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Knocking on Tax Haven's Door: Multinational Firms and Transfer Pricing

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Knocking on Tax Haven's Door: Multinational Firms and Transfer Pricing KNOCKING ON TAX HAVEN’S DOOR: MULTINATIONAL FIRMS AND TRANSFER PRICING Ronald B. Davies, Julien Martin, Mathieu Parenti, and Farid Toubal* Abstract—This paper analyzes the transfer pricing of multinational firms. intrafirm, is generally not available. Moreover, it is impos- Intrafirm prices may systematically deviate from arm’s-length prices for two motives: pricing to market and tax avoidance. Using French firm-level sible to observe the counterfactual arm’s-length prices of an data on arm’s-length and intrafirm export prices, we find that the sensi- intrafirm transaction (see Diewert et al., 2006, for details). tivity of intrafirm prices to foreign taxes is reinforced once we control for Since the arm’s-length price is not observed, tax authorities pricing-to-market determinants. Most important, we find no evidence of tax avoidance if we disregard tax haven destinations. Tax avoidance through have to determine the market price, which raises obvious transfer pricing is economically sizable. The bulk of this loss is driven by definitional and methodological issues. the exports of 450 firms to ten tax havens. In this paper, we overcome both difficulties. We observe the export prices under each mode (arm’s length or intrafirm) I. Introduction at the level of firms, countries, and products. Moreover, our econometric methodology allows us to compare the intrafirm wealth of empirical evidence finds that within a multi- price used between a multinational and its affiliate with the Anational enterprise (MNE), reported profits vary sys- corresponding arm’s-length price charged by a firm shipping tematically with local corporate tax rates.1 This may be due to an unrelated party. We show that the bulk of tax avoidance to several types of efforts within the firm, including transfer comes from a few large firms through exports in a handful pricing. From the perspective of the tax authorities, inter- of industries to a relatively limited number of tax havens, nal transactions between related parties should be valued where the baseline estimates find that intrafirm prices are on at their market price: this is the arm’s-length principle (see average 11% lower than arm’s length prices. This suggests OECD, 2012, for details). That said, as described in OECD that by targeting enforcement efforts, tax authorities may be (2010), there are numerous ways to determine the arm’s- able to mitigate transfer pricing and raise tax revenues while length price, including the use of comparable prices and keeping enforcement costs low. The granular dimension of cost-plus methods. Thus, the flexibility in these rules allows tax avoidance should facilitate the implementation of global firms to choose transfer pricing methodologies that support enforcement such as the one proposed by Zucman (2014). the use of internal prices, shifting profits from high- to low- In order to frame our empirical analysis, we discuss tax countries.2 This is in addition to the potential for outright the theoretical determinants of arm’s-length and intrafirm tax evasion via transfer pricing. prices using a highly stylized model. This simple model Direct empirical evidence of tax-induced transfer pricing, captures both tax-induced transfer pricing and pricing-to- however, is scarce. Identifying such a strategy faces two market strategies. The latter has been receiving increasing major difficulties. While multinationals’ exports are directly attention in the field of international trade. The model shows observable, detailed information on the prices of products that were transfer pricing costless, an MNE would systemat- and their modes of transaction, whether it is arm’s length or ically find it optimal to deviate from the arm’s-length price exporting to a country with a different corporate tax. How- Received for publication September 30, 2015. Revision accepted for ever, the presence of a fixed component in the concealment publication December 2, 2016. Editor: Amit K. Khandelwal. cost generates a band of inaction. The deviation is profitable * Davies: University College Dublin; Martin: Université du Québec à Montréal, and CEPR; Parenti: Université Libre de Bruxelles, and CEPR; when the tax differential between the home and the host Toubal: Ecole Normale Supérieure de Cachan, CREST, and CEPII. countries is sufficiently important and when the firm exports We thank the editor and three anonymous referees for their very con- sufficiently large volumes. The wedge between the intrafirm structive suggestions. We also thank Andrew Bernard, Kristian Behrens, Robert Cline, Paola Conconi, Anca Cristea, Meredith Crowley, Lorraine price and the arm’s-length price is a decreasing function of Eden, Peter Egger, Lionel Fontagné, Thomas Gresik, James Hines, Patrick the host tax. We also show that arm’s-length and intrafirm Legros, Lindsay Oldenski, Bernard Sinclair-Desgagné, Nicholas Sly, and prices are likely to have a different sensitivity to transport many seminar audiences for helpful comments. A supplemental appendix is available online at http://www.mitpress costs, tariffs, and GDP per capita—variables governing pric- journals.org/doi/suppl/10.1162/REST_a_00673. ing to market. These results suggest that one should be 1 See Fuest, Huber, and Mintz (2003) for a survey on the impact of taxation mindful of this difference in sensitivity in the empirical on real MNE activity. analysis. If one of these variables is significantly correlated 2 The OECD reaches the conclusion that “tax administrations see trans- fer pricing as one of the most significant tax risks they have to manage” with the level of corporate tax rates (something that is true (OECD, 2012, p. 15). Gresik (2001) provides a survey with an emphasis on in our data), the estimated coefficients would be biased if the transfer pricing literature. Diewert, Alterman, and Eden (2006) examine we were not allowing coefficients to differ across pricing the different rationales for manipulating internal prices. A meta-analysis by Heckemeyer and Overesch (2013) shows that transfer pricing and licens- modes. ing are two important means of shifting profits abroad. Recent theoretical On the empirical side, we rely on a unique data set that has contributions on tax-induced transfer pricing include Behrens, Peralt, and finely grained information on the intrafirm and arm’s-length Picard (2014), Bernard, Jensen, and Schott (2006), and Keuschnigg and Devereux (2013), who provide a recent model of non-tax-induced transfer quantities and prices of exported products at the firm level pricing, one motivated instead by manipulating managerial incentives. for almost all exporting firms in France in 1999. The richness The Review of Economics and Statistics, March 2018, 100(1): 120–134 © 2018 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology doi:10.1162/REST_a_00673 Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/REST_a_00673 by guest on 03 October 2021 KNOCKING ON TAX HAVEN’S DOOR 121 of this data set allows us to provide a clear-cut identification directed to countries with very low tax rates. Interestingly, of transfer pricing in the cross-section. low taxes are not the entire story. Transfer pricing strate- The case of France is particularly suited to analyzing the gies of multinational firms systematically involve tax havens. transfer pricing strategies of MNEs as it exempts foreign These countries not only have low corporate tax rates but income from taxation. Compared with the United States and also provide an overall tax environment that facilitates profit other countries where foreign tax credits, income baskets, shifting. According to the classification of Hines and Rice and deferral complicate a firm’s tax planning problem, the (1994), in addition to a low tax rate, a tax haven must have relatively streamlined French system provides a cleaner map- a legal system allowing banking secrecy and a good com- ping between tax differences and firm incentives.3 Roughly munication infrastructure, and it must seek to promote itself speaking, when a U.S. firm earns profits overseas, it adds up as a center for financial offshoring. Thus, as the OECD’s its worldwide income into a single income basket and cal- (2013) Action Plan on Base Erosion and Profit Shifting strives culates the U.S. tax owed on this amount when it repatriates to clarify, a tax haven is not simply a low-tax country but these foreign earnings. The U.S. tax authorities then grant a one that facilitates tax avoidance for firms by “artificially credit against this liability that is equal to the taxes already segregating taxable income from the activities that gener- paid to foreign governments on the firm’s overseas income. ate it” (p. 13). Extending our analysis, we find that profit If the firm has paid more taxes overseas than what is owed to shifting through transfer pricing is primarily done by large the United States, it is in an excess credit position and owes multinational firms.4 no taxes to the United States. If not, it is in an excess limit A simple exercise suggests that the tax losses driven by case and must pay the remainder to the U.S. tax authorities. the profit shifting of multinational firms to the ten tax havens Thus, even when there are two U.S. firms with an affiliate in our sample amount to about 1% of total corporate tax in a tax haven, the incentive to shift profits to the tax haven revenues in France. We further show that 450 MNEs account depends on where else the firm pays taxes. Complicating the for over 90% of intrafirm exports to these ten tax havens. issue, the U.S. tax liability is not triggered until profits are Together, these imply that a large share of transfer pricing repatriated or used inactively (i.e., it is no longer Subpart may be curbed by focusing enforcement on a small number F income), and excess credits in a year can be carried into of firms.
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