Lecture 5-7

Question 1

What is the benefits and costs of External debt?

Answer 1

External debt: U-shaped cost functionCE (bEi)per unit of capital

⋄Benefits: Capital market monitors firm / Reduction in moral hazard
(e.g., limiting empire-building)

⋄Costs: Bankruptcy costs / Debt-overhang

⇒Optimal leverage (in absence of taxation):b∗

Question 2

What is the benefits and costs of Internal debt?

Answer 2

Internal debt: convex concealment costsCI (bI i) per unit of capital
⋄Hiring tax experts (lawyers, consultants…)
⋄Avoiding thin capitalization rules and CFC taxation

Comparing types of debt costs
⋄costs of debt fundamentally differing
⋄internal debt de facto tax-preferred equity
⇒(Additive) Separability sensible assumption

Some costs tax-deductible, some costs not deductible (e.g., fines)
→no qualitative effect from tax deductibility, rather quantitative impact

Question 3

What are the implications of Tax-efficient Capital Structure?

Answer 3

internal bank always located in lowest-taxed affiliate; i.e., country 1
⇒maximizing internal debt tax shield / minimizing financing costs

optimal to use both external and internal debt

balancing debt tax shields (LHS) against (net) costs of debt(RHS)

ifC f=0, identical external leverage in MNCs and domestic firms ⇒forC f=0, MNCs’ affiliates having higher total leverage due to internal borrowing

Question 4

Capital structure of internal bank

Answer 4

b 1=β 0+β 1·t 1+β 2· ∑ j6=1ρ j(t 1−t j).

Question 5

What are the Three mechanisms for tax avoidance?

Answer 5

Standard (external) debt tax shield (mechanism 1)
•Trading off costs and benefits (incl. tax deductibility) ofexternaldebt
⇒Cost-benefit evaluation: Optimal debt-to-asset ratio<1
⇒MNCs and domestic firms benefiting equally from external debt
•Driven by host country tax rate t

External debt shifting: (mechanism 2)
•Trading off tax savings and costs at parent level from creditguarantees
⇒Cost-benefit evaluation: An increase in t imakes it profitable to use more
debt in affiliate i. But more debt increases the risk of bankruptcy for the
group, and in order to keep bankruptcy costs in check, debt isreduced
in all other affiliates (rebalancing effect)
•Driven by weighted tax difference: ∑ i6=jρ j(t i−t j)

Internal debt shifting (mechanism 3)
Trading off costs and benefits of usinginternaldebt
⇒Cost-benefit evaluation: The higher is the tax difference between affili-
ate i and the lowest-taxed affiliate (affiliate 1), the largeris the internal
debt tax shield in affiliate i; thus, the more internal debt isused.
•Driven by themaximumtax difference:(t i−t 1);

Question 6

How does the MNC can exploit debt better than domestic firms?

Answer 6

By shifting both external and internal debt across affiliates, MNCs can exploit the debt tax shield more aggressively than domestic firms. It is always optimal to use both external and internal debt shifting. On average, an affiliate of an MNC has a higher debt-to-asset ratio than a comparable domestic firm (within the same industry).

Question 7

What is the effect of debt shifting on investment?

Answer 7

Debt shifting (i.e., thin capitalization) in MNCs reduces effective capital costs leading to higher real investment and more capital-intensive production, compared to equivalent domestic firms within the same industry.

Question 8

(Internal) Debt shifting vs. transfer pricing.

Answer 8

Transfer pricing
⋄over-/underinvoicing intra-firm trade in intermediate goods and intangibles
⋄shifting profits, reaping tax savings in low-tax country
⋄investment effect only indirectly via volume of intermediate input
⋄shifting via intermediate-input volume only if benefits from reduced tax planning costs
⇒indirect, second-order effect on capital investment

Internal debt shifting
⋄replacing equity by internal debtat the market interest rate
⋄investing replaced equity in internal bank
⋄effectively shifting tax payments, after-tax profit in high-tax affiliate increasing
⋄direct, first-order effect on capital costs (replacing non-deductible
costs of equity)
⇒always positive effect on investment (in profitable affiliates)

Transfer pricing (also in interest rates) and debt shiftingfully separable
as long as tax planning costs separable (and affiliate profitable)

Question 9

What is important for Consistency check in empirical research?

Answer 9

•Estimate external and internal debt-to-asset ratios separately

•External leverage
⋄driven by standard debt tax shield and external debt shifting
⋄internal debt / internal bank does not matter

•Internal leverage
⋄driving force maximum tax rate differential (internal bank)
⋄no role of standard debt tax shield at all
⋄external debt shifting weakly significant:
due to measurement error / identification of internal banks!?

Question 10

What does the empirical research has found for MNCs?

Answer 10

Empirical evidence shows that MNCs use all three mechanisms for thin capitalization. The standard debt tax shield accountsfor about 40% of a tax-induced increase in the debt-to-asset ratio. 60% of thin capitalization in MNCs is driven by their unique capacity to shift debt internationally. Thereby, external and internal debt shifting are of about the same importance.

Question 11

Reasons for minority ownership / joint ventures

Answer 11

⋄legal requirements to have local partners (e.g., in China)
→exogenous minority ownership
⋄local partners having more experience in local markets
∗familiarity with local customs
∗network connections, access to local supply/distrib. chains
∗political support
⋄MNC providing enhanced industry-specific skills
∗advanced technology
∗international synergy effects (supply/distribution chains)
⇒Cooperation cost-reducing or productivity-enhancing

Question 12

Arguments for decline in minority ownership

Answer 12

⋄Conflicts between minority owners and MNC due to profit-shifting
(exploitation by transfer-pricing)
⋄Appropriation of technologies by local partners (weak property rights)
⋄Conflicts when desire to restructure production world-wide

Question 13

Effect of Minority Ownership on Internal Debt

Answer 13

•Intuition
⋄internal debt tax shield increasing with domestic tax rate
→higher internal leverage (see (6.5))
⋄internal debt tax shield decreasing with internal bank’s tax rate
→less internal leverage (see (6.6))

Intuition
⋄minority shareholders fully profiting from tax savings in affiliatei
⋄no sharing of tax payments on shifted interest in internal bank
→cost externality benefitting minority shareholders

⇒Internal debt less attractive for MNC

Question 14

What is the optimal ownership structure for MNC?

Answer 14

trading off benefits and costs of minority shareholding

→increase in capital costs due to cost externality making internal debt less
attractive

→increased internal leverage reducing capital costs in all other affiliates

Note: internal bank economically ‘loss making’ as equity non-
deductible

⇒Incentive to increase minority ownership until upper bounddue to
⋄entry cost reductions in country 1
⋄capital cost reductions in affiliatesi>1 (improved debt shifting)
⋄loss-sharing in financing internal debt shifting
•No minority shareholders willing to join in since internal bank less prof-
itable than non-bank affiliates (πe 1−t 1πt 1<0, if no production at all)
⇒Internal bank must be fully owned by MNC

Question 15

What is the effect of minority shareholders on MNCs?

Answer 15

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.

Question 16

Profit Shifting and Anti-avoidance Regulation

Answer 16

•Erosion of tax revenue by both transfer pricing, thin capitalization, and international debt shifting
•Surprisingly strong focus in OECD BEPS Action Plan on debt shifting
•Curtailing international tax planning by government action
⇒Main regulation and legal limitations: OECD BEPS Action 4 and 3
⋄thin-capitalization rules (TC rules)
⋄controlled-foreign-company rules (CFC rules)

Question 17

What are the Thin Capitalization Rule strategies?

Answer 17

• No TC rules: few developed countries, but many in total
• Earnings-stripping rules (‘non-specific TC rules’) - restricting tax deductibility of (internal) interest expenses relative to earnings measures (usually EBITDA or EBIT)

Safe-harbor rules (‘specific TC rules’) - restricting tax deductibility of debt if a certain debt-to-asset ratio is exceeded
-> mostly targeting debt from shareholders

Question 18

What are the features of Safe-harbor Rules?

Answer 18

•Usually applicable for debt from shareholders with significant influence on management (only few countries restricting total debt)
•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(excessive) internal debt
•Excessive debt determined by fixed debt-to-equity ratio
•Safe harbor: no TC rules, if debt-to-equity ratio below threshold ratio 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

Question 19

What are the features of Earnings-stripping Rules?

Answer 19

• Restricting interest deductions of internal (and potentially external) debt if net interest payments exceeding defined threshold
• Qualifying interest payments above certain percentage of earnings measure (mostly EBITDA) as taxable profit / dividends

⋄tax threshold of 3 million euro (rules apply to full amount ofinter-
est expenses, when threshold exceeded)
⋄trust clause
∗no application of earnings-stripping rules, if firm not partof a
corporate group/trust
⋄escape clause
∗no application of earnings-stripping rules, if affiliate’sdebt-to-
asset ratio is equal to or less than group-wide leverage
∗exceeding of not more than 2 percentage points harmless

•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

Question 20

Economic Effects of Thin-Capitalization Rules on Debt-to-asset Ratio?

Answer 20

Strictly binding TC (safe-harbor) rules
Implications:
⋄standard result carrying over as long as optimal internal leverage within safe harbor
⋄if marginal costs of internal debt very low, corner solution: positive debt tax shield driving internal leverage to threshold
⋄no tax deductibility above threshold turning tax shield negative:
no tax savings in affiliate, additional tax payments in internal bank
⇒No internal debt beyond threshold ̄ bIi

Safe-harbor rules with leeway
•Implications
⋄TC rules reducing optimal internal debt-to-asset ratio
⋄no qualitative change in standard results
⋄internal debt-to-asset ratio exceeding threshold ̄ bI
i
⋄firms incurring higher tax-engineering costs

Question 21

What is the main aim of TC rules and what are the two possibilities of it?

Answer 21

•TC rules mainly aimed to curb internal debt-shifting

•Two possibilities:
⋄TC rules strictly binding at level ̄ bIi
→introduction of upper bound (ceiling) for internal leverage
⋄some leeway in working around TC rules, but tax avoidance be-
coming more expensive
→flexible internal leveragebI
i, but increased costs of internal debt

Question 22

Economic Effects of Thin-Capitalization Rules on Real Investment?

Answer 22

Real capital investment less profitable (compare equation (5.17))
⇒Effective TC rules reducing real investment in MNCs

Question 23

Choice safe-harbor vs. earnings-stripping rules?

Answer 23

•Extended model with transfer pricing (in interest rates)
•Relaxing a binding safe-harbor rule increasing investment
⇒Never optimal to have both rules binding at the same time
•Safe harbor rule with no (direct) impact on transfer pricing
•Earnings-stripping rule increasing costs of transfer pricing
•Switch from safe-harbor to earnings-stripping rule reducing transfer
pricing, but fostering debt financing
•Transfer pricing without beneficial effects on welfare / investment
⇒Switch in rules still with beneficial effect on revenue, but also giving
more investment
•Debt shifting reducing corporate tax distortions whereas transfer pricing
‘big evil’
⇒Always optimal to replace binding safe-harbor rule by a regime with
only an earnings-stripping rule

Question 24

Economic Effects of Thin-Capitalization Rules on Tax Competition?

Answer 24

•TC rules fostering corporate tax competition (Haufler/Runkel, 2012)
•Weak TC rules alleviating effective tax burden on mobile capital
•Higher corporate taxation of immobile capital possible
•For harmonized corporate tax rates:
⋄TC rules turning 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

Question 25

What are the empirical finding of Thin capitalisation rules?

Answer 25

⋄highly leveraged incorporated affiliates reducing internal-debt-to-
equity ratio (IRAT) and internal debt, but increasing equity
⋄only effect on IRAT significantly different (5%-level) fromeffect
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’)

Question 26

Are there theoretically and empirical evidence for Thin capitalisation rules?

Answer 26

Thin-capitalization rules are theoretically and empirically par-
tial explanations for the low tax sensitivity of (internal)debt. Effective thin-
capitalization rules reduce leverage and investment. Nevertheless, empirical
studies also provide evidence for sufficient leeway to sustain all qualitative
results on mechanisms of international debt shifting.

Question 27

What are the features of Controlled-Foreign-Company Rules?

Answer 27

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

Problem: conflict with EU law
⋄inclusion only in low-tax countries; imbalance to domesticor high-
tax affiliates
→violation of freedom of establishment
(ECJ ruling 2005 on UK’s CFC rules in Schweppes-Cadbury case)
⋄seeking tax advantage not sufficient for restricting freedom of es-
tablishment (‘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
•But: CFC rules recommended in BEPS Action Plan by OECD (2015)

Question 28

What are the effect of CFC rules with leeway?

Answer 28

⋄CFC rules reducing optimal internal debt-to-asset ratio
⋄firms incurring 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

Question 29

What are the effect of Strictly binding CFC rules?

Answer 29

⋄standard result collapsing for low-tax affiliates:bI
i=0 ift i≤t CFC
⋄standard results qualitatively robust for affiliates witht i>t CFC
⋄internal bank now located in countrykthat just fulfills CFC regu-
lation:t k=t CFC
⋄additional tax revenue for countryphosting MNCpif CFC rule
such thatt CFC=t p

Question 30

What is the CFC rules Effects on Real Investment?

Answer 30

•Transfer pricing in royalties (e.g., licenses)
⋄under OECD standard methods, no effect from tax on abusive
royalty payments
⋄higher tax on arm’s-length payment under sales-dependent royal-
ties increasing effective capital costs
⋄see section 3.3.4 on transfer pricing
⇒Negative effect from enforcing higher tax on arm’s-length component

•Debt shifting
⋄CFC rules restricting tax savings from financial policy
⋄reduced internal debt tax shield increasing effective capital costs ̃r i
for MNCs (just like thin-capitalization rules)
⋄real capital investment less profitable (compare equation (5.17))
⇒Effective CFC rules reducing real investment in MNCs

Question 31

What are the theoretical and empirical results of CFC?

Answer 31

Controlled-foreign-company rules are an effective instrument to
reduce income shifting and partially can also explain the low tax sensitivity
of internal debt. Theoretically, binding CFC rules should reduce leverage,
transfer pricing, and investment. Empirical evidence supports these predic-
tions and suggests that internal banks and profit centers are placed just above
the threshold of a binding CFC rule.

Question 32

Comparison of Thin-capitalization and CFC Rules

Answer 32

TC rules
⋄restricting tax avoidance by (internal) debt shifting in country of
application
⋄negatively affecting domestic investment
⋄affecting domestic affiliates of both residing and foreign MNCs
⋄low sustainability in tax-competition setting

CFC rules
⋄restricting use of internal debt and transfer pricing to taxhavens in
all countries for domestic MNCs
⋄affecting 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 (!?)

Question 33

Why using both rules at the same time?

Answer 33

•TC rules targeting all affiliates within a country (similar:TP regulation)
•CFC rules only targeting ‘home-owned’ affiliates, but harming foreign
affiliates of ‘home MNCs’
•Combination allowing for ‘double discrimination’ of MNCs whenever
positive transaction costs for FDI
⋄investment of foreign MNCs more tax elastic than of home MNCs
⋄differentiated TC rules optimal, but legally not possible
⋄set weak TC rules to attract mobile capital / FDI
⋄tough CFC rule reducing tax advantage for less elastic home MNCs