Exploiting a Window of Opportunity: Multinationals Profit Shifting in the Absence of Restrictions

Transcription

1 Exploiting a Window of Opportunity: Multinationals Profit Shifting in the Absence of Restrictions Carolin Holzmann September 2014 Abstract This paper asks whether and how multinational enterprises (MNEs) tax planning responds to changes in the tax law that create new opportunities for profit shifting. We analyze MNEs internal debt shifting during a window of opportunity. The window opened because of a ruling of the European Court of Justice in 2006 that restricted the application of controlled foreign corporation rules within the European Economic Area. The window closed with a subsequent anti-shifting legislation on thin capitalization in Our empirical identification strategy exploits random variation in the time length of MNEs windows that results from the firm-specific introduction mechanism of the anti-shifting legislation. We use data from the Microdatabase Direct Investment which provides detailed information on foreign subsidiaries of German MNEs. Generally, our results show that the window has an impact on both the probability and the volume of internal lending. Even conservative estimates indicate an increase in the probability by 7% and in the volume by 14.4% per 90-day window. Fiscal consequences in terms of tax revenue losses, however, appear to be negligible because the average volume of internal lending is rather small. Keywords: multinational firms, corporate taxation, profit shifting, anti-tax-avoidance legislation, European Court of Justice ruling JEL classification: F23, H25, H32 Address: Friedrich-Alexander-University Lange Gasse 20 D Nuremberg Germany Phone: Fax: carolin.holzmann@fau.de Acknowledgements: We thank participants at the Annual Congress of the IIPF 2014, Lugano, the Cebid Conference 2014, Nuremberg, the Taxing Multinationals Conference 2013 and the Public Finance Conference 2014 both at the ZEW, Mannheim. Access to the Microdatabase Direct Investment provided by the Deutsche Bundesbank is gratefully acknowledged. This project has received financial support from the German Science Foundation (DFG) and the Faculty of Law and Economics, FAU Erlangen-Nuremberg.

2 1 Introduction The last two decades saw many countries implementing anti-tax-avoidance legislation to tackle tax-base erosion and profit-shifting activities of multinational enterprises (MNEs). Crosscountry comparisons show that today most developed countries tax laws incorporate transfer pricing regulations and thin capitalization rules (Lohse et al., 2012; Buettner et al., 2012). Furthermore, countries commonly apply controlled foreign corporation (CFC) rules to prevent MNEs from profit shifting to low-tax jurisdictions. In September 2006, however, the international development towards stricter anti-tax-avoidance legislation relapsed when the European Court of Justice (ECJ) rather unexpectedly declared CFC rule application within the European Economic Area (EEA) 1 in large parts unconstitutional. The court s decision basically eliminated, with immediate effect, a number of EEA countries provisions against profit shifting to EEA low-tax countries. This paper investigates whether and how MNEs internal debt shifting to EEA low-tax subsidiaries responds to a temporary suspension of anti-tax-avoidance legislation. We analyze the case of Germany where a window of opportunity for internal debt shifting opened because of the ECJ ruling in 2006 and closed with a subsequent anti-tax-avoidance legislation on thin capitalization in The exact date at which the anti-tax-avoidance legislation took legal effect depended on the starting date of MNEs business years. As MNEs start their business years at different dates throughout the calender year, the time length of the window varied between MNEs by up to 365 days. MNEs starting dates of the business year can plausibly be assumed to be independent from the ECJ ruling. Thus, we can estimate the causal effect of the window length on MNEs probability to receive internal lending from EEA low-tax subsidiaries and on the respective volume of internal lending. 1 As of 2013 the European Economic Area consists of Iceland, Norway, Liechtenstein, and the 27 EU member states. 1

3 The paper relates to several strands of literature that investigate MNEs response to anti-taxavoidance legislation. A number of papers find CFC rules to be effective means against MNEs profit shifting to low-tax jurisdictions. Altshuler and Hubbard (2002) show that after US CFC legislation was tightended in 1986, the worldwide location of assets in financial service firms became less sensitive to foreign location taxes. Ruf and Weichenrieder (2012) exploit changes in German CFC legislation in the early 2000 s. The authors find that German CFC rules effectively prevent German MNEs from profit shifting to foreign low-tax subsidiaries. Egger and Wamser (2011) investigate whether CFC legislation effects real economic activity of MNEs. Based on a regression discontinuity approach, their results indicate a negative impact of CFC legislation on foreign direct investment. In case CFC regulation is loosened, previous studies show an immediate increase in MNEs profit shifting activities. Mutti and Grubert (2009) and Altshuler and Grubert (2006) find that US MNEs use US check-the-box rules to circumvent CFC legislation and to retain great shares of foreign profits in low-tax subsidiaries. Ruf and Weichenrieder (2013) investigate changes in MNEs allocation of profit-generating passive investments by exploiting the restriction in CFC rule application within the EEA due to the ECJ decision in Using a difference-in-differences approach, the authors find that after the ECJ decision German MNEs statistically significantly increased their passive investments in EEA low-tax subsidiaries compared to a control group of non-eea low-tax subsidiaries. Another strand of literature investigates MNEs response to anti-shifting provisions that tackle thin capitalization. 2 Cross-country studies confirm that thin capitalization rules which limit interest deduction for internal debt indeed reduce internal debt finance (Wamser, 2013; Overesch and Wamser, 2010; Buettner et al., 2012; Blouin et al., 2014). Two recent papers analyze the effects of a general limitation of interest deduction for both internal and external 2 For an overview on practical issues as well as theoretical and empirical implications of previous studies on thin-capitalization rules see Ruf and Schindler (2013). 2

4 debt. A study by Dressler and Scheuering (2012) shows that German MNEs once subject to the German interest barrier lower their debt-to-equity ratio significantly. In contrast, Buslei and Simmler (2012) find that of those German firms which are potentially subject to the interest barrier only a fraction opts for reducing its debt-to-equity ratio to effectively escape the interest barrier. This paper contributes to the literature by providing new insights into MNEs tax planning. In particular, MNEs response to the window of opportunity is indicative of whether MNEs were effectively exposed to German corporate taxation before the window opened. A small or no response would indicate that MNEs were not effectively restricted in their tax planning. Possibly, they had competing tax shields or managed to switch to alternative tax planning not (effectively) subject to anti-tax-avoidance legislation. In contrast, a significant response would indicate that MNEs were effectively restricted in tax planning before the window opened, therefore, pointing to a comprehensively effective set of anti-tax-avoidance legislation at that time. We use panel data on foreign direct investment provided by the German Central Bank. A unique feature of the database is its detailed information on firm-internal lending and borrowing that allows us to analyze responses to the window of opportunity in internal financial relations. Here, the analysis focuses on a particular channel of debt shifting: low-tax subsidiaries internal lending that enables internal debt shifting through interest deduction at the level of the German parent. We find that the window had statistically significant impacts on both the probability and the volume of internal lending. For the probability, the results indicate a statistically significant increase of 0.33 percentage points per 90 days window length. Given that the average probability for internal debt shifting amounts to only 4.7% before the window emerges, this is equal to an increase in the probability by 7% per 90-day window. For the volume of internal lending, we 3

5 find that a 90-day window increases the total internal lending of EEA low-tax subsidiaries to their German parents by around 14.4%. Evaluated for the average German MNE with about 4.3 million Euro pre-window internal lending from EEA low-tax subsidiaries and a window length of 467 days, this is equivalent to an increase of approximately 3.21 million Euro. Considering the usual nominal interest rate of 5% on German MNEs bonds listed in the RDAX at that time and a German corporate tax rate of 30%, this translates into a loss in German corporate tax revenue for the average window of about 62,000 Euro per MNE. Since the effect is, on average, rather small in absolute terms, we argue that MNEs were pre-window not effectively subject to German corporate taxation, presumably due to competing tax shields or tax planning channels not restricted by the then anti-tax-avoidance legislation. Consequently, the total loss in German corporate tax revenue resulting from the window is minor as compared to total corporate tax revenue at that time. This paper proceeds as follows. Section 2 gives information on the institutional background concerning the window of opportunity for profit shifting. Section 3 describes the data. Section 4 describes the empirical approach. Section 5 presents the empirical results. Section 6 concludes. 2 Institutional Background 2.1 The pre-window period: CFC legislation In the pre-window period until September 2006, German MNEs were subject to strict CFC legislation that aimed at preventing profit shifting to foreign low-tax subsidiaries ( 7-14 German Foreign Transaction Tax Act). German CFC legislation lists three criteria which precisely determine under which conditions profit shifting to low-tax subsidiaries does not result in tax relief for the MNE. Once the criteria are all fulfilled, the respective profits are treated as if they were generated by the German parent and not by the foreign low-tax subsidiary. The three 4

6 criteria are: firstly, a foreign subsidiary has to be a controlled foreign corporation of a German parent. This is the case if the parent holds more than 50% either of ordinary shares or voting rights in the foreign subsidiary. 3 Secondly, the application of German CFC rules depends on the local tax rate which the income of a controlled foreign corporation is subject to. The minimum tax rate which must not be undercut is 25%. Thirdly, the CFC rules apply only to passive income of foreign controlled corporations. German tax code thoroughly lists all sorts of passive income ( 8 (1) German Foreign Transaction Tax Act). Amongst others and crucial for our further analysis, the tax code defines foreign low-tax subsidiaries interest income from internal lending as passive if the funds are raised within the group. In legal jargon, this type of lending is called positive net lending, however, in this paper, we simply refer to it as internal lending. Hence, under German CFC legislation internal debt shifting to low-tax subsidiaries does not provide tax relief for German MNEs. Ruf and Weichenrieder (2012) show that German CFC rules effectively prevent German MNEs internal debt shifting to low-tax subsidiaries before the year The opening of the window: the ECJ ruling On September 12th, 2006 the European Court of Justice rather unexpectedly declared CFC rule application within the EEA in large parts unconstitutional. 4 The court s decision basically eliminated, with immediate effect, a number of EEA countries provisions against profit shifting to EEA low-tax countries. The ECJ decision affected also German CFC rules. As a consequence 3 Direct and indirect participation are treated the same, and the criterion applies furthermore to ownership chains. 4 The ECJ decided in the case C-196/04, Cadbury-Schweppes and Cadbury-Schweppes overseas, that the British CFC legislation constituted a restriction on freedom of establishment within the meaning of Community Law. The court s ruling severely restricted the application of the British CFC rule within the EEA. As ECJ ruling takes legal effect for the entire EEA, not only the British CFC legislation was affected, but all EEA member states CFC legislations of similar design. 5

7 of the ECJ decision, German anti-tax-avoidance legislation on internal debt shifting to low-tax subsidiaries was temporarily suspended within the EEA. The ECJ decision placed very tight constraints on CFC rule application within the EEA. Accordingly, CFC legislation was only permitted to apply to wholly artificial tax minimization schemes. The ECJ pointed out that solely a firm s intention to obtain tax relief does not suffice to conclude that there is a wholly artificial arrangement. In case a low-tax subsidiary located in an EEA member state is an actual establishment which physically exists in terms of premises, staff and equipment (e.g. no letter-box companies), EEA member states must no longer apply CFC legislation. Tax experts generally agreed that as consequence of the ECJ ruling, German CFC rules could basically no longer be effectively applied to counteract MNE s profit shifting within the EEA. The German Ministry of Finance officially instructed German tax authorities in January 2007 to restrict the application of CFC legislation within the EEA backdated to September 2006 following the ECJ ruling (Bundesministerium der Finanzen, 2007). Hence, since September 2006, German MNEs internal debt shifting to EEA low-tax subsidiaries was tax effective. Single precondition was that the low-tax subsidiary physically existed. The cessation of CFC rules left a gap in German provisions against MNEs internal debt shifting, as there was no other anti-shifting provision that would have restricted interest deduction at the level of the German parent. 5 Beyond that, German tax code grants corporations tax exemption for foreign dividends ( 8b (1) Corporation Income Tax Law). Further, within the EU the Parent-Subsidiary Directive ensured zero withholding taxes on cross-border dividend payments. This should have even increased the incentive for internal debt shifting because repatriation of shifted profits in form of dividends is tax exempt. In general, the conditions for 5 German tax code incorporated a thin-capitalization rule ( 8a Corporate Income Tax Law) that restricted interest deduction for German controlled corporations in case they borrowed from major foreign shareholders (participation larger than 25%). The thin-capitalization rule was, however, no substitute for the ineffective CFC rule that is in principle concerned with exact the opposite case: lending of foreign controlled corporations to their German shareholders. 6

8 internal debt shifting to EEA low-tax subsidiaries were after the ECJ decision very attractive. From German MNEs perspective, the ECJ decision opened a window of opportunity for profit shifting, basically, in the absence of any restrictions. 2.3 The closing of the window: the interest barrier In May 2007 as part of a major German business tax reform, German legislator introduced a new anti-shifting provision on thin capitalization to restrict German firms level of debt finance, called interest barrier. The crucial novelty with the interest barrier is a general limitation of the tax deductibility of net interest payments 6 to 30% of a firm s EBITDA 7 ( 4h (1) German Income Tax Act). The interest barrier targets firms with high debt finance and foreign relations (Bach and Buselei, 2009), a description matching that of German MNEs. 8 Consequently, MNEs internal debt shifting, which relies on tax effective interest deduction as mechanism for shifting tax base to low-tax jurisdictions, is under the interest barrier subject to limitation. Therefore, the introduction of the interest barrier marks up from May 2007 the end of the window of opportunity for profit shifting in the absence of restrictions. The introduction mechanism of the interest barrier referred to MNEs starting date of the business year. The interest barrier applied for the first time for those business years which started after May 25th, 2007 ( 52 (12d) German Income Tax Act). As MNEs starts of the business year are spread over the calendar year, MNEs windows of opportunity varied in their time length. Figure 1 illustrates how the variation in the window length arises referring to two German MNEs, MNE A and MNE B (both hold a subsidiary in an EEA low-tax country). 6 Net interest is the difference between interest expenditures and interest earnings. The term interest comprehends both interest for internal and external debt. 7 The EBITDA (earnings before interest, taxes, depreciation and amortization) is a measure of a firm s operational profit and calculated as follows: EBITDA=taxable income + interest expenses - interest income + depreciation and amortization. 8 The interest barrier involves several exemptions ( 4h (2) German Income Tax Act), for a closer description see Buslei and Simmler (2012). These exemptions mainly ensure that small firms and firms with sufficient equity financing are protected from disproportionate tax burden. 7

9 Assume that A s parent starts its business year on May 26th, B s parent starts its business year just one day earlier on May 25th, This only one day earlier start of the business year leads to a time difference of 365 days which parent B is later subject to the new interest barrier than parent A. While MNE A is subject to the new interest barrier for the first time with its business year that starts on May 26th, 2007, MNE B s first business year under the interest barrier starts on May 25th, As the day of the windows opening is for both MNEs identically the date of the ECJ decision, September 12th, 2006, B s window of opportunity for profit shifting happens to be one entire year longer than A s. Firstly subject to the new interest barrier are those business years that start after May 25th, Consequently, the later an MNE starts its respective business year after May 25th, 2007, the relatively longer the MNE s window. Under the reasonable assumption that MNEs starts of the business year are random with respect to the date of the ECJ decision, the variation in the length of MNEs windows of opportunity is exogenous. In this case our analysis exploits a quasi-experimental setting to evaluate MNEs internal debt shifting during the window of opportunity. In the Appendix, we provide an illustrative example of a German MNE s operations under the distinct institutional changes. 2.4 Hypotheses We seek to assess MNEs response to the window of opportunity for profit shifting by exploring how the window s time length affected internal lending of EEA low-tax subsidiaries to their German parents. MNEs might have responded in two ways. First, in the probability that the MNE s German parent receives internal lending from EEA low-tax subsidiaries. And, second, in the total amount of internal lending that the EEA low-tax subsidiaries provide. 8

10 Even tax experts did not expect the ECJ to give such a far reaching ruling in its decision from September By stating that MNEs intention to gain tax relief does not per se justify CFC rule application within the EEA, the ECJ opened up extensive tax planning opportunities for MNEs with subsidiaries in EEA low-tax jurisdictions. After the decision, MNEs faced an entirely new legal situation that they had to assess first. Although the ECJ ruling was unexpectedly far reaching in the way it restricted CFC rule application within the EEA, it left legal uncertainty created by a side clause in the ruling. The ECJ stated in its decision that national CFC legislations could still be justified in case the legislation particularly related to wholly artificial arrangements aimed solely at escaping national tax normally due. Internal lending of EEA low-tax subsidiaries is according to German CFC legislation artificial profit shifting. Therefore, it was after the ruling unclear whether and under which circumstances internal debt shifting was possibly still subject to German CFC legislation. Even a subsequent official letter of German treasury from January 2007 did not entirely remove ambiguity (Bundesministerium der Finanzen, 2007). In the letter the treasury explicitly recognized the ECJ ruling, however, advised tax authorities to prevent any purely artificial constructions that provide illegitimate tax relief. A precise legal definition of illegitimate tax relief was missing though. During the first months after the ECJ decision its consequences for German tax practice were rather unclear. Under these circumstances, one expects MNEs to act with precaution. With progressing window time, proper legal assessment of the situation and increasing experience in the new tax practice of tax authorities should have made legal uncertainty decline. Those MNEs with relatively long windows benefitted from the increasing experience in how to exploit the window for tax purposes. Further, the longer the window the more time had MNEs to adjust internal lending. Hopland et al. (2014) show that, independent from any legal uncertainty, MNEs are in the short run relatively inflexible in adjusting internal lending for tax purposes. Thus, we expect a 9

11 positive effect of the window length on the probability for internal debt shifting to EEA low-tax subsidiaries. In addition, the window s length should affect the volume of internal lending. One mechanism is related to the declining legal uncertainty about the actual scope for internal debt shifting. With increasing window time, we expect MNEs to assess the legal leeway for the volume of internal debt shifting. As there is no legal upper limit for internal debt shifting during the window, we expect the volume of internal lending to increase in the window s length due to the decrease in legal uncertainty. Further, the longer the window, the more time MNEs had to adjust their internal lending structures resulting in a higher volume of internal lending. Hence, we expect those MNEs with the longest windows to show the highest volumes of internal lending. There is, however, a second opposite effect of window on the volume of internal lending. German corporate tax law restricts the interest rate for internal lending to the arm s length price ( 1 (3) German Foreign Transaction Tax Act). Given a fixed (market) interest rate and the exogenous time length of window, the volume of internal lending is, therefore, the only parameter that an MNE can freely choose to determine its volume of profit shifting. Assuming that MNEs are homogenous in terms of profits and applying simple interest calculus, we expect that the shorter the window of opportunity, the higher the amount of internal lending ceteris paribus. Due to the two opposing effects, the sign and the magnitude of the overall effect of window on the amount of internal lending is eventually an empirical question. 3 Data The analysis is based on the Microdatabase Direct Investment (MiDi) provided by the German Central Bank. The panel data set comprehends annual firm-level data on German outbound foreign direct investment (FDI). As German firms investing abroad are legally required to re- 10

12 port, the database includes comprehensive and reliable balance sheet information on almost all foreign subsidiaries of German firms (for details see Lipponer, 2009). A unique feature of the data set is its detailed and comprehensive information on MNE-internal lending and borrowing. This feature determines a main advantage of the Microdatabase Direct Investment as compared to other firm-level panel data sets, e.g. the Amadeus firm database by Bureau van Dijk. We use information on foreign subsidiaries lending to shareholders. By drawing a sample of subsidiaries which are owned at 100% by their German parent, we ensure that internal lending reported by the foreign subsidiaries is owed by their German parent. The sample is restricted to corporations. Further, we exclude all MNEs operating in the agricultural, mining and banking sector as well as governmental institutions and private households which are generally subject to different tax rules. As ECJ decisions take legal effect for the EEA, we focus our analysis on countries within the EEA. We follow Buettner et al. (2013) and define corporate low-tax countries using two alternative criteria. Firstly, we define countries that offer a statutory corporate tax rate smaller or equal to 20% as a corporate low-tax country. Secondly, we also include countries with specific corporate tax regimes that guarantee effective corporate tax rates below 20% for MNEs (independent from the country s statutory corporate tax rate). Both selection criteria ensure that the drawn sample of low-tax subsidiaries is actually subject to a profit tax lower than 25% and, consequently, with its passive income pre-window subject to German CFC rules. Table 2 lists the EEA low-tax countries identified. By aggregating the subsidiary information on internal lending to the MNE level, we generate the internal-debt-shifting outcomes for a sample of MNEs that may react to the window of opportunity. The sample consists of 5,717 MNE-year observations covering the time span between September 2003 and September The panel 11

13 structure of the data set allows us to rule out potential bias through MNEs changing their start of the business year in order to extend the length of their windows. The explanatory variable of interest indicates the time length of MNEs windows which is the number of days between the ECJ decision on September 12, 2006 and the starting date of an MNE s first business year under the interest barrier. The majority of German MNEs have a window of 475 days due to their start of the business year on January 1st. The shortest windows of opportunity last 291 days and the longest 596 days. We analyze internal debt shifting of German parents to their EEA low-tax subsidiaries. In case the funds for internal lending are raised within the group, German CFC rules apply to this so called positive net lending. Hence, we calculate each subsidiary s positive net lending which is the amount of the subsidiary s lending to the German parent that exceeds the subsidiary s funds from external sources. Table 1 lists annual volumes of internal lending. 4 Methods We aim at estimating the effect of the window length on the probability for internal lending. For that purpose, we use linear probability models to estimate the following equation: y it = α + βwindow it + γ x it + λ t + u i + ε it. (1) y it is a binary indicator of whether at least one of the MNE s EEA low-tax subsidiary provides internal lending to the German parent i in period t. Thus, MNE parents are the unit of observation. The variable window measures the elapsed time length of the window. Our interest is in the corresponding coefficient β that is the effect of the window length. λ t denotes a set of fixed time effects, each covering the time span between September 12th of a year and September 11th of the following year. x it is a vector of time-varying MNE characteristics including the 12

14 MNE s size and degree of internationalization at time t as measured by the number of foreign subsidiaries, number of the German parent s employees and the number of foreign subsidiaries employees. u i denotes unobserved heterogeneity and ε it is an idiosyncratic error. We apply pooled OLS and fixed-effects regressions. Standard errors are clustered at the level of the parent to take account of heteroskedasticity in the linear probability models and to allow for possible correlation in the error. The fixed-effects regression additionally allows for correlation between explanatory variables and time-invariant unobserved heterogeneity. The pooled OLS regressions additionally include a set of dummies for the sector of industry because we found evidence for correlation between the sector and the start of an MNE s business year, which is used for the calculation of MNEs window lengths. 9 As a robustness check, we estimate logit and fixed effects conditional logit models that explicitly take the discrete nature of the dependent variable into account. Our second goal is to evaluate the effect of the window length on the total volume of internal lending that German parents receive from their EEA low-tax subsidiaries. Here, we have to address two issues: first, the dependent variable takes on only nonnegative values with excess zero values. 10 Second, the distribution of internal lending is right skewed. Econometric models often use logarithmic transformations to deal with skewed dependent variables. However, we do not have this option due to the zero values. Therefore, we model the functional relationship between the expectation of the volume and the explanatory variables using a Poisson model with mean E(y it ) = exp(α + βwindow it + γ x it + λ t ). (2) 9 The results of a regression of the MNEs start of the business year on various MNE characteristics are in the Appendix (Table 7). Controlling for the sector of industry, we also take account of potentially confounding factors that may impact on the outcome and the window length in the case when sector itself is a determinant of the MNE s probability for profit shifting. 10 Pre-window approximately 95% of all German parents report zero internal lending from EEA low-tax subsidiaries. 13

15 Using the pooled sample, we apply the Poisson quasi-maximum likelihood estimator (QMLE) that is known to be fully robust to distributional misspecification (Wooldridge, 2010). 11 That is, the Poisson QMLE is consistent even if the outcome is not Poisson distributed given the explanatory variables. However, the variance estimator will be inconsistent in this case. To address this problem, we use robust estimates of the variances to assess statistical significance (Cameron and Trivedi, 2009). 5 Empirical results 5.1 Probability of internal lending This section presents empirical evidence on the question of whether MNEs are more likely to have internal lending the longer their window of opportunity lasts. Table 4 reports the estimation results for the effect of the window length on the probability for internal lending. 12 All models include a set of year indicators to control for a time trend but are different with respect to control variables. The results from linear probability models in Columns 1 to 3 unanimously indicate positive effects of the window length on the probability of internal lending. Pooled OLS models with and without control variables for the parent and sector show an increase in the probability by 0.6 and 0.7 percentage points per 90-day window, respectively. The effects are statistically significant at the 10%-level. Fixed-effects models that control in addition for unobserved time-invariant characteristics of the MNEs yield an attenuated estimate of the window length, indicating an increase of 0.33 percentage points per 90-day window (p = 0.04). Although the estimates are small in magnitude, their relative size is however of considerable 11 We also tried to estimate random-effects and fixed-effects versions of the model in equation 2. However, the random effects model failed to converge. The fixed effects model converged but showed insignificant results with large standard errors. The imprecise estimation may be due to the considerably reduced sample size that results from the fact that the fixed-effects Poisson regression does not use information on those MNEs which have internal lending equal to zero in all time periods. The estimation results are available upon request. 12 Full estimation results for the control variables are available upon request. 14

16 importance. Even the conservative estimate of 0.33 percentage points translates into a relative increase in the probability of 7% over the 90-day window, as the probability for internal lending is on average only 4.7% before the opening of the window. Next, we use a second order polynomial fit to allow for a nonlinear effect of the window length on the probability of internal lending. 13 The estimation results are in Column 4. Figure 2 shows the predicted probability for particular window lengths. The graph indicates that the window is divided into two parts. First, the predicted probability is almost constant. MNEs don t respond significantly to window lengths under 180 days. The probablility reaches its minimum at a window length of approximately 180 days. Once the window length exceeds 180 days, we observe a clear increase in the probability until the window closes. Interestingly, the increase occurs after the German legislator announced a draft legislation to introduce an interest barrier in March 2007 (Deutscher Bundestag, 2007). The draft legislation already included detailed information on the interest barrier s introduction mechanism that created the MNEspecific window lengths. Consequently, we argue that the announcement of an approaching introduction of the interest barrier and not its actual introduction in May 2007 triggered MNEs response. The steep increase in the second part of the window suggests a gathering of knowledge on how to play on the window. Presumably, it took MNEs some time to assess the entire legal situation and to adjust internal lending structures accordingly in order to exploit the window of opportunity. MNEs with long window lengths had better opportunities to gather the knowledge over time than MNEs with short window lengths. Figure 2 shows that MNEs with the maximum window length (596 days) have predicted probabilities for profit shifting of almost 10%. In 13 We also estimated a model with a third order polynomial function of the window length. However, the model fit was not improved, indicating that the nonlinearity is appropriately described by a square function. 15

17 contrast, MNEs probability in case of the minimum window length of 291 days is only about 5%. Thus, the window length clearly determines the probability of internal lending. Finally, we perform two robustness checks: first, we take explicitly into account the discrete nature of the response variable and report results from pooled logit and fixed effects conditional logit regressions in Columns 5 and 6 in Table 4, respectively. The logit model confirms a positive effect of the window length on the probability of internal lending, though the coefficient marginally misses statistical significance at the ten percent level. The fixed effects conditional logit model, which allows for correlation between explanatory variables and unobserved timeinvariant heterogeneity, has an almost identical coefficient. However, its drawback is that the estimates rely exclusively on those MNEs that change their lending status over time such that the sample size is considerable reduced and the effect is estimated imprecisely with large standard errors so that statistical significance is not achieved at conventional levels. As a second robustness check, we test whether the variable window might pick up a seasonal pattern that occurs repeatedly over time in MNEs internal debt shifting. Our test uses a pseudowindow that emerges two years earlier. That is, the pseudo-window opens on September 12th, Its closing is again firm-specific depending on an MNE s start of the business year after May 25th, The estimation results using the pseudo-window instead of the true window are reported in Table 6. In general, the coefficient of the pseudo-window is estimated to be near zero and statistically insignificant. Also, its sign changes depending on the model specification. Overall, this suggests that the window length does not capture a recurring seasonal pattern. 5.2 Volume of internal lending Table 5 reports evidence on the effect of the window length on the volume of internal lending. We begin with estimation results from pooled OLS regressions (Column 1). The coefficient 16

18 indicates that the amount of internal lending increases, on average, by approximately 875,000 Euro per 90-day window. Based on an average volume of 4.3 million in the pre-window period, this is equivalent to a relative increase of about 20%. Next, we consider results from Poisson regressions that may be more appropriate than the linear model to model our skewed dependent variable with many zero outcomes. The coefficient in column 2 indicates a 22% increase in internal lending per 90-day window. The coefficient is statistically significant at the 10% level. Column 3 presents results from pooled Poisson QMLE with additional variables for the firm-specific averages of time-variant explanatory variables. The idea here is to allow for arbitrary correlation between explanatory variables and unobserved time-invariant heterogeneity (Wooldridge, 2010). The model indicates an increase of internal lending by 14.4% per 90-day window, though the coefficient does not achieve statistical significance at conventional levels. For the average window length of 467 days, the estimates from the pooled Poisson models point to an increase in internal lending between 74% and 114%, indicating an economically substantial effect. Theoretically, the sign of the overall effect of the window length on the volume of internal lending was unclear. The empirical results show, however, a clearly positive effect. Accordingly, the negative interest effect of the window length is overcompensated by the window length s positive effects related to declining legal uncertainty and adjustment time. To put these results into perspective, we finally perform a back-of-the-envelope calculation for the total loss in corporate tax revenue in Germany resulting from the window of opportunity. The average internal lending in non-window periods is around 4.3 million Euro for each MNE. The increase due to the average window of opportunity which lasts 467 days is according to our Poisson regression estimates between 3.2 million and 4.92 million Euro. Applying the market interest rate for German RDAX-listed firms at that time of 5%, which we assume to 17

19 be the appropriate arm s length price for internal lending, and a German corporate tax rate of 30%, the loss in German corporate tax revenue caused by the average window of opportunity is between 62,000 and 96,000 Euro per MNE. As our data set results from legally obligatory reporting, it includes all German MNEs with EEA low-tax subsidiaries. Therefore, we take the number of almost 1,000 German MNEs which we observe to have EEA low-tax subsidiaries during the window period and multiply. Accordingly, the total German corporate tax revenue approximately amounts to 62 million respectively 96 million Euro. Compared to total German corporate tax revenue in 2007 of 22,929 million Euro and 15,868 million Euro in 2008 (Bundesministerium der Finanzen, 2011), the loss in corporate tax revenue resulting from MNEs windows of opportunity is minor. The tax loss estimates provided in this paper have to be seen as a lower boundary for the true corporate tax revenue loss. We analyze internal lending of low-tax subsidiaries which are held at 100% participation by their German parent. The entire structure of multinational firms is usually more widespread, so our results reflect only the reaction of a very specific part of German MNEs which should, however, react very sensitive to the incentives induced by the window of opportunity. 6 Conclusion This paper analyzes how MNEs internal debt shifting responds to a temporary suspension of anti-shifting provisions. Through an ECJ decision in 2006 and a subsequent introduction of an anti-shifting provision on thin capitalization a window of opportunity for profit shifting emerged for German MNEs. Due to the introduction mechanism of the anti-shifting provision which refers to MNEs start of the business year, the time length of the windows of opportunity 18

20 differs between MNEs at a maximum by 365 days. We exploit this exogenous variation in the window length to analyze MNEs response in their probability and volume of internal lending. Regression results indicate that MNEs respond statistically significantly and positively to the window of opportunity. On average MNEs benefitted from a window of opportunity lasting 467 days. Based on regression results, this translates into an increase in their probability for internal debt shifting of at least 36% which is economically remarkable. Surprisingly, however, the percentage of MNEs that conduct internal debt shifting is despite the unique opportunity during the window small in absolute terms. Even for those MNEs which benefit from the maximum window of 596 days, the predicted probability is only about 10%. The window of opportunity leads to an increase in MNEs volume of internal lending. The average German MNE reports pre-window approximately 4.3 million Euro internal lending that it receives from EEA lowtax subsidiaries. The average window of 467 days increases internal lending according to our most conservative estimates by around 3.21 million Euro. Again, this means an economically significant response. The results translate into a corporate tax revenue loss of 62,000 per MNE. The total German corporate tax revenue loss for an underlying population of around 1,000 MNEs amounts to approximately 62 million Euro. Compared to total German corporate tax revenue in 2007, however, this is less than 0.3%. The empirical findings raise the question why MNEs response, although statistically and economically significant, is nevertheless modest in absolute terms and, consequently, of very low fiscal impact considering the unique profit shifting opportunities that the window provided. As the ECJ ruling was rather unexpected to create such vast tax planning opportunities, it is possible that it took MNEs some time to adjust their internal lending accordingly. In case of those MNEs with short windows (the minimum window is 291 days), it is thinkable that adjustment cost might have exceeded the tax benefit from internal debt shifting. This study s findings 19

21 indeed do not reveal statistically significant effects of short window lengths on internal debt shifting. However, we either find a strong and sizeable effect for the maximum window length (one year and nine month). A second possible explanation why MNEs responded with reserve is legal uncertainty. A side-clause of the ruling created legal uncertainty concerning the tax effectiveness of internal debt shifting. But the results indicate that uncertainty diminished in the course of the window such that MNEs should finally react more strongly. A third explanation for MNEs modest response is that German parents profits were pre-window not effectively subject to German corporate taxation. This would have been the case if German parents made losses or had competing tax shields at their disposal, e. g. loss-carry forwards. Competing tax shields act in the way that they reduce German parent s taxable income. As a consequence, parts of the parent s profit are not subject to German corporate tax, and, therefore, the effective German tax burden is reduced. Consequently, MNEs would respond only modestly to the window s shifting incentives. Similarly, German parents would be pre-window not effectively subject to German corporate taxation if German anti-tax-avoidance legislation was not comprehensively restricting their tax planning. Already sufficiently saturated with tax-planning opportunities, MNEs simply had no need for further profit shifting opportunities. Consequently, they only weakly responded to the window. It is plausible that despite extensive German anti-shifting legislation MNEs were still able to shift profits via not regulated or difficult to regulate shifting channels (e.g. transfer pricing). The small absolute response to the window indicates that MNEs remaining scope for profit shifting might have been substantial though. Future research should focus on the investigation of possible evasion mechanisms that MNEs use to circumvent anti-tax-avoidance legislation. Basically, this poses the question of substitutional relations between different profit shifting channels under anti-tax-avoidance legislation. 20

22 References Altshuler, Rosanne and Harry Grubert (2006). Governments and multinational corporations in the race to the bottom. Tax Notes International, 41:p Altshuler, Rosanne and R. Glenn Hubbard (2002). The effect of the tax reform act of 1986 on the location of assets in financial services firms. Journal of Public Economics, 87:p Bach, Stefan and Hermann Buselei (2009). Empirische Analysen zur Zinsschranke auf Grundlage von Handelsbilanzdaten. DIW Berlin Research Notes 30 Blouin, Jennifer; Harry Huizinga; Luc Laeven et al. (2014). Thin Capitalization Rules and Multinational Firm Capital Structure. IMF Working Paper 14/12 Buettner, Thiess; Carolin Holzmann; Michael Overesch et al. (2013). Anti-tax-avoidance rules and the demand for tax-haven subsidiaries. mimeo Buettner, Thiess; Michael Overesch; Ulrich Schreiber et al. (2012). The impact of thincapitalization rules on the capital structure of multinational firms. Journal of Public Economics, 96:p Bundesministerium der Finanzen (2007). Hinzurechnungsbesteuerung nach dem Aussensteuergesetz (AStG). URL Content/ DE/ Downloads/ BMF_Schreiben/ Internationales_Steuerrecht/ Allgemeine_Informationen/ 013.html Bundesministerium der Finanzen (2011). Kassenmaessige Steuereinnahmen nach Gebietskoerperschaften URL dip21.bundestag.de/ dip21/ btd/ 16/ 048/ pdf Buslei, Hermann and Martin Simmler (2012). The Impact of Introducing an Interest Barrier. DIW Discussion Paper 1215 Cameron, A. Colin and Pravin K. Trivedi (2009). Microeconometrics Using Stata. StataCorp LP Deutscher Bundestag (2007). Gesetzentwurf der Fraktionen der CDU/CSU und SPD, Entwurf eines Unternehmensteuerreformgesetzes 2008, Drucksache 16/4841. URL dip21. bundestag.de/ dip21/ btd/ 16/ 048/ pdf Dressler, Daniel and Uwe Scheuering (2012). Empirical Evaluation of Interest Barrier Effects. ZEW Discussion Paper No Egger, Peter and Georg Wamser (2011). The impact of controlled foreign company legislation on real investments abroad: a two dimensional regression discontinuity design. Centre for Economic Policy Research, 8460 Hopland, Arnt O.; Mohammed Mardan and Dirk Schindler (2014). Tax Avoidance Strategies in (Probably) Loss-Making Affiliates. mimeo Lipponer, Alexander (2009). Microdatabase Direct Investment MiDi, A Brief Guide, Technical Documentation Lohse, Theresa; Nadine Riedel and Christoph Spengel (2012). The Increasing Importance of Transfer Pricing Regulations - a Worldwide Overview. Oxford University Centre for Business Taxation WP 12/27 21

23 Mutti, John and Harry Grubert (2009). International Trade in Services and Intangibles in the Era of Globalization, Ch. The Effect of Taxes on Royalties and the Migration of Intangible Assets Abroad, p University of Chicago Press Overesch, Michael and Georg Wamser (2010). Corporate tax planning and thin-capitalization rules: evidence from a quasi-experiment. Applied Economics, 42:p Ruf, Martin and Dirk Schindler (2013). Debt Shifting and Thin-Capitalization Rules - German Experience and Alternative Approaches. mimeo Ruf, Martin and Alfons J. Weichenrieder (2012). The taxation of passive foreign investment: lessons from German experience. Canadian Journal of Economics, 45(4):p Ruf, Martin and Alfons J. Weichenrieder (2013). CFC Legislation, Passive Assets and the Impact of the ECJ s Cadbury-Schweppes Decision. CESifo Working Paper 4461 Wamser, Georg (2013). The Impact of Thin-Capitalization Rules on External Debt Usage - A Propensity Score Matching Approach. Oxford Bulletin of Economics & Statistics, forthcoming Wooldridge, Jeffrey M. (2010). Econometric Analysis of Cross Section and Panel Data. The MIT Press, 2 Aufl. 22

24 Appendix A Figures Figure 1 Variation in the length of MNEs windows of opportunity May 26th, 2006 Sept 12th, 2006 ECJ Decision Cadbury-Schweppes Interest barrier* May 26th, 2007 May 26th, 2008 window MNE A window MNE B * Firm-specific introduction mechanism referring to MNEs starting date of the business year MNE A starts its business year on May 26th, 2007: 255-day window of opportunity MNE B starts its business year on May 25th, 2007: 620-day window of opportunity 23

25 Figure 2 Regression results: Quadratic window effect on probability Predictive Margins with 90% CIs Linear Prediction window Note: Predictions based on linear probability model with fixed MNE effects. Joint significance of polynomial terms of window: p =

26 B Tables Table 1 Internal debt shifting over time Probability Volume of internal lending Note: Probability indicates the ratio of MNEs whose German parent receives internal lending from at least one EEA low-tax subsidiary in a certain year. Volume is the mean volume of internal lending (in thousand Euro) received by MNEs German parent from EEA low-tax subsidiaries in a certain year. 25

27 Table 2 German MNE activities in EEA low-tax countries EEA low-tax country MNE-year observations Netherlands 1,799 Poland 1,971 Hungary 520 Slovak Republic 422 Ireland 322 Romania 143 Czech Republic 142 Belgium 97 Luxembourg 95 Bulgaria 59 Malta 48 Lithuania 36 Cyprus n.a. Iceland n.a. Latvia n.a. Liechtenstein n.a. Note: MNE-year observations for all EEA low-tax countries: number of MNEs with at least one subsidiary in the respective country in a certain year. Data source: Microdatabase Direct Investment (MiDi), German Central Bank. n. a. indicates statistical single values which are not available due to German data protection law. 26