Theory Flashcards
How is the term ‘multinational company’ defined? Why does the underlying structure imply that multinationals are better able to avoid corporate taxation than domestic firms?
A multinational company has affiliates in at least two countries (i.e., a parent company owns at least one affiliate in another country). Due to their international presence, multinationals face international tax differentials. This allows them to save taxes by shifting profits to lower-taxed entities. This option is not available for domestic firms where all affiliates face the same tax rate.
What is meant by ‘arm’s length pricing’ and why is it complicated to enforce such pricing?
The arm’s length price is the price that two independent parties would trade at in a comparable unrelated transaction.
Firms that are part of the same group are not independent, and it is difficult to determine if they trade at arm’s length because the real value of a firm-specific traded item is private information of the multinational.
For tangible goods, comparable transactions might be hard to establish because there are differences in quality and specification of the traded goods.
For intangibles, there might be no market parallels at all, because intangible goods usually/often are not
traded with independent parties.
Intuitively explain the two mechanisms by which multinationals can tax-efficiently shape their capital structure beyond the standard debt tax shield mechanism that is also available to domestic firms.
The first relevant mechanism is external debt shifting. Usually, multinationals guarantee for part of the external debt in their affiliates and, by this, face overall bankruptcy cost (from external debt) on parent level. For a given level of total debt, it is therefore optimal to maximize the total tax savings. This can be achieved by allocating debt to high-tax affiliates and by reducing debt in low-tax affiliates. This increases tax savings while keeping overall bankruptcy costs in check (all else equal).
The second mechanism that matters here is internal debt shifting. A multinational places equity in an internal bank that passes the equity on as internal debt (i.e.,debt from a affiliate). The interest expenses on internal debt create tax savings in the borrowing affiliates and cause tax payments in the internal bank lending out internal debt. If the internal bank has a sufficiently low tax rate (e.g., if it is optimally placed in the lowest-taxed affiliate), the tax savings from having internal debt in the borrowing affiliates are always larger than the tax payments on interest
income received in the internal bank. Hence, replacing equity by internal debt (i.e., tax-preferred equity) increases the total after-tax profits of the multinational.
Explain how minority ownership in a high-tax affiliate affects transfer pricing decisions in a multinational. Then, compare your answer to the case of internal debt shifting in the same setting. Provide a brief intuition.
From point of view of a multinational, the ownership share of minority shareholders in an affiliate acts like an implicit tax on the profits of the affiliate. Shifting profits via transfer pricing to another (lower-taxed) affiliate does not only saves tax payments, but also avoids sharing profits with the minority shareholders.
Consequently, there is an incentive for more ‘tax-aggressive’ transfer pricing and this kind of profit shifting increases with minority shareholding, all else equal.
The opposite result applies to internal debt shifting, because there, minority shareholders impose a financing externality on the multinational. Replacing equity by internal debt triggers tax savings in the affiliate where the minority shareholders hold ownership, but creates additional tax payments in the internal bank of the multinational in which the minority shareholders do not participate. Hence, internal debt shifting becomes less attractive with increasing minority ownership share.
The fundamental reason is that under transfer pricing both profits and tax payments are shifted (the tax savings accrue in the low-tax affiliate/profit center), whereas under debt shifting only tax payments are shifted and the tax savings accrue directly in the high-tax affiliate.
Briefly summarize the general design and the main aims of thin capitalization rules that get implemented in form of safe harbor rules in country i. How do these rules affect behavior of a domestic affiliate (in country i) that is owned by a foreignly headquartered multinational (residing in country j)?
Safe harbor rules of country i apply to all affiliates present in country i and deny them tax deductibility of internal debt borrowed from related affiliates and shareholders whenever the level of borrowing exceeds a pre-specified threshold (i.e., the safe harbor). The threshold can be defined over internal or total leverage.
These rules aim for curbing excessive thin capitalization (i.e., replacement of equity by - internal – debt) and for limiting tax losses from using debt finance in country i.
As these rules apply to any affiliate in country i, it does not matter who owns this affiliate. An effective safe harbor rule reduces the internal debt tax shield and
by this the internal leverage in all national affiliates of both domestic and foreign multinationals. As less internal leverage implies higher effective capital costs in these affiliates, the real investment in country i will drop.
When being accused for profit shifting and ‘not paying their fair share in taxes’, multinationals like to defend themselves by that in return they make a ‘big contribution to the domestic economy’ by fostering investment and economic activity in the high-tax country. Assume that the above model is an accurate description of thereal world.
From the optimal capital investment K∗[alternatively: from the FOC FK (K,S) = r1−t for capital] follows that optimal investment does not directly depend on transfer pricing and that this profit shifting only has an indirect effect via the use of the intermediate input S.
Under the Transactional Net Margin method, however, there is no incentive to manipulate the use of the intermediate input to facilitate profit shifting. Consequently, the intermediate input is independent from transfer-pricing decisions (see the previous question) and so is capital investment then. Therefore, the claim by the multinationals is incorrect in the given setting: transfer pricing only leads to losses in tax revenue, but not to higher economic activity in country 2.
Briefly explain what is understood under the ‘internal lending constraint’ when it comes to debt shifting.
The internal lending constraint requires in this example that
∑I r ·bi ·Ki = ∑I r ·Di = 0
For a real internal capital market, all interest expenses on internal debt must show up in the balance sheet/profit statement of another affiliate (i.e., in the internal bank) as interest income received. Therefore, total interest expenses on internal debt must sum up to zero when profits of the affiliates get consolidated.
What is meant by the term `international (legal) double taxation’ ? Briey explain the two methods that the OECD model double tax treaty proposes in order to eliminate such double taxation. Which tax principles do these methods effectively implement?
Legal double taxation occurs if two sovereign countries levy a comparable tax on the same taxable object (e.g., income) of the same taxable entity (e.g., natural person) within the same period of time (i.e., in the same tax year). When unlimited and limited tax liability collide, an investor is taxed twice on the same income and faces a higher total tax burden than the tax burden in any of the two countries in isolation.
In order to eliminate/avoid legal double taxation, the OECD proposes in its model double tax treaty the use of either the Exemption Method or the tax Credit Method.
Under the Exemption Method, the residence country waives its taxing rights on foreign income
(usually under the condition that the income was liable to tax abroad). Hence, it is only the foreign, source country that levies taxes and the total tax burden is equal to the foreign tax rate. Thus, the exemption method implements territorial taxation and is equivalent to the treatment under the source principle.
Under the credit method, world-wide income is liable to tax in the residence country, but foreign tax payments (payment of comparable tax on the same income) are credited against the domestic tax burden. Foreign tax payments directly reduce the domestic tax
bill. The final tax burden is equal to the domestic tax rate (the tax rate of the resident country) and the world-wide income approach is maintained. Thus, the credit method implements the residence principle.
Define the term `debt tax shield’. Why is this usually interpreted as giving a preference for debt over equity financing?
The debt tax shield is the tax savings from the deductibility of debt in the corporate tax base.
Usually, costs of equity are not deductible under the corporate tax. For identical (risk-adjusted) capital costs before tax, debt is always cheaper because of the additional tax savings. This is usually interpreted as a preference for ‘debt over equity’.
What is understood as the arm’s-length principle? Define the concept. Then, explain briey the Comparable Uncontrolled Price Method and the Cost-plus Method as approaches to determine arm’s-length transfer prices. Characterize the fundamental dierence between both methods.
The arm’s-length principle states that transactions between related parties (e.g., parent-subsidiary or two affiliates of the same group) should follow the same conditions (particularly, prices) that would have been agreed upon if the transaction would have happened
between two unrelated, independent parties. Thus, controlled transactions should follow the rules of comparable uncontrolled transactions.
The Comparable Uncontrolled Price Method tries to implement the arm’s-length principle directly by identifying market prices for comparable transactions between independent parties. These market prices are stipulated as internal transfer prices.
In contrast, the Cost Plus Method identifies (direct and indirect) production costs of the internally transferred good or service. Then, the internal transfer price is determined by adding an average, function- and industry-specific profit mark up (relative to margins in
comparable uncontrolled transactions) on the identified cost basis.
The fundamental difference is that the Comparable Uncontrolled Price Method requires the existence of external markets for the traded good or service so that market prices can be observed. For the Cost Plus Method, knowledge about production costs and avera-
ge profit margins is necessary, but no information on market prices and transactions is needed.
Briefly explain the internal lending constraint related to internal debt shifting. Where should the internal bank of a multinational be located? Give a brief economic argument.
For a real internal capital market, all interest expenses on internal debt must show up in the balance sheet (rather: profit statement) of another affiliate, that is, in the internal bank, as interest income received. Therefore, total interest expenses on internal debt must sum up to zero.
The internal bank should be located in the lowest-taxed affiliate. The multinational wants to maximize the internal debt tax shields (ti −t1) ·r ∀i. Therefore, it is necessary to minimize the tax payments on interest income received (in the internal bank, being labelled
as affiliate 1) from lending out internal debt. Hence, the internal bank should have the lowest possible tax rate.
Explain the two mechanisms for international debt shifting intuitively. What are their driving forces, determining the tax shield effects? Why will any analysis missing one of the mechanisms suffer from ‘omitted-variable bias’ when one wants to determine the impact that international tax incentives have on the capital structure of a multinational?
Intuition for mechanisms
• replacing equity by debt reduces tax payments
• internal debt shifting
using internal debt generates tax savings in leveraged affiliates and creates tax payments (on shifted interest) in internal bank value of tax savings larger than tax payments if internal bank located in lowest-taxed affiliate (tax haven)
driving force formally: (ti −t1)
balancing against costs of internal debt necessary, but no effect on trade-off between costs and benefits of external debt
• external debt shifting
using external debt increases risk of bankruptcy and induces bankruptcy costs
on parent level as well (if parent guarantees debt of affiliates, i.e., C f (b f ) >0) total level of external debt in multinational must be balanced against overall
bankruptcy costs on parent level tax savings per unit of external debt in high-taxed affiliates larger than in lower- taxed affiliates
⇒ optimal to allocate more external debt in high-taxed affiliates and to reduce
external debt in low-taxed affiliates in order to keep overall bankruptcy costs in
check (and to mitigate the increase in overall bankruptcy costs, respectively)
driving force formally: ∑ j6=i ρ j(ti −t j)
not optimal to allocate all debt in highest-taxed affiliate, since still trade-off
with external debt costs on affiliate level necessary
• omitted variable bias since both mechanisms are highly positively correlated with
the domestic debt mechanism: domestic tax rate ti is driving both international me-
chanisms and the domestic tax shield effect. Hence, missing one of the internationalmechanisms will underestimate the international component, because part of the effect will be picked up by the domestic mechanism. Furthermore, the contribution of
the remaining international mechanism gets overestimated.
Assume that there are no bankruptcy costs on the parent level of the multinational. Compare the tax shields of external and internal debt. Which kind of debt provides (potentially) larger tax savings, all else equal? Why do multinationals still use both kinds of debt? Give brief explanations.
Tax shields of debt
• Debt tax shield: tax savings from claiming interest expenses on debt in corporate tax base(s)
• Tax shield of external debt: ti ·r ·DEi
• Tax shield of internal debt: (ti −t1)·r ·DIi
→ External debt in principle generates higher tax savings (given identical interest rates), since internal debt creates additional tax payments in the internal bank (i.e., affiliate 1)
• Cost of external and internal debt are independent and different. Thus, it is optimal to use both kinds of debt, as long as they produce positive net tax savings:
Describe the general design, the main aims, and the main effects of the following rules:
a) Thin capitalization rules (focus on safe harbor rules)
Thin capitalization rules in country i
General design: Deny tax deductibility of internal debt from shareholders with significant influence on management, if threshold ̄bIi (i.e., safe harbor) is exceeded.
Main aim: Prevent thin capitalization and tax losses from overly using debt finance in country i.
Effects: Reducing internal leverage in all national affiliates of both domestic and foreign multinationals, and with it real investment in country i.
Describe the general design, the main aims, and the main effects of the following rules:
Controlled-foreign-company (CFC) rules
Controlled-foreign-company (CFC) rules in country i
General design: Overrule tax-exemption principle and deny low taxation of passive income in CFC (i.e., in profit center and in the internal bank), if CFC resides in low-tax country (tax haven). Include passive income (e.g., license fees and interest income) in tax base of parent on accrual bases and apply (higher) domestic tax rate. CFC rules only apply to MNCs that have their headquarters in country i.
Main aim: Prevent use of tax haven as shelter for profits, and increase tax rate in internal bank reducing internal debt tax shield, as well.
Effects: Reducing transfer pricing (at least in intangibles and interest rates) and internal leverage in all affiliates (worldwide) of domestic multinationals
and decrease investment of domestic multinationals in all countries present. No effect on foreign multinationals headquartered in country j 6= i, even if they are active in country i.
