Capital Structure and International Debt Shifting in Europe H. Huizinga, L. Laeven, G. Nicodème

1. Capital Structure and International Debt Shifting in EuropeH. Huizinga, L. Laeven, G. Nicodème Comment Julian Alworth

2. General • Original • This appears to be the first n country x n country study • Interesting model of financing decision of multi-tiered company • Estimating financial decisions of companies taking account of interrelationships in a multidivisional and multinaltional

3. General comment • Rich sample of “leverage” data on companies • Free standing • “Groups” (domestic) • Multinationals • Foreign subsidiaries by home country • Foreign subsidiaries by host country • What do we want to compare? • What type of questions do we want to address? • Within group, across group, across country, over time? • Example: group (1) across countries; group (1) with group (5) • Heterogeneity and control groups

4. Tax system: losses • Free Standing companies: Losses provide heterogeneity in tax rates • Auerbach-Altshuler, Mackie-Mason, Graham etc. • Cross section variation in “effective” tax rates => debt policy • Intra-group relief for losses • Consolidation mitigates effects of losses on debt policy • Not all countries apply group relief (some Imputation countries utilise other methods to achieve similar results) • Cross-border consolidation is not the norm • Econometric implications • Heterogeneity • within-country (single company and groups) • within-country (domestic and multinational groups) • Cross country (are differences in losses more important than cross-country differences in rates n.b. little evidence of time series effects) • Differentiation between effects of statutory rates and firm specific tax factors • Establish Control groups

5. Personal tax level and intragroup • Free Standing company • Strong theoretical implications on personal taxation impact on debt vs. equity finance • evidence that variation in personal tax rates affects financing (US, Italy) • Group level: intercompany taxation • Taxes may affect group structure and governance: • lower rates of intercompany taxes encourage pyramid structures(Berle and Means, Morck, Desai Zingales), i.e. Less equity is needed by controlling groups (not all shareholders and managers are treated alike)

6. Personal tax: multinational • Parent company financing will depend on personal tax rates • Multinational financing complicated in presence of personal taxs • Financing of subsidiary from parent depends on source of funds for parent • H&L stripped down version • Alworth (1988) and OECD (1993) present a more complicated model of financing (at least 8 possible financing alternatives) • Personal taxes appear to matter empirically • imputation and dividend credit system tends to discriminate foreign source income • think of UK discussion on ACT and foreign income dividends

7. Too Complicated to estimate? • Empirically, not all possibilities need be considered • role of personal taxes should be considered when looking at overrall leverage of multinational relative to domestic companies • Heterogeneity • Further tests on differences between free standing domestic companies, groups of companies and multinationals • Additional control variable

8. n +...m countries • Objectives of MNC: • “profits” must be taxed in the low tax country • Repatriations must be as tax efficient as possible • Multinationals establish complex webs: pairwise comparisons may be insufficient to capture the full picture and measure the true advantages to debt

9. Pairwise vs. Triangulation • Example • Assumption • No withholding tax; • participation exemption • 3 countries; home h; production f; offshore o • Direct Loan from parent: (1-th) • Equity from parent: (1-tf) • Equity from h to o and loan from o to f: 0 • Econometric Implications • Test for host country taxes independently • Contrast countries with credit and exemption mechanisms

10. Non-debt tax shields • Debt is an alternative to other ways of reducing taxable income • Standalone company: depreciation, leasing, but also stock options (Graham et al.) • Group companies: important intercompany allocations of expenses to mitigate impact of losses • Multinationals?:

11. Transfer pricing • Multidimensional and varies by industry • Pharmaceutical companies • Intangibles • Finance • What interest rate? • Econometrics • Opportunity to test for differences across countries • Standalone companies. • Book-Tax differences (rate countries by significance; NB IAS may have increased differences) • Multinationals: • Do subsidiaries of multinationals use debt as a tax shield more than host country companies?

12. Summary • Construct theory around rich data • Increase dimensionality of questions attempting to exploit heterogeneity in tax positions of companies • Exploit domestic literature on company financial decisions and work outwards towards questions which are specifically multinational

13. Model • Modigliani-Miller (or Miller) world: investment, i.e. the level of “Outside assets”, is unaffected by taxes which in turn only affect the level of financing • “Lower tax rates” do not lead to higher levels of investment for example, through a cost of capital mechanism • Two level decision in which at the higher level taxes do not matter • Why are you in the country in the first place? What is the determinant of the overall size of investment • Second level: how much debt do we wih to assume • Third level: how much is intracompany

14. Holding company • Is there any holding company structure in place? Participation exemption Companies need to take into account spin-offs. Corporate reorganisations are typical activities? • With a credit system without deferral we would observe the following: debt financed investments in a high tax jurisdiction which allows generous debt finance and equity financed investments in low tax jurisdictions. Hence local (subsidiary) tax rates would leave financing decisions indeterminate

15. Variables • Volatility of earnings can be proxy for risk. Model of leverage à la Merton • Thin capitalisation rules. • Debt-equity but also the level of interest rates? There is a transfer pricing problem in addition to leverage

16. Data availability • What is\available on Amadeus • Number of years of observations • How do you cope for changes over time in sample size • Table does not clarify how many subsidiaries are domestic and how many are foreign • How many countries allow domestic consolidation and how many do not. In the former case prsumably the intercompany debt should not matter • Average tax, depreciation etc. • How comparable are the financial data across countries and over time

17. Other • Book-tax conformity? Average tax rates would give us some idea of how different . • The marginal tax rate is the statutory rate but it should somehow take account of the probability of loss • List of control variables: more financial variables • Are we measuring domestic subsidiaries • The tax variable is a home-subsidiary difference. In actual fact most major multinationals would tend (where deferral matters) to accumulate cash in low tax jurisdictions.ALos with exemption you would try to shift lending from high to low jurisdictrions. • The sample is Europe but tax planning may not be undertaken within Europe (offshorre centres) • Voltality of earnings: if not from profiatbility by industry from listed companies in sector: two sectors may be similar from a profitability standpoint • Exploit credit versus exemption country differences

18. Econometrics • Assumption: investment decision is independent of location. Two level decision but which can blend into one. Error term attached as a nuisance. Can we endogenise the error term (heckman trying another maximising expression) • “High profitability to lower leverage” ; but low profitability may also lead to lowe leverage because the tax advantaeg to leverage declines • Appropriate tsax variable for leverage (Graham); • Importance of non-debt tax shields • Heterogeneity in data – • Mention Us record repatriations laast year following the partial exemption (quote from Chapel hill last year • Thin capitalisation rules • Paradoxes on exemption and credit system