Assessing the Tax Benefits of Hybrid Arrangements — Evidence from the Luxembourg Leaks

National Tax Journal, June 2018, 71 (2), 295–334 https://doi.org/10.17310/ntj.2018.2.04

Assessing the tax benefits of Hybrid Arrangements — Evidence from the Luxembourg Leaks

Inga Hardeck and Patrick U. Wittenstein

Using the Luxembourg Leaks database, we study how multinational firms avoid taxes via hybrid arrangements and assess their corresponding tax benefits. Confidential tax rulings included in this database enable us to deduce and classify the tax arrangements that 123 firms implemented by means of conduit entities in Luxembourg. Based on a difference-in-differences methodology, we show that hybrid arrangements are related to substantial and continuous effective tax rate reductions. These results hold under several robustness checks. Overall, our paper is one of the first to provide empirical support for the considerable benefits of hybrid arrangements outlined in prior theoretical research.

Keywords:advance tax ruling, hybrid arrangement, LuxLeaks, tax avoidance, tax haven JEL Codes: H25, H26, K34

I. Introduction ultinational companies (MNCs) use many tax avoidance strategies to increase Mtheir after-tax income. One important strategy consists of hybrid arrangements that “exploit differences in the tax treatment of an entity or instrument under the laws of two or more tax jurisdictions to achieve double non-taxation, including long-term deferral” (OECD, 2015, p. 11). Kleinbard (2011, p. 702) refers to “stateless income” in these cases. Whereas extensive empirical evidence reveals tax avoidance via transfer pricing (e.g., Bartelsman and Beetsma, 2003; Bernard, Jensen, and Schott, 2006; Cristea and Nguyen, 2016; Klassen, Lisowsky, and Mescall, 2017), systematic evidence on hybrid arrangements is lacking (Riedel, 2014). We bring together economics and legal perspectives on taxation to provide insights into the use of hybrid arrangements by MNCs. Our research purpose is twofold. First, we illustrate precisely how MNCs avoid taxes via hybrid arrangements by using the

Inga Hardeck: School of Economic Disciplines, University of Siegen, Siegen, Germany (inga.hardeck@ uni-siegen.de) Patrick U. Wittenstein: Faculty of Business Administration, University of Hamburg, Hamburg, Germany ([email protected]) 296 National Tax Journal

Luxembourg Leaks (LuxLeaks) database to infer, describe, and classify different types of hybrid arrangements. Second, we combine our classification with statistical analyses and study the extent and the durability of effective tax rate (ETR) reductions depending on the tax arrangements employed. This procedure enables us to directly assess the tax benefits of hybrid arrangements. Hybrid arrangements of MNCs take different incarnations. Previous legal tax literature predominantly mentions hybrid entities and hybrid securities, which pertain to the group of financial instruments with hybrid features (e.g., Finnerty et al., 2007; Bless- ing, 2012). Hybrid entities have characteristics of both partnerships and corporations, whereas hybrid securities combine debt and equity features. MNCs use both hybrid entities and hybrid securities to create hybrid mismatches between at least two countries to achieve double non-taxation. Furthermore, some financial instruments reduce tax liabilities by converting the character of income; for example, dividends can be characterized as interest or capital gains for tax purposes. These “false” characterizations enable repatriation of large profits to offshore tax havens such as Bermuda or the Cayman Islands that are not subject to withholding taxes. Often, conduit structures that interpose entities in a third country (e.g., Luxembourg) between home and source country facilitate tax avoidance. Such a structure increases the scope for hybrid arrangements because firms can exploit differences in the qualification of hybrid securities and hybrid entities between any pair of third countries (Johannesen, 2014). One example of hybrid entities from the LuxLeaks database is how Amazon shifted 519 million euros of royalties from European operating subsidiaries through a Luxembourg corporation in 2009.1 In the next step, Amazon apparently transferred the royalties to a Luxembourg limited partnership (société en commandite simple — SCS) with United States and Gibraltar partners.2 Since the Luxembourg tax authorities regarded the SCS as a non-taxable flow-through entity, it remained untaxed in Luxembourg. However, the United States, applying its “Check-the-Box” regulations, presumably classified the SCS as a taxable entity in Luxembourg and refrained from taxing it (Tavares, Bogenschneider, and Pankiv, 2016). In the end, there is a result of tax-deduction in the European operating subsidiaries without (immediate) corresponding taxation in Luxembourg or the United States. Studying hybrid arrangements is highly challenging since they are not directly observable from financial data (Johannesen, 2014). Moreover, the actual magnitude of realized benefits from hybrid arrangements often remains unclear because benefits depend on the interaction of complex features of different countries’ tax laws (Desai and Dharmapala, 2015). Except for some empirical evidence related to German MNCs

1 Number based on the 2009 corporate tax returns of Amazon EU S.à r.l. https://assets.documentcloud.org/ documents/1345295/amazon-2010-corporate-tax-returns.pdf. Favorable transfer-pricing arrangements ensured that only a small profit occurred in Luxembourg. 2 Information based on the 2009 tax returns of Amazon Europe Holding Technologies S.C.S. https://assets. documentcloud.org/documents/1345296/amazon-2010-corporate-tax-returns.pdf. Assessing the Tax Benefits of Hybrid Arrangements 297 by Mintz and Weichenrieder (2010), previous literature focuses on formal approaches (Johannesen, 2014), estimations based on forward looking ETRs (Spengel et al., 2016), and anecdotal evidence (e.g., Ting, 2014). The LuxLeaks database offers a unique opportunity to study how MNCs avoid taxes via hybrid arrangements and to assess their corresponding tax benefits. The data was released by the International Consortium of Investigative Journalists (ICIJ) in November 2014 (ICIJ, 2014) and reveals comprehensive insights into confidential unilateral advance tax rulings (ATRs) granted by Luxembourg tax authorities to MNCs for the period from 2002 to 2011. An ATR is a procedure that allows taxpayers to gain early certainty concerning the tax consequences of an envisaged transaction (Givati, 2009). To obtain such an ATR in Luxembourg, taxpayers provide a written outline of all facts and circumstances of the planned transaction and then offer a tax analysis to the tax authorities. If the authorities agree, they issue a confirmation letter to the taxpayer (Schmitz and Warner, 2015). The LuxLeaks database contains all of these elements, so we are able to infer the exact nature of underlying tax arrangements and their approximate date of implementation. Luxembourg is a key country when it comes to international tax avoidance via hybrid arrangements. It is one of the most important host countries for “‘flow-through’ capital” (Lewellen and Robinson, 2013, p. 14) and a typical tax haven insofar as it facilitates the avoidance of tax payments that might otherwise have to be paid to other countries (Dharmapala and Hines, 2009; Hines and Rice, 1994; Slemrod and Wilson, 2009).3 Some Luxembourg law firms explicitly advertise hybrid arrangements and their tax benefits (e.g., Ogier, 2017). Inconsistent characterizations of financial instruments or entities for tax purposes are more likely between countries with different legal traditions (Blessing, 2012). Since Luxembourg has a legal system based on civil law, its tax law is likely to generate mismatches with common law countries such as the United States or the United Kingdom. Moreover, Luxembourg does not feature several of the characteristics that, according to Johannesen (2014), typically restrict the use of hybrid arrangements. First, demarcation rules to differentiate between equity and debt, or between corporations and flow-through entities, are to some degree ambiguous. Consequently, the treatment of a particular instrument may be uncertain from a taxpayer’s perspective. Luxembourg’s convenient ruling procedure helps firms to overcome a priori uncertainty related to the qualification of hybrid arrangements. Second, Luxembourg’s favorable transfer-pricing rules (Warner and Schmitz, 2004) for intra-group financing and licensing ensure that only minimal tax liabilities occur in a Luxembourg conduit entity. Third, firms do not have to fear any anti-avoidance rules targeting hybrid arrangements in Luxembourg (Meldgaard, Bundgaard, and Weber, 2016). We proceed as follows: our sample comprises 123 firms which stem from 22 countries and which requested ATRs in Luxembourg (“LuxLeaks firms”). About 34 percent are U.S. firms, and 14 percent are from the United Kingdom. We investigate about 6,000

3 Note that Luxembourg does not fit the popular image of tax havens that either facilitate tax evasion by individuals or do not levy taxes at all. 298 National Tax Journal pages of ATRs and classify three types of hybrid arrangements: (1) hybrid entities, (2) hybrid securities, and (3) hybrid conversions. Moreover, to disentangle tax benefits arising from hybrid arrangements from those of other tax avoidance strategies that are used simultaneously, we additionally deduce various transfer pricing and other tax arrangements from ATRs. We then employ a difference-in-differences (D-in-D) design and use a one-to-one nearest neighbor propensity score matching (PSM) technique to generate a control group. The aim of this procedure is to generate a control group that yields a similar probability of implementing a tax haven arrangement prior to the ATR, in order to account for the reasonable assumption that tax avoiders may self-select by implementing tax arrangements in a tax haven such as Luxembourg. In additional tests, we try to address an important limitation of the LuxLeaks database. The database reveals only a fraction of all ATRs that Luxembourg tax authorities issued during the period of investigation. Because of the confidentiality of tax information, we cannot rule out that some control firms had similar arrangements within that period in Luxembourg or in a comparable tax haven such as the Netherlands (e.g., Gravelle 2009; van ´t Riet and Lejour, 2017). We therefore supplement our PSM approach with data on firms’ subsidiaries to generate another control group without subsidiaries in Luxembourg and a further control group without subsidiaries in either Luxembourg or the Netherlands. An analysis of the LuxLeaks firms’ ATRs reveals that 60 firms employed hybrid arrangements. Comparing LuxLeaks firms to matched control firms suggests that, in contrast to other tax arrangements, hybrid arrangements are related to substantial and continuous ETR decreases. These findings remain unchanged if we control for the simultaneous use of transfer-pricing arrangements. We then disentangle the benefits of hybrid securities and entities that both provide for double non-taxation as well as hybrid conversions that mitigate withholding taxes. Whereas the first group of instruments is associated with long-term ETR decreases, hybrid conversions tend to generate short- term tax benefits. Our results hold under several robustness checks. Overall, the findings provide the first empirical support for the considerable benefits of hybrid arrangements outlined in prior theoretical research. The remainder of this paper is organized as follows: First, we explain hybrid arrangements and present the relevant literature. Then, we describe the sample selection, followed by the classification of tax arrangements. Finally, statistical analyses shed light on ETR reductions related to the hybrid arrangements.

II. theoretical Background

A. hybrid Mismatches Despite economic globalization, tax laws are not aligned across countries. Instead, they remain diverse across the various tax jurisdictions (e.g., Martinez Laguna, 2017). Consequently, mismatches arise between the cross-border tax treatment of income. Two important origins of these mismatches are organizational forms and financial instruments Assessing the Tax Benefits of Hybrid Arrangements 299 that receive inconsistent characterizations for tax purposes and are therefore referred to as hybrid (OECD, 2015). Among hybrid organizational forms, (1) hybrid entities can lead to a differing tax treatment in the two jurisdictions concerned and lead to double non-taxation. Similar results can be achieved via (2) hybrid securities, which we define as hybrid financial instruments serving constant financing purposes. Another type of hybrid financial instruments is (3) hybrid conversions. Their main tax benefit comes from avoiding withholding taxes on large repatriations. In the following, we shed light on these three types of hybrid arrangements (Figure 1). (1) Hybrid entities: The various tax jurisdictions apply different approaches to classify an organizational form as a taxable entity or a non-taxable flow-through entity. In 1997, the United States introduced “Check-the-Box” regulations. These simply allow the tax status of a legal entity to be chosen (e.g., Lokken, 2005). In contrast, several European countries, most of which follow a civil law tradition (David and Brierley, 1985), apply a strong link for tax purposes to their respective commercial laws (Baersch and Spengel, 2013). Germany, for instance, tries to assign a foreign legal entity to a domestic legal entity based on a comparison test. If the conduit country classifies an entity as a non- taxable flow-through and the parent country as a taxable corporation, payments (e.g., for interest or royalties) from operating subsidiaries to the hybrid entity would result in a deduction at the level of the subsidiaries without (immediate) taxation at the level of the conduit and parent company. (2) Hybrid securities: In a similar vein, whereas payments on debt-like securities (i.e., interest payments) are generally tax-deductible in most tax jurisdictions, payments on equity-like securities (i.e., dividends) often are not (OECD, 2015). Hybrid securities show characteristics of both debt and equity instruments. The various tax jurisdictions

Figure 1 Types of Hybrid Arrangements in Conduit Structures 300 National Tax Journal apply different approaches to determine whether a security is debt-like or equity-like. Schön (2014) provides in-depth details on the demarcation lines between debt and equity for tax purposes in various jurisdictions. The United States, for instance, has histori- cally used a “factor-based” approach4 to differentiate between debt and equity. Civil law jurisdictions often link the tax treatment of securities to the accounting treatment for statutory financial reporting purposes (Blessing, 2012). Typically, hybrid securities feature cross-border interest payments at a fixed rate. The paying tax jurisdiction classifies these yields as tax-deductible business expenses, whereas the receiving tax jurisdiction treats them as tax-exempt or tax-deferred dividends. (3) Hybrid conversions: Desai and Dharmapala (2015) state that withholding taxes could diminish or eliminate double non-taxation attained via hybrid arrangements. Withholding taxes are regularly due on dividend distributions to offshore tax havens, which serve to retain foreign capital. Therefore, in order to repatriate large profits, instead of dividend distributions, MNCs use hybrid conversions that do not trigger withholding taxes on large profit distributions, but rather convert dividend distributions to interest or reclassify dividend payments as withholding-tax-free liquidation proceeds. There is a unilateral mismatch insofar as hybrid conversions transform profit distributions — which as ordinary dividend payments would be subject to withholding taxes — to tax-free repatriations. Some hybrid conversions mitigate withholding taxes on occasional distributions of large profits, whereas others are able to repatriate profits continuously without withholding taxes. Under a worldwide tax system such as that of the United States, hybrid arrangements generally do not generate tax-free income at the level of the parent entity of the MNC because, unlike under a territorial system, foreign profits do not benefit from a participation exemption regime (Donohoe, McGill, and Outslay, 2013). Therefore, MNCs operating under a worldwide tax system appear to temporarily store their profits in low-tax countries. Until the final repatriation via cash payments eventually takes place, they achieve long-term tax deferral (Foley et al., 2007) and, along with that, low foreign ETRs (Donohoe, McGill, and Outslay, 2012). Efficient implementation of hybrid arrangements requires the simultaneous use of transfer-pricing arrangements. Often, favorable prices for inter-affiliate financing and royalty arrangements help to minimize taxable profits in source and conduit countries and thus maximize the realized double non-taxation (e.g, Kleinbard, 2011). Otherwise, MNCs risk high profit margins remaining taxable in the source and conduit country.

B. literature Overview Several legal scholars, such as Schön (2014), discuss causes of hybrid mismatches and provide in-depth details on the demarcation lines between debt and equity for tax purposes in various jurisdictions. Another stream of legal tax research (e.g., Rosen-

4 Several factors serve to determine whether U.S. tax law classifies an instrument as debt or equity, as stipulated by the Internal Revenue Code (I.R.C.) § 385(b) and as discussed in literature (e.g., Krahmal, 2005). Assessing the Tax Benefits of Hybrid Arrangements 301 bloom, 2000; Lokken, 2005; Kleinbard, 2011) has indicated tax benefits related to hybrid arrangements. Furthermore, anecdotal evidence (e.g., Berrong, 2010; Sandell, 2012; Ting, 2014) shows examples of how well-known MNCs use hybrid arrangements to decrease their tax burdens. Since the beginning of the 2010s, more and more political institutions have been concerned with hybrid arrangements (Joint Committee on Taxation, 2011; OECD, 2012; European Commission, 2012). Recent studies by the OECD (2015) and the European Commission (Meldgaard, Bundgaard, and Weber, 2016) provide very detailed examples of various forms of hybrid arrangements and options to tackle mismatches. However, previous empirical research on hybrid arrangements is scarce (Riedel, 2014). Using a sample of German foreign direct investments, Mintz and Weichenrieder (2010) find that inter-affiliate debt provided by the parent entity replaces third-party debt in case of conduit entities, which implies the existence of hybrid arrangements. Johannesen (2014) shows theoretically that hybrid securities may serve to avoid a tax burden entirely. Spengel et al. (2016) estimate forward-looking ETRs and find that hybrid securities lead to the lowest ETRs among all profit-shifting methods via interest payments.

III. Sample Selection The LuxLeaks database includes confidential ATRs from 345 firms for the period from 2002 to 2011. Initially, the ICIJ (2014) published ATRs from 338 firms on November 5, 2014. The journalists received these ATRs from a former Big Four employee who had copied the documents during his work at the Luxembourg auditing firm. The ICIJ leaked a small number of additional documents from various sources on December 9, 2014. The database does not feature every ATR that Luxembourg tax authorities issued during this period. Given the confidentiality of tax information, we are not aware of potential additional Luxembourg ATRs among the LuxLeaks firms or other firms in Luxembourg. Following Marian (2017), we assume that the tax arrangements found in the LuxLeaks ATRs are not specific to an auditing firm, period, or type of firm. To test this assumption, we first examine whether the auditing firm whose employee leaked the data to the ICIJ was the exclusive provider of these tax arrangements.5 For this we investigate brochures, presentations, and homepage information of nine well-known auditing and law firms and find that almost every firm mentions these arrangements. Second, the former Big Four employee insisted that he did not leak ATRs that are specific to a type of firm. Instead, he just came across the ATRs on his last day of work and “[w]ithout any particular intention or precise plan [, he] copied [them].”6 Third, although LuxLeaks ATRs cover the period from 2002 to 2011, the majority date from 2008 to 2010. In their report on ATR activity for the year 2015 (ACD, 2016), the Luxembourg tax authorities

5 The LuxLeaks tax arrangements are outlined in our classification (Section IV). 6 “Luxembourg Whistle-Blower Plays Down Role in Tax Deals,” The Independent, December 16, 2014, http://www.independent.co.uk/news/business/news/luxembourg-whistle-blower-plays-down-role-in-tax- deals-9927176.html. 302 National Tax Journal mention comparable topics. Moreover, very few tax arrangements are related to loss situations that might be attributable to the financial crisis at that time. We therefore assume that the LuxLeaks tax arrangements were implemented in other periods as well. Table 1 (Panel A) presents the data on the sample selection. We focus on the 338 firms provided in the initial leak at the beginning of November 2014, because the additional leak does not necessarily stem from the employee’s random selection. We narrow the sample to the 173 firms with available data in either Compustat North America or Compustat Global and require them to have at least five firm-year observations without missing data around the ruling year. From 145 remaining LuxLeaks firms, we exclude 15 U.S. firms that undertook corporate inversions during the examination period. To this end, a U.S.-domiciled MNC may have relocated its place of incorporation to a low-tax country by either establishing a foreign subsidiary of the MNC in this country as its new parent entity, or by acquiring, and merging with, a foreign company in a low-tax country (Babkin, Glover, and Levine, 2017).7 The main tax benefit is that the inverted firm no longer faces the U.S. worldwide tax system, and hence foreign income is no longer subject to U.S. taxation. For instance, Seida and Wempe (2004) show that the ETRs of inverted firms are 7.6 percentage points lower than the ETRs of non-inverted firms. Therefore, we cannot rule out that tax benefits come from the inversion instead of from tax arrangements in Luxembourg. Finally, we eliminate seven firms that lack comparable control firms according to our PSM approach. The final sample consists of 123 LuxLeaks firms. The plurality are U.S. firms (34 percent), followed by UK firms (14 percent), and Swiss firms (7 percent). About 43 percent of the firms are financial firms (among them 23 banks, 10 insurance firms, 4 real estate firms, and 16 trading firms). Table 1 (Panel B) describes the LuxLeaks firms as regards first ruling year, country of origin, and industry.

IV. classification of Tax Arrangements

A. Method and Overview This section identifies, describes, and classifies tax arrangements within our sample of LuxLeaks ATRs. ATRs are not a Luxembourg invention and are offered in many jurisdictions (Romano, 2002). In the United States, for instance, they are known as “private letter rulings” (Givati, 2009). By requesting an ATR, taxpayers may seek upfront clearance from the tax authorities for an anticipated future transaction that will affect their tax liabilities. To achieve this, taxpayers normally first provide a written outline of the facts and circumstances of the planned transaction and then offer a tax analysis of these fact patterns. If the tax authorities agree with the taxpayer’s analysis, they consent by formally approving the content of the letter: in Luxembourg, for instance, via a confirmation letter sent to the taxpayer.8

7 U.S. anti-inversion regulations have been subject to change since 2004. 8 During the time of the LuxLeaks ATRs, taxpayers could often request preliminary verbal guidance from the Luxembourg tax authorities in a personal meeting. In the case of holding and financing companies, the head of the competent tax office was responsible, which meant that in general one person was in charge. “Business-friendly bureaucrat helped build tax haven in Luxembourg,” The Wall Street Journal, October 21, 2014, http://www.wsj.com/articles/luxembourg-tax-deals-under-pressure-1413930593. Assessing the Tax Benefits of Hybrid Arrangements 303

Table 1 Sample Selection Process and Details on the Sample

Panel A: Sample Selection LuxLeaks entries as set forth on the website 345 − Duplicated firms 2 + Additional firms from joint ventures / demergers 3 Total unique LuxLeaks firms 346 − ATRs from additional leak dated December 9, 2014 8 Total unique LuxLeaks firms from initial leak dated November 5, 2014 338 − Not part of Compustat database 165 − Inversions during the examination period 15 − Insufficient data 28 Total unique LuxLeaks firms with sufficient data 130 − Firms with no matched control 7 Final sample 123 Panel B: Details on the Sample Year Frequency Percent Country Frequency Percent 2002 2 1.63 AUS 4 3.25 2003 1 0.81 BEL 4 3.25 2005 1 0.81 BMU 3 2.44 2006 2 1.63 BRA 3 2.44 2007 2 1.63 CAN 5 4.07 2008 23 18.70 CHE 8 6.50 2009 64 52.03 DEU 6 4.88 2010 27 21.95 FIN 2 1.63 2011 1 0.81 FRA 7 5.69 Total 123 100.00 GBR 17 13.82 Industry Frequency Percent HKG 3 2.44 Food 3 2.44 IRL 2 1.63 Mining and minerals 2 1.63 ISR 1 0.81 Oil and petroleum products 4 3.25 ITA 5 4.07 Textiles, apparel, footwear 4 3.25 JPN 3 2.44 Consumer durables 1 0.81 LUX 2 1.63 Chemicals 1 0.81 NLD 1 0.81 Drugs, soap, perfumes, tobacco 8 6.50 NOR 1 0.81 Construction, construction materials 4 3.25 PHL 1 0.81 Steel works 1 0.81 RUS 1 0.81 Fabricated products 2 1.63 SWE 2 1.63 Machinery, business equipment 7 5.69 USA 42 34.15 Automobiles 2 1.63 Total 123 100.00 Transportation 3 2.44 Utilities 1 0.81 Retail stores 4 3.25 Banks, insurance, other financials 53 43.09 Other 23 18.70 Total 123 100.00 304 National Tax Journal

In a first step, we manually extract the tax arrangements mentioned in the ATR(s) based on the items described in the facts and circumstances section and the Luxembourg tax analysis section. The latter section generally includes references to the applicable provisions of the Luxembourg tax code, relevant double tax treaties, or European Union law.9 Additionally, we consider information provided by appendices of the ATR(s), if available. In a second step, we group and classify our observations. International tax planning literature (e.g., Finnerty et al., 2007) as well as Luxembourg tax law literature (e.g., Scardoni, Sergiel, and Thomas, 2012; Schmitz and Warner, 2015) serve as the basis for our classification. We further ensure the reliability of this procedure through both expertise in Luxembourg taxation and independent coding by two researchers. The expertise is reflected in the knowledge and experience of one of the authors, based on years of professional activity in Luxembourg.10 Inconsistent judgments by the two coders are individually assessed and discussed by the authors. Figure 2 shows the frequency and distribution of tax arrangements which occur among at least five LuxLeaks firms. An ATR may simultaneously contain more than one tax arrangement, and therefore multiple entries are possible. The results reveal an enormous diversity of tax arrangements that pertain to many areas of international taxation. In most cases, they relate to several other jurisdictions.11 Table 2 provides details on the identified tax arrangements, including scope and reference to their respective legal bases in the Luxembourg tax code.12 Overall, 60 firms implemented at least one hybrid arrangement. Transfer-pricing arrangements are even more widespread, with 94 observations. Since tax residency in Luxembourg is a prerequisite for ATR applications (Warner and Schmitz, 2004), firms often ask for a confirmation of their residency status.

B. hybrid Arrangements in the LuxLeaks Database Consistent with a higher probability of mismatches between a civil law country such as Luxembourg and common law countries, hybrid arrangements occur significantly more often in relation to firms from common law countries.13 LuxLeaks ATRs concern hybrid entities (#8, n = 23), hybrid securities (#9, n = 20), and hybrid conversions (#4, n = 44), which are described in the following paragraphs.

9 Because some of its pages are missing, one ATR was not properly analyzable. In one further case, tax returns were enclosed instead of ATRs. We then considered the tax-relevant facts from the tax returns. We focus on ATRs in the first ruling year. The vast majority of ATRs were in English, and those remaining were in French or German, Luxembourg’s official languages. We did not consider information on Luxembourg net-wealth tax issues for coding purposes. 10 This author holds an official certificate in Luxembourg taxation (“Diplôme de Fiscalité délivré par le Ministère de l’Éducation nationale et de la Formation professionnelle”). 11 Luxembourg ATRs do not cover tax consequences that may arise in other jurisdictions. Therefore, the ATRs do not enable a definite analysis from the perspective of other tax jurisdictions. 12 To ensure that our descriptive evidence on tax arrangements is representative of all LuxLeaks firms, we randomly examine 10 percent (22) of all remaining 215 unique LuxLeaks firms from the initial leak (Table 1), and find similar arrangements. Results are available on request. 13 In detail, 47 of 77 MNCs from common law countries use hybrid arrangements, compared to 13 of 46 MNCs from civil law countries. Forty-seven hybrid arrangements is significantly more than expected (p = 0.042), based on a one-tailed binomial test. Assessing the Tax Benefits of Hybrid Arrangements 305

Figure 2 Frequency of Luxembourg Tax Arrangements

Notes: This figure lists the different categories of tax arrangements found within the sample of 123 LuxLeaks firms by frequency. Tax arrangements in black color represent hybrid arrangements. LuxLeaks firms generally feature more than one tax arrangement.

Hybrid entities (Figure 3a): The sample is composed of Luxembourg SCS arrangements comparable to the aforementioned example of Amazon, as well as other hybrid entities from various countries. We assume hybrid entities if the hybrid status is evident from the ATR itself (e.g., by reference to a deviating tax status in the other state or an arrangement chart indicating the hybrid nature) or if existing tax literature points out the hybrid mismatch potential (e.g., Tavares, Bogenschneider, and Pankiv, 2016; Delauriere and Prest, 2008). We further include obvious cases of hybrid branches (i.e., non-trading Irish branches [Kerr, 2009]), which also lead to a double non-taxation. Hybrid securities (Figure 3b): The sample includes a variety of Luxembourg hybrid securities without conversion features: interest-free loans, preferred equity certificates (PECs), jouissance rights, mandatorily redeemable preference shares, and other preference shares. Luxembourg uses various indications to classify a security as debt: for instance, the maturity of the security.14 With the exception of some interest-free loans,

14 Further indications include, among other things, predetermined fixed or variable interest, lack of participation in profits or liquidation proceeds, lack of rights for conversion, and lack of voting rights (Schmitz and Warner, 2015). 306 National Tax Journal

Table 2 Luxembourg Tax Arrangements

# Tax Arrangement Scope Panel A: Hybrid Arrangements (HYB) #4 Hybrid conversions Hybrid conversions enable a reduction of withholding taxes on profit distributions to offshore tax havens. Hybrid conversions in the sample are profit participating loans including master/credit facility agreements showing comparable characteristics, CPECs and other convertible bonds, alphabet shares, long-term certificates, and total return swaps. Tax law literature mentions equivalent arrangements (Scardoni, Sergiel, and Thomas, 2012). #8 Hybrid entities Hybrid entities in cross-border situations qualified as taxable entity in one state, but flow-through entity in another state; thus, there occurs double non-taxation. Luxembourg applies a comparison test (“Typenvergleich”) by assessing the individual characteristics of a company to determine the tax status. Hybrid entities in the sample are Luxembourg SCSs (if most likely a taxable entity for U.S. tax purposes), French SCI arrangements (Delauriere and Prest, 2008), Japanese TMK arrangements (Sekiguchi, 2014), and other legal forms (including branches) with explicit reference to the deviating tax status in the other country. #9 Hybrid securities Hybrid securities show a mixture of debt and equity features, for example, maturity, voting rights, rank, participation in profits/liquidation proceeds, and interest rate (Schmitz and Warner, 2015). The securities in the sample are interest-free loans, PECs, jouissance rights, mandatorily redeemable preference shares, and other preference shares. Arrangements with conversion features are not listed here, but under #4. Tax law literature mentions equivalent securities with debt and equity features (Scardoni, Sergiel, and Thomas, 2012). Panel B: Transfer-Pricing Arrangements (TP) #2 Inter-affiliate financing Determination of arm’s length profit margin in inter-affiliate back- arrangements to-back financing arrangements; since 2011 covered by various dedicated circulars.1 Until then, Luxembourg tax authorities did not explicitly request a transfer-pricing study to be enclosed. #11 Goodwill arrangements Capitalization, valuation, and subsequent depreciation of transferred goodwill in the financial services sector, circular LIR no. 101 of 1985. #13 IP arrangements Determination of arm’s length profit margin in inter-affiliate back-to- back royalty arrangements, deemed royalty income or expenses, or effective exemption of 80 percent of royalty income (Art. 50bis LIR). #14 Miscellaneous Various other transfer-pricing arrangements including inter-affiliate transfer-pricing factoring services, inter-affiliate management services, inter-affiliate arrangements leasing services, treasury center, valuation of issues of shares, air- planes and option agreements, and profit allocation issues.

1 The Luxembourg tax authorities issued the first of these circulars in January 2011. “Circulaire du directeur des contributions L.I.R. n° 164/2,” Administration des contributions directes, January 28, 2011, http://www.impots directs.public.lu/content/dam/acd/fr/legislation/legi11/Circulaire_L_I_R__n___164-2_du_28_janvier_2011.pdf. Assessing the Tax Benefits of Hybrid Arrangements 307

Table 2 (Continued) Luxembourg Tax Arrangements

# Tax Arrangement Scope Panel C: Other, Mostly Confirmative ATR Requests #1 Tax residency Corporations qualify as Luxembourg tax resident entities (Art. 159 LIR). #3 Participation Tax exemption of certain dividend payments and capital gains (Art. 166 LIR). exemption Similar tax exemptions are included in other European and worldwide tax laws. regime Remarkably, some cases confirm the non-applicability of that exemption regime (i.e., they confirm the imposition of tax). #5 Debt-to-equity Administrative anti-avoidance regulation. This rule generally limits the related- ratio party debt financing of participations to 85 percent. Firms can reduce the required equity of 15 percent. The amount of tax-deductible interest is held to 85 percent debt and 15 percent equity financing. #6 Foreign Functional currency: common non-Euro currency for business reporting purposes exchange issues without creating exchange differences caused by a deviating tax calculation in euros; other foreign exchange issues. #7 Withholding tax Withholding tax exemption on certain profit distributions (Art. 147 LIR). Similar exemption tax exemptions are included in other European and worldwide tax laws. Remark- ably, some cases confirm the non-applicability of that exemption regime (i.e., they confirm the imposition of tax). #10 Permanent Domestic branches of foreign corporations as well as foreign branches of domes- establishments tic corporations as defined by Luxembourg domestic tax law (§ 16 Steueranpas- sungsgesetz, Art. 156 LIR) and provisions of the respective double tax treaties, except for obvious hybrid branches (#8). #12 Major corporate Mergers, demergers, liquidations, transformations, corporate migrations, closing restructurings of branches, and transfer of businesses (Art. 22bis, Art. 159, Art. 169 to 172bis LIR); except for goodwill transactions in the financial services sector (#11). #15 Tax Application of the Luxembourg tax consolidation regime as determined by Art. consolidation 164bis LIR. #16 Other legal Tax qualification of legal forms as determined by Art. 175 LIR and German tax forms doctrine (“Typenvergleich”) developed since 1930s; except for arrangements under #8 with clear hybrid features. #17 Capital Repayments of share capital, share premium or capital reserves as determined by repayments Art. 97 (3) (b) LIR. #18 Non-resident Nonresident taxation of capital gains resulting from the disposal of short-term share disposal shareholdings, which is a clearly defined rule within the Luxembourg tax code taxation (Art. 156 (8) LIR). #19 Hidden capital Hidden capital contributions (Art. 18 LIR), that is, shifting of advantages to a contributions corporation motivated by the shareholding relationship. #20 Holding 1929 Conversion of Holding 1929 companies from corporations exempt from taxation to taxable ones. The Holding 1929 regime was found to be incompatible with the European Single Market. A grandfathering rule for existing Holding 1929 companies ended in 2010 (Bogaerts, 2005). #21 Others Arrangements, which occur less than five times, for example, foreign tax credits, deviating fiscal years, securitization vehicles, investment companies in risk capital (SICARs). 308 National Tax Journal

Figure 3 Hybrid Arrangements Assessing the Tax Benefits of Hybrid Arrangements 309

Figure 3 (Continued) Hybrid Arrangements

Notes: This figure illustrates the hybrid arrangements outlined in Section IV. 310 National Tax Journal the aforementioned securities qualified as debt from a Luxembourg tax perspective in the ATRs. The predominant PECs, for instance, are hybrid securities between Luxembourg and the United States that feature a maturity of 49 years. From a Luxembourg perspective, securities with such a maturity still qualify as debt. The United States apparently regard the PECs as equity-like (Cummings, 2016). This will result in deductible interest expenses in Luxembourg without corresponding taxation in the United States, as long as no repatriation takes place. Hybrid conversions: In our sample, the following hybrid conversions appear to avoid withholding taxes on occasional large profit distributions: alphabet shares, convertible PECs (CPECs), and other convertible bonds. An additional group of instruments enables the continuous repatriation of varying profits over a longer period without a withholding tax burden and without limitation with regard to the number of occasions they are used. This group consists of profit participating loans, including master/credit facility agreements that show comparable characteristics, long-term certificates, and total return swaps. We use alphabet shares and profit participating loans to illustrate the two types of hybrid conversions. Luxembourg corporate law allows corporations to issue several classes of shares, which are designated A, B, C, and so on. The particular advantages of alphabet shares become evident when a Luxembourg corporation redeems and cancels an entire class of shares. The subsequent share capital reduction qualifies as partial liquidation.15 The liquidation payments made to the next offshore tax haven company thus qualify as (partial) liquidation proceeds of the Luxembourg holding company. As confirmed in the LuxLeaks ATRs, such liquidation proceeds are not subject to the Luxembourg dividend withholding tax of 15 percent.16 At the same time, the Luxembourg holding company can continue its business operations because it has only partially entered into liquidation. Profit participating loans (Figure 3c) are often linked to specific income. The profit participating loan effectively neutralizes a substantial amount of the income of the entity that would normally be taxable, leaving only a small portion taxable in Luxembourg. The key to profit participating loans is a variable interest rate. The flexible interest payments are tax deductible in Luxembourg and avoid the dividend withholding tax. If a recipient country with a territorial tax system classifies the loan as equity or does not levy any tax at all (i.e., an offshore tax haven), the arrangement even results in double non-taxation.

C. overlap between Hybrid and Transfer-Pricing Arrangements Since transfer pricing supports the efficiency of hybrid arrangements, we investigate their simultaneous use more closely. Panel A of Table 3 shows a high degree of overlap between hybrid arrangements and transfer-pricing arrangements: 88 percent of the 60 firms that use hybrid arrangements also employ transfer-pricing strategies. The association is less obvious in reverse: Of all 94 firms that employ transfer-pricing

15 Art. 101 (1) and (2) LIR. 16 According to Art. 97 (3) (d) LIR, liquidation proceeds do not qualify as capital income, and they are not listed within the withholding tax catalog of Art. 146 LIR. Assessing the Tax Benefits of Hybrid Arrangements 311

Table 3 Overlap between Hybrid Arrangements and Transfer-Pricing Arrangements

Panel A: Two-Way Table of Frequency Counts HYB TP 0 1 Sum 0 22 7 29 1 41 53 94 Sum 63 60 123 Panel B: Overlap of Three Types of Hybrid Arrangements with Each Other and Transfer-Pricing Arrangements Hybrid Entities Hybrid Securities Hybrid Conversions Total 23 20 44 Thereof Overlap with Other Arrangements Hybrid entities n.a. 5 19 (n = 23) 0.250 0.432 Hybrid securities 5 n.a. 5 (n = 20) 0.217 0.114 Hybrid conversions 19 5 n.a. (n = 44) 0.826 0.250 Transfer pricing 19 15 41 (n = 94) 0.826 0.750 0.932 thereof financing 18 15 36 (n = 61) 0.783 0.750 0.810 thereof IP 2 3 2 (n = 11) 0.087 0.150 0.046 thereof goodwill 0 0 2 (n = 18) 0.000 0.000 0.046 thereof miscellaneous 0 0 4 (n = 11) 0.000 0.000 0.091 No overlap 0 3 0 0.000 0.150 0.000 Notes: Panel A presents a two-way table of frequency counts of hybrid and transfer-pricing arrangements for the 123 LuxLeaks firms. Panel B illustrates the overlaps of three types of hybrid arrangements with each other and transfer-pricing arrangements. Frequencies and relative shares are reported. Numbers are in bold if the overlap is significantly higher than expected (p < 0.1). We use one-tailed binomial tests to assess the significance level. To give an example: Among 123 LuxLeaks firms, 23 firms use hybrid entities and 20 hybrid securities. We would therefore expect (23*20)/123 = 3.7 firms with both arrangements at the same time. The actual number of five firms with both arrangements is not significantly higher than expected (p = 0.320). 312 National Tax Journal arrangements, 56 percent make simultaneous use of hybrid arrangements. The LuxLeaks sample includes inter-affiliate financing (#2,n = 61), intellectual property (IP) arrangements (#13, n = 11), and the capitalization, valuation, and subsequent depreciation of transferred goodwill in the financial services sector (#11,n = 18). Eleven miscellaneous transfer-pricing arrangements, such as profit determination on inter-affiliate factoring or management services (#14) also occur. Panel B of Table 3 shows overlaps of the three types of hybrid arrangements with each other as well as the four types of transfer-pricing arrangements. We use one-tailed binomial tests to assess whether an overlap between two arrangements is significantly higher than expected. Hybrid entities, securities, and conversions have a significantly higher overlap with inter-affiliate financing (i.e., overlaps of 75−81 percent). To give an example: Among 123 LuxLeaks firms, 23 firms use hybrid entities and 61 use inter- affiliate financing. Assuming a random distribution, we would expect (23*61)/123 = 11.4 firms with both arrangements at the same time. The actual overlap of 18 firms is significantly higher than expected p( = 0.035). Inter-affiliate financing arrangements (Figure 3d), which are also referred to as “back- to-back financing,” have the following characteristics: A loan receivable to other group companies equals or almost equals a loan payable of the Luxembourg legal entity. The interest rate on the receivable, however, slightly exceeds the interest rate on the payable (e.g., 7 percent versus 6.875 percent). Concerning the contractual arrangements, the terms and conditions of the payable and receivable are almost equal (e.g., maturity, entitlement to voting rights, profit participation rights, and subordination). Because of that, the Luxembourg entity would realize only a small profit, the so-called margin, on the spread between the interest rate of the receivable and the payable (e.g., 0.125 percent).17 The result is a very low tax burden in Luxembourg. Why do most firms that employ hybrid arrangements also use inter-affiliate financing arrangements? Without the ability to realize a small taxable margin, the hybrid arrangements would lose part of their attractiveness because of an additional tax burden arising in Luxembourg. By contrast, inter-affiliate financing arrangements alone only help to reduce tax burdens both in source countries and in Luxembourg. A tax burden on the interest income in the recipient country still remains. Moreover, non-constant profit repatriations would be generally subject to dividend withholding taxes. Thus, for both scenarios, double non-taxation cannot be achieved. Finally, examining overlaps between hybrid arrangements themselves, we find a significantly higher overlap between hybrid entities and hybrid conversions. Apparently, hybrid entities seem to depend strongly on tax-deductible expenses and elimination of withholding taxes.18 By combining these two arrangements, firms can generally achieve a flexible tax-deduction and mitigation of withholding taxes at the level of the paying entity and simultaneously avoid corresponding taxation at the level of the recipient.

17 The margin may also be higher or lower as discussed in the literature (e.g., Marian, 2017). Luxembourg levied an aggregated corporate statutory tax rate of roughly 29 percent on such profits. 18 Existing literature (Kleinbard, 2011) illustrates such dependencies, taking the example of the “Double Irish” tax arrangement, which U.S. technology firms in particular have been using for a while. Assessing the Tax Benefits of Hybrid Arrangements 313

V. eMpirical Research Design

A. d-in-D Design This section aims to examine ETR reductions related to hybrid arrangements that MNCs implemented in Luxembourg. Our basic research design follows a D-in-D methodology (Clair and Cook, 2015). The D-in-D estimator enables us to assess differences between the LuxLeaks and the matched control firms while accounting for general changes over time that might affect tax measures that are not observed in our model (Gallemore, Maydew, and Thornock, 2014). These changes may be country-specific or global macroeconomic forces, changes in the competitive environment in a particular industry, or tax law changes in the countries over time. The D-in-D design, however, is not able to control for unobserved time varying firm-specific characteristics such as executive turnover. We specifically estimate the following equation:

(1) ETRL3*it,0=+ββ12UX ii++ββLUXPOSTL2*it,3UX iiPOST 2*,tiHYB C ++ββ4,LUXPii*5OSTLti5,UX *5POST it* HYBCiC+ ∑ β ontrolsit, C ++YEAR FE ε it, .

We employ three-year average book ETRs as the dependent variable (ETR3), which is the total tax expense from t − 2 to t, divided by the total of pre-tax book income for the same period (Blouin, 2014). This commonly used proxy for tax avoidance is available for publicly listed firms in a worldwide sample and is a widely accepted measure of tax avoidance (e.g., Hanlon and Heitzman, 2010). Research has revealed that public firms are primarily concerned with their book ETR (Blouin, 2014). Moreover, according to Dyreng, Hanlon, and Maydew (2008), long-run ETRs are better proxies for corporate tax avoidance. ETR3 is winsorized at 0 and 1 to make the measure more interpretable. Turning to the explanatory variables, LUX is a time-invariant indicator variable equal to one for the treatment firms, which are thosefi rms that are part of the LuxLeaks database, and zero for the control firms. We assume that the ruling year offered by the LuxLeaks database corresponds to the year of implementation of the underlying tax arrangement (i.e., the event). POST is an indicator variable set equal to one for both LuxLeaks and control firms in the years following this event. We simultaneously look at two time periods to differentiate between temporary and continuous ETR changes. A two-year period (POST2) reflects temporary ETR changes, while taking into account that most tax arrangements’ benefits need some time to become evident. A five-year period (POST5) is intended to capture ETR changes that arise consistently after implementing an arrangement. Interaction terms of LUX and POST thus reflect changes in ETRs among all LuxLeaks firms in the years following the event. We are specifically interested in the triple interaction terms LUX*POST*HYB, which aim to assess additional changes of hybrid arrangements among LuxLeaks firms compared to other tax arrangements. If β3 and β5 were significantly negative, this would indicate additional 314 National Tax Journal

ETR reductions through hybrid arrangements. Finally, year dummies (YEAR) capture time-specific effects in the years following the event and account for further changes throughout the whole period of investigation.19 We include several firm characteristics that could influence a firm’sETR3 (Table 4). Firm size (SIZE), measured as the natural logarithm of total assets accounts for size effects. We use return on assets (ROA) to measure a firm’s profitability. Leverage (LEV) controls for the impact of a company’s capital arrangement. Intangible assets (INTAN) and the firm’s capital intensity (CAP_INT) represent standard control variables in tax avoidance literature. Given that some arrangements relate to major restructurings that might affect the firms’ ETR3, we control for acquisition intensity (ACQ_INT). Since all firms are MNCs, we do not control for the existence of foreign income. All financial variables are taken from Compustat North America and Compustat Global. We employ regressions with firm fixed-effects and bootstrapped standard errors with 10,000 replications.20 Fixed-effects regressions dummy out the time-invariant LUX term and capture the effect of all time-invariant variables such as country, industry, and management attitudes on firms’ tax outcomes. All variables are defined in Table 4.

B. pSM Approach Our design is hindered by the fact that the treatment is not an exogenous shock; instead, it is an endogenous event. Firms decide whether to implement tax arrangements in a tax haven such as Luxembourg. Following Clair and Cook (2015), we aim to reduce selection bias by matching LuxLeaks firms to control firms that are as similar as possible in the year before the event. Admittedly, our approach only helps find a control group based on observable variables. Unobservable variables such as shareholder composition or group structure are likely to contribute to selection bias as well. The control group is generated with a one-to-one nearest-neighbor PSM in the financial year prior to the ATR. We retain those matched firms throughout all tests. Following Graham and Tucker (2006), one-to-one matching should ensure that the analysis is not dominated by firms which have a large number of appropriate matches (as in the case of most U.S. firms). In creating the control group, we use all firms from Compustat North America and Com- pustat Global database with available financial data during the entire investigated period. These data are merged with Orbis and 10-K data about the firms’ subsidiaries. As a first step, a probit model serves to estimate the probability of becoming a LuxLeaks firm (i.e., the propensity score) (Rosenbaum and Rubin, 1983). The probit model includes the proxy for tax avoidance (ETR3), the control variables of the D-in-D design (SIZE, ROA, LEV, INTAN, ACQ_INT, CAP_INT), and country, industry, and year fixed effects (Appendix).

19 We do not include separate dummies for POST2 and POST5 and use year fixed effects instead. Including POST terms and year fixed effects at the same time does not change the results. 20 The bootstrap is a resampling method to approximate standard errors, confidence intervals, and p-values for test statistics. Using 10,000 bootstrap samples leads to accurate approximations of standard errors (Hesterberg, 2015). Additionally, we test cluster-robust standard errors at firm-level and find similar results. Assessing the Tax Benefits of Hybrid Arrangements 315

Table 4 Variable Measures and Description

Variable Measures Description Source ETR3 Three-year total tax expense (TXT) over the period t − 2 to Compustat t, divided by three-year pre-tax income (PI) over the same period. ETR1 Annual total tax expense (TXT) divided by annual pre-tax Compustat income (PI). CUR_ETR1 Annual current tax expense (TXC) divided by annual pre-tax Compustat income (PI). lux Indicator variable equal to one, if the firm is part of the Lux- ICIJ database Leaks database (i.e., a LuxLeaks firm) and zero otherwise. POST2 Indicator variable equal to one, for both the LuxLeaks and ICIJ database matched control firms, in the two years after the event, and zero otherwise. POST5 Indicator variable equal to one, for both the LuxLeaks and ICIJ database matched control firms, in the five years after the event, and zero otherwise. HYB Indicator variable equal to one for both the LuxLeaks and Own control firm, if the LuxLeaks firm used hybrid arrangements, and zero otherwise. HYB_SEC_ENT Indicator variable equal to one for both the LuxLeaks and Own control firm, if the LuxLeaks firm used hybrid securities or entities, and zero otherwise. HYB_CON Indicator variable equal to one for both the LuxLeaks and Own control firm, if the LuxLeaks firm used hybrid conversions, and zero otherwise. TP Indicator variable equal to one for both the LuxLeaks and Own control firm, if the LuxLeaks firm used transfer-pricing -ar rangements, and zero otherwise. intAN Intangible assets (INTAN) scaled by total assets (AT). To Compustat maximize the sample, the variable is set to zero if the data are missing (Dyreng and Lindsey, 2009). roa Pre-tax income (PI) divided by total assets (AT). Compustat size Natural log of total assets (AT). Compustat lev Long-term debt (DLTT) scaled by total assets (AT). To Compustat maximize the sample, the variable is set to zero if the data are missing (Dyreng and Lindsey, 2009). CAP_INT Net property, plant, and equipment (PPENT) scaled by total Compustat assets (AT). ACQ_INT Acquisitions (ACQ) scaled by total assets (AT). The variable Compustat is set to zero if the data are missing. YEAR Year dummies. Compustat 316 National Tax Journal

As a second step, we use a one-to-one nearest neighbor matching and match each LuxLeaks firm to one control firm with the closest propensity score. To ensure an adequate level of similarity between the LuxLeaks and the control firms, we employ a caliper of 0.5.21 We require that each control firm have its headquarters (LOC), and thus its tax residency, in the same country as the corresponding LuxLeaks firm, and be in the same industry as outlined in the Fama and French 17-industry classification (French, 2017). The tax avoidance potential largely depends on the existence of foreign operations. In contrast to Compustat North America, Compustat Global does not offer information on foreign income. We therefore merge Compustat data with Orbis and 10-K data (Dyreng and Lindsey, 2009) about subsidiaries to determine whether a firm is a multinational. In detail, we classify firms as multinational if at least one of the following requirements is fulfilled: (1) reporting of foreign income (PIFO) according to Compustat North America database, (2) at least one directly or indirectly held majority-owned subsidiary outside their home country according to Orbis data,22 or (3) disclosure of at least one material subsidiary outside their home country according to “Exhibit 21” of form 10-K. We match LuxLeaks firms only to multinational firms which meet these criteria.23 The final sample consists of a panel of 123 LuxLeaks and 123 matched control firms over the period from 2000 to 2015. When combining D-in-D and a matching strategy, a balanced panel prevents sample attrition from affecting the results. We ensure that treatment and control firms have the same year-observations in all tests. Therefore, we delete firm-year observations of control firms if the corresponding LuxLeaks firm has missing data in that year (121 observations). From the remaining observations, we further exclude a firm’s and the matching firm’s corresponding firm-year observations if the denominator of ETR3 is negative. The final sample consists of 2,920 firm-year observations.

VI. Results

A. descriptive Evidence and Univariate Analyses Table 5 reports the descriptive statistics for both the LuxLeaks and the control group for the event year. Distributions of all variables are very similar between the groups; all

21 Although Austin (2011) suggests that a caliper of 0.2 is optimal, he shows that a caliper of 0.5 still leads to adequate results when it comes to reduction in bias and mean squared error. Moreover, a narrow caliper can result in a small number of appropriate matches and bias the estimation, because the effect of treatment is not estimated, but rather the effect of treatment in those subjects for whom we find appropriate matches (Lunt, 2014). As a robustness test, we apply a caliper of 0.2 and find similar effect patterns in our later regression analyses. 22 Orbis data are static. We approximate foreign subsidiaries in the matching year according to the financial year 2016. 23 With one exception, all LuxLeaks firms are multinationals according to these criteria. Manual research on this firm’s website also reveals the existence of foreign operations. Assessing the Tax Benefits of Hybrid Arrangements 317 p -val. 0.718 0.898 0.769 0.959 0.179 0.484 0.836 0.797 0.624 t-test p s > 0.1). SD 0.137 0.182 0.232 0.200 0.069 2.508 0.167 0.206 0.036 P50 0.272 0.250 0.194 0.053 0.030 19.170 0.150 0.102 0.000 Control Firms ned in Table 4. All of the continuous 4. All of the variables Table are de fi ned in fi rms. 0.253 0.254 0.210 0.159 0.046 19.192 0.196 0.161 0.018 mean CUR_ETR1 are winsorized at 0 and 1 and firm-year observations with negative able 5 T Descriptive Statistics Descriptive ETR3 , and SD 0.184 0.187 0.246 0.195 0.064 2.471 0.173 0.203 0.052 ETR1 , P50 0.250 0.232 0.160 0.052 0.040 19.434 0.157 0.078 0.000 LuxLeaks Firms 0.262 0.257 0.198 0.158 0.059 19.445 0.201 0.154 0.021 mean fi rms, that is, LuxLeaks firms, and their 123 matched control Variable ETR3 is com - sample The year). matching (i.e., event the to prior year the in analyses the used in variables for the statistics descriptive presents table This Notes: posed of 123 treatment variables are winsorized at the 1st and 99th percentiles. 99th and 1st the at winsorized are variables between both groups for all dependent and control variables (all reveal no significant differences T-tests pre-tax income were excluded. ETR1 CUR_ETR1 INTAN ROA SIZE LEV CAP_INT ACQ_INT 318 National Tax Journal t-statistics are nonsignificant, suggesting that the matching procedure was successful (all ps > 0.1). In particular, both groups show a comparable level of tax avoidance before requesting the ATR in Luxembourg (ETR3Lux = 0.253, ETR3Control = 0.262, p = 0.718). We therefore account for the fact that tax avoiders may self-select into implementing tax arrangements in a tax haven. Variance inflation factors (VIFs) of less than 1.37 indicate that multicollinearity should not affect the results. Figure 4 shows mean ETR3 for LuxLeaks and control firms in the event time for (1) the whole sample and (2) a subsample of LuxLeaks firms that employed hybrid arrangements. In contrast to the whole sample, the 60 LuxLeaks firms with hybrid arrangements seem to experience a substantial and long-term decrease in their ETR3 compared to control firms. These findings emphasize that the hybrid element is the main source of ETR reductions, at least in this setting. The following figures then differentiate between (3) firms with hybrid securities and entities that provide for double non-taxation or long- term tax deferral and (4) firms with hybrid conversions that mainly avoid withholding taxes. Hybrid securities and hybrid entities yield stronger ETR reductions for longer periods compared to hybrid conversions.

B. Multivariate Analyses

1. Benefits of Hybrid Arrangements In a first step, we examine ETR3 reductions following the implementation of tax arrangements in Luxembourg in general and the implementation of hybrid arrangements in particular (event). In our specification, we simultaneously examine short- term (LUX*POST2) and long-term (LUX*POST5) changes in ETR3 after the event for all LuxLeaks firms and additional short-term (LUX*POST2*HYB) and long-term (LUX*POST5*HYB) changes in ETR3 for LuxLeaks firms that employed hybrid arrangements. The coeffcients of primary interest in the following multivariate estimation are β3 and β5. A negative β3 (β5) would indicate an additional short-term (long-term) decrease of ETR3 after the event for firms with hybrid arrangements relative to control firms over the same period. When interpreting the coefficients, we have to keep in mind that the dependent variable is a three-year ETR measure. Thus, newly implemented tax arrangements should have only a gradual effect on these ETRs. For instance, ETRs that directly follow the ATR request are still influenced by pre-ATR periods.24 Table 6 reveals neither short-term nor long-term reductions in ETR3 for all LuxLeaks firms across all specifications. Looking at additional tax benefits of hybrid arrangements, we find a decrease inETR3 of about 6.1 percent during a long-term period after the event (p = 0.031) (column 4). Accordingly, implementing hybrid arrangements seems to be an effective way to decrease ETRs, superior to other tax arrangements. The coefficient for LUX * POST2 * HYB is only significantly negative if we run a separate specification for a two-year period only (column 5). Long-term benefits are plausible since, except

24 We additionally test annual ETRs in the robustness tests. Assessing the Tax Benefits of Hybrid Arrangements 319

Figure 4 ETR3 for LuxLeaks and Control Firms

(1) All firms .4

.35 R3

.3 Mean ET

.25

.2 –4 –3 –2 –1 0 1 2 3 4 5

LUXCONTROL

(2) Firms with hybrid arrangements .4

.35 R3 .3 Mean ET

.25

–4 –3 –2 –1 0 1 2 3 4 5

LUXCONTROL 320 National Tax Journal

Figure 4 (Continued) ETR3 for LuxLeaks and Control Firms

(3) Firms with hybrid securities and entities .4

.35 R3 .3 Mean ET .25

–4 –3 –2 –1 0 1 2 3 4 5

LUXCONTROL

(4) Firms with hybrid conversions .4

.35 R3 .3 Mean ET .25

–4 –3 –2 –1 0 1 2 3 4 5

LUXCONTROL

Notes: The ﬁgures plot the mean ETR3 for LuxLeaks (LUX) and control ﬁrms (CONTROL) in the event time both for the entire basic sample and for subsamples. The y-axis denotes the ETR3. The x-axis denotes the year through which the ETR3 was calculated, with year 0 being the event year. ETR3 is measured as three-year average total tax expense divided by three-year average pre-tax income. Assessing the Tax Benefits of Hybrid Arrangements 321

Table 6 Benefits of Hybrid Arrangements

(1) (2) (3) (4) (5) (6) (7) Dependent Variable etr3 etr3 etr3 etr3 etr3 etr3 ETR3 LUX n.a. n.a. n.a. n.a. n.a. n.a. n.a.

LUX*POST2 −0.015 −0.015 −0.015 −0.015 0.003 −0.045** (0.014) (0.019) (0.014) (0.019) (0.019) (0.018)

LUX*POST2*HYB −0.001 −0.001 −0.049** 0.014 (0.023) (0.024) (0.021) (0.024)

LUX*POST5 −0.010 0.020 −0.011 0.022 0.016 0.028 (0.018) (0.025) (0.018) (0.025) (0.023) (0.020)

LUX*POST5*HYB −0.056** −0.061** −0.062** −0.083*** (0.029) (0.028) (0.024) (0.027)

INTAN −0.021 −0.019 −0.019 −0.020 0.005 (0.069) (0.069) (0.069) (0.068) (0.008)

ROA −0.307** −0.320*** −0.313*** −0.320*** −0.171*** (0.122) (0.122) (0.121) (0.118) (0.012)

SIZE −0.000 −0.001 −0.001 −0.001 0.012*** (0.008) (0.008) (0.008) (0.008) (0.001)

LEV 0.066 0.068 0.066 0.069 0.021*** (0.050) (0.050) (0.050) (0.051) (0.006)

CAP_INT 0.195** 0.195** 0.193** 0.196** 0.041*** (0.085) (0.086) (0.085) (0.088) (0.006)

ACQ_INT −0.048 −0.052 −0.049 −0.052 −0.046*** (0.057) (0.055) (0.057) (0.055) (0.010)

Constant 0.306*** 0.306*** 0.296* 0.307* 0.303* 0.308** 0.073*** (0.011) (0.011) (0.157) (0.157) (0.157) (0.156) (0.014)

Firm fixed effects Yes Yes Yes Yes Yes Yes Yes Year fixed effects Yes Yes Yes Yes Yes Yes Yes Observations 2,920 2,920 2,920 2,920 2,920 2,920 350,175 R-squared 0.047 0.053 0.067 0.074 0.069 0.074 0.017 Number of firms 246 246 246 246 246 246 46,285 Notes: Columns 1−6 present the results of FE regressions of ETR3 on independent and control variables for the basic sample. Column 7 presents the results of FE regressions using all firms from Compustat North America and Compustat Global with available data. ETR3 is the three-year average total tax expense divided by three-year average pre-tax income. All other variables are as defined in Table 4. We use bootstrapped standard errors with 10,000 replications (in parentheses). *** denotes significance at the 1 percent level, ** denotes significance at the 5 percent level, and * denotes significance at the 10 percent level, all for two-tailed tests. 322 National Tax Journal for a small subgroup of hybrid conversions that provide for occasional withholding tax reductions, all hybrid arrangements should work continuously after their implementation. Finally, we assess the relevance of our matching approach and run the estimation for all firms from Compustat North America and Compustat Global instead of using the matched sample (column 7). Again, results show a strong and significant long-term decrease in ETR3 for LuxLeaks firms with hybrid arrangements. However, we do detect a significant additional short-term decrease inETR3 for all LuxLeaks firms. This implies that our matching approach at least partially accounts for potential self-selection by LuxLeaks firms when it comes to tax avoidance.

2. Comparison of Different Hybrid Arrangements Our classification reveals three main types of hybrid arrangements: hybrid entities, hybrid securities, and hybrid conversions. Whereas the first two types (HYB_SEC_ENT) are likely to provide for double non-taxation and long-term tax deferral, respectively, the third type (HYB_CON) aims to avoid withholding tax on repatriations. In the following, we aim to disentangle tax benefits of these two groups and estimate the following equation:

(2) ETRL3*it,0=+ββ12UX ii++ββLUXPOSTL2*it,3UX iiPOST 2*,tiHYBC_ ON

++ββ4,LUXPii*2OSTHti*_YB SECE_*NT 5,LUXPiiOST5 t

++ββ6,LUXPii*5OSTHti*_YB CONL7,UX ii*5POST t C *_HYBSEC _.ENTCiC++∑ βεontrolsit,,YEAR FE + it C Table 7 shows that hybrid securities and entities are associated with long-term ETR reductions (β7 = −0.051, p = 0.063). These instruments seem to be the main driver of long-term tax benefits, which is reasonable given their potential to provide for continuous double non-taxation. We do not detect any short-term reductions that are different from the long-run reductions in all specifications. Turning to hybrid conversions, the pattern is less obvious. In contrast to the former group, there is some evidence for additional short-term tax benefits (e.g., column 1). In the full specification (column 3), we find a marginally significant ETR reduction within a short-time horizon (b3 = −0.033, p =

0.179) and long-time horizon (b3 = −0.034, p = 0.235). Short-term benefits might result from hybrid conversions such as alphabet shares or CPECs that repatriate high profits without withholding tax on an occasional basis. However, given the small sample size and related statistical power issues, we need to be careful drawing definite conclusions.

3. Comparison of Hybrid and Transfer-Pricing Arrangements Since hybrid arrangements often coincide with transfer-pricing arrangements, we additionally include the triple interaction terms LUX*POST2*TP and LUX*POST5*TP in equation (1). This procedure is intended to ensure that we do not misattribute to hybrid arrangements tax benefits arising from transfer pricing. Like the variable HYB, TP represents a dummy variable, which takes the value one for the LuxLeaks and corresponding control firm if the LuxLeaks firm employed transfer-pricing arrangements. Assessing the Tax Benefits of Hybrid Arrangements 323

Table 7 Comparison of Different Hybrid Arrangements

(1) (2) (3) Dependent Variable etr3 etr3 etr3 LUX n.a. n.a. n.a. LUX*POST2 0.008 −0.009 (0.018) (0.018) LUX*POST2*HYB_CON −0.060*** −0.033 (0.020) (0.025) LUX*POST2*HYB_SEC_ENT −0.022 0.017 (0.020) (0.023) LUX*POST5 0.016 0.020 (0.022) (0.024) LUX*POST5*HYB_CON −0.047** −0.034 (0.024) (0.029) LUX*POST5*HYB_SEC_ENT −0.044* −0.051* (0.023) (0.027) INTAN −0.018 −0.021 −0.019 (0.069) (0.067) (0.067) ROA −0.315*** −0.322*** −0.322*** (0.122) (0.122) (0.121) SIZE −0.001 −0.001 −0.001 (0.008) (0.008) (0.008) LEV 0.066 0.070 0.068 (0.051) (0.051) (0.051) CAP_INT 0.194** 0.197** 0.197** (0.086) (0.086) (0.086) ACQ_INT −0.052 −0.052 −0.052 (0.055) (0.056) (0.057) Constant 0.304* 0.310** 0.306* (0.158) (0.158) (0.159) Firm fixed effects Yes Yes Yes Year fixed effects Yes Yes Yes Observations 2,920 2,920 2,920 R-squared 0.071 0.076 0.077 Number of firms 246 246 246 Notes: This table presents the results of FE regressions of ETR3 on independent and control variables for the basic sample. ETR3 is the three-year average total tax expense divided by three-year average pre-tax income. All other variables are as defined in Table 4. We use bootstrapped standard errors with 10,000 replications (in parentheses). *** denotes significance at the 1 percent level, ** denotes significance at the 5 percent level, and * denotes significance at the 10 percent level, all for two-tailed tests. 324 National Tax Journal

The triple interaction term LUX*POST5*HYB remains highly significant after controlling for TP arrangements (Table 8, columns 1−3). TP arrangements alone do not provide additional tax benefits compared to all tax arrangements, as indicated by the nonsignificant triple interaction terms. We can therefore mitigate concerns that the observed ETR3 reductions result from the transfer-pricing element alone instead of the hybrid element.

VII. additional Analyses

A. robustness Tests and Further Measures One concern in our D-in-D design is that it captures preexisting trends rather than an actual association between the tax arrangement and ETR3 reductions. To check for such confounding trends, we use a placebo test (Li and Tang, 2016) in which we incorrectly assign the treatment to two years before the actual event. The coefficients for the triple interaction terms LUX*POST2*HYB and LUX*POST5*HYB are no longer significant.25 Thus, a preexisting trend is unlikely to have driven decreasing ETRs among LuxLeaks firms. A critical assumption in our D-in-D design is that the event is the year in which the firm first implemented the underlying tax arrangement. However, some ATRs indicate that the firm had previous ATRs in Luxembourg even though information on their content is often missing. Therefore, we delete 38 LuxLeaks firms and their partners which had previous ATRs more than one year before the actual event. By examining this subsample, we aim to distinguish firms requesting ATRs for the first time in Lux- embourg from those with previous ties to Luxembourg. Column 4 of Table 8 provides the results of the estimation with the remaining LuxLeaks and control firms. As one would expect, for hybrid arrangements the findings reveal a slightly larger decrease of 7.1 percent in ETR3 after the event. The large proportion of financial firms in the sample is not very common in profit- shifting studies. With a few exceptions that focus on profit shifting among banks (e.g., Heckemeyer and de Mooij, 2017; Langenmayr and Reiter, 2017), researchers often exclude banks because the banking industry is significantly different in terms of tax planning. In another robustness check, we estimate equation (1) without the LuxLeaks banks (i.e., firms in industry 45 of the Fama French 49 industry classification) and their corresponding control firms. Column 5 shows that firms’ETR3 decreases by 6.4 percent after the implementation of a hybrid arrangement, which is 0.3 percentage points higher than the whole sample. This research relies on long-term ETRs because they capture tax avoidance more appropriately. However, annual ETRs have the advantage of measuring the effect after the event without being influenced by prior years. For instance, ETR3 in year 1 after

25 In detail, the coefficient is 0.005 (p = 0.840) for the term LUX*POST2*HYB and 0.019 (p = 0.437) for the term LUX*POST5*HYB. Assessing the Tax Benefits of Hybrid Arrangements 325 (9) variables are as variables n.a. Yes Yes Yes 158 1,748 0.097 0.004 0.055 etr 3 −0.030 (0.047) (0.035) (0.045) (0.029) −0.103** A ll without Luxembourg/ PSM with Control Firms Netherlands Subsidiaries (8) n.a. Yes Yes Yes 198 2,362 0.081 0.041 etr 3 −0.020 −0.017 (0.030) (0.027) (0.027) (0.021) −0.050* Subsidiaries Luxembourg Luxembourg Firms without PSM with Control (7) All n.a. Yes Yes Yes 232 0.011 2,518 0.093 0.037 Firms −0.042 −0.005 (0.030) (0.034) (0.024) (0.027) cur _ etr 1 CUR_ETR1 respectively, for the basic sample. Columns 8−9 present ETR1, (6) All n.a. Yes Yes Yes 244 2,960 0.055 0.009 etr 1 Firms −0.027 (0.024) (0.028) (0.019) (0.020) 0.038** −0.046*

(5) n.a. Yes Yes Yes 200 2,396 0.081 0.031 etr 3 Banks −0.015 −0.004 (0.034) (0.026) (0.031) (0.021) Without Without −0.064* able 8 T Robustness Tests Robustness Tests (4) n.a. Yes Yes Yes 170 2,058 0.062 0.032 0.004 etr 3 −0.017 (0.036) (0.027) (0.032) (0.021) −0.070* Basic Sample Luxembourg Known ATRs in Known ATRs Without Previous Without for the basic sample when controlling for transfer-pricing arrangements. Columns 4−5 present the results of FE of results the present 4−5 Columns arrangements. transfer-pricing for controlling when sample basic the for ETR3 (3) All n.a. Yes Yes Yes 246 2,920 0.076 0.037 0.002 0.002 etr 3 Firms −0.023 −0.024 (0.034) (0.027) (0.024) (0.024) (0.039) (0.022) −0.057** (2) All n.a. Yes Yes Yes 246 2,920 0.075 0.036 etr 3 Firms −0.032 (0.032) (0.022) (0.038) −0.056** (1) All n.a. Yes Yes Yes 246 2,920 0.070 0.031 etr 3 Firms −0.042 (0.020) (0.027) (0.030) −0.042** ETR3 for different subsamples. Columns 6−7 present the results of FE regressions of for two further control samples without subsidiaries in Luxembourg, respectively, in Luxembourg and the Netherlands. in Luxembourg respectively, the results of FE regressions ETR3 for two further control samples without subsidiaries in Luxembourg, We use bootstrappedTable standard 4. defined errors in with 10,000 replications (in parentheses). *** denotes significance at the 1 percent level, ** denotes significance at the 5 percent level, and * denotes significance at the 10 all for two-tailed tests. Notes: Columns 1−3 present the results of FE regressions of regressions FE of results the present 1−3 Columns Notes: of regressions Firm fixed effects fixed effects Year Observations R-squared Number of firms Controls LUX*POST5*TP LUX*POST2*TP LUX*POST5*HYB LUX*POST5 LUX*POST2 LUX*POST2*HYB LUX Dependent Variable Dependent 326 National Tax Journal the event captures the average ETR of the year prior to the event, the event year, and year 1. Therefore, we replicate the estimations with annual book ETR (ETR1) (Hanlon and Heitzman, 2010).26 As with ETR3, column 6 shows that firms achieve a decrease in their ETR1 by 4.6 percentage points within a long-term period after the event (p = 0.053). The lower decrease is likely attributable to the higher volatility of an annual ETR measure. Thus, our prior findings do not seem to result exclusively from the impact of the years before the event. Measures that rely on total tax expense are not affected by a tax strategy that defers taxes (Blouin, 2014; Hanlon and Heitzman, 2010). Thus, in an international sample, we additionally test a measure based on current income tax expense, which is an adequate book approximation of total worldwide cash taxes paid (Markle and Shackelford, 2012b). CUR_ETR1 represents the annual current tax expense scaled by annual pre-tax income. In a territorial system, hybrid arrangements should decrease total taxes paid without triggering compensating effects through deferred taxes. Decreasing deferred tax liabilities could occur, however, if existing deferred tax liabilities for withholding taxes on future repatriations are eliminated because of a hybrid conversion. In a worldwide tax system, MNCs generally can achieve a long-term deferral of tax payments without compensating deferred tax liabilities if, as in the case of the United States, earnings are declared permanently reinvested abroad. Column 7 reveals a decrease of CUR_ETR1 by 4.1 (p = 0.165) among LuxLeaks firms that employed hybrid arrangements. The higher volatility of current tax expense and a loss of about 15 percent of all firm-year observations due to missing data for that variable might explain why the coefficient is smaller and only marginally significant based on two-tailed tests.

B. alternative Control Groups The LuxLeaks database does not reveal all ATRs that Luxembourg tax authorities issued during the period of investigation. It is possible that some control firms had similar arrangements within that period in Luxembourg. While we cannot directly observe whether the control firms had such arrangements because of tax secrecy regulations, we are able to at least find a proxy for whether a firm had a physical presence in Luxembourg. Orbis provides reliable information on firms’ subsidiaries, including shares and loca- tion. Nevertheless, the database suffers from somewhat less comprehensive coverage of U.S. firms. For this group, we additionally make use of 10-K data as provided by Dyreng and Lindsey (2009). Item 601 of SEC Regulation S-K (§229.601) requires the disclosure of all significant subsidiaries in Exhibit 21 to Form 10-K for SEC-listed firms. We acknowledge that our approach has some drawbacks. Orbis data are static, and we infer a residency in Luxembourg during our period of examination according to subsidiaries in 2016. Regarding Item 601, these data are non-static, but we have to keep in mind that this regulation offers some discretion, because firms can declare their subsidiaries as nonsignificant. Before replicating our one-to-one nearest neighbor PSM

26 Again, we delete observations with negative denominators, as well as the corresponding matching partner’s firm-year observation. Assessing the Tax Benefits of Hybrid Arrangements 327 procedure outlined in Section V, we exclude all potential control firms that have at least one subsidiary in Luxembourg during our examination period. We find appropriate matching partners for 99 LuxLeaks firms. Prior literature (e.g., Gravelle 2009; van ´t Riet and Lejour, 2017) describes the Neth- erlands as a comparable tax haven. Even if control firms were not engaged in Luxem- bourg, they could have benefitted from similar tax arrangements in that country. For the second alternative sample, we delete potential control firms with subsidiaries in either Luxembourg or the Netherlands prior to the PSM and find 79 appropriate control firms. As outlined in columns 8 and 9 of Table 8, ETR3 decreases within a five-year period among LuxLeaks firms that employed hybrid arrangements in both samples. In sum- mary, we carefully conclude that control firms that could have had similar arrangements during the period of investigation do not affect our D-in-D design.

VIII. Conclusion Based on the LuxLeaks database, we investigate how firms avoid taxes via hybrid arrangements as well as related ETR reductions, and thereby are the first to empirically assess the benefits of hybrid arrangements. Analyzing ATRs from 123 LuxLeaks firms reveals the frequent use of hybrid arrangements. These arrangements could result in (1) double non-taxation or long-term deferral of income generated in source countries and (2) mitigation of withholding taxes on repatriations to offshore tax havens. Using a D-in-D design, we provide evidence that hybrid arrangements lead to continuous and substantial ETR reductions, whereas the other tax arrangements found in the LuxLeaks database, such as transfer pricing, do not. However, transfer-pricing arrangements support the efficient use of hybrid arrangements, as they help to reduce taxable margins in source and conduit countries. Moreover, hybrid securities and hybrid entities seem to be the main driver of continuous ETR reductions. Our results remain qualitatively unchanged through multiple robustness checks. Overall, our findings provide empirical support for the tax benefits of hybrid arrangements outlined in prior theoretical research (e.g., Johannesen, 2014; Spengel et al., 2016). These benefits could to some degree explain why MNCs that use subsidiaries in tax havens experience lower ETRs (Dyreng and Lindsey, 2009; Markle and Shack- elford, 2012a, 2012b). Moreover, Saunders-Scott (2015) shows that, when it comes to profit shifting, transfer pricing and debt are substitutes. Our legal analysis extends this understanding insofar as it shows that some MNCs use hybrid arrangements, transfer pricing, and debt as complementary arrangements. Given their substantial tax avoidance potential, future research should deepen understanding of hybrid arrangements. In particular, there is a need to advance innovative datasets that enable hybrid arrangements to be studied on a larger scale. Confidential data on mandatory disclosure of tax avoidance schemes could potentially represent a valuable source of information in this regard. Turning to regulatory implications, one option to tackle hybrid arrangements consists of neutralizing their tax outcome. The OECD (2015) offers automatic linking rules that neutralize the effects of hybrid securities and entities by means of Action 2 of the Base Erosion and Profit Shifting (BEPS) project. The OECD, for instance, recommends 328 National Tax Journal that countries deny the taxpayer’s deduction for a payment to the extent that it is not included in the taxable income of the recipient in the other jurisdiction concerned. From the perspective of source countries, since withholding taxes may serve as a second line of defense for avoiding double non-taxation, policymakers should consider innovative withholding tax proposals (e.g., Fuest et al., 2013). Taking into account that U.S. MNCs tend to be overrepresented in hybrid arrangements, changes to the U.S. tax system could further reduce their attractiveness.27 Grubert and Altshuler (2013) have developed several proposals in this regard. For instance, repealing the “Check-the-Box” regulation would create fewer opportunities for internationally deviating classifications of organizational forms. This research is subject to several limitations. We focus on arrangements in a specific tax haven country (Luxembourg) at a specific time, which could limit the generalizabil- ity of the results. Given the fact that Luxembourg is, in particular, a conduit financing country (e.g., Mintz and Weichenrieder, 2010), transfer-pricing arrangements often deal with the determination of profit margins on inter-affiliate financing arrangements (e.g., Marian, 2017; ACD, 2016). Further types of transfer-pricing arrangements, such as royalties, could be underestimated in comparison to other tax jurisdictions. Since we base our analysis on ATRs, similar limitations could occur if ATRs are not equally important for different tax arrangements. However, both transfer-pricing and hybrid arrangements are associated with high uncertainty due to necessary judgments and should equally necessitate ATRs. Therefore, we are confident that our research offers important insights into the benefits of hybrid arrangements.

Acknowledgments We would like to thank the editors William M. Gentry and Stacy Dickert-Conlin as well as three anonymous reviewers for very valuable comments and suggestions. Moreover, we appreciate the helpful comments of Christina Elschner, Siegfried Grotherr, Ruth Heilmeier (discussant), Martin Jacob (discussant), Kenneth Klassen, Agnieszka Magdalena Kopec, Andreas Oestreicher, Christian Ott, Jaron Wilde, Jens Wüstemann, Sonja Wüstemann, participants at the Annual Congress of the European Accounting Association 2016, the 3rd Annual MaTax Conference, the 6th Conference on Current Research in Taxation, the 2016 Spring Conference of the Section Business Taxation in the German Academic Association for Business Research (VHB), and two anonymous referees for the Annual Congress of the European Accounting Association 2016 as well as workshop participants at Macquarie University, University of Göttingen, and European University Viadrina. Finally, the authors would like to thank Arne Kosmetschke, Lisa Noerenberg, and Mareike Hinrichs for their research assistance. All errors remain our own. Earlier versions of this paper were entitled “Achieving Tax Certainty and Avoiding Taxes? — Evidence from Luxembourg Tax Rulings” and “Assessing the Benefits and Costs of Tax Haven Rulings – Evidence from the Luxembourg Leaks.”

27 Note that the Tax Cuts and Jobs Act includes among others an anti-hybrid rule. Assessing the Tax Benefits of Hybrid Arrangements 329

DISCLOSURES The authors have no financial arrangements that might give rise to conflicts of interest with respect to the research reported in this paper.

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appendix Results of the PSM Estimation Dependent Variable LUX ETR3 0.063 (0.2579

INTAN 0.045 (0.330)

ROA 0.445 (0.493)

SIZE 0.285*** (0.026)

LEV 0.622** (0.282)

CAP_INT −0.881** (0.382)

ACQ_INT 0.240 (0.967)

Constant −6.052*** (0.783)

Industry fixed effects Yes Country fixed effects Yes Year fixed effects Yes Observations 6,247 Pseudo R-squared 0.308 Notes: This table presents the results of probit estimations of the binary variable LUX on explanatory variables. The probit estimation includes all 130 LuxLeaks firms in the financial year prior to the ATR that meet our selection requirements as well as all potential control firm-year observations. Control firm-year observations are firm-year observations from all multinational firms from Compustat North America and Compustat Global with available financial data from 2000−2015 and industry, country, and year combinations that fit with at least one LuxLeaks firm in the year prior to the ATR. All variables are as defined in Table 4. *** denotes significance at the 1 percent level, ** denotes significance at the 5 percent level, and * denotes significance at the 10 percent level, all for two-tailed tests.