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International Tax and Public Finance

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01-10-2016

Restricted interest deductibility and multinationals’ use of internal debt finance

Authors: Thiess Buettner, Michael Overesch, Georg Wamser

Published in: International Tax and Public Finance | Issue 5/2016

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Abstract

This paper reconsiders the role of interest deductibility for internal debt financing of multinational corporations (MNCs). We provide quasi-experimental evidence using restrictions on interest deductibility through thin-capitalization rules. Explicitly distinguishing between firms subject to a binding restriction and unrestricted firms, a panel data sample selection model is used to explore the tax sensitivity of the capital structure of foreign subsidiaries of MNCs. Our results confirm that the tax incentive for using internal loans is effectively removed for restricted subsidiaries. While internal debt financing of unrestricted subsidiaries positively responds to taxes, the effects are relatively small.

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For details, see Buettner et al. (2012).

Sec. 26 Aussenwirtschaftsgesetz (Foreign Trade and Payments Act) in connection with Aussenwirtschaftsverordnung (Foreign Trade and Payment Regulations). Each German multinational has to report its foreign assets, including both direct FDI and indirect FDI, conditional on some lower threshold level for mandatory reporting. Since 2002, FDI has to be reported if the participation is \(10 \,\%\) or more and if the balance-sheet total of the foreign object exceeds 3 million euros (for details, see Lipponer 2006). Though previous years showed lower threshold levels, we apply this threshold level uniformly in all years in order to avoid discrete changes in the sample selection.

In some countries where the safe haven debt-to-equity ratio refers to total debt, loans from financial institutions are not considered. However, our dataset does not allow us to distinguish between different sources of external debt.

In unreported placebo tests, we split our sample along the level of debt financing and do not consider host countries’ thin-capitalization rules. These additional tests, however, do not suggest that highly leveraged firms are generally insensitive to taxes.

See Table 1 in Buettner et al. (2012) for this information. The Kyriazidou (1997) estimator uses the first-stage estimation in order to define weights that are used for a second-stage weighted least squares regression. Since weights are determined specifically for each observation, we use two different sets of weights, depending on the specific type of rule in place in a host country. The coefficient vectors of the two estimations shown in columns (1) and (2) of Table 2 are then used to construct observation-specific weights (results are shown in columns (4) and (5) of Table 3).

Note that the fixed effects logit estimator removes all observations where no change in the regime is observed. As a consequence, the number of observations is relatively small.

Additional tests replicating columns (3) and (4) but using a first-differencing transformation suggest that the difference in the tax responsiveness between columns (4) and (2) is mainly related to the way how the unobserved affiliate heterogeneity is taken into account (first-differencing vs. demeaning of the equation) rather than to sample selection effects.

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Title: Restricted interest deductibility and multinationals’ use of internal debt finance
Authors: Thiess Buettner
Michael Overesch
Georg Wamser
Publication date: 01-10-2016
Publisher: Springer US
Published in: International Tax and Public Finance / Issue 5/2016
Print ISSN: 0927-5940
Electronic ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-015-9386-8

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