Developing economies face difficulties in raising tax revenues. The taxation of multinational firms operating in these countries is an important potential source of tax revenue. But due to the nature of their activities, taxing these firms raises a number of issues. One issue is that multinational firms may engage in tax planning and use debt financing or transfer pricing to shift income from high-tax to low-tax countries. Developing economies are particularly vulnerable to this type of tax avoidance because their tax authorities often lack the resources to effectively protect the domestic tax base.
In this project we exploit a particular data set which covers all German multinational firms and their worldwide subsidiaries, for the time span from 1996 to 2007. We ask whether these firms use debt financing to shift income from high to low tax countries and whether this tax planning differs between affiliates located in developing and developed countries. We focus on intra-company debt because this type of debt is particularly suitable for tax planning purposes. Our results suggest that the reaction of financing structures to tax rate differences is indeed stronger in developing countries. We find that an increase in the host country corporate income tax rate by ten percentage points increases the ratio of intra company debt to overall assets by 2.7 percentage points in developing countries. In developed countries, the same tax increase would raise the debt ratio only by 1.1 percentage points.
We also investigate whether the response of debt financing to tax rate differences differs between firms with and without a presence in countries classified as tax havens. We find no such difference in the data. Among other things, this may be due to the fact that the classification of countries as tax havens is controversial and changes over time. A possible explanation of our finding is that tax rate differences are the key driver of tax motivated debt financing and other features that characterize tax havens like bank secrecy do not play a key role for multinational firms.
Developing countries may want to consider a review of their anti tax avoidance legislation related to debt financing, in particular thin capitalisation rules and controlled foreign companies legislation. Secondly, they may want to investigate whether the resources devoted to the auditing of multinational firms and their financing structures are employed efficiently.
