Curbing profit shifting
Empirical evaluation of Norway's thin capitalization rules
Differences in corporate tax rates across countries and jurisdictions give multinational companies incentives for profit shifting to reduce the total tax burden. One way of doing this is through internal debt from a closely affiliated company in a low-tax jurisdiction, because interest costs are deductible before tax in Norway. In an attempt to combat such tax avoidance, Norway introduced thin capitalization rules in 2014 that limited the total amount of internal interest cost that is deductible relative to pre-tax earnings.
This report aims to evaluate the effects of the introduction of this rule on the use of internal debt, tax revenue and profit shifting more generally. Exploiting rich registry data on firm balance sheets, tax liabilities and unique data on internal interest costs and loans affected the thin capitalization rule, we first show descriptive trends in the interest costs limited by the rule, including the country to which the debt is owed. Surprisingly, a large share of the internal interest costs that is limited by the rule is owed to Norwegian close affiliates, where there should be no incentives for profit shifting.
Furtermore, we exploit plausibly exogenous variation in exposure to the thin capitalization rule in a generalized difference in differences model to estimate effects of the rule on tax revenue, internal interest cost and other outcomes. Results suggest that companies exposed to the rule reduce their use of internal debt significantly more than otherwise similar firms following the reform. This in turn leads to significant increases in tax revenue, with back of the envelope calculations suggesting around 2.5 billion NOK in additional tax revenue per year in the following two years after the introduction due to thin capitalization rules. This does not seem to come at the cost of reduced investment or profitability in the affected companies.
Finally we compare the response to the thin capitalization rules in companies with stronger ties to internal partners in low-tax countries compared to those without such ties. Results suggest smaller response in the companies more likely to be using internal debt as a way to shift profits to low-tax jurisdictions, indicating that these companies may have other mechansisms for profit shifting that substitute for internal debt. Nonetheless, we find increased tax revenue also from these companies, leading us to conclude that the introduction of thin capitalization rules to some extent limited the extent of international profit shifting from Norwegian companies altogether.