Exploiting a Window of Opportunity:Multinationals’ Profit Shifting in the Absence of Restrictions

Carolin Holzmann † ‡

September 2014

Abstract

This paper asks whether and how multinational enterprises’ (MNEs) tax planning responds tochanges in the tax law that create new opportunities for profit shifting. We analyze MNEs’internal debt shifting during a window of opportunity. The window opened because of a rulingof the European Court of Justice in 2006 that restricted the application of controlled foreigncorporation rules within the European Economic Area. The window closed with a subsequentanti-shifting legislation on thin capitalization in 2007. Our empirical identification strategy ex-ploits random variation in the time length of MNEs’ windows that results from the firm-specificintroduction mechanism of the anti-shifting legislation. We use data from the Microdatabase Di-rect Investment which provides detailed information on foreign subsidiaries of German MNEs.Generally, our results show that the window has an impact on both the probability and the vol-ume of internal lending. Even conservative estimates indicate an increase in the probabilityby 7% and in the volume by 14.4% per 90-day window. Fiscal consequences in terms of taxrevenue losses, however, appear to be negligible because the average volume of internal lendingis rather small.

Keywords: multinational firms, corporate taxation, profit shifting, anti-tax-avoidance legisla-tion, European Court of Justice ruling

JEL classification: F23, H25, H32

† Address: Friedrich-Alexander-UniversityLange Gasse 20D-90403 NurembergGermany

Phone:Fax:E-mail:

+49 911 5302 201+49 911 5302 396carolin.holzmann@fau.de

‡ Acknowledgements: We thank participants at the Annual Congress of the IIPF 2014, Lugano, the Cebid Con-ference 2014, Nuremberg, the Taxing Multinationals Conference 2013 and the Public Finance Conference2014 both at the ZEW, Mannheim. Access to the Microdatabase Direct Investment provided by the DeutscheBundesbank is gratefully acknowledged. This project has received financial support from the German ScienceFoundation (DFG) and the Faculty of Law and Economics, FAU Erlangen-Nuremberg.

1 Introduction

The last two decades saw many countries implementing anti-tax-avoidance legislation to tackle

tax-base erosion and profit-shifting activities of multinational enterprises (MNEs). Cross-

country comparisons show that today most developed countries’ tax laws incorporate trans-

fer pricing regulations and thin capitalization rules (Lohse et al., 2012; Buettner et al., 2012).

Furthermore, countries commonly apply controlled foreign corporation (CFC) rules to prevent

MNEs from profit shifting to low-tax jurisdictions. In September 2006, however, the interna-

tional development towards stricter anti-tax-avoidance legislation relapsed when the European

Court of Justice (ECJ) rather unexpectedly declared CFC rule application within the European

Economic Area (EEA)1 in large parts unconstitutional. The court’s decision basically elimi-

nated, with immediate effect, a number of EEA countries’ provisions against profit shifting to

EEA low-tax countries.

This paper investigates whether and how MNEs’ internal debt shifting to EEA low-tax sub-

sidiaries responds to a temporary suspension of anti-tax-avoidance legislation. We analyze the

case of Germany where a window of opportunity for internal debt shifting opened because of

the ECJ ruling in 2006 and closed with a subsequent anti-tax-avoidance legislation on thin cap-

italization in 2007. The exact date at which the anti-tax-avoidance legislation took legal effect

depended on the starting date of MNEs’ business years. As MNEs start their business years

at different dates throughout the calender year, the time length of the window varied between

MNEs by up to 365 days. MNEs’ starting dates of the business year can plausibly be assumed

to be independent from the ECJ ruling. Thus, we can estimate the causal effect of the window

length on MNEs’ probability to receive internal lending from EEA low-tax subsidiaries and on

the respective volume of internal lending.

1 As of 2013 the European Economic Area consists of Iceland, Norway, Liechtenstein, and the 27 EU memberstates.

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The paper relates to several strands of literature that investigate MNEs’ response to anti-tax-

avoidance legislation. A number of papers find CFC rules to be effective means against MNEs’

profit shifting to low-tax jurisdictions. Altshuler and Hubbard (2002) show that after US CFC

legislation was tightended in 1986, the worldwide location of assets in financial service firms

became less sensitive to foreign location taxes. Ruf and Weichenrieder (2012) exploit changes

in German CFC legislation in the early 2000’s. The authors find that German CFC rules ef-

fectively prevent German MNEs from profit shifting to foreign low-tax subsidiaries. Egger and

Wamser (2011) investigate whether CFC legislation effects real economic activity of MNEs.

Based on a regression discontinuity approach, their results indicate a negative impact of CFC

legislation on foreign direct investment. In case CFC regulation is loosened, previous studies

show an immediate increase in MNEs profit shifting activities. Mutti and Grubert (2009) and

Altshuler and Grubert (2006) find that US MNEs use US “check-the-box” rules to circumvent

CFC legislation and to retain great shares of foreign profits in low-tax subsidiaries. Ruf and

Weichenrieder (2013) investigate changes in MNEs’ allocation of profit-generating passive in-

vestments by exploiting the restriction in CFC rule application within the EEA due to the ECJ

decision in 2006. Using a difference-in-differences approach, the authors find that after the ECJ

decision German MNEs’ statistically significantly increased their passive investments in EEA

low-tax subsidiaries compared to a control group of non-EEA low-tax subsidiaries.

Another strand of literature investigates MNEs’ response to anti-shifting provisions that

tackle thin capitalization.2 Cross-country studies confirm that thin capitalization rules which

limit interest deduction for internal debt indeed reduce internal debt finance (Wamser, 2013;

Overesch and Wamser, 2010; Buettner et al., 2012; Blouin et al., 2014). Two recent papers

analyze the effects of a general limitation of interest deduction for both internal and external

2 For an overview on practical issues as well as theoretical and empirical implications of previous studies onthin-capitalization rules see Ruf and Schindler (2013).

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debt. A study by Dressler and Scheuering (2012) shows that German MNEs once subject to

the German interest barrier lower their debt-to-equity ratio significantly. In contrast, Buslei and

Simmler (2012) find that of those German firms which are potentially subject to the interest

barrier only a fraction opts for reducing its debt-to-equity ratio to effectively escape the interest

barrier.

This paper contributes to the literature by providing new insights into MNEs’ tax planning.

In particular, MNEs’ response to the window of opportunity is indicative of whether MNEs’

were effectively exposed to German corporate taxation before the window opened. A small

or no response would indicate that MNEs were not effectively restricted in their tax planning.

Possibly, they had competing tax shields or managed to switch to alternative tax planning not

(effectively) subject to anti-tax-avoidance legislation. In contrast, a significant response would

indicate that MNEs were effectively restricted in tax planning before the window opened, there-

fore, pointing to a comprehensively effective set of anti-tax-avoidance legislation at that time.

We use panel data on foreign direct investment provided by the German Central Bank. A

unique feature of the database is its detailed information on firm-internal lending and borrowing

that allows us to analyze responses to the window of opportunity in internal financial relations.

Here, the analysis focuses on a particular channel of debt shifting: low-tax subsidiaries’ internal

lending that enables internal debt shifting through interest deduction at the level of the German

parent.

We find that the window had statistically significant impacts on both the probability and the

volume of internal lending. For the probability, the results indicate a statistically significant in-

crease of 0.33 percentage points per 90 days window length. Given that the average probability

for internal debt shifting amounts to only 4.7% before the window emerges, this is equal to an

increase in the probability by 7% per 90-day window. For the volume of internal lending, we

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find that a 90-day window increases the total internal lending of EEA low-tax subsidiaries to

their German parents by around 14.4%. Evaluated for the average German MNE with about 4.3

million Euro pre-window internal lending from EEA low-tax subsidiaries and a window length

of 467 days, this is equivalent to an increase of approximately 3.21 million Euro. Considering

the usual nominal interest rate of 5% on German MNEs’ bonds listed in the RDAX at that time

and a German corporate tax rate of 30%, this translates into a loss in German corporate tax

revenue for the average window of about 62,000 Euro per MNE. Since the effect is, on average,

rather small in absolute terms, we argue that MNEs were pre-window not effectively subject to

German corporate taxation, presumably due to competing tax shields or tax planning channels

not restricted by the then anti-tax-avoidance legislation. Consequently, the total loss in German

corporate tax revenue resulting from the window is minor as compared to total corporate tax

revenue at that time.

This paper proceeds as follows. Section 2 gives information on the institutional background

concerning the window of opportunity for profit shifting. Section 3 describes the data. Section 4

describes the empirical approach. Section 5 presents the empirical results. Section 6 concludes.

2 Institutional Background

2.1 The pre-window period: CFC legislation

In the pre-window period until September 2006, German MNEs were subject to strict CFC

legislation that aimed at preventing profit shifting to foreign low-tax subsidiaries (§§ 7 - 14

German Foreign Transaction Tax Act). German CFC legislation lists three criteria which pre-

cisely determine under which conditions profit shifting to low-tax subsidiaries does not result

in tax relief for the MNE. Once the criteria are all fulfilled, the respective profits are treated as if

they were generated by the German parent and not by the foreign low-tax subsidiary. The three

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criteria are: firstly, a foreign subsidiary has to be a controlled foreign corporation of a German

parent. This is the case if the parent holds more than 50% either of ordinary shares or voting

rights in the foreign subsidiary.3 Secondly, the application of German CFC rules depends on

the local tax rate which the income of a controlled foreign corporation is subject to. The mini-

mum tax rate which must not be undercut is 25%. Thirdly, the CFC rules apply only to passive

income of foreign controlled corporations. German tax code thoroughly lists all sorts of passive

income (§ 8 (1) German Foreign Transaction Tax Act). Amongst others and crucial for our

further analysis, the tax code defines foreign low-tax subsidiaries’ interest income from internal

lending as passive if the funds are raised within the group. In legal jargon, this type of lending

is called positive net lending, however, in this paper, we simply refer to it as internal lending.

Hence, under German CFC legislation internal debt shifting to low-tax subsidiaries does not

provide tax relief for German MNEs. Ruf and Weichenrieder (2012) show that German CFC

rules effectively prevent German MNEs internal debt shifting to low-tax subsidiaries before the

year 2006.

2.2 The opening of the window: the ECJ ruling

On September 12th, 2006 the European Court of Justice rather unexpectedly declared CFC

rule application within the EEA in large parts unconstitutional.4 The court’s decision basically

eliminated, with immediate effect, a number of EEA countries’ provisions against profit shifting

to EEA low-tax countries. The ECJ decision affected also German CFC rules. As a consequence

3 Direct and indirect participation are treated the same, and the criterion applies furthermore to ownership chains.4 The ECJ decided in the case C-196/04, Cadbury-Schweppes and Cadbury-Schweppes overseas, that the British

CFC legislation constituted a restriction on freedom of establishment within the meaning of Community Law.The court’s ruling severely restricted the application of the British CFC rule within the EEA. As ECJ rulingtakes legal effect for the entire EEA, not only the British CFC legislation was affected, but all EEA memberstates’ CFC legislations of similar design.

5

of the ECJ decision, German anti-tax-avoidance legislation on internal debt shifting to low-tax

subsidiaries was temporarily suspended within the EEA.

The ECJ decision placed very tight constraints on CFC rule application within the EEA.

Accordingly, CFC legislation was only permitted to apply to wholly artificial tax minimization

schemes. The ECJ pointed out that solely a firm’s intention to obtain tax relief does not suffice

to conclude that there is a wholly artificial arrangement. In case a low-tax subsidiary located in

an EEA member state is an actual establishment which physically exists in terms of premises,

staff and equipment (e.g. no letter-box companies), EEA member states must no longer apply

CFC legislation. Tax experts generally agreed that as consequence of the ECJ ruling, German

CFC rules could basically no longer be effectively applied to counteract MNE’s profit shifting

within the EEA. The German Ministry of Finance officially instructed German tax authorities

in January 2007 to restrict the application of CFC legislation within the EEA backdated to

September 2006 following the ECJ ruling (Bundesministerium der Finanzen, 2007). Hence,

since September 2006, German MNEs’ internal debt shifting to EEA low-tax subsidiaries was

tax effective. Single precondition was that the low-tax subsidiary physically existed.

The cessation of CFC rules left a gap in German provisions against MNEs internal debt

shifting, as there was no other anti-shifting provision that would have restricted interest de-

duction at the level of the German parent.5 Beyond that, German tax code grants corporations

tax exemption for foreign dividends (§ 8b (1) Corporation Income Tax Law). Further, within

the EU the Parent-Subsidiary Directive ensured zero withholding taxes on cross-border divi-

dend payments. This should have even increased the incentive for internal debt shifting because

repatriation of shifted profits in form of dividends is tax exempt. In general, the conditions for

5 German tax code incorporated a thin-capitalization rule (§8a Corporate Income Tax Law) that restricted interestdeduction for German controlled corporations in case they borrowed from major foreign shareholders (partic-ipation larger than 25%). The thin-capitalization rule was, however, no substitute for the ineffective CFC rulethat is in principle concerned with exact the opposite case: lending of foreign controlled corporations to theirGerman shareholders.

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internal debt shifting to EEA low-tax subsidiaries were after the ECJ decision very attractive.

From German MNEs’ perspective, the ECJ decision opened a window of opportunity for profit

shifting, basically, in the absence of any restrictions.

2.3 The closing of the window: the interest barrier

In May 2007 as part of a major German business tax reform, German legislator introduced a

new anti-shifting provision on thin capitalization to restrict German firms’ level of debt finance,

called interest barrier. The crucial novelty with the interest barrier is a general limitation of

the tax deductibility of net interest payments6 to 30% of a firm’s EBITDA7 (§ 4h (1) German

Income Tax Act). The interest barrier targets firms with high debt finance and foreign rela-

tions (Bach and Buselei, 2009), a description matching that of German MNEs.8 Consequently,

MNEs’ internal debt shifting, which relies on tax effective interest deduction as mechanism

for shifting tax base to low-tax jurisdictions, is under the interest barrier subject to limitation.

Therefore, the introduction of the interest barrier marks up from May 2007 the end of the win-

dow of opportunity for profit shifting in the absence of restrictions.

The introduction mechanism of the interest barrier referred to MNEs’ starting date of the

business year. The interest barrier applied for the first time for those business years which

started after May 25th, 2007 (§ 52 (12d) German Income Tax Act). As MNEs’ starts of the

business year are spread over the calendar year, MNEs’ windows of opportunity varied in their

time length. Figure 1 illustrates how the variation in the window length arises referring to

two German MNEs, MNE A and MNE B (both hold a subsidiary in an EEA low-tax country).

6 Net interest is the difference between interest expenditures and interest earnings. The term interest compre-hends both interest for internal and external debt.

7 The EBITDA (earnings before interest, taxes, depreciation and amortization) is a measure of a firm’s oper-ational profit and calculated as follows: EBITDA=taxable income + interest expenses - interest income +depreciation and amortization.

8 The interest barrier involves several exemptions (§ 4h (2) German Income Tax Act), for a closer description seeBuslei and Simmler (2012). These exemptions mainly ensure that small firms and firms with sufficient equityfinancing are protected from disproportionate tax burden.

7

Assume that A’s parent starts its business year on May 26th, 2007. B’s parent starts its business

year just one day earlier on May 25th, 2007. This only one day earlier start of the business

year leads to a time difference of 365 days which parent B is later subject to the new interest

barrier than parent A. While MNE A is subject to the new interest barrier for the first time

with its business year that starts on May 26th, 2007, MNE B’s first business year under the

interest barrier starts on May 25th, 2008. As the day of the windows’ opening is for both MNEs

identically the date of the ECJ decision, September 12th, 2006, B’s window of opportunity for

profit shifting happens to be one entire year longer than A’s. Firstly subject to the new interest

barrier are those business years that start after May 25th, 2007. Consequently, the later an

MNE starts its respective business year after May 25th, 2007, the relatively longer the MNE’s

window. Under the reasonable assumption that MNEs’ starts of the business year are random

with respect to the date of the ECJ decision, the variation in the length of MNEs’ windows

of opportunity is exogenous. In this case our analysis exploits a quasi-experimental setting to

evaluate MNEs’ internal debt shifting during the window of opportunity.

In the Appendix, we provide an illustrative example of a German MNE’s operations under

the distinct institutional changes.

2.4 Hypotheses

We seek to assess MNEs’ response to the window of opportunity for profit shifting by exploring

how the window’s time length affected internal lending of EEA low-tax subsidiaries to their

German parents. MNEs might have responded in two ways. First, in the probability that the

MNE’s German parent receives internal lending from EEA low-tax subsidiaries. And, second,

in the total amount of internal lending that the EEA low-tax subsidiaries provide.

8

Even tax experts did not expect the ECJ to give such a far reaching ruling in its decision

from September 2006. By stating that MNEs’ intention to gain tax relief does not per se justify

CFC rule application within the EEA, the ECJ opened up extensive tax planning opportunities

for MNEs with subsidiaries in EEA low-tax jurisdictions. After the decision, MNEs faced an

entirely new legal situation that they had to assess first. Although the ECJ ruling was unex-

pectedly far reaching in the way it restricted CFC rule application within the EEA, it left legal

uncertainty created by a side clause in the ruling. The ECJ stated in its decision that national

CFC legislations could still be justified in case the legislation particularly related to wholly

artificial arrangements aimed solely at escaping national tax normally due. Internal lending

of EEA low-tax subsidiaries is according to German CFC legislation artificial profit shifting.

Therefore, it was after the ruling unclear whether and under which circumstances internal debt

shifting was possibly still subject to German CFC legislation. Even a subsequent official letter

of German treasury from January 2007 did not entirely remove ambiguity (Bundesministerium

der Finanzen, 2007). In the letter the treasury explicitly recognized the ECJ ruling, however,

advised tax authorities to prevent any purely artificial constructions that provide illegitimate tax

relief. A precise legal definition of “illegitimate tax relief” was missing though. During the

first months after the ECJ decision its consequences for German tax practice were rather un-

clear. Under these circumstances, one expects MNEs to act with precaution. With progressing

window time, proper legal assessment of the situation and increasing experience in the new tax

practice of tax authorities should have made legal uncertainty decline. Those MNEs with rela-

tively long windows benefitted from the increasing experience in how to exploit the window for

tax purposes. Further, the longer the window the more time had MNEs to adjust internal lend-

ing. Hopland et al. (2014) show that, independent from any legal uncertainty, MNEs are in the

short run relatively inflexible in adjusting internal lending for tax purposes. Thus, we expect a

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positive effect of the window length on the probability for internal debt shifting to EEA low-tax

subsidiaries.

In addition, the window’s length should affect the volume of internal lending. One mecha-

nism is related to the declining legal uncertainty about the actual scope for internal debt shifting.

With increasing window time, we expect MNEs to assess the legal leeway for the volume of in-

ternal debt shifting. As there is no legal upper limit for internal debt shifting during the window,

we expect the volume of internal lending to increase in the window’s length due to the decrease

in legal uncertainty. Further, the longer the window, the more time MNEs had to adjust their

internal lending structures resulting in a higher volume of internal lending. Hence, we expect

those MNEs with the longest windows to show the highest volumes of internal lending. There

is, however, a second opposite effect of window on the volume of internal lending. German

corporate tax law restricts the interest rate for internal lending to the arm’s length price (§ 1 (3)

German Foreign Transaction Tax Act). Given a fixed (market) interest rate and the exogenous

time length of window, the volume of internal lending is, therefore, the only parameter that an

MNE can freely choose to determine its volume of profit shifting. Assuming that MNEs are

homogenous in terms of profits and applying simple interest calculus, we expect that the shorter

the window of opportunity, the higher the amount of internal lending ceteris paribus. Due to the

two opposing effects, the sign and the magnitude of the overall effect of window on the amount

of internal lending is eventually an empirical question.

3 Data

The analysis is based on the Microdatabase Direct Investment (MiDi) provided by the German

Central Bank. The panel data set comprehends annual firm-level data on German outbound

foreign direct investment (FDI). As German firms investing abroad are legally required to re-

10

port, the database includes comprehensive and reliable balance sheet information on almost all

foreign subsidiaries of German firms (for details see Lipponer, 2009). A unique feature of the

data set is its detailed and comprehensive information on MNE-internal lending and borrowing.

This feature determines a main advantage of the Microdatabase Direct Investment as compared

to other firm-level panel data sets, e.g. the Amadeus firm database by Bureau van Dijk. We

use information on foreign subsidiaries’ lending to shareholders. By drawing a sample of sub-

sidiaries which are owned at 100% by their German parent, we ensure that internal lending

reported by the foreign subsidiaries is owed by their German parent. The sample is restricted to

corporations. Further, we exclude all MNEs operating in the agricultural, mining and banking

sector as well as governmental institutions and private households which are generally subject

to different tax rules.

As ECJ decisions take legal effect for the EEA, we focus our analysis on countries within

the EEA. We follow Buettner et al. (2013) and define corporate low-tax countries using two

alternative criteria. Firstly, we define countries that offer a statutory corporate tax rate smaller

or equal to 20% as a corporate low-tax country. Secondly, we also include countries with

specific corporate tax regimes that guarantee effective corporate tax rates below 20% for MNEs

(independent from the country’s statutory corporate tax rate). Both selection criteria ensure that

the drawn sample of low-tax subsidiaries is actually subject to a profit tax lower than 25% and,

consequently, with its passive income pre-window subject to German CFC rules. Table 2 lists

the EEA low-tax countries identified. By aggregating the subsidiary information on internal

lending to the MNE level, we generate the internal-debt-shifting outcomes for a sample of

MNEs that may react to the window of opportunity. The sample consists of 5,717 MNE-year

observations covering the time span between September 2003 and September 2010. The panel

11

structure of the data set allows us to rule out potential bias through MNEs changing their start

of the business year in order to extend the length of their windows.

The explanatory variable of interest indicates the time length of MNEs’ windows which is

the number of days between the ECJ decision on September 12, 2006 and the starting date of

an MNE’s first business year under the interest barrier. The majority of German MNEs have a

window of 475 days due to their start of the business year on January 1st. The shortest windows

of opportunity last 291 days and the longest 596 days.

We analyze internal debt shifting of German parents to their EEA low-tax subsidiaries. In

case the funds for internal lending are raised within the group, German CFC rules apply to this

so called positive net lending. Hence, we calculate each subsidiary’s positive net lending which

is the amount of the subsidiary’s lending to the German parent that exceeds the subsidiary’s

funds from external sources. Table 1 lists annual volumes of internal lending.

4 Methods

We aim at estimating the effect of the window length on the probability for internal lending.

For that purpose, we use linear probability models to estimate the following equation:

yit = α+βwindowit + γ′xit +λt +ui + εit . (1)

yit is a binary indicator of whether at least one of the MNE’s EEA low-tax subsidiary provides

internal lending to the German parent i in period t. Thus, MNE parents are the unit of observa-

tion. The variable window measures the elapsed time length of the window. Our interest is in

the corresponding coefficient β that is the effect of the window length. λt denotes a set of fixed

time effects, each covering the time span between September 12th of a year and September

11th of the following year. xit is a vector of time-varying MNE characteristics including the

12

MNE’s size and degree of internationalization at time t as measured by the number of foreign

subsidiaries, number of the German parent’s employees and the number of foreign subsidiaries’

employees. ui denotes unobserved heterogeneity and εit is an idiosyncratic error.

We apply pooled OLS and fixed-effects regressions. Standard errors are clustered at the

level of the parent to take account of heteroskedasticity in the linear probability models and

to allow for possible correlation in the error. The fixed-effects regression additionally allows

for correlation between explanatory variables and time-invariant unobserved heterogeneity. The

pooled OLS regressions additionally include a set of dummies for the sector of industry because

we found evidence for correlation between the sector and the start of an MNE’s business year,

which is used for the calculation of MNEs’ window lengths.9 As a robustness check, we esti-

mate logit and fixed effects conditional logit models that explicitly take the discrete nature of

the dependent variable into account.

Our second goal is to evaluate the effect of the window length on the total volume of internal

lending that German parents receive from their EEA low-tax subsidiaries. Here, we have to

address two issues: first, the dependent variable takes on only nonnegative values with excess

zero values.10 Second, the distribution of internal lending is right skewed. Econometric models

often use logarithmic transformations to deal with skewed dependent variables. However, we

do not have this option due to the zero values. Therefore, we model the functional relationship

between the expectation of the volume and the explanatory variables using a Poisson model

with mean

E(yit) = exp(α+βwindowit + γ′xit +λt). (2)

9 The results of a regression of the MNEs’ start of the business year on various MNE characteristics are in theAppendix (Table 7). Controlling for the sector of industry, we also take account of potentially confoundingfactors that may impact on the outcome and the window length in the case when sector itself is a determinantof the MNE’s probability for profit shifting.

10 Pre-window approximately 95% of all German parents report zero internal lending from EEA low-tax sub-sidiaries.

13

Using the pooled sample, we apply the Poisson quasi-maximum likelihood estimator

(QMLE) that is known to be fully robust to distributional misspecification (Wooldridge,

2010).11 That is, the Poisson QMLE is consistent even if the outcome is not Poisson dis-

tributed given the explanatory variables. However, the variance estimator will be inconsistent in

this case. To address this problem, we use robust estimates of the variances to assess statistical

significance (Cameron and Trivedi, 2009).

5 Empirical results

5.1 Probability of internal lending

This section presents empirical evidence on the question of whether MNEs are more likely to

have internal lending the longer their window of opportunity lasts. Table 4 reports the estima-

tion results for the effect of the window length on the probability for internal lending.12 All

models include a set of year indicators to control for a time trend but are different with respect

to control variables. The results from linear probability models in Columns 1 to 3 unanimously

indicate positive effects of the window length on the probability of internal lending. Pooled

OLS models with and without control variables for the parent and sector show an increase in

the probability by 0.6 and 0.7 percentage points per 90-day window, respectively. The effects

are statistically significant at the 10%-level. Fixed-effects models that control in addition for

unobserved time-invariant characteristics of the MNEs yield an attenuated estimate of the win-

dow length, indicating an increase of 0.33 percentage points per 90-day window (p = 0.04).

Although the estimates are small in magnitude, their relative size is however of considerable

11 We also tried to estimate random-effects and fixed-effects versions of the model in equation 2. However, therandom effects model failed to converge. The fixed effects model converged but showed insignificant resultswith large standard errors. The imprecise estimation may be due to the considerably reduced sample size thatresults from the fact that the fixed-effects Poisson regression does not use information on those MNEs whichhave internal lending equal to zero in all time periods. The estimation results are available upon request.

12 Full estimation results for the control variables are available upon request.

14

importance. Even the conservative estimate of 0.33 percentage points translates into a relative

increase in the probability of 7% over the 90-day window, as the probability for internal lending

is on average only 4.7% before the opening of the window.

Next, we use a second order polynomial fit to allow for a nonlinear effect of the window

length on the probability of internal lending.13 The estimation results are in Column 4. Figure 2

shows the predicted probability for particular window lengths. The graph indicates that the

window is divided into two parts. First, the predicted probability is almost constant. MNEs

don’t respond significantly to window lengths under 180 days. The probablility reaches its

minimum at a window length of approximately 180 days. Once the window length exceeds 180

days, we observe a clear increase in the probability until the window closes. Interestingly, the

increase occurs after the German legislator announced a draft legislation to introduce an interest

barrier in March 2007 (Deutscher Bundestag, 2007). The draft legislation already included

detailed information on the interest barrier’s introduction mechanism that created the MNE-

specific window lengths. Consequently, we argue that the announcement of an approaching

introduction of the interest barrier and not its actual introduction in May 2007 triggered MNEs’

response.

The steep increase in the second part of the window suggests a “gathering of knowledge”

on how to play on the window. Presumably, it took MNEs some time to assess the entire legal

situation and to adjust internal lending structures accordingly in order to exploit the window of

opportunity. MNEs with long window lengths had better opportunities to gather the knowledge

over time than MNEs with short window lengths. Figure 2 shows that MNEs with the maximum

window length (596 days) have predicted probabilities for profit shifting of almost 10%. In

13 We also estimated a model with a third order polynomial function of the window length. However, the modelfit was not improved, indicating that the nonlinearity is appropriately described by a square function.

15

contrast, MNEs’ probability in case of the minimum window length of 291 days is only about

5%. Thus, the window length clearly determines the probability of internal lending.

Finally, we perform two robustness checks: first, we take explicitly into account the discrete

nature of the response variable and report results from pooled logit and fixed effects conditional

logit regressions in Columns 5 and 6 in Table 4, respectively. The logit model confirms a

positive effect of the window length on the probability of internal lending, though the coefficient

marginally misses statistical significance at the ten percent level. The fixed effects conditional

logit model, which allows for correlation between explanatory variables and unobserved time-

invariant heterogeneity, has an almost identical coefficient. However, its drawback is that the

estimates rely exclusively on those MNEs that change their lending status over time such that the

sample size is considerable reduced and the effect is estimated imprecisely with large standard

errors so that statistical significance is not achieved at conventional levels.

As a second robustness check, we test whether the variable window might pick up a seasonal

pattern that occurs repeatedly over time in MNEs’ internal debt shifting. Our test uses a pseudo-

window that emerges two years earlier. That is, the pseudo-window opens on September 12th,

2004. Its closing is again firm-specific depending on an MNE’s start of the business year after

May 25th, 2005. The estimation results using the pseudo-window instead of the true window

are reported in Table 6. In general, the coefficient of the pseudo-window is estimated to be near

zero and statistically insignificant. Also, its sign changes depending on the model specification.

Overall, this suggests that the window length does not capture a recurring seasonal pattern.

5.2 Volume of internal lending

Table 5 reports evidence on the effect of the window length on the volume of internal lending.

We begin with estimation results from pooled OLS regressions (Column 1). The coefficient

16

indicates that the amount of internal lending increases, on average, by approximately 875,000

Euro per 90-day window. Based on an average volume of 4.3 million in the pre-window period,

this is equivalent to a relative increase of about 20%.

Next, we consider results from Poisson regressions that may be more appropriate than the

linear model to model our skewed dependent variable with many zero outcomes. The coefficient

in column 2 indicates a 22% increase in internal lending per 90-day window. The coefficient is

statistically significant at the 10% level. Column 3 presents results from pooled Poisson QMLE

with additional variables for the firm-specific averages of time-variant explanatory variables.

The idea here is to allow for arbitrary correlation between explanatory variables and unobserved

time-invariant heterogeneity (Wooldridge, 2010). The model indicates an increase of internal

lending by 14.4% per 90-day window, though the coefficient does not achieve statistical signif-

icance at conventional levels. For the average window length of 467 days, the estimates from

the pooled Poisson models point to an increase in internal lending between 74% and 114%,

indicating an economically substantial effect.

Theoretically, the sign of the overall effect of the window length on the volume of internal

lending was unclear. The empirical results show, however, a clearly positive effect. Accord-

ingly, the negative interest effect of the window length is overcompensated by the window

length’s positive effects related to declining legal uncertainty and adjustment time.

To put these results into perspective, we finally perform a back-of-the-envelope calculation

for the total loss in corporate tax revenue in Germany resulting from the window of opportu-

nity. The average internal lending in non-window periods is around 4.3 million Euro for each

MNE. The increase due to the average window of opportunity which lasts 467 days is according

to our Poisson regression estimates between 3.2 million and 4.92 million Euro. Applying the

market interest rate for German RDAX-listed firms at that time of 5%, which we assume to

17

be the appropriate arm’s length price for internal lending, and a German corporate tax rate of

30%, the loss in German corporate tax revenue caused by the average window of opportunity

is between 62,000 and 96,000 Euro per MNE. As our data set results from legally obligatory

reporting, it includes all German MNEs with EEA low-tax subsidiaries. Therefore, we take the

number of almost 1,000 German MNEs which we observe to have EEA low-tax subsidiaries

during the window period and multiply. Accordingly, the total German corporate tax revenue

approximately amounts to 62 million respectively 96 million Euro. Compared to total German

corporate tax revenue in 2007 of 22,929 million Euro and 15,868 million Euro in 2008 (Bun-

desministerium der Finanzen, 2011), the loss in corporate tax revenue resulting from MNEs’

windows of opportunity is minor .

The tax loss estimates provided in this paper have to be seen as a lower boundary for the

true corporate tax revenue loss. We analyze internal lending of low-tax subsidiaries which are

held at 100% participation by their German parent. The entire structure of multinational firms

is usually more widespread, so our results reflect only the reaction of a very specific part of

German MNEs which should, however, react very sensitive to the incentives induced by the

window of opportunity.

6 Conclusion

This paper analyzes how MNEs’ internal debt shifting responds to a temporary suspension

of anti-shifting provisions. Through an ECJ decision in 2006 and a subsequent introduction

of an anti-shifting provision on thin capitalization a window of opportunity for profit shifting

emerged for German MNEs. Due to the introduction mechanism of the anti-shifting provision

which refers to MNEs’ start of the business year, the time length of the windows of opportunity

18

differs between MNEs at a maximum by 365 days. We exploit this exogenous variation in the

window length to analyze MNEs’ response in their probability and volume of internal lending.

Regression results indicate that MNEs respond statistically significantly and positively to the

window of opportunity. On average MNEs benefitted from a window of opportunity lasting 467

days. Based on regression results, this translates into an increase in their probability for internal

debt shifting of at least 36% which is economically remarkable. Surprisingly, however, the

percentage of MNEs that conduct internal debt shifting is despite the unique opportunity during

the window small in absolute terms. Even for those MNEs which benefit from the maximum

window of 596 days, the predicted probability is only about 10%. The window of opportunity

leads to an increase in MNEs’ volume of internal lending. The average German MNE reports

pre-window approximately 4.3 million Euro internal lending that it receives from EEA low-

tax subsidiaries. The average window of 467 days increases internal lending according to our

most conservative estimates by around 3.21 million Euro. Again, this means an economically

significant response. The results translate into a corporate tax revenue loss of 62,000 per MNE.

The total German corporate tax revenue loss for an underlying population of around 1,000

MNEs amounts to approximately 62 million Euro. Compared to total German corporate tax

revenue in 2007, however, this is less than 0.3%.

The empirical findings raise the question why MNEs’ response, although statistically and

economically significant, is nevertheless modest in absolute terms and, consequently, of very

low fiscal impact considering the unique profit shifting opportunities that the window provided.

As the ECJ ruling was rather unexpected to create such vast tax planning opportunities, it is

possible that it took MNEs some time to adjust their internal lending accordingly. In case of

those MNEs with short windows (the minimum window is 291 days), it is thinkable that adjust-

ment cost might have exceeded the tax benefit from internal debt shifting. This study’s findings

19

indeed do not reveal statistically significant effects of short window lengths on internal debt

shifting. However, we either find a strong and sizeable effect for the maximum window length

(one year and nine month). A second possible explanation why MNEs’ responded with reserve

is legal uncertainty. A side-clause of the ruling created legal uncertainty concerning the tax

effectiveness of internal debt shifting. But the results indicate that uncertainty diminished in the

course of the window such that MNEs should finally react more strongly. A third explanation

for MNEs’ modest response is that German parents’ profits were pre-window not effectively

subject to German corporate taxation. This would have been the case if German parents made

losses or had competing tax shields at their disposal, e. g. loss-carry forwards. Competing tax

shields act in the way that they reduce German parent’s taxable income. As a consequence, parts

of the parent’s profit are not subject to German corporate tax, and, therefore, the effective Ger-

man tax burden is reduced. Consequently, MNEs would respond only modestly to the window’s

shifting incentives. Similarly, German parents would be pre-window not effectively subject to

German corporate taxation if German anti-tax-avoidance legislation was not comprehensively

restricting their tax planning. Already sufficiently saturated with tax-planning opportunities,

MNEs simply had no need for further profit shifting opportunities. Consequently, they only

weakly responded to the window.

It is plausible that despite extensive German anti-shifting legislation MNEs were still able

to shift profits via not regulated or difficult to regulate shifting channels (e.g. transfer pricing).

The small absolute response to the window indicates that MNEs’ remaining scope for profit

shifting might have been substantial though. Future research should focus on the investigation

of possible evasion mechanisms that MNEs use to circumvent anti-tax-avoidance legislation.

Basically, this poses the question of substitutional relations between different profit shifting

channels under anti-tax-avoidance legislation.

20

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Appendix

A Figures

Figure 1Variation in the length of MNEs’ windows of opportunity

-

May 26th, 2006

Sept 12th, 2006ECJ Decision

Cadbury-Schweppes

May 26th, 2007Interest barrier*

May 26th, 2008

window MNE A

window MNE B

* Firm-specific introduction mechanism referring to MNEs’ starting date of the business year

MNE A starts its business year on May 26th, 2007: 255-day window of opportunity

MNE B starts its business year on May 25th, 2007: 620-day window of opportunity

23

Figure 2Regression results: Quadratic window effect on probability

0.0

5.1

.15

Lin

ear

Pre

dic

tion

110 200 291 383 475 565 window

Predictive Margins with 90% CIs

Note: Predictions based on linear probability model with fixed MNE effects. Joint significance of polynomialterms of window: p = 0.0844.

24

B Tables

Table 1Internal debt shifting over time

2004 2005 2006 2007 2008 2009

Probability 0.0474 0.0477 0.0495 0.0542 0.0488 0.0452Volume of internallending

9101.28 4663.36 2940.85 6638.30 1179.83 1689.49

Note: Probability indicates the ratio of MNEs whose German parent receives internal lending from at least oneEEA low-tax subsidiary in a certain year. Volume is the mean volume of internal lending (in thousand Euro)received by MNEs’ German parent from EEA low-tax subsidiaries in a certain year.

25

Table 2German MNE activities in EEA low-tax countries

EEA low-tax country MNE-year observationsNetherlands 1,799Poland 1,971Hungary 520Slovak Republic 422Ireland 322Romania 143Czech Republic 142Belgium 97Luxembourg 95Bulgaria 59Malta 48Lithuania 36Cyprus n.a.Iceland n.a.Latvia n.a.Liechtenstein n.a.Note: MNE-year observations for all EEA low-tax countries: number of MNEs with at least one subsidiary in therespective country in a certain year. Data source: Microdatabase Direct Investment (MiDi), German CentralBank. “n. a.” indicates statistical single values which are not available due to German data protection law.

26

Table 3Descriptive statistics of regression variables and internal lending

Variable Definition Mean Std.Dev.

Window Time-length of window of opportunity forprofit shifting measured in days.

.9782 1.837

Probability internal lending Binary variable that takes value unity if aGerman parent receives internal lending fromEEA low-tax subsidiaries.

.0520 .2220

Internal lending Amount of internal lending which a Germanparent receives from its EEA low-taxsubsidiaries.

Note: 5,717 MNE-year observations. Information derived from the Microdatabase Direct Investment, GermanCentral Bank.

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Table 4Estimation results for the probability for internal lending

1 2 3 4 5 6Pooled OLS Pooled OLS Fixed-effects Fixed-effects Pooled logit FE cond. logit

Window .0064 * .0071 * .0033 ** -.0100 .2460 .2647(.10) (.062) (0.038) (0.336) (.118) (.357)

Window squared .0025(0.210)

P-value joint significance (0.084)Fixed time effects X X X X X XMNE controls X X X X XFixed sector effects X XFixed MNE effects X X XObservations 5,717 5,717 5,717 5,717 5,518 584Note: Dependent variable: binary indicator for internal lending at MNE level. Time length of window measured in quarters of years (90 days). All models (except logit fe)include constant. P-values in parentheses. Significance: *<0.1, **<0.05. Standard errors are clustered at MNE level.

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Table 5Estimation results for the volume of internal lending

Parent level Subsidiary level1 2 3 4 5

Pooled OLS Pooled Poisson Pooled Poisson Pooled Poisson Pooled PoissonWindow 874.57 .220 * .144 .333 .138(p-value) (0.266) (0.096) (0.290) (0.314) (0.372)Fixed time effects X X X X XMNE controls X X X X XFixed sector effects X X X X XFixed MNE effectsMundlack terms

X X

Observations 5,717 5,517 5,717 10,171 10,171Note: Dependent variable: volume of internal lending in thousand Euro at MNE or subsidiary level. Time length of window measured in quarters of years (90 days). P-valuesin parentheses. Significance: *<0.1, **<0.05. In pooled OLS models standard errors are clustered at MNE level. For Poisson models robust standard errors are reported.

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Table 6Regression results: Robustness checks probability

1 2 3Pooled OLS Fixed-effects Fixed-effects

Pseudo-window .002 -.001 -.020(p-value) (0.564) (0.338) (0.513)Pseudo-window2 .009(p-value) (0.430)Pseudo-window3 -.001(p-value) (0.340)Fixed time effects X X XMNE controls X X XFixed sector effects XFixed MNE effects X XObservations 5,717 5,717 5,717P-value joint significance - - 0.683Note: Dependent variable: binary indicator for internal lending at MNE level. Time length of pseudo-windowmeasured in quarters of years (90 days). All models include constant. P-values in parentheses. Significance:*<0.1, **<0.05. Standard errors are clustered at MNE level.

30

Table 7Regression results: MNEs’ start of the business year

Variable EstimateMNE sector

Manufacture of food products and beverages -64.61 *(-2.50)

Manufacture of textiles -10.61 **(-1.67)

Manufacture of pulp, paper and paper products -18.33(-1.15)

Manufacture of chemicals and chemical products -9.54(-1.64)

Manufacture of pharmaceutical products 1.13(0.61)

Manufacture of rubber and plastic products 1.49(0.87)

Manufacture of other non-metallic mineral products -13.76(-1.43)

Manufacture of basic metals -19.39(-1.53)

Manufacture of metal products -9.39(-1.25)

Manufacture of machinery and equipment n.e.c. -12.73(-1.54)

Manufacture of office machinery and computers -37.11 ***(-3.26)

Manufacture of motor vehicles, trailers and semi-trailers -33.50 **(-2.36)

Electricity, gas, steam and hot water supply -17.18(-1.59)

Construction sector -35.10 *(-1.65)

Wholesale trade and commission trade (except of motor vehicles and motorcycles) -29.72 ***(-3.58)

Retail trade, except of motor vehicles and motorcycles; repair of personal and household goods -118.50 **(-2.87)

Land transport; transport via pipelines -13.24(-1.51)

Housing enterprises -25.81(-1.34)

Computer and related activities -33.32(-1.30)

Other business activities -19.89 *(-1.92)

Management activities of holding companies -25.29 ***(-7.38)

Parent characteristics

Number of employees parent .0001(0.95)

Sales parent 2.87e-07(0.63)

Balance sheet volume parent -1.19e-07(-0.29)

Foreign subsidiaries characteristics

Number of foreign subsidiaries -.05(-0.49)

Sum assets foreign subsidiaries 1.19e-06(1.61)

Number of employees foreign subsidiaries .0002(1.25)

Sales foreign subsidiaries -2.36e-07(-0.66)

Observations 5,717

Note: Dependent variable: indicator for an MNEs start of the business year ranging from 1 to 365. MNE sector classification follows NACERev. 1. Pooled OLS regression includes constant. Standard errors in parentheses. Significance: *<0.1, **<0.05, **<0.01. Standard errorsare clustered at MNE level.

31

C Example

A German MNE holds a foreign subsidiary in a low-tax country, e. g. Ireland. Let the German

tax rate be τh and the Irish τl where τh > τl . The parent provides the subsidiary with internal

funds F . Then, the low-tax subsidiary lends these funds F back to the parent. In return the

parent pays interest rF . Interest deduction at the level of the parent ensures that tax base rF is

shifted from the high-tax country Germany to the low-tax country Ireland. The amount rF is

now taxed at the low Irish and not the high German tax rate. Hence, the MNE reduces its overall

tax bill by (τh− τl)rF . The described finance structure ensures that the parent has at any time

funds F at its disposal and at the same time improves the MNE’s tax efficiency. The example

illustrates two necessary preconditions for effective tax relief. First, the interest deduction in

the high-tax country is tax effective (precondition 1). Second, the parent’s and the subsidiary’s

profits are separately taxed in their respective locations (precondition 2), e. g. no consolidation

of parent and subsidiary profits for taxation.

This finance structure, however, is according to German CFC rules not tax effective, as the

Irish subsidiary’s income rF is passive due to the fact that the German parent entirely pro-

vides the funds F . Further, the Irish subsidiary is held at 100% by the German parent and the

Irish corporate tax rate undercuts the threshold of 25 % (in 2014 Ireland taxes corporate prof-

its at a 12.5% rate). Hence, all three criteria for German CFC rule application are fulfilled.

In case of passive income, the German CFC rules deny separate taxation of the parent’s and

the subsidiary’s profits in their respective locations which violates precondition 2 for internal

debt shifting to be tax effective. The subsidiary’s income considered as passive is added to the

32

German parent’s tax base, and, eventually, subject to the high German corporate tax and not as

originally intended to the low Irish.14

After the ECJ decision in September 2006, German CFC rules were basically ineffective

and the interest deduction of rF at the level of the German parent provided the MNE tax relief

of (τh− τl)rF . During the resulting window of opportunity, the two preconditions for internal

debt shifting to be tax effective were given. Up from May 2007, German legislator restricted

interest deduction to 30 % of the parent’s EBITDA. Under the interest barrier, precondition 1

was consequently violated. Once the German parent is subject to the interest barrier, depending

on the parent’s EBITDA relative to interest deduction rF , the interest deduction might not any

longer be entirely tax effective. The interest barrier, therefore, generally marks the end of the

temporary situation of unrestricted internal debt shifting which has been prevailing since the

ECJ decision in September 2006. Assuming the German parent used to shift its entire EBITDA

abroad, hence, EBITDA = rF . Under the interest barrier, only 30% of the German parent’s

EBITA can be tax-effectively shifted. The excess amount (70% of EBITA) is still subject to

German tax. At the same time the entire amount that is shifted to the Irish subsidiary, rF , is

subject to Irish taxation as it is part of the Irish subsidiary’s corporate income. As a result any

excess amount shifted that exceeds 30% of EBITDA is subject to both German and Irish tax. In

order to avoid double taxation, one would expect the MNE to reduce internal debt shifting the

way that the interest deduction equals 30 % of the German parent’s EBITDA at a maximum.

Consequently, one would expect to observe a decline in low-tax subsidiaries’ internal lending

once their German parent’s window of opportunity is closed and the MNE is subject to the

interest barrier.

14 In practice, the passive income of the Irish subsidiary is subject to both, the Irish and the German corporatetax. The Irish subsidiary is an Irish resident and, therefore, with its entire income subject to Irish taxation.According to German CFC legislation a separate taxation of the German parent and its Irish subsidiary isdenied for passive income. Therefore, the passive income is also subject to the German corporate tax. To avoidinternational double taxation, the German parent receives a tax credit for the tax paid by the Irish subsidiary onthe passive income.

33