New research examines whether anti-tax avoidance regulations are effective in curbing profit-shifting by multinational firms (MNCs). The study by Katarzyna Bilicka, Yaxuan Qi and Jing Xing considers the effects of a 2010 UK reform that targeted debt-shifting, one of the main ways in which MNCs avoid corporate taxes.
They find that following the reform, MNCs reduce the amount of debt they hold in the UK. But they also show that these firms move the debt that they held in the UK to other high-tax countries. This debt reallocation is accompanied by real operations reallocations. MNCs affected by the reform moved a share of their total assets and employment away from the UK to where they locate their debt.
Thus, this reform did not change the MNCs’ overall tax payment and did not limit profit-shifting, as intended. Instead, this study provides novel evidence on the ineffectiveness of such tax avoidance regulations and on how multinationals circumvent them.
Allocating debt across different tax jurisdictions is a popular method that MNCs use to lower their overall tax burden. A subsidiary of an MNC can internally borrow money from its low tax subsidiaries and reduce tax payments by paying interest on that debt. Interest is tax deductible; hence, it reduces firm’s taxable income. When these payments flow from high tax countries to low tax countries, this reduces firm’s overall tax bill.
Before the recent corporate tax rate cuts, the UK with its 30% corporate tax rate in 2008, was considered a high tax country, thus a preferred location for debt holdings for MNCs. In 2010, UK introduced a ‘worldwide debt cap’, an anti-tax avoidance reform that targeted firms with large debt holdings in the UK. The reform disallowed interest deductions on excess debt for firms that had over 75% of their total debt held in the UK.
This study uses the introduction of this reform to consider how MNCs respond to anti-tax avoidance regulations. The authors compare debt and real business operations of firms that crossed this 75% threshold to those with smaller debt holdings before and after the reform.
They show that MNCs affected by the reform reduced their debt in the UK by 74% after the reform. They also show that at the same time, debt holdings of the affected MNCs increased abroad, especially in countries with high corporate tax rates. This is consistent with shifting debt for tax-minimisation purposes.
The study shows that this also led to reallocation of real operations. MNCs affected by the reform reduced total assets, fixed assets and employment in their UK subsidiaries by 7.5%, 11.4% and 3.9% respectively. At the same time, they substantially increased their real operations in their non-UK subsidiaries, especially in those to which they moved debt. This suggests that the unilateral introduction of tax avoidance regulations may hurt the employment of a country that introduces them.
This study is the very first examination of the effectiveness of the ‘worldwide approach’ as a new anti-tax avoidance measure. Many countries have stand-alone rules that limit MNC borrowing, but the evidence on their effectiveness is mixed. Worldwide approach is considered more difficult to circumvent, thus has been recommended by policy-makers and academics to complement existing rules.
In December 2017, the United States passed the Tax Cuts and Jobs Act in which similar limits on net interest expense deductions of MNCs were put into effect. It is likely that more countries will adopt the worldwide approach to tackle MNCs’ tax avoidance in the near future. Therefore, these findings have important implications for the current policy debate.
Authors: Katarzyna Bilicka, Yaxuan Qi and Jing Xing
Corresponding author: Katarzyna Bilicka
Email: Katarzyna.anna.bilicka@gmail.com
Twitter: @KatarzynaBilic1
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