (b E i )+C I (b I i)] K i CES Lecture: The Case of Debt Shifting 29 Lecture 1: Background and Theory

30 World-wide profits and value of MNC Π p = V L = i V L i C f = i (π e i t i π t i) C f = i π i C f (3.3) Optimal capital structure (for fixed inputs K i, L i ) max D E i,di i Π p = i { (1 t i ) [F(K i,l i ) w i L i ] r K i (3.4) ] + t i r [D i E +Di I (1 ti ) [ C E (b E i )+C I (b I i) ] K } i C f (b f ) s.t. i r D I i = 0, (λ) s.t. b a i = Da i K i, a = {E,I}, b f = ide i i K i CES Lecture: The Case of Debt Shifting 30 Lecture 1: Background and Theory

31 3.2 Tax-efficient Capital Structure Rearranging the FOCs: t i r = (1 t i ) CE (b E i ) b E i + C f(b f ) b f 1 i K i > 0 i (3.5) (t i λ) r = (1 t i ) CI (b I i ) b I i 0 i (3.6) Lagrange parameter λ: shadow costs (tax payments) of shifted interest From equation (3.6): λ = min i t i = t 1 see Schindler and Schjelderup (2012a), Lemma 1 CES Lecture: The Case of Debt Shifting 31 Lecture 1: Background and Theory

32 Implications internal bank always located in lowest-taxed affiliate; i.e., country 1 maximizing internal debt tax shield / minimizing financing costs optimal to use both external and internal debt balancing debt tax shields (LHS) against (net) costs of debt (RHS) if C f = 0, identical external leverage in MNCs and domestic firms for C f = 0, MNCs affiliates have higher total leverage due to internal borrowing CES Lecture: The Case of Debt Shifting 32 Lecture 1: Background and Theory

33 Comparative-static analysis Implicit derivatives H(x,y) 0 dx dy = H/ y H/ x Effects of tax rate changes: differentiate FOCs (3.5) and (3.6) db E i dt i = r + C E / b E i (1 t i )( 2 C E / b E2 i )+( 2 C f / b 2 f ) > 0, (3.7) K i ( i K i) 2 db I i r + C I / b I i = dt i (1 t i )( 2 C I / b I2 > 0, i ) (3.8) db I i r = dt 1 (1 t i )( 2 C I / b I2 < 0. i ) (3.9) CES Lecture: The Case of Debt Shifting 33 Lecture 1: Background and Theory

34 Intuition increase in domestic tax rate t i increase of tax shield increase of tax subsidy on affiliate-specific debt costs external and internal leverage increase increase in tax rate of internal bank t 1 decrease of internal tax shields in all affiliates internal leverage decreases in affiliates i > 1 CES Lecture: The Case of Debt Shifting 34 Lecture 1: Background and Theory

35 3.3 Anecdotic Evidence and Illustration Statoil Coordination Center in Mechelen/BE (Aftenposten, ) equity from Statoil Norge (HQ): 12.4 billion euro loans to affiliates worldwide: 10.9 billion euro profit (in 2012): 400 million; effective tax rate: 8.4% 20 employees, all board members living in Norway Statkraft Treasury Sentre in Brussels/BE (Aftenposten, ) equity from Statkraft Norge (HQ): 7.6 billion euro loans to affiliates worldwide: 7.8 billion euro profit (in 2012): 330 million; effective tax rate: 12.4% 6 employees, 2 board members living in Norway CES Lecture: The Case of Debt Shifting 35 Lecture 1: Background and Theory

36 Formula One Holding Delta Topco (in 2011) Sylt and Reid (2011), The Independent (July 24, 2013) affiliates worldwide, mainly in Great Britain and on Jersey British affiliates loaded with 3.0 billion euro internal debt HMRC-allowed interest expense: 463 million euro interest rate on internal debt: 15% (confirmed by tax authorities) internal bank sitting on Channel Island Jersey Jersey well-known tax haven total tax payment: 1.1m euro in UK m euro overseas total revenues: 1.15 billion euro effective tax rate: 0.98% CES Lecture: The Case of Debt Shifting 36 Lecture 1: Background and Theory

37 CES Lecture: The Case of Debt Shifting 37 Lecture 1: Background and Theory