AN IMF Working Paper has concluded that corporate/income tax rates in different countries influence the capital structures that the multinational banks select for their operations.

Captioned ‘Taxation and Leverage in International Banking' the Paper found that “taxes matter significantly, through both the traditional debt bias channel and the international debt shifting that is due to the international tax differentials. The latter channel is more robust and tends to be quantitatively more important. Our results imply that taxation causes significant international debt spillovers through multinational banks, which has potentially important implications for tax policy.”

The paper, which was released on 30th November, analyzed the dataset for 558 commercial bank subsidiaries of the 86 largest multinational banks in the world over 1998–2011.

It has noted that in most countries, firms can deduct interest expenses from their corporate tax base, but not equity returns. This causes a tax advantage of debt finance, the so-called debt bias of taxation.

According to the Paper, the excessive leverage induced by corporate taxation has regained policy interest in the wake of the financial crisis. Indeed, while taxes are unlikely to have caused the crisis, the high indebtedness might have made firms more vulnerable to the negative shock and could well have deepened the crisis.

A multinational can choose the financial structure of its subsidiaries in different countries partly on the basis of tax differences. In a high-tax location, debt finance is attractive because the interest costs can be deducted at a higher rate. In a low-tax location, equity finance is more attractive since the returns will be taxed at a lower rate with the repatriated dividends usually exempt for the parent.

The Paper concluded that a bank's leverage ratio depends on corporate taxes in two ways: (i) the traditional form of debt bias, measured by the local tax rate in the host country of the subsidiary; and (ii) international debt shifting, measured by the international tax difference vis-a-vis other bank subsidiaries in the same group.

While the tax effects are statistically significant and large, the international debt shifting channel appears to be more robust and is often larger in the regressions than the traditional debt bias. It implies that tax policy induces significant international spillovers through its impact on multinational bank behavior.

The policy implication of these findings is that international spillovers may intensify the incentives for tax competition by governments, which may lead to inefficient policies. It could strengthen the case for international tax coordination.

The second implication is that countries may seek measures to remedy international debt shifting?such as, by imposing thin capitalization rules that restrict the deductibility of interest on intra-company loans. These measures, however, generally do not apply to banks and raise the issue of specific bank regulation or bank taxation.