Financial Structure of Foreign Affiliates in China and Corporate Tax Rates - Case Study Example

Financial Structure of Foreign Affiliates in China and Corporate Tax Rates It is generally believed that the capital structure of a firm depends on the taxation policies of the country in which it is operating. Basically, firms tend to use more debt when tax rates are high than when rates are low. In like manner, we expect multinational firms borrow more in countries with high tax rates than in countries with low tax rates. The aim of this paper is to investigate this theory using data of foreign affiliates of multinational firms in China over the period 2000 to 2008. 1. Introduction. Tariff reductions, falling transport costs, and reduced barriers to international capital flows have created extensive opportunities for multinational firms and investors in increasingly integrated global markets. (Desai, 2008). For example, the outbound foreign direct investment (FDI) position of American firms grew at an average annual rate of 11 percent to $2.4 trillion from 1982 to 2006 while inbound FDI to the United States grew to $1.8 trillion. Foreign portfolio investment (FPI) has grown similarly. By 2005, 16 percent of all U.S. long-term securities (equity and debt) were held by foreigners. Foreign holdings of American stocks increased from $400 billion to $2.3 trillion over the last decade, while American holdings of foreign stocks increased from $600 billion to $3 trillion. (Desai, 2008). In the midst of this rapid integration, investors and firms still face tax systems and investor protections that differ across countries, and these differences have the potential to affect major investment and financing decisions. (Desai, 2008). Governments anxious to attract FDI often consider the use of tax incentives to lure multinational firms, and governments of FDI source countries -- including the United States -- often wonder whether their tax treatment of foreign income is appropriate. (Desai, 2008). Similarly, investor protections and the broader institutional environment remain distinctive around the world and may influence investors portfolio decisions and firms operational and financing decisions. (Desai, 2008). International tax planning has important implications for the international financial structure especially for a multinational company. Multinational companies often suffer from double taxation of their profits. This often occurs in situations where the home country has no double taxation treaties with the host country. Multinational activity has increased recently and multinationals have begun investing in markets where little or nothing is known about the taxation policies of these countries. Consequently, the question then arises as to how these companies cope with respect to differences in taxes. Miller and Modigliani (1958) suggest that the capital structure of a firm is irrelevant, that is, a firm is not better off or worse of by whichever capital structure it adopts. However, because Miller and Modigliani’s capital structure irrelevance proposition was based on a number of simplifying assumptions, there have been a number of papers contesting their view. For example, it has been suggested by many studies that the corporate tax rate has important implications on how a firm selects its capital structure. This is particularly true in the United States where dividends are treated as a non-tax deductible expenditure while interest on debt is tax deductible. As a consequence, a firm generates more shareholder value when it employs more debt than when it employs only equity, thus making the capital structure of a firm relevant. Desai et al. (2004) suggests that the financing of foreign subsidiaries is likely to be influenced by local tax rates, as well as the capital market conditions on the after-tax cost of funds and by the ability of the subsidiaries to obtain resources from the parent company. The effect of taxes on the capital structure, the impact of institutions on financing choices, as well as the workings of internal capital markets are therefore very important in determining the international financial structure of multinational companies. (Desai et al., 2004). When a company makes interest payments on its outstanding debt, many jurisdictions allow these interest payments to be fully deducted from taxable income whereas dividends are often treated as non-deductible expenditure. (Myers and Brealey, 2002; Ross et al., 1999). As a consequence, companies are encouraged to use debt financing rather than equity financing because of the tax advantage inherent in debt financing. (Desai et al., 2004). Desai et al. (2004) notes that the incentive to use debt financing rises with the tax rate. High corporate tax rates therefore lead to high use of debt. Estimating the sensitivity of capital structure to tax incentive is however difficult because corporate tax rates turn to be constant. Despite this difficulty, numerous studies have shown that firms tend to increase leverage along with rising corporate tax rates. For example, Mackie-Mason (1990) cited in Desai et al. (2004). To better understand the debate on the relationship between tax and financial structure a number of studies decided to perform the analysis in an international setting and employing a cross-section of multinational companies as sample firms. The evidence suggests that multinational firms tend to locate debt in regions with very high corporate tax rates so as to benefit from corporate tax shields that arise from the deductibility of interest. For example, Graham et al. (1998) and Graham (1999) employ the a sophisticated measure of the marginal tax rate in the United States based on simulations and prevailing tax rules. Hodder and Senbet (1990) suggest that in perfect capital markets, all firms will locate debt in the most tax-advantaged jurisdictions. According to Desai et al. (2004) since multinational firms operate in perfect capital markets, they face a single cost of capital and as such the relative tax advantage of debt in any market is simply a function of local tax rates. The sensitivity of foreign affiliate’s capital structure to foreign tax rates offers a powerful and clean test of the response of leverage to differential tax advantages to debt. (Desai et al., 2004). We investigate this hypothesis using firm level panel data of foreign affiliates in China. The rest of the paper is organized as follows: section two provides a theoretical and empirical literature review on the topic; whereas section 3 provides a description of the research methodology to be adopted in the study, as well as the data and sources of data to be used in the study. 2. Literature Review 2.1 Theoretical Literature Review 2.1.1 Financial Structure/Capital Structure. According to WebFinance Inc (1997-2008) The financial structure of a firm refers to “the right side of a firms balance sheet, detailing how its assets are financed, including debt and equity issues”. (http://www.investorwords.com/1958/financial_structure.html). This implies that the financial structure simply shows how the firm raises money to finance its business assets. The financial structure is related to the capital structure, which according to WebFinance Inc. (1997-2008) refers to “The permanent long-term financing of a company, including long-term debt, common stock and preferred stock, and retained earnings”. (http://www.investorwords.com/733/capital_structure.html). The financial structure however differs from the capital structure in that the capital structure of a firm considers only the permanent long-term financing (long-term debt and equity financing) whereas the financial structure incorporates both short-term debt and accounts payable. (Myers and Brealey, 2002; Ross et al., 1999). 2.1.2. Financial Structure/Capital Structure of Foreign Affiliates. As earlier mentioned above, multinational firms have a number of foreign affiliates. The financial/capital structure of the foreign affiliate may be different from that of the parent company. The foreign affiliate’s capital structure will constitute more debt during periods of high tax rates and less debt during periods of low tax rates. As earlier defined above, this capital or financial structure is referred to as the different sources of finance for the foreign affiliate’s assets, that is, the right side of the balance sheet. Yonezawa et al (2006) note that the capital structure choice of the foreign affiliate is of particular importance for multinational companies because the capital markets differ among countries with respect to the degree of development. Accordingly, a multinational company should be able to maximize its consolidated firm value under such differences. This implies that the firm should raise necessary capital in a country where the cost of raising capital is low and optimally allocate the funds to the firms that provide it with the highest value. (Yonezawa et al., 2006). Multinational companies may either raise the finance for financing the foreign affiliate in their home country or in the domestic market. In addition, the multinational company has to determine whether the foreign affiliate with be financed using debt or equity. Finally, the currency in which the funds will be denominated has to be determined. According to Yonezawa et al. (2006) multinational companies often find it difficult to raise equity capital in the host country and as such must rely on borrowing in the local market. This implies that the foreign affiliate’s capital structure is more likely to compose of equity raised from the parent country while debt is raised in the host country. 2.1.3 Taxation and Capital Structure. Taxes play an important role in the capital structure of a firm. As earlier mentioned in section 1. A firm’s long-term financing constitutes debt and equity components. The cost of equity capital is dividends while the cost of debt is interest. There are differences in the tax treatment of these two costs. While interest is tax-deductible, dividends are treated as an appropriation of after-tax profit, that is, they are not tax-deductible. This difference in tax treatment has a significant impact on the value of a firm. Consequently, firms take into consideration the taxation policies when deciding on the capital structure decision. Since interest is tax deductible, while dividends are not, it has been shown that the value of an all-equity firm tends to be higher than that of a firm with a mixture of debt and equity. (Myers and Brealey, 2002; Ross et al., 1999). Consequently, firms prefer financing long-term investments with debt rather than with equity. Differences in tax laws as well as corporate tax rates across countries have significant effects on the capital or financial structure of multinational companies. Moore and Ruane (2005) suggest that countries have chosen either to exempt foreign income from taxation or to subject foreign income to taxation with credits/deductions given for taxes paid. In addition, Moore and Ruane (2005) note that the tax-deductibility of interest payments suggests that higher (host-country) corporate tax rates should be associated with a greater proportion of debt-financed FDI, as foreign income tax credit system should, in theory, limit the benefits of shielding foreign income from host country taxation. This indicates that foreign affiliates in regions with high corporate tax rates should exhibit higher debt-to-equity ratios that foreign affiliates operating in regions with lower corporate tax rates. 2.2 Empirical Literature Review. A number of studies have been performed on the effects of international taxation on the financial structure of foreign affiliates of multinational firms. For example numerous studies have shown that multinational firms tend to locate debt in taxed advantaged jurisdictions (e.g., Hodder and Senbet, 1990; Graham, 1999; Desai et al., 2004). Moore and Ruane (2005) provide evidence that whilst multinational from tax exemption countries adjust the financial structure of foreign investments in response to corporate tax rates, the effects of corporate tax rates is significant in FDI originating from tax credit countries thus indicating that there is an additional channel through which foreign income tax credit systems attenuate the forces of tax competition. Ramb and Weichenrieder (2005) analysed the financial structure of German FDI. Noting that intra-company loans granted by the parent should be all the more strongly preferred over equity the lower the tax rate of the parent and the higher the tax rate of the German affiliate, Ramb and Weichenrieder (2005) employ a panel of 8,000 non financial German Affiliate to show that there are only small effects of the tax rate of the foreign parent. On the contrary, the results show that the on average profitable German affiliates react more strongly to changes in the German corporate tax rate, which lead to the conclusion that high German taxes are partly responsible for the high levels of intra-company loans. (Ramb and Weichenrieder, 2005). The latter evidence is supported by Buettner et al. (2006) who analyse the impact of taxes and lending conditions on the financial structure of multinationals’ affiliates. Using a sample large panel of affiliates of German multinationals in 26 countries in the period 1996 to 2003, Buettner et al. (2006) observe that in accordance with the theoretical predictions, the effect of local taxes on leverage is positive for both types of debt (internal and external debt). Despite the huge presence of multinational activity in China, little is known about the financial structure of foreign affiliates in China as well as how this financial structure is related to corporate tax rates in China. 3. Research Methodology and Data Research methods refer to the procedures used to gather and analyze data related to some research question whereas methodology is the strategy, plan of action, process or design lying behind the choice and use of particular methods and linking the choice and use of methods to the desired outcome. (Crotty, 1998). This study shall adopt an “objective view”. Objectivism refers to the “epistemological view that things exist as meaningful entities independently of consciousness, and experience, that they have truth and meaning residing in them as objects and that careful (scientific) research can attain that objective truth and meaning”. (Crotty, 1998). It should be noted that epistemology is the theory of knowledge embedded in the theoretical perspective and thus in the methodology, where the theoretical perspective refers to the philosophical stance informing the methodology and thus providing a context for the process and grounding its logic and criteria. (Crotty, 1998). An objective view in effect indicates a positivist approach. A positivist spirit enables the research to engage in survey research, employing the quantitative method of statistical analysis. (Crotty, 1998). Although this study does not engage in survey research, it is going to adopt a positivist approach in that, quantitative data will be gathered from reliable secondary sources and analysed using the quantitative methods of statistical analysis. A case study approach to research will be adopted in this study. The case study in this case is China. The reason for selecting China is the fact that China is one of the regions with the highest levels of inward foreign direct investment. In addition, China has one of the highest levels of exports in the global economy today. Virtually every product in the market today ranging from electronics, footwear, clothing, etc have a label on them “Made in China”. Without China, there would be a shortage of a wide variety of consumer goods. Large inward foreign direct investment, growing levels of exports, high levels of economic growth in China make makes one to ask the question: How do companies in China make their investment decision, how do they estimate the cost of capital for their investments and thus the study of capital budgeting techniques in China become inevitable? A case study is a research design that entails the detailed and intensive analysis of a single case. (Bryman and Bell, 2007). It may be extended to include the study of just two or three cases for comparative. (Bryman and Bell, 2007). Another definition by Robson (1993: p. 40) is found in Saunders et al. (2000: p. 94) as follows: “the development of a detailed, intensive knowledge about a single case, or a small number of related cases”. The advantage of the case study approach is that it enables a researcher to gain a detailed understanding of the context of the research, as well as the process being enacted. It also enables a researcher to provide answers to why, what and how questions. (Saunders et al., 2000: p. 94). However, the case study approach is limited by the fact that it may be difficult to generalise results from one case to all cases. (Saunders et al., 2000). Despite this limitation, it has been argued that a case study may enable a researcher explore an existing theory. (Saunders et al., 2000). In addition, a researcher can challenge an existing theory or paradigm and identify new hypotheses through the use of a well-developed case study. 3.1. Model Specification This paper employs quantitative methods of statistical analysis to achieve its objective. The paper is going to use correlation analysis and regression analysis to study the relationship between the capital structure of foreign affiliates in China and the tax rates. The capital structure or financial structure of a firm is made up of two components debt and equity. As a result one can write the value of a firm as follows: (1) Where represents the value of foreign affiliate i, at time t; is the value of equity of foreign affiliate i, at time t; and is the value of debt of foreign affiliate i, at time t. The extent of debt financing or leverage in the capital structure of the firm can be measured using the debt-to-equity ratio. Therefore the debt-to-equity ratio from equation 1 can be written as D/E. To understand how the capital structure of a firm varies with tax rates, we in effect study the strength of the relationship between the debt-to-equity ratio of the firm and taxes. This will be done using correlation and regression analyses. 3.1.1 Correlation Analysis Correlational research describes the linear relationship between two or more variables without any limit of attributing the effect of one variable on the other. Correlational research is very powerful as a descriptive technique because it indicates whether variables share something in common with each other. (Salkind, 2008). Correlation can be direct or positive, indicating that a change in the value of one variable in one direction leads to a change in the value of the other variable in the same direction. Correlation can also be negative indicating that as one variable changes in value in one direction the other variable changes in value in the opposite direction. (Salkind, 2008). The strength of the relationship is measured using the correlation coefficient, a numerical index that reflects the relationship between two variables. (Salkind, 2008). The correlation coefficient lies between -1 and +1 (i.e, -1 ≤ ρ ≤ 1; where ρ is the correlation coefficient). A negative correlation coefficient indicates that the two variables move in opposite directions while a positive correlation coefficient indicates that the variables move in the same direction. A correlation of zero indicates that the two variables are uncorrelated, that is a change in the value of one variable does not lead to a change in the value of the other variable. (Salkind, 2008). The extreme values of -1 and +1 indicate perfect negative correlation and perfect positive correlation respectively. If we assume two variables e.g., X and Y, we can calculate the Pearson correlation coefficient (also known as the sample correlation coefficient between the two variables) as an estimate of the correlation between the two variables as follows (Salkind, 2008): (2) Where and represent the sample means for the x and y variables respectively. and represent the sample standard deviations for x and y respectively. xi and yi represent sample observations (i=1, 2, 3,…,n) over n periods and n represents the total number of observations. Being a group statistic, it is difficult to employ conclude anything about individual performance and impossible to attribute causality using correlation. For example, the correlation between tax rates and the debt-to-equity ratio does not tell us which variable explains the other. Consequently, we employ regression analysis to better understand how the debt-to-equity ratio depends on tax rates. 3.2.2 Regression Analysis Regression analysis studies the relationship between one dependent and one or more independent variables. The independent variables are otherwise referred to as explanatory variables. (Anderson et al., 2005). The occurrence of the dependent variable is contingent upon the occurrence of the independent variable. For example, a firm’s output depends on the amount of labour and capital that it employs in the production process. Unless the firm employs labour and capital it is unlikely that it is going to produce any output. Output is therefore a dependent variable, whereas labour and capital are independent variables. There are three types of regressions, time-series, cross sectional and panel regressions. Time series regressions study the relationship between two variables over time while cross sectional regression studies the relationship between variables over a cross section. Panel regression incorporates both time-series and cross-sectional data. This is because we intend to analyse a cross-section of firms over a given period of time. We can state the relationship between the debt-to-equity ratio and the tax rate in the form of a regression as follows: (3) Where represents the debt-to-equity ratio of foreign affiliate i at time t; represents the corporate tax rate at time t; represents the foreign affiliate’s debt-to-equity ratio in period t-1, we include this because firms tend to maintain a target debt-to-equity ratio and thus we expect the current period’s debt-to-equity ratio to be a function of the previous period’s debt-to-equity ratio; is the intercept of the regression line; is the slope coefficient of the line, which measures the sensitivity of the debt-to-equity ratio to the previous periods debt-to-equity ratio, we expect a positive and statistically significant coefficient if the current period’s debt-to-equity ratio depends on the previous period’s debt-to-equity ratio of the foreign affiliate; measures the strength of the relationship between the foreign affiliate’s debt-to-equity ratio and corporate tax rates, we also expect this coefficient to be positive and statistically significant if the foreign affiliate’s capital or financial structure depends significantly on the tax rate; represent a firm fixed effect and is a random error term with mean zero. The coefficients in the regression model above are estimated using the generalized method of movements (GMM) regression. Because of the lagged variable in the model, the debt-to-equity ratio and tax rates are lagged once and twice and used as instruments. 3.2.2.1 Hypothesis Formulation There are two main types of research: non-experimental and experimental research. Our focus in this paper is on non-experimental research. (Salkind, 2008). Figure 1 below shows the two types f researches and when they should be used. Non-experimental research includes a variety of different methods that describe relationships between variables. As shown in figure 1 below, the non experimental method of research is used when we are not interested in differences between groups. (Salkind, 2008). We are interested in the relationship between two variables and the effects of one variable on the other. As shown in figure 1, if we are not interested in the effect of one variable on the other, then correlational research would be considered good. However, we are interested in the impact of international tax rates on foreign affiliate’s capital structure. As a result, correlational research is not very good since it cannot tell us the effect of international taxation on the foreign affiliate’s financial structure. It can give us the relationship but not the impact of one variable on the other. As a result this paper reconsidered the problem and found that the best research method to adopt would be regression analysis which enables us to determine the effect of one variable on the other, as well as the strength of this effect. Figure 1. Research Methods. Source: Salkind (2008) To measure the strength of the effect of one variable on the other, regression analysis requires the formulation of a hypothesis. Going back to equation 3, the significance of the coefficient beta can be tested by stating two hypotheses as follows: Ho: = 0 Ha: ≠ 0 It should be noted that is the slope coefficient of equation 1. This indicates that if the relationship between capital structure in the current year and capital structure in the previous year is significant, then we should have a slope coefficient that is different from zero and thus the null hypothesis should be rejected. On the other hand, we cannot reject the null hypothesis when the relationship between economic growth and foreign direct investment is not statistically significant. To help make this decision, we need to carry out a number of tests. We run the regression using Eviews. The t-tests can be carried out by visually inspecting the p-values provided by the computer or Eviews output. The P-value is the cumulative probability for getting a t-value equal to or greater than the calculated t in absolute terms. (Wang and Jain, 2003). We usually do not reject the null hypothesis when the calculated t value is less than the critical value, which can be observed using probability tables. Therefore to make a decision as to whether to reject the null hypothesis or not based on the p-value, we specify a significance level of 0.05 since we want to be 95% confident that we do not make a Type I error (a type I error is rejecting the null hypothesis when it is true as an alternative1). We therefore compare the p-value from the computer output with the level of significance of 0.05. We reject the null hypothesis for a p-value less than or equal to 0.05. Since the t has a cumulative probability near zero, the null hypothesis is rejected. Otherwise, we do not reject the null hypothesis for a p-value above 0.05. (Wang and Jain, 2003). To investigate the strength of the relationship between the foreign affiliate’s capital structure and tax rates, we set-up two hypothesis as follows: Ho: = 0 Ha: ≠ 0 We carry out tests similar to the case described earlier for the relationship between the capital structure in the previous year and the capital structure in the current year. 3.3 Data Annual balance sheet data for foreign affiliates over the period 2000 to 2008 for foreign affiliates in China shall be collected from Thomson Financial DataStream database. The debt-to-equity ratio shall be calculated for each year and for each firm based on the balance sheet data. Data on corporate tax rates will also be collected over the period 2000 to 2008. We use a period of base period of 2000 because it was around this period that China began attracting a lot of multinational companies following its economic reforms as well as its increased prospects as a potential investment environment. Bibliography. Anderson D. R., Sweeney D. J., Williams T. A. (2005). Statistics for Business and Economics. Ninth Edition. Thomson South-Western. Bryman A., Bell E. (2007). Business research methods, 2nd ed., Oxford. Buettner T., Overesch M., Wamser G. (2006). Taxation and Capital Structure Choice Evidence from a Panel of German Multinationals Crotty, M. (1998). The foundations of social science research: Meaning and perspectives in the research process. SAGE Publications. Desai, M.A., C.F. Foley and J.R. Hines (2004), A multinational perspective on capital structure choice and internal capital markets, The Journal of Finance 59, 2451-2487. Desai M. A. (2008). Capital Flows, Taxation, and Institutional Variation NBER Reporter: Research Summary 2008 Number 3, available online at: http://www.nber.org/reporter/2008number3/desai.html Hodder, J.E. and L.W. Senbet. 1990. International Capital Structure Equilibrium. Journal of Finance. 45: 1495-1516. Graham, J.R. 1999. Do Personal Taxes Affect Corporate Financing Decisions?, Journal of Public Economics, Vol. 73, 147-185. Modigliani, F., and M. Miller. 1958. The Cast of Capital, Corporation Finance, and the Theory of Investment. American Economic Review. 48: 261-297. Moore, Padraig James and Ruane, Frances,Taxation and the Financial Structure of Foreign Direct Investment(October 2005). IIIS Discussion Paper No. 88 Available at SSRN: http://ssrn.com/abstract=922041 Myers S.C. Brealey S. (2002). Principles of Corporate Finance. Seventh edition. McGraw-Hill Irwin. Ramb F., Weichenrieder A. (2005). Taxes and the financial structure of German inward FDI Fred Ramb Discussion Paper Series 1: Studies of the Economic Research Centre No 05/2005 Ross S. A, Westerfield R. W and Jaffe J. F (2002), Corporate Finance, 6th edition. McGraw Hill: New York, Salkind N. J. (2008). Exploring Research (6th Edition) SAGE Publications. Saunders M., Lewis P., Thornhill A. (2000). Research methods for Business Students. Second Edition. Prentice Hall, Financial Times. WebFinance Inc. (1997-2008). Financial Structure. Available online at: http://www.investorwords.com/1958/financial_structure.html Yonezowa Y., Yamaguchi H., Yamamoto T., Nambu T. (2006). Capital Structure choice of foreign affiliates of Japanese Multinational Firms: Characteristics and Problems. Japanese Center for Economic Research (JCER). Read More