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Strategic Line Drawing between Debt and Equity

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  • Niels Johannesen

    (Department of Economics, University of Copenhagen)

Abstract

Corporate tax systems generally maintain a sharp distinction between debt and equity, however, the advent of hybrid instruments has transformed the universe offinancial instruments into a debt-equity continuum and tax systems therefore need to draw lines that distinguish the set of debt instruments from the set of equity instruments. When countries draw these lines differently, there is a scope for international tax planning: A multinational firm financing a foreign investment with a hybrid instrument categorized as debt in the host country and equity in the home country combines the benfits of tax deductible interest payments in the host country and tax favored dividend payments in the home country. This paper develops a theoretical model of strategic line drawing between debt and equity in the presence of hybrid instruments. In the absence of international cooperation, lines are generally drawn in a globally suboptimal manner. The inefficiency ciency typically derives from the endeavors of policymakers to draw lines in ways that facilitate hybrid financing by domestic multinational firms and impede hybrid financing by foreign multinational firms with a view to eroding foreign taxation of domestic firms and enforcing domestic taxation of foreign firms.

Suggested Citation

  • Niels Johannesen, 2011. "Strategic Line Drawing between Debt and Equity," EPRU Working Paper Series 2011-04, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
  • Handle: RePEc:kud:epruwp:11-04
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    Cited by:

    1. Niels Johannesen, 2012. "Cross-border hybrid instruments," EPRU Working Paper Series 2012-02, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
    2. Johannesen, Niels, 2014. "Tax avoidance with cross-border hybrid instruments," Journal of Public Economics, Elsevier, vol. 112(C), pages 40-52.

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