1 Introduction
Interest in corporate tax planning has reached an all-time high, and both the financial media and academics identify cross-jurisdictional income and debt shifting as key sources of tax savings (e.g., Atwood et al.
2012; Beuselinck et al.
2015; Collins et al.
1998; Klassen et al.
1993; Klassen and Laplante
2012; Markle
2015; Newberry and Dhaliwal
2001; Rego
2003). However, designing and implementing cross-jurisdictional shifting schemes can be costly and is not necessarily the single tool available for corporations to avoid paying high taxes. Dyreng et al. (
2017), for instance, observe that effective tax rates (ETRs) for U.S. corporations have declined for both multinational
and domestic firms over the 25 years from 1988 through 2012. This finding suggests that for domestic firms, too, a wide array of local tax avoidance opportunities exist and these can as well give rise to lower tax bills.
Ample anecdotal and academic evidence suggests that corporations lower their tax bill by focusing on
local tax optimization schemes, which do not necessarily require investments in cross-jurisdictional shifting. Local schemes can take various forms, including investments in research and development (R&D) tax credits (Berger
1993; Rao
2016), investments in tax-favorable local assets (Engel et al.
1999), exploiting within-country regional tax differences (Dyreng et al.
2013), and utilizing prior-period loss offsetting. It is generally accepted that local tax avoidance schemes are important for firms and this is also often echoed by the view of tax professionals.
1
A defining feature of local tax avoidance schemes is that they do not necessarily require investments in cross-jurisdictional shifting. However, some locally designed avoidance opportunities reduce the tax base or the tax rates by so much that multinationals may also respond by shifting income to the respective country. Examples include advanced tax rulings, special purpose entities (e.g., Fox and Luna
2005; Feng et al.
2009), intellectual property box regimes (Bornemann et al.
2020), and allowance for corporate equity (Hebous and Ruf
2017; Zangari
2014), making it challenging to examine the continuum of a corporation’s global versus local tax avoidance strategies empirically. One reason for this is the conceptual difficulty in separating local versus global tax strategies, and another reason relates to the lack of affiliate-level data. In this paper, we make a first attempt to observe and provide more empirical evidence of these complementary tax planning strategies.
In recent years, the tax and accounting literature at-large has gained important new insights through larger-scale parent and affiliate entity data that became available via Amadeus (Europe) and Orbis (Global), both Bureau van Dijk products. These databases bring the advantage that they allow investigations of corporate groups, including information on reporting sub-entities from the same ultimate owners, and it has proven to be useful in several international tax studies including the work of Huizinga and Laeven (
2008), Beuselinck et al. (
2015), Markle (
2015), De Simone (
2016), De Simone et al. (
2017) and Alexander et al. (
2020). We also rely on the Orbis database to identify the global network of European headquartered multinational groups and propose a novel calculation approach to identify the importance of and dynamics in local tax strategies vis-a-vis profit shifting. Our method is based on the observed relationship between the multinational consolidated effective tax rate (ETR) and the sum of the (pretax income-weighted) subsidiary-country ETRs and aims to bring a novel, yet parsimonious, measure that can complement other profit shifting studies in identifying tax optimization strategies.
Our logic develops as follows. Theoretically, and absent consolidation differences, a multinational group-level effective tax rate (ETR) is a weighted function of its subsidiaries’ ETRs. So, if all subsidiaries decrease their ETR by one percentage point, the groups’ overall ETR will also drop by one percent. In such a stylized example, the correlation coefficient between the groups’ ETR and the pre-tax income-weighted subsidiaries’ ETR would be equal to one. However, the correlation coefficient may differ from one if not all subsidiaries are observed. For example, details on tax haven subsidiaries are often undisclosed so that we do not know how much income these subsidiaries report and how much taxes, if any, are due. Therefore, for each multinational (S) that decides to shift part of its profits to unobservable tax havens, one will observe a group-level ETR that is less systematically correlated with the ETR of the traceable subsidiaries. In other words, more profit shifting into unobservable tax havens automatically shifts the positive correlation between S’s consolidated ETR and its observable pre-tax income-weighted subsidiaries’ ETR downward (i.e., toward zero).
Alternatively, an economically comparable multinational (L) can decide not to shift profits to tax havens but rather invest in local tax planning strategies by exploiting subsidiary country tax opportunities and loopholes and still reach a similar ETR as S. Yet, for L all potential tax optimization strategies will also manifest in the observable subsidiary ETR, which then results in a positive correlation coefficient between the consolidated ETR and its respective subsidiary ETRs that is closer to one. In reality, however, we expect multinationals to pursue both global and local tax strategies simultaneously, which would result in a correlation coefficient between zero and one. Consequently, we propose that a group level versus income-weighted subsidiary level ETR correlation can serve as an inverse measure of profit shifting and that a lower correlation coefficient indicates more profit shifting, relative to local tax planning as part of the overall tax planning strategy.
Empirically we proceed as follows. We compile subsidiary-level financial data (154,022 subsidiary-year observations) from the Bureau Van Dijk Orbis database to calculate GAAP ETRs of subsidiaries and group-level data (32,849 multinational group-year observations) to calculate GAAP ETRs of European multinational groups over the period of 2006–2014. Next we regress the group consolidated GAAP ETR on the pre-tax income weighted GAAP ETR for the entirety of its observable subsidiaries. A low association between the pre-tax income-weighted ETR of the subsidiaries and the group-level ETR indicates profit shifting, whereas a high association indicates affiliate entity ETRs being more aligned with the overall group tax planning.
We first document that, for the average multinational, subsidiary local tax planning explains around 13 percent of total multinationals’ tax planning. In line with our expectations, the correlation is considerably higher (43 percent) for subsamples where we observe at least half of the consolidated sales in affiliate entities. We acknowledge that, like in any other study on intra-group profit shifting, results can be influenced by incomplete subsidiary information or because aggregating net income across affiliates can lead to double counting of at least some income in complex group structures (Blouin and Robinson
2020). For these reasons, initial correlation results should not be regarded in isolation. However, our measure does allow for explorations of which set of firms (e.g., by industry or by country) have a higher correlation between the groups’ ETR and subsidiary ETRs, compared to another set of firms. Furthermore, we find that the coefficient more than doubles from around 10 percent in the early observation years to around 21 percent toward the end of the observation period, which is consistent with the decreasing trend in profit shifting over time, as documented in the literature (e.g. Alexander et al.
2020).
2 In a nutshell, the proposed proxy is a useful initial screening tool for observing cross-sectional or intertemporal profit shifting differences.
Beyond its descriptive appeal, the measure may be particularly helpful to study the effectiveness of regulatory changes initiated to curb a particular form of tax avoidance, such as cross-jurisdictional income shifting. To this end, we validate our measure by using the staggered adoption of transfer pricing documentation requirements across the 27 EU analyzed countries over the period of 2006–2014 as a source of exogenous variation in the enforcement of international tax compliance. In support of prior findings documenting a significant reduction in profit shifting after the installment of stricter documentation requirements (e.g., Beer and Loeprick
2015; Alexander et al.
2020), we observe a significant increase in the correlation coefficient after the transfer pricing documentation requirements adoption. Timing tests, in the spirit of Bertrand and Mullainathan (
2003), confirm that the parallel trends assumption holds, and the effect is only observed from the tranfer pricing documentation requirements introduction onwards. This observation, in combination with stable group ETR levels pre compared to post-transfer pricing documentation requirements, not only indicates that multinationals reduce profit shifting but also that multinationals rely significantly more on local tax avoidance to achieve stable group-level ETRs when shifting costs increase.
We next exploit cross-sectional heterogeneity to identify the channels through which the transfer pricing documentation requirements differently affect the importance of local versus global tax policies. In particular, we perform two additional validation tests for subsamples where theoretical motivations would predict local tax avoidance to become more pronounced when shifting costs increase. First, we expect the substitution effect to be more pronounced in groups where a relatively high proportion of reported profits are generated in low-tax countries for various reasons. One reason is that these groups may be better designed to exploit income shifting activities and a sudden increase in shifting costs is expected to rebalance that equilibrium toward relatively less income shifting and more local tax avoidance. Further, this scenario is especially expected to materialize since affiliate managers’ incentive contracts are likely to be redesigned so that local managers are prompted to refocus their tax planning in line with the new group-level optimum (Ortmann and Schindler
2021). Both rationales predict stronger results for groups that realize a large fraction of their results in low-tax rate countries. Our results confirm this rationale.
We also examine the responsiveness of substituting income shifting by local tax avoidance in relation to ETR target pressure. Kim et al. (
2019) show that firms invest resources in tax planning until a target ETR is achieved. If the demand for a target ETR is highly inelastic, managers who experience the greatest ETR target pressure may be willing to incur higher nontax costs to achieve this target ETR, causing them to invest relatively more in local tax planning after profit shifting opportunities are curbed. Consistent with this rationale, we observe that groups facing a greater ETR pressure resort to more local tax avoidance post-transfer pricing documentation requirements while this is not observed for firms with low ETR target pressure.
Our findings are consistent with the Scholes-Wolfson framework and suggest that firms pursue tax planning opportunities that optimize after-tax returns (Scholes et al.
2016) in such a way that, when shifting costs increase, multinationals rebalance tax-planning strategies toward local tax planning opportunities. Our study makes a methodological contribution in that it provides a relatively easy-to-interpret proportional measure of subsidiary
local tax planning within multinationals and further allows for dynamic interpretations of multinational tax planning strategies over time. Whereas other measures on local tax avoidance may be precise on the exact impact of country- or region-specific tax initiatives, our measure can be generated for the universe of Orbis industrial firms and is available for both publicly listed and unlisted firms.
Further, our study provides international insights into the dynamics of tax planning and adds to recent related work by Lampenius et al. (
2021), who decompose tax avoidance into a tax rate and tax base component. We also contribute to the literature that investigates how local and global tax strategies may influence each other and relate to the type of tax system that is applied (Kohlhase and Pierk
2020). Finally, our work provides out-of-sample evidence consistent with the findings of Kim et al. (
2019) that corporations—when confronted with out-of-equilibrium optimal tax planning—rebound relatively quickly by adjusting their tax planning strategies.
Our examination method and findings are of importance for regulators, academics, and policymakers, as documenting dynamics between alternate tax strategies and identifying specific tax strategies are empirically very challenging (Wilde and Wilson
2018). Moreover, national governments have increasingly responded to threats of tax base erosion by strengthening transfer pricing regulations and increasing the capacity of tax auditors (Alexander et al.
2020; Lohse and Riedel
2013) as well as with initiatives on country-by-country reporting (Joshi et al.
2020). It is crucial for tax authorities to recognize to what extent multinationals focus on local tax planning strategies and perhaps use these as a substitute for cross-jurisdictional income shifting. Our findings suggest that political decision-makers should not neglect the importance of local tax planning opportunities when debating fair tax rules at the international level.
The remainder of the paper is as follows. Section
2 describes the conceptual components of global versus local tax strategies and relates that to examples and prior academic work. Section
3 elaborates on the hypotheses. Section
4 discusses the research design. Section
5 presents the sample, results, and robustness sections. Section
6 concludes.
2 Local versus global tax planning strategies
An extensive literature shows that multinationals avoid taxes by shifting income from high-tax to low-tax jurisdictions, including tax havens (e.g., Dharmapala
2014; Dharmapala and Riedel
2013; Dyreng and Markle
2016; Huizinga and Laeven
2008). There exists, however, evidence that the corporate tax bill can also be lowered by techniques other than international profit shifting. In fact, Dyreng et al. (
2017) document that effective tax rates (ETRs) for U.S. corporations have declined for domestic-only corporations in equal proportions as for multinationals over the period 1988 to 2012. This finding suggests that domestic firms also have an array of tax planning opportunities without having access to lower-taxed offshore locations.
3 Despite the consensus that both local and global tax strategies can reduce the overall tax burden, there exists very little insight into the firm-specific tactics to use one versus the other strategies. To this end, we describe and position various examples of commonly identified local versus global tax planning strategies. Identification of such local (i.e., within jurisdictions) versus global (i.e., cross-border) tax strategies is essential in understanding the empirical concepts and conceptual logics of our empirical proxy in the following sections.
We structure this overview into three parts: First, we discuss tax-motivated cross-country income shifting, that is, tax planning that we label as “global” tax avoidance and that mainly relates to income shifting via altering transfer prices or inter-company loans. Second, we focus on local tax avoidance strategies (“local”), which reduce the effective tax rate of the respective affiliate but do not necessarily incentivize multinationals to alter their global tax strategies. And, third, we discuss local tax avoidance strategies that are either known or that we consider at least likely, to also affect profit shifting and as such relate to both the local and global components of tax avoidance. For each category, we give a brief conceptual overview followed by several examples.
4
2.1 Global tax planning opportunities
Global tax planning, in general, refers to tax strategies enabled via access to the international web of countries and tax regulations where global firms (multinationals) are present. Widely recognized global tax avoidance schemes often manifest in actions of relocating assets and risks across affiliate countries or via the manipulation of intra-firm transactions so that income is reported in low-tax countries. The global tax avoidance literature has been extensively reviewed by Hanlon and Heitzman (
2010) and, more recently, Wilde and Wilson (
2018) and Jacob (
2021).
2.2 Local tax planning opportunities
Local, that is, jurisdiction-specific, tax planning refers to tax optimization schemes that do not require investments in cross-jurisdictional profit shifting. In essence, these belong to a set of jurisdiction-specific tax advantage schemes that are generally available for any corporation that is operating on a specific territory or for a corporation that satisfies specific conditions.
Similarly, the international evidence is consistent with the view that group tax optimization may also occur within one country or jurisdiction. Gramlich et al. (
2004), for instance, show that Japanese keiretsu group members strategically shift income across affiliate companies. Shevlin et al. (
2012) document that Chinese domestic groups shift income in response to regional tax incentives and that, in particular, intangible-intensive groups and groups with minimum equity requirements are the most frequent shifters. Beuselinck and Deloof (
2014) find that Belgian business groups (holding companies) manage domestic earnings in response to tax incentives and that intra-group transactions facilitate such earnings management.
2.3 Local tax planning opportunities incentivizing cross-country shifting
This final category includes local tax planning opportunities that may either reduce the tax base or the tax rate to such a large extent that multinationals can be incentivized to shift assets or income to the respective country. The combination of local and global tax avoidance concertation can also be labeled “glocal” tax avoidance. Without claiming to be exhaustive in the summarized examples, we highlight four prominent cases of these kinds of tax avoidance schemes.
3 Hypotheses development
An important research stream in the taxation literature examines the dynamics of corporate tax strategies. According to the Scholes-Wolfson framework, a corporate tax strategy refers to a system of decision-making activities and corporate actions with respect to tax planning that maximizes after-tax returns (Scholes et al.
2016). The traditional view on tax planning trade-off decisions has considered the relative importance of tax benefits against the associated nontax costs (e.g., Scholes et al.
1992). The literature that investigated nontax costs of tax planning strategies is extensive and has broadly focused on financial reporting consequences of tax decisions and the effects of agency costs on tax minimization. (See Shackelford and Shevlin (
2001) and Hanlon and Heitzman (
2010) for extensive overviews.)
One area of corporate tax planning decisions that received little attention so far relates to the dynamics of local versus international tax planning strategies. In fact, while the recent public debate on multinational tax avoidance has often focused on tax avoidance through profit shifting, the evidence presented in Section
2 also clearly illustrates that several other local channels exist through which internationally active firms can reduce their global tax bill. In principle, multinationals are expected to shift as much as possible and to claim local benefits until the relative cost of doing both becomes too high (Scholes et al.
2016). Research suggests that, although tax planning activities have increased over the last several decades, the relative cost of profit shifting may have grown in several jurisdictions worldwide and especially in Europe (Beuselinck et al.
2015; Dharmapala
2014). Alexander et al. (
2020) observe a substantial increase in the tax base for a sample of 26 European countries, which they see as a likely reason for the decreasing trend in profit shifting over time. Therefore we first validate our new measure and hypothesize that multinationals reduce their profit shifting when the practice becomes more costly. Empirically, we expect an increase in the correlation between the groups’ ETRs and the weighted subsidiaries’ ETRs over time.
Consistent with the idea that local tax avoidance serves as a counterbalance in times when shifting costs increase, we expect multinationals to rebalance their tax strategies and revert relatively more to local tax strategies, compared to before the cost increase. In other words, the relative net benefit of pursuing local tax strategies increases. Empirically, we expect that, while the correlation between the groups’ ETRs and the subsidiaries’ ETRs increases, the overall ETR does not change as groups rely more on local tax avoidance.
Although the economic intuition of relying more on local tax avoidance after a positive shock to the cost of global income shifting is intuitive, it is also important to consider the possibilities of multinationals in doing so. Theoretically, if all firms would be fully tax-efficient, then, all else being equal, they would have exhausted local tax planning opportunities until the marginal cost of doing this exceeded the marginal benefit. However, it is likely that cross-sectional variation in tax avoidance practices is observed and that income shifters by default react more strongly to increased shifting costs, compared to firms that were already focusing more on local tax avoidance. We therefore conjecture that firms for which income shifting is relatively more important are more likely to substitute income shifting by local tax avoidance when shifting costs increase.
At the same time, recent studies (Ortmann and Schindler
2021; Klassen and Valle Ruiz
2022) suggest that tax-efficiency updates in income shifting indirectly affect managers’ incentives and that the way in which firms respond to this via adjusting incentive packages signals their tax aggressiveness. The analytical model of Ortmann and Schindler (
2021), for instance, predicts that multinationals update incentive contracts of affiliate managers to compensate for any offsetting effect of intangibles shifting. Therefore, if profit shifting gets more expensive, the group is expected to respond by changing the incentive contract of the local manager to pursue local tax avoidance strategies at the subsidiary level. The combined arguments lead to the expectation that multinationals with a relatively high proportion of profits realized in low-tax affiliate countries, that is, the ones that have the opportunities to shift, are the ones that are more likely to respond by substituting income shifting by local tax avoidance after an increase in profit-shifting costs. This combined rationale results in our Hypothesis 2a.
In addition, the demand for a target ETR may be highly inelastic so that managers are willing to bear higher
nontax costs to achieve it. Under these conditions, managers who bear the largest pressure may be willing to incur higher nontax costs to achieve an optimal target ETR. This type of pressure may relate to a firm’s public listing status as well as its historical tax efficiency. Public groups, for instance, are relatively more sensitive to capital market pressures than private groups (Graham et al.
2011) and may therefore respond more to target ETR pressures. Relatedly, Blouin et al. (
2012) find that repatriation of foreign earnings as a dividend to the U.S. parent by public firms is more sensitive to the repatriation tax rate than repatriation by private firms.
Also, target ETR pressure may depend on whether a firm is above or below its optimal tax avoidance level. Kim et al. (
2019) show that the speed of adjustment toward its target ETR is almost twice as high if a firm is below its optimal level of tax avoidance, compared to when it is above its optimal level.
8 Combined, this leads to the expectation that multinationals with higher target ETR pressure (proxied by their public listing status and by their ETR level, compared to industry-country peers) are more likely to respond by more local tax avoidance after an increase in profit shifting costs, compared to multinationals with lower target ETR pressure:
6 Conclusion
The current study proposes a novel calculation to identify the importance of and dynamics in local tax strategies vis-a-vis profit shifting. Our method is based on the observed relationship between the multinational consolidated effective tax rate (ETR) and the sum of the (income-weighted) subsidiary-country ETRs and aims to introduce a measure that can complement existing profit shifting studies in identifying tax optimization strategies.
Our main results show that the consolidated tax planning of the average multinational in our sample relates significantly to the subsidiaries’ tax planning. This finding is consistent with the conjecture that multinationals’ tax planning is partly explained by its affiliate country tax planning and is not originating exclusively from cross-jurisdictional income shifting. We validate our measure by showing it captures decreased profit shifting after the introduction of transfer pricing documentation requirements.
Our findings are consistent with the Scholes-Wolfson framework and suggest that firms pursue tax planning opportunities that optimize after-tax returns (Scholes et al.
2016) in such a way that when shifting costs increase, multinationals rebalance tax-planning strategies toward less costly local tax planning opportunities. Our findings also have important policy implications. First, our study suggests that multinationals trade off both local and global tax planning strategies and that, when the cost structure of the tax strategy components changes, corporations flexibly adjust tax planning strategies toward the relatively less costly technique. Therefore it is important that tax regulators and policy debates also consider within-country tax planning as a potentially important tax planning mechanism. In addition, our findings suggest that in times where the pressure for a fairer tax game is growing and initiatives are launched to curtail profit shifting opportunities (OECD
2013), multinationals can work around regulations via updated tax planning strategies and maintain an ETR relatively close to their target ETR.
Our study has limitations. First, country differences in reporting requirements for private entities may result in incomplete coverage of the web of multinational subsidiaries, which may weaken the validity of our proposed measure. For example, countries like the United States have no reporting requirements for private firms, and data is consequently not available for all legal entities. Second, affiliate-level data does not necessarily allow for precisely determining how much of the consolidated group result is impacted by intercompany reporting and consolidation methods. Blouin and Robinson (
2020), for example, show that aggregating net income across affiliates will lead to double counting of at least some income in complex group structures, especially when a directly owned subsidiary itself owns another entity and reports its profit as equity income. Double counting of income in such a way would also bias affiliates’ ETRs downward. For both reasons, we wish to caution researchers that the proposed metric ideally should not be used in isolation. However, in combination with an exogenous shock or regulation change, the proxy can yield interesting insights into the dynamics of local versus global tax planning strategies. Third, we discuss global versus local tax strategies based on the literature and the popular press, but we acknowledge that a clear distinction is not always possible and eventually one also affects the other. Our measure and analyses are only a step toward a better understanding of the dynamics of global and local tax planning dynamics.
Future research might consider changes other than tax law regulations affecting multinational decisions to substitute local tax planning for income shifting or can investigate the governance determinants of local versus global tax planning decisions. Furthermore, our results suggest that there exists considerable variation across countries. Further exploring such country-level variation could be a fruitful area of research, especially for local researchers with advanced knowledge of the specific tax rules.
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