**Policy, Research, and External Affairs**

<!-- Start of picture text --> eband International Flnance |<br><!-- End of picture text -->

WPS 765

- This paper a product of the Debt and International Finance Division, International Economics Departmentis part of PRE's continuing effort to understand what determines the cost and quantity of commercial bank credit available to developing countries. Copies are available frce from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Sheilah King-Watson, room S8-040, extension 31047 (32 pages).

Many countries levy withholding taxes on interest payments on international bank loans and ether debt instruments. These withholding taxes can be credited against taxable income in the major creditor nations, such as the United States and the United Kingdom.

estimated 56 cents for every dollar of tax withheld at the source. U.S. banks passed on close to 100 percent of their potential U.S. income tax credits to developing countries by way of lower interest spreads during the go-go lending years of 1976-78.

International bank loan contracts conventionally state the interest rate or spread above the benchmark rate net of withholding taxes. For a given net interest rate, an increase in the withholding tax rate increases the withholding taxes paid in the borrower country as well as creditable in the creditor country. So intemational bank loans become more profitable to the banks the higher the rate of withholding tax imposed by the borrower country.

As banks compete for loans, one expects these institutions to offer low interest spreads to countries that impose high withholding taxes. Huizinga shows empirically that international differences in withholding tax rates are indeed largely reflected in bank credit terms.

Using a sample of 510 loans to 14 debtor nations originated bctween 1971 and 1981, he finds that the developing countries have been able to reduce their interest expense by an The cost of bank credit to developing countries is made unstable, however, as loan spreads reflect the cyclical marginal value of tax credits to the commercial banks. In particular, tax credits were fully reflected in loans with maturities of four years or less, but only partially in longer-term loans. The rationale appears to be that banks have doubts whethcr tax credits flowing from long-tenm loans will still be allowed in the future. They may also doubt whether they will have enough taxable incorne to actually realize the full tax savings offered by the tax credit.

Huizinga concludes that tax treatment in tlhe creditor country of interest income from foreign sources probably still has an important effect on credit terms. In particular, limits on tax credits for foreign-interest withholding taxes, as effectively introduced by the 1986 U.S. tax refonn, will probably lead to less favorable credit tenns.

The PRE Working Paper Scrics disseminates the findings of work under wa) in the Bank's Policy, Rescarch. and Extemal Affairs Complex. An objectiveofthescries is to get these findings out quickly, evcn if prescntations arc lcss than fully polishie(l. The findings, intcrpretations, and conclusions in these papers do not nccessarily represent official Bank policy.

Produced by the PRE Dissemination Centcr