Abstract
Thin capitalization rules limit firms’ ability to deduct internal interest payments from taxable income, thereby restricting debt shifting activities of multinational firms. Since multinational firms can limit their tax liability in several ways, regulation of debt shifting may have an impact on other profit shifting methods. We therefore provide a model in which a multinational firm can shift profits out of a host country by issuing internal debt from an entity located in a tax haven and by manipulating transfer prices on internal goods and services. The focus of this paper is the analysis of regulatory incentives, (i) if a multinational firm treats debt shifting and transfer pricing as substitutes or (ii) if the methods are not directly connected. The results provide a new aspect for why hybrid thin capitalization rules are used. Our discussion in this paper explains why hybrid rules can result in improvements in welfare if multinational firms treat methods of profit shifting as substitutes.
Highlights
The loss of tax revenue caused by earnings stripping is a prominent subject of both public debate and academic literature
Our prediction is that countries with a high ratio of inward to outward foreign direct investment can have an interest in protecting the tax revenues paid by multinational corporation (MNC) through an additional safe harbor rule
Countries with a low ratio of inward to outward foreign direct investment are more interested in domestic tax revenues and wages and only implement an additional safe harbor rule if the MNC increases the amount of capital it holds
Summary
The loss of tax revenue caused by earnings stripping is a prominent subject of both public debate and academic literature. To the best of our knowledge, we are the first to analyze a general equilibrium model which incorporates the simultaneous application of both safe harbor rules and earnings stripping rules in an environment where a multinational firm treats different channels of profit shifting as substitutes. Our results suggest that the substitution of profit shifting methods alters the choice of the MNC in a specific way and alters the effective tax rates and, as a consequence, the cost of capital. Countries with a low ratio of inward to outward foreign direct investment are more interested in domestic tax revenues and wages and only implement an additional safe harbor rule if the MNC increases the amount of capital it holds.
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