Despite the seminal work by Modigliani and Miller (1958) and Miller (1977) highlighting the importance of differences in marginal tax rates for the optimal debt policy of firms, the empirical literature on capital structure choice has thus far not been very successful in identifying the importance of the relative tax advantage of debt with respect to retained earnings for firm leverage (Rajan and Zingales, 1995). This paper shows that national tax policies do matter for corporate debt structures, using a unique dataset on internal debt positions of multinational firms and their foreign subsidiaries.
In most countries, interest expenses are deductible for corporate tax purposes while dividends have to be paid out of net-of-tax corporate income. Most tax systems thus favor debt finance over equity finance, but to different degrees given the dispersion in top statutory corporate tax rates. In determining their financial structure, purely domestic firms only have to deal with the domestic tax system. Multinational firms, however, face the more complicated choice of determining their overall indebtedness and the allocation of their debts to the parent firm and the subsidiaries across all countries in which the multinational operates. As a consequence, the financial structure of a multinational firm is expected to reflect the tax systems of all the countries where it operates.
In an international setting, the tax costs of debt and equity finance depend on the combined tax systems of the subsidiary and parent countries of the multinational firm. Dividends, as indicated, have to be paid out of the subsidiary’s income after subsidiary country corporate tax and in addition may be subject to a non-resident dividend withholding tax in the subsidiary country. In the parent country, the dividend income may again be subject to corporate income tax. If so, double tax relief may or may not be provided for the previously paid corporate income and non-resident withholding tax. The tax costs of equity finance thus reflect tax rates as well as the double-tax relief convention used by the parent country. This paper collects detailed information on all of these aspects of the international tax system for European multinationals.
A firm’s financial policies are affected by tax as well as non-tax considerations. A non-tax consideration is that indebtedness of the overall multinational firm should not be too high to keep the probability of costly bankruptcy low. In contrast, an advantage of debt finance is that it reduces the free cash flow within the firm and hence can act as a disciplining device for otherwise overspending managers. The disciplining properties of debt finance can explain generally positive debt levels at each of a multinational’s individual establishments (i.e., its parent company and its foreign subsidiaries). These various considerations give rise to an optimal overall capital structure for the overall multinational firm for non-tax reasons.
Download
PDF Ebook Capital Structure and International Debt Shifting
