Internal Finance Research Paper

Multinational groups can structure their financing activities in a way that they minimise their own tax burden. Internal loans may serve as a vehicle for profit shifting activities due to reasons which will briefly be described in the following: \cite{Buettner} \\

Contrary to interest payments for loans, dividend payments as well as returns on equity in the form of capital gains are subject to corporate taxation. \cite{Auerbach} Tax systems usually make a fundamental distinction between the tax treatment of equity and debt and hence rather encourage the use of debt than equity finance. Debts are regarded as a resource that does not belong to the firm. As such, interest payments for external financing are tax deductible from corporate profits

Generally speaking, the use of debt finance for new projects or business operations may allow firms to achieve a return on investment which is higher than the cost of debt. This is known as the “leverage effect”. Leverage in general refers to the effect of debt financing on the return on equity, which, in other words, is the ratio of a firm’s profits to its equity capital. The higher a firm’s debt ratio, the higher will be the return on equity, as most business activities are financed by debt. A high return on equity is at the same time a good indicator for a firm’s economic success, which again attracts investors. Paradoxically, firms thus deliberately increase their debt finance to raise their profitability. The leverage effect remains positive, as long as the cost of debt is smaller than the overall return on investment.

Shallow capital markets, weak credit rights or increased political risk might encourage a multinational firm to rather use debt instead of equity finance. \cite{Desai et al} If access to external debt proves to be difficult or costly, the existence of internal credit markets allows for the substitution of external with internal debt at more favourable conditions. Motives for the optimisation of a subsidiary’s leverage and hence a move towards a tax-efficient capital structure need to be distinguished from tax avoidance or profit shifting motives. Nevertheless internal debt can also serve as a vehicle for profit shifting: Subsidiaries located in low-tax countries lend money to subsidiaries in high-tax countries, which allows the latter to reduce profits by deducting interest payments. Multinationals who wish to minimise overall tax payments will borrow in countries with high-tax regimes and declare interest-payments in low-tax countries. \cite{Buettner}