Financing of multinational subsidiaries: Parent debt vs. external debt

Financing a multinational subsidiary by intra-firm parent debt has the advantage that while interest payments on the debt are tax deductible, there are no offsetting bankruptcy costs. Tax authorities put limits on the rate the parent is allowed to charge since the multinational firm has incentives to exaggerate the interest rate on the intra-firm debt when the foreign corporate tax rate is higher than the domestic rate. Since the interest rate on external debt — which entails potential bankruptcy costs — is determined competitively in the market, this can be used as a benchmark to justify the rate charged on intra-firm debt. We show that the firm would finance the subsidiary partly by intra-firm parent debt and partly by external debt, both of equal seniority, but it sometimes would choose to pay its external debtors in full even when it is not contractually obligated to do so. For any given level of total debt financing, higher corporate tax rates in the foreign country are associated with a larger proportion of debt financing by external debt, higher interest rates and a larger probability of bankruptcy; higher corporate tax rates in the home country are associated with a smaller proportion of debt financing by external debt, lower interest rates and a smaller probability of bankruptcy.