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Anti profit-shifting rules and foreign direct investment

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Abstract

This paper explores the effects of unilateral tax provisions aimed at restricting multinationals’ tax planning on foreign direct investment (FDI). Using a unique dataset which allows us to observe the worldwide activities of a large panel of multinational firms, we test how limitations of interest tax deductibility, so-called thin-capitalization rules, and regulations of transfer pricing by the host country affect investment and employment of foreign subsidiaries. The results indicate that introducing a typical thin-capitalization rule or making it more tight exerts significant adverse effects on FDI and employment in high-tax countries. Moreover, in countries that impose thin-capitalization rules, the tax-rate sensitivity of FDI is increased. Regulations of transfer pricing, however, are not found to exert significant effects on FDI or employment.

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Fig. 1

Source See the Appendix

Fig. 2

Source Own computations based on Lohse and Riedel (2013)

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Notes

  1. We do not consider withholding taxes as they are usually fixed in bilateral tax treaties. It should also be noted that tax law provisions in the home country of the multinational may have important implications for the host countries’ tax effects on FDI as well. The current paper, however, focuses on measures by the host country.

  2. While we focus on formal thin-capitalization rules, it should be noted that a country may also restrict excessive interest deduction by means of a general substance over form rule, although it has no explicit thin-capitalization rule.

  3. See also the International Fiscal Association’s report on thin-capitalization, which provides an overview of thin-capitalization rules in 29 countries (Piltz 1996). More recent overviews about thin-capitalization rules in Europe are provided by Ambrosanio and Caroppo (2005) and Dourado and de la Feria (2008).

  4. While thin-capitalization rules tend to identify profit-shifting using the level of debt, firms might resort to setting high interest rates at low debt levels. However, this would tend to conflict with the arm’s length principle and only offers limited leeway for profit shifting (Piltz 1996: 103 p).

  5. Although countries often establish special rules for financial institutions and holdings, we do not report these ratios here as the corresponding subsidiaries are excluded from our empirical analysis. For instance, financial institutions in Australia enjoy a more generous debt-to-equity rule similar to banks and insurance companies in South Korea, or holding companies in Germany up to 2003. Similar exceptions hold in the Czech Republic and in Mexico.

  6. The tightness indicator can be interpreted as the minimum share of capital that needs to be financed with equity capital in order to avoid tax penalties. To see this, note from above that interest deduction is not restricted if debt obeys \( D \; \le \; \sigma E. \) Denote the share of equity capital with \(\varepsilon .\) Then \( 1-\varepsilon \; \le \; \sigma \varepsilon \) and \(\varepsilon \; \ge \; \frac{1}{1+\sigma }.\)

  7. Examples are the ‘cost plus method,’ the ‘transactional profit-split method,’ or the ‘transactional net-margin method.’

  8. Also Haufler and Runkel (2012) provide a theoretical analysis of tax planning with restrictions of the interest deductibility.

  9. An empirical analysis of the characteristics of firms with debt exceeding the safe haven debt-to-equity ratio is provided by Buettner et al. (2016).

  10. Schindler and Schjelderup (2013) argue that regulation of transfer prices also affects the cost of profit-shifting via debt financing. This adds support to the joint analysis of the effects of transfer-pricing and thin-capitalization rules on FDI.

  11. See Deutsche Bundesbank (2012), Statistische Sonderveroeffentlichung 10, Table 1.2a, Frankfurt.

  12. Becker et al. (2012) emphasize that taxes also exert quality effects on FDI in the sense that taxation affects the profitability and labor intensity of FDI projects. Since our data mainly provide information on the volume of FDI and the number of employees, the exploration of the effects of profit-shifting rules on this dimension of FDI is left for future research.

  13. The average tax rate of countries that have implemented thin-capitalization restrictions is about 35%, compared to a sample average of 33%. Also the variation in thin-capitalization rules is mainly observed in countries with higher tax rates. The two most important countries in our data with newly introduced TCRs are Italy and Poland with 5493 and 3922 observations and tax rates in the year before TCR implementation of 38.25% and 36%. Similarly, the most relevant case where a TCR has been made more strict is Canada (1784 observations) with a tax rate of 44.6% before the reform.

  14. For surveys, see De Mooij and Ederveen (2003) or Feld and Heckemeyer (2011). In a meta-analysis, Feld and Heckemeyer (2011) find a higher tax effect but also note that studies using micro-level data (like our study) typically find significantly smaller tax effects in absolute values. For example, Wamser (2011) uses the same firm-level data and finds a tax semi-elasticity of about −0.5. Thus, the tax effect of about −0.83 found in column (1) of Table 2 is in accordance with previous findings.

  15. Since Lohse and Riedel (2013) have shown that the transfer-pricing regulations have significant effects on profit shifting, it is an interesting question why the empirical results do not detect significant FDI effects of these regulations. A possible reason could be that the study by Lohse and Riedel (2013) is based on the Orbis dataset provided by Bureau van Dijk. This dataset includes multinational parent firms, whose headquarters can be anywhere around the world, and their foreign subsidiaries. In the MiDi data used in our study, only German parent firms are reporting their (worldwide) foreign transactions. If German firms find it easier to engage in profit shifting via internal debt or more difficult to engage in transfer pricing than MNCs from other countries, transfer pricing could be less of an option for their subsidiaries.

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Acknowledgements

We thank seminar participants at the Oxford University Centre for Business Taxation, at CESifo, Munich, and at the Free University of Berlin, for helpful comments. Data access by the Deutsche Bundesbank and financial support by the German Science Foundation (DFG) is gratefully acknowledged.

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Authors and Affiliations

  1. University of Erlangen-Nuremberg and CESifo, Lange Gasse 20, 90403, Nuremberg, Germany

    Thiess Buettner

  2. University of Cologne, Albertus-Magnus Platz, 50923, Cologne, Germany

    Michael Overesch

  3. University of Tuebingen and CESifo, Mohlstr. 36, 72074, Tuebingen, Germany

    Georg Wamser

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  1. Thiess Buettner
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Correspondence to Thiess Buettner.

Appendix: Datasources

Appendix: Datasources

  • Micro-level data are taken from the micro-level dataset (MiDi) of the Deutsche Bundesbank (see Lipponer 2011, for an overview) using a version that covers the period from 1996 to 2007.

  • Corporate taxation data are taken from the International Bureau of Fiscal Documentation (IBFD) and from tax surveys provided by Ernst & Young, PricewaterhouseCoopers (PwC), and KPMG. The statutory tax rate variable contains statutory profit tax rates modified by restrictions on interest deduction—as in the case of the Italian IRAP. For details on the tax rates used, see Table 5.

  • Thin-capitalization rules Basic information about thin-capitalization rules has been obtained from the same sources as the tax data. As in Buettner et al. (2012), this information was augmented and cross-checked with questionnaires sent out to country experts of PricewaterhouseCoopers. Table 6 provides the safe haven debt-to-equity ratios.

  • Transfer-pricing regulations are taken from the study by Lohse and Riedel (2013) who provide a classification of the strictness of national transfer-pricing regulations, see Table 7 for details. The empirical analysis basically focuses on a binary variable, which is unity if the transfer-pricing regulations are categorized in the two top classes (class 4 or 5).

  • Macroeconomic indicators such as GDP and GDP per Capita in US dollars, current prices, as well as GDP Growth and Inflation are taken from the IMF World Development Indicators.

  • Heritage indicators ‘Financial Freedom’ and ‘Freedom from Corruption’ are taken from the Heritage Database. Scores range from 0 to 100.

Table 5 Corporate tax rates.
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Table 6 Thin-capitalization debt-to-equity ratios
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Table 7 Strictness of transfer-pricing regulation.
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Buettner, T., Overesch, M. & Wamser, G. Anti profit-shifting rules and foreign direct investment. Int Tax Public Finance 25, 553–580 (2018). https://doi.org/10.1007/s10797-017-9457-0

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