The impact of special-purpose entities on euro area cross-border financial linkages

Prepared by Lorenz Emter, Fausto Pastoris, Carmen Picón Aguilar and Martin Schmitz

Published as part of the ECB Economic Bulletin, Issue 7/2024.

Newly released ECB data on special-purpose entities (SPEs) show that these have a considerable impact on euro area cross-border financial linkages. In the context of external sector statistics, SPEs are defined as legal entities controlled by non-resident investors with no autonomy of decision-making and no meaningful economic activity in the country of incorporation.^[1] The interpretation of global cross‑border statistics has become challenging in recent decades owing to the growing importance of financial centres and the increasing complexity of financial intermediation chains.^[2] Multinational enterprises (MNEs), in particular, tend to use complex organisational structures involving numerous entities (including SPEs) as part of their tax optimisation and profit maximisation efforts. Hence, data on SPEs are essential for proper analysis of euro area financial linkages. The newly released ECB data identify the external transactions and positions of SPEs separately. This allows the impact of SPEs on the cross-border financial linkages of individual euro area countries and the euro area as a whole to be investigated.^[3]

Although SPEs contribute to outsized cross-border financial linkages, these tend to have a very limited impact on real economic activity in the host economy. Non-residents set up SPEs to benefit from advantages in the host jurisdiction, such as a lower regulatory or tax burden, easier access to capital markets and financial services, or high levels of investor protection. SPEs in the euro area include passive holding companies, entities involved in intra-group lending activities, financial conduits and entities collecting intra-group royalties and licensing fees. SPEs often involve large “pass-through” flows which are not absorbed into the domestic economy but inflate global cross-border investment. Moreover, such flows complicate analysis of the geography of global financial linkages, as SPEs disproportionately involve financial centres. In addition, SPEs may blur the link between cross-border investment flows and real economic activity.

SPEs account for more than 10% of total euro area cross-border financial linkages and 30% of euro area foreign direct investment (FDI) linkages, driven by a number of financial centres in the euro area. SPEs also account for around 20% of the gross FDI income flows of the euro area, mostly reflecting profits or interest income passing through them from foreign subsidiaries to foreign parents. At the level of individual countries, SPEs dominate the external accounts of Malta and Cyprus (particularly for FDI) and have a substantial impact on those of Luxembourg, the Netherlands and Ireland (Chart A).

Chart A

Relevance of SPEs for euro area external accounts

(SPEs’ shares of the respective totals)

Although SPEs inflate the gross external positions of the euro area, their impact on the net international investment position is limited. SPEs contribute more than €4 trillion to the gross external assets and liabilities of the euro area (Chart B, panel a), accounting for 12% of the total. The large gross FDI positions of the Netherlands and Luxembourg decrease considerably when linkages due to SPEs are removed (Chart B, panel b). The sizeable gross FDI positions of Ireland, on the other hand, are not due to SPEs, mostly reflecting affiliates of foreign MNEs with some physical presence and production in the country.^[4] Malta and Cyprus, the smallest euro area countries in terms of GDP, also have outsized gross FDI positions owing to SPEs. Despite these large gross external positions, the net international investment positions of SPEs tend to be balanced, both for the euro area as a whole and for each individual euro area country (Chart B, panel a), as the assets and liabilities of SPEs are, by definition, largely vis-à-vis non-residents.

Chart B

SPEs inflate the external positions of financial centres in the euro area

a) External assets and liabilities of SPEs

(EUR trillions; end of Q2 2024)

b) Contributions of SPEs to gross FDI positions

(EUR trillions; end of Q2 2024)

The contributions of SPEs to the total external assets and liabilities of the euro area have declined recently from a high level amid national and global initiatives affecting regulatory and taxation environments for MNEs. While SPEs accounted for more than 15% of the total external assets and liabilities of the euro area at the beginning of 2020, their share has gradually declined, standing at 12% at the end of the second quarter of 2024. This mainly reflects developments in FDI, where the shares of SPEs in total assets and liabilities have fallen. This is linked, for example, to foreign investors downsizing or closing affiliates in the euro area or repaying outstanding intra-group loans. In the quarterly profile of the underlying transactions, the retrenchments in SPE assets and liabilities have been strongly correlated, which supports the hypothesis that foreign investors have been reducing the balance sheets of SPEs in the euro area.^[5] This may indicate that MNEs have restructured their global activities and corporate structures in response to recent corporate tax reform initiatives at a global, EU and national level, such as the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting, the EU directive on a global minimum level of taxation for MNEs, and changes to national corporate income tax legislation.^[6]

The recent retrenchment episode in euro area FDI has been linked to SPEs and “other financial institutions” with similar characteristics, while non-financial corporations have shown more resilience in terms of their investment patterns. Indeed, strong divestment patterns have been observed over the past two years for “other financial institutions” that share certain characteristics with SPEs but do not meet all of the criteria in the definition of SPEs (Chart C). These are mostly “captive” financial institutions that are instrumental to MNEs’ intra-group holdings and financing activities and may be affected by corporate restructuring considerations similar to those relating to SPEs. In contrast, non-financial corporations tend to be associated with more traditional forms of FDI (such as greenfield investment, investment for the expansion of capacity, and mergers and acquisitions), and their investment dynamics are normally aligned more closely with euro area and global economic and financial cycles.^[7]

Chart C

Sectoral decomposition of euro area FDI transactions

(EUR billions; four-quarter cumulative flows)

The evidence in this box highlights the important role that SPEs play in euro area financial linkages, particularly as regards developments in the FDI of financial centres. For many policy-relevant questions, it is useful to exclude the contributions of SPEs – and “other financial institutions” with similar characteristics – from the data. Further improvements to available statistics, such as information on the ultimate controlling countries involved in an FDI relationship, could contribute to an even better understanding of the euro area’s cross-border financial developments.