Why countries differ in thin capitalization rules: The role of financial development

Abstract

In the absence of financial frictions, the purpose of thin capitalization rules is to limit multinational firms' possibilities of engaging in tax planning via debt shifting. This paper analyzes the effects of thin capitalization rules in the case where firms have limited access to external funding. First, we show that a host country allows positive internal interest deductions if its financial development is sufficiently low. This amount increases when the financial development of the host country worsens. Then we ask which of the two most common thin capitalization rules used in practice is better suited to maximizing welfare of the host country. We show that welfare under a safe haven rule is higher than under an earnings stripping rule if firms are not able to manipulate transfer prices. Welfare, however, can be higher under an earnings stripping rule if firms are able to manipulate transfer prices. The analysis provides an explanation for why countries differ in the strictness and in the type of thin capitalization rule. JEL-Code: H250, G380, F230.

Immobilizing corporate income shifting: Should it be safe to strip in the harbor?

“…More closely related to our paper is Mardan (2015) who investigates earnings stripping rules and rules in a setting with two countries and capital as the only input. His focus is on how credit market constraints may affect leverage and thincapitalization rules.…”

“…Internal debt also generates costs of complying with thin capitalization rules and adjusting managerial incentive contracts. Consistent with Egger et al (2010), Mintz and Smart (2004), Schindler and Schjelderup (2012) and Mardan (2015), we assume the multinational incurs debt-financing costs of D(B/K) that are strictly increasing and strictly convex in the subsidiary's debt to equity ratio for B > 0. We also…”

Tax competition between developed, emerging, and developing countries – Same same but different?

“…Otherwise, the selection and classification of countries follows the procedure described in footnote 3. The data for the debt-to-asset ratios, which reference to 2013, are taken fromMardan (2017), but inverted such that countries without a binding thin capitalization rule have a lower limit of zero. The result of a simple OLS regression confirms that the correlation displayed inFigure 2is statistically significant at the 1% level.6 We are agnostic about whether developing countries are unable to curb profit shifting, due to,…”

Double tax discrimination to attract FDI and fight profit shifting: The role of CFC rules

“…Mardan (2017) analytically 8 The only theoretical contribution of which we are aware is Weichenrieder (1996). He shows that CFC rules increase capital costs and decrease the foreign investment of home-based multinationals.…”

“…For an analysis where internal debt also serves to overcome capital market imperfections, see Mardan (2017).…”