Profit shifting via intragroup lending quantified in Italy

A Banca d'Italia working paper provides novel evidence on profit shifting through intragroup lending.

The study finds multinational firms are more likely to use related foreign party debt when their group has affiliates in low-tax jurisdictions.

Interest rates on related party debt also tend to be higher than for non-related counterparties.

This tax motivation is confirmed by a disproportionate reliance on internal borrowing from tax haven affiliates, particularly for firms with higher EBITDA and spare interest deductibility capacity.

The paper quantifies corporate tax dodged via intragroup lending in Italy from 2013-2022, estimating approximately 280 million euros in shifted profits annually, or 67 million euros in avoided tax.

This figure is relatively modest overall and aligns with existing micro-based estimates.

Profit shifting via this channel appears to have declined since 2019, possibly due to Italy's 2018 Anti-Tax Avoidance Directive, though other factors like the pandemic or changes in corporate tax rates may also contribute.

Intragroup lending is a key channel for profit shifting, where multinational groups minimize tax liability by exploiting the 'debt bias' – the tax deductibility of interest payments.

This occurs when affiliates in low-tax jurisdictions lend to those in high-tax ones, reducing taxable income in the latter.

Despite policy efforts to curb such practices, enforcement challenges persist.

Tax authorities struggle to apply the arm's length principle to complex intragroup financial transactions, which can be structured to justify high interest rates or utilize 'hybrid mismatch arrangements.'

This Banca d'Italia paper offers a more comprehensive assessment by uniquely considering both the volume of related-party debt and the interest rates charged, an advantage over prior research that typically focused on only one of these channels.