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International Tax and Public Finance

Erschienen in:

09.07.2019

The Cadbury Schweppes judgment and its implications on profit shifting activities within Europe

verfasst von: Sabine Schenkelberg

Erschienen in: International Tax and Public Finance | Ausgabe 1/2020

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Abstract

In 2006, the European Court of Justice (ECJ) decided with the Cadbury Schweppes judgment that European Controlled-Foreign-Company (CFC) rules infringe the principle of freedom of establishment and restricted the applicability thereof. This paper analyzes the impact of mandatory amendments to European CFC rules on tax planning activities within Europe. Using a difference-in-differences approach, my results provide robust evidence that pre-tax earnings of subsidiaries located in European low-tax jurisdictions have increased by around 10% after the Cadbury Schweppes judgment. My analysis shows further that the increase in pre-tax earnings is related to facilitated profit shifting activities. Multinational corporations with high incentives or enhanced profit shifting opportunities react more to the Cadbury Schweppes judgment. The findings point out that CFC rules became less effective, and thus, profit shifting activities within Europe are less restricted after the ECJ judgment. Additional tests suggest further that on average 85% of the increase in pre-tax earnings is attributable to strategic transfer pricing determination, while less than 15% is attributable to debt shifting activities.

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E.g., Ikea and Vodafone, see further Bloomberg (19/12/2017), available at https://www.bna.com/eu-launches-tax-n73014473326/; The Guardian (22/10/2010), available at https://www.theguardian.com/commentisfree/2010/oct/22/vodafone-tax-case-leaves-sour-taste.

E.g., Portugal and Sweden have established such a black list.

C.f. European Court of Justice, Judgment from September 12, 2006.

Restricting the control group to only US-owned subsidiaries ensures a homogeneous group. This mitigates a potential bias that could arise from a heterogeneous control group, e.g., influences that arise due to earnings shocks in specific countries. As the tax environment was very constant in the USA during the period of my sample and because US MNCs are one of the main competitors of European ones, US-owned subsidiaries seem to be an adequate counterpart to form the control group in this setting.

To avoid losing subsidiaries that do not hold any intangible assets, I follow previous studies (e.g., Weichenrieder 2009; Hilary and Lennox 2005; Plassmann and Tideman 2001) and add a small constant (0.1) to the value of intangibles before computing the log of those subsidiaries.

Please note that due to the use of subsidiary fixed effects I do not have to include the proxy variable as a stand-alone variable into the regression.

Firms with the three-digit SIC codes 283 (pharmaceutical), 357, 367, 737 (computers), and 738 (services) are classified as firms operating in the income mobile sector.

Due to an overlap of financial expenses or revenues, financial profit can be either positive or negative. As I am also interested in firms with financial losses and using logs would drop those observations, I add to each observation a constant C that reflects the smallest financial profit of the sample. Doing so, all observations have a positive financial profit while the relative distributions to other observations are not affected. Thus, even negative financial profits will be considered in the regressions. This procedure is in line with prior practice (e.g., Dharmapala and Riedel 2013).

The ownership data are only available for the most recent year, which is mainly 2012 in this sample. The use of a constant ownership data could lead to a bias as group structures usually vary over time. Following previous studies (e.g., Budd et al. 2005) I am not too concerned about this issue, since a potential misclassification would bias the results toward zero.

The Appendix provides more details. Please refer to Table 10 to get a detailed data development. Table 11 provides additional information regarding the origin of all subsidiaries, and Table 12 presents a list of jurisdictions with CFC rules in 2005.

Those jurisdictions are Ireland, Iceland, Latvia, Poland, Slovakia, and Hungary. Note that my basic results are essentially unchanged if a less restricted tax rate threshold of 22.5% is considered. My results might further be underestimated as the jurisdictions listed on country-specific black lists are not necessarily included under the selected tax threshold. However, untabulated tests confirm my findings when Luxembourg, the Netherlands, and Belgium are additionally considered as low-tax jurisdictions. Those jurisdictions have implemented a preferential tax regime for different types of income and are thus typically considered on a black list, e.g., on the Swedish black list.

The definitions and data sources of all variables are presented in the Appendix, Table 13. Please note that to guarantee comparability, I use annual average exchange rates to convert financial data to Euros, if necessary.

Instead of showing the mean, Fig. 1 shows the sum of pre-tax earnings of both groups in order to illustrate the total increase in both groups. Moreover, illustrating the sum of pre-tax earnings captures in addition the establishment of new subsidiaries in European low-tax countries.

In line with Halvorsen and Palquist (1980), I interpret the dummy variable coefficients (c) in this logarithmic specification with the formula \( { \exp }(c)-1 \).

2005 is the year immediately before the Cadbury Schweppes judgment and thus is treated as the reference group.

Please note that the years of the financial crisis (2008 and 2009) are excluded from the sample. Different from the other post-years, no significant treatment effect is found for 2010. This might still be related to the financial crisis and supports my decision to exclude the years 2008 and 2009. However, untabulated regressions that include the years of the financial crisis show similar results.

To further prove that the prior found effect is not caused by a general profitability increase of European-owned subsidiaries, I include parent country-year fixed effects into the basic regressions in untabulated tests. However, controlling for a general time trend of the parent company’s country does not change my basic results.

Assuming that the increase in pre-tax earnings is related to profit shifting activities (please refer to Sect. 5.1), it is reasonable to find a smaller effect when including subsidiaries with a higher statutory tax rate.

A possible explanation therefore might be the small (big) share of pre-tax earnings located in low-tax (high-tax) subsidiaries. Based on the overall pre-tax earnings of all European subsidiaries within a group, only 8% are attributable to low-tax subsidiaries, while the remaining 92% are attributable to high-tax subsidiaries. My basic results suggest a 10% increase in pre-tax earnings of low-tax subsidiaries after the ECJ judgment. Even assuming a completely corresponding (decreasing) effect in high-tax subsidiaries, the effect would be much smaller in magnitude due to the relatively high amount of pre-tax earnings in high-tax subsidiaries. Thus, I am not too concerned about not finding a significant negative effect in column (2).

However, a treatment effect is expected when repeating the same approach and excluding the year 2006. Untabulated tests confirm this expectation, as the result demonstrates a positive and significant treatment effect.

France and Spain anticipated the ECJ judgment and changed their CFC rules already in 2004 and 2005, respectively. The earlier amendment of France and Spain demonstrates that even prior to 2006 a discussion about the compatibility of CFC rules with the European principles existed and might be a potential explanation for the prompt reaction of MNCs in 2006.

According to the Fama and French classification of 17 different industry groups.

Untabulated results based on the chosen one-to-five nearest neighbor matching are robust to applying a caliper of 0.02 and 0.03.

Figure 3 in the Appendix demonstrates graphically that the standardized bias is reduced for each firm characteristic after applying the propensity score matching.

Untabulated tests show also robust results when including the third-order polynomial of STAF, CAPITAL, INTAN, and LEV as determinants for the propensity score matching procedure.

E.g., pre-tax earnings of a Hungarian subsidiary of the German Lufthansa AG increased by 51.5% to 660,630 Euro in 2006. However, the total pre-tax earnings of the Lufthansa group in 2006 are more than 1,613,000,000 Euro. Thus, even if the increase of more than 50% in pre-tax earnings seems to be high at a first glance, it presents only 0.04% of the overall pre-tax earnings of the group.

Due to the use of unconsolidated financial statements of the subsidiaries, this ratio itself might be affected by profit shifting activities. To mitigate a potential bias the computation of a ratio based on consolidated statements is recommended. In an untabulated test, I compute the ratio of EBIT over EBT based on consolidated data offered by Compustat and Compustat Global. This procedure, however, leads to similar findings as the presented results.

Derived by computing [(0.0919/0.0968) * 100 = 94.90%, with slight adjustment due to rounding].

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Titel: The Cadbury Schweppes judgment and its implications on profit shifting activities within Europe
verfasst von: Sabine Schenkelberg
Publikationsdatum: 09.07.2019
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 1/2020
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-019-09553-w

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