Abstract
This paper examines how taxes affect bilateral internal debt financing among foreign entities of multinational firms. Our data allows us to construct precise bilateral tax-rate differentials between borrowers and lenders of internal debt, which are found to be positively related to internal debt financing of borrowing entities. Compared with previous studies, the estimated tax-elasticity of internal debt exceeds earlier findings by far, most probably accruing to the bilateral specification of tax incentives. Additional investigations on whether and to what extent countries effectively impose anti-tax-avoidance measures show that thin-capitalization rules in host countries are particularly effective.
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Notes
Until now, only a few studies have investigated the effectiveness of anti-tax avoidance rules. Weichenrieder and Windischbauer (2008) as well as Overesch and Wamser (2010) exploit reforms of the German TC rule and find an impact of these reforms on internal debt financing of foreign affiliates. Moreover, Wamser (2008) shows that subsidiaries that were affected by a tightening of the German rule in 2001 avoided the restriction imposed on internal-debt interest deductibility by using more external debt. Buettner et al. (2012) use German outbound FDI data and find a negative impact of the existence as well as the tightness of TC rules on debt financing. Furthermore, the paper by Altshuler and Grubert (2006) illustrates that the US CFC rule is quite ineffective. In contrast, a recent study by Ruf and Weichenrieder (2012) finds that the German CFC rule is generally very effective in restricting tax planning of German multinationals.
This conflict is similar to the free cash flow theory introduced by Jensen (1986).
Besides, in some countries, other preconditions have to be fulfilled. In the US, for example, deduction for interest payments to non-US affiliates or other tax exempt corporations must exceed 50 % of adjusted taxable income (see Sec. 163 (j) IRC). Several countries add requirements related to the ownership share of the creditor.
While the tax penalty depends on the interest rate, it may be possible that firms can avoid the tax penalty by issuing only a small amount of related party debt and instead set a rather high rate of interest. However, high interest rates would generally conflict with the arm’s length principle.
For computing the debt-to-equity ratio, the TC rules of the following countries refer to total debt: Australia, Bulgaria, Denmark, Hungary, Japan, Latvia, Lithuania, Mexico, Netherlands, Poland, Romania, Switzerland, UK, USA. In the following countries only internal debt is considered: Belgium, Canada, Croatia, Czech Republic, France, Germany, Italy, Luxembourg, Portugal, Slovakia, Slovenia, Spain, South Korea, Turkey. It is important to note, though, that, although different definitions of debt are relevant when computing the debt-to-equity thresholds, interest deduction is in all cases only denied for debt provided by related parties.
Note that we are only able to identify bilateral borrowing if we consider a specific group of indirectly-held wholly-owned subsidiaries which are reported in our data (see below). This requires to focus on multinationals that consist of at least two foreign subsidiaries to identify the bilateral tax differential. In this sense, the company structure is held constant.
Lipponer (2008) provides a detailed description of MiDi.
All EU and OECD member states are included, except Romania, because no lending rates were available for this country, and Iceland, because no subsidiaries of German multinationals are reported in our dataset. Additionally, we consider Croatia. Germany is not included as it is the country of the parent companies.
We exclude observations from mining, agriculture, non-profit and membership organizations, because special tax regimes may be available. Furthermore, we exclude observations whose German parent is not an incorporated and legally independent entity, as well as subsidiaries which are not legally independent.
Sec. 26 of Foreign Trade and Payments Act (Aussenwirtschaftsgesetz) in connection with Foreign Trade and Payments Regulation (Aussenwirtschaftsverordnung). Since 2002, FDI has to be reported if the participation is 10 % or more and the balance-sheet total of the respective foreign investment in Germany exceeds 3 million Euros. For details see Lipponer (2008). Though previous years showed lower threshold levels, we apply this threshold level uniformly for all years in the panel.
Note that MiDi allows us to exactly identify bilateral internal debt in this setting. The borrowing affiliate might also use internal parent debt, which is, however, not considered in our analysis. This explains why the average share of internal debt in Table 1 is comparatively low. While one central idea of our empirical analysis is to consider entity j-specific as well as entity i-specific characteristics, parent debt could not be included since relevant information on parent characteristics is not reported in our data. Another reason for focussing on BIDR ijt is that our approach allows us to assign a specific tax-rate differential to the internal loan. This would no longer be possible once parent debt is simply added to our bilateral debt variable.
The tax incentives of debt financing are reduced if an affiliate suffers or carries forward any losses, because the affiliate can offset current profits, thereby reducing the tax base. In some countries a loss carryback is—usually to a very limited degree—possible and additional interest deductions may result in some tax refunding. Owing to the lack of information on the current profitability before interest payments, we can only consider the impact of loss carryforwards on internal debt financing.
More collateral may make a liquidation less costly for shareholders as well as for debt holders, who can resort to liquidation in order to attain a more effective management control. Harris and Raviv (1990) find a positive correlation between companies’ liquidation values (proxied by the fraction of tangible assets) and the optimal debt levels.
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Acknowledgments
We thank an anonymous referee, participants of the IIPF Conference 2010 in Uppsala, the conference on “Taxation of Foreign Profits” at the Max Planck Institute for Tax Law and Public Finance in Munich, and seminar participants at the University of Dortmund for helpful comments, the Deutsche Bundesbank for granting access to the MiDi database and the German Research Foundation (DFG) for financial support. The usual disclaimer applies.
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Overesch, M., Wamser, G. Bilateral internal debt financing and tax planning of multinational firms. Rev Quant Finan Acc 42, 191–209 (2014). https://doi.org/10.1007/s11156-012-0339-3
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DOI: https://doi.org/10.1007/s11156-012-0339-3