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Internal Debt and Multinational Profit Shifting: Empirical Evidence from Firm-Level Panel Data

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Internal Debt and Multinational Profit Shifting: Empirical Evidence from Firm-Level Panel Data National Tax Journal, March 2013, 66 (1), 63–96 INTERNAL DEBT AND MULTINATIONAL PROFIT SHIFTING: EMPIRICAL EVIDENCE FROM FIRM-LEVEL PANEL DATA Thiess Buettner and Georg Wamser This paper explores the role of internal debt as a vehicle for shifting profi ts to low- tax countries. Using data on German multinationals, it exploits differences in taxes in more than 100 countries over 10 years. The results confi rm that internal debt is used more by multinationals with affi liates in low-tax countries and increases with the spread between the host-country tax rate and the lowest tax rate among all affi liates. However, tax effects are small, suggesting that profi t shifting by means of internal debt is rather unimportant for German fi rms. Further testing indicates that this is partly due to the German controlled foreign corporation (CFC) rule. Keywords: capital structure, multinational corporations, internal debt, corporate taxation, tax planning, profi t shifting, income shifting JEL Codes: H25, G32, F23 I. INTRODUCTION ue to the rising importance of foreign direct investment (FDI) and multinational Dfi rms, international tax issues are of increasing importance for tax policy. As noted in the literature (Gresik, 2001), a multinational corporation has several ways to structure its activities in order to minimize the burden of taxation. This tax planning partly involves conventional decisions to set up fi rms in a tax-effi cient way, for example by using debt rather than equity fi nance. Yet multinational tax planning also involves less conventional practices that exploit the specifi c characteristics of multinationals. In particular, tax planning employs profi t-shifting techniques that only require the adjustment of the internal structure of the multinational fi rm. While there are several possible routes, a prominent strategy involves internal loans: borrowing from affi liates located in low-tax countries and lending to affi liates located in high-tax countries will allow the latter to reduce profi ts by deducting interest payments, which are then taxed Thiess Buettner: Friedrich-Alexander-University, Nuremberg, Germany, and CESifo (Thiess.Buettner@ wiso.uni-erlangen.de) Georg Wamser: University of Tuebingen, Tuebingen, Germany, and CESifo ([email protected]) 64 National Tax Journal as earnings in the low-tax country.1 While several papers document that tax-planning activities have signifi cant effects on the distribution of taxable profi ts of multination- als (Grubert and Mutti, 1991; Hines and Rice, 1994; Huizinga and Laeven, 2008), so far, the empirical literature has not provided direct evidence about the extent to which internal debt is used for profi t-shifting purposes. The extent to which the different ways of profi t shifting are used by multinational fi rms has important implications for business tax reforms. In particular, high-tax coun- tries, suffer from adverse revenue effects and from a discrimination against domestic fi rms that do not have access to international income shifting strategies. These countries need to know about the importance of the different channels of profi t shifting when they consider designing measures to prevent it. Anti-tax-avoidance measures, such as transfer pricing regulations or measures that restrict interest deductibility for internal debt, imply not only a higher tax burden for foreign fi rms, but might cause substantial compliance costs as well as distortions of the fi rms’ decisions. Whether there is a net benefi t associated with such measures depends crucially on the importance of the specifi c channel of profi t shifting addressed by these measures. Clarifying the importance of profi t shifting by means of internal debt will also improve our understanding of the existing empirical evidence on the tax-sensitivity of the capital structure. A number of papers show that the capital structure of multinationals’ affi liates is sensitive to the tax rate in the host country of an affi liate (Jog and Tang, 2001; Mills and Newberry, 2004; Huizinga, Laeven, and Nicodème, 2008; Egger et al., 2010; Møen, Schindler, and Schjelderup, 2010; de Mooij, 2011). Whereas most of the literature has focused on the total debt-to-asset ratio, Altshuler and Grubert (2003), Desai, Foley, and Hines (2004a), Mintz and Weichenrieder (2005) and Ramb and Weichenrieder (2005) fi nd effects of the host-country tax rate on internal debt. Focusing on fl ows rather than stocks, Collins and Shackelford (1998) fi nd that interest payments from foreign affi li- ates respond to taxes. While this empirical literature supports the view that internal debt is sensitive to taxes, the fi ndings do not allow us to draw conclusions on whether and to what extent internal debt is really used for profi t shifting or whether these effects refl ect the conventional tax shelter of debt fi nance. Although the interest deduction results in revenue losses in both cases, this distinction has implications for tax policy. If the conventional tax shelter is the primary motivating factor, restrictions on interest deductibility for related party debt are a potential countermeasure. If profi t shifting drives internal debt fi nance, those restrictions might cause a shift towards other forms of profi t shifting, and lowering or eliminating effective tax-rate differentials relative to other countries is the ultimate remedy. In this context, this paper investigates whether and to what extent internal debt is used by multinational fi rms for profi t-shifting purposes. As has been emphasized in the theoretical literature on profi t shifting, the extent to which a multinational engages in profi t shifting depends not only on the tax burden faced in the host country. It also 1 There are other strategies to shift taxable profi ts to low-tax countries, including transfer pricing (Haufl er and Schjelderup, 2000; Swenson, 2001; Clausing, 2003). Internal Debt and Multinational Profi t Shifting 65 depends on the tax conditions faced by the other entities of the multinational group. More specifi cally, as emphasized by Graham (2003) and Mintz and Smart (2004), a foreign affi liate of a multinational can be expected to use more internal debt if the multinational holds some other corporate entity in a low-tax country and if the spread between the host-country tax rate and the lowest tax rate within the multinational group is large. To test these predictions we use a micro-level panel database of virtually all German multinationals made available for research by the Deutsche Bundesbank (the German Central Bank) that includes virtually all German multinationals. A distinguishing charac- teristic of this dataset is that it reports the actual amount of internal debt between related parties used by foreign affi liates. These data allows us to restrict the focus of the empirical analysis on internal loans from non-German affi liates and to exclude loans granted by the German parent. This focus on interaffi liate borrowing is important because under standard conditions and given the relatively high German tax rates — at least in the period before the 2008 tax reform — there is little reason to expect that German parents use internal loans to foreign affi liates to shift foreign profi ts into Germany. Because the data reports the location of all foreign affi liates of each multinational including corporate entities in tax havens, we can precisely measure the tax incentive for profi t shifting faced by the individual affi liate. This enables us to distinguish multinationals’ profi t shifting from use of the conventional tax shield of debt fi nance. While the dataset has been used previously to test whether foreign subsidiaries rely more on debt fi nance in host countries where tax rates are high (Mintz and Weichenrieder, 2005; Buettner et al., 2009), none of these papers has tested whether the usage of internal debt can be explained by profi t shifting. Our empirical results confi rm that internal debt is used more heavily by multinationals that have some affi liates in low-tax countries. Moreover, we fi nd a robust and signifi cant impact of both the host-country tax rate as well as the lowest tax rate within the multina- tional group on the use of internal debt, indicating that an increase in the spread between the host-country tax rate and the lowest tax rate within the multinational group results in an increase of internal debt. However, even if we focus on majority-owned subsidiaries, the implied tax effects are rather small. Compared with existing empirical evidence on the tax-sensitivity of taxable profi ts, our fi ndings suggest that, on average, internal debt is a rather unimportant vehicle for profi t shifting. One possible explanation is that anti-tax- avoidance provisions curb profi t shifting through the use of internal debt. In accordance with this view, we fi nd that the tax conditions faced by subsidiaries that are subject to the German controlled foreign corporation (CFC) rule — such as subsidiaries in tax havens — have no signifi cant predictive power for the multinationals’ use of internal debt. The paper is organized as follows. In Section II we provide some theoretical back- ground and discuss its empirical implications for internal debt fi nancing. Section III gives a short description of the dataset and discusses the investigation approach. Section IV provides descriptive statistics. The basic results are presented in Section V. Section VI extends the analysis and explores the robustness of the fi ndings to alternative speci- fi cations of the profi t-shifting incentive. We also consider the effects of some specifi c institutional details concerning the tax treatment of the parent company, including CFC rules and double taxation treaties. Section VII provides a summary and concludes. 66 National Tax Journal II. THEORETICAL ISSUES AND EMPIRICAL IMPLICATIONS One general benefi t of debt fi nance is that associated interest expenses are deductible from corporate profi ts, while returns to equity are not.
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