2. MULTINATIONAL COMPANIES AND CAPITAL STRUCTURE
2.2.2 Debt versus the share price
! ∗ !!
!
! >0 and,
!"
!"!!= 𝑡! −𝜆 ∗𝑟= 1−𝑡! ∗!!! !!!
!!!!
There are certain implications attached to the formulas above. Due to the tax benefit, the internal bank is located in the lowest-tax affiliate. The external leverage and the financial structure are affected by tax rates, cost of capital, bankruptcy costs on the affiliate and the parent level. The external debt is not affected by the company’s internal bank or the internal debt-to-asset ratio. The internal leverage is affected by the affiliate’s corporate tax rate, cost of capital, concealment costs and the tax rate in the group’s internal bank.
2.2.2 Debt versus the share price
As discussed, MNCs can use internal debt in order to avoid tax obligations by utilizing differences in international tax rates. As tax obligations decrease, earnings increase.
John P. Kennedy, partner at Deloitte Tax LLP, speaking at a conference in Philadelphia Nov.
3rd 2010, gave the following example to show the CFO’s and other option holding managers incentive to rig the company’s capital structure favouring tax avoidance;
5 Møen et al. 2011
For a hypothetical company that has 1,000 shares outstanding, has pretax income of $5,000 and trades at 20 times earnings, cutting just 2 percentage points off the rate could drive the share price up $2.6
Minority owners will benefit from holding shares in borrowing affiliates due to its tax savings (Schindler and Schjelderup (2012)). Since parts of the tax engineered profit fall on the minority owners and not the parent company, wholly owned affiliates use more internal debt than affiliates with minority owners (Schindler and Schjelderup (2012)). For wholly owned affiliates in emerging markets of multinationals, their debt-to-asset ratio increases by 27 percentage points given a 10% increase in its corporate tax rate.7 The same review does not find any evidence of debt shifting for partially owned affiliates. It goes to say that affiliates with minority owners are also less tax sensitive and that wholly owned subsidiaries have a 5 percentage points higher leverage ratio of internal debt compared to non-majority owned.8 Schindler and Schjelderup (2012) present the worldwide profits of a MNC with minority owners with the formula:
= !!(1−𝐽!)(𝜋! −𝑡! ∗𝜋!!) (2.3) Where 𝐽! is the minority shareholders contribution.
Although it relies on linear profit sharing rules, it shows how the minority ownership in country i reduces the profit income in country i for the MNC.
6 Drucker, 2010
7 Weichenrieder, A.J., 2010
8 Büttner, 2007
Tax efficient capital structures in Multinationals 2.3
2.3.1 Debt tax shield effects
Møen, Schindler, Schjeldrup and Tropina (2011) shows that there are three debt tax shield effects that MNCs can use. They define the drivers behind the total debt to asset ratio, b!, of an affiliate with the formula below9.
𝑏! =𝛽!+𝛽!∙𝑡! +𝛽!∙ !!!𝑝! 𝑡! −𝑡! +𝛽!∙ 𝑡! −𝑡! ,∀ 𝑖> 1 (2.4) The following paragraphs will explain each driver and the three mechanism of this formula.
The standard debt tax shield
𝑏!!"!"#!$# !"#$ !"# !!!"#$ =𝛽!+𝛽!∙𝑡!
𝛽! = 𝜇∙𝑏∗
𝜇+𝛾,𝛽! = 𝑟 𝜇+𝛾
Figure 2.2 In chapter 2 we elaborate the effects of the standard debt tax shield. We can see that the size of the tax shield is affected by the corporate tax rate in affiliate i and will increase along with the tax shield until the FOC = 0 when 𝑏!! >0.
External debt shifting mechanism
Figure 2.3 MNCs will allocate external debt in those affiliates that produce the highest absolute tax savings hence those with the highest effective corporate tax rate10 relatively to the affiliate
9 Møen et al. 2011
with the lowest effective corporate tax rate. Other effects of leverage are the decreased level of free cash flow11 forcing managers to run the firm as efficiently increasing the productivity.12
Internal debt shifting mechanism
Figure 2.4 The internal debt shifting mechanism affects the total debt-to-asset ratio through internal debt. MNCs can exploit this by maximizing the tax rate gap between the affiliates and the company’s internal bank (i.e. locate the internal bank in the jurisdiction with the lowest tax rate). By doing so, company i deducts a higher level of interest payments than company/internal bank 1 has in taxable payments provided that 𝑡! ≠ 𝑡!. The MNC will therefore have incentives to increase the debt-to-asset ratios in the high tax affiliates.13
Minority ownership structure 2.4
In regard of the two companies in this thesis, there is one main difference in the ownership structure that is not directly associated with holding, royalty and interest conduit structures.
The Coca-Cola Company (KO) has minority owners, meaning they are on the stock exchange and could be bought by anybody.
A minority ownership is when:
• Joint ventures or diversified investors hold shares in the company.
10 Formula standard debt shield proves that corporate tax rates affect tax savings
11 As the debt-to-asset ratio increases we assume that interest payments increases as well implying that the access to free cash flow decreases
12Berk, J. & DeMarzo, 2011
13 Møen et al. 2011
• The multinational fully controls its affiliates (Total share of minority owners < 50%)
2.4.1 Tax-efficient structure with minority shareholding
We assume that there are no overall bankruptcy costs on parent level (𝐶!= 0), the sum of minority shares in affiliate 𝑖 is given by 𝐽!, market entry costs 𝐶!!(𝐽𝑖) which are decreasing with minority shares !"!"#!! <0 and ! !"#!!!! <0.
Setting up the economic profit in affiliate 𝑖:
𝜋!! =𝐹 𝐾!,𝐿! −𝑤!×𝐿!−𝐾! 𝑟+𝐶! 𝑏!! +𝐶! 𝑏!! −𝐶!!(𝐽𝑖) (2.5) Production factors are real capital - 𝐾! and labor - 𝐿!. The production function: 𝑥! = 𝐹 𝐾!,𝐿! (with decreasing marginal productivities in each factor). External debt cost function (agency costs) is given by 𝐶! 𝑏!! and internal debt cost function (concealment costs) 𝐶! 𝑏!! . The wage rate is set by 𝑤! and the rental cost of capital per unit, 𝑟.
Taxable profit in affiliate 𝑖:
𝜋!!= 𝐹 𝐾!,𝐿! −𝑤!×𝐿! −𝐾! 𝑟(𝑏!! +𝑏!!)+𝐶! 𝑏!! +𝐶! 𝑏!! −𝐶!!(𝐽𝑖) (2.6)