CES Lecture Series Tax Avoidance in Multinationals: The Case of Debt Shifting Dirk Schindler (Norwegian School of Economics) Lecture 3: Regulation, Minority Ownership and Transfer Pricing as Limiting Factors
Potential (important) factors limiting debt shifting: Thin-capitalization rules (TC rules) Controlled-foreign-company rules (CFC rules) Minority ownership in affiliates Interplay with transfer pricing CES Lecture: The Case of Debt Shifting 76 Lecture 3: Limiting Factors
5 Thin-capitalization Rules and Controlledforeign-company Regulation Thin-capitalization rules Few countries without TC rules, e.g., Cyprus, (still) Norway Otherwise trend from TC rules in strict sense (safe harbor rules) to non-specific TC rules (earnings-stripping rules / Zinsschranke ) Controlled-foreign-company rules Banned by European Court of Justice for EEA affiliates in 2006 Part of BEPS proposal by OECD (2013) Some overview on details in Ruf and Schindler (2012) CES Lecture: The Case of Debt Shifting 77 Lecture 3: Limiting Factors
5.1 Thin-Capitalization Rules 5.1.1 General Features of TC rules (in Strict Sense) Applicable for debt from shareholders with significant influence on management Threshold for influence mostly direct and indirect holding of at least 25% (or higher values) of shares / voting rights If applicable, no tax deductibility of interest expenses on (excess) internal debt Excess debt determined by fixed debt-to-equity ratio Safe harbor: no TC rules, if debt-to-equity ratio below threshold ratio CES Lecture: The Case of Debt Shifting 78 Lecture 3: Limiting Factors
Average safe harbor in EU (2008): 3.4:1 debt-to-equity Usually exemption (or preferable rules) for financial institutions and holding companies Often escape clause: arm s-length comparison: replacement of internal debt by external debt at same conditions possible? if proof provided, no application of TC rules For EU member states: no discrimination of non-residents from other EU countries (Lankhorst-Hohorst ruling by ECJ) no TC rules for EU-resident companies (e.g., Spain, Portugal) TC rules for non-resident and for resident companies alike CES Lecture: The Case of Debt Shifting 79 Lecture 3: Limiting Factors
Example: German TC rules until 2007 Introduction of (first) TC rule in 1994 Only applicable for foreign investors (inbound investment) No tax-deduction of interest expenses on internal debt, if: (direct and indirect) investor s share in German affiliate 25% internal-debt-to-equity ratio > 3:1 (from 2001: 1.5:1) Concept of fixed debt-to-equity ratio with safe harbor Preference for holding companies: safe harbor of 9:1 (from 2001: 3:1) CES Lecture: The Case of Debt Shifting 80 Lecture 3: Limiting Factors
Holding company, if restriction to providing financial services only, or ownership share in total assets 75% Escape clause: no application of TC rules if arm s-length comparison successful Due to Lankhorst-Hohorst ruling of ECJ from 2004 on: TC rules applying to foreign and domestic investors alike abolition of preference for holding companies introduction of tax threshold: no TC rules if interest expenses < 250.000e CES Lecture: The Case of Debt Shifting 81 Lecture 3: Limiting Factors
5.1.2 Non-specific Thin-capitalization Rules: Earnings-stripping Disqualifying interest deductions from taxable income if equity is not adequate from commercial perspective (Austria) Restricting interest deductions of both internal and external debt, if interest payments exceed defined threshold (Germany, USA) Qualifying interest payments above certain percentage of profits / EBIDTA as taxable profit / dividends CES Lecture: The Case of Debt Shifting 82 Lecture 3: Limiting Factors
Example: German earnings-stripping rules since 2008 In place (with minor corrections) since 2008: 4h EStG, 8a KStG Restricting tax-deductibility of external and internal debt Net interest expenses deductible from tax base until 30% of EBIDTA EBIDTA = earnings before interest, depreciation, taxes + amortization No deductibility of net interest expenses exceeding 30% of EBITA, but potential deductibility in following years ( interest carry-forward ) Attempt to protect tax base against any kind of debt shifting CES Lecture: The Case of Debt Shifting 83 Lecture 3: Limiting Factors
Exceptions tax threshold of 3 million euro (rules apply to full amount of interest expenses, when threshold exceeded) trust clause no application of earnings-stripping rules, if firm not part of a corporate group/trust escape clause no application of earnings-stripping rules, if affiliate s debt-toasset ratio is equal to or less than group-wide leverage exceeding of not more than 2 percentage points harmless CES Lecture: The Case of Debt Shifting 84 Lecture 3: Limiting Factors
Aims limit revenue losses from international debt shifting exempt small enterprises no distortion in investment + debt financing by domestic creditors Problem rules can bite in and foster liquidity crises CES Lecture: The Case of Debt Shifting 85 Lecture 3: Limiting Factors
5.2 Economic Effects of Thin-Capitalization Rules 5.2.1 Effects on Debt-to-asset Ratio TC rules aimed to curb internal debt-shifting Two possibilities: TC rules strictly binding at level b I i introduction of upper bound (ceiling) for internal leverage some leeway in working around TC rules, but tax avoidance becomes more expensive flexible internal leverage b I i, but increased costs of internal debt CES Lecture: The Case of Debt Shifting 86 Lecture 3: Limiting Factors
Strictly binding (specific) TC rules Focus on specific TC rules (neglecting earnings-stripping) Safe harbor translating into fixed debt-to-asset ratio b I i No tax-deductibility for interest expenses on excessive internal debt, i.e., if b I i > b I i No effect on external debt No change in FOC for external debt D E i Only weakly positive marginal costs of internal debt: CI (b I i ) b I i 0 CES Lecture: The Case of Debt Shifting 87 Lecture 3: Limiting Factors
Implications: standard result carries over as long as optimal internal leverage within safe harbor if marginal costs of internal debt very low, corner solution: positive debt tax shield drives internal leverage to threshold no tax-deductibility above threshold turns tax shield negative: no tax savings in affiliate, additional tax payments in internal bank No internal debt beyond threshold b I i CES Lecture: The Case of Debt Shifting 88 Lecture 3: Limiting Factors
Specific TC rules with leeway Definition of safe harbor, but leeway to work around TC rules Exceeding threshold b I i possible, but costly equivalent to positive shock on marginal costs of internal debt Define parameter α i as measure for tightness of TC rules in country i Redefine costs of internal debt as C I = C I (b I i,α i ) Again: no effect on external debt (exception: earnings-stripping rules) no change in FOC for external debt D E i CES Lecture: The Case of Debt Shifting 89 Lecture 3: Limiting Factors
Adjusted FOC for internal debt: (t i λ) r (1 t i ) CI (b I i,α i ) b I i = 0 i (5.1) From comparative-statics b I i = 2 C I (b I i,α i)/( b I i α i) α i 2 C I (b I i,α i)/( b I < 0, (5.2) i )2 since 2 C I (b I i,α i) b I i α i > 0 and 2 C I (b I i,α i) ( b I i )2 > 0 Tighter TC-rules reduce internal debt shifting CES Lecture: The Case of Debt Shifting 90 Lecture 3: Limiting Factors
Implications TC rules reduce optimal internal debt-to-asset ratio no qualitative change in standard results internal debt-to-asset ratio will exceed threshold b I i firms will incur higher tax-engineering costs if 2 C I (b I i,α i) b I i α i approach collapses to strictly binding TC rules CES Lecture: The Case of Debt Shifting 91 Lecture 3: Limiting Factors
5.2.2 Effects on Real Investment TC rules restrict tax savings from financial policy Reduced debt tax shields increase effective capital costs for MNCs: r > r TC i = r γ TC i (t i ) ψ TC i (t i,t 1 ) > r i (5.3) Real capital investment less profitable (compare equation (3.17)) Effective TC rules reducing real investment in MNCs CES Lecture: The Case of Debt Shifting 92 Lecture 3: Limiting Factors
5.2.3 Effects on Tax Competition TC rules foster corporate tax competition (Haufler/Runkel, 2012) Weak TC rules alleviate effective tax burden on mobile capital (MNCs) Higher corporate taxation of immobile capital possible For harmonized corporate tax rates: TC rules turn into main instrument for tax competition lax TC regulation to attract MNCs and mobile capital shift in tax competition efforts Challenging sustainability of strict TC rules at least, argument in favor of TC rules with some leeway CES Lecture: The Case of Debt Shifting 93 Lecture 3: Limiting Factors
5.3 Empirical Evidence on Thin-Capitalization Rules Mostly studies on German MNCs or on German rules (using Bundesbank MiDi data for both cases) (Almost) No studies of earnings-stripping rules since rules not operationalizable (and lack of data respectively) TC rules (rather) effective in reducing internal debt Effect on real investment ambiguous (not existing) CES Lecture: The Case of Debt Shifting 94 Lecture 3: Limiting Factors
5.3.1 German Inbound Foreign Direct Investment Weichenrieder/Windischbauer (2008): MiDi data from 1996 to 2004 Estimating effects of German TC rules on financing of German affiliates of foreign MNCs Testing effect of reform in 2001: tightening TC rules Branches as control group: not affected by TC rules controlling for time trend (and reductions in tax rates) Identification strategy: split sample of corporations (branches) in affiliates with high/low level of internal debt before 2001 compare effects between corporations and branches CES Lecture: The Case of Debt Shifting 95 Lecture 3: Limiting Factors
Findings highly leveraged incorporated affiliates reduce internal-debt-toequity ratio (IRAT) and internal debt, but increase equity only effect on IRAT significantly different (5%-level) from effect on branches (control group) TC rules (somehow) effective effect driven by group of incorporated affiliates with highest internal-debt ratios (IRAT > 5) no effect on investment behavior ( fixed and intangibles assets ) CES Lecture: The Case of Debt Shifting 96 Lecture 3: Limiting Factors
Table 4.1: Differential effects on thin capitalization of incorporated firms IRAT Log of fixed assets Log of financial Log of equity Log of inter- log of thirdand intangibles assets company loans party debt b 1 : Corp-high-01-02 -1.624*** 0.062 0.084 0.138*** -1.034*** 0.142 (0.00) (0.42) (0.57) (0.00) (0.00) (0.11) b 2 : Branch-high-01-02 -0.417-0.230-0.826 0.022-1.161** -0.260 (0.43) (0.45) (0.14) (0.78) (0.01) (0.53) b 3 : Branch-low-01-02 0.061-0.128 0.136-0.077 0.335-0.072 (0.61) (0.44) (0.57) (0.35) (0.43) (0.50) b 4 : Log of sales -0.009 0.037-0.008 0.007 0.072* 0.066** (0.77) (0.11) (0.82) (0.23) (0.08) (0.02) Test b 1 = b 2-1.207** 0.361 0.910 0.11 0.127 0.402 (0.03) (0.36) (0.10) (0.14) (0.78) (0.34) Observations 5097 5097 5097 5097 5097 5097 Firms 1699 1699 1699 1699 1699 1699 Adjusted R-squared 0.77 0.92 0.93 0.92 0.83 0.82 *** significant at 1% level, ** significant at 5% level, * significant at 10% level Weichenrieder and Windischbauer (2008), table 2 CES Lecture: The Case of Debt Shifting 97 Lecture 3: Limiting Factors
Interpretation Dourado/de la Feria (2008): TC rules effective at low costs since no effect on real investment alternative view: TC rules can be circumvented since no effect on real investment Leeway: holding structure evidence for holding structure and consolidation ( Organschaft ) holding facing higher safe harbor evidence for increases of (holding) debt in groups with pronounced leverage and binding TC rules Avoiding TC rules on group level CES Lecture: The Case of Debt Shifting 98 Lecture 3: Limiting Factors
5.3.2 German Outbound Foreign Direct Investment Büttner et al. (2012): using Bundesbank MiDi data from 1996 to 2004 Estimating effects of (foreign) TC rules on financing of foreign affiliates of German MNCs Identification strategy: cross-country and time variation in TC rules of 36 countries dummy measuring effect of existence of TC rules on internal debt estimating effect of tightness of TC rules by regressing on safeharbor threshold splitting sample to analyze affiliates facing non-binding and binding TC rules separately CES Lecture: The Case of Debt Shifting 99 Lecture 3: Limiting Factors
Findings (for interacted effects) existence of TC rules ( Rules ) reducing tax-rate effect on int. debt lesser safe harbor ( Tight ) diminishing tax sensitivity of int. debt for threshold of 1.5:1 ( Tight = 0.4) tax-rate effect reduced by 54% (i.e., 0.287 0.4 0.213 0.54) TC rules (very) effective however: using (affiliate-specific) fixed effects not allowing for creating new affiliates for holding purposes etc. in WP-version (2008): strong negative effect on real investment ( fixed assets ) CES Lecture: The Case of Debt Shifting 100 Lecture 3: Limiting Factors
Table 4.2: Thin-capitalization Rules and Internal Debt (1) (2) (3) Statutory tax rate (STR) 0.214** 0.209** 0.213** (0.095) (0.094) (0.093) STR x Rule (TC rule exists) -0.049* (0.028) STR x Thight (safe harbor) -0.287** (0.120) R-squared 0.7643 0.7644 0.7645 Observations 42,950 42,950 42,950 Affiliate Fixed Effects yes yes yes *** significant at 1% level, ** significant at 5% level, * significant at 10% level Büttner et al. (2012), table 4 CES Lecture: The Case of Debt Shifting 101 Lecture 3: Limiting Factors
Interpretation foreign TC rules more effective than German TC rules potential problem: no information on loopholes and no possibility to test for potential loopholes binding TC rules costly: strong effect on investment behavior confirmation of theoretical predictions CES Lecture: The Case of Debt Shifting 102 Lecture 3: Limiting Factors
5.4 Controlled-Foreign-Company Rules 5.4.1 General Features Dirk Schindler Affiliates in low-tax countries fostering tax avoidance haven for valuable assets and internal debt haven for license fees and patents tax shelter for resulting passive incomes Controlled-foreign-company (CFC) rules to curb tax avoidance denying low taxation in resident country of CFC inclusion of passive income in tax base of parent on accrual basis applying (higher) domestic tax rate on passive income (license fees, patents, interest on internal debt) in foreign CFC CES Lecture: The Case of Debt Shifting 103 Lecture 3: Limiting Factors
Problem: conflict with EU law inclusion only in low-tax countries; imbalance to domestic or hightax affiliates violation of freedom of establishment (ECJ ruling 2006 on UK s CFC rules in Schweppes-Cadbury case) seeking tax advantage not sufficient for restricting freedom of establishment ( no abuse ) exception: purely artificial structures (e.g., letterbox companies) not yet tested: violation of freedom of movement of capital Applicability of CFC rules (within EEA) legally rather impossible CES Lecture: The Case of Debt Shifting 104 Lecture 3: Limiting Factors
5.4.2 Example: German Controlled-foreign-company Rules Förster/Schmidtmann (2004); Ruf/Weichenrieder (2012); 7-14 AStG German CFC rules biting, when following requirements fulfilled: a) controlling ownership share b) passive income c) low taxation a) Ownership share ownership of 50% or more in shares or voting rights in foreign corporation no matter whether directly or indirectly held CES Lecture: The Case of Debt Shifting 105 Lecture 3: Limiting Factors
b) passive income negative definition: whatever is not qualified as active active income in particular income from production, agriculture and dividends; but also banking, trade, services etc. as long as main business partners are non-related third parties capital income active if proven that capital raised from unrelated persons c) low taxation effective tax rate less than 25% passive income calculated according to German tax law effective tax burden decisive (tackling beneficial tax regimes) CES Lecture: The Case of Debt Shifting 106 Lecture 3: Limiting Factors
Legal consequences inclusion of passive income in tax base of German parent no shelter from exemption principle or double tax treaties tax exemption if passive income distributed as dividend later Passive income (immediately) taxed at German tax rate German CFC rules and EU legislation in principle, interfering with freedom of establishment and freedom of movement of capital conflict with EU law CFC rules waived for affiliates residing in EEA countries CES Lecture: The Case of Debt Shifting 107 Lecture 3: Limiting Factors
5.4.3 Economic Effects of Controlled-foreign-company Rules CFC rules with leeway CFC rules apply, but leeway to work around Increased (tax-engineering) costs of internal debt equivalent to shock on marginal costs of internal debt (cf. TC rules) Define parameter γ as measure for CFC rule tightness (for parent p) Redefine costs of internal debt as C I = C I (b I i,γ) No effect on external debt no change in FOC for external debt D E i CES Lecture: The Case of Debt Shifting 108 Lecture 3: Limiting Factors
Adjusted FOC for internal debt: (t i λ) r (1 t i ) CI (b I i,γ) b I i = 0 i (5.4) From comparative-statics b I i γ = 2 C I (b I i,γ)/( bi i γ) 2 C I (b I i,γ)/( bi i )2 < 0, i (5.5) since 2 C I (b I i,γ) b I i γ > 0 and 2 C I (b I i,γ) ( b I i )2 > 0 Stricter CFC-rules reduce internal debt shifting CES Lecture: The Case of Debt Shifting 109 Lecture 3: Limiting Factors
Implications CFC rules reduce optimal internal debt-to-asset ratio firms will incur higher tax-engineering costs relevant for domestic MNCs only, but affecting financial policy in all their affiliates worldwide (reduced internal tax savings) no effect on domestic affiliates of foreign MNCs less real investment in affected MNCs since higher capital costs CES Lecture: The Case of Debt Shifting 110 Lecture 3: Limiting Factors
Strictly binding CFC rules Define t p as tax rate of parent company CFC rules enforce tax rate t p in internal bank Decrease of internal debt tax shield for all affiliates Internal debt tax shield negative for affiliates with t i < t p No effect on external debt no change in FOC for external debt D E i Additional constraint on internal debt: λ t p CES Lecture: The Case of Debt Shifting 111 Lecture 3: Limiting Factors
Kuhn-Tucker problem for optimal capital structure (cf. equation (3.4)) max D E i,di i Π p = i { (1 t i ) [F(K i,l i ) w i L i ] r K i (5.6) ] + t i r [D i E +Di I (1 ti ) [ C E (b E i )+C I (b I i) ] K } i C f (b f ) λ i r D I i η(t p λ) s.t. b a i = Da i K i, a = {E,I}, b f = ide i i K i CES Lecture: The Case of Debt Shifting 112 Lecture 3: Limiting Factors
FOC for internal debt D I i in country i: Dirk Schindler Π D I i = (t i λ) r (1 t i ) CI (b I i ) b I i 0 and λ t p i (5.7) Optimal to place internal bank in headquarters: min i λ = t p For affiliates with t i < t p : increased tax payments from internal debt Π D I i < 0 D I i = b I i = 0 For t i t p : reduced internal debt tax shield ( ) 0 < b I i = C I( 1) ti t p r 1 t i Lower internal leverage in high-tax affiliates ( ) < C I( 1) ti t 1 r 1 t i CES Lecture: The Case of Debt Shifting 113 Lecture 3: Limiting Factors
Implications: standard result collapsing for low-tax affiliates: b I i = 0 if t i t p standard results qualitatively robust for affiliates with t i > t p internal bank now located in headquarters additional tax revenue for country p hosting MNC CES Lecture: The Case of Debt Shifting 114 Lecture 3: Limiting Factors
5.4.4 Empirical Evidence on Controlled-foreign-company Rules Ruf/Weichenrieder (2012): MiDi data from 1996 to 2006 Estimating effects of German CFC rules on location of internal banks of German MNCs Internal banks: conduit entities with positive net lending Testing effect of reform in 2003: tightening CFC rules for affiliates in countries without activity clause in double tax treaty Control group: affiliates in countries with activity clause in tax treaty Hypotheses: higher likelihood to host internal bank if no activity clause effect vanishing after 2003 CES Lecture: The Case of Debt Shifting 115 Lecture 3: Limiting Factors
Findings for likelihood to own internal bank in country i Dirk Schindler binding CFC rule ( CFC-Dummy ) reducing likelihood by 45% absence of activity clause ( CFC-Dummy*NOACTI ) increasing probability by 55% activity-clause effect roughly nullified by reform in 2003 ( CFC-Dummy*NOACTI*Post2003 ) caveat: activity clause effects exclusively based on observations in Ireland German CFC legislation effective in curbing tax avoidance CES Lecture: The Case of Debt Shifting 116 Lecture 3: Limiting Factors
Table 4.3: Locating Conduit Entities with Positive Net Lending Panel logit OLS, linear probability Corporate Tax Rate -1.664-0.0527 (1.38) (0.055) CFC-Dummy -0.659*** -0.0270*** (0.25) (0.0089) CFC-Dummy*NOACTI 0.815** 0.0381*** (0.38) (0.014) CFC-Dummy*NOACTI*Post2003-1.066** -0.0577*** (0.52) (0.021) Pseudo R-squared / R-squared 0.07 0.19 Observations 24,951 25,282 Affiliate Fixed Effects yes yes Time Fixed Effects yes yes *** significant at 1% level, ** significant at 5% level, * significant at 10% level Ruf and Weichenrieder (2012), table 9 CES Lecture: The Case of Debt Shifting 117 Lecture 3: Limiting Factors
Table 4.4: Conduit entities of German MNC with positive net lending by country (2006) Country Lending to affiliated companies Number of conduit Statutory less liabilites (in Mio. euro) entities tax rate USA 53,824 58 0.4 UK 3,574 38 0.3 Switzerland 610 31 0.29 France 563 30 0.3333 The Netherlands 807 26 0.296 Belgium 2,607 12 0.3399 Austria 309 10 0.25 South Africa 82 9 0.396 Luxembourg 1,109 8 0.2963 Ireland 718 7 0.125 Spain 28 6 0.35 Sweden 71 6 0.28 Canada 405 5 0.361 Italy 226 5 0,3725 Cayman Islands 4,406 4 0 Malta 243 3 0.35 Sources: Ruf and Weichenrieder, 2012, table 6, MiDi database CES Lecture: The Case of Debt Shifting 118 Lecture 3: Limiting Factors
5.5 Comparison of Thin-capitalization and Controlled- Foreign-Company Rules TC rules restrict tax avoidance by (internal) debt shifting in country of application negatively affect domestic investment affect domestic affiliates of both residing and foreign MNCs low sustainability in tax-competition setting CES Lecture: The Case of Debt Shifting 119 Lecture 3: Limiting Factors
CFC rules restrict use of internal debt in all countries for domestic MNCs affect only residing (domestic) MNCs / potentially reduced competitiveness negative effect on investment in all affiliates of domestic MNCs potentially additional gains in tax revenue if internal bank located in headquarters of MNC sustainable under tax competition (!?) CES Lecture: The Case of Debt Shifting 120 Lecture 3: Limiting Factors
Result 5.1. Both thin-capitalization rules and controlled-foreign-company rules are theoretically and empirically potential explanations for low tax sensitivity of internal debt. Nevertheless, empirical studies provide evidence for sufficient leeway to sustain all qualitative results on mechanisms of international debt shifting. CES Lecture: The Case of Debt Shifting 121 Lecture 3: Limiting Factors
6 Other Limiting Factors 6.1 Minority Ownership Minority ownership: definition joint ventures or diversified (minor) investors MNC fully controlling its affiliates total share of minority owners less than 50% (cf., OECD-/IMF-definitions; Navaretti/Venables, 2004, ch. 1.1) Minority ownership in US-MNC (Desai et al., 2004, JFE) wholly-owned affiliates amounting to 80.4% of all affiliates in 1997 share increased by 8.1 percentage points between 1982 and 1997 CES Lecture: The Case of Debt Shifting 122 Lecture 3: Limiting Factors
Minority ownership in German MNC (Hebous/Weichenrieder, 2010) average share of partially-owned affiliates in number of all affiliates in 2006: 20% for emerging markets: decrease of partially-owned affiliates from 46% in 1996 to 30% in 2006 for OECD countries: decrease of partially-owned affiliates from 25% in 1996 to 18% in 2006 effects hold across all sectors Strong and significant trend in reducing minority ownership in affiliates CES Lecture: The Case of Debt Shifting 123 Lecture 3: Limiting Factors
Tax-efficient capital structure Start out from model in chapter 3.1 (cf., Schindler/Schjelderup, 2012) For simplicity: no overall bankruptcy costs on parent level (C f = 0) no external debt-shifting Sum of minority shares in affiliate i given by J i Cooperation on basis of cost savings C M i = C M i (J i ) > 0 CES Lecture: The Case of Debt Shifting 124 Lecture 3: Limiting Factors
Minority shareholders contributing J i % of equity E i no change in affiliate s after-tax profit (except for market-entry costs) π i = V L i = (1 t i ) [F(K i,l i ) w L i C M i (J i ) ] r K i + t i r [D E i +D I i] (1 t i )[C E (b E i )+C I (b I i)] K i, but minority shareholders earning J i % of after-tax profits World-wide profits of MNC Π p = V L = i (1 J i )V L i = i (1 J i )π i (6.1) No change in internal lending constraint r Di I = b I i r K i = 0 i i CES Lecture: The Case of Debt Shifting 125 Lecture 3: Limiting Factors
Optimal capital structure (for fixed inputs K i, L i ) max Π p = { (1 J i ) (1 t i ) [ F(K i,l i ) w i L i C Di E i M (J i ) ] r K i,di i i ] + t i r [D i E +Di I (1 ti ) [ C E (b E i )+C I (b I i) ] K } i (6.2) s.t. i r D I i = 0, (λ) and b a i = Da i K i, a = {E,I} Rearranging the FOC for external debt: t i r = (1 t i ) CE (b E i ) b E i (6.3) identical to basic model without minority shares No influence on external debt decision (as long as C f = 0) CES Lecture: The Case of Debt Shifting 126 Lecture 3: Limiting Factors
Rearranged FOC for internal debt C I (b I i) b I i = [(1 J i) t i λ] r (1 J i )(1 t i ) = t i λ 1 J i 1 t i 0, i (6.4) Balancing marginal costs against effective internal debt tax shield Locate internal bank in affiliate with lowest effective tax rate λ = min i (1 J i )t i = t e 1 (by assumption, country 1) not necessarily the lowest-taxed affiliate CES Lecture: The Case of Debt Shifting 127 Lecture 3: Limiting Factors
Effect of minority ownership on level of internal debt db I i t e = 1 r dj i C I (b I i ) (1 J i) 2 (1 t i ) < 0, i > 1 (6.5) Effect of minority ownership on tax sensitivity of internal debt ) db I ( i dt i t e = 1 r J i C I (b I i ) (1 J i) 2 (1 t < 0, i > 1 (6.6) i ) 2 Internal debt less attractive for MNC CES Lecture: The Case of Debt Shifting 128 Lecture 3: Limiting Factors
Intuition minority shareholders fully profiting from tax savings in affiliate i no sharing of tax payments on shifted interest in internal bank cost externality benefitting minority shareholders CES Lecture: The Case of Debt Shifting 129 Lecture 3: Limiting Factors
Opposite effect compared to transfer pricing (Kant, 1988, SEJ) Cost externality decreasing with effective tax rate t e 1 in internal bank Empirical evidence effect of tax rate on internal debt 40% larger in wholly-owned affiliates compared to partially-owned ones (Büttner/Wamser, 2009) significant reduction of tax sensitivity (e.g., Büttner/Wamser, 2009; Hebous/Weichenrieder, 2010; Desai et al., 2004, JFE) not transfer-pricing conflicts, but cost externality should drive negative effect (Schindler/Schjelderup, 2012) CES Lecture: The Case of Debt Shifting 130 Lecture 3: Limiting Factors
Result 6.1. Since they do not participate in the tax payments in the internal bank, but profit from tax savings in borrowing affiliates, minority shareholders cause a cost externality reducing the attractiveness of internal debt shifting for MNCs. The resulting increase in effective capital costs constitutes an additional cost effect when determining the optimal ownership structure in affiliates. CES Lecture: The Case of Debt Shifting 131 Lecture 3: Limiting Factors
6.2 Combining Debt Shifting and Transfer Pricing Questions: Interaction of transfer pricing and debt shifting? Implications for tax sensitivity? Effectivity of governmental regulation? Use standard model as in section 3.1 Add interest-rate manipulation: surcharge r i on internal debt, i.e., ri I r + r i See Schindler and Schjelderup (2013) CES Lecture: The Case of Debt Shifting 132 Lecture 3: Limiting Factors
Internal lending constraint: total sum of internal loans zero r Di I = r b I i K i = 0 i i Profit shifting in affiliate i: P i = r i Di I = r i b I i K i Profit shifting constraint: P i = r i b I i K i = 0 i i Specification and definition of concealment costs for internal debt and transfer pricing crucial CES Lecture: The Case of Debt Shifting 133 Lecture 3: Limiting Factors
Definition 6.1. Properties of marginal cross-over effects: Complementarity in concealment costs implying 2 C I b I i P i, 2 C P b I i P i < 0 Substitutability in concealment costs implying 2 C I b I i P i, 2 C P b I i P i > 0 CES Lecture: The Case of Debt Shifting 134 Lecture 3: Limiting Factors
Findings All interaction taking place via concealment cost functions Concealment cost complementarity ( 2 C I b I i P i < 0) increasing tax sensitivity of both debt and profit shifting; that is db I i /dt i > 0 and dp i /dt i > 0. Concealment cost substitutability ( 2 C I b I i P i > 0) reducing tax sensitivity of both debt and profit shifting and db I i /dt i 0 and dp i /dt i 0. CES Lecture: The Case of Debt Shifting 135 Lecture 3: Limiting Factors
Intuition all else equal: higher tax rate increasing both internal debt and profit shifting cost complementarity ( 2 C I b I i P i < 0): cost-mitigating cross-over effect economies of scale and scope reducing marginal costs of both taxengineering activities cost substitutab. ( 2 C I b I i P i > 0): additional costs from cross-over effect higher internal debt (profit shifting) increasing marginal costs of profit shifting (internal debt) CES Lecture: The Case of Debt Shifting 136 Lecture 3: Limiting Factors
Effectiveness of Governmental Regulation Tightening TC rules or arm s-length principle win-win situation for cost complementarity: reducing debt shifting and profit shifting unintended effects for cost substitutability: either debt shifting or profit shifting can increase Intuition complement.: less debt shifting makes profit shift. more expensive substitutab.: reducing one activity makes other strategy cheaper CES Lecture: The Case of Debt Shifting 137 Lecture 3: Limiting Factors
Result 6.2. The (main) interaction of debt shifting and transfer pricing is driven by the concealment costs. Cost complementarity will amplify, cost substitutability will reduce the tax sensitivity of internal debt. On the other hand, cost complementarity simplifies the regulation of profit shifting as a whole, while cost substitutability can trigger unintended effects. CES Lecture: The Case of Debt Shifting 138 Lecture 3: Limiting Factors
6.3 A Step Back: Some Open Issues Very few theoretical literature on TC rules maybe not promising enough (so, be careful) Empirical estimates of investment effects of TC rules to date at most ambiguous or lacking Earnings-stripping rules not really tested empirically / hard to get suitable data some papers now coming: Blouin et al., Buslei/Simmler, Holzmann CES Lecture: The Case of Debt Shifting 139 Lecture 3: Limiting Factors
CFC rules: OECD proposal to foster CFC rules theoretical literature dead silent about foundation/justification (Specific) Empirical test for externality result for minority ownership? Most interesting: shape of concealment cost functions little theoretical work, no empirical evidence obviously more knowledge relevant for policy design could be helpful for interpreting (empirical) findings CES Lecture: The Case of Debt Shifting 140 Lecture 3: Limiting Factors