The Indirect Side of Direct Investment : Multinational Company Finance and Taxation [1 ed.] 9780262289658, 9780262014496

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The Indirect Side of Direct Investment

CESifo Book Series Hans-Werner Sinn, editor The Political Economy of Education: Implications for Growth and Inequality Mark Gradstein, Moshe Justman, and Volker Meier The Decline of the Welfare State: Demography and Globalization Assaf Razin and Efraim Sadka, in cooperation with Chang Woon Nam The European Central Bank: Credibility, Transparency, and Centralization Jakob de Haan, Sylvester C. W. Eijffinger, and Sandra Waller Alleviating Urban Traffic Congestion Richard Arnott, Tilmann Rave, and Ronnie Scho¨b Boom-Bust Cycles and Financial Liberalization Aaron Tornell and Frank Westermann Social Security and Early Retirement Robert Fenge and Pierre Pestieau Children and Pensions Alessandro Cigno and Martin Werding Currency Boards in Retrospect and Prospect Holger C. Wolf, Atish R. Ghosh, Helge Berger, and Anne-Marie Gulde Economic Prosperity Recaptured: The Finnish Path from Crisis to Fast Growth Seppo Honkapohja, Erkki A. Koskela, Willi Leibfritz, and Roope Uusitalo The Indirect Side of Direct Investment: Multinational Company Finance and Taxation Jack M. Mintz and Alfons J. Weichenrieder See http://mitpress.mit.edu for a complete list of titles in this series.

The Indirect Side of Direct Investment Multinational Company Finance and Taxation

Jack M. Mintz and Alfons J. Weichenrieder

The MIT Press Cambridge, Massachusetts London, England

( 2010 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. For information about special quantity discounts, please email special_sales@mitpress .mit.edu This book was set in Palatino on 3B2 by Asco Typesetters, Hong Kong. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data Mintz, Jack M. The indirect side of direct investment : multinational company finance and taxation / Jack M. Mintz and Alfons J. Weichenrieder. p. cm. — (CESifo book series) Includes bibliographical references and index. ISBN 978-0-262-01449-6 (hbk. : alk. paper) 1. International business enterprises— Finance. 2. International business enterprises—Taxation. 3. Investments, Foreign. I. Weichenrieder, Alfons J. II. Title. HG4027.5.M56 2010 332.67'3—dc22 2009054144 10 9 8

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Contents

Series Foreword vii Acknowledgments ix

1

Introduction

1

2

International Corporate Tax Systems at a Glance

3

Indirect Financing Structures

4

Holding Companies and Ownership Chains

5

The Financial Structure of German Outbound FDI

6

What Governments May Do: Policy Options

13

43 63 111

127

Appendix: Historic Statutory Corporate Income Tax Rates, 1985–2007 Notes 163 References 173 Index 181

157

Series Foreword

This volume is part of the CESifo Book Series. Each book in the series aims to cover a topical policy issue in economics. The monographs reflect the research agenda of the Ifo Institute for Economic Research and they are typically ‘‘tandem projects’’ where internationally renowned economists from the CESifo network cooperate with Ifo researchers. The monographs have been anonymously refereed and revised after being presented and discussed at several workshops hosted by the Ifo Institute.

Acknowledgments

This book has greatly benefited from comments, discussions, and help from various scholars, colleagues, and assistants. We would like to personally thank Rosanne Altshuler, Alan Auerbach, Robert Brown, Frank Blasch, Oliver Busch, Thiess Bu¨ttner, Harry Grubert, Albert Ra¨dler, Nadine Riedel, and Hans-Werner Sinn for their discussion and advice on previous versions of various chapters. We also received very competent and extremely constructive comments from three anonymous referees. In addition, we appreciate the comments from participants of presentations and seminars at CESifo, the NBER, the University of Innsbruck, the University of Paderborn, the University of Osnabru¨ck, Tilburg University, the University of Zu¨rich, the International Institute of Public Finance, and the German Economic Association. We have received excellent research assistance from Andrey Tarasov, Helen Windischbauer, Michanne Haynes, Qing Hong, Tina Klautke, and Yi Jiang. It goes without saying that any remaining errors are solely ours. Jack Mintz would like to thank the New York University Law School that was hosting him during the final phase of the book. Alfons Weichenrieder gratefully acknowledges financial support by the DFG (German Research Foundation). This book would have not been possible without the hospitality of the Research Centre of the Deutsche Bundesbank, and we would like to express our gratitude for the great support we have received from Heinz Herrmann, Alexander Lipponer, Fred Ramb, Dietmar Scholz, and Beatrix Stejskal-Passler. We also thank CESifo in Munich that has hosted us during different phases of the book. Last but not least, we are indebted to our families for their support and appreciation during the time of writing.

1

Introduction

International taxation is a highly complex subject. For an expert, it is a challenge just to understand the domestic tax system, never mind the meshing of several tax systems at the international level. Although multinational taxation has been studied for decades, including seminal work on foreign direct investment by Hartman (1980), Horst (1971, 1977), and Musgrave (1969), much greater research focus in recent years has been directed at multinational taxation, in part reflecting the demonstrative increase in cross-border flows of foreign direct investment.1 Numerous researchers have examined the interrelationship between taxation and multinational decision making. While much research has concentrated on tax effects on multinational investment (see Haufler 2001 and the comprehensive surveys by Hines [1997, 1999] and Gresik [2001]), far less analysis has been devoted to multinational financial structure and taxation issues. The aim of this monograph is to modestly expand our knowledge of multinational finance and tax research by exploring more deeply multinational financial structures, especially with respect to leverage and what we call ‘‘indirect financing structures.’’ Indirect financing structures involve a corporate chain in which businesses organize themselves in groups with several tiers of ownership. For example, a multinational parent (a corporation) may directly own several affiliates (corporations or other special entities like branches, partnerships, and trusts). In turn, each affiliate may own one or more affiliates creating three tiers of a corporate chain. If a third-tier affiliate owns its own affiliates, the corporate chain would therefore have four tiers. Corporations set up multiple tiered structures for a variety of reasons. They may desire to have such structures to manage specific businesses separately for better management. They may also need to

2

Chapter 1

comply with government regulations that require separate entities to operate in a specific jurisdiction. Our interest is to examine indirect financing structures used to reduce worldwide taxes for a multinational group especially with regard to corporate income taxes and withholding taxes. The important contribution in this monograph is to spell out in more detail how different types of multinational financial planning and tax policy affect the choice of financing structures. We not only discuss these ideas in theory but also test empirically effects on financial and ownership structures, using a unique data set (MiDi) on German multinationals provided by the Deutsche Bundesbank in Frankfurt. Using this unique German data that allows one to trace foreign direct investment for multiple tiered groups, we find that such indirect financing structures have been prevalent. In the case of outbound investment, over 40 percent of assets placed in German-owned operative companies abroad are held via a company in the same jurisdiction or through a third country in 2001. For inbound German entities, almost 30 percent of assets in foreign-owned German affiliates are held by an intermediate company rather by a parent in 2001, almost double the level in 1989. When German companies use third countries for conduit investments before investing in foreign jurisdictions, they most frequently use the Netherlands and Switzerland as intermediate countries at least in 2001. For inbound foreign direct investment, the Netherlands and the United Kingdom have been the most important third countries as a stepping-stone for foreign investors into Germany. Our objective is to improve our knowledge of the tax reasons behind the importance of conduit investment. In part, it should lead to a better understanding as to how tax policy can affect macroeconomic flows of capital in the global economy. Certainly, and more at the focus of this book, important conclusions can be derived for rules that governments apply to multinationals as part of their overall corporate tax policies. Two specific tax policies are of major concern in terms of their impact on corporate chains. The first is related to withholding tax rates applied by countries on dividend, interest, and royalty payments to nonresidents. A U.S. parent company investing in a country like Germany, for example, might wish to avoid paying withholding tax paid to the German government when remitting income to the United States. If the Netherlands through its treaties negotiates zero withholding taxes to relieve such payments from tax, a U.S. company might create a conduit in the Netherlands to route money to the United States to

Introduction

3

avoid German withholding taxes. Therefore, companies might create conduits to avoid withholding taxes through so-called treaty shopping. We find evidence that this is the case and later discuss policies that try to restrict the avoidance of withholding taxes. The second tax policy that influences indirect financing structures is related to the deduction provided for interest expense under the corporate income tax. Teams of lawyers and accountants devise worldwide financial structures to reduce corporate taxes paid by multinationals by maximizing interest deductions. Governments, wary of an eroding corporate tax base in the presence of tax planning, look to protect their revenues by imposing restrictions on interest deductions. On the other hand, many governments will often promote multinational investments abroad by taking a tolerant eye toward tax planning in order to encourage multinationals to exploit international markets. One important method by which companies might reduce worldwide corporate taxes is to establish conduit entities to achieve so-called double-dip interest deductions, to be reviewed in more detail later in this chapter and book. For example, an operating affiliate could be financed by debt owed to an affiliated conduit company. If this conduit, because of special provisions or a zero corporate tax rate, is able to earn tax-free income and pays out dividends to the parent (that might be also exempt), the parent could achieve a second deduction for interest by financing the equity investment in the conduit with a loan taken in the home country. Two interest deductions are achieved both in the host and home countries. Thus, a conduit is established just to maximize interest deductions. We examine the role of interest deductions in establishing conduits for German outbound and inbound investments. Indeed, intercorporate debt plays an important role in the financing of affiliates. We find that for outbound investments, German rules seemed to have curtailed the use of these structures with certain tax-avoidance rules, while, on the other hand, foreign companies seem to be using these corporate structures to reduce German tax that result in greater debt financing of German affiliates. In recent years, governments have been revisiting their corporate tax policies with the aim of improving the attractiveness of their economies for investment as well as combating base erosion arising from international tax planning. In response to corporate tax planning, governments have been cutting corporate income tax rates and announcing tightening reforms to reduce the scope for tax base erosion. The

4

Chapter 1

European countries have especially felt these pressures as several rulings by the European Court of Justice have led to significant changes in corporate tax policies. Countries were required to change the relationship of corporate income taxation and personal dividend taxes, their regulation, which limits the deductions for interest expense on related-party debt (thin-capitalization), the taxation of passive income earned by multinationals, and the tax treatment of foreign income received from corporate affiliates. Germany, which is a special focus of this manuscript, has legislated recent reforms that follow this pattern of worldwide corporate tax reforms. In the last part of this book, we will discuss policy options and whether countries like Germany are on the right track. 1.1

Multinational Direct and Indirect Financial Structures

Typically, most economic research on taxation and debt financing decisions has focused on domestic companies operating in a single jurisdiction (e.g., MacKie-Mason 1990; Gentry 1994; Graham 1999). When multinational financing issues are considered, the analysis is broadened to consider multinational affiliates—including subsidiaries, branches, unlimited liability companies, trusts, and partnerships— operating in several countries. However, only fairly simple tax structures are considered whereby an affiliate is financed solely by equity or loans from the parent. Some papers have also examined theoretically or empirically tested the extent to which companies might shift their debt finance from high- to low-taxed affiliates operating in separate countries (see, e.g., Jog and Tang 2001; Desai, Foley, and Hines 2004; Altshuler and Grubert 2003; Mintz and Smart 2004). This form of parent and affiliate models is illustrative of what we call ‘‘direct financial structures.’’ Direct financing is the case in which a parent company operates, say, in Germany, and has a financial relationship solely with an affiliate operating in, say, the United States. The German parent directly funds the U.S. affiliate’s investment either in the form of share capital or intercompany loans, and no other affiliates in the worldwide group have a financial relationship with the affiliate. In principle, consistent with the notion of direct financial markets, the U.S. affiliate could also seek financing from ‘‘arm’s-length’’ or ‘‘unrelated’’ parties by issuing shares or debt securities to domestic or offshore institutions and investors.

Introduction

5

However, the direct financing structures do not account for the important role that intermediate holding companies—which we will call conduit entities—play in financing affiliates. As discussed earlier, indirect financing structures are a chain of ownership whereby the German parent invests in the equity or debt issued by an affiliate, such as one in the Netherlands or Switzerland, that in turn invests in equity stocks or intercompany loans of the United States. These financial structures are not only considered in theory but empirically examined in this book in terms of their importance and impact on leverage decisions. Several excellent studies have used U.S. data (Desai, Foley, and Hines 2004; Altshuler and Grubert 2003), but the U.S. tax system is quite unique in its taxation of remitted earnings with global credit for foreign taxes that reduces home tax liabilities on remitted sources of income. The United States also has special earningsstripping and interest allocation rules that limit domestic interest deductions taken by nonresident or U.S. firms, respectively. For many countries, like Germany and Canada (where the two authors live), dividends received from foreign affiliates are generally exempt from taxation in the country where the parent resides. Experiences of these countries may be particularly interesting for those countries that are currently discussing a move toward exemption, including the United Kingdom and the United States. Our unique contribution to the literature is to examine multinational ownership chains for both inbound and outbound German foreign direct investment so that we can distinguish between direct and indirect financial structures to identify how important these structures are in determining the impact of taxation on multinational company investment. Many German-owned holding companies operate in the same host country as the German operating affiliate, such as in the case of the United States. Other holding companies operate in third countries, provoking the questions of why conduit holding companies are used at all in corporate structures. 1.2

The Role of Conduit Holding Companies

Companies for a variety of nontax and tax reasons may use holding companies as part of the corporate chain. The nontax reasons are primarily related to the theory of ‘‘public inputs’’ in production—corporate management operations are best left

6

Chapter 1

to a central body (including overall management, financial, accounting, tax, legal, human resources, and research) that provides services to the various operations separated by function and geography. The holding company is therefore related to the notion of ‘‘economies of scope’’ (Panzar and Willig 1981) whereby services from a public factor are used in other parts of the corporate operations—the public factor’s services itself are placed in a separate entity called the holding company. Thus, it is not uncommon for a holding company to operate at the top of a corporate ownership chain. Some functions, like research, financial intermediation, and insurance services, are commonly spun off into separate affiliates that sell their intangibles to other members of the worldwide group of companies, while the central management team who operates the holding company is normally at the top of the corporate chain with the responsibility to head the corporate group. However, the question still begs why conduit (or intermediary) holding companies are also used. One reason is related to economies of scale. Given that multinational companies are huge—for example, the merger of Bank One and Morgan Chase led to the creation of a banking enterprise equal to $1.2 trillion in assets—it might be appropriate to split some of the central operations to manage unrelated markets since it would otherwise be too administratively complex or costly to set up the operations at a single location only. Therefore, holding companies might be established on a regional basis (Europe, Southeast Asia, and North America) since different legal, financial, and regulatory systems are unique to the area and more easily served where the management is closer to the market. They might also be set up to service specialized markets. For example, a conglomerate might establish separate holding companies to manage affiliates engaged in different markets like resources, power, and finance. Some holding companies are used to provide intermediary finance functions for the worldwide group (they operate like in-house banks by managing cash funds and lending capital to operations around the world or on a regional basis). Insurance and reinsurance intermediary conduits may also be established to service the worldwide group of companies. Of course, conduit holding companies might also be used for tax reasons. Some conduits might be established in low or zero-tax tax havens where a multinational can park liquid assets to earn better profits. Other conduits might be established to take advantage of complexities in international tax laws that enable corporations to achieve so-called

Introduction

7

tax efficiency, a term commonly used in legal and accounting literature. In this regard, an important example of tax efficiency is what has been billed as ‘‘multiple’’- or ‘‘double’’-dipping whereby a company is able to deduct multiple times an expense for the same activity. A typical indirect financing structure used for multiple dipping requires the use of a conduit entity operating in a third country. For example, suppose a Canadian parent wishes to invest in the United States. It could loan money directly to the U.S. affiliate. In this case, an interest deduction is taken in the United States (providing a tax savings of roughly 40 cents for each dollar of deductible interest at the existing U.S. federal-state corporate tax rate), but the interest on the intercompany loan would be subject to tax at almost the same tax rate in Canada (a credit is given for any U.S. withholding tax on interest paid to the parent if applicable). If instead, a Canadian parent invests in equity in a Dutch holding company, which then loans money to the U.S. affiliate, a far better tax result is accomplished. The interest is deductible in the United States, exempt from withholding tax by treaty, and subject to a modest corporate tax in the Netherlands. The dividends from the Netherlands are repatriated to the Canadian parent free of both Dutch withholding tax and Canadian corporate tax or left in the Dutch low-taxed holding company for use elsewhere. If the Canadian parent also borrowed money to invest in the equity issued by the Dutch holding company to the parent, then two interest deductions are accomplished for an investment in the United States—one taken by the U.S. affiliate and the other by the Canadian parent. Given the use of these mind-boggling financial structures, one can better understand some of the arcane policies used by governments to counter tax avoidance of this form. One measure to counter multipledip financing structures is to limit interest deductions taken by the parent if the loan is used to finance the foreign subsidiary. This approach was used by Germany until the 2001 reform.2 Germany also applies certain ‘‘passive income’’ rules that may require the German parent to pay tax on interest received by the controlled foreign corporation (such as the interest received from the Dutch conduit entity from the U.S. subsidiary).3 The effectiveness of the rules in curtailing multipledip financing structures depends ultimately on their application in all cases. In contrast, Canada imposes no limitations on interest deductibility (although a failed 2007 reform disallowed deductions for interest incurred to finance Canadian tax-exempt investments in foreign

8

Chapter 1

affiliates and double-dip structures), and its passive income rules do not apply to interest received by a conduit entity since it is viewed that such income is paid out from ‘‘active business’’ income. The use of tax-efficient financing structures prevails in most jurisdictions. Recently, many countries have been debating whether to impose more strict rules on interest deductibility since multinational companies, including private equity and hedge funds engaged in international tax arbitrage, have a tax-advantaged cost of capital to acquire businesses. Typically, target companies are recapitalized with ‘‘hyperdebt’’ financing, eliminating corporate tax payments in the host countries. The interest income is then streamed to tax-exempt institutional investors (such as U.S. pension funds) or entities operating in tax haven jurisdictions (providing an opportunity for multiple-dip financing structures). Denmark, for example, recently announced measures to limit interest deductions in order to reduce the advantage given to private equity and other tax-arbitrage lenders.4 The use of direct and indirect financial structures may matter a lot, at least in theory, when interpreting how taxes affect multinational finance and investment. The possible use of multiple tax deductions for interest can considerably reduce the cost of capital relative to direct financing structures or domestic investment.5 Multinationals engaged in indirect financing structures will seek the most advantageous conduit countries with the lowest corporate and withholding taxes (treaty shopping) to minimize their overall taxes (or, in other words, to reach tax efficiency). The empirical identification of the extent to which companies engage in treaty shopping is one of the contributions of this book. Empirically, we are also able to analyze German company data with respect to the length of the corporate ownership chain since both direct and indirect financing structures are used. We find in both cases that high corporate tax rates contribute to greater leverage of the German affiliates operating abroad, whether or not the affiliate is owned by a holding company. There is also evidence that taxation affects the financing structures of inbound investment in Germany with greater debt financing associated with higher corporate tax rates (Ramb and Weichenrieder 2005). The sensitivity of financing structures to domestic and international corporate tax policies invites a policy response. High corporate income tax rates encourage companies to load debt into the jurisdiction, thereby eroding the tax base. Therefore, cuts to corporate income tax

Introduction

9

rates and tighter restrictions on debt finance may largely preserve tax revenues since the corporate tax base expands. If governments are interested in not just improving revenue but also the efficiency and fairness of their tax structures, international tax policies should be developed with these goals in mind. Unfortunately, answers are not simple since many different economic decisions are affected by tax policies. Governments might wish to ensure that international tax policies are neutral between domestic and foreign investments made by multinationals operating from their jurisdiction. However, they may also wish to give tax preferences to foreign affiliates of domestic multinationals. Otherwise, benefits from economic rents derived from research, manufacturing, distribution, administrative, and headquarters functions could be acquired by multinationals from other jurisdictions with more favorable tax policies. It seems that recent German tax policies to lower statutory tax rates and broaden tax bases are consistent with an approach to improve the domestic competitiveness of multinational corporations while combating base erosion. Most countries have been cutting corporate tax rates for two decades, and, as we show later, corporate tax revenues as a share of GDP have failed to decline as the tax bases have been broadened. The question is whether corporate tax policies that have followed this general approach can be maintained in the future. The average statutory corporate income tax rate in industrialized (OECD) countries has dropped from 46 percent in 1985 to 28 percent in 2007 (see chapter 6). Since further cuts are in the offing, a serious question arises as to whether the corporate income tax can survive (Mintz 1994; Chen and Mintz 2000; Auerbach, Devereux, and Simpson 2007). 1.3

What This Book Is Not About

Our monograph highlights the role of indirect financial and ownership structures at the international level. Some issues are related to this subject that we shall touch upon later. Others are unrelated and therefore not a subject for our analysis and, if anything, may be only mentioned in passing. Organizational forms As remarked earlier, multinational companies (our generic term) can be organized as corporations, branches, trusts, and partnerships. A corporation is registered and incorporated in a country, and it issues shares to owners who have voting rights and

10

Chapter 1

a claim to the profits and losses. The residency of the corporation is not based on where shareholders live but instead on where multinationals are incorporated or where they are managed and controlled.6 If the corporation operates with limited liability, the shareholders are not responsible for losses beyond the value of assets held in the corporation. Branches are entities that have no distinct legal character as it is part of the operations of a corporation or partnership that derives profits from the branch and liable for all losses. Trusts are entities created by a person for beneficiaries who receive distributions of income and capital from the trust. Partnerships are companies that are jointly owned by investors—the partnership can be organized as a limited liability partnership or not. In our discussion of taxation and financial structures, the type of organization will be relevant. However, in our empirical analysis, the corporate form of organization is dominant and therefore the main focus of our discussion. Leasing and insurance Part of financial structuring is related to leasing and insurance arrangements. A lease is used when a company rents to another a fixed asset such as a building or a machine for a fee to cover depreciation, financing charges, including the imputed cost equity finance, and other services such as insurance. Multinationals can effectively shift income across jurisdictions through leasing arrangements since all debt and imputed equity financing expenses are included in the lease costs. Insurance and reinsurance activities of multinationals can also result in income being shifted across jurisdictions since subsidiaries pay a fee for insurance services that are earned by an insurance affiliate operating in a different country. In our discussion, we will focus on debt financial structuring by multinationals although some of the analysis we provide could be easily applied to leasing and insurance structuring. Dividend policy Companies structure not only the degree to which their subsidiaries are financed by debt and equity but also the extent to which cash flow is financed by retained profits. Dividend payments from profits reduce the retained earnings available for investments.7 Further, companies could use retained earnings to repurchase equity shares, which result in shareholders receiving capital gains on shares. Dividend policy plays an important role in understanding the impact of taxation on multinational financial structuring. However, our empirical analysis focuses on company leverage (debt-to-equity ratios) with shareholders’ equity being defined to include both retained earnings and share issues.

Introduction

11

Intangibles Intangibles are related to research and marketing undertaken by a multinational to the benefit of the worldwide group. Royalties are paid by subsidiaries using a patent or brand to the owner of the intangible within the multinational group. Companies can therefore shift income by changing licensing arrangements so that royalty payments are paid to the owner of the intangible residing in a low-tax country. Our discussion will not deal with royalties and intangibles although this example of structuring results in the reduction of taxes paid by a multinational company (cf. Grubert 2003). Transfer pricing The issue of transfer pricing has received special focus in the recent literature on foreign direct investment (FDI).8 Transfer pricing is related to the determination of charges for goods and services charged on the intrafirm sales from one corporation to another. Under the OECD guidelines followed by most developed countries, the transfer price should be equal to comparable uncontrolled prices that would be charged between two independent companies under similar circumstances. Since such prices are often not observable, other methodologies are used to determine transfer prices. Given the scope for dispute, multinationals may be able to shift income across jurisdictions by adjusting transfer prices so long as the transfer price can be justified as the true price. Our discussion in this monograph is not about transfer pricing. We assume that prices are set at the comparable uncontrolled price (such as interest rate is set equal to the market interest) so that the financial structuring we consider are legitimate means of shifting income from one jurisdiction to another. In some countries such as the United Kingdom, transfer pricing rules have been used to challenge some financial structures if the debt is viewed to be in excess of what would occur under an arm’s-length arrangement. This approach differs from the legal restrictions used by other countries. 1.4

The Plan of This Book

To reiterate, the taxation of multinational income is one of the most complex areas of tax policy. Our intention is not to review all aspects of international taxation as they affect business decision making and tax policy but instead to focus on financial structures that play a significant role in the development of international tax policy. In chapter 2, we begin with a descriptive framework in order to provide the reader a comprehensive understanding of the basic issues related to tax policy in the area of financial structuring by multinationals.

12

Chapter 1

Specifically, issues can be separately classified according to three areas: the determination of residency, treatment of income earned and expenses incurred on outbound investment (capital exports), and the treatment of income and expenses incurred on inbound investment (capital imports). Chapter 3 provides a theoretical background to derive some hypotheses for empirical testing. Specifically, we consider the tax preferences of foreign affiliates and parents for equity and debt, taking into account corporate ownership chains, as discussed earlier. The fourth and fifth chapters turn to the empirical analysis. Chapter 4 describes ownership chains in German inward and outbound direct investment. We will not only throw light on the empirical importance of conduit entities and the dominating conduit countries but also consider the rising use of country holdings that are located in the same country as the operating foreign subsidiary. The chapter identifies withholding taxes on dividends as an important variable that influences the decision of multinationals to use a conduit entity. We find only mixed evidence, though, that this choice influences the overall leverage of an operating subsidiary. Chapter 5 provides evidence of the host country’s corporate tax influence on leverage. Specifically, we find that the debt-to-asset ratios of German outbound investment significantly depend on the host country tax rates. Intracompany loans react quite elastic to tax rate changes, while third-party debt appears less flexible. Finally, chapter 6 is devoted to an analysis of policy. We review the conflicting aims and trade-offs that governments face and discuss some optional policies for governments to consider. We focus not only on changes to corporate income tax policies but also on whether international cooperation could improve domestic tax policy.

2

2.1

International Corporate Tax Systems at a Glance

Introduction

International corporate taxation is focused on the treatment of outbound and inbound cross-border investments. Given the interaction of national taxes worldwide, the description of international tax systems can be highly complex. Special rules, regulations, and concepts, such as controlled foreign company legislation, passive income, interest allocation, excess and deficient tax credits, deferral, per-country limitation, and thin-capitalization legislation, to name only a few, make it hard for new entrants to get an easy grasp of the field. The complexity of international tax systems is not accidental. Cross-border investment has to cope with at least two jurisdictions and tax systems. Therefore, conflict and coordination issues abound. Jurisdictions usually have different taxes on company income, introducing incentives for multinationals to shift income in far-from-transparent ways to low-taxed entities. Governments, fearing the loss of tax revenues from business tax planning, take various countermeasures to limit tax avoidance. In the review that follows, we attempt to provide a primer on salient features of international tax systems. A focus will be on those issues that are most important to understanding current policy debates. While we will describe rules and examples of recent changes in a number of developed countries, special emphasis is given to German legislation as our empirical chapters will focus on German data. As the general topic of this volume concentrates on indirect financing structures of multinationals, another major focus of this chapter will be with respect to rules that have been implemented to attract holding companies of multinationals. Taxes that are particularly relevant to cross-border financing decisions are related to income. Corporate and personal income taxes and

14

Chapter 2

nonresident withholding taxes that are levied on investment income (dividends, capital gains, rents, royalties, and interest) influence multinational cross-border activity most profoundly—and these are the taxes that are central to our investigation here. Sales taxes on capital input purchases are confined to domestically produced and imported capital goods and are not a significant tax issue for the analysis of financial flows. Asset-based taxes, such as the German capital taxes (abolished in the mid-1990s), Canadian federal and provincial capital taxes, Latin American net worth taxes, and U.S. franchise fees could affect financing (if the tax is applied to equity and not debt) or leasing arrangements if the asset-based tax is applied to book assets only. However, asset-based taxes are not significant in most countries today and therefore are not a focus of our analysis. This chapter concentrates on the taxation of businesses or companies, which are generic terms that include corporations with limited liability stock ownership, branches, partnerships (income is flowed through to investors with or without the application of limited liability), and trusts (assets controlled by trustees to pay distributions to beneficiaries). Therefore, a parent company could invest in affiliated companies including branches, subsidiaries (with limited liability), partnerships, and trusts. Ownership could involve companies held indirectly through a corporate chain, which is a primary focus of our theoretical and empirical analysis. A foreign direct investment implies that the foreign investor holds a qualified interest in a foreign affiliate, namely, a certain level of ‘‘non-arm’s-length’’ or ‘‘related-party’’ equity. According to a widely used definition by the United Nations, at least 10 percent of the votes or the value of shares have to be controlled by the foreign investor. In contrast, portfolio investments are widely held by arm’s-length investors with a small degree of ownership. In this chapter, we focus on those aspects of the international tax system that influence foreign direct investment, particularly with respect to direct and indirect financing structures that are highly affected by the interaction of worldwide corporate tax systems. In the discussion that follows, we begin with the concept of residency and double taxation treaties. This is followed by a discussion of taxing outbound investment from Germany and other major capitalexporting countries in relation to the taxation of foreign-source income and the allocation of costs between domestic and foreign activities. We then focus on inbound issues related to withholding taxes and the allocation of costs between domestic affiliates and foreign related parties.

International Corporate Tax Systems at a Glance

15

The chapter concludes with a discussion of conduit entities and implications for German outbound and inbound investment. 2.2

Residency

The basis of taxation for a person or a company connected to a jurisdiction depends on the critical concept of residency.1 Once a taxpayer is a resident of a country, the taxpayer is liable for tax on both domestic and worldwide income (if the latter is subject to tax). If no residency is established, only income derived from country sources is subject to tax. Nonresidents typically are taxed in two ways. Nonresidents who are employed or conduct business in a jurisdiction pay tax on the income earned from these sources based on the schedule of tax rates, subject to some adjustments. Typically, many countries do not provide the same benefits as they do to their residents—for example, they might limit the amount claimed for exemptions or credits that would be given to residents in determining their personal or corporate income tax. (The United States provides a partial exemption for nonresidents when paying tax on employment and business income, while Canada provides no exemptions or credits that would normally be claimed by residents.) Further, nonresidents may be subject to withholding tax at a flat rate on investment income, including interest, dividends, rents, royalties, and sometimes capital gains upon disposal of assets. Treaties generally reduce tax rates both for income and withholding tax purposes. Most governments, including Germany, tax individuals based on residency although a few will tax individuals based on citizenship regardless of whether the person is a resident or not (e.g., the United States). Residency for individuals is usually based on a period that the person lives in a country, using tests such as having a home address, bank account, automobile license, and other indicators of attachment to the jurisdiction. Germany uses the concept of ‘‘habitual abode,’’ implying an intention to live in Germany more than temporarily such as a minimum of six months. If the person is not a resident of a country, then income paid to him or her will be subject to withholding taxes or, in the case of employment and business income, personal income taxes (that could be applied differently than for a resident as discussed earlier). The residency of its trustees establishes the residency of a trust. Company residence is based on a legal connection including place of incorporation and registration (the United States and Japan) or economic or commercial connection such as effective or central

16

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management and control (as well as incorporation), tested by criteria such as where the board of directors meet, where financial books are kept, and so forth (Canada, Germany, and the United Kingdom). Differences in the tax treatment of residency status across countries can result in some anomalies giving rise to tax complexity and opportunities for tax planning. For example, if one country treats a company as a resident based on incorporation but another believes the same company to be resident due to its criteria for effective management, then both may believe that the worldwide income should be taxable. This dual residency could give rise to some interesting results. For example, a company earning losses or claiming depreciation of tangible assets might be able to deduct them twice from profits earned by related companies in both countries (such as in the case of U.S. consolidation rules and the U.K. loss transfer system). This problem was so extensive that recently the United Kingdom and the United States established rules disallowing deductions if a deduction was taken elsewhere. Germany has no statutory rules applied to dual residency status. Box A Tax planning and dual residency

In general, treaties establish rules that limit taxing jurisdiction to one country only. However, in some situations, tax planning opportunities arise that allow a company to deduct the same loss in two different jurisdictions. For example, the United States uses incorporation as a basis for defining residency while the United Kingdom uses effective management and control. It is possible to establish a holding company incorporated in the U.S. but managed in the United Kingdom, simultaneously recognized in both countries as a taxable entity. If the holding company claims an interest expense and depreciation cost deductions (such as with leased assets) that leads to losses being incurred, it can reduce both U.S. and UK corporate taxes on profits. The United Kingdom and the United States changed their rules to disallow a company taking a loss deduction if it were already used in other tax jurisdictions. In the past, German ‘‘real seat’’ theory effectively disallowed companies from being recognized under company law if it had central management in Germany but registered in different countries. The European Court of Justice ruled in 2002 (ECJ, C-208/00) the Germany’s company law would need to accept the legal personality of a company that has central management in Germany but remaining incorporated in another EU state (Ault and Arnold 2004, 356). This may enable the possibility of greater use of dual residency planning strategies.

International Corporate Tax Systems at a Glance

2.3

17

Change of Residency Status

Individuals or companies might change residency by moving to new jurisdictions and departing from others. The tax rules applied when status changes differ somewhat between individuals and companies. When an individual becomes resident in a country, assets and liabilities are valued for tax purposes based on a ‘‘fresh start’’ basis such as fair market value at date of entry (Canada). Alternatively, the new resident may be subject to tax by reconstructing the history as if the person lived in the country all the time: assets and liabilities are kept in historical prices and domestic rules are applied to determine the value of assets and liabilities held at the time of entry (Germany). Thus, when an asset is sold by the resident, the disposal gain will depend on whether the original cost is the fair market value or the undepreciated historical cost when the taxpayer became a resident. If an individual becomes a nonresident of a jurisdiction, two approaches have been developed to apply ‘‘departure taxes.’’ One approach is to treat the resident as if all income is realized, including capital gains earned on those assets that have not been sold off. Alternatively, taxes may be applied for a period after a person has departed from a jurisdiction, especially for real estate assets that have not yet been disposed. In some situations, no tax event arises when departure occurs (the United Kingdom). The tax treatment of change of status for corporations is, in principle, similar to the tax treatment of individuals although the most interesting complications arise with respect to the departure of a corporation. A company becoming a nonresident of a country may be viewed as being disposed of by its owners: its assets are valued at market value and are subjected to capital gains taxes. Even a ‘‘departure tax’’ on the accumulated dividends, measured as the difference between its assets and paid-up capital and liabilities, may apply (e.g., in the case of Canada). While liquidation might normally be a taxable event, many countries might provide for some relief at the time of departure if the company is still connected to the jurisdiction. No tax will be applied in the United States on a departure of a domestic corporation if the company continues its operations as a foreign company in the United States. A reorganization resulting in an exchange of shares in the domestic corporation for a foreign corporation in the United States would therefore not be a taxable event. Until 1990, the United Kingdom required corporations to seek permission from the Treasury to depart. Since then, company departures will not require permission but will result in taxation of

18

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assets. No taxable event will arise if the departing company is a subsidiary of a U.K. parent. Germany treats departures as taxable events and collects corporate tax on the difference of book and market values even if assets remain in a German branch. The complicated rules determining the status of residency can have important consequences. On one hand, departure taxes can be a barrier to corporate mobility since corporate and personal taxes might be triggered when leaving a jurisdiction, a concern relevant to a recent decision by the European Court of Justice. The ruling in the case Lasteyrie du Saillant (C9/02 of March 11, 2004) found that a French regulation that introduced a tax on hidden reserves upon a move to another country was an infringement to the freedom of establishment, which is an essential right in the EU treaties.2 On the other hand, change-of-status rules can provide creative opportunities for corporations to reduce worldwide tax. Corporate inversions that recently took place in the United States include the examples of Tyco, a diverse business in telecommunications, health, electronics, and others, and Accenture, focused on business consulting and informational technology services. Both companies substantially reduced U.S. tax on foreign-source income by inverting the parentsubsidiary relationship. The parent became a subsidiary in a low-tax foreign jurisdiction, and the U.S. company became a subsidiary of the foreign parent and therefore only taxable on income earned in the United States (see the discussion of corporate inversions in box B for details). The effect of corporate inversions was to eliminate the tax on foreign-source income earned by some large U.S. multinationals although Congress has effectively blocked this transaction since 2004. 2.4

Double Taxation Treaties

Most countries have bilateral tax treaties with others to facilitate crossborder trade, income, and capital flows. These agreements eliminate the double taxation of income by capital-exporting and capital-importing states, provide a basis for the exchange of information and dispute resolution among tax authorities, and agree to a sharing of tax revenues by negotiating often significant reductions in withholding tax rates on dividends, interest, royalties and other cross-border flows of income. Double taxation is avoided by agreeing to a set of rules whereby the resident of a treaty country is not generally taxable on business income carried on in another country. Countries agree to either provide a

Box B An example of the relevance of residency rules for tax planning: U.S. corporate inversions

The rules for establishing and changing residency status are particularly important in leading to corporate inversions whereby some large U.S. multinational parents became subsidiaries of foreign parents that were previously U.S.-owned subsidiaries operating in low-tax jurisdictions. An important motivation for corporate inversions was to avoid U.S. taxation of worldwide income since a U.S. resident company would be subject to tax on income sourced in the United States and in foreign jurisdictions while a foreign corporation would be subject to tax on U.S.source income only. The use of corporate inversions nicely exemplifies how the application of various residency rules can impact on planning structures. For example, a typical corporate inversion with a U.S. subsidiary in the Caribbean Islands was structured as follows. The shares in a parent resident in the U.S. would be exchanged for shares of a Bermuda-based U.S.-owned corporation. After a share-for-share exchange that would require U.S. shareholders to pay one-time capital gains taxes on the disposal of the shares for Bermuda shares, the U.S. parent company would become a corporation owned by the Bermuda-based company. Since Bermuda levies no corporate income tax, any income received by the Bermuda corporation would be untaxed, including interest, royalty or other income that would be deductible from U.S. taxable profits earned by the U.S. subsidiary. However, since Bermuda does not have a tax treaty with the United States, the United States would deny treaty benefits by applying high withholding taxes (at 30 percent) on the interest and other income paid to the Bermuda parent. Enter Barbados that has a treaty with the United States. By having some board meetings in Barbados, the Bermuda corporation would show effective management and control in a Barbados International Banking Centre (IBC) and establish residency in Barbados for the purposes of the U.S.–Barbados tax treaty (the IBC is taxed at a rate as low as 1 percent and not subject to Barbados withholding taxes). This allowed the Bermuda corporation to avoid nontreaty U.S. withholding taxes on interest and dividends since the Barbados treaty provided an exemption for U.S. payments to Barbados companies. Effectively, the U.S. multinational avoided not only U.S. taxes on foreign-source income but also any withholding taxes paid by the U.S. subsidiary to the parent. In 2004, the U.S. government effectively eliminated corporate inversions by imposing certain tests, including a look-through provision that if 80 percent of the shares of the U.S. corporation were involved, then the U.S. corporation would be treated as the parent. The U.S. also denies treaty benefits to companies taking advantage of the U.S.–Barbados treaty. With respect to the latter, the exemption from U.S. withholding tax would be possible only if a Barbados company were to show sufficient connection to Barbados such as having shares traded primarily on the Jamaica or Barbados stock exchange.

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credit for foreign income taxes or exempt dividends received from foreign direct investment in the other country. Except for real property gains, capital gains realized by residents in one country are generally exempt from tax in the other and therefore, only subject to capital gains in the capital-exporting country. Some countries, including the United States and Germany, provide double taxation relief under domestic law rather than through treaties. Thus, even without a treaty, double taxation relief is often provided on a unilateral basis to encourage foreign direct investment. The role of treaties in this case is to establish rules for residency as well as other benefits such as information exchange and withholding tax rate reductions as discussed earlier. Like most capital-exporting countries, Germany has an extensive network comprising of more than ninety treaty countries. We discuss withholding tax provisions later when considering inbound investments. 2.5

Taxation of Income Derived from Foreign-Source Income

To understand the influence of taxes on outbound and inbound investment, it is important to outline the various approaches taken by countries with respect to the taxation of foreign-source income. Such income is generally taxed in the foreign country but the capital-exporting country typically reserves the right to tax foreign-source income earned by its residents (subject to credit and exemption approaches mentioned earlier). Important economic effects of international tax policy arise when double taxation is not fully avoided and restrictions are placed on deductions incurred in the investor’s home country that relate to business activities carried out in the host country. Governments may have two objectives in taxing foreign-source income of resident multinationals: capital export neutrality and competitiveness (sometimes referred to as capital import neutrality or capital ownership neutrality [Desai and Hines 2003]).3 Capital export neutrality is achieved when domestic and foreign investments of resident multinationals are subject to the same degree of taxation.4 An important implication of capital export neutrality for governments is that it protects the domestic tax base. If capital income is taxed at the same rate whether invested abroad or domestically, this clearly reduces the incentive of companies to shift capital or income to foreign jurisdictions.

International Corporate Tax Systems at a Glance

21

The second objective is to ensure that resident multinationals are internationally competitive in that worldwide tax burdens do not undermine their ability to compete with multinationals of other nations. Underlying this objective is the belief that foreign investments are complementary with domestic activities so that the inability to penetrate foreign markets could have harmful effects on domestic production and incomes derived by residents arising from the business activities of their multinationals. Accordingly, residents operating in a foreign location should face the same level of taxes on these operations as domestic and other foreign investors do when investing in the same jurisdiction. Little consensus exists in the literature as to whether domestic and foreign investments are substitutes or complements with each other. This issue is also highly relevant to the outsourcing debate. Feldstein (1995) suggests that more capital invested abroad by a multinational reduces domestic capital investment at home. Becker et al. (2005) argue that there is a substitution between domestic jobs at the parent firm and jobs at foreign subsidiaries for Swedish and German parent companies. Lipsey (1995) suggests that the empirical literature supports foreign investment increasing the demand for goods and services produced at home. International competitiveness arguments rest strongly on the assumption that activities are complementary. Given that there is only one instrument (the tax on foreign-source income) and two objectives, national governments are unable to find the ‘‘right’’ result for tax policy. Almost all governments exempt some form of income earned by multinationals (such as reinvested earnings) and tax others earned abroad (passive income from portfolio investments held abroad). Vann (2004) suggests that industrial nations have been shifting their policies to exempt greater amounts of foreign source income. Certainly, recent German and U.S. reforms in 2001 and 2004 respectively suggest that this is the case, as will be discussed in more detail later. The U.S. 2004 reform provided greater latitude to U.S. companies to average foreign tax credits so that U.S. tax paid on repatriated foreign income could be eliminated. Instead of seven baskets to calculate U.S. tax and credits (general active income, interest income subject to high withholding tax, shipping income, etc.), the 2004 reform moved to a two basket distinction—active and passive income. This change made it easier for companies to bring back low-tax foreign income (e.g., interest and shipping income) as part of other active business income without paying U.S. tax. Politicians do seem increasingly

22

Chapter 2

concerned about international competitiveness of their resident multinationals. The various approaches to taxation of foreign-source active business or passive income can be categorized neatly as follows: The accrual (current) method by which foreign income is subject to tax when earned and a credit is provided for income-related corporate and withholding taxes.




The deferral method by which reinvested profits earned abroad are recognized as exempt. Only repatriated earnings are subject to tax with a direct tax credit provided for foreign withholding taxes and an indirect credit provided for foreign corporate income taxes that are levied on profits prior to their distribution to parent.




The exemption method by which foreign-source income is exempt from home country taxation and, therefore, no credit is provided for foreign withholding and corporate income taxes.




Many countries use all of these methods for taxing foreign-source income. Where they differ is the degree to which one method might be used compared to another. Some countries like Japan, the United Kingdom, and the United States have relied on the deferral method for taxing company income while others, including Canada, France, Germany, the Netherlands, and Switzerland, provide an exemption for dividends and some other sources of active business income. Branch and passive income is often subject to the accrual method, although some governments (including Germany) exempt foreign-source branch income from tax. Since the credit and exemption systems are most widely used in practice, we will briefly elaborate. We start with a simple model of a credit system. To illustrate, we introduce some variables. Let T  be the corporate tax payable by the affiliate in the host country and tw be the applicable withholding tax on dividends levied by the host country. Then, in a first step, the tax credit T c for a given year can be calculated as Tc ¼

T D  þ tw D  ; P  T 

ð2:1Þ

where D  is the current dividend of the subsidiary, P  denotes total pretax (gross) profits of the foreign affiliate.5 If t  is the corporate

International Corporate Tax Systems at a Glance

23

tax rate of the host country, then the pretax profits necessary to pay the dividend is D  =ð1  t  Þ. The total tax bill, T, in the home country is given by the tax on the underlying foreign profit, namely, tD  =ð1  t  Þ, less the foreign tax credit T c :  tP   T   T¼D  tw : P  T  




ð2:2Þ

The net-of-tax dividend of the parent may be written as z  D  ¼ D  ð1  tÞ=ð1  t  Þ;

ð2:3Þ

where z  ¼ ð1  tÞ=ð1  t  Þ represents an effective tax on distributed dividends. From equation (2.3) it appears that with a credit system the effective tax on distributed foreign income is given by the tax rate of the home country. However, if ðt  t  Þ=ð1  t  Þ  tw < 0, this would require that the home country gives a subsidy: the tax credit would be higher than the tax collected by the home country. To avoid this, capitalexporting countries generally limit the maximum size of the tax credit. One of two approaches may be taken. Per country limitation If the capital-exporting country uses a per country limitation, then the tax liability of the parent is separately calculated for each group of affiliates located in a specific country, say j. The tax on repatriated dividends Tj is calculated by using equation (2.3), together with a non-negativity constraint on Tj . The minimum tax on the foreign income therefore is zero. Worldwide limitation With a worldwide limitation, the parent may receive the full tax credit for its affiliates in country j even though Tj may P become negative. The restriction j Tj b 0 however rules out that the parent enjoys a negative tax on its overall foreign source income in its home country. Given a limit on tax credits a parent company may find itself in one of two situations. Deficient credit position In this case, the parent has too few tax credits to eliminate home taxation on foreign source dividends. All foreign taxes can be credited. The home taxes of the parent indeed are calculated as given by equation (2.2).

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Chapter 2

Excess credit position If a limitation on the tax credit is binding, then there are excess credits that can not be used to reduce the parent’s taxes. The effective tax on the foreign profits is now higher than the tax on the equivalent amount of domestic profits. In the case of a single foreign subsidiary, the net-of-tax dividend of the parent can now be written as6 z  D  ¼ D  ð1  tw Þ:

ð2:4Þ

The effective tax on dividends is rather simple if the capital-exporting country uses an exemption system. In this case equation (2.4) immediately represents the calculation of the parent’s net-of-tax dividend. Since 2001, Germany exempts 95 percent of a foreign dividend received by a domestic corporation; 5 percent of the dividend are assumed to reflect the overhead cost of the German parent necessary to earn the tax free income and are therefore not tax-deductible. Before the reform, Germany applied a credit system in the case of dividends coming from nontreaty countries,7 but exempted qualified dividends from most treaty countries. With the recent reform, the participation exemption does not require minimum shareholding requirements or a minimum holding period unlike previous years when a 10 percent minimum threshold of ownership of shares was required. The exemption also applies to not only subsidiaries but also dividends paid from branches set up abroad. Further, capital gains on participations earned by corporate owners are also exempt. Before the 2001 reform, Germany provided a full imputation system to avoid double taxation of corporate profits: shareholders subject to German personal income tax received a tax credit for the underlying corporate tax when they received a dividend. Therefore, distributed profits were effectively taxed at the rate of the personal investor, and the corporate tax was fully refunded. In an exemption system the question arises of what to do with profits that have not been subject to domestic taxation at the corporate level such as exempt foreign income. One approach is to grant a tax credit to shareholders if these profits are distributed even though there was no corporate tax paid on the income prior to distribution, an approach used in Canada. Germany resisted this idea and, until 1993, levied a compensatory tax on distributions to make sure that all dividends, which carry an imputation credit, were paid from taxable profits. One difficulty with this approach was that it made it impossible to channel foreign income

International Corporate Tax Systems at a Glance

25

through Germany without tax implications, making it unsuitable as a country for holding companies. As a remedy introduced in 1994, foreign-source income was no longer subject to the compensatory tax, but the portion of a dividend that was paid out of tax-exempt income was not eligible for a personal imputation tax credit.8 Moreover, no tax credit was granted if a dividend from a foreign corporation was received by a domestic individual. In rulings in the late 1990s, the European Court of Justice (ECJ) argued the lack of dividend tax credit eligible to shareholders of companies resident in other EU member states contradicted the freedom of establishment and mobility provisions of the EU treaty, therefore requiring amendment.9 By abolishing its imputation system, Germany complied with EU Court of Justice decisions. All other EU countries have abolished their full imputation systems, the last one being France in 2005. Like Germany, they have adopted a presumptive approach in which personal taxes were reduced on dividends so that the combined corporate and personal tax paid on the dividends roughly matches taxes paid on other sources of income (see also Vann 2004). With respect to passive income, such as interest income earned on bonds held by affiliates, many countries will tax on an accrual basis investment income with a credit given for foreign corporate and withholding taxes.10 The justification for accrual taxation of passive income is to ensure full personal taxation of a resident’s income. In absence of tax on passive income earned abroad, resident taxpayers will have an incentive to establish investment companies to hold personal assets abroad rather than at home. A key element of controlled foreign companies (CFC) rules is to define the border between passive and active business income since the latter is exempt or subject to tax on a deferral basis. The rules for taxing passive income are intended to be applied to capture tax on investment income such as dividends, rents, and royalties although exemptions are often provided if such income is earned from active business investments. Countries may only apply the rules to low-tax jurisdictions such as in the case of France and Japan to limit the exemption or deferral of tax on dividends. The United States has rules (Subpart F) to limit deferral by applying tax to passive income of a controlled foreign corporation with exemptions given for same country transactions and for a ‘‘base’’ company income arising from an economic connection to the jurisdiction.

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Chapter 2

Passive income taxation applies when companies are sufficiently controlled by nationals or residents. The U.S. definition is based on 50 percent or more ownership by U.S. nationals with at least 10 percent ownership in the foreign corporation. Canada applies the rules when a Canadian company is directly or indirectly controlled by five or fewer Canadians. Sweden applies passive income taxation for shareholders with at least 25 percent interest (votes or value) in foreign corporations with a tax rate that is less than 55 percent of the Swedish rate. Germany taxes such income on an accrual basis if earned by CFCs that is controlled by a majority of German resident shareholders. For passive portfolio income, CFC taxation applies for any resident taxpayer who owns at least 1 percent in a foreign corporation or less than 1 percent if the CFC almost exclusively earns passive portfolio income. Passive income will be subject to tax if the income is earned in a ‘‘low rate’’ country (i.e., an income tax rate of less than 25 percent). Any CFC income is taxed at the German investor’s personal or corporate tax rate including municipal trade taxes. 2.6

Allocation of Costs for Domestic and Outbound Investments

Multinationals operating domestic and foreign companies in a corporate group incur certain overhead costs, especially interest costs to finance worldwide investments. A significant aspect of international tax law is whether the overhead cost deductions incurred to earn foreign-source income should be disallowed as a deduction from domestic income. Practice varies widely by country. One approach is to limit the deductibility of interest expense if the indebtedness is traced to an exempt foreign investment. Some countries have followed or are following this approach in limiting interest deductibility, including Luxembourg and the Netherlands.11 This tracing approach has limited effect since companies could adjust borrowing to fund domestic investment and use cash to fund foreign investments. Financial institutions and other large multinationals with multiple investments easily follow such ‘‘cash damming’’ practices. Tracing is only effective in limiting interest deductions when the tracing cannot be hidden such as in the case of a large acquisition of a foreign company. Another approach, used by the United States, is to allocate interest expenses according to a pro rata share. In 1986, the United States intro-

International Corporate Tax Systems at a Glance

27

duced an allocation rule in which domestic interest expense would be allocated to foreign-source income earned by the U.S. company according to the share of net foreign assets to the sum of domestic and net foreign assets. This is known as the ‘‘water-edge’’ formula that applies at present.12 Given the deferral approach used by the United States, the allocation method has no impact on U.S. tax payments when the multinational’s foreign tax credits are less than the U.S. home country tax payable on repatriated foreign-source income. However, if foreign tax credits are in excess of home tax liabilities on foreign-source income, the allocation of interest expense to foreign earnings will result in a loss of the deduction: the reduced interest deduction for the parent increases the tax bill, while the reduced foreign income in a situation of excess credits leads to no reduction in the U.S. tax on foreign income.13 Chapter 6 will cover the new interest allocation rules to be adopted in the United States. Some countries do not have any statutory rules to limit interest deductions for outbound investment. Austria and the United Kingdom, for example, might limit deductions as an anti-abuse measure if debt ratios seem excessive for that industry by commercial standards. Germany used to limit the deduction of interest expense incurred to earn tax-exempt income on a tracing basis (those expenses that are directly connected to the foreign exempt income). If a loan was taken out to acquire a foreign participation, then the interest on the loan was nondeductible to the extent that a tax-free income was derived. The German tracing rules had a well-known loophole, however. If the foreign affiliate accumulated foreign earnings and only paid dividends from time to time, interest deductibility was unrestricted in those years if no tax-free dividend were paid. This fluctuating repatriation policy is known among tax planners as ‘‘ballooning.’’ Since 2001, 5 percent of all foreign dividends are taxable. At the same time, full-interest deductibility is now possible without limit even if the loan was taken out to finance a foreign investment with (95 percent) tax-free income. As a general point, countries with exemption systems tend to soften their rules with respect to indebtedness to provide greater flexibility to resident multinationals to finance their operations. However, as discussed later, recent changes among European countries are leading to a tightening up of interest deductions through new approaches to limit thin-capitalization, which affects both inbound and outbound capital flows.

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2.7

Chapter 2

Inbound Investment

Taxation of inbound investment raises two issues for governments— attracting foreign direct investment and protection of revenues. Treaties prohibit discriminatory taxes on foreign investors, thereby limiting governments to impose similar tax rates on domestic and inbound investments. The two most frequently used instruments to protect revenues are withholding taxes and limitations on interest deductions incurred by nonresident companies.14 2.7.1 Withholding Taxes The intent of withholding taxes on nonresidents is to ensure that the source country receives some tax on income that could otherwise be paid to foreigners. This is especially relevant to cross-border charges such as interest, rents, royalties, and employment compensation that are deductible expenses for the nonresident company. Capitalexporting countries will credit withholding taxes if they tax the income derived from the source country as earned by their residents. Nonetheless, withholding taxes often discourage capital inflows because they may not be credited abroad. As discussed previously, many capital-exporting countries exempt certain sources of income from their tax and provide no credit for foreign corporate income and withholding taxes. This can be especially important for dividends that are often not subject to tax in the home country. Further, even if the capital-exporting country subjects the income to tax and provides a tax credit, the withholding tax may not be credited. The withholding taxes are imposed on the income gross of costs received by the investor who pays tax to his or her resident country on the income net of costs earned on the transaction. If net income is sufficiently small, the withholding tax may be significantly higher than the tax levied by the capital-exporting country on the net income. The investor must either receive a higher return from the investments to compensate for the withholding tax or invest in other investment opportunities that are not subject to high withholding taxes. This issue is especially important with respect to withholding taxes on interest. For example, a 10 percent withholding tax on a bond offering an interest rate of 7 percent implies a tax equal to 0.7 cents (70 basis points) on each dollar of the investment. However, if a financial institution is borrowing at 6.5 percent (including transaction costs), the net yield on the

International Corporate Tax Systems at a Glance

29

financial transaction is only 0.5 percentage points (50 basis points), which would be subject to corporate tax in the home country at, say, 30 percent (15 basis points in tax). In this example, the withholding tax is not only higher than the capital exporter’s tax liability but more than the profits that could be earned on the transactions. Companies would therefore have significant difficulty raising capital from international markets when withholding taxes erect a significant barrier to financial flows. Similar problems arise with respect to the taxation of financial derivatives (e.g., interest rate and currency swaps, options, and hedges). Withholding taxes imposed on financial derivative income can virtually eliminate derivatives since nonresidents are asymmetrically taxed on the gains and unable to reduce withholding tax payments if losses are incurred. For this reason, many countries exempt financial derivatives from withholding taxes (see Mintz 2004b). It is not surprising, therefore, that treaties have substantially reduced withholding taxes on dividends, interest, rents, and royalties. Many countries now exempt substantial amounts of interest from withholding tax with treaty partners including the EU countries, the United States, and Switzerland. Dividends are more likely to be subject to withholding tax although countries have increasingly moved to exempt dividends from withholding tax with major treaty partners, such as in the case of the United Kingdom and the United States. The EU parent-subsidiary directive (90/435/EEC) requires payments by EU companies to resident companies in EU countries to be exempt from withholding tax if the participation in the EU company is at least 10 percent. Without a treaty, Germany levies withholding taxes on payments to nonresidents equal to 20 percent for dividends and royalties. Interest payments to nonresidents are exempt from German withholding taxes. An exception applies only for loans that are collateralized with German immobile property, interest on convertible shares and profitsharing bonds, or in cases of over-the-counter business. With respect to dividends, the withholding tax is reduced to 5 percent under many treaties, and in the case of a minimum 10 percent ownership of a German company and for shares held more than one year, dividends paid to the foreign investor located in an EU country are exempt from German withholding tax.

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2.7.2 Interest Expense Restrictions for Inbound Investment Normally, interest is deductible from company income; therefore, leaving aside interest withholding taxes, a host country will not tax income flowing to nonresident lenders. Of deeper concern to the host government is that the lender to the company may be a related party so foreign companies operating there may be highly leveraged to eliminate company taxes to be paid in that jurisdiction. Thus, many countries impose restrictions on interest deductions for foreign-owned companies, especially when the debt is owned by related parties (the parent or affiliates). Two types of statutory restrictions are typically imposed to limit indebtedness. The first is a limitation on ratio of debt to equity or thincapitalization rules. Interest expense on indebtedness in excess of a threshold level is disallowed as a deduction and, instead, treated as dividend payment to the owner (and possibly subject to dividend withholding taxes). The second approach is to impose an earningsstripping rule whereby interest is disallowed as a deduction if it exceeds a percentage of earnings gross of interest, depreciation, and taxes. Since companies could have low earnings in any year due to economic reasons, the earnings-stripping rule allows companies to carry back or forward the excess interest to be deducted in other years, if possible. Further, the harshness of the earnings-stripping rule is ameliorated by a safe harbor debt-to-equity ratio so that the rule only applies to companies with high degrees of leverage. Thin-capitalization rules are the more common approach to limit indebtedness with respect to related parties. The threshold is based on the amounts of debt and equity held by related companies in the foreign subsidiary operating in the host country. Countries may impose back-to-back loan rules so that if the debt is held by an unrelated party that in turn obtains finance from a related company (or guaranteed by the parent), a look-through provision is invoked that will include the loan as part of related-party indebtedness. France’s thin-capitalization rule disallows interest expense on loans from shareholders to the extent that these loans exceed 150 percent of the equity of the firm. Since 2007, new rules apply with respect to investors from EU countries and certain treaty countries. The 150 percent threshold is used as a safe harbor. But if the ratio is exceeded, certain escape clauses apply (threshold for total interest deductions, comparison of subsidiary debt with total group leverage).

International Corporate Tax Systems at a Glance

31

As mentioned earlier, in 2004 the Netherlands introduced a thincapitalization rule denying interest deductions based on two thresholds: average debt in excess of three times average equity or debt in excess of the worldwide debt-to-equity ratio for the corporate group (the first @500,000 of excess debt is not included in determining the disallowed interest). The United States uses an earnings-stripping rule for related-party indebtedness. Interest in excess of 50 percent of adjusted taxable income (earnings before interest and depreciation) is deferred until it can be written off profits in future years. A safe harbor provides that foreign-owned companies with indebtedness below 1.5 times equity are not subject to the earnings-stripping rule. A new approach was proposed in November 2004 to measure the safe harbor as a debt-toasset ratio, which would be an average of permitted debt-asset ratios depending on the type of business. Further, the interest limitation is proposed to be based on 25 percent instead of 50 percent of adjusted earnings, and the carryforward of excess interest deductions would be limited to ten years. President Bush’s 2008 budget recommended to Congress that (1) the safe harbor be abolished; (2) the interest limitation be lowered to 25 percent of adjusted earnings (although 50 percent would apply when including guaranteed debt); and (3) a ten-year limitation would apply to the carryforward of unused interest deductions (these provisions have not been passed by Congress). Earnings-stripping rules are gaining attention in other countries. Denmark recently introduced an earnings-stripping rule whereby interest expense in excess of 80 percent of earnings before the deduction of interest and taxes would be disallowed. A second test applies in which net interest expense exceeding DKK 20 million (some US$3.5 million) are deductible up to a cap equal to 6.5 percent of the tax value of Danish assets and 20 percent of the value of foreign subsidiaries. Another country that recently has replaced its thin-capitalization rules with an earnings-stripping rule is Italy. Germany’s thin-capitalization rules have undergone significant change as well in the past several years. In the past, Germany used a thin-capitalization rule for related-party debt whereby interest may be treated as a constructive dividend for both the federal corporate income tax and municipal trade taxes when indebtedness is in excess of 1.5 times equity. Before 2004, holding companies whose primary purpose is investing or financing subsidiaries had a higher safe harbor of

32

Chapter 2

three times equity.15 A back-to-back rule is applied to unrelated-party debt that has recourse to the shareholder. Equity is shareholders’ equity as shown on financial statements at the end of the previous year and is reduced by losses only if no profits or contributions have been made within three years. Recently, the European Court of Justice disallowed thincapitalization rules that applied to nonresident-owned companies operating in Germany if the shareholders are living in an EU member country.16 A new thin-capitalization rule was introduced in 2004 to eliminate discrimination among companies owned by Germans and other EU shareholders. The revised rules applied to any company regardless of the residency of its shareholders or residence of the related lending party with a de minimis threshold for interest of @250,000 (about US$192,000). The previously higher threshold for holding companies was also reduced to 1.5 times equity, similar to other corporations. Further, interest expenses paid on intercompany debt to finance a related-party acquisition of shares are to be treated as constructive dividends. As of 2008, Germany uses an earnings-stripping approach to thincapitalization substituting the previous thin-capitalization legislation. Net interest expenses incurred on borrowings from both related- and third-party lenders are deductible up to 30 percent of earnings before the deduction of net interest, depreciation, and taxes. A de minimis exemption applies to firms with up to 3 million euros of interest expenses (some US$3.9 million). The interest deduction can also be preserved if proof is given that the leverage of the corporation does not exceed the average leverage in the group. Disallowed interest deductions can be carried forward indefinitely although they would be lost in the event of a corporate reorganization. 2.8

Conduit Entities

In recent years, many countries have established special regimes to attract headquarters, holding company, group financing, and other central administration operations to their jurisdictions. Low taxes are levied on such income providing an opportunity for multinational companies to finance their international operations on a tax-efficient basis. As this is a primary focus of this book, the rules related to conduit entity regimes are described in some detail here.

International Corporate Tax Systems at a Glance

33

Conduit entities have three potential roles in minimizing taxes. Treaty shopping A conduit entity pays little or no withholding tax on income received from affiliates of the corporate group. Nor does it pay withholding tax on payments made to affiliate companies, including the parent. One important motivation for routing income through conduit entities is treaty shopping to reduce withholding tax payments.




Tax efficiency (double-dipping) The conduit entity provides an opportunity to reduce company taxes by lending money or providing a service to an affiliate operating in a high tax country. The conduit earns income that is taxable at a low rate while the affiliate deducts the expense at a high tax rate, thereby reducing foreign taxes. Further, if the income paid by the conduit is passed onto another affiliate (such as the corporate parent) and subject to little tax, the recipient can deduct expenses associated with the transaction against domestic income. This gives rise to the well-known ‘‘double-dip’’ transaction whereby routing money through the conduit can achieve two deductions for one investment activity.17 For instance, interest double-dip deductions can be accomplished if the parent borrows funds and invests equity in a conduit and dividend and capital gain income derived from the conduit is tax-free in the hands of the parent. The conduit lends money to an affiliate in a high-tax country. It pays no tax interest income (such income may be treated as active not business not passive income by the parent’s resident country and therefore exempt) and the interest is deductible as an expense by the high-taxed affiliate. Effectively, two interest deductions have been incurred for one capital investment that takes place in the high-taxed affiliate. Double-dip deductions can arise for insurance (and reinsurance) services and leasing expenses, among other deductible charges for services.




Parking income to avoid tax on remitted income to an affiliate (parent) Income earned in the entity is subject to a low rate of company tax if at all. If the income is parked in the entity and invested in real or financial assets, it can accumulate at a faster rate although the passive income rules discussed previously might limit the incentive to use entities for this purpose. This motivation is particularly important for multinationals resident in a country using the deferral system since income remitted to the parent may be subject to additional tax.




In chapter 3, we will provide the formal conditions needed for parent companies to set up conduit entities to finance subsidiaries, while

34

Chapter 2

Table 2.1 Top ten countries with the highest ratio of foreign direct investment (FDI) inflows and outflows as a percentage of GDP (averaged over 2001–2005) FDI inflows (%)

Sum of inflows and outflows (%) 639.3

Rank

Country

FDI outflows (%)

1

Luxembourg*

296.6

342.6

2

Hong Kong (China)

13.5

14.0

27.5

3 4

Singapore Iceland

8.5 15.1

13.7 5.5

22.2 20.6

5

Netherlands

11.0

5.9

16.9

6

Belgium*

6.8

9.8

16.6

7

Ireland

6.6

5.3

12.0

8

Lesotho

0.0

10.9

10.9

9

Switzerland

7.5

2.4

9.9

10

Bulgaria

0.1

9.1

9.3

Sources: International Monetary Fund, International Financial Statistics, June 2007; United Nations Statistics Division, United Nations Common Database, June 2007. * The averages for Luxembourg and Belgium are over the period of 2002–2005. Prior to 2002, the combined FDI inflows and outflows were reported for these countries.

in chapter 4 we provide data on the countries used for conduit entities for German companies. The key point is that many governments have established conduit regimes in order to attract headquarters, holding companies, and group financing structures that provide important tax benefits to multinational companies. Countries that have established special conduit regimes for multinationals have generally pursued three policies: no withholding taxes on interest, dividends, and other payments such as royalties; low corporate income taxes on conduit income; and few if any limitations with respect to the deduction of interest expense to related parties. As shown in tables 2.1 and 2.2, inflows and outflows of foreign direct investment as a proportion of GDP tend to be highest in many wellknown conduit countries, including Luxembourg, the Netherlands, and Switzerland. The choice of the conduit entity’s location is sensitive to the interaction of the home and host country tax regimes. Much depends on tax treaties, rules related to the treatment of passive income, and the corporate and withholding tax regime in the conduit country, as discussed previously. For example, some capital-importing countries like the United States have added Limitation on Benefit clauses to their

International Corporate Tax Systems at a Glance

35

Table 2.2 Top ten countries with the highest aggregate foreign direct investment inflows and outflows (averaged over 2001–2005) FDI outflows (million USD)

FDI Inflows (million USD)

Sum of inflows and outflows (million USD)

Rank

Country

1

United States

139,980.8

111,653.6

251,634.4

2

Luxembourg*

107,257.7

99,311.9

206,569.6

3 4

United Kingdom France

75,900.8 80,238.2

68,747.2 50,472.3

144,648.0 130,710.5

5

Netherlands

58,807.8

28,066.3

86,874.0

6

Spain

39,151.6

28,268.9

67,420.5

7

Belgium*

28,177.7

32,249.8

60,427.5

8

China

4,472.2

54,937.8

59,410.0

9

Canada

32,380.7

18,499.2

50,879.9

10

Germany

22,514.8

24,886.1

47,400.9

Sources: International Monetary Fund, International Financial Statistics, June 2007. * The averages for Luxembourg and Belgium are over the period of 2002–2005. Prior to 2002, the combined FDI inflows and outflows were reported for these countries.

treaties that reduce the scope for treaty shopping by levying nontreaty withholding tax rates on any payments to nonresidents who try to use third countries to avoid U.S. withholding taxes but fail to have substantive economic activity in this third country. Various countries might be popular conduit countries for multinationals such as Ireland for U.S. companies, Hong Kong for those investing in China, and Barbados International Banking Centres for Canadian companies. As will be discussed in chapter 4, the Netherlands and Switzerland are especially important conduit countries for German investments. Switzerland has been a popular conduit country in part because of its bank secrecy rules. However, it provides several important tax benefits to investors with its extensive treaty network, low withholding taxes, and special regimes to reduce company income tax, especially at the cantonal level (the effective federal rate is 7.8 percent but the canton rates are much higher adding about another 15 percent to the general tax rate). A holding company regime allows qualifying companies to earn dividends, interest, capital gains, and other income-derived financial participation to be exempt from cantonal tax with only the federal tax of 7.8 percent applied to such income.

36

Chapter 2

Another regime enables domiciliary and mixed companies to pay low federal and cantonal taxes on profits derived from non-Swiss sources, especially involving sales, financing, and intellectual property. As well, principal companies conducting activities in Switzerland including purchasing, research and development, manufacturing and distribution, marketing, and headquarter functions are provided a favorable tax treatment with rates ranging from 5 to 10 percent. Tax holidays are also available for ten years depending on substance and location. A service company regime also provides tax benefits similar to domiciliary and mixed companies located in Switzerland to service multinational groups. Until 2004, a safe harbor was provided by which federal and cantonal taxes were levied on a profit rate equal to 5 percent of costs. Therefore, by shifting income to the Swiss service company, a multinational would not pay additional tax beyond the safe harbor. The safe harbor provision has been withdrawn in response to OECD and EU pressure. The Netherlands have provided a number of tax benefits under its conduit regimes that have attracted holding companies, headquarters, and group financing vehicles used by multinationals for many years, much of which is now subject to change. The group financing regimes allow Dutch companies servicing affiliates in a corporate group operating in at least four countries or two continents to establish a reserve up to 80 percent of its financial services income.18 The reserve is intended to cover risks related to participations held by the Dutch group as well as provide financing, leasing, licensing of intangible assets, and administrative services to the corporate group. Tax-free withdrawals up to 50 percent of the amount invested in subsidiaries may be made (in some cases up to 100 percent of amounts invested). Effectively, 80 percent of income is exempt, resulting in an effective tax rate of 7 percent (the Dutch corporate tax rate until recently was 35 percent). The group financing facility has been determined to be a form of state aid, meaning that new facilities may no longer be created. Existing facilities will be terminated by 2010. The Netherlands also provide a participation exemption that exempts certain benefits earned by qualifying companies, including holding companies, from Dutch tax. The benefits include cash dividends, dividends-in-kind, bonus shares, hidden profit distributions, and capital gains from Dutch tax. Investment funds are exempt from company tax. Other tax benefits for conduit regimes include tax-free

International Corporate Tax Systems at a Glance

37

reserves for reinvestments—gains on asset disposals can be deferred if funds are reinvested within three years and an equalization reserve in anticipation of uncertain future expenditures such as ship maintenance, overhauling, pension payments, and warranty costs. Similar to Switzerland, Luxembourg has also facilitated conduit regimes with bank secrecy laws as well as special tax benefits associated with conduit regimes. Companies qualifying for the so-called 1929 holding company regime are exempt from corporate and withholding tax, although a new provision for 2005 limits the 1929 holding company status to those companies that receive at least 95 percent of their dividend income from jurisdictions that levy taxes comparable to Luxembourg. Existing structures are grandfathered until 2011. Investment funds are only subject to a flat fee. France provides a special headquarters and logistics center regime, similar to the Swiss service regime,19 whereby income equal to 6–10 percent of costs is subject to corporate tax. Belgium recently replaced its tax-preferred coordination regime with a new approach to corporate taxation that affects all businesses, not just group financing companies. Under the new Belgium regime, a deduction, which in principle is available for all Belgian corporations, is provided for the imputed cost of equity finance that significantly reduces taxes to be paid on investments. This deduction, along with interest expense write-offs, also enables a company locating conduit structures in Belgium to pay little or no tax on income routed through the conduit. Conduit entities need not be established in third countries. Tax advantages may also arise if a holding company structure is used within a country. For example, Delaware holding companies are popular in the United States, in part for regulatory reasons and also to minimize state-level taxes.20 Holding company structures in Switzerland can be used to minimize cantonal taxes. Further, some tax-efficient transactions involving holding companies can arise from bilateral transactions that take advantage of gaps arising from uncoordinated tax systems. A particularly important example is related to the growth of hybrids in the United States after the adoption of ‘‘check-the-box’’ rules. Since 1997, U.S. companies can label an entity as a corporation, branch, or limited liability partnership for tax purposes even though the legal structure might be of a different form. The check-the-box rules provide an opportunity for U.S. and international multinationals to reduce income and withholding taxes, double up on foreign tax credits, or develop a double-dip deduction for interest

Box C U.S. hybrids: An example

As discussed in the text, the 1997 introduction of check-the-box rules in the United States created tax planning opportunities typically referred to as a U.S. hybrid (for outbound investments from the U.S.) or reverse hybrid (for inbound investments in the United States). Effectively, hybrids provide an opportunity for double-dip interest deductions by establishing a conduit entity without the use of a third country. As an example provided in figure 2.1, we describe a reverse hybrid for a Canadian investment in the United States (a somewhat more elaborate version is described in Finance Canada (2007)). The Canadian parent creates a U.S. partnership that is held by it (and another Canadian subsidiary—not shown). A bank lends money to the U.S. partnership. With these funds, the U.S. partnership invests in shares of a U.S. subsidiary (1) that in turns loans money to an operating U.S. subsidiary (2). The Canadian tax authorities view the U.S. subsidiary (2) as a corporation. Under Canadian tax law, dividends paid to the U.S. partnership are nontaxable. The U.S. partnership has an interest deduction by borrowing from the bank, thereby creating an interest deduction that is used to reduce income earned in Canada. The interest borrowing provided by the bank is therefore used to reduce Canadian tax. The U.S. authorities view the U.S. partnership as a U.S. corporation under check-the box rules—the U.S. subsidiary (1) is consolidated with the U.S. corporation and thus ‘‘irrelevant’’ since it is not a separate entity. The loan to U.S. subsidiary (2) creates a deduction that reduces U.S. tax. Thus, two interest deductions are incurred to finance an investment made by U.S. subsidiary (2)—the first taken in Canada arising from the bank loan and second taken by U.S. subsidiary (2) with a loan from the U.S. corporation (that is viewed as partnership by Canadian authorities). Several other aspects of tax law are involved. A U.S. withholding tax rate on dividends paid to the Canadian parent and subsidiary would be applied at a rate of 5 percent that does offset a proportion of the tax benefit. Also, the borrowing by the U.S. subsidiary (2) would need to be made to avoid the application of U.S. earnings-stripping rules, and the Canadian parent would need taxable income to use the interest deduction available to it by financing the U.S. partnership. In 2007 the Canada introduced legislation that would deny the interest deduction in Canada for reverse hybrids of this type—the proposal has been withdrawn.

Figure 2.1 Ownership chain with partnership

International Corporate Tax Systems at a Glance

39

expense without having to involve a third country. Outside of withholding taxes and the need to work around rules such as the U.S. earnings-stripping rules, tax-efficient financing is achieved by creating an extra entity in the United States. Germany does not provide any special regimes to attract headquarters, holding companies, or group financing structures. However, the exemption of dividends and capital gains from German tax since 2001 has made Germany more attractive as a center for these forms of conduit entities. 2.9

What Have We Learned So Far?

The review of international tax systems in this chapter provides a glimpse of the complexity involved in understanding the economic implications of various rules affecting cross-border investments. Table 2.3 provides a summary that outlines some of the tax provisions of the countries with the most significant cross-border investments with Germany. A number of important conclusions are derived from the preceding discussion that will be critical to the theoretical and empirical analysis in forthcoming chapters. Germany generally exempts dividends earned on outbound investment, thereby providing a different case study than others that have focused on the United States with its deferral approach for taxing dividend income.




Passive income earned by multinationals is subject to tax in many countries. However, not all forms of payments, deductible from taxable income of a subsidiary, may be treated as passive income and subjected to accrual taxation. For example, according to German rules, interest received by a German-owned intermediate company abroad on loans used to finance tangible and intangible capital expenditures are treated as active business income either if the funds have been raised at local capital markets (i.e., are not provided by the German parent) or if the recipient of the loan is doing active business in the same country as the recipient of the intra-company interest payment.




While countries might restrict interest deductions associated with tax-exempt foreign investments, rules are not effective in limiting interest deductions since borrowings are rarely traced to investments that are exempt from taxation.




0

0

Interest-in

Interest-out

Thin-cap (1.5:1)

Accrual

Allocation and earnings stripping

Passive

Restrictions on interest Deductions9

No statutory rule

Accrual

Deferral8

0

0

0 0

Thin cap (4:1) and Pro-rata

Accrual

Deferral

0

0

0 0

Thin cap (3:1)

Accrual

Exempt

0

0

0 0

Yes3

25.5%1

NL

Maximum debt relative to type of asset

Accrual

Exempt

0

0

0 0

Yes4

13–30%

Switzerland

No statutory rule

Accrual

Exempt

0

0

0 0

Yes5

29.6%

Luxembourg

No statutory rule

Accrual

Exempt

0

0

0 0

No

25%

Austria

Source: Ernst & Young 2008. 1 Corporate income tax (CIT) rates are combined central and subnational government rates. A regional tax in Italy varying from 4.25 percent (industrial) to 8.5 percent (commercial) applies to value-added (income adjusted to exclude the deduction of payroll and net interest expense). 2 A special headquarters and logistics regime in France applies in which the corporate tax is applied to an assumed markup for profits equal to 6–10 percent of qualifying costs. Foreign-owned branches pay tax on 5 percent of dividends received as provided more generally to companies under the parent-subsidiary regime. 3 Although some significant changes to the Netherlands law are currently planned, Dutch companies were provided several regimes.

Accrual

Deferral

Exempt

0

0

0 0

Dividends

Foreign-source income7

5% 5%

Div-in Div-out

Withholding tax rates6

No

33%1

28%1 No

34.4% Yes2

39%

No

CIT rate

Conduit regime

Italy

United Kingdom

France

United States

Table 2.3 Major partner tax provisions as related to German outbound and inbound investments (2008)

40 Chapter 2

A reinvestment reserve deduction shelters book profits from the disposal of tangible and intangible assets against the cost of a reinvestment asset. Subject to certain conditions, a group finance company could establish a reserve up to 80 percent of its financial services income. A tax-free withdrawal from the reserve could be made equal to 50 percent of investments in affiliates or up to 100 percent for certain indirect investments. The group financing facility reserve deduction has been determined to be a form of state aid by the European Commission and will be terminated by 2010.
Qualified investment corporations are exempt from tax.

Swiss holding companies are only subject to federal tax (7.8 percent) for income from financial participations. A principal company regime for Swiss-based companies within a worldwide group that assumes risks and responsibilities for purchasing, manufacturing, research and development, marketing, logistics, and headquarter operations could be favorably taxed at a rate of 5 to 10 percent. Service companies providing management services to a multinational group are taxed on income subject to a safe harbor equal to 5 percent of costs (until 2004). 5 1929 holding companies are exempt from Luxembourgian corporate and withholding tax. Investment funds are subject to duty only. 6 Div-in/Interest-in: withholding rates levied by the source country on dividends/interest paid to a German investor. Div-out/Interest-out: withholding rates levied on the payments of a foreign owned affiliate to its parent. The quoted withholding taxes assume that the company receiving the payment qualifies for the participation level needed to claim the lowest rate possible. 7 The form of tax treatment is assumed to apply for qualifying participation threshold levels applied in each country. Foreign tax credits are generally provided for deferral and accrual cases. The accrual approach applies to passive income earned by companies under qualifying CFC rules that vary by country. 8 An exemption system was adopted by the United Kingdom in 2009. 9 Restrictions on interest expense apply with respect to related-party transactions. Where no statutory rule applies, some limitation on interest deductions is applied based on certain tests.

4







International Corporate Tax Systems at a Glance 41

42

Chapter 2

Withholding taxes are reduced by treaty, often eliminated if levied on payments between major industrial countries. Germany levies few, if any, withholding taxes on interest payments to nonresidents. Dividends are also exempt from German withholding taxes for EU partners and taxed at a low rate if paid to the United States.




Thin-capitalization and earnings-stripping rules have some effect in limiting interest deductions taken by nonresident companies in a host country although to a large extent are limited in scope.




Conduit tax regimes are available in many countries providing significant tax benefits to multinational groups by reducing or eliminating withholding taxes, providing opportunities for double-dip financing, and allowing companies to park their funds in a low-taxed conduit entity.




These observations will be more formally developed in the next chapter. We then analyze German data to see how taxes affect the financing structures of German companies.

3

Indirect Financing Structures

The literature on foreign direct investment (FDI) has identified an ample set of financing structures that may be used by a parent company in one country to finance its subsidiary in another country. These financing arrangements are widely understood in those cases that we call ‘‘direct’’ financing structures:1 a parent corporation finances investments in foreign locations by directly holding a foreign affiliate, choosing to put debt into the parent or subsidiary facing the highest tax rate and shifting income to the entity with the lowest tax rate. Conversely, ‘‘indirect’’ structures imply that a multinational parent will take advantage of another entity, often set up in a third country, to hold an affiliate. There has been little theoretical research on these more elaborate structures.2 In this chapter we will systematically analyze the financing opportunities that derive from using an intermediate corporation in a third country. For further reference we will call such an intermediate company a conduit entity or conduit company. 3.1

Direct versus Indirect Financing Structures

In the theory of direct FDI finance, the parent may use one of three sources of finance: debt, retained earnings, and equity from newly issued shares. The subsidiary, in turn, may use third party (external) debt, (internal) loans from the parent, and retained earnings, or may issue new shares that are bought by the parent. This allows for up to eight different financing channels, which are laid out in table 3.1. Things become more involved if indirect structures via a conduit entity in a third country are considered as illustrated by figure 3.1. In this case, the parent uses an intermediate firm (conduit entity) in a third country to own the subsidiary.

44

Chapter 3

Table 3.1 Direct financing structures Financing of the parent

Financing of the subsidiary

1. New share emission by the parent to buy 2. New share emission by the parent to provide an

new shares issued by the subsidiary intracompany loan to the subsidiary

3. External debt to buy

new shares issued by the subsidiary

4. External debt to provide an

intracompany loan to the subsidiary

5. Retained earnings to buy

new shares issued by the subsidiary

6. Retained earnings to provide an

intracompany loan to the subsidiary

7. — 8. —

Retained earnings Third-party debt

Figure 3.1 A simple conduit structure

As is visible in table 3.2, this small addition considerably increases the set of possible financial arrangements. Even though the table abstracts from retained earnings of the conduit entity, the opportunity set is considerably larger than that of table 3.1. This increase in the opportunity set partly results from a possible transformation of financial flows through the conduit: the conduit entity may receive equity and forward these funds as a loan to the subsidiary or may conversely receive a loan from the parent and forward the funds as equity. While the structure described in the twenty-two cases of table 3.2 is indirect in the sense that the subsidiary is held via a (wholly owned) conduit

Indirect Financing Structures

45

Table 3.2 Indirect financing structures Financing of the parent

Conduit entity

Financing of the subsidiary

New share emission by the parent to buy

new shares issued by the conduit entity

to buy new shares issued by the subsidiary to give an intracompany loan to the subsidiary

New share emission by the parent to provide an

intracompany loan to the conduit entity

to buy new shares issued by the subsidiary to give an intracompany loan to the subsidiary

External debt to buy

new shares issued by the conduit entity

to buy new shares issued by the subsidiary to give an intracompany loan to the subsidiary

External debt to provide an

intracompany loan to the conduit entity

to buy new shares issued by the subsidiary to give an intracompany loan to the subsidiary

Retained earnings to buy

new shares issued by the conduit entity

to buy new shares issued by the subsidiary to give an intracompany loan to the subsidiary

Retained earnings to provide an

intracompany loan to the conduit entity

to buy new shares issued by the subsidiary to give an intracompany loan to the subsidiary

New share emission by the parent

—

to give an intracompany loan to the subsidiary to buy new equity

External debt

—

to give an intracompany loan to the subsidiary to buy new equity

Retained earnings

—

to give an intracompany loan to the subsidiary to buy new shares issued by the subsidiary

—

external debt

to give an intracompany loan to the subsidiary to buy new shares issued by the subsidiary

—

—

Retained earnings

—

—

Third-party debt

46

Chapter 3

Figure 3.2 Direct financing structure

entity, there is still the option for the parent to give a direct loan to the subsidiary (cases 13, 15, and 17) just as in the case of a direct structure. Clearly, the tax preferences of the different financing arrangements will depend on the exact tax rates and tax systems of the up-to-three countries involved, and are therefore less straightforward. A possible tax reduction scheme that has received quite some attention is a double-dip situation in which an interest deduction is used in two countries.3 This may be achieved if the parent company of a multinational takes out a loan to inject equity into a conduit company, which then forwards the funds as an intracompany loan to the affiliate. Since the interest on the loan is in general tax-deductible, both the affiliate and the parent may use this deduction, while taxation on the interest received by the conduit may be low if this corporation is located in a low-tax jurisdiction or is granted special holding privileges. The next section will more formally investigate the tax preferences for such and other financing arrangements. 3.2

A Model of Indirect Financing Structures

Table 3.2 gave an overview of the ample financing possibilities that a multinational with a conduit entity may use. In this section we will use pairwise comparisons of financial instruments and draw conclusions regarding the tax advantage of indirect holding structures. The strategy to do so is to assume constant capital stocks ðK; K
Þ at home and abroad. We then are able to clarify whether—depending on the specific tax parameters—a small change of the financing structure increases ultimate shareholder wealth.4 As mentioned, the standard framework to analyze foreign direct investment is a model with a simple two-tier structure, where a (representative) shareholder owns a parent firm that in turn owns an incorporated subsidiary abroad. Figure 3.2 illustrates the possible flow of funds in this case. Equity purchases ðQÞ by shareholders are one source

Indirect Financing Structures

47

Figure 3.3 A simple indirect structure

of external finance by the parent. Another one may be third-party debt ðBÞ. The subsidiary, in turn, may receive equity finance ðQ P Þ or loans ðF
Þ from the parent. In addition it can take out third-party debt B
. A more complicated and indirect structure is illustrated by figure 3.3. Here the parent uses a conduit entity that at least holds a fraction of the affiliate’s equity. Note that it is conceivable that the parent also holds some fraction of the affiliate’s equity directly. The relevant equity injection is then labeled Q P . In addition, the conduit may be financed by new equity from the parent ðQ  Þ, loans from the parent ðF  Þ, or third-party debt ðB  Þ. The additional instruments to finance the affiliate are loans granted by the conduit ðF
Þ and equity injected by the conduit entity ðQ
Þ. Since the structure in figure 3.2 is only a special case of that in figure 3.3, we will jump directly into modeling this latter structure. While our interest in financial structure allows the simplification of taking real capital ðK; K
Þ to be exogenous, we have to distinguish carefully the possible avenues to finance real capital. Considering the affiliate, its capital stock can either be financed by loans from the holding ðF
Þ, external debt ðB
Þ, loans of the parent ðL
Þ, equity attributable to the conduit ðE
Þ, or equity directly attributable to the parent ðE P Þ:5 K
¼ B
þ F
þ L
þ E
þ E P:

ð3:1Þ

By assumption, the holding has no real capital, which reflects the assumption of a pure conduit. It can use its own equity ðE  Þ, the loans taken out from the market ðB  Þ, and the intrafirm lendings by the

48

Chapter 3

parent ðF  Þ to lend to the affiliate ðF
Þ and to hold equity in the affiliate ðE
Þ. E
þ F
¼ B  þ E  þ F :

ð3:2Þ

Finally, the parent can use its equity and debt for holding real assets, for equity of the holding and equity in the affiliate, and for lending to the holding and the affiliate. E  þ K þ F  þ L
þ E P ¼ B þ E

ð3:3Þ

Irrespective of whether there is a conduit or a direct financing structure, dividends net of corporate tax, D, paid by the parent to the shareholder may be subject to a personal dividend tax and/or may carry a imputation credit so that the shareholder receives ð1  yÞ for every euro of dividends paid, where y captures the features of the corporate tax system.6 With a classical system, lacking relief on the personal level for corporate taxes paid on the corporate level, we have that y equals the shareholder’s tax rate on capital income m. If dividends were exempted at the shareholder level, then y equaled zero. In addition to a personal tax on dividends and interest, there may be an effective tax rate c on the shareholder’s capital gains.7 Several assumptions and simplifications should be mentioned before we further develop the model. Tax rates are assumed to be constant (as it is usual in the KingFullerton type literature on financing and capital cost).



The home country of the multinational is assumed to run an exemption system as this holds for multinationals from Germany and many other European countries.





The nontax costs related to financing structures are ignored.

In case the multinational firm is sold (i.e., the shares of the parent), the assumption is that the marginal shareholder’s tax rate stays the same.





The subsidiaries abroad are assumed not to be separately fungible.

All loans are serviced at the arm’s-length interest rate i. Exchange rates are set to unity.



At any point in time t, the shareholder will be indifferent between holding his or her stocks worth V and selling it for acquiring an alternative investment with return i if

Indirect Financing Structures

49

ið1  mÞVðtÞ ¼ DðtÞð1  yÞ  QðtÞ þ ðV_ ðtÞ  QðtÞÞð1  cÞ Solving for the change in corporate value, V_ , integrating forward over time, and setting the integration constant to zero yields the value of the multinational that for time 0 can be written as8 V0 ¼

ðy D 0


 1y 1 1m Q  exp i t  dt 1c 1c 1c

ð3:4Þ

The dividends that the parent pays to the shareholder can be derived from the following cash flow identity: D ¼ ð1  tÞðp  iB þ f  iF  þ f
iL
Þ þ z  D  þ z P D P þ B_  F_   L_
 Q   Q P þ Q  K_

ð3:5Þ

Here t denotes the corporate income tax in the parent’s home country and p the profits (before interest and taxes) originating in that country. z  is the fraction of foreign dividends received net of tax if the holding company pays one euro of dividends after corporate tax.9 In a similar fashion, z P is the fraction of foreign dividends received net of tax by the parent if the affiliate pays one euro of dividends after corporate tax directly to the parent. In a similar vein, f  ðf
Þ measures the interest that the parent receives before domestic tax if the conduit (the affiliate) pays interest of one euro. If the host country and the conduit country either have no withholding tax on interest payments or this withholding tax is fully credited in the home country of the parent, then f  and f
equal unity. D  is the dividend paid by the conduit. The dividends paid by the holding follow from another cash flow identity: D  ¼ ð1  t  Þðf
iF
 iB   iF  Þ þ Q  þ F_  þ B_   Q
 F
þ z
D
ð3:6Þ In a similar vein, we have for the dividends paid by the affiliate: D
¼ ð1  t
Þðp
 iB
 iF
 iL
Þ þ B_
þ Q
þ Q P þ F_
þ L
 K_
ð3:7Þ To model direct as well as indirect financing structures, we introduce a variable o that measures the fraction of equity held by the parent directly. If o equals unity, the conduit holds no equity in the affiliate and the affiliate pays all its dividends directly to the parent.

50

Chapter 3

In the other extreme case, o ¼ 0, all equity is held indirectly via the conduit and all dividends are channeled via the conduit. Consolidating the cash flow constraints (3.5), (3.6), and (3.7) and taking advantage of the variable o yields D ¼ ð1  tÞðp  iB þ f  iF  þ f
iL
Þ þ B_  F_   L_
 Q   Q P þ Q  K_ þ z  fð1  t  Þðf
iF
 iB   iF  Þ þ Q  þ F_  þ B_   Q
 F
g þ ½z
z  ð1  oÞ þ z P oðð1  t
Þðp
 iB
 iF
 iL
Þ þ B_
þ Q
þ Q P þ F
þ L_
 K_
Þ:

ð3:8Þ

This definition of the dividend can now be used in the objective function of the multinational as given by (3.4). A useful instrument to tackle intertemporal maximizing problems like this one is to form the Hamiltonian of the problem. The (current-value) Hamiltonian of the maximization problem that we receive from adding to the objective function the flow constraints with the associated Lagrange multipliers is given by H¼

1y 1 D Q þ b  B_ þ b  B_  þ b
B_
1c 1c þ l
L_
þ j  F_  þ j
F_
þ sK_ þ s
K_
;

ð3:9Þ

where b, b  , b
, l, j  , j
are the shadow prices of the various types of external and internal debt. s and s
are the shadow prices associated with the real capital of the parent and the affiliate. Since in the following we will concentrate on only financial perturbations, they are irrelevant (i.e., K_ ¼ K_
¼ 0 by assumption). Financial perturbations often have two effects: an immediate one and an effect on future cash flows. For example, additional third-party debt ðBÞ may allow that dividend payments can be increased currently. This is the immediate effect. But in the future, the increased interest payments will restrict dividend capacity. The effects of perturbations in the financial structure can be analyzed with the help of the Hamiltonian as future effects are captured in the shadow prices. They measure the effect on the value of the objective function, if, for exogenous reasons, the stock of the respective variable (i.e., B, B  , B
, F  , F
, or L
) is increased. In all cases, the value of the shadow price is derived by forming the cash value of the changes in future dividends resulting

Indirect Financing Structures

51

form the increase in the stock variable.10 Formally, the values of the shadow prices can be derived by differentiating the value of the objective function at time t ¼ 0 with respect to the stock variable under consideration (B, B  , B
, F  , F
, or L
). 
 ðy dV0  1y 1m ð1  tÞi  exp it b¼ ¼  dt 1c 1c dB t¼0 0 ¼

j ¼

¼

ð1  yÞð1  tÞ ð1  mÞ

ð3:10Þ


 ðy dV  1y 1m    iff it dt ¼ ð1  tÞ  z ð1  t Þg  exp  dF  t¼0 1c 0 1c ð1  yÞff  ð1  tÞ  z  ð1  t  Þg ð1  mÞ

ð3:11Þ


 ðy dV0  1y 1m   ½ð1  t Þz i  exp it b ¼  ¼  dt 1c 1c dB t¼0 0 

¼

b
¼

z  ð1  yÞð1  t  Þ ð1  mÞ

ð3:12Þ

 ðy dV0  1y fð1  t
Þig½ð1  oÞz  z
þ z P o ¼  1  c dB
t¼0 0
 1m it dt  exp  1c

¼

½ð1  oÞz  z
þ z P oð1  yÞð1  t
Þ ð1  mÞ

ð3:13Þ

 ðy dV0  1y  fz ð1  t  Þf
i  ½ð1  oÞz  z
þ z P oð1  t
Þig j ¼
 ¼ dF t¼0 0 1c



 1m it dt  exp  1c ¼

ð1  yÞfz  ð1  t  Þf
 ½ð1  oÞz  z
þ z P oð1  t
Þg ð1  mÞ

ð3:14Þ

52

Chapter 3

 ðy dV  1y
ff ð1  tÞ  i  ½ð1  oÞz  z
þ z P oð1  t
Þig l ¼
 ¼ dL t¼0 0 1c





 1m it dt  exp  1c ¼

ð1  yÞfð1  tÞf
 ½ð1  oÞz  z
þ z P oð1  t
Þg ð1  mÞ

ð3:15Þ

Armed with the values of the shadow prices, we can now look at financial perturbations from a tax perspective. 3.2.1

Financial Arbitrage in Financing the Affiliate

3.2.1.1 Internal versus External Debt Finance of the Affiliate First, we will look at the relative merits of internal and external loans for the affiliate. A first issue is whether it is better to grant an internal loan to the affiliate via the parent or the conduit. The wealth increase from the perspective of the shareholder if the multinational increases the loans from the conduit to the affiliate and correspondingly reduces the loans by the parent is given by the following (using equations [3.14] and [3.15]): qH qH 1y 1y  f1  z  g þ fz ð1  t  Þf
 ð1  tÞf
g: 
¼
_ _ 1c 1m qF qL ð3:16Þ The second term on the right-hand side shows the effects on future net of tax cash flows. These are taxed at the rate t if the loan is granted by the parent and by t  if the loan is given by the conduit. Moreover, there is a differential effect if the parent gives the loan, since a possible dividend tax on distributions by the conduit (if z  < 1) is avoided. The first term captures the immediate effect of reducing parent loans and increasing loans via the conduit. The dividend capacity of the conduit is reduced and that of the parent is increased. In the case where dividends of the conduit are effectively taxed ðz  < 1Þ, this comes at a tax cost. In the case z  ¼ 1, the interest should be received by the corporation with the smaller tax rate. For the likely case that the conduit country is chosen such that no withholding tax rate is paid on the dividends of the conduit and no further home country taxes apply ðz  ¼ 1Þ, then a conduit loan dominates a loan by the parent if the corporate tax rate of the conduit is lower than that of the parent.11

Indirect Financing Structures

53

Next, consider the choice between external debt ðB
Þ and intracompany loans provided by the conduit ðF
Þ. Marginally increasing thirdparty debt and reducing F
affects shareholder value according to   qH qH 1  y  1 ð1  t  Þf
z   ¼ : 1c 1m qB_
qF_
1  c

ð3:17Þ

The interpretation is as follows. Taking out third-party debt to reduce internal debt increases the dividend capacity of the firm. The shareholder has more cash and can invest at the going interest rate net of personal taxes. If the effective taxation of (retained) interest income, which consists of a tax on interest at the corporate level and a capital gains tax at the personal shareholder level, is higher than the effective rate on personal interest income, external debt dominates. This is the case if ð1  t  Þf
ð1  cÞ < ð1  mÞ and then the terms in the curled bracket of equation (3.17) will be positive. The third pair of debt instruments of the affiliate that can be compared is parent loans versus third-party loans. Again, differentiation of the Hamiltonian gives us the effect on shareholder wealth.   qH qH 1 ð1  tÞf
  ¼ ð1  yÞ : 1c 1m qB_
qL_


ð3:18Þ

The result is analogous to the one in equation (3.17): external loans are tax preferred if the effective taxation of the interest receiving corporation (here the parent) is lighter than taxation of interest in the hand of the shareholder. Table 3.3 brings together the results from equations (3.16)–(3.18). Although the relevant tax rate of the decisive shareholder is difficult to identify, it is interesting to note that for internal debt to dominate external debt, it must hold that the relevant personal tax rate is positive. Effectively, the use of additional external debt allows to increase dividends and personal investment by the shareholder compared to the Table 3.3 Preferences of the affiliate over debt instruments Preference

Condition to be met

Conduit loans dominate parent loans

ð1  cÞf
fð1  tÞ  z  ð1  t  Þg < ð1  mÞð1  z  Þ

Conduit loans dominate external debt

ð1  t  Þf
ð1  cÞ > ð1  mÞ

Parent loans dominate external debt

ð1  tÞf
ð1  cÞ > ð1  mÞ

54

Chapter 3

case of internal debt finance. If the shareholder faces no tax on her financial investments ðc ¼ m ¼ 0Þ, then the internal use of funds cannot compete from a tax perspective and external debt always dominates internal debt as long as t
; t  > 0. But even if m is sufficiently large to give a preference for loans by the conduit, a tax preference for a double dip additionally requires that the parent finds it advantageous to use debt financing. We will return to this point later. A first major result from the conditions in table 3.3 that we want to highlight refers to the role of the host country tax rate t
. Result 1 (Local tax irrelevance) The relative tax advantage of loans provided by the parent, the conduit, or a third party is not influenced by the level of the host country tax rate. The intuition for this result is quite simple: whatever debt instrument is used by the affiliate, the interest payments on all three instruments are deductible and provide a tax shelter from the host country tax rate. We also want to note the role of the tax rate t  in the conduit country for future reference. Result 2 (Low local tax requirement) For conduit loans to be tax efficient, the conduit country’s tax rate must be sufficiently low. Another point worth emphasizing is that the fractions of equity owned via the conduit or the parent turn out to be irrelevant for the relative merits of the various debt instruments that may be employed by the affiliate: the value of o fails to show up in any of the three preceding pairwise comparisons. Result 3 (Ownership irrelevance) The preferences over the three alternative debt instruments to finance the affiliate are independent of the fractions of equity that are held directly or via the conduit. 3.2.1.2 Retained Earnings versus Debt Financing of the Affiliate In a next step we ask under what conditions it is tax efficient to use retentions rather than debt to finance the affiliate. The profitability of increasing third-party debt and reducing retained earnings is given by   qH 1 ð1  t
Þ
 P  ¼ ½ð1  oÞz z þ z oð1  yÞ ; 1  c ð1  mÞ qB_


ð3:19Þ

Indirect Financing Structures

55

where the derivation makes use of the value of b
as given by equation (3.13). The sign of qH=qB_
only depends on the effective taxation of personal interest on the one hand and the tax on retained earnings of the affiliate on the other hand. If the combined tax on retentions from the corporate tax ðt
Þ and the capital gains tax ðcÞ is lighter than the taxation of personal interest income, namely, ð1  t
Þð1  cÞ > ð1  mÞ, then retentions dominate external debt. If this is the case, the value of qH=qB_
, namely, the intensity of the preference for retentions, also depends on the effective tax on dividends when these are channeled from the affiliate to the shareholder. The stronger this preference is, the less tax falls on the distribution of the profits by the affiliate, namely, the higher ½ð1  oÞz
z  þ z P oð1  yÞ. Next consider the tax efficiency of replacing retained earnings of the affiliate by using loans from the conduit company. The profitability of the financial arbitrage is given by   qH 1 ð1  t
Þ
 P  ¼ ½ð1  oÞz z þ z oð1  yÞ 1  c ð1  mÞ qF_
 1  t
1 f  þ ð1  yÞz : 1c 1m 




ð3:20Þ

The first part of the right-hand-side expression is identical to the expression in equation (3.19), while the second term to the right corresponds to the expression in equation (3.17) and is related to the advantage of conduit loans versus third-party debt. If conduit loans are tax preferred compared to third-party debt, then this is also reflected in the ranking with respect to equity. The same logic applies if we compare retained earnings and loans from the parent. Again, we can derive an expression that falls into two parts and where the second part reflects the relative advantage of internal loans by the parent compared to third-party debt:   qH 1 ð1  t
Þ
 P  ¼ ½ð1  oÞz z þ z oð1  yÞ 1  c ð1  mÞ qL_

 1t
1 f  þ ð1  yÞ : 1m 1c From the last three equations we can state the following.

ð3:21Þ

56

Chapter 3

Result 4 (Shareholder tax versus local corporate tax) Third-party debt dominates retentions by the affiliate if the effective taxation of retained earnings, captured by the rate c þ t
ð1  cÞ, exceeds the tax rate m on the shareholder’s alternative investment. To the extent that intracompany loans are tax preferred or disadvantaged compared to third-party debt, this also shows up in the comparisons between loans and retentions. An increase in the tax rate t
of the affiliate ceteris paribus improves the tax efficiency of all three debt instruments when compared to retentions. 3.2.1.3 Retained Earnings of the Affiliate versus New Equity Besides debt and retentions, the affiliate may use new share emissions to the parent or the conduit company to finance its stock of capital. As it is well known from the tax literature on international FDI, new equity is never a tax-preferred way of financing if dividends trigger a tax on distributions.12 Instead of distributing earnings and plugging back the amounts by issuing new equity, it is more tax-efficient for the multinational to retain the initial earnings and avoid a tax on dividends. The same holds also in our two-tier model of FDI. There is a slight complication, though. If the dividend share o depends on the relative share of stock capital held by the parent and the conduit, then a new share issue may change o if we start from an interior situation in which Q P ; Q
> 0. To simplify things, we concentrate on border cases, in which the multinational uses either Q P or Q
and o therefore acts as a zero-one indicator. In this case, increasing the only source of capital injection will not change o. Hence, the effect on shareholder value if the affiliate pays a dividend that is compensated by new equity from the parent is given as qH 1y P ½z  1 ¼ qQ P 1  c

ð3:22Þ

if Q
¼ 0. Since 0 a z P a 1, the right-hand side can only be negative or zero, at best. Similarly, with Q P ¼ 0, an increase in new equity provided by the conduit company through a reduction in dividend payments to the parent is given by qH 1y
 ½z z  z  :
¼ qQ 1c

ð3:23Þ

From 0 a z
; z  a 1, the marginal effect on the Hamiltonian can never be positive.

Indirect Financing Structures

57

3.2.2 Tax-Preferred Ownership Chains An interesting question that has received relatively little attention in the literature is what drives the setup of indirect ownership patterns. The model presented earlier is richer than previous modeling efforts as financing instruments based on the existence of a conduit company are explicitly taken into consideration. But still there is a deficiency in the sense that we analyze the financing preference of mature companies that pay dividends. The setup of the various corporations of the multinational firm is beyond the scope of this chapter. In simplified settings, during which conduit entities have been assumed away, the establishment phase has been modeled by various authors (Sinn 1993; Hines 1994; Weichenrieder 1995). Since in these models the establishment of the foreign subsidiaries may include a tax-induced internal growth phase in which an affiliate grows by retaining all its earnings, the multinational may have to adapt to this growth phase by injecting less equity into the foreign affiliate at the time of establishment. But even though we abstain from drawing up a full-fledged model of the setup phase, some observations can be made. A simple case is the one where the conduit must be newly established along with the affiliate. In this case, the parent has the alternatives of directly injecting equity into the affiliate, or to hand new equity to the new conduit, which then forwards this sum as an equity injection to the affiliate. If the tax rates and systems are considered constant, then the multinational will at the time of the setup of the affiliate use the type of ownership chain that will maximize future net of tax dividends received from the affiliate. This is the case if o is chosen such that for any euro of distributed dividends, the net of tax dividend for the shareholder, ½ð1  oÞz
z  þ z P oð1  yÞ, is maximized. Hence, routing dividend payments through the conduit ðo ¼ 0Þ is profitable if the value of z
z  exceeds z P . One might think that the decision on o interferes with the possibility of using indirect intracompany loans, but such loans by the conduit entity are even possible with o ¼ 1. An obvious case for z-values that fall short of unity is the applicability of withholding taxes. If direct dividend payments from the affiliate to the parent are taxed highly, but the combined tax on dividends that are channeled via the conduit is low, then the use of a conduit is tax preferred. Somewhat more is involved if, for some reasons, the parent already owned an existing conduit company. In this case, the multinationals may find it profitable at the time of establishment of the affiliate to use

58

Chapter 3

retained earnings of the conduit to inject new equity into the affiliate. If there is an additional tax on these funds when they are distributed to the parent ðz  < 1Þ, their shadow price is lower than that of the funds provided by the parent, which creates an additional incentive to use equity provided by the conduit. For any euro that is provided to the affiliate, the parent forgoes z  euros in dividends rather than one euro. While our model does not explicitly cover the foundation decision, this logic is visible in equation (3.23) where the impact on shareholder wealth when retained earnings of the conduit are used to finance the affiliate is governed by the difference of z
z   z  rather than by the factor z
z  alone. We want to summarize the preceding discussion as a separate result. Result 5 (Treaty shopping) The preferences over different types of ownership chains are dependent on the tax load on dividends as applicable when these are directly paid from the affiliate to the parent and the tax load when these are channeled via the conduit. Ceteris paribus, a high tax load on direct distributions to the parent, for example, due to withholding taxes that are not credited in the home country of the parent, tends to favor an indirect ownership structure. In the applied tax literature, the search for favorable ownership structures that try to avoid taxes on dividend distributions has been labeled ‘‘treaty shopping.’’ In chapter 4 we will return to this issue to empirically identify the scope of these firm policies. 3.2.3 Financial Arbitrage in Financing the Parent The profitability of financial arbitrage for a domestic firm has been studied in a seminal contribution by King (1977). As is shown here, his results do not change if this firm owns a foreign affiliate.13 3.2.3.1 New Equity versus Retained Earnings The impact on shareholder wealth that results from an increase of new equity at the expense of retained earnings can be derived by differentiating the Hamiltonian with respect to new equity. qH 1 1y ¼ þ qQ 1c 1c

ð3:24Þ

Equation (3.24) captures the effect if the parent distributes one euro of retained earnings to plug back the funds by raising new equity. As in

Indirect Financing Structures

59

the case of an increase in Q
, this is not an optimal policy if dividend distributions trigger additional taxation, namely, y > 0. Conversely, when this is not the case ðy ¼ 0Þ, then new equity finance and retained earnings have the same tax cost. 3.2.3.2 Debt versus Retained Earnings Equation (3.25) derives the wealth effect of additional external debt that goes with a higher dividend payout by the parent. The derivation takes advantage of the value of b as given in equation (3.10). qH 1  y ð1  yÞð1  tÞ  : ¼ 1c ð1  mÞ qB_

ð3:25Þ

The sign of this expression depends on whether the shareholders’ tax on alternative investments is higher than the combined tax burden on retained earnings that results from a capital gains tax and the corporate tax rate on retained earnings. Retained earnings dominate if ð1  cÞð1  tÞ > ð1  mÞ. 3.2.3.3 New Equity versus Debt Finally, the wealth effect of raising additional equity to pay back one unit of parent debt can be derived from the expression qH qH 1 ð1  yÞð1  tÞ  þ : ¼ qQ qB_ 1c ð1  mÞ

ð3:26Þ

We are now in a position to analyze the tax factors that make it worthwhile to use a double-dip structure, where an interest deduction is taken both by the parent that uses third-party debt and by the affiliate that uses intracompany loans granted by the conduit. Table 3.3 has identified conditions for the relevant incentives at the affiliate level. From the last three equations, we have that the parent has a tax incentive to use debt financing if the effective level of taxation is higher for retained earnings of the parent than for alternative income of the shareholder: ð1  cÞð1  tÞ < ð1  mÞ. Result 6 (Limits on double dips) A double-dip structure, in which the parent uses debt to forward it to the conduit in the form of equity and the conduit lends to the affiliate, is only tax preferred (1) if there is a sufficiently high tax rate of the shareholder and (2) if the effective taxation of retained earnings of the parent is higher than the tax on the shareholder’s alternative investment income.

60

Chapter 3

Given that two tax deductions look to have a clear advantage at first sight, this restricted incentive for a double dip may come as a surprising result. The intuition behind it is as follows. A high personal tax rate of the shareholder is required so that the intrafirm debt dominates third-party debt. Since a shift toward third-party debt allows dividend distributions that the shareholder can reinvest, a low tax on this reinvestment makes the distribution (and the third-party debt) worthwhile. For a double dip, not only the subsidiary but also the parent must be debt financed. So, in addition, the effective tax on retained earnings must be sufficiently high compared to the tax on dividend distributions. A simplification of this model is that our multinational faces no liquidity constraints and hence no restriction on the use of external debt. There may be situations in which the existence of an overall debt-equity restriction is an additional argument for intracompany loans via the conduit since an external loan is not available. But the increased attraction of intracompany loans is subject to qualifications. For example, a double-dip strategy, in which the parent takes out a loan to forward the funds as an equity injection to the conduit (that in turn gives a loan to an affiliate), would imply an increase in the overall debt-equity ratio and would not work in the presence of a global debt restriction. As a caveat we should add that we have assumed a multinational that tries to maximize shareholder wealth. Managerial firms with interests distinct from their shareholders may have a somewhat higher tendency to employ highly leveraged double-dip structures since managers may be interested in worldwide corporate tax minimization rather than in shareholder wealth maximization. While ignorance of managers toward shareholder wealth may increase the scope for double-dip financing structures, there are specific tax regulations that may also hinder applicability. First, unlike the model in this chapter assumed, the home country may use a credit system of taxation. In this case the advantage of a low tax t  in the conduit country may be partly compensated by a reduced tax credit of the parent on foreign income. Technically speaking, z  would depend on t  in this case and the interpretation of some of the conditions derived earlier needed careful reconsideration. Second, the home country of the parent may apply a CFC regulation affecting the taxation of passive income, as discussed in chapter 2, which could increase the tax on interest income earned by the parent through the conduit.

Indirect Financing Structures

61

Eventually, it is an empirical question to what extent indirect financing structures are used and lead to additional debt financing. We will turn to these questions in the next chapter. To summarize, the findings of this chapter suggest that indirect structure should be more common if direct structures are plagued with high taxes on repatriations. They also verify that the higher the respective corporate tax rate is, the higher is the incentive to finance a particular affiliate with debt. An interesting fact that was borne out by the model is that the use of intracompany debt to substitute for external debt is a strategy that tends to strenghten the equity basis of the multinational, a strategy that is hard to evaluate without knowledge of the ultimate investor’s tax rate on alternative investments. A major advantage of indirect structures arises if interest income of the conduit is taxed lower than interest income received by the parent, although repatriation taxes, as they may arise if the home country of the parent uses a credit cum deferral system of taxation, could destroy the profitability of such an arrangement.

4

Holding Companies and Ownership Chains

The pervasive economic model of foreign direct investment is one where a parent company in one country holds a production or sales company in another country. At the same time, as we have pointed out in the last chapter, investment strategies are often much more involved and imply not only the existence of several foreign subsidiaries but often quite complicated ownership chains. In this chapter we will empirically identify the scope and the factors behind those more complicated structures. A frequent instrument is the setup of holding companies. A first type of holding company may be termed a ‘‘country holding.’’ A country holding brings under one umbrella a subset or all operations that a multinational pursues in one country. A second possibility is the setup of holding companies in the home country of the parent. Sometimes multinationals seem to establish separate holding companies just to control a single foreign corporation.1 And, finally, holding companies may be located in third countries. This is the conduit entity case as discussed in chapter 2. Clearly, all three types of holding companies may be motivated by efforts to organize foreign activities in an economically efficient and sensible way and may also make sense in the absence of taxation. In particular when it comes to the third type of constructing an ownership chain, however, taxes allegedly are a prime motive. To give a simple example, imagine a parent firm in country A that wishes to set up a subsidiary in country B. Assume there is a large withholding tax rate of 25 percent applicable on any dividend paid from a subsidiary in B to a parent firm in A. Then an obvious tax strategy is to look for a third country that has a more favorable tax treaty with B. Assume companies in country C can receive dividends that are exempted from the withholding tax from a firm in country B and at the same time country

64

Chapter 4

C does exempt dividends paid to a controlling firm in A. In this case, the setup of a conduit entity in C is an instrument to avoid the withholding tax. The strategy to channel cash flows through jurisdictions that have favorable tax treaties has been dubbed ‘‘treaty shopping,’’ and holding companies are obvious instruments to shop for the most favorable tax treaties. This incentive to set up an intermediate company has also been identified in the theoretical model of chapter 3 (see result 5 [Treaty shopping]). But even in the case of conduit entities in third countries, it is far from clear that the shape of the ownership chain is purely tax motivated. For example, the quality of the legal and corporate codes in different countries may make it a wise decision to not establish a country holding there but to move it to some other, more reliable, environment. Conversely, even a country holding may be tax motivated. One reason for such a motivation may be profit and loss consolidation. If consolidation between two corporations is allowed, the losses of one corporation may be used to reduce the taxable profits of the other corporation. While almost all countries disallow profit and loss consolidation across borders, many countries may allow consolidation between domestic companies. In this case a country holding is a simple device to carry out such a consolidation for tax purposes. As discussed in chapter 2, some holding companies may be used within a country for tax planning reasons besides consolidation. A holding company could be located in low-tax state or province to reduce taxes paid at the subnational level (such as Delaware in the United States and Quebec in Canada). Further, the use of hybrid entities that could accomplish double-dip interest deductions would need a holding company to be established in the same country as the target (Finance Canada 2007). In this chapter we want to empirically investigate the tax and some nontax motives of establishing conduit entities in third countries as well as the motives for establishing country holdings. We will give some descriptive evidence for the increasing role of holding companies and ownership chains, making use of the Deutsche Bundesbank’s FDI data (MiDi), and will show some explorative regressions that show the significance of tax factors behind ownership chains. The analysis of the German data suggests that tax factors are indeed important for ownership chains in international investment. If taxes on dividends from a destination country to a home country of the investor are high, then the probability that the foreign affiliate is held via a conduit entity

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65

in a third country is significantly higher than in a case where withholding taxes on dividends are absent. To the best of our knowledge, this is the first micro-based econometric evidence for the scope of treaty shopping.2 It also becomes evident from the data that the possibility to consolidate foreign profits abroad influences the decision to set up country holdings. The chapter also looks at the financial structure of foreign affiliates. Since holding companies are often located in countries that lightly tax interest income received by holding companies, a plausible hypothesis is that firms that are held via tax-favored holding companies may be induced to use more debt than other firms. According to result 2 (Low local tax requirement) of chapter 3, cross-border conduit loans are particularly tax preferred if the tax rate of the conduit company on interest income is low. Indeed, several important conduit countries have special schemes to achieve such a low tax rate. As highlighted in chapter 2, the Netherlands, for example, has a special tax regime3 that leads to a reduced tax on interest income received from foreign subsidiaries. In Switzerland, the income of holding companies is exempted from cantonal taxes, leaving only a moderate federal tax level of about 8 percent. Yet, from analyzing the financial structures of subsidiaries held via conduit entities, we find only mixed evidence that the existence of a conduit company changes the overall debt ratio of a dependent subsidiary. While in the case of German outbound investment in manufacturing the introduction of a foreign holding company seems to go along with a better equity base, the evidence on the inbound side points to a larger leverage following the establishment of a Swiss or Dutch conduit entity. The remainder of the chapter is organized as follows. In a first step we will give a detailed overview of the structure of ownership chains as it can be distilled from German FDI data. In a next step we will discuss possible factors that may influence the decision for routing direct investment through holding companies and will perform the econometric identification, before section 4.6 concludes. 4.1

Ownership Chains in German Outbound Investment

The use of conduit entities seems to be on the rise. If we look at macroeconomic figures, this is suggested in the parallel increase in FDI imports and exports of some small host countries like Luxembourg, the Netherlands, and Belgium. The special role of several smaller countries for performing financial services is also present when we look at

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Table 4.1 A ranking of destination countries for German FDI (2002) Fixed assets and intangibles

Rank

Jobs

1

USA

43.2%

1

USA

2

UK

10.2%

2

F

F

4.4%

3

UK

7.3%

4

A

3.2%

4

A

5.6%

6.3%

5

E

3.1%

5

E

4.8%

4.2%

6

CZ

3.0%

6

CZ

4.7%

IRL I

4.1% 2.6%

7 8

NL I

2.7% 2.6%

7 8

PL I

4.4% 3.6%

9

CH

1.9%

9

PL

2.2%

9

BR

3.6%

10

B

1.9%

10

H

1.9%

10

H

3.3%

11

E

1.7%

11

CH

1.9%

11

NL

2.9%

12

J

1.3%

12

J

1.9%

12

VRC

2.3%

13

ROK

0.9%

13

CDN

1.9%

13

CH

2.1%

14

AUS

0.9%

14

MEX

1.7%

14

MEX

2.1%

15

NZ

0.9%

15

B

1.4%

15 ...

B

1.9%

16

LUX

1.3%

39

IRL

0.4%

LUX

0.3%

Rank

Total assets

Rank

1

USA

34.8%

2

UK

9.8%

3

NL

9.0%

3

4

LUX

8.6%

5

A

6

F

7 8

... 34

18.0% 8.0%

... IRL

0.3%

42

Source: Bundesbank MiDi database. Note: Country shares are calculated from nonconsolidated firm data. Values are weighted by the ownership fraction of German investors. Country abbreviations: A: Austria; B: Belgium; BR: Brazil; CDN: Canada; CH: Switzerland; CZ: Czech Republic; E: Spain; F: France; H: Hungary; I: Italy; IRL: Ireland; J: Japan; LUX: Luxembourg; MEX: Mexico; NL: Netherlands; PL: Poland; ROK: South Korea; UK: United Kingdom without overseas territories; USA: United States; VCR: China.

German multinationals. Table 4.1 presents three different measures of German FDI in top host countries. In the first three columns, countries are ranked according to the aggregated balance sheet totals of Germanowned firms. To the right, recipient countries of German FDI are ranked according to how much total fixed investment (plus intangibles) and how many jobs they are hosting. Three smaller countries that appear high in the first ranking are Luxembourg, the Netherlands, and Ireland. While German-owned companies in these countries account for a huge sum of total assets, they reflect a large part of neither German-owned fixed investment nor jobs. While the Netherlands, for example, accounts for 9 percent of balance sheet total in German-

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67

owned firms abroad, it makes up for less than 3 percent if FDI is measured by fixed assets or jobs. As set out in chapter 2, there is evidence from macrodata that some countries, judged from the simultaneously high imports and exports of FDI, act as conduit countries, and this becomes also apparent from the aggregated German data presented in table 4.1. There is little information in usual macro FDI data on what preferred ownership chains look like in practice and how important conduit structures really are compared to direct financing structures.4 The usual data on FDI as provided by the International Monetary Fund (IMF) or the Organisation for Economic Co-operation and Development (OECD) cannot reveal how investors structure their foreign investments. We begin to fill this gap by first looking at evidence from German outbound investment. German investors are legally obliged to report to the Deutsche Bundesbank on their immediate foreign participations. They are also required to provide information on affiliates that are held via intermediate companies. Information on a directly held affiliate (DHA) must be provided if the stake of the German investor accounts for 10 percent or more of the equity of the DHA.5 If a DHA, at a second tier, owns another foreign affiliate (let us call it a second-tier affiliate, or STA), information on the STA must be provided if the DHA is a majority holding of the German parent and the ownership stake of the DHA in the STA is 10 percent or larger. An information requirement for the third and further tiers is only available if the ownership chain between the DHA and the penultimate tier always consists of 100 percent holdings. Figure 4.1 illustrates. Reporting requirements not only include a minimum participation but also a certain minimum size measured by balance sheet total. Table 4.2 summarizes how these thresholds have developed since 1989. The micro data on German outbound FDI confirm the increased importance of holding companies. While the numbers of holding companies and other German-owned firms have grown in similar proportions, there is a considerable difference when we consider asset values. As depicted in figure 4.2, total assets of German-owned holding companies have increased by 1,400 percent from 1989 to 2001 while combined total assets of all other German-owned companies recorded in the Bundesbank FDI database have grown only by 634 percent. Asset values of all types of foreign investments decline after 2000, in part connected to the rising value of the euro with respect to the U.S. dollar.6 Another reason lies in the relaxed reporting requirement for

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Chapter 4

Figure 4.1 Reporting requirement: Ownership fraction Source: Lipponer 2003.

Table 4.2 Thresholds for reporting requirements Reporting period

Participation

Threshold for balance sheet total

From 1989

>20%

DM 500,000

From 1993

>20%

DM 1,000,000

From 1999

b10%,