Systems for corporate taxation
Formula Apportionment (FA)
A corporations should consolidate the income of its affiliates in to a single measure of taxable global income, which is then allocated among jurisdictions according to a common formula reflecting the corporate group’s activity within each jurisdiction.
Seperate accounting (SA) (used by most countries)
Each individual country computes the income generated by firms locted within its jurisdiction using arm’s length prices on intra-firm transactions, and subsequently applies the national tax rate to it.
==> SA is based on reported income, while FA is based on reported activity. Which is better depends on how easy it is for MNCs to shift profit by transfer prices. If easy FA is better.
Two types of profit shifting
- Transfer pricing
Overinvoice or underinvoice tangible and intangible goods and services to shift income to low-tax affiliates - Debt shifting
Borrowing and lending strategies where affiliates in high tax countries are overcharged on interest expenses so that taxable income is reduced (more debt means more interest deductions hence the term thin capitalization).
Briefly explain why we should – on average – expect affiliates of multinationals to feature larger capital investments than comparable domestic firms within the same industry.
(Under the assumption that costs of external and internal debt are separable,) MNCs’ affiliates and comparable domestic firms should – on average – feature the same external leverage. But, affiliates of MNCs will use internal debt in addition so that they reap additional tax savings and have lower effective capital costs. Lower effective capital costs then trigger larger capital investment in MNCs’ affiliates, relative to comparable domestic firms within the same industry.
Safe-harbor vs earnings-stripping
Binding TC rules negatively affect real investment. (there having both is never optimal)
Safe harbor rule has no (direct) impact on transfer pricing, while earning-stripping increases cost of transfer pricing.
Therefore switching from safe-harbor to earning-stripping reduces transfer pricing, but fosters debt financing. This is a good thing as transfer pricing has no effect on welfare/investment, and this change therefore still gives the beneficial tax-revenue effect, but gives more real investment than safe-harbor rule.
–> Transfer pricing is the big evil
==> Always optimal to replace binding safe-harbor with a regime with only earning-stripping
Where should a multinational locate its internal bank, doing all internal lending?
The MNC wants to maximize the internal debt tax shields (ti − t1) · r ∀i. Therefore, it is necessary to minimize the tax payments on interest income received (in the internal bank, being labelled as affiliate 1) from lending out internal debt. Hence, the internal bank should have the lowest possible tax rate.
Arbitrage condition
Return to equity (div plus capital gains) must equal opportunity cost p(t) (reutrn to alternative investment)
Reasons for/against JV’s
- *For**
- Legal requirements to have local partners
- Local partners having more experience in local markets
- MNC providing enhanced industry-specific skills
==> cooperation cost-reducing or productivity-enhancing
- *Against**
- Conflicts between minority owners and MNC due to profit-shifting
- Appropriation of technologies by local partners
- Conflicts when desire to resturcture production world-wide
TC+CFC??
- *Combination allowing for ‘double discrimination’ of MNCs**
- set weak TC rules to attract mobile capital / FDI
- investment of foreign MNCs more tax elastic than of home MNCs
- differentiated TC rules legally not possible
- tough CFC rule reducing tax advantage for less elastic home MNCs
With same interest for internal and external debt, why cannot the internal debt tax shield be bigger than the external one?
Internal debt creates tax payments in the internal bank (for interest income received there), which reduce the internal debt tax shield. For external debt, there are no such additional tax payments. Hence, for an identical interest rate, the internal debt tax shield can never be larger than the external one.
Problem with CFC rule
Conflict with EU law, applicability of CFC rules within EEA legally rather impossible.
Centralized vs decentralized decision making
Centralized: The HQ maximizes the global profit after tax setting TP as well as prices.
- Find optimal TP based on tax differences
- Instert TP into global after-tax profit and find optimal Q
Decentralized
- HQ sets the TP
- Each affiliate sets the price (or Q)
- -> Solved by backwards induction.
Thin-Capitalization (TC) rules vs CFC rules
- A thin-capitalization rule targets all affiliates within the country that sets the thincapitalization rule. A CFC rule only applies to affiliates of multinationals that are headquartered in the country that uses the CFC rule
- Binding TC rule denies tax deductibility of interest expenses in borrowing affiliates. Binding CFC rule denies low taxation of passive income generated in the internal bank.
- Tax-comp sets incentive to weaken TC rules. CFC rules on the other hand are rather compatible with tax-comp, because the do not affect incoming FDI, but they harm foreign affiliates of domestic MNCs.
Capital market equilibrium (with and without personal taxation)
Without
p(t)=i(t)
with p(t)=i(t)*(1-t(p))
Arm’s length principle: Definition
The price that would have been set between independent trading partners in the market place.
This is the international consensus for correct transfer price.
External vs internal debt: Basic Difference
External debt stems from third parties (the ‘capital market’), i.e., from creditors that are not part of the same (multinational) company. Internal debt is borrowed from related affiliates within the same trust (multinational company).
Why should we expect the external leverages of a Norwegian affiliate of a multinational company and a domestic Norwegian firm to differ, even if the two firms are identical in all other respects?
Usually, multinationals guarantee for part of the external debt in their affiliates and, by this, face overall bankruptcy cost on parent level. That gives an incentive to external debt shifting across affiliates. The latter incentive is absent in domestic firms so that one should expect that their external leverage differs from the one in a multinational’s affiliate, even if all firms are identical otherwise.
The mechanism works as follows. External debt creates bankruptcy costs on parent level. For a given level of total debt, it is therefore optimal to maximize the total tax savings. This can be achieved by allocating debt to high-tax affiliates and by reducing debt in low-tax affiliates. This increases tax savings while keeping overall bankruptcy costs in check (all else equal).
Arm’s length principle: Ways to adjust TP
- *Comparable Unctonrolled Price (CUP) method**
- CUP compares the price charged between firms in a group with the price charged in a comparable transaction undertakes between independent parties
- *Cost plus method**
- The mark-up on costs that the manufacturer or service provider earn from the intra-firm transaction is compared to the mark-up on costs from comparable independent transaction.
- *The Resale Price Method (RPM)**
- Evaluates whether the amount charged in a intra-firm transaction is arm’s length by reference to the gross profit margin realized in comparable independent transaction.
Very briefly explain two non-tax benefits and three non-tax costs of external debt
Non-tax benefits of external debt are, for example
⋄ Loading a firm with external debt restricts free cash-flows and potential empire building (pet projects) of managers.
⋄ External debt induces the capital market to exert a monitoring function on firm’s performance.
In both cases, external debt is beneficial by reducing moral-hazard problems (between shareholders and managers).
Non-tax costs of external debt are, for example
⋄ Debt financing might lead to liquidity problems, financial distress and bankruptcy. All these events trigger so-called bankruptcy costs.
⋄ Excessive risk taking (due to limited liability) reduces firm value or causes increased risk-premia when borrowing debt.
⋄ In a debt-overhang situation, profitable investment oppportunities might not be undertaken because nobody is willing to finance them.
Debt tax shield: Definition
The tax savings generated by the deductibility of interest expenses on debt.
What percentages of MNC thin capitalizations is driven by external and internal mechanisms?
The standard debt tax shield accounts for about 40% of a tax-induced increase in the debt-to-asset ratio.
60% of thin capitalization in MNCs is driven by their unique capacity to shift debt internationally.
MNC: Definition
A MNC is characterized by having affiliates in several, at least in two, countries (and by facing different tax rates).
Two types of TC rules
Earning-stripping rules
Restricts tax deductibility of interest expenses relative to earnings measures (EBIT or EBITDA typically) (on internal debt)
Safe-harbor rules
Restircts tax deductibility of internal debt if a certaindebt-to-asset ratio is exceeded
Briefly explain how internal debt can be used for debt-shifting purposes.
For saving taxes via internal debt, a multinational invests equity in an internal bank that lends on the capital as internal debt to other affiliates. Internal debt creates tax savings in affiliates where it replaces equity, and it causes tax payments in the internal bank lending out internal debt. If the internal bank is located in the lowest-taxed affiliate, the tax savings from having internal debt in all other affiliates are always larger than the tax payments on interest income received in the internal bank. Hence, replacing equity by internal debt (i.e., tax-deductible equity) increases the total after-tax profits of the multinational.
Why does minority ownership in productive affiliates reduce internal leverage? Provide a short intuition.
Minority shareholders benefit in full from tax savings by borrowing internal debt. However, they do not participate in the tax payments on shifted interest income in the internal bank. This gives rise to a cost externality that benefits minority shareholders and that makes internal debt less attractive for MNCs.
