Capital Structure and International Debt Shifting
Author: Harry Huizinga1, Mr. Luc Laeven, and Gaëtan Nicodème
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Authors’ E-Mail Addresses: H.P.Huizinga@uvt.nl, llaeven@imf.org, and Gaetan.Nicodeme@cec.eu.int
Publication Date:
01 Feb 2007
ISBN:
9781451866032
Language:
English
Keywords:
WP; capital structure; multinational firm
Download PDF (162.7 KB)

This paper presents a model of a multinational firm's optimal debt policy that incorporates international taxation factors. The model yields the prediction that a multinational firm's indebtedness in a country depends on a weighted average of national tax rates and differences between national and foreign tax rates. These differences matter because multinationals have an incentive to shift debt to high-tax countries. The predictions of the model are tested using a novel firm-level dataset for European multinationals and their subsidiaries, combined with newly collected data on the international tax treatment of dividend and interest streams. Our empirical results show that corporate debt policy indeed not only reflects domestic corporate tax rates but also differences in international tax systems. These findings contribute to our understanding of how corporate debt policy is set in an international context.

Abstract

This paper presents a model of a multinational firm's optimal debt policy that incorporates international taxation factors. The model yields the prediction that a multinational firm's indebtedness in a country depends on a weighted average of national tax rates and differences between national and foreign tax rates. These differences matter because multinationals have an incentive to shift debt to high-tax countries. The predictions of the model are tested using a novel firm-level dataset for European multinationals and their subsidiaries, combined with newly collected data on the international tax treatment of dividend and interest streams. Our empirical results show that corporate debt policy indeed not only reflects domestic corporate tax rates but also differences in international tax systems. These findings contribute to our understanding of how corporate debt policy is set in an international context.

I. Introduction

In most countries, interest expenses are deductible for corporate tax purposes, while dividends have to be paid out of net-of-tax corporate income. Most tax systems thus favor debt finance over equity finance, but to different degrees given the dispersion in top corporate tax rates. In determining their financial structure, purely domestic firms have to deal only with the domestic tax system. Multinational firms, however, face the more complicated choice of determining their overall indebtedness and the allocation of their debts to the parent firm and the subsidiaries across all countries in which the multinational operates. As a consequence, the financial structure of a multinational firm is expected to reflect the tax systems of all the countries where it operates.

In an international setting, the tax costs of debt and equity finance depend on the combined tax systems of the subsidiary and parent countries of the multinational firm. Dividends, as indicated, have to be paid out of the subsidiary’s income after subsidiary-country corporate tax and in addition may be subject to a nonresident dividend withholding tax in the subsidiary country. In the parent country, the dividend income may again be subject to corporate income tax. If so, double tax relief may or may not be provided for the previously paid corporate income and nonresident withholding tax. The tax costs of equity finance thus reflect tax rates as well as the double-tax-relief convention used by the parent country. This paper collects detailed information on all of these aspects of the international tax system for European multinationals.

A firm’s financial policies are affected by tax as well as nontax considerations. A nontax consideration is that indebtedness of the overall multinational firm should not be too high to keep the probability of costly bankruptcy low. In contrast, an advantage of debt finance is that it reduces the free cash flow within the firm and hence can act as a disciplining device for otherwise overspending managers. The disciplining properties of debt finance can explain generally positive debt levels at each of a multinational’s individual establishments (i.e., its parent company and its foreign subsidiaries). These various considerations give rise to an optimal overall capital structure for the overall multinational firm for nontax reasons.

This paper first presents a model of the optimal overall capital structure of the multinational firm reflecting tax and nontax factors. Generally, the tax advantages of debt finance lead the firm to choose a higher leverage than would be desirable for purely nontax reasons. At the same time, a change in tax policy optimally causes the firm to rebalance its capital structure in all the countries where it operates. Specifically, stronger incentives for debt finance in one country encourage debt finance in that country but at the same time discourage debt finance in other countries to keep the overall indebtedness of the multinational in check. The model yields the result that the optimal debt-to-assets ratio at any establishment of the multinational is positively related to the national tax rate and to differences between the national and foreign tax rates. The relevant tax rates in this regard are the effective tax rates that take into account any double taxation and double taxation relief. International tax rate differences matter, since they determine the incentives to shift debt internationally within a multinational firm.

Next, the paper presents evidence on the impact of taxation on firm indebtedness for a sample of 33 European countries over the 1994–2003 period using a unique firm-level database on the financial structure of domestic and multinational firms, including their parent companies and their subsidiaries. For stand-alone domestic firms, we estimate that a 10 percent increase in the overall tax rate (reflecting corporate income taxes and nonresident dividend withholding taxes) increases the ratio of liabilities to assets by 1.84 percent. For multinational firms, the leverage ratio is found to be more sensitive to taxation on account of international debt-shifting. As an example, we can consider a multinational with two equal-sized establishments in two separate countries. A 10 percent overall tax increase in one country is found to increase the leverage ratio in that country by 2.44 percent, while the leverage ratio in the other country decreases by 0.6 percent. Corporate debt policy appears to reflect local, source-level taxes rather than residence-level taxes levied on a multinational’s worldwide income, perhaps because these latter taxes can often be deferred. Similarly, debt policy appears to reflect corporate income taxation rather than bilateral nonresident dividend withholding. In practice, multinationals may be able to avoid bilateral withholding taxes through triangular arbitrage involving a conduit company in a third country.

Several authors consider the relationship between firm leverage and taxation with U.S. data. Among these, MacKie-Mason (1990) and Gordon and Lee (2001) identify a tax effect by exploiting the different effective taxation faced by previously loss-making firms and firms of different sizes, respectively. Graham (2000) calculates the value of the tax benefits of debt finance for the U.S. case. Studies that use cross-country data have the advantage that they allow for international variation in tax rates. Examples are Rajan and Zingales (1995) and Booth, Aivazian, Demirgüc-Kunt, and Maksimovic (2001). The latter set of authors finds a weak effect on leverage for a tax variable that measures the tax shield of debt finance. Next, there is a set of papers that consider the debt finance of multinationals with either parent companies or subsidiaries in the United States. Specifically, Hines and Hubbard (1990), Collins and Shackelford (1992), Froot and Hines (1992), and Grubert (1998) provide evidence that U.S. multinational financial structure and the pattern of intrafirm interest and other income flows are consistent with tax minimization objectives. Newberry and Dhaliwal (2001) find that the debt issuance location of U.S. multinationals is affected by these firms’ jurisdiction-specific tax-loss carry-forwards and binding foreign tax credit limitations on the value of debt tax shields. Desai, Foley, and Hines (2004) find that both the internal and external financing of outward U.S. Foreign Direct Investment (FDI) is sensitive to foreign tax rates. Mills and Newberry (2004) analogously find that non-U.S. multinationals from countries with relatively low tax rates use relatively intensive debt finance of their foreign-controlled corporations in the United States.

Jog and Tang (2001) consider the leverage of firms in Canada that may or may not be part of U.S.-based or Canada-based multinationals. The debt-to-assets ratios of Canadian corporations without foreign affiliates are found to be more sensitive to Canadian tax rates than the debt-to-assets ratios of U.S.-controlled corporations located in Canada. Using data for member countries of the European Union, Moore and Ruane (2005) examine the leverage of 8,500 foreign subsidiaries. They find that leverage ratios of these subsidiaries are sensitive to the local corporate tax rate, unless the parent country operates a foreign tax credit system. This paper nests the approaches of the latter two papers by considering how both multinational firm structure and the international tax system affect leverage in Europe. Hence, we take into account whether a firm is a parent or a subsidiary of a multinational or a domestic firm. At the same time, we account for the tax systems of all the countries where the multinational operates. Thus, unlike previous research, our modeling and our empirical work take a fully multilateral approach. The main contribution of our paper is to explore in an international context the possibility that multinationals set the capital structure of individual subsidiaries by taking into account the tax rate faced by all other subsidiaries of the firm. Our finding that subsidiary leverage within a multinational firm responds to bilateral tax rate differences vis-à-vis both the parent firm and other foreign subsidiaries provides direct support for this multilateral approach.

In the remainder, Section II describes the international tax treatment of the debt and equity finance of multinational firms. Section III presents the model. Section IV discusses the company-level data. Section V presents the empirical results, and Section VI offers conclusions.

II. The International Tax System

This section describes the main features of the corporate income tax system applicable to a multinational firm with subsidiaries in one or more foreign countries.2 To fix ideas, let us consider a multinational firm that operates a foreign subsidiary in country i and has the parent firm in country p. The deductibility of interest from corporate income implies that there is no corporate taxation of interest to external debt holders. Dividends paid by the subsidiary to the parent firm, in contrast, are generally subject to corporate taxation in at least one country.

The subsidiary’s income in county i is first subject to the corporate income tax ti in this country. The first column of Table 1, indicates the statutory corporate tax rate on corporate profit for a sample of 33 European countries in 2003. These tax rates include regional and local taxes as well as specific surcharges. Germany has the highest tax rate at 39.6 percent, while Ireland is at the bottom with a tax rate of 12.5 percent. This and all other tax system information in this paper has been collected from the International Bureau of Fiscal Documentation and various websites of national ministries of finance. We have collected the tax system data reported in Tables 1–5 for all years in our sample period but only report the figures for the year 2003 due to space constraints.3

Table 1.

Corporate Taxation and Double-Tax-Relief Systems for Dividend Received in Selected European Countries in 200315

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Note: Dividends are assumed to be paid by fully owned subsidiaries. Source: International Bureau of Fiscal Documentation.
Table 2.

Bilateral Withholding Tax on Dividend Payments Between Fully Owned Foreign Subsidiary and Parent on January 1, 2003

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Notes: (a) The Parent-Subsidiary directive is binding between EU Member States and provides exemption from withholding tax when holding is at least 25%. (b) Ireland: companies located in EU or treaty countries are exempt from withholding tax provided that they are not under the control of persons not resident in such countries, (c) Estonia: general exemption from withholding tax if holding in foreign company is at least 25%. (d) Italy: if the recipient can prove a tax is paid in its country on the dividend, the Italian authorities can provide a refund equal to the tax claimed limited to 4/9 of the Italian withholding tax. (e) Lithuania: general exemption from withholding tax if holding in foreign company is at least 25%. (f) Luxembourg: exemption from withholding tax for EU and treaty partners if holding in foreign company is at least 10%. (g) Sweden: no withholding tax if holding is 25% and there is normal corporate taxation in the foreign country and if the shares are held for business-related reasons. Source: International Bureau of Fiscal Documentation.
Table 3.

Existence of a Bilateral Tax Treaty on January 1, 2003

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Source: International Bureau of Fiscal Documentation, various ministries’ websites.
Table 4.

Bilateral Withholding Tax on Interest Payments Between Fully Owned Foreign Subsidiary and Parent on January 1, 2003

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Notes: (a) Ireland: interest paid to a 75% nonresident parent is deemed to be a dividend, (b) Spain: interest is generally exempt from tax in Spain provided the direct beneficiary is a resident in another EU Member State, (c) Estonia: 0% if rate in recipient country is not lower man 2/3 of the Estonia tax rate on interest of 26%. (d) Switzerland: no withholding tax on ordinary loans, 35% on bonds and deposits. (e)Turkey: exemption for government bonds and debentures, as well as loans obtained from foreign companies and institutions, (f) Italy: zero withholding tax with treaty countries for public bonds, private bonds, and deposits; 27% with non-treaty countries for deposits and private bonds of maturity of less than 18 months; 12.5% otherwise. Source: International Bureau of Fiscal Documentation.