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International Tax and Public Finance

Erschienen in:

10.05.2019

Safe haven or earnings stripping rules: a prisoner’s dilemma?

verfasst von: Zarko Y. Kalamov

Erschienen in: International Tax and Public Finance | Ausgabe 1/2020

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Abstract

Multinational firms use internal debt financing to shift profits from high-tax to low-tax countries. Therefore, governments restrict the deductibility of interest expenses by applying thin-capitalization rules (TCRs). TCRs fall into two main categories: safe haven rules (SHR) and earnings stripping rules (ESR). We analyze the optimal TCR choice in a two-country tax competition model. We show that unilateral replacement of SHR by ESR imposes a negative profit shifting externality on the other country. This effect can explain the recently observed switch from SHR to ESR in many countries. However, ESR may be a dominant strategy even when SHR is socially optimal, i.e., the observed policies of ESR implementation may indicate a prisoner’s dilemma.

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ESRs are sometimes applied if some debt-to-equity ratio is exceeded, i.e., together with an SHR. This is the case in the USA (Gresik et al. 2017).

For a further description and overview of thin-capitalization rules, see Ambrosanio and Caroppo (2005) and Dourado and de la Feria (2008).

While the results of Hong and Smart (2010) point to a positive impact of tax havens on high-tax countries’ welfare, Slemrod and Wilson (2009) find that tax havens worsen the welfare of non-haven jurisdictions. In the model of Slemrod and Wilson (2009), the existence of tax havens leads to a wasteful expenditure of resources by both firms (that engage in tax planning) and governments (that implement tax enforcement policies).

Furthermore, Mardan (2017) shows that countries with low financial development are more likely to allow positive internal interest deductions.

Internal debt financing is usually restricted by the agency and bankruptcy costs of debt. Due to these costs, investments are at least partly equity financed even in the absence of TCRs. We show in an extension in Sect. 7 that the inclusion of these costs does not affect the results.

In Eq. (1), we assume that the interest rate on internal debt is the true interest rate r. However, MNEs may also distort this interest rate to additionally shift profits to the tax haven through transfer price manipulation (see, e.g., Mardan 2017; Gresik et al. 2017). We consider interest rate manipulation in an extension in Sect. 7.

We consider the implications of an endogenous tax rate in an extension in Sect. 7.

In the following analysis, we drop the superscript when no ambiguity arises.

Note that the deviation considered above is such that \(k=k^*\) only to ensure that the foreign government’s first-order condition remains unaffected. We do not claim that \(k=k^*\) must hold in the ES, SH equilibrium. It is, however, sufficient to show that there exists a deviation from the symmetric SH equilibrium, which makes the deviating country better-off, without triggering a response from the other country, to prove that keeping SHR cannot be a best response.

As in the benchmark model, we assume that the concealment costs are not tax deductible.

I would like to thank one of the referees for pointing out the problem of uneven tax revenue distribution.

When there is no risk of confusion, we drop the superscript \(^{SH}\) for clarity.

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Titel: Safe haven or earnings stripping rules: a prisoner’s dilemma?
verfasst von: Zarko Y. Kalamov
Publikationsdatum: 10.05.2019
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 1/2020
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-019-09545-w

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