Debt Shifting in Europe

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1 Debt Shifting in Euope Fancesca Baion Paolo Panteghini Univesità di Bescia Ra aele Miniaci Univesità di Bescia Maia Laua Paisi Univesità di Bescia Mach 1, 011 Abstact This aticle aims at analyzing the link between subsidiaies capital stuctue and taxation in Euope. Fist we intoduce a tade-o model, which studies a MNCs nancial stategy and in paticula debt shifting fom low-tax to high-tax juisdictions. By letting the MNC choose both leveage and the pecentage of po t shifting, we depat fom the elevant liteatue which has mainly focused on the latte. Using the AMADEUS dataset we show that: i) subsidiaies leveage inceases with the statutoy tax ate, levied in the county whee it opeates; ii) this positive e ect is lowe, the highe the paent company tax ate is. Futhemoe, an incease in the paent company s tax ate is estimated to aise its subsidiaies leveage. JEL classi cation: G31, H5, H3. Keywods: capital stuctue, default, debt shifting, multinationals, taxation. 1

2 1 Intoduction The liteatue on multinational companies (MNCs) has gatheed inteesting evidence egading both nancing decisions and thei ability to shift debt fom high- to low-tax juisdictions. In paticula, this evidence shows that debt can be shifted by means of debt policies, and that the amount of debt shifted depends on tax ate di eentials. Most empiical wok on MNCs choices is based on US and Canadian data. 1 Moe ecently, howeve, scholas have focused on tax deteminants of Euopean companies stategy. In paticula, Buettne et al. (006, 009), Buettne and Wamse (007), and Mintz and Weicheniede (005, 010) have analyzed the impact of taxation on Geman companies. Huizinga et al. (008) have applied a static model of a multinational m s optimal debt shifting policy. Using AMADEUS m-level dataset fo Euopean companies, they have shown that thei theoetical pedictions ae suppoted by the evidence. In paticula, a foeign subsidiay s capital stuctue depends on local copoate tax ates as well as on the di eence between its paent company s tax ate and othe foeign subsidiaies ates. It is woth noting that the existing liteatue has been using the tax ate di eential between the subsidiay s and the paent company s tax ate, as the main deteminant of debt shifting within a goup. In paticula, denoting this di eential as ( A B ) ; with A and B being the paent company s and the subsidiay s tax ate, espectively, scholas expect that B stimulates the subsidiay s leveage and that opposite is tue when A ises. As we will show, howeve, tax e ects ae moe complex. This is due to the fact that taxes a ect both a MNC s boowing decision and the distibution of debt among its entities. In othe tems, taxation a ects not only the bene t of 1 Fo instance, Collins and Shackelfod (199) and Foot and Hines (1995) use consolidated nancial accounting data fom Compustat. They show that ms nancial activities ae a ected by taxation. Altshule and Mintz (1995) study the impact of the changes to inteest allocation ules in the 1986 tax efom, using the data of lage companies. Desai et al. (004a) use con dential individual data and nd that tax ates stongly a ect the use of debt by a liates. Thei cental estimate is that a 10% highe tax ate is associated with.8% highe a liate debt as a popotion of assets. Intenal debt is paticulaly sensitive. Income shifting activities ae also been dealt with by Altshule and Gubet (003), Desai et al. (004), Gaham and Tucke (005), Hines (1999), Jon and Tang (001), Mills and Newbey (004), Newbey and Dhaliwahl (001), Mintz (000) and Mintz and Smat (004). Fo futhe details, see also Deveeux (007), Gaham (005) and Gaham and Tucke (006).

3 each Euo of debt shifted fom one county to anothe (accoding to the elevant liteatue), but also the absolute value of boowing. Theefoe, any attempt to use the (linea) tax ate di eential as the only egesso may lead to an estimation bias. In ode to analyze a MNC s nancial choices, we will use a dynamic tade-o model, whee default is a contingent event, which depends on the EBIT s volatility as well as on othe deep paametes (such as the isk-fee inteest ate and the expected gowth of EBIT). We will then study a MNC s choices in tems of both optimal leveage and debt shifting, theeby depating fom standad models which usually focus only on the fome decision. As will be shown, the paent company s tax ate may have a positive e ect on a subsidiay s leveage. The easoning behind ou nding is staightfowad. On the one hand, an incease in the paent company s tax ate A educes the tax bene t of debt shifting. On the othe hand, the tax ate incease leads to an incease in the MNC s oveall tax ate, theeby inceasing the tax bene t of inteest deductibility. This latte e ect encouages both the paent and the subsidiay to aise moe debt. If theefoe this latte e ect dominates the fome, the paent tax ate has a positive impact on a subsidiay s leveage. Since tax e ects ae non-linea and have an ambiguous sign, we can theefoe explain why, as agued by Godon (010), tax esponses may be limited: this may be due to o setting e ects. In ode to test the pedictions of ou theoetical model, we look at the link between subsidiaies capital stuctue and taxation in Euope. Using the AMADEUS dataset we will use subsidiaies leveage as the dependent vaiable and show that it inceases with its host county tax ate ( B ) and that this positive e ect is lowe the highe the paent company tax ate A is. Moeove, an incease in the paent company tax ate is estimated to aise the leveage of its subsidiaies. The stuctue of the aticle is as follows. Section discusses the tade-o model and focuses on the tax deteminants of nancial choices. Section 3 deals with the AMADEUS dataset and discusses some peliminay evidence on ou sample. Section 4 povides an empiical investigation of the deteminants of subsidiaies nancial stuctue. Section 5 summaizes ou ndings. As pointed out by Godon (010), "[t]hat puely intenal use of debt is moe esponsive to taxes than is extenal debt is not supising. The supise instead is that the esponse is as limited as is found in the data" (p. 168). 3

4 The model In this section we intoduce a tade-o model descibing the nancial choices of a epesentative MNC esident in county A, and owning a subsidiay located in county B. Hee, we assume that ou MNC (both the paent company and its subsidiay) can boow fom a thid-paty lende opeating in a pefectly competitive secto, which is chaacteized by a given isk-fee inteest ate and by symmetic infomation. As pointed out in the intoduction, we will let ou MNC choose both its oveall leveage and the distibution of debt within the goup. To complete ou famewok, we will also intoduce the following: Assumption 1 The MNC s EBIT (Eaning Befoe Inteest and Taxes), de- ned as (t), follows a geometic Bownian motion d (t) (t) = dt + dz (t) ; with (0) > 0; (1) whee is the expected ate of gowth, is the instantaneous standad deviation of d(t), and dz (t) is the incement of a Wiene pocess. (t) Assumption Within the multinational goup, the paent company poduces a potion (0; 1) of the oveall EBIT; the emaining pat (1 ) is poduced by its foeign subsidiay. Assumption 3 At time 0, the MNC can decide how much to boow and consequently pays a constant coupon, de ned as C, fo debt nance. Assumption 4 Debt is optimally divided between the paent company and its subsidiay with weights a and (1 a), espectively. Assumption 5 Debt is non-enegotiable and default occus when the MNC s net cash ow falls to zeo. Assumption 6 The cost of default is (0; 1) times the value of the bankupt MNC. Accoding to assumption 1, a MNC s EBIT evolves stochastically and is jointly poduced by the paent company A and the subsidiay B, with weights 4

5 (see assumption ) and (1 ), espectively. 3 Accoding to assumption 3, the MNC chooses its leveage atio by setting a coupon C. 4 Assumption 4 states that the MNC chooses how to divide debt between the paent company and its subsidiay. As explained by Smith and Wane (1979), if debt enegotiation is costly o even impossible (accoding to assumption 5), default may take place. 5 In ou model, default occus when the MNC s net cash ow falls to zeo. 6 In this case, the MNC is expopiated by the lende, who faces a sunk cost. 7 In line with Leland (1994), such a cost is assumed to be popotional to the MNC value (assumption 6). Taxation plays a cucial ole in ou model. Indeed, with zeo tax ates the MNC would have no incentive to boow: debt nance might cause costly default with no bene t. When howeve taxation is intoduced and inteest payments ae deductible, a tax bene t aises fom debt nance. Hence, both A and B will a ect debt nance. Fo simplicity, we let taxation be fully symmetic (i.e., po t and loss ae teated symmetically) and assume that it follows the souce pinciple. 8 In this case, the MNC nds it optimal to boow by taking account of both the tax bene t and the expected cost of default. Accoding to assumption 4, debt can be divided between the paent company and its subsidiay. It is woth noting that, wheneve tax ates acoss counties ae di eent, a MNC has an incentive to shift debt. In paticula, we expect that the MNC s entities will sign a nancial aangement accoding to which the entity opeating in a high-tax county boows fom the entity placed in the low-tax 3 By setting and (1 ) as exogenously given, we assume that the locational choice has aleady been made. We will leave the joint analysis of locational and nancial decisions fo futue eseach. 4 Given C we can calculate the fai value of debt. Fo futhe details on this point see Leland (1994). Also, notice that hee we focus on pue debt nance. Fo an analysis of hybid deivatives and thei tax teatment see Panteghini (010). 5 Fo an analysis of costly debt enegotiation see, e.g., Goldstein et al. (001). 6 This also implies that debt is secued. As explained by Smith and Wane (1979, p. 17) "[s]ecuing debt gives bondholdes title to pledged assets until the bonds ae paid in full". As pointed out by Leland (1994), minimum net-woth equiements, implied by secued debt, ae moe common in shot-tem debt nancing. 7 Fo futhe details on default conditions see Smith and Wane (1979), and Leland (1994). Fo a study of copoate taxation unde default isk see also Panteghini (006, 007 and 009). 8 Notice that the existence of defeal possibilities and limited cedit ules can de facto lead to the application of the souce pinciple. 5

6 county. This leads to the payment of an inteest which educes (inceases) the epoted po t whee taxation is high (low). The MNC s oveall tax buden is thus educed. Shifting debt is costly. This is due to two main factos: one is elated to advising activities and the othe is due to anti-avoidance ules. On the one hand, shifting debt usually equies the costly advice of tax and nancial expets. On the othe hand, counties aim to pevent tax-avoiding pactices by intoducing ad hoc ules, such as thin capitalization and eanings-stipping ules. 9 It is woth noting that if tax ates wee equal thee would be no incentive to divide debt and EBIT with di eent weights. Denoting a and (1 a) by the paent company s and subsidiay s weight, espectively, we would expect that, given the same tax ate, the equalities a = and hence, (1 a) = (1 ) hold. If howeve tax ates wee di eent, the MNC could a 6= so as to minimize its oveall tax buden. Denoting (a) as the concealment cost paid by the MNC to shift debt fom one entity to anothe, we intoduce the following: Assumption 7 Debt shifting entails a quadatic concealment cost function, i.e., (a) = n ( a) + [(1 ) (1 a)] : 4 Accoding to assumption 7, setting a 6= is costly. As usual, we assume that such a cost function is quadatic. Moeove, it is popotional to the summation between the paent company s debt shifting cost, ( a), and the subsidiay s one, [(1 ) (1 a)]. Paamete n allows us to deal with both institutional deteminants and tax and nancial advising activities. In othe tems, the intoduction of thin capitalization and eanings-stipping devices, aiming to pevent tax avoiding activities, aises n and hence, the costs of debt shifting. Moeove, the decease in the cost of tax shelteing opeations, which is linked to the degadation of book and tax po ts (see, e.g., Desai, 003, 005), leads to a decease in n. 10 With no loss of geneality, we will impute the concealment cost to the paent company. 9 Fo a discussion on the application of these devices in EU counties see Gabaino and Panteghini (007), and Mintz and Weicheniede (010). 10 If thus, n goes to zeo, the m can shift all the debt at no cost. If, instead, n goes to in nity, debt shifting is impossible. 6

7 Given these assumptions, we can now wite the MNC s afte-tax po t function: 11 N () = f(1 A ) [ ac] (a) Cg whee paent company s afte-tax po t +f(1 B ) [(1 ) (1 a) C]g subsidiay s afte-tax po t = (1 b) [1 C (a)] C; b A + (1 ) B is the MNC s e ective tax ate levied on a MNC s EBIT and () C (a) A a + B (1 a) (a) (3) is the net tax bene t of debt nance. As pointed out (assumption 5), default occus when N () goes to zeo. Theefoe, setting () equal to zeo and solving fo gives the default theshold point: 1 = 1 C (a) C: (4) 1 b Using (4) we can now wite the MNC s value (see Appendix A) as: V (C; a; ) = (1 b) + C (a) C (1 b) + C (a) C ; (5) whee = is the q so-called dividend yield (see Dixit and Pindyck, 1994) and = < As can be seen, function (5) consists of thee tems. The st tem measues the net pesent value of the afte-tax EBIT. The second tem measues the oveall net bene t aising fom debt nancing. The thid tem measues the expected cost of default. This cost is popotional to the coupon paid. Moeove, it depends both on the tax bene t lost (i.e., C (a)) afte default and on the cost of default. The tem measues the pesent value of 1 Euo contingent on the event of default. 11 In line with Panteghini and Schjeldeup (006), we also assume that the cost of income shifting is non-deductible. The quality of esults would not change if we assumed patial o full deductibility of such costs. 1 The quality of esults does not change if we set a di eent theshold value. Fo futhe details on default conditions, see, e.g., Bennan and Schwatz (1977), Smith and Wane (1979), and Leland (1994). 13 Fo simplicity we let be non-negative. 7

8 .1 The MNC s choices The MNC can make two tax-motivated decisions. Fistly, it can choose the goup s leveage. Secondly, it can decide how much debt can be shifted fom one county to anothe. Accodingly, in ou model the MNC optimally chooses its oveall coupon (C ) and the pecentage of debt shifting (a ). Given (5), a and C ae the solutions of the following poblem: 14 Solving (6) we obtain (see Appendix B): max V (C; a; ) : (6) C;a and a = + A 8 >< C 1 b = 4 h >: 1 C (a ) (1 ) (1 n B C (a ) : (7) i C (a )) + C (a ) >= >; (8) As shown in (7), a depends on the copoate income tax ate di eential ( A B ). If A = B, no debt is shifted and the oveall amount of debt is divided with weights and (1 ). Othewise, it is optimal fo the MNC to choose a di eent allocation of debt. In paticula, if A > B ; the MNC shifts debt fom the foeign to the home county and vice vesa. Using (7) the net tax bene t of shifting 1 Euo of debt is equal to: C (a ) = A a + B (1 a ) (a ) = (1 ) B + A + ( A B ) n = b + ( A B ) n As can be seen, the optimal tax bene t of debt shifting depends on both B and the tax ate di eential ( A B ). When the equality A = B holds, it is easy to show A = B = 0 (see Panteghini 007). When howeve tax ates ae di eent, the e ect of taxation on C is much moe complex. It depends on both the e ective tax 14 The maximization of the MNC s oveall value (including debt) implicitly ules out any agency con ict between shaeholdes and the lende. 8

9 ate b and the net tax bene t C (a ) : In paticula, the choice of a a ects C (a ) and theefoe the choice of the coupon. It is woth noting that this e ect has usually been disegaded by the existing liteatue. 15. The subsidiay s leveage As pointed out in the intoduction, we will focus on subsidiaies leveage atio. To calculate it, we stat fom the subsidiay s coupon, which is equal to C S (1 a ) C : It is easy to show that: dc S > 0: d B Not supisingly, an incease in B is expected to aise C S : such a tax ate incease causes a ise in the MNC s aveage tax ate, theeby stimulating boowing. Moeove, it induces the MNC to shift moe debt towads the host county whee the subsidiay opeates. The e ect of A, howeve, is ambiguous. As shown in Appendix C, diffeentiating C S w..t. A gives: 8 9 dc >< S 1 da 1 dc >= = + C d A 1 a >: d {z A C } S : (9) d {z A } >; <0 As shown in (9), the e ect of an incease in A is twofold. On the one hand, it educes the weight (1 a ). On the othe hand, it a ects C. As shown in Appendix C, if A > B we have dc d A > 0: Othewise the e ect is ambiguous..3 Binging the model to the data So fa we have focused on ow athe than stock vaiables. In the empiical pat of this aticle, howeve, we will use nancial statements data to estimate 15 As shown in (8), C is popotional to the cuent EBIT,. It is also easy to < 0; i.e., an incease in the sunk cost of default educes the popensity to boow. As shown by Leland (1994), the value of debt is a U-shaped function of volatility (i.e., it is inceasing up to a cetain theshold value of the coupon). Fo futhe details see Leland (1994) and Goldstein et al. (001). 9?0

10 the sign and size of the tax ate e ects. Hence, the dependent vaiable will be equal to D S () L S () = E S () + D S () ; (10) whee D S () and E S () ae the subsidiay s debt and equity value, espectively. As shown in Appendix D they ae equal to: D S () = ( (1 )(1 B ) h (1 a )C + (1 )(1 )(1 B ) i (1 a )C a.d., b.d., and 8 >< 0 a.d., E S () = (1 B ) h (1 ) (1 a ) C i >: (1 ) (1 a ) C o b.d. As will be shown the impact of taxation on the leveage atio L S () usually has the same sign as the impact on the coupon C. To see this, we povide a numeical simulation of the optimal coupon and leveage function (10). We will then assume ealistic tax ate values, (i.e., 0 A 0:5, 0 B 0:5), and, in line with Dixit and Pindyck (p. 157 and p. 193, 1994; 1999), we will set = 0:04; = 0 and = 0:. Finally, we assume = 1, v = 0:, n =, and = 0:5 (i.e., we assume that the paent company and its subsidiay have equal weight). Given B = 0:0, we show in Figue 1 simulated Equity, Debt, Optimal Coupon, Leveage as functions of the paent company tax ate, A ; and, in line with evidence, we assume that A > B. As can be seen, both Leveage and the Optimal coupon ae inceasing in A. Moeove, an incease in A aises the subsidiay s coupon C S. As a consequence, its equity value deceases while debt inceases. Fo this eason, the subsidiay s leveage is inceasing in A. Π = 1, = 0.04, µ = 0, σ = 0.0, ν = 0.4, χ = 0.5, n =, τ = 0. B Π = 1, = 0.04, µ = 0, σ = 0.0, ν = 0.4, χ = 0.5, n =, τ = 0.5 B 10

11 Similaly, Figue shows the simulated Debt, Equity, Leveage, Optimal Coupon as functions of A (see the legend unde the pictue), given B = 0:50. In this case, we focus on the less ealistic case, whee the subsidiay s tax ate is highe than (o equal to) the paent company s one. As can be seen, Debt is now a deceasing function of the domestic tax ate. This is due to the fact that debt nance is heavily a ected by the tax ate di eential ( A B ) (which has now the opposite sign). Theefoe, if the B is high enough, an incease in the paent company s tax ate educes the tax ate di eential and the multinational goup tends to diminish the total amount of Debt. Optimal Coupon is deceasing until it eaches a minimum. Then, fo values of A close to B ; it stats to incease. Despite the negative sign of ( A B ) ; leveage is still inceasing in A. This is due to the fact that the ate of eduction in Debt is less than the ate of eduction of total value of the m. It is woth noting that ou esults ae quite obust and hold fo a wide ange of paametes Data and peliminay evidence The elation between tax schemes and m capital stuctue fo foeign owned companies can be studied exploiting both the time vaiation of the national tax ates and the coss-national heteogeneity of thei home county tax ates. A longitudinal dataset of companies esident in di eent counties is povided by the AMADEUS database collected by Bueau van Dijk. This database povides standadized annual balance sheet and po t & loss items (consolidated and unconsolidated), fo up to 1.6 million companies fom 38 Euopean counties (fo up to 14 yeas), togethe with infomation on the county whee ms ae located, thei legal fom and owneship stuctue. In ode to be included in the database, companies must satisfy at least one of the following citeia: i) moe than 100 employees; ii) opeating evenues of at least 10 million euos; iii) total assets of at least 0 million euos. Despite the e ot made by Bueau van Dijk to standadize balance sheet and po ts & loss items of di eent counties, accounting pactices ae so heteogeneous that di eences in the intepetation of ms nancial data 16 Sensitivity analysis, ebading paametes ; n and is available upon equest to the authos. 11

12 acoss counties still pesist. Futhemoe, linking subsidiaies and ownes accounting data may induce a non-andom selection poblem in the sample fo at least two easons: (i) we do not have access to accounting data fo non-euopean companies, and (ii) the coveage of the AMADEUS database vaies acoss counties and company types. We theefoe povide two sets of estimates, the st fo the complete sample of subsidiaies, and a second one fo the subsample of subsidiaies we ae able to link with the accounting data of thei ultimate ownes. We focus on limited companies and limited liability companies, 17 esident in Belgium, Denmak, Spain, Fance, Geat Bitain, Italy, Nethelands, Noway, Potugal, and Sweden whose ultimate owne is esident aboad in a known county and it is not an individual o a family. We de ne the ultimate owne as the company which diectly o indiectly possesses at least 50% of the shaes of a subsidiay. We decide fo a high shae of owneship because a paent company with a lowe level of (diect o indiect) owneship may not be able to a ect debt policy choices (Mintz and Weicheniede, 005). Finally, as infomation on owneship efes to 005, we keep only those companies whose accounting data ae available at least fo 005. We exploed the possibility to use infomation on the subsidiaies located in Gemany, Luxemboug, Slovakia and Switzeland, but due to the limited coveage of the AMADEUS database fo these counties and the sample selection citeia adopted, the contibution of these counties in tems of additional ms was extemely poo (at most 90 ms pe county), and hence, decided to dop them fom the sample consideed. We have theefoe obtained panel data fo 1301 subsidiaies contolled by foeign companies. The numbe of available obsevations pe each m vaies acoss counties (see Table 1), going fom the aveage of fo Denmak to 6.3 yeas fo Fance. The empiical liteatue on tax-motivated debt nance uses book data athe than mak-to-maket values. We also follow the pactice, which is dictated by the dataset AMADEUS, that contains the nancial epots of both listed and non-listed companies. Only fo the fome companies, book and mak-to-maket values ae likely to be close, due to the application of intenational accounting pinciples (IAS/IFRS). As to non-listed companies 17 Fom Amadeus Intenet Guide: Limited Companies: companies whose capital is divided into shaes which can be o eed to the geneal public and whose membes ae only liable fo its debts to the extent of any amount unpaid on thei shaes; Limited Liability Companies: companies whose capital is divided into shaes which cannot be o eed to the geneal public. The liability of its membes is limited to the amount of thei shaes. 1

13 (that is, a lage majoity), instead, accounting pinciples may allow us to eckon histoical athe than fai values. In this case, the book value of one item may di e fom the fai value. Table 1 shows the 005 median values of the main balance sheet items conditional on the esidence county. As the population of ms is typically composed by many small-medium size companies and few lage ones, we pefe to efe to median values to summaize the chaacteistics of ou sample (in many cases the aveage of the vaiable falls well above the 75 th pecentile). Table epots some nancial atios: the leveage, the etun on assets (ROA), the shae of xed assets ove total assets, and the Z-scoe. We calculate the Z-scoe with the weights poposed in the liteatue (see Altman, 00): Z scoe = 6:56x 1 + 3:6x + 6:7x 3 + 1:05x 4 ; whee x 1 is the atio between woking capital and total assets, x is the vaiation of the "othe shaeholdes funds" ove total assets, x 3 is the atio between EBIT and total assets, and x 4 = shaeholdes f unds non cuent liabilities + cuent liabilities : In line with most eseach (see, e.g., Altshule and Gubet, 003, Desai et al., 003, Jog and Tang, 001, and Mintz, 000), leveage is given by the atio between debt (long- and shot-tem liabilities, excluded commecial debt) and total assets. The stiking heteogeneity shown in Tables 1 and highlights the actual di eences in the companies size, togethe with the vaiety of accounting and disclosue obligations and pactices. All these factos must be consideed when compaing, fo instance, the median value fo the total assets of the 80 Novegian subsidiaies (4.5 mil. Euo) with the coesponding value of the 344 Bitish companies (146 mil. Euo), o the median eanings befoe inteest and taxation (EBIT) of the 59 Dutch ms (4.3 mil. Euo) with those of the 117 Fench subsidiaies consideed (only 341 thousand Euo). Such di eences ae somehow educed when we look at the nancial atios: the median leveage anges between 55% fo the Bitish subsidiaies and 75% of the Italian ones, the ROA goes fom a minimum of 4.9% fo the Italian companies to 9.9% of the Nowegian ones. The Bitish subsidiaies account fo 8% of the oveall sample, followed by Spanish (14%), Italian (1%), Belgian (11%) and Fench (10%). When we complement the subsidiaies data 13

14 County Total assets Shaeholde funds Non cuent liabilities Cuent liabilities Woking capital Fixed assets Opeating evenue BE 11,077 3, ,649 1,15 1,656 1, DK 15,563 5, ,977,444,080 6, ES 15,674 4, ,817 4,34 3,063 19, FR 9,678 3,63 0 4, ,491 9, GB 145,880 49,4 1,398 53,910 9,1 19, ,819 3,734 IT 15,481 3,759 1,144 8,134 3,31 1,519 18, NL 71,746,3 5,107 3,476 3,951 1,169 85,109 4,59 NO 4,51 1, ,10 1, , PT 0,474 7, ,867 6,374 3,178 5, SE 1,69 3, ,656 1,844,137 17,11 60 Total,104 7, ,00 3,43 3,743 6, EBIT Table 1: Median values of the main balance sheet items, 005, thousand of Euo. 14

15 County Leveage ROA F ixed Assets Limited Yeas Numbe Z-scoe T otal Assets companies available of ms BE 67.0% 5.7% 19.1% % DK 6.8% 8.1% 17.3% %.0 57 ES 63.0% 5.8% 4.6% % FR 59.7% 5.4% 17.9% % GB 54.7% 6.1% 14.4% % IT 74.8% 4.9% 1.5% % NL 61.8% 7.3% 33.7% % NO 70.0% 9.9% 13.0% % PT 56.9% 5.0% 5.7% % SE 66.8% 5.9% 3.5% % Total 63.5% 6.1% 17.9% % Table : Median value fo leveage, ROA, xed to total assets atio and Z- scoe, pecentage of limited companies in 005, aveage numbe of yeas fo which data ae available, and total numbe of ms in the sample. with the balance sheets of thei ultimate ownes, we dop fom the sample those subsidiaies whose paent company is located in the US, Japan and othe non-euopean counties. We ae able to ecove the accounting data of the ultimate owne fo about 74% of the 841 emaining (Euopean owned) subsidiaies. The nationality mix of the esulting sample is emakably diffeent fom the oiginal one: the shae of Bitish subsidiaies dops to 18%, the Spanish ms account fo 16% of the sample, 15% ae Belgian and 1% Swedish. Table 3 pesents the desciptive statistics of the linked companies: these ms ae typically smalle but of compaable po tability and cedit wothiness. The subsidiaies median leveage is usually highe than thei ultimate owne s one (with the lagest di eences in Italy, Noway, Sweden and Fance), while the convese is tue fo Geat Bitain and Potugal, whee ultimate ownes have a highe median leveage (64% vs. 57% of thei subsidiaies). In this aticle, we will use statutoy copoation tax ates. In doing so, we depat fom Huizinga et al. (008), who use e ective tax ates (accounting fo withholding taxes levied on intenational tansactions) on both cossbode dividends and inteest payments. Thei appoach would be necessay 15

16 County Total assets Shaeholde funds Non cuent liabilities Cuent liabilities Woking capital Fixed assets Opeating evenue BE 9,611, ,38 1,094 1,573 11, DK 14,418 4,979 7,399,810,57 7, ES 14,814 4, ,875 4,337 3,19 19, FR 8,9, , ,431 8, GB 109,414 37,069 1,595 41,559 9,378 17,477 15,350 3,58 IT 17,11 3,758 1,13 9,14 4,079 1,531 19, NL 58,58 0,90 5,140 0,153 18,994 1,665 77,008 3,579 NO 3,988 1, ,99 1, , PT 19,493 7, ,53 6,017 3,101 4, SE 11,05 3, ,016 1,833,098 15, Total 16,76 5, ,957 3,071,870, Median values of the main balance sheet items, 005, thousand of Euo. County Leveage Ultimate owne leveage ROA F ixed Assets Z-scoe T otal Assets Limited companies Yeas available EBIT Numbe of ms BE 67.1% 64.% 5.7% 19.0% % DK 63.7% 6.8% 8.4% 18.1% % ES 64.4% 65.1% 5.8% 5.8% % FR 6.7% 58.0% 5.3% 18.% % GB 57.3% 64.1% 6.7% 16.0% % IT 75.9% 65.0% 4.8% 11.6% % NL 63.7% 6.4% 7.7% 38.6% % NO 71.3% 59.8% 11.0% 13.5% % PT 57.% 64.0% 4.8% 8.5% % SE 66.8% 61.1% 5.7% 5.0% % Total 65.7% 63.3% 6.3% 19.8% % Table 3: Desciptive statistics fo the subsample of subsidiaies with accounting infomation of thei ultimate owne. 005, thousand of Euo. 16

17 if: i) po t was always distibuted to the paent company; ii) no othe intagoup tansaction would be made (apat fom inteest payments); iii) high withholding tax ates wee levied. Howeve, we know that a subsidiay s po t is not necessaily distibuted: at least a potion of it can be etained aboad. Apat fom dividends, thee ae many othe kinds of inta-goup tansactions (e.g., oyalties and commission fees paid by one entity to anothe inside the same goup). Since we have no infomation on inta-goup tansactions and the withholding tax ates in the counties of ou sample ae low (o even zeo), we pefe to focus on statutoy tax ates. Figue 3 shows the statutoy tax ate of the subsidiaies (ight-hand axis) togethe with the gowth ate of the pe capita goss domestic poduct based on puchasing-powe-paity (PPP) (souce: IMF, left-hand axis). The infomation about statutoy tax ates is dawn fom KPMG s Copoate Tax Rate Suvey (available at the site In the time inteval consideed, the copoate income tax ate emained constant at 8% in Noway and Sweden, at 35% in Spain, and to 30% since 1999 in Geat Bitain. The tax ate changed only once in Belgium (fom 40% to 34% in 003) and Denmak (fom 30% to 8% in 005) and moe fequently in othe counties. Belgium, Fance, Italy and Potugal ae the counties that cut the tax ates the most, and they mainly did it duing peiods of slow down of the GDP gowth ate. Figue 3 makes it clea that we cannot ely only on time dimension to identify the e ect of changes in the subsidiay tax ate on subsidiay s capital stuctue. A simila pictue can be dawn fo the statutoy tax ates of the ultimate ownes. Again, substantial time vaiation of the tax ates is limited to few counties (e.g., Gemany, Ieland, Slovakia and Lithuania), while thee is no vaiation at all fo othes (e.g., United States, Switzeland, Noway and Sweden). As a consequence, thee is little time vaiation of the home (paent) - foeign (subsidiay) county tax di eentials ( A B ). To appeciate which of these di eentials ae mostly elevant fo ou analysis it is useful to note that United States, Gemany and Fance ae the counties of esidence fo 47% of the ultimate ownes we conside and the opeating evenues of thei subsidiaies account fo about 5% of the cumulated evenues of the companies in the sample. US companies almost always play a signi cant ole as ultimate ownes, although Scandinavian subsidiaies tend to be owned by othe Scandinavian companies, and Belgian subsidiaies ae likely to be owned by Geman, Fench o Dutch companies. In Table 5 we show the aveage of the foeign-home tax di eential 17

18 18 Figue 3: Subsidiay tax ates and pe-capita PPP GDP gowth ates

19 Subsidiay county of esidence Yea BE DK ES FR GB IT NL NO PT SE % -8.7% -3.9% 3.8% -.1% -8.1% 1999.%.6% -8.0% -.5% -4.7% -0.7% -7.4% 000.8% -3.% 0.4% -7.8% -0.% -.5% -4.5% -3.% -7.0% % -0.6% 0.7% -6.0% 0.% -1.1% -3.6% -0.7% -5.5% % -0.1% -0.% -5.3% 0.8% -1.5% -3.5% -.3% -5.3% % -5.8% 0.1% 0.3% -5.1% -1.1% -0.9% -3.5% -.% -5.% % -3.0% 0.6% 0.6% -4.8% -.0% -0.% -3.4% -7.9% -5.0% % -4.5% 1.% -0.6% -4.3% -1.% -.8% -.7% -7.4% -3.9% Aveage of the foeign - home tax di eential Subsidiay county of esidence Yea BE DK ES FR GB IT NL NO PT SE % -9.4% -5.5% 9.6% 7.3% -8.0% % 1.4% -8.6% -.7% -7.6% -1.8% -8.4% 000.4% -3.1% -0.7% -8.% -1.% -.5% -7.6% -4.% -8.1% % -1.1% -0.9% -6.5% 0.0% -1.3% -6.1% -0.8% -7.4% % -0.5% -1.7% -5.8% 0.4% -1.8% -5.7% -.6% -7.% % -10.1% -0.4% -1.4% -5.5% -1.% -1.6% -6.0% -.8% -7.% % -.8% -0.1% -1.1% -5.0% -.3% -1.1% -6.% -8.5% -7.0% % -4.5% 0.5% -.4% -4.3% -1.4% -3.5% -5.7% -8.0% -6.1% Weighted aveage of the foeign - home tax di eential, weights given by the opeating evenues of the subsidiay Table 4: Aveage of the foeign-home tax di eential (t B t A ) ( B A ), that is the aveage of the di eence between the statutoy tax ate of the subsidiay and that of the paent company. We st calculate the simple aveage of these di eences and then the weighted aveage, whee each subsidiay s contibution to the mean is popotional to its opeating evenue. Fo each county the aveage of the st available yea is not infomative because of the few numbe of obsevations in the cell. As we can see, apat fom Belgian subsidiaies between 1999 and 00, paent companies statutoy tax ate is highe than the subsidiay s one. This may suggest that paent companies pefe to locate subsidiaies in low-tax counties. 19

20 4 Regession analysis Ou theoetical model pedicts that the leveage of the subsidiay L S () is a complex function of both paent company tax ate ( A ) and its own tax ate ( B ). In ou empiical execise we appoximate L S () with Taylo expansion: L S () ' const S A ( A A ) S () A = B ( B (11) B ) B = B + 1 L S A L S B ( A A = A A ) L S () ( B B ) B = B ( A A ) ( B B ) A = A B = B Consistently, we conside a egession equation which includes a quadatic function in A and B : A set of covaiates coming fom past nancial accounts of the companies (F it 1 ) is intoduced in ode to contol fo di eent factos a ecting the access to cedit makets and ms demand fo loans, and the PPP pe-capita GDP gowth ate (B t ) is used to contol fo business cycle e ects. In pactice, as the estimated paametes associated with the squaed values Bit and Ait wee neve signi cantly di eent fom zeo, we pesent the estimate of the following egession equation 3 5 : L it = Ait + Bit + 3 Ait Bit + F 0 it 1 e + T 0 it + B 0 t e + i + " it ; (1) whee i identi es the subsidiay m and t denotes the yea of efeence. We pefe conside equation (1), with a quadatic function in A and B, to an altenative speci cation whee the tax di eential ( A B ) is used as a egesso. This altenative appoach would equie the [L it j] =@ Bit [L it j] =@ Bit. Since this constaint is not imposed by ou theoetical model, we need not to intoduce it in ou estimation. Following Fan et al. (003), we include in Fit 0 1 the past values of the ROA, the logaithm of the opeating evenues, the Z-scoe index, the atio between xed assets ove total assets and a dummy vaiable which equals one if at time t 1 the subsidiay geneated negative opeating po ts. 18. We include a measue of m po tability such as ROA (i.e., the atio EBIT/total 18 We also consideed the inclusion of the past value of woking capital, but its estimated 0

21 assets) because moe po table companies have lowe incentives to implement debt policies as they could nance thei investments though thei own esouces. Fims epoting losses have no scal incentives fo inceasing thei debts and they might face cedit constaints. At the same time, they ae likely to demand fo moe loans. We evaluate which of the two e ects is moe elevant by including in F it 1 a dummy vaiable indicating whethe companies end up with a loss in the pevious scal yea. Since bankuptcy cost may be lowe fo lage ms (Wane, 1977; Ang et al., 198; Pettit and Singe, 1985) we include a measue of m size (the logaithm of the opeating evenue). We also conside the xed-to-total assets atio in ode to assess to what extent ms assets stuctue a ects the level of leveage. Indeed, xed assets ae guaantees fo ceditos and can positively in uence a m s leveage (Myes, 1977; Scott, 1977; Hais and Raviv, 1990). Finally, the Z-scoe index is included in the egession in ode to take into account the cedit wothiness of the company (Desai et al. 004; Fan et al. 003; Panteghini, 009). We estimate equation (1) fo the full sample and the subsample of the linked subsidiaies. We povide xed e ects estimates, which take into account all the (time invaiant) unobseved heteogeneity which chaacteizes ms and its likely coelation with the obseved chaacteistics. Theefoe they povide esults which ae obust to the measuement eo poblem, to the omitted vaiables poblem and to the sample selection issue when we estict ou analysis to the subsample of the linked subsidiaies. In Table 6 we pesent the estimates of equation (1). Let us conside the esults fo the full sample st. As expected, pevious yea ms po tability, ROA it 1 ; negatively a ect ms leveage; ms with a negative opeating po t in the pevious yea have a highe leveage; and a highe level of xed assets aises the leveage. Ou estimates suggest that one pecentage point moe of GDP gowth ate inceases leveage by 0.4 pecentage points. The paametes elated to the tax ates ae moe pecisely estimated by using (1). Due to the pesence of the inteaction tem, the maginal vaiation of the expected value of the subsidiay leveage due to a maginal vaiation of the subsidiay tax ate is given [leveage it jf it 1 ; Bit ; Ait ; B t Bit = B + B A Ait ; e ect on the leveage was not signi cantly di eent fom zeo, once contolled fo the vaiables descibed above. 1

22 All sample Ultimate owne tax ate 0:7553 (0:13313) Subsidiay tax ate 1:03048 (0:15101) UO * Subsidiay tax ate 1:45838 (0:4013) GDP gowth ate 0:4083 (0:05349) Negative po ts in t-1 0:03138 (0:00156) ROA t 1 0:00478 (0:00104) log(opeating evenue t 1 ) 0:00707 Fixed Assets Total Assets (0:00084) 0:064 t 1 (0:00519) Z-scoe t 1 /1000 0:00016 (0:00041) Only linked subsidiaies 0:8143 (0:18664) 0:86809 (0:050) 1:5476 (0:55995) 0:15103 (0:07501) 0:03088 (0:009) 0:0015 (0:0010) 0:00736 (0:0011) 0:03463 (0:00763) 0:009 (0:00145) (Ultimate owne leveage) t 1 0:01907 (0:00853) Constant 0:09071 (0:05054) 0:13608 (0:0693) Obsevations Numbe of ms Robust standad eos in paentheses * signi cant at 10%; ** signi cant at 5%; *** signi cant at 1% Table 5: Fixed e ects estimate, standad eos clusteed fo foeign - home county coelation

23 whee Ait is the ultimate owne tax ate. Similaly, the maginal e ect of the ultimate owne statutoy tax ate is given [leveage it jf it 1 ; Bit ; Ait ; B t Ait = A + B A Bit ; whee Bit is the subsidiay tax ate. Theefoe, the maginal e ect of the subsidiay (ultimate owne) tax ate is a linea function of the ultimate owne (subsidiay) tax ate with slope coe cient equal to the paamete of the inteaction tem (i.e., B A ). The estimated e ects ae depicted in Figue 5: an incease in eithe the subsidiay o the ultimate owne tax ate always has a positive e ect on the subsidiay leveage. A change in the subsidiay tax ate always has a geate impact than a change in the tax ate of the paent company. The maginal e ect of a tax ate is smalle, the highe the level of the othe is. At the aveage level of the ultimate owne tax ate (that is A = 0:35) the maginal e ect of the subsidiay tax ate is equal to 0.5 (1: : :35 = 0:5). This means that 1 p.p. incease in the subsidiay tax ate leads to a 0.5 p.p. incease in its leveage. At the aveage level of the subsidiay tax ate (that is B = 0:34) the maginal e ect of the paent company tax ate is equal to 0.53 (0:7553 1:458380:34 = 0:53), that is 1 p.p. incease in the ultimate owne tax ate give ise to a 0.5 p.p. incease in its subsidiay s leveage. By focusing on the subsample of subsidiaies fo which the balance sheet infomation of thei ultimate owne ae available, we can take into account the capital stuctue of the contolling company. We enich the oiginal speci cation of equation (1) by adding the leveage of the ultimate owne at t 1 as a contol vaiable. As shown in Table 6, contolling fo the leveage of the paent company has poved to be impotant, but neithe its intoduction no the emakable di eences between the subsample consideed and the complete set of subsidiaies have had elevant e ects on ou main paametes: the maginal e ects of both the tax ates ae simila to the peviously discussed case. Ou empiical esults can be compaed with Mintz and Weicheniede (005) fo subsidiaies of Geman companies and Huizinga et al. (008) fo a sample of Euopean subsidiaies. Mintz and Weicheniede estimated that at aveage values a one pecentage point subsidiay tax ate incease causes leveage to ise by 0:41 pecentage points. The size of thei estimates is consistent with the coesponding maginal e ect we estimate (see the left panel in Figue 5). As they used only subsidiaies of Geman companies, 3

24 4 Figue 5: Estimated maginal e ects (and con dence inteval) of the subsidiay and ultimate owne tax ates. Estimates based on the full sample and xed e ects appoach.

25 they wee not able to evaluate the e ect of a vaiation of the home county tax ate A. Similaly to ou execise, Huizinga et al. (008) used a sample of Euopean subsidiaies, but they used a measue of the e ective tax ates athe than the statutoy tax ates, and they opted fo a di eent speci cation. In paticula they assumed that the elative weight of the assets of the subsidiay ove the total amount of assets of the MNC was given and consideed the following speci cation: # L it = Fit 0 e nx 1 + B Bit + A "( Bit Ajt ) p + ( Bit Bjt ) j +B 0 t e + i + " it ; whee i = A i = (A p + P k A k), k = 1; : : : ; n, identi es the subsidiaies of the MNC and p the paent company. The tem in squaed backets is "meant to e ects the impact of intenational tax ate di eences on the optimal leveage in county i on account of intenational debt shifting". On the one hand, they consideed that the paent company may have had subsidiaies in moe than one foeign county and theefoe the leveage of subsidiay i could be also a ected by the tax ate faced by the subsidiay j: 19 On the othe hand, they assumed that the vaiations in the host county tax ate ( Ait ) and those in the othe subsidiaies tax ates ( Bjt ) had an e ect of the same sign on the leveage of subsidiay i (the sign of A ), while the elative size of such e ects was given by the atio A j =A p. The maginal e ect of the subsidiay i tax ate Bi on its own leveage was B + A p + P n j6=i j < B + A. The e ect of Bj was equal to A j and that of the paent company tax ate A was A p. When they consideed m-speci c isk they obtained b B = 0:19 and b A = 0:1. This implies that a one pecentage point foeign tax ate incease causes subsidiay leveage to ise by less than 0:19 + 0:1 = 0:31 pecentage points, a value still consistent with ou esults although on the lowe bound of ou estimates (see Figue 5). The e ect of the home county tax ate A is negative and economically negligible if the asset shae of the 19 Notice that in ode to be fully consistent with the theoetical model i and the elated tax incentive vaiable must take into account all the subsidiaies of the MNC, no matte if the subsidiaies ae included in the sample of the egession execise o not. As we ely on AMADEUS, we cannot know the value of the assets of non Euopean subsidiaies (and paents), thus we ae not in the position to compute this vaiable in a sensible way. j6=i 5

26 paent company p is small. Howeve, this esult is in contast with ou ndings. As we have shown, one pecentage point incease of paent company tax ate aises subsidiay s leveage by 0.5 pecentage points, when the subsidiay tax ate equals 35%. Huizinga et al. (008) ae imposing that the maginal e ect of A and B must have opposite sign. Ou theoetical model shows that such a constaint is not necessay, and ou estimates povide evidence that it is in fact ejected by the data. 5 Conclusion In this aticle we have intoduced a theoetical model, descibing a MNC s nancial stategies. We have analyzed how multinational goups shift debt fom low-tax to high-tax juisdictions. Ou model di es fom those used in the elevant liteatue, whee a MNC s leveage atio is usually exogenously given. In ou famewok, howeve, both the multinational goup s leveage and the pecentage of debt shifting ae endogenously detemined. We have thus shown that tax-motivated activities inteact with each othe. This inteaction between tax-motivated decisions is a cucial ationale fo undestanding ou empiical esults. Using the AMADEUS dataset we have shown that when the paent company tax ate is at 40%, a one pecentage point incease in the foeign county tax ate causes a 0.5 pecentage points incease in the subsidiay leveage. At the same time, when the subsidiay tax ate is 35% a one pecentage point incease in the paent company tax ate causes a 0.5 pecentage points ise in of the subsidiay leveage. This latte e ect, usually disegaded in the elevant liteatue, is fully consistent with ou theoetical model and suggests that, when the paent company tax ate inceases, the positive e ect on leveage due to the oveall incease in the tax ate pevails on the debt shifting incentives. In this case, an incease in the paent company s tax ate can positively a ect a subsidiay s leveage. 6

27 A The deivation of (5) Let us st calculate the value of debt, unde the assumption that, befoe default, the lende is tax exempt. 0 When, in the event of default, the lende becomes shaeholde, howeve, it is subject to the souce-based tax levied on the subsidiay. Using dynamic pogamming, debt can be witten as (1 b) dt + e D () = dt [D( + d)] a.d., Cdt + e dt [D( + d)] b.d., (13) whee [:] is the expectation opeato, and a.d. and b.d. mean afte default and befoe default, espectively. Expanding the RHS of (13), applying Itô s Lemma and eaanging gives D() = L + D () + D (); (14) whee L = (1 b) ; C; closed-fom solution of function (14) is and D D() : The whee = and D () = (1 b) + P i=1 B i i a.d., C + P i=1 D i i b.d., (15) 1 = 1 s > 1; = 1 s 1 + < 0 ae the two oots of the chaacteistic equation ( 1) + = 0: To calculate B i and D i fo i = 1;, we need thee bounday conditions. Fist of all, we assume that, wheneve goes to zeo, the lende s claim is nil, namely condition D (0) = 0 holds: This implies that B = 0: Secondly, we assume that nancial bubbles do not exist. This means that B 1 = D 1 = 0: 1 0 It is well-known that e ective tax ates on capital income ae faily low. Fo simplicity we assume that the lende s pe-default tax buden is nil. 1 Fo futhe details on these bounday conditions see Dixit and Pindyck (1994). 7

28 Thidly, we must conside that, at point =, the pe-default value of debt must be equal to the post-default one, net of the default cost. Applying Assumption 6 and using the two banches of (15) we theefoe obtain (1 b) Solving fo D gives (1 ) (1 b) D = (1 b) = C + D : {z } default cost We can theefoe wite the value of debt as follows: D () = ( (1 b) h C + (1 )(1 b) i C C : a.d., b.d. (16) Befoe default, D () consists of two tems. The st one, C, is the pesent value of a pepetual ent with the discount ate. The second tem accounts fo any futue expected change in po tability caused by default. In paticula, the tem measues the pesent value of 1 Euo contingent on the event default. Afte default, the lende becomes shaeholde and he cedit is theefoe conveted into equity. The m s value is theefoe equal to (1 b). Let us next calculate the value of equity. Applying dynamic pogamming we can wite: 0 a.d., E () = N () dt + e dt (17) [E( + d)] b.d. Expanding the RHS of (17), applying Itô s Lemma, eliminating all tems multiplied by (dt) and dividing by dt gives: E () = N () + E () + E () ; (18) whee solving gives and E E() : Substituting () into (18) 0 E () = (1 b) a.d., (1 C (a))c + P i=1 A i i b.d. 8 (19)

29 Let us next calculate A i with i = 1; : In the absence of nancial bubbles, we have A 1 = 0. Moeove, to calculate A we let the two banches of (19) meet at point =, theeby obtaining E = (1 Solving (0) fo A gives A = b) (1 b) (1 C (a)) C + A (1 C (a)) C ; = 0: (0) so that the value of equity is equal to: 8 >< 0 a.d., (1 b) (1 C (a))c E () = h i >: (1 b.d. b) (1 C (a))c (1) Summing (16) and (1) gives the value function (5). Let us nally substitute (4) into (5) V (C; a; ) = (1 b) (1 C (a)) C (1 ) (1 b) C + + C (1 b) + (1 C (a)) C () and eaange, so as to obtain (5). B The MNC s choices Di eentiating V (C; a; ) with espect to a and C gives the following st ode (C; a; = C (1 (1 b) + = C (a) + C + C C C C (a) 9

30 (C; a; = C (a) (1 b) + + C (a) C + C (a) 1 (4) Using (3) and eaanging gives: (C; a; " C hi + C C # {z } 8 >0 = C = 0; 9 >< h + (1 >: i C (a)) C C (a) 1 {z } 1 1 C (a) <0 >= > 0: >; This means that the optimal value of a is such that: and C = A B + n ( a) = 0 C < 0; B a = + A : n Recall now f.o.c. (4). Reaanging one obtains: " C = 1 b C (a) 1 C (a) (1 ) (1 C (a)) + C (a) # 1 : 30

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