Does Public Country-by-Country Reporting Deter Tax Avoidance and Income-Shifting? Evidence from Capital Requirements Directive IV
Preetika Joshi Schulich School of Business York University [email protected]
Edmund Outslay Broad College of Business Michigan State University [email protected]
Anh Persson Broad College of Business Michigan State University [email protected]
August 2018
PRELIMINARY DRAFT DO NOT DISTRIBUTE WITHOUT PERMISSION
Acknowledgments: We thank Jeff Gramlich, Kenneth Klassen, Amin Mawani, Devan Mescall, Rucsandra Moldovan, Jerry Zimmerman, and the participants at the 2018 University of Waterloo’s Deloitte Tax Symposium, the 2018 Telfer Accounting and Finance Conference, and the EIASM 8th Conference on Current Research in Taxation for their helpful comments and suggestions. We gratefully acknowledge support from the Eli Broad College of Business at Michigan State University and from Schulich School of Business at York University. All errors remain our own.
1
Does Country by Country Reporting Deter Tax Avoidance and Income-Shifting? Evidence from Capital Requirements Directive IV
Abstract We examine the effect of increased tax transparency on tax avoidance and income shifting. Treating the introduction of public country-by-country reporting under the Capital Directive IV (CRD IV) as an exogenous shock to disclosure requirements and using affiliate-level data of European banks, we document a significant decrease in the income shifting activities by the financial affiliates in the post-adoption period. Concurrently, we find evidence of an increase in income shifting activities by these banks’ industrial affiliates, which are not subject to reporting and disclosure requirements under CRD IV. Finally, we do not document robust empirical evidence of a significant decrease in the tax avoidance behavior of European multinational banks relative to the control groups. Our findings suggest that public tax transparency can act as a deterrent for tax-motivated income shifting, but the tax avoidance behavior likely will not change if firms are able to increase income shifting activities among the less transparent affiliates. Our findings have important policy implications for the continuing debates among the European Parliament, the OECD, and governments on the proposal to require all multinational to publish their country-by-country reports.
Keywords: Public Country-by-country Reporting, Tax Transparency, Income Shifting, Tax Avoidance
2 Does Country by Country Reporting Deter Tax Avoidance and Income-Shifting? Evidence from Capital Requirements Directive IV
1. INTRODUCTION
In this study, we examine the reactions of European banks to an exogenous shock to the disclosure requirements imposed by Article 89 of Capital Requirement Directive IV (CRD IV), which requires public disclosure of select tax and financial metrics on a country-by-country basis. Using affiliate-level data from BankFocus (by Bureau van Dijk) over the period between 2010 to 2017, we find that the financial affiliates of the EU banks engaged in significantly less tax-motivated income shifting following implementation of the public country-by-country reporting (CbCR) requirements under CRD IV. In contrast, we document a simultaneous increase in the level of income-shifting activities among the industrial affiliates, which are not subject to reporting and disclosure requirements under CRD IV. These findings suggest that banks responded to CRD IV by reducing tax-motivated income shifting in the group subject to the public disclosure requirement while increasing tax-motivated income shifting in another part of the group that is less transparent.
Finally, while we do observe a significant increase in the effective tax rates reported by EU multinational banks in the post-adoption period, relatively to those of the EU domestic banks, this result seems to be driven by the decrease in the effective tax rates of the control group. Using U.S. multinational banks as an alternative control group, we do not document any significant change in the tax avoidance behavior of the EU multinational banks between the pre- and post-CRD IV period.
3 Despite the dramatic change in the global landscape of tax transparency, there is still a lack of broad empirical evidence on the impact of tax disclosure initiatives (i.e., public CbCR under
CRD IV and Action Item 13 of the Organisation for Economic Co-operation and
Development/G20’s Base Erosion and Profit Shifting project) on income shifting and tax avoidance. The extant literature that examines the impact of increased disclosure on firm behavior primarily focuses on the effect of a country-specific disclosure requirement on firms’ overall tax avoidance (i.e., Dyreng et al. 2016, Hoopes et al. 2017). The effect of public disclosure of a firm’s global activities and tax information on income shifting behavior is, however, less well- understood. This gap in the extant literature is one of the primary motivations of this study. We believe that an evaluation of the effectiveness of public CbCR in reducing tax-motivated income shifting is both relevant and timely, as both the FASB and the European Commissions are currently considering the adoption of such disclosure requirements to large multinational corporations
(Eurodad, 2017; Silbering-Meyer, 2017; Martin, 2018).
There are several reasons to expect that public disclosures of CbCR under CRD IV could affect profit shifting behavior. Firms trade off the benefits of tax avoidance activities with the political and reputational costs, as well as the detection risk from tax authority, that come with increased disclosures (Dyreng et al., 2016). Public disclosure of CbCR could alter the nature of these trade-offs. First, the disclosures of CbCR could direct public and regulatory scrutiny toward banks that report abnormally high income in low tax jurisdictions, thereby increasing both the reputational and political costs associated with income shifting. Second, CbCR could provide the
4 transparency necessary for the tax authorities to detect any misalignment between the profits generated in each country to firm’s tax payments, resulting in increases in tax enforcement. 1
It is, however, unclear to what extent CbCR results in additional insights to the tax authorities (Evers, Meier and Spengel 2014). This is because the existing provisions in most
European countries have already required multinational banks to supply additional tax information, including the tax payments and transfer pricing documentation, to the local tax authorities. As Evers et al. (2014) also argue, because the common tax minimization strategies employed by MNCs are based on loopholes in the tax laws and are not themselves illegal, it is merely speculative to reason that CbCR would urge companies to pay taxes at an amount that truly reflects the companies’ economic activity and its utilization of public infrastructure in a particular country. Therefore, the question of whether public CbCR would have a deterrent effect on MNCs’ profit-shifting and tax avoidance behavior is ultimately an empirical question.
In addition to creating an exogenous shock to public disclosure requirements, CRD IV also provides us with a unique setting to evaluate whether and how banks regulate the levels of income shifting between affiliates that are subject to less stringent transparency requirements. Under CRD
IV, EU banks have the option to avoid full consolidation in their CbCR by opting for a prudential consolidation approach. According to the European Banking Authority’s single rulebook, entities that undertake purely non-financial commercial activities are excluded from the scope of prudential consolidation (EBA, 2013). As such, to the extent that EU banks have any industrial affiliates, country level information for these affiliates does not have to be disclosed under CRD
IV. Given the potentially higher cost to shift profits among the financial affiliates in the post-
1 For example, following the leak of the Panama Papers, the U.K. tax administration was able to recover approximately $125 million in unpaid taxes (BBC, 2017).
5 adoption period, EU banks have an incentive to increase income-shifting activities among the industrial affiliates to offset any increases in their tax burden. Therefore, we also examine whether there is a change in the income-shifting activities in industrial affiliates of EU multinational banks.
Our study makes several contributions to the literature. First, it provides broad empirical evidence on the effect of public disclosure of CbCR under CRD IV on the tax-motivated income shifting behavior of financial and industrial affiliates of EU banks. To our knowledge, this is the first paper to test for this effect. The findings in this study help reconcile the empirical evidence documented in current studies of CRD IV. In a concurrent work, Overesch and Wolff (2017) examine the same setting as the one in our study and document a significant decline in firm tax avoidance in the post-adoption period. This finding is somewhat contradictory with the fact that investors do not seem to view public CbCR under CRD IV to increase the net costs of firm tax avoidance, as evident by the lack of noticeable market response to the implementation decision by the EU (Dutt, Ludwig, Nicolay, Vay, and Voget, 2018). While in this study, we do observe a significant increase in the effective tax rates reported by EU multinational banks in the post- adoption period, relative to those of the EU domestic banks, this result seems to be driven by the decrease in the effective tax rates of the control group. Using U.S. multinational banks as an alternative control group, we do not document any significant change in the tax avoidance behavior of the EU multinational banks, suggesting that a reduction in profit shifting in the financial affiliates is offset by the increase in income shifting in industrial affiliates. Our findings contribute needed empirical evidence for the ongoing debate about the benefits of increased transparency and disclosure requirements like CbCR, and hence should be of interest to policymakers.
Second, our study contributes to the literature that examines cross-sectional differences in tax-motivated income shifting. Previous studies in this literature examine the cross-sectional
6 determinants of the use of tax havens to shift income (Desai et al., 2006), the differences in income shifting under territorial tax systems and worldwide tax systems (Markle, 2016), the impact of
IFRS adoption on income shifting (DeSimone, 2016), as well as the interaction of income shifting and transfer pricing rules (Klassen and Laplante, 2012). Our study enhances this literature by focusing on the role global transparency initiatives play in deterring tax-motivated income shifting.
Third, this study is in response to the call by Hanlon and Heitzman (2010) for more evidence on tax avoidance activities of financial firms. In the aftermath of the recent economic crisis, several scandals exposed the pervasive use of tax avoidance strategies used by banks and their growing presence in tax haven countries (UBS offshore leaks 2013; Lux leaks 2014; Swiss leaks 2015; Panama Papers 2016; and Paradise Papers 2017). Although the topic of tax avoidance by big MNCs like Apple, Starbucks, and Walmart has received a lot of attention, there is limited empirical evidence on the tax avoidance activities of banks. This gap in the literature is perhaps due to the lack of information on bank’s activities and methodological challenges in separating tax incentives from other economic factors (Bouvatier et al., 2017). In this paper, we attempt to overcome these difficulties by using the comprehensive affiliate-level data from Orbis and
BankFocus databases. We also overcome some of the methodological challenges by exploiting an exogenous shock to firms’ tax disclosure requirements imposed by CRD IV in Europe. Using a sample of EU headquartered multinational banks and their affiliates, we document the presence of tax-motivated income shifting in the banking industry.
The rest of the paper proceeds as follows. The next section reviews the institutional background that motivates our paper. Section 3 provides a literature review. Section 4 presents the hypothesis development, and section 5 describes the sample and research design. Sections 6 and 7
7 present the main results and additional analyses, section 8 discusses the robustness tests, and section 9 concludes.
2. Institutional Background
2.1 Capital Requirement Directive (CRD) IV
Following the financial crisis of 2008,2 the Basel Committee on Banking Supervision,3 issued a new framework of “global regulatory reforms” that were intended to:
… strengthen global capital and liquidity rules with the goal of promoting a more resilient banking section. The objective of the reforms is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy (Basel III 2010, p.1).
In addition, these reforms also aimed to improve risk management and governance as well as strengthen banks’ transparency and disclosure (Basel III, 2010).
The European Union implemented (most of) the changes recommended in Basel III in
Directive 2013/36/EU (otherwise known as Capital Requirements Directive IV), which was published on June 26th, 2013. The main focus of CRD IV is to improve the quality and quantity of banks’ regulatory capital and enhancing coverage of their capital base (liquidity and leverage). EU member states were required to implemented CRD IV by January 1st, 2014, with the first reporting from June 30th, 2014. In addition to the changes recommended by Basel III, the EU Commission introduced further changes, one of which was “enhanced governance.” The Commission stated that the proposal “will introduce clear principles and standards applicable to corporate governance
2 The International Monetary Fund estimated that crisis-related losses incurred by European banks between 2007 and 2010 approximated $1 billion, or 8 percent of the EU GDP (CRD IV – Frequently Asked Questions, 2011). 333 The committee included representatives from Belgium, France, Germany, Italy, Luxembourg, Netherlands, Sweden, Spain, Switzerland, and the United Kingdom,
8 arrangements and mechanisms within institutions.” (CRD IV, 2011). The Commission did not target specific risk-taking activities such as aggressive tax planning.
Consistent with the Commission’s goal of increasing governance, in February 2013, members of the European Parliament (MEPS) introduced a proposal that would require each institution subject to CRD IV to disclose certain information publicly on a “country-by-country” basis, beginning from January 1, 2015. This proposal, adopted as Article 89 to CRD IV, requires institutions to disclose on a consolidated basis the (a) name(s), nature of activities and geographic location; (b) turnover; (c) number of employees on a full-time equivalent basis; (d) profit or loss before tax; (e) tax on profit or loss; and (f) pubic subsidies received. Institutions were required to disclose the information required by (a), (b), and (c) by July 1, 2014. Institutions are to publish the required information as an extension to their annual reports (see Appendix 3 for an example of
HSBC Holdings Plc.’s disclosure of its country-by-country information in 2015).
2.2 Other Country-by-Country Reporting Initiatives
Murphy (2003), writing on behalf of the Association for Accountancy and Business Affairs, first proposed the concept of country-by-country reporting as an International Accounting Standard in
2003. The goal of the standard was to provide governments and other interested parties with information that would allow them to appraise a transnational corporation with regard to its corporate social responsibility, investment risk, tax risk, its contribution by way of value added to the societies in which it operates, and its contribution to national well-being by way of tax payment within those locations (Murphy, 2003).
Concurrent with European Commission’s discussion of CRD IV, the Organization for
Economic Cooperation and Development (OECD) issued its report titled “Addressing Base
Erosion and Profit Shifting” in February 2013 (OECD 2013a). The OECD followed up its initial
9 report with an “Action Plan on Base Erosion and Profit Shifting” (OECD 2013b) in July 2013.
Both reports were motivated by concern that multinational enterprises (MNEs) were exploiting the
“boundaries of acceptable tax planning,” (OECD 2013b, 8) and thus depriving governments of substantial tax revenue. To combat BEPS, the OECD developed 15 Actions, one of which (Action
13) requires MNEs with at least $750 million in annual revenue to file “country-by-country” reports (CbCR) for fiscal years beginning on or after January 1, 2016, with automatic exchange between tax jurisdictions beginning no later than June 2018. It should be noted that the BEPS
CbCR template asks for more detailed information than CRD IV (bifurcating related and unrelated party revenues, bifurcating income tax paid from income tax accrued, accumulated earnings, and stated capital). In addition, the CbCR data under BEPS are not publicly available.
3. Literature Review
3.1 Tax Avoidance in the Financial Sector
The interest in corporate tax avoidance has accelerated in recent years as political, economic, and technological factors fuel the public’s focus on corporate tax behavior (Wilde and Wilson 2017).
Academic research on corporate tax avoidance also has grown, benefiting from new data sources, developments in tax avoidance measures, and improved econometric techniques (Donohoe,
McGill, and Outslay 2014). However, current research has focused primarily on the corporate tax behavior of industrial firms; as a result, empirical evidence on tax avoidance activities of financial institutions is still limited.
Financial institutions, such as commercial and investment banks, act as intermediaries between parties in a financial transaction and therefore serve a critical function in the economy.
From a microeconomic perspective, the standard optimal taxation theory suggests that intermediate goods and services should not be taxed (Uggady, 2010). Contrary to this view, banks
10 are subject to general corporate income taxation around the world. Consequently, a broad focus in the prior literature has been on the effects of taxation on the profitability of financial firms, and whether these firms bear the entire burden of taxes levied on them (Demirgüç-Kunt and Huizinga,
1999; Cardoso, 2003; and Albertazzi and Gambacorta, 2010).
Although banks appear to be able to pass on a significant portion of their tax burden to their customers, there is evidence that banks still actively avoid corporate taxation. Wilson and
Wolfson (1990) examine whether changes in tax rules can explain banks’ financing and investment policies, and document that a significant shift in bank holdings of municipal bonds attributed to changes in the tax deductibility of interest expense. Subsequently, Hemmelgarn and Teichmann
(2014) analyze the effect of corporate income tax reforms on banks’ leverage, dividend policies, and earnings management and find that taxation influences all three decisions. In a more recent paper, Andries et al. (2017) examine how the corporate tax system, through its treatment of loan losses, affects bank financial reporting. The authors find that loan loss provisions increase with the tax rates in countries that allow general provision tax deductibility. These studies suggest that the corporate tax rate is an important determinant of banks’ financial reporting, investment, and capital structure decisions, and similar to industrial firms, banks also attempt to reduce their overall tax liability, albeit through different means.
These findings also are supported by anecdotal evidence on banks’ tax avoidance. For example, in 2003, the SEC exposed at least ten major U.S. banks that were responsible for sheltering hundreds of millions of dollars from federal and state income taxes through private investment funds that paid tax-exempt dividends (Simpson, 2003). In the U.K., a study by an independent tax group research in 2005 reported that five of the world’s largest investment banks
11 paid no U.K. corporate tax even though they earned billions of dollars of profit in the U.K. (Austin,
2015).
3.2 Tax-Motivated Income Shifting in the Financial Sector
Extensive prior literature on multinational tax planning provides evidence that MNCs shift income in response to tax (Hines and Hubbar, 1990; Altshuler and Newlon, 1993; Desai, Foley, and Hines,
2001 and 2007), financial reporting (Shackelford et al., 2011; Graham et al., 2011), and financing incentives (Faulkender and Petersen, 2012). Theory on income shifting predicts that mobile taxable income will flow towards low tax jurisdictions either through the transfer of real operations
(i.e., real income shifting) or manipulation of transfer pricing (i.e., paper income shifting) (Markle et al., 2016). In addition, recent studies have shown that income shifting can result in a lock-out of foreign cash, which in turn affects investments by MNCs (Faulkender and Petersen, 2012;
Hanlon et al., 2015; Edwards et al., 2016), and dividend policies (Nessa, 2017).
Similar to MNCs, subsidiaries of a multinational bank are subject to corporate income tax in their country of residence. The gaps and mismatches in international tax laws provide banks with the opportunity to shift profit from high-taxed to low-taxed subsidiaries (Merz and Overesch,
2016). Whereas profit-shifting activities of industrial firms often are related to intangible assets and manipulation of transfer prices, banks rely on an array of other strategies to shift profits. For example, banks can allocate intra-firm financial transactions (i.e., interest margins and service fees) or highly mobile segments (i.e., trading and asset management) to a low tax country. Banks also can distribute credit risk to a high tax country by contracting out the liability of a loan (Merz and Overesch, 2016).
12 The academic literature documents significant income-shifting activities by financial service institutions. In the U.S. context, Petroni and Shackelford (1995) provide evidence consistent with property-casualty insurers structuring their expansion across U.S. states, through licensing or subsidiary, in a manner that mitigates both state taxes and regulatory costs. In an international context, Demirgüc-Kunt and Huizinga (2001) document that foreign banks’ profitability rises relatively little with their domestic tax burden, and that taxes paid by these banks rise relatively little with the local statutory tax. The authors interpret these findings as supporting the hypothesis that foreign banks extensively engage in profit shifting. Merz and Overesch (2016) use subsidiary level data and find that banks seem to have more flexibility in shifting their profits, compared to non-financial firms. The tax response coefficient estimated in their study is approximately three times compared to estimates for non-financial MNCs in previous studies.
The presence of tax-motivated income shifting in banks also is consistent with anecdotal evidence. In a recent study, Oxfam International noted that large banks in the EU disproportionally use tax havens to benefit from their favorable tax and regulatory rules. They estimated that
Europe’s most prominent banks funneled as much as $27 billion through overseas tax havens in
2015 (Aubry and Dauphin, 2017).
Banks also can shift income among their industrial affiliates to reduce the total tax liability at the consolidated level. Although there are some restrictions on the size of the investment in an industrial firm, bank ownership in industrial firms is permitted with some restrictions (Arping and
Rochetrau, 2000). In Europe, for example, the Second Banking Directive requires that each 10- percent-or-more ownership in industrial firms cannot exceed 15 percent of the bank’s total funds, and such ownership on an aggregate basis cannot exceed 60 percent of its own funds. A few
13 countries impose additional regulations4 Banks own industrial firms for several reasons, including
(1) acquisitions related to the classical banking business; (2) acquisitions as part of special financial services; and (3) strategic and other reasons (Baums, 1992).5
Extant literature has focused soley on the income shifting activity among the financial affiliates of multinational banks (i.e., Demirgüc-Kunt and Huizinga 1999, 2001; Huizinga et al.,
2014; Merz and Overesch, 2016). To our knowledge, there has not been any evidence of income shifting among the industrial affiliates. Our study contributes to this stream of literature by investigating income shifting behavior within both groups of affiliates in the same bank.
3.3 Research Using CRD IV CbCR data
To date, there have been a few initial studies investigating the implementation of CbCR requirements under CRD IV. Existing studies primarily focus on evaluating either the use of tax havens or the misalignment of the location of profits and turnover in European banks. These studies find a high presence by thirty-six of the most prominent EU banks in tax haven countries (Murphy
2015), as well as a significant misalignment between the location of profit and the location of bank activities in term of turnovers and employees (Jelínková, 2016).
In a concurrent working paper, Dutt et al. (2018) investigate the stock price reaction around the day of the decision to include CbCR in CRD IV and find no significant abnormal returns for the banks affected. None of these studies examine the effect of CbCR public reporting on changing the income shifting behavior of European banks. Our study contributes to this stream of literature
4 For instance, in Canada, banks cannot hold more than 10 percent in a firm; and in the United States, bank holding companies can hold up to 5 percent of the voting shares and up to 25 percent of the voting and non-voting shares in a firm. 5 Bank ownership in industrial affiliates, albeit common, is not without controversy. Critics of bank’s industrial ownership argue that ownership in industrial affiliates can lead to severe conflicts of interest for banks and can have anti-competitive effects on product markets as it fosters product market collusion and concentration (Arping and Rochetrau, 2000).
14 by providing broad empirical evidence of the effect of public CbCR under CRD IV on the banks’ income shifting activities as well as their overall tax avoidance behavior.
Hanlon (2017) notes that a potential benefit of public disclosure of CbCR reporting “might be found in a potential behavioral response on the part of companies to curb income shifting once they have to disclose activities and income on a country-by-country basis.” (p. 2). Citing the above disclosure literature, she further conjectures that “a behavioral response is possible in which companies either alter where taxable income is reported to be more in line with where economic activity occurs, or they move economic activity to be located in jurisdictions where they want to report income” (Hanlon, 2017).
4. HYPOTHESIS DEVELOPMENT
As previously mentioned, firms trade off the benefits of tax avoidance activities with political and reputational costs, as well as the detection risk from tax authority, that come with increased disclosures (Dyreng et al., 2016). First, increases in geographic and tax-related disclosures can aid tax authorities with their decisions to allocate enforcement resources (Mills, 1998; Bozanic,
Hoopes et al. 2016).6 Public CbCR could provide the transparency necessary for some tax authorities to detect any misalignment between the profits generated in each country to firm’s tax payments. Second, the information contained within firm’s CbCR could direct both political and public scrutiny toward firms that report abnormally high income in low tax jurisdictions. Hence, one could surmise that public disclosure of country-level information increases the cost of income shifting among the financial affiliates, leading to a reduction in their income shifting activities.
6 For example, following the leak of the Panama Papers, the U.K. tax administration was able to recover approximately $125 million in unpaid taxes (BBC, 2017).
15 It is not at all obvious whether and to what extent public CbCR will result in additional insights and benefits to the public, regulators, and tax authorities. Foreign activities of MNCs, especially those of banks, are already subject to numerous financial and regulatory disclosure requirements for both accounting and tax purposes. In addition, existing provisions in most
European countries require the disclosure of certain tax information, including the tax payments and transfer pricing documentation, to the tax authorities (Evers, Meier, and Spengelm, 2014).
Moreover, given the highly regulated nature of the financial sector, the ability of banks to adjust their income shifting (without attracting regulatory scrutiny) may be limited. Therefore, we state the first hypothesis in the null form:
HYPOTHESIS 1: Following the implementation of public CbCR under CRD IV, financial
affiliates of EU banks do not change their income-shifting activity.
As explained above, under partial and individual reporting basis, industrial affiliates are excluded from the scope of CRD IV, and hence are not subject to the same scrutiny arising from CbCR disclosure requirement. In such a scenario, banks would have incentives to increase the level of tax-motivated income shifting among the industrial affiliates to offset the tax increases due to a reduction of such activities among the financial affiliates. However if the banks choose to report on the full consolidated basis, then information on all affiliates must be reported, and both financial and industrial affiliates are subject to the same level of scrutiny. Therefore, it is an empirical question whether and to what extent the CbCR under CRD IV affects the income shifting behavior of industrial affiliates. We state our second hypothesis in the null form:
HYPOTHESIS 2: Following the implementation of public CbCR under CRD IV, industrial
affiliates of EU banks do not change their income-shifting activity.
16 Lastly, if we observe a simultaneous reduction in tax-motivated income shifting activities among the financial affiliates and a surge in tax-motivated income shifting activities among the industrial affiliates of the same bank, then it is unclear whether the CbCR requirement under CRD IV affects a firm’s level of overall tax avoidance. If, following the adoption of CbCR, the increase in income shifting among industrial affiliates is not enough to offset the decline in income shifting among financial affiliates, we would expect a decline in the overall tax avoidance of the EU bank, and vice versa. Due to these competing arguments, we make no directional prediction for tax avoidance following the implementation of CbCR and state the hypothesis in the null form below:
HYPOTHESIS 3. The level of tax avoidance by EU banks does not change following the
implementation of public CbCR under CRD IV.
5. DATA AND METHODOLOGY
5.1 Data
We obtain the financial statement and ownership data for banks and financial affiliates from the
Bank Focus database compiled by Bureau van Dijk. We obtain the financial statement data for the industrial affiliates from the Orbis database, which is also compiled by Bureau van Dijk. The data cover a period between 2010 and 2017. The full CbCR requirements under CRD IV came into effect in 2015, but EU banks had to disclose some information directly to their local tax authorities in 2014. Therefore, in our empirical tests, we compare a firm’s income shifting and tax avoidance activities during the four years prior to the adoption of CRD IV (2010-2013) with those in the subsequent years (2015-2017). We exclude the observations in 2014 from the dataset because most financial institutions were anticipating the issuance of CbCR rules by early 2014, and as such, we cannot treat 2014 as a pre-implementation year. At the same time, because no public disclosure
17 was required in 2014, we cannot treat it as a CbCR year either. In a set of sensitivity analyses, we included firm-year observations for 2014, and the results do not change qualitatively.
Orbis and Bank Focus databases identify a firm as the global ultimate owner (GUO) if it controls at least one subsidiary and is itself not controlled by any other single entity. The sample begins with all EU headquartered multinational banks that are identified as GUOs in the Orbis database and that have at least one foreign subsidiary. We exclude central banks, governmental credit institution, and micro-finance institutions, as their incentives to shift income might differ from other banks (Merz and Overesch, 2016). The final sample consists of 114 EU headquartered multinational banks.
For each EU bank, we obtain a list of all financial and industrial affiliates from Orbis. An affiliate is considered ultimately controlled by the GUO if all links in the ownership chain between it and the GUO have ownership percentages greater than 50 percent. As such, we include subsidiaries of all levels in the sample. For the test of H1, the subjects of interest are all financial affiliates of all EU-headquartered multinational banks listed in our databases. The definition of
“Institutions” in CRD IV includes credit and investment firms. Therefore, we restrict our sample to bank affiliates to avoid the inclusion of affiliates that may be outside the scope of CRD IV. We also exclude any affiliates that are not active, do not have unconsolidated data, or are central banks, governmental credit institution and micro-finance institutions. The final sample for H1 includes
233 financial affiliates with 639 affiliate-year observations.
For the test of H2, the subjects of interest are all industrial affiliates of the 114 EU headquartered banks. We classify an affiliate as an industrial affiliate if it does not operate in the financial industry or auxiliary financial industry.7 In this test, the control group includes non-
7 Technically a number of affiliates in the financial industry may be outside the scope of CRD IV and we could include these firms in our test of H2 (i.e. insurance firms). However, the income shifting model used for H2 is not directly applicable for financial
18 financial affiliates of industrial multinationals headquartered in the EU. The final sample for H2 includes 2,107 industrial affiliates (7,632 affiliate-year observations) in the treatment group and
10,739 affiliates (42,636 affiliate-year observations) in the control group. Table 1 provides an overview of the sample selection criteria.
The final sample for H3 consists of 114 EU-headquartered multinational banks (462 firm- year observations) in the treatment group. The control group consists of 55 domestic EU- headquartered banks (169 firm-year observations) with available data from Bank Focus. The alternative control group for the test of H3 consists of 51 (328 firm-year observations) U.S.- headquartered multinational banks with available data.
5.2 Income Shifting Model for Financial Affiliates
To test for the impact of CbCR on the tax-motivated income shifting behavior of financial affiliates, we extend the original model of income shifting developed by Hines and Rice (1994) and later expanded by Huizinga and Laeven (2008). The main idea underlying the Huizinga and
Laeven (2008) model is that reported earnings before taxes (PBT) of a subsidiary in period t is equal to the sum of true earnings before taxes and those profits that are shifted. Because the true profit of the affiliate in the absence of income shifting is not observable, Huizinga et al. (2008) use return on capital to estimate true earnings where return on capital (K), labor (L), and productivity function (A) are jointly employed by a firm to produce output Q.
In contrast to the production function of an industrial affiliate, the production process of a financial firm includes the borrowing of funds from surplus spending units and lending those funds to deficit spending units (Sealey and Lindley, 1977). Applying the factors of the production model
firms and as such we do not include these firms in our sample to test H2. The scope of CRD IV within the financial industry is not very clear and there is some ambiguity in the application of CRD IV across different European nations. As it is universally (within EU) accepted that commercial and saving banks are clearly within the scope of CRD IV, we use this subset of firms for H1 and H3.
19 of financial firms identified by Sealey and Lindley (1977), we use earning assets as the primary measure of outputs in financial affiliates and labor, total assets and total customer deposits as the primary measure of inputs. We modify Huizinga et al. (2008) income shifting model to account for the nature of the input, output, and tax incentive variable for financial affiliates and estimate the following regression equation to test H1:
LOGPTIit= β0 + β1 πit + β2 POST + β3 πit * POST+ βXit+ δit+ uit + εit (1)
LogPTI is the primary dependent variable in equation (1) and is defined as the log of pre- tax earnings of affiliate i of parent r in year t. πit is the tax incentive variable and is proxied for by
Cit in the primary analysis. Cit is a composite tax variable that measures both the profit shifting incentives (by using the statutory tax rate in affiliate country) as well as the profit shifting opportunities (by using the scale of firm’s operation) (Huizinga and Laeven, 2008). Previous papers (De Simone, 2016; Markle, 2016) use the affiliate revenue to measure the scale of affiliate operations (훽) in each country. Because earning assets are traditionally used to measure the outputs of financial firms, we use total earning assets to measure the scale of financial affiliate operation in each country. To mitigate any concerns regarding endogeneity of total eanings assets, we also calculate the tax incnetive varible using Total Assets. The calculation of a bank specific tax
b incentive variables (C it) is given by the equation below: