Tax Avoidance Strategies in (Probably) Loss-making

Transcription

1 Tax Avodance Strateges n (Probably) Loss-makng Afflates Arnt O. Hopland Petro Lsowsky Mohammed Mardan Drk Schndler August 26, 2014 Abstract When afflates run operatng losses, there s an ncentve to shft n profts, no matter how hgh the statutory tax rate s. Ths paper studes the flexblty of multnatonal frms to revert ther earnngs-management strateges wthn a tax year n order to react on such operatng losses. Usng data on Norwegan frms, we fnd that transfer prcng gves substantal flexblty to adjust proft shftng ex post (.e., at the end of the tax-year). In contrast, we do not fnd any evdence for flexblty n the captal structure. The latter mples, however, that optmal debtshftng behavor antcpates the possblty of operatng losses and s adjusted ex ante so that the expected tax rate dfferental and not the statutory tax dfferental s decsve for the nternal leverage rato. Ths has strong mplcatons for the debtshftng lterature as ts tradtonal approach wll underestmate the tax effect. Keywords: tax avodance, multnatonal frms, losses, debt shftng, transfer prcng JEL classfcaton: F23, H25, H87 We are grateful to Jula Tropna Bakke, Andreas Haufler, Domnka Langenmayr and Martn Ruf for valuable support and dscussons. The foundatons for ths project were lad whle Drk Schndler was guest researcher at the CES n Munch. He wshes to thank ths nsttuton and ts people for ther hosptalty and support. Department of Busness and Management Scence, Norwegan School of Economcs and NoCeT, Helleveen 30, 5045 Bergen, Norway; emal: Arnt.Hopland@nhh.no Department of Accountancy, Unversty of Illnos at Urbana-Champagn, Champagn, Unted States; e-mal: lsowsky@llnos.edu Department of Management, Technology and Economc, Edgenösssche Technsche Hochschule, 8092 Zürch, Swtzerland; e-mal: mardan@kof.ethz.ch Department of Accountng, Audtng and Law, Norwegan School of Economcs, NoCeT and CESfo, Helleveen 30, 5045 Bergen, Norway; emal: Drk.Schndler@nhh.no

2 1 Introducton In recent years, tax avodance and earnngs management n afflates of multnatonal companes are hotly debated ssues. Popular newspapers and government commssons (e.g., Bergn, 2012; Levn and McCan, 2013) pcked up the cases of bg global player such as Apple, Google and Starbucks that hardly pay any taxes anymore. In ts Base eroson and proft shftng (BEPS) report, the OECD (2013) confrms that the losses n tax revenue are substantal and dentfes transfer prcng and debt shftng (.e., thncaptalzaton, partcularly by usng nternal debt from related companes) as the two man strateges for shftng profts from hgh-tax to low-tax countres. Both devces to reduce multnatonals overall tax payments are well-analyzed and well-understood n the accountng, the fnance, as well as the economcs lterature. 1 It s also well-known and ntutvely straghtforward that the ncentve to shft profts out of hgh-tax countres s reversed f the afflates n such countres are runnng losses. In loss-makng afflates, the effectve tax rate drops to zero, and because ntertemporal loss offsets are lmted and cannot be carred forward wth nterest, multnatonals have a clear ncentve to balance losses mmedately by shftng n ncome from other afflates. Hence, there s some bunchng around zero profts for afflates of multnatonals (compared to domestc frms), see Grubert et al. (1993, chapter 7.4). Maybe due to the fact that ths ntuton appears to be very smple at frst glance, the lterature on proft shftng n lossmakng afflates has been very small and lmted to date. However, all avalable lterature has totally neglected that revertng the tax-avodance mechansms wthn a tax year, n order to shft n profts nstead of shftng profts to low-taxed proft centers, requres a lot of flexblty. In prncple, ths flexblty can be lmted, because revertng proftshftng channels can nterfere wth nternal ncentve systems for local management; arse suspcon at tax authortes; and be bounded by other transacton costs. 2 Ths paper ponts out n ts theory part that (n-)flexblty n revertng the proftshftng streams has crucal mplcatons for frm s behavor n achevng a tax-effcent earnngs management also under losses. Only under perfect flexblty, any proft shftng can be adjusted ex post ( at year s end ) to ensure zero taxable profts. If there s hardly any flexblty, all frms are forced to take the lkelhood of runnng losses at year s end nto account and need to adjust ther tax-management strateges ex ante no matter whether they wll run operatng profts or losses n the end. Our emprcal approach provdes evdence for the assumpton that transfer prcng gves substantal flexblty to 1 Gresk (2001) and Göx and Schller (2007) survey relevant transfer-prcng lterature; Mntz and Wechenreder (2010) provde an overvew on (nternal) debt shftng, whle Huznga et al. (2008) and Møen et al. (2011) ntroduce external debt shftng nto the pcture. The accountng lterature on emprcal tax research s revewed by Shackelford and Shevln (2001) and Hanlon and Hetzman (2010). 2 When n addton takng nto account that, for multnatonal afflates, the average probablty of runnng a loss s qute substantal (e.g., Norwegan based multnatonals experence losses n 38% of the observatons), t s even more surprsng that none of the three felds took ths ssue. 2

3 frms so that they can adjust ther proft shftng ex post. On the contrary, we do not fnd any evdence for flexblty n the captal structure. Accordngly, we can suggest that most debt-shftng decsons must be taken at the begnnng of the tax year (or even earler). One mportant mplcaton from our fndng on debt shftng s then that t s the expected tax-rate dfferental that should be taken nto account when estmatng the effect of tax shelds on multnatonals captal structures. By neglected ths ssue, the debt-shftng lterature underestmates both the mpact taxes have on frm s (nternal) debt-to-asset ratos and the magntude of debt shftng. In order to analyze these ssues, we set up a smple model of a multnatonal company that owns productve afflates n n countres and hosts a proft and fnancal center n a tax haven. The tax-haven afflate uses ts equty to lend nternal debt to the other related afflates. Moreover, t charges them user fees for a fxed factor (e.g., royaltes on technology) and t serves as a vendor, buyng an ntermedate good at the world market and resellng t wth a mark-up to the productve afflates (e.g., the Apple Sales Internatonal case, see Levn and McCan, 2013). Thus, our model captures proft shftng by transfer prcng both n ntangbles and n ntermedate goods as well as nternal debt shftng. Shocks on the sale prce of the fnal good ntroduce the rsk to end up wth net operatng losses at the end of the tax year. To focus on the effects of (n-)flexblty of revertng earnngs-management strateges durng the tax year, we assume central decson makng by the headquarters. Ths assumpton neglects both the ncentve role of transfer prces on management n decentralzed unts and ts nteracton wth the tax aspect of transfer prcng. 3 But, t allows to solate how flexblty nfluences the cost structures of afflates that are ex ante dentcal, but, ex post, report net operatng losses and profts, respectvely. One justfcaton s that frms can always rely on two books and multple transfer prces n order to separate the tax-drven earnngs management from handlng prncpal-agent problems n a decentralzed trust structure (cf. Smth, 2002; Nelsen and Ramondos-Møller, 2012). Furthermore, from the economcs lterature, t s well-known that centralzaton becomes the domnant strategy when tax dfferentals become large and tax savngs mportant (Nelsen et al., 2008). Göx and Schller (2007, p. 692) survey mxed emprcal evdence for the use of two books, but anecdotc evdence fosters the vew that bg multnatonal companes that are very tax effcent (aggressve) operate wth multple transfer prces. 4 From our model, we derve three testable hypothess: (H1) Multnatonals afflates should consstently report lower profts and lower losses, respectvely, than comparable 3 See Göx and Schller (2007) for an overvew on these aspects. Ths assumpton s not made because we beleve that the ncentve role s not mportant. But, for the comparson of ex-post dfferences n exante dentcal afflates, allowng for decentralzaton would add complexty wthout producng addtonal nsghts on the tax ncentves. 4 A pont n case here s General Electrcs. See Danel Kocenewsk on G.E. s Strateges Let It Avod Taxes Altogether n The New York Tmes of March 24, 2011, and nformal statements by General Electrc s Treasury offcals. 3

4 domestc frms,.e., multnatonals afflates bunch around zero proftablty. (H2) Under full flexblty n revertng earnngs-management decsons durng the tax year ( ex-post proft shftng ), all multnatonal afflates wll report roughly zero profts. However, otherwse comparable multnatonals afflates wth the same output level, wll dsclose hgh transfer payments and a hgh nternal leverage when runnng net operatng profts, and wll report low transfer payments and no nternal debt when they face net operatng losses. (H3) If there s no flexblty n earnngs management and all fnal tax decsons need to be settled at the begnnng of the tax year ( ex-ante proft shftng ), otherwse comparable afflates of multnatonals wll report dfferent proftablty levels (.e., sgnfcant profts or losses), but wll dsclose the same transfer prce payments and nternal leverage. Usng a frm-level panel data set ncludng all Norwegan based frms, we are able to test several mplcatons of the theoretcal model. Frst, by comparng multnatonals to domestc frms, we confrm that multnatonals to a larger extent bunch around zero. Second, we conduct a regresson analyss to test whether or not frms have flexblty to adjust ex post (consstent wth H2) or must commt to an ex-ante strategy (consstent wth H3). Ths s done by regressng nternal transfer payments and nternal leverage on a dummy varable equal to one f the frm experences a loss poston n that year. If beng n a loss poston sgnfcantly reduces nternal leverage and transfer payments from the Norwegan afflate, ths ndcates flexblty to shft ex post. Ex ante expectatons are controlled for by ncludng both the lagged loss poston, whch s strongly correlated wth the present status, and an nteracton-term varable that captures whether the frm was n a loss poston both at tme t and t 1. The results ndcate that multnatonals have the possblty to adjust ther transfer prcng ex post. 5 Hence, wth respect to transfer prcng, we fnd clear support for H2. For nternal leverage, we obtan the expected sgn, but the effect from beng n a loss poston s nsgnfcant. Thus, H3 seems to be closer to realty n the case of nternal leverage. Note that, snce less outgong transfers and less leverage reduce the rsk of experencng a loss, our estmates may suffer from an attenuaton bas. Therefore, t s stll possble that frms have some flexblty to also adjust nternal leverage ex post. But, there should be a least qute some rgdty n nternal captal structures, and transfer prcng s the more flexble nstrument of the two proft-shftng devces. Our fndngs have some polcy mplcatons for governments n hgh-tax countres, beng concerned about an eroson of ther tax base by proft shftng n multnatonal frms. Our results foster the concluson by De Smone and Sedman (2013) that tax authortes should not only focus on transactons between proftable afflates n hgh-tax countres 5 Consstent wth fndngs n Dschnger et al. (2014), we fnd that there are mportant dfferences between multnatonals afflates, controlled from abroad, and (Norwegan) parent companes. We pont out that flexblty s more mportant for daughter companes. 4

5 and related partes n low-tax countres, but should also scrutnze payments made to lossmakng afflates n other hgh-tax countres. Ths s partcularly true for frms that are flexble n revertng ther earnngs management strateges,.e., frms wth large transferprce payments. Our fndngs mply, however, that less flexble frms mght be just as tax-aggressve even though they sometmes report profts and losses. By antcpatng ex ante the lkelhood of operatonal losses, they can stll shft substantal profts and t would be mprudent just to focus the audt on those frms whose profts bunch around zero. Ths cautonary note matters n partcular for frms wth low transfer-prcng possbltes, but large amounts of fnancal captal. We contrbute n at least four ways to the lterature. Frst, there s, as sad, a small lterature that analyzes proft shftng under losses. Klassen et al. (1993, secton 4.1) dscuss dstnctve features of afflates wth net operatng losses and pont out that there s an ncentve to shft n profts nto such afflates. But, the authors decde to drop lossmakng afflates n ther man sample, nstead of testng for ther characterstcs. 6 Usng ndrect evdence from IRS panel data on US companes from 1980 to 1987, Grubert et al. (1993) suggest that roughly 50% of the return-rate dfference between foregn- and domestcally controlled frms needs to be attrbuted to tax-nduced transfer prcng and earnngs management. In chapter 7.4, the authors pont out that foregn-controlled frms not only dsclose sgnfcantly less taxable ncome, but also consstently acheve to have ther proftablty bunched around zero, wth sgnfcantly less devatons compared to domestc frms. Ths s taken as clear evdence for actve earnngs management and proft shftng. 7 Closest to our paper s de Smone and Sedman (2013) who focus on profts shfted to unproftable afflates of multnatonals and who recognze that there are adjustment costs. Utlzng the Amadeus data base, they analyze ndependent and afflated European frms over the perod from 2002 to The authors not only fnd strong evdence for a bunchng around zero proftablty, but also that, besdes rsk-sharng motves, tax factors explan the proftablty dfference between domestc frms and multnatonals afflates. Partcularly adjustment costs, nstrumented by the statutory tax rate, have a strong effect on the reduced loss reportng n multnatonals relatve to domestc frms. 8 We confrm the fndng of bunchng around zero profts n multnatonals afflates 6 Ths became the domnant strategy n (almost) all papers on both transfer prcng and debt shftng n order to, apparently, avod any bas from reversed ncentves under net operatng losses. 7 Maydew (1997) ponts out that, on the contrary, there can be an ncentve to report hgh losses also n multnatonal afflates f these net operatng losses can be settled mmedately aganst taxable ncome from prevous tax years. He fnds evdence of such loss-carryback behavor for US frms n the years after the 1986-tax reform that reduced corporate taxes substantally. However, the avalablty of loss carrybacks has been massvely lmted both n magntude and n tme (mostly to one year only now) n the last 15 years, at least n European countres. 8 Furthermore, both Gramlch et al. (2004) and Onj and Vera (2010) analyze proft-shftng behavor wthn domestc Japanese trusts ( keretsus ) and fnd evdence that net operatng losses n some Japanese afflates are balanced by shftng n profts from other Japanese afflates. Onj and Vera credt ths behavor to tax motves that arse from the fact that the Japanese corporate ncome tax dd not provde group provson n order to consoldate keretsus overall taxable ncome. 5

6 and extend ths lterature by pontng out that flexblty n revertng the tax-avodance mechansms matters for the extend of ths bunchng. By comparng ntra-company transfer payments and nternal nterest expenses between otherwse dentcal loss-makng and proftable afflates of multnatonals, our approach allows to test drectly for flexblty n ncome shftng and sheds lght onto the queston to whch extend multnatonals can actually adjust ther earnngs management ex-post. Based on our emprcal fndngs, afflates that can do a lot of transfer prcng can balance losses better than afflates that must manly rely on thn-captalzaton because they nether have large nternal sales nor royalty/patent payments. Second, the fnance lterature reports a sgnfcant rgdty n captal structures so that they cannot be easly adjusted to changed envronments. Fscher et al. (1989) argue that frms wll only adjust to ther target captal structure when the losses from a suboptmal leverage are gettng larger than the costs of adjustng. Partcularly fnancally dstressed (e.g., loss makng) frms face hgh costs of adjustng ther overleveraged external debt-to-asset ratos and lnger around longer wth ther suboptmal captal structure (e.g., Glson, 1997; Strebulaev, 2007). Reasons are hold-out problems (no enforcement n settlement) and regulatory dsncentves for nsttutonal lenders to turn ther debt nto equty. Korteweg (2010, secton 5C) summarzes ths dscusson and, usng a new strategy to dentfy net benefts of debt fnancng, provdes evdence for sgnfcant costs of suboptmal captal structures. Thereby, the costs of beng overleveraged are much hgher. Moreover, Korteweg reports evdence that frms are underleveraged on average. Our emprcal results on the nflexblty of (nternal) debt-to-asset ratos support ths vew. Even a strong tax ncentve (.e., a drop from a 28% tax rate to an effectvely zero tax rate) does not nduce a change n the captal structure durng the tax year. Hence, the short-term rgdty seems to be substantal. Furthermore, the lagged adjustment also apples to nternal debt that should nether suffer from transacton costs related to agency costs nor from costs of renegotatng wth external lenders. Fnally, a strategc underleveragng could be drven by takng nto account the loss probabltes under exante decson makng. Thrd, although the effects from tax debt shelds on external and nternal debt shftng are always hghly sgnfcant, the estmated magntudes n studes such as Desa et al. (2004), Huznga et al. (2008), Egger et al. (2010), Møen et al. (2011) or Büttner and Wamser (2013) are surprsngly low. The estmates for the sem-elastcty of nternal debt le between 0.69 and 1.3; for external debt the range s between 0.34 and Stll, debt shftng s seen as an mportant channel to shape earnngs dsclosures and tax payments, and the lmted effects are perceved as knd of a puzzle n ths lterature. Büttner and Wamser suggest that the adjustment costs of the captal structure should be very hgh. They also fnd that mnorty ownershp reduces the tax-rate senstvty of debt, but pont out that ths effect s not strong enough to solve the puzzle. 6

7 Our results ndcate now an addtonal reason for the low tax-rate senstvtes. All the studes base ther estmatons on tax dfferentals between statutory tax rates. When frms are forced to antcpate potental losses ex ante, however, the correct tax rate dfferental wll be the expected tax rate dfferental whch can be sgnfcantly lower. Consequently, by overestmatng the decson-relevant tax dfferental, the debt-shftng studes to date underestmate the mpact of debt tax shelds on captal structures. To put t dfferently, the standard procedure of excludng (or controllng for) loss-makng afflates does not heal the problem, because even proftable afflates wll have adjusted ther captal structure to the (ex-ante) rsk of runnng losses. Fourth, we suggest an addtonal explanaton for the emprcal fndngs of strong tax mpacts n the transfer-prcng lterature. For a long tme, t was dffcult to properly dentfy the effect of transfer prcng on proft dfferentals. 9 Comng up wth frst drect evdence, Oyelere and Emmanuel (1998) pont out that foregn-owned afflates n the UK are characterzed by lower profts but hgher dvdend dstrbutons (than UK-controlled frms). Ther fndngs confrm sgnfcant proft shftng by foregn-controlled afflates and drectly dentfy transfer prcng as major drvng force for ths. Pak and Zdanowcz (2001) and Bernard et al. (2006) calculate that the absolute losses n US tax revenues, stemmng from transfer prcng by US multnatonals, are massve. Bartelsman and Beetsma (2003) study OECD data and pont out that the addtonally earned tax revenue, stemmng from a unlateral tax ncrease, would be by a factor three to eght hgher f proft shftng by transfer prcng could be shut down. Studes such as Swenson (2001), Clausng (2003) and Langl and Saudagaran (2004) confrm the strong mpact of transfer prcng. Conventonal wsdom n the lterature s that t s easer to shft large amounts of profts by msprcng ntra-frm trade than to rely on thn captalzaton (and potentally low nterest rates) for reducng the tax burden. Furthermore, transfer prcng s seen to cause less concealment costs, because t s more dffcult to enforce the arm s-length prncple for transfer prces than to enforce effectve thn-captalzaton rules. 10 Based on our fndngs, some part of the (comparably) hgh tax-dfferental senstvty of transfer prcng could be explaned by the fact that transfer prcng provdes suffcent flexblty to adjust the earnngs management durng the tax year. For transfer prcng, multnatonals do not need to take nto account the loss probablty too much and the expected tax rate dfferental matters less. Hence, the emprcal studes on transfer prcng suffer less than the debt-shftng lterature under usng an ncorrect tax dfferental 9 Most, and partcularly the earler, studes only provde ndrect evdence by showng that proftablty substantally dffers between domestc and multnatonal frms and that these dfferences should be explaned by proft shftng (transfer prcng). See, e.g., Grubert and Mutt (1991), Harrs (1993), Klassen et al. (1993), Hnes and Rce (1994), Collns and Shackelford (1995), and Jacob (1996). 10 Another ndrect evdence for the strong mpact of transfer prces on tax avodance s provded n Lohse and Redel (2013). Analyzng European multnatonals, they pont out that tghtenng the documentaton rules for transfer prces substantally reduces proft shftng and pays-off for tax authortes, even though the admnstratve burden of ths regulaton s hgh. 7

8 and excludng loss-makng frms ndeed elmnates (at least to a larger extend) ncentves of revertng proft-shftng channels n case of losses. The outlne of the paper s as follows. In secton 2, we set up the theoretcal model and derve some predctons on frm behavor that can be emprcally tested. A descrpton of the data set and descrptve statstcs are provded n secton 3. In secton 4, we outlne the emprcal strategy, report our emprcal fndngs and provde a dscusson of the results. Fnally, we offer some concludng remarks n secton 6. 2 Model 2.1 The settng Consder a multnatonal frm (henceforth MNC) that has afflates n n countres. Let be country 1 the country wth the lowest tax rate so that t > t 1, = 2,..., n. As a smplfcaton, we assume that the afflate n the low-tax country (e.g., a tax haven) acts exclusvely as a fnancal center of the MNC and therefore does not produce any goods. All other afflates use captal K and an ntermedate good S to produce a homogenous fnal good y accordng to the producton technology y = F (K, S ; X), whch s concave n both nputs. The prce p of the fnal good s stochastc and drawn from a cumulatve dstrbuton functon H(p) wth support on [p, p]. X represents a fxed factor that we nterpret as acqured technologcal know-how (e.g., resultng from R&D nvestment wthn the MNC group). The fnancal center purchases the ntermedate good S = S at margnal costs of q S on the world market and re-sells t at prce G S + q S to the other afflates, pretendng that t has added value to the nput good. The correct arm s-length prce of S, however, s q S. Furthermore, the patent rghts for the technologcal know-how X are also located n the proft center whch clams lcense fees G X + q X, whle the true arm s-length prce s q X. Any devaton from the true arm s-length prce leads to convex concealment costs C P (P X, P S ), where P X = G X X and P S = G S S, wth CP > (<)0 f G a G a > (<)0 > 0, a = {X, S}. The concealment costs are defned over shfted profts and and 2 C P (G a )2 correspond to the set up n Allngham and Sandmo (1972), where a fne s calculated based on undeclared ncome. Ths concept of concealment costs n transfer prcng mrrors the comparable proft method proposed by the OECD. 11 The headquarters (henceforth HQ) of the MNC endows the fnancal center wth equty E 1 and provdes the producng afflates wth the equty necessary to reach both a tax-effcent fnancng structure and the optmal level of real captal. Thus, productve 11 The alternatve approach would be to rely on the devaton of the true arm s-length prce only, featurng the comparable unrelated prce method, see OECD (2013) and Gresk and Osmundsen (2008) for nsttutonal detals. Qualtatvely, our results do not depend on whch approach s chosen. 8

9 captal K n afflate 2 s fnanced by equty E provded by the HQ and by nternal debt D I borrowed from the fnancal center so that K = E + D I. 12 The fnancal center uses ts equty E 1 to fnance ts nternal lendng DI to all the other afflates so that E 1 = DI. For expostonal purposes, we defne the leverage rato of the producng afflate as b = D I /K and assume that both types of fnance are free of rsk and carry the world-market nterest rate r. In lne wth most tax systems, we assume that the costs of equty are not tax deductble whlst nterest expenses related to debt can be deducted from the corporate tax base. As s standard n the lterature (e.g., Mntz and Smart, 2004; Schndler and Schjelderup, 2012), the MNC needs to ncur concealment costs C I (b ) n order to conceal thn captalzaton. These costs are proportonal to the amount of captal employed and convex for any postve nternal leverage b > 0, but zero otherwse (.e., C I (b ) = 0 for b 0). Gven these assumptons, the economc proft of afflate s gven by revenue from the sales of the output good mnus the lcences cost, the cost for the ntermedate good and the user cost of captal π e = p y (G X + q X ) X (G S + q S )S C P (P X, P S ) C I (b )K rk. (1) Taxable proft dffers from economc proft n that opportunty costs of equty and concealment costs are not tax-deductble. Furthermore, we assume that no loss offset s granted when the afflate s runnng taxable losses. Hence, f the realzaton of the output prce p s too low, the government does not partcpate n the resultng losses and the tax payments are zero. 13 Let p 0 be the prce for whch the taxable proft of afflate s just zero. The taxable proft of afflate can then be wrtten as p π t y (G X + q X ) X (G S + q S )S rb K, f p > p 0 = 0, f p p 0. The surplus of the fnancal center n country 1 amounts to π 1 = (1 t 1 ) π + (1 t 1 ) (G X + q X ) X + (G S + q S )S + rb K q X X qs S ] rb K = (1 t 1 ) π + (1 t 1 ) G X X + G S S t 1 r b K. (2) 12 For smplcty and wthout any consequences for our man results, we have assumed that there are no external captal markets for debt avalable. 13 In realty, loss carry forwards mply that current losses can be deducted aganst future profts. However, loss carry forwards are not nflated wth nterest so that the present dscounted value decreases. Therefore, our smplfyng assumpton of no loss offsets s harmless, because multnatonals always have the ncentve to settle losses n one afflate wth taxable profts n other afflates. 9

10 Hereby, π > 0 represents postve exogenous profts n the fnancal center. 14 The HQ of the MNC maxmzes total after-tax profts Π by choosng the optmal tax-avodance actvty,.e., by optmzng over leverages b, and the transfer prces G X and G S. Wth respect to the tmng of the tax plannng strateges of the MNC, two scenaros are applcable. Frstly, the MNC could choose ts tax-plannng strateges after the realzaton of the output prce, say, at the end of the year. We wll refer to ths scenaro as ex-post proft shftng. Secondly, t could be that the MNC has to decde on and to commt to ts proft-shftng actvtes before the revelaton of the output prces. We wll refer to ths settng as ex-ante proft shftng. 2.2 Ex-post proft shftng Ex-post the MNC knows about the realzaton of the output prces p. Takng ths nto consderaton, the MNC optmally shfts ncome nto the afflates that gve the hgher effectve reducton n tax payments. We can dstngush the two cases p > p 0 and p p 0. Postve taxable profts. In the frst case, the producng afflates makes economc profts and therefore face the local tax rate t. The overall proft of the MNC can be wrtten as max b,g X,GS Π = π 1 + s.t. π t > 0, rb K = 0, π e t π t G X X = 0, G S S = 0. (3) Dfferentatng the total after-tax profts for the three tax-avodance varables and consderng λ as the Kuhn-Tucker multpler yelds t t 1 1 r C I b λ, (4a) t t 1 CP P X λ, (4b) t t 1 CP P S λ, where the frst-order condtons hold wth equalty and λ = 0 f π t > 0. The frst-order condtons state that the effectve margnal concealment costs for each 1 C proft shftng devce equalze n the optmum,.e. I r b = CP G X (4c) = CP. Furthermore, G S 14 In a full-fledged model, there would be other (proftable) afflates that shft profts to the fnancal center. In order to account for that and to make sure that the multnatonal can shft profts to the hgh-tax afflates n case of taxable losses n these afflates, we assume π > 0 as a shortcut. 10

11 f the taxable proft n the producng afflates s postve, the MNC s unconstraned n the use of all proft shftng channels (λ t = 0) and effectve margnal concealment costs are equal to the margnal tax savngs t t 1. The consequences are that the MNC sets transfer prces above the correct arm s-length prces, and that the fnancal center lends nternal debt to the hgh-tax afflates n order to shft profts nto the tax haven. Non-postve taxable profts. Whenever the output prce s equal to or below the break-even prce (p < p 0 ), the producng afflates have nether economc nor taxable profts. Therefore, ther tax payments drop to zero. The overall profts of the MNC can be wrtten as max b,g X,GS Π = π 1 + π e s.t. π t 0, rb K = 0, G X X = 0, G S S = 0. (5) The optmzaton problem s smlar to the case wth postve taxable profts and yelds t r C I b λ, (6a) t 1 + CP P X λ, (6b) t 1 + CP P S λ, where for the Kuhn-Tucker parameter holds λ = 0 f π t 0. Once more, the frst-order condtons state that the effectve margnal concealment costs for each proft shftng devce are equalzed n the optmum. In the case of taxable losses (π t < 0), the effectve margnal concealment costs, n absolute terms, equal the margnal loss t 1 from shftng out profts. Accordngly, the MNC has an ncentve to reduce the transfer prce for the ntermedate good as well as for the lcence fee below the correct arm s-length prce. 15 Moreover, the nternal debt tax sheld n afflate becomes negatve and nternal debt wll drop to zero. Actually, the MNC has even an ncentve to use the hgh-tax afflates as nternal bank as long as these afflates are n a loss poston and ther effectve tax rate s zero. (6c) We wll, however, assume that the MNC cannot reallocate ts equty. For tax savngs, the total nterest deducton over the entre tax year matter so that an nverted fnancal structure at year s end wll not delver any reward. In sum, the MNC shfts profts nto the hgh-tax countres whch means that the ncentves 15 Implcty, we assume that there are no concealment costs related to shftng profts out of a tax haven, because the tax haven does not montor the fnancal flows. 11

12 for proft shftng are completely reversed n a loss poston. Tax-effcent captal structure. The mechansm at play under debt shftng s that nterest ncome s earned n the low-tax country and deducted n hgh-tax countres so that the tax savngs arsng from the deductons n hgh-tax countres exceed the correspondng tax payments n the low-tax country. Followng the emprcal debt-shftng lterature (e.g., Huznga et al., 2008, Møen et al., 2011), we assume concealment costs of (nternal) debt to be quadratc n leverage,.e., C I (b ) = η b 2 (b ) 2 (7) η b represents a constant cost parameter of debt shftng. Applyng equaton (7) n the frst-order condton (4a), we fnd as optmal nternal leverage n the case of a proftable producng afflate b = (t t 1 ) r η b > 0. (8) All afflates > 1 wll borrow nternal debt from the fnancal center and, due to mproved possbltes to save taxes, the nternal leverage s ncreasng n the nternal tax debt sheld, that s b t = r η b > 0 and b t 1 = r η b < 0. If taxable profts are negatve nstead, the afflate experences a negatve debt tax sheld ( t 1 r) and the optmal nternal leverage s zero n afflates that are n a loss poston π t < 0. Optmal transfer prcng. As for debt shftng, the lterature on transfer prcng suggests quadratc concealment costs (e.g., Haufler and Schjelderup, 2000; Grubert, 2003; Nelsen et al., 2010). Snce the MNC n our model has two devces for shftng profts by transfer prcng, G X and G S, t s reasonable to consder the two as cost substtutes,.e., the two devces are mutually ncreasng each others concealment costs. We defne the concealment cost functon of proft shftng as C P (P X, P S ) = 1 [ ηx 2 2 ( P X ) 2 + η S 2 ( P S ) 2 ] 2. (9) Usng (9) as the cost functon leads to the followng optmal (abusve) transfer prces for the lcence fee and the ntermedate good 16 ( ) G X η = 3 S 2 η S + η X (η X ) (1 t 2 t 1 ) 1 X 1, f π t > 0, 1 = 0, f π t We delver a full dervaton of the optmal transfer prces n the appendx. (10a) 12

13 ( ) G S η = 3 X 2 η S + η X (η S ) (1 t 2 t 1 ) 1 1, f π t > 0, 1 = S 0, f π t 0. (10b) Not surprsngly, the surcharge on the correct arm s-length prces s postve n case of a proftable afflate (G X, G S > 0). In ths case, the mark-up ncreases wth the tax rate of the producng afflates t, but decreases wth the tax rate t 1 of the fnancal center G a t > 0 and Ga t 1 < 0, a = X, S. A hgher tax dfferental makes transfer prcng more attractve, because shftng profts wll result n hgher tax savngs. In contrast, the MNC sets a transfer prces that les below the correct arm s-length prce f the afflate s n a loss poston (G X, G S < 0). Ths s because the effectve margnal tax rate s zero, regardless of t. Consequently, proft-shftng ncentves are reversed as long as the producng afflates have non-postve taxable profts (.e., zero tax payments). In ths case, the tax rate t does not affect the magntude of the transfer prces. Contrary to before, an ncrease of the tax rate t 1 n the proft center leads to a decrease n the transfer prces and to more profts shfted to the producng afflates, now. The reason s that the tax dsadvantage of the tax haven relatve to the effectvely zero tax burden n the hgh-tax countres ncreases. Puttng both aspects together, afflates of MNCs are bunchng around zero taxable profts. For proftable afflates, the HQ has an ncentve to shft profts nto the low-tax country, whereas afflates wth taxable losses n the operatng busness wll receve profts from afflates abroad (the fnancal center). For zero taxable profts, the ncentves to shft concde and collapse. Because domestc companes cannot shft profts nternatonally, these companes cannot buffer ther operatng profts and losses. Hence, the proft dstrbuton around zero s much less compressed for domestc frms than for afflates of MNCs. Emprcal studes by Grubert et al. (1993, chapter 7.4) and by Møen and Tropna (2013) fnd emprcal support for ths result. 2.3 Ex-ante proft shftng If the MNC must decde ex ante on transfer prces as well as the level of nternal debt, t cannot revst these decsons after the output prces revealed. The MNC s HQ maxmzes the expected overall profts takng nto consderaton that the output prces p are stochastc and follow a cumulatve dstrbuton functon H(p) wth support [p, p]. Then, 13

14 expected profts of the hgh-tax afflates are E(π ) = p p p h(p) dp y (G X + q X ) X (G S + q S )S rk + [1 H(p 0 )] t [(G X + q X ) X + (G S + q S )S + rb K ] p t p h(p) dp y C P (P X, P S ) C I (b )K. (11) p 0 The frst lne dsplays afflates economc profts. The sze of the economc profts depends on the realzaton of p whch s ex-ante uncertan. Addtonally, afflates have to pay taxes n the case of a suffcently hgh output prce. Ths happens only wth the lkelhood [1 H(p 0 )]. In any other case, tax payments n country are zero. The MNC ncurs also concealment costs for debt shftng and transfer prce manpulaton. Accordngly, overall expected profts of the MNC can be wrtten as E(Π) = E(π ) + (1 t 1 ) G X X + G S S t 1 r b K. (12) Dfferentatng the expected after-tax profts of the MNC for the three tax-avodance varables, takng nto consderaton that the prce p 0 s affected by changes n the transfer prces and nternal debt, gves 17 [1 H(p 0 )]t t 1 = 1 r C P b, (13a) [1 H(p 0 )]t t 1 = CP, (13b) P X [1 H(p 0 )]t t 1 = CP. (13c) P S Wth uncertanty n the realzaton of the output prce, the rsk neutral MNC s more cautous n settng transfer prces and allocatng nternal loans. The MNC only wants to shft profts to the fnancal center f the producng afflate has taxable profts. The probablty for ths case (π t > 0) to happen s 1 H(p 0 ). Therefore, t s the expected tax rate of the producng afflate, [1 H(p 0 )] t, that matters for determnng the tax savngs ex ante. Consequently, overnvocng transfer prces and nternal debt shftng becomes less attractve f the probablty of beng unproftable, H(p 0 ), ncreases. 2.4 Theoretcal predctons To summarze, the theoretcal model offers several predctons, some of whch we are able to test emprcally. Frstly, n lne wth the exstng lterature (Grubert et al., 1993; 17 We delver a full dervaton of the ex-ante optmalty condtons n the appendx. 14

15 de Smone and Sedman, 2013), the model predcts that, compared to purely natonal frms wthn the same ndustry, afflates of MNCs should have lower tax payments f the afflate s proftable. Analogously, afflates of MNCs should report lower taxable losses than comparable purely natonal frms. In both cases, the reason s that MNCs can adjust ther transfer prces and the fnancal structure to shft profts tax effcent between countres. We summarze ths fndng n: Predcton 1 Hgh-tax afflates should have lower tax payments (lower losses) when runnng profts (losses) as compared to natonal frms. Secondly, we should expect that tax payments of hgh-tax afflates are bunchng around zero f the MNC has the possblty to adjust proft shftng strateges ex post,.e., at the end of the year when the actual output prce p s known. As a result, comparable afflates of MNCs (wth the same output) wll dffer n ther cost structures, but wll all bunch around zero profts. More precsely, our model predcts: Predcton 2 Tax payments of hgh-tax afflates are bunchng around zero n the case of ex-post proft shftng. Otherwse comparable afflates wth the same output level, however, wll under ex-post shftng feature hgh transfer payments and a hgh nternal leverage f they are proftable (.e., π t > 0 before any tax avodance operaton), whereas they wll carry low transfer payments and no nternal debt f they are n a loss poston (π t < 0). Thrdly, f the MNC must commt to ts proft-shftng strategy ex ante, we should observe dfferences n the proft levels of these afflates whch stem from dfferences n the realzaton of the output prce. However, ncentves for proft shftng are the same for all afflates ex-ante,.e. we should observe an dentcal cost and fnancal structure across afflates. We summarze ths n: Predcton 3 If ex-ante proft shftng s the relevant scenaro, comparable afflates of MNCs wll show dfferent proft levels (.e., dfferent tax payments), but wll feature the same transfer prce payments and nternal leverage. Fourthly, f the probablty of beng unproftable ncreases, we should observe a reducton n the proft shftng ncentves of ex-ante proft shfters only. Incentves for ex-post proft shfters are not affected by the ex-ante probablty of beng unproductve snce they decde on proft shftng strateges after the realzaton of the output prce. We summarze ths n: Predcton 4 An ncrease n the probablty of beng unproftable only affects the proftshftng behavor of MNCs that are forced to do ex-ante proft shftng. 15

16 3 Data and descrptve statstcs The sample s constructed by combnng three unque data sources. Frst, Dun&Bradstreet provdes data on all fnancal statstcs for all companes regstered n Norway. Second, SIFON gves nformaton about foregn ownershp of Norwegan frms. Thrd, the Tax Authortes (Skattedrektoratet) has data on transactons and debt relatonshps between Norwegan frms and foregn afflates (Utenlandsoppgaven). These three sources are merged, usng an dentfcaton key that dentfes each Norwegan frm unquely. classfy a Norwegan frm as a MNC f t ether controls at least one daughter company abroad or s controlled by a foregn owner. That s, the Norwegan frm s an MNC f t ether owns, drectly or ndrectly, at least 50% of a foregn afflate, or a foregn owner drectly controls at least 50% of the shares of the Norwegan frm. Outgong transfers nclude royaltes, lcense fees, rental expendtures, and purchases the Norwegan frm makes from a foregn afflate. Our panel data covers the eght-year perod from 1998 to 2005, and t ncludes all frms except fnancal frms and producers of ol and gas whch are subject to specal laws and regulatons. The varaton n the data s lmted; n partcular, there s not much varaton n each frm s loss/proft postons over tme. Therefore, we try to preserve as much as possble of the orgnal data. We only exclude some very few observatons wth extreme values, notably negatve sales and negatve total assets. Fnally, the measures for transfer prces are wnsorzed at the 1st percentle, whle we restrct the total nternal leverage to the nterval [0; 1]. 18 Appendx A.4 for detals. We Several of the control varables are also wnsorzed, see We start out by lookng at the dstrbuton of results before taxes of both domestc frms and MNCs n Fgure 1. It s clear from the graphcs that profts are lower for MNCs than for domestc frms. The pcture s somewhat less clear for frms n a loss poston, but the quantle marks ndcate that MNCs to a larger extent than domestc frms bunch around break-even also when n a loss poston. These observatons are n lne wth Grubert et al. (1993) as well as De Smone and Sedman (2013), and they provde support to our frst theoretcal predcton (cf. Predcton 1 n secton 2.4). The theoretcal model suggests that the observed bunchng s due to reversed ncentves for proft shftng. It s, however, uncertan how much flexblty the MNCs have when t comes to adjustng ther transfer prces and nternal leverage. The theoretcal model offers two contrastng predctons. Predcton 2 states that, under ex-post shftng, afflates wth the same output level wll feature hgh transfer payments and a hgh nternal leverage f they are proftable (.e., π t > 0 before any tax-avodance operaton), whereas they wll carry low transfer payments and no nternal debt f they are n a loss and 6 observatons, respectvely, are deleted from the sample of MNCs due to negatve sales and negatve total assets. 303 observatons wth an nternal leverage outsde the nterval [0; 1] are excluded from the analyss of nternal debt, but these are ncluded n the study of transfer payments. 16

17 Fgure 1: Dstrbuton of results over assets before taxes poston (π t < 0). Predcton 3 consders the low-flexblty stuaton where MNCs have to commt to proft-shftng strateges ex ante. If ths s the correct scenaro, we should observe dfferences n the proft levels of these afflates whch stem from dfferences n the realzaton of the output prce. However, ncentves for proft shftng are the same for all afflates ex-ante,.e. we should observe an dentcal cost and fnancal structure across afflates. Actually, we would lke to test Predcton 4 on the effect of an ncrease of the loss probablty emprcally, as well. But, our data set provdes us wth too lttle varaton and nformaton to do so. Therefore, the remander of the emprcal analyss seeks to dentfy whch of the two predctons H2 vs. H3 s most correct,.e., to whch extent proft-shftng strateges are functons of whether or not the afflate experences a loss. In order to study ths, we generate a dummy varable (L t ) equal to 1 f the Norwegan frm s n a loss poston n year t. Table 1 takes a frst, descrptve look at the relatonshp between beng n a loss poston and proft-shftng strateges. In order to adjust for frm sze, we standardze the transfer payments and leverage by the frm s (.e., Norwegan afflate s) mean total assets over the perod. Usng the mean total asset n the denomnator secures that any changes n the dependent varable are caused by changes n proft shftng rather than n the denomnator. Frst, we note that frms experence losses n a substantal number of cases, as much 17

18 Table 1: Descrptve statstcs. Average (st.dev) The loss poston dummy (N = 7, 457) 0.38 (0.49) Full sample In loss poston Not n loss poston Dfference Net outgong transfer payments All MNCs ** (St.dev.) (9.29) (8.19) (9.89) Number of obs. 7,457 2,829 4,628 Norwegan daughters *** (St.dev) (7.48) (5.16) (8.56) Number of obs Total nternal debt All MNCs *** (St.dev.) (14.51) (13.50) (15.08) Number of obs. 7,159 2,698 4,481 Norwegan daughters ** (St.dev) (15.32) (12.45) (16.79) Number of obs Transfer payments and nternal leverage are standardzed as % of the frm s average total assets over the tme perod. *** p<0.01, ** p<0.05, * p<0.1 as n 38% of our observatons. In contrast to what theory predcted, we observe that MNCs n a loss poston have hgher net outgong transfers when studyng the full sample of MNCs. 19 Ths s a puzzle, but recent fndngs by Dschnger et al. (2014) offer a plausble explanaton. They fnd that the proft dstrbuton s skewed n favor of the headquarter s locaton. Ths ndcates that the headquarter plays a specal role n the MNCs, or to quote the ttle of ther paper There s no place lke home. Moreover, ther results are well grounded n theory that ponts to agency costs and moral-hazard problems between the headquarters and the proft center/nternal bank. 20 Hence, we also look at the sub-sample of MNCs that are controlled by foregn owners,.e., at daughter companes only. For that sub-sample, we get the expected negatve sgn, and the dfference s also clearly statstcally sgnfcant. The dfference between the full sample of MNCs and the Norwegan daughters s less dramatc when lookng at nternal leverage. In both cases, t seems that frms n a loss poston hold less debt than those n a break-even or proft poston. However, the dfference s larger for the sub-sample of daughters. These dfferences seem to suggest that there s flexblty n both devces for tax avodance. However, t would be premature to draw any concluson at ths stage. In order to dscuss causalty, a more rgorous econometrc procedure, whch deals wth a number of emprcal challenges, s requred. A frst concern s the potental for autocorrelaton n performance. If losses n prevous years are a good ndcator of the probablty of runnng losses also at tme t, frms can adjust ther strateges based not only on present, but also on past performance. Falng to control for such dynamc adaptons wll gve rse to an omtted varables bas. We report the autocorrelaton n Table 2. It s evdent that beng n a loss poston n 19 Net outgong transfers s defned as outgong transfer payments less ncomng transfer payments. Consequently, postve values mply that the Norwegan afflate pays out more transfers than t receves. 20 See, e.g., O Donnel (2000), Chang and Taylor (1999), and Hamlton and Kashlak (1999). 18

19 Table 2: Autocorrelaton n loss postons Loss poston at tme t Correlaton Loss poston at tme t 1 (N = 6, 605) 0.41*** Loss poston at tme t 2 (N = 5, 746) 0.28*** *** p<0.01, ** p<0.05, * p<0.1 one year s a strong predctor of the performance also n the next year, and even n the next few years to come. Therefore, ths should be taken nto account when establshng the emprcal model. 4 Emprcal analyss 4.1 Emprcal strategy Accordng to the theoretcal model, the proft-shftng strategy should be a functon of the tax dfferental between Norway and the tax haven, and the loss poston (gven ex-post shftng) or the expectaton of experencng a loss (gven ex-ante proft shftng). The emprcal nvestgaton thus reles on OLS estmatons of varatons of the equaton y jt = β 0 + β 1 L jt + β 2 L jt 1 + β 3 L jt L jt 1 + κt l jt + z jt θ + δ t + α j + ɛ jt (14) where the dependent varable y jt s transfer payments or nternal leverage n afflate, beng actve n ndustry j at year t. 21 In the man specfcatons, we use net outgong transfers and total nternal leverage, but we wll also report results from regressons on gross ncomng and outgong transfers, as well as short-term and long-term nternal leverage. L jt s the loss-poston dummy, gvng that β 1 s the coeffcent of most nterest n our study. Accordng to our Predcton 2, β 1 should be sgnfcantly negatve f frms have the flexblty to adjust ther proft shftng ex post. If the ex-ante scenaro s relevant, however, t follows from Predcton 3 that β 1 should be zero and nsgnfcant, because frms must commt to ther transfer payments and leverages, respectvely, at the begnnng of the tax year. Beng n a loss poston should not have any nfluence n the latter scenaro. As dscussed above, the substantal autocorrelaton n losses gves that earler years performance s an mportant control for the expectatons on performance n year t. Moreover, ths expectaton can have a drect mpact on how a frm reacts to losses n year t. Hence, we nclude the lagged loss poston and an nteracton term between the present and lagged loss poston n the regressons. The nteracton term gves a new dummy that 21 Followng our theoretcal approach, we have tred to run the emprcal analyss whle splttng the transfer payments nto the categores royaltes, lcense fees, rental expendtures on the one hand and purchases (cost of materals) on the other hand. But, ths reduces the varaton n the data too much and no meanngful results can be obtaned. 19

20 s equal to one f a frm experenced a loss poston both at tme t and t 1. By dong so, we try to control for the expectatons on the loss probablty H(p 0 ), beng relevant n the ex-ante shftng scenaro, cf. equatons (13a) to (13c). Next, t l jt s the tax rate n the foregn afflate wth the lowest tax rate (.e., the tax haven ), capturng the maxmum tax rate dfferental. z jt s a vector of control varables and ncludes several key characterstcs of the frm. The choce of control varables s motvated by earler lterature on proft shftng, see, e.g., Møen et al. (2013), Büttner and Wamser (2009), Huznga et al. (2008), and Rajan and Zngales (1995). Frst, the result as share of total assets serves as a performance measure. Second, the loss carry forward s also a potentally mportant control. Ths varable captures loss carry forward and losses on sold assets. Thrdly, total assets and number of employees act as sze measures. Fourth and fnally, we nclude the age of the frm. 22 In addton, all regressons nclude for tme and ndustry fxed effects, represented by δ t and α j, respectvely. In the descrptve statstcs, we saw that losses seem to affect proft shftng n dfferent manners for parent and daughter companes. Ths observaton s consstent wth fndngs n the lterature suggestng that MNCs partally shft profts nto the parent company rather than optmzng the tax structure (Dschnger et al., 2014). Hence, we wll estmate the model both for all MNCs and for Norwegan frms controlled by foregn parents. A word of warnng s n place before proceedng to the results of the emprcal nvestgaton. Even when condtonng on the set of control varables, one should show cauton when nterpretng the coeffcent for the loss-poston dummy. For two reasons, the pont estmates are most lkely based. Frst, snce the proft shftng decsons affect the probablty of beng n a loss poston, and, thus, L jt, β 1 can be plagued by a smultanety bas. In Appendx A.3 the bas s derved and studed formally. The concluson s that the smultanety gves an attenuaton bas n our man results, suggestng that these are conservatve estmates. Second, the nterpretaton of our results depend crucally on our ablty to control for relevant characterstcs of the frms. Snce the data does not contan enough varaton to use frm fxed effects, one may fear that the results are drven by unobservable characterstcs. Specfcally, t s problematc that the baselne regressons compare companes wth very dfferent performances. Companes wth large profts or losses can be very dfferent from those that are close to break-even, despte beng on the same sde of zero. In order to nvestgate whether or not our results are senstve to ths, we wll also estmate the model usng sub-samples consstng only of frms close to break-even. Smlar strateges for reducng problems related to unobservable characterstcs have been used, e.g., by Ferraz and Fnan (2008) and Hopland (2014). Gven these two caveats, we do not nterpret the pont estmates as margnal effects 22 Descrptve statstcs for the control varables are presented n Appendx A.4. 20