Multinational tax avoidance: Is it all about profit shifting? Christof Beuselinck, IESEG School of Management and LEM Jochen Pierk, Erasmus University Rotterdam ABSTRACT The standard perception of international tax planning strategies is that multinational companies (MNCs) avoid taxes via cross-jurisdictional income shifting. In the current paper, we exploit MNC parent and subsidiary entity level data to study this allegation by investigating the importance of within-country (local) tax avoidance, which we measure as the abnormal GAAP effective tax rate (AETR) relative to the country-industry-year average GAAP ETR. For a large sample of over 150,000 domestic and foreign affiliate observations pertaining to more than 7,600 European MNCs, we observe that time-invariant MNC (group) fixed effects explain close to 80 percent of the total explained variation in subsidiary local tax avoidance. This evidence supports the idea that the MNC corporate style is largely responsible for the design and orchestration of subsidiary local tax avoidance strategies. Further, we document that the level of subsidiary local tax avoidance is positively related to group tax avoidance suggesting that not all tax avoidance pertains to income shifting. Moreover, this group-subsidiary level association has also more than doubled over the period of study (2006-2014), confirming that MNCs rely increasingly more on local tax avoidance strategies in more recent years, i.e., when income shifting has landed in the eye of the debate on ethical tax planning. Finally, the focus on local tax avoidance is largest in domestic subsidiaries and in vertically integrated subsidiaries. While the former result suggests that the familiarity with the headquarters’ local tax administration gives rise to larger local tax avoidance opportunities, the latter result supports the idea that subsidiary local tax avoidance becomes more important when transfer prices can be challenged more by tax authorities as it is the case in vertically integrated transactions. Draft: September 8, 2017 This paper has benefited from comments by Kathleen Andries and Anna Alexander. We thank workshop participants at University of Gothenburg (Sweden), University of Bristol (UK), University of Paderborn (Germany), the Research Day in Accounting hosted by the University of Antwerp (Belgium), the 1st ERIM Accounting Day at Erasmus University Rotterdam (Netherlands), and conference participants at the 40th Annual Congress of the European Accounting Association in Valencia (Spain) for their valuable comments. Corresponding author: Jochen Pierk, Burgemeester Oudlaan 50, 3062 PA Rotterdam, Netherlands, E-mail: [email protected], Phone: +31/10/4082248 1 1. Introduction The interest in corporate tax avoidance has reached an all-time high level and the financial and academic perspective is dominated by the idea that cross-jurisdictional income and debt shifting is the primary source of tax gains (e.g., Atwood et al., 2012; Beuselinck et al., 2015; Collins et al., 1998; Klassen et al., 1993; Klassen and Laplante, 2012; Markle, 2015; Newberry and Dhaliwal, 2001; Rego, 2003). In line with the increasing demand for a fairer corporate taxation game for global multinational corporations (MNCs) versus domestic-only corporations, where such shifting opportunities are non-existing, the Base Erosion and Profit Shifting (BEPS) action plan by the OECD (2013) is working on several proposals and guidelines to ensure that profits are taxed where economic activities are generated. This attention seems warranted and is in line with the common perception that excessive income shifting activities should no longer be part of contemporary sustainable business strategies as is evidenced in the rise to the term “tax shaming” (Barford and Hold, 2013). However, recent academic evidence by Dyreng et al. (2017) suggests that over the 25 year period 1988 - 2012 the effective tax rates (ETRs) for U.S. corporations have declined for both multinational as well as domestic firms. This suggests that even for domestic firms a wide range of tax avoidance opportunities can have become available, for instance, by income shifting across states (e.g., Dyreng et al., 2013); by intra-company transactions between business group members within a specific jurisdiction (Beuselinck and Deloof, 2014; Gramlich et al., 2004); by focusing on specific locally available tax planning strategies such as investments in tax favored assets, usage of accelerated depreciation schemes, tax credits, and allowances for corporate equity (Anning et al., 2015); or via optimizing tax schemes that are temporarily available within one specific tax jurisdiction (Shevlin et al., 2012). These observations seem to suggest that the focus 2 on income shifting to capture MNCs tax avoidance behavior is potentially understating the full spectrum of tax avoidance strategies that international corporations have at their disposal. Our study on the more complete picture of MNC tax avoidance is important because local tax planning opportunities are not only available in the multinationals’ parent country, but also in all its foreign subsidiary countries. Moreover, local tax avoidance is asymptotically equivalent to income shifting and potentially less costly because it does not suffer from cross-jurisdictional shifting costs. In the current paper, we investigate this issue in more detail by observing subsidiary entity-level as well as MNC group-level GAAP ETRs for a sample of 7,660 European MNCs (34,111 observations) that are headquartered in one of 27 EU Member States and their 42,115 domestic and foreign affiliates (158,749 observations) across the globe.1, 2 To do so, we conceptually follow Kohlhase and Pierk (2017) and we distinguish between tax avoidance across countries (income shifting) and tax avoidance within countries (local tax avoidance). While prior studies (e.g., Atwood et al., 2012; Markle, 2015) have shown that MNCs headquartered in worldwide tax systems shift income to a lesser extent across countries compared to MNCs headquartered in territorial tax system countries, Kohlhase and Pierk (2017) additionally show for an international panel of observations that MNCs from worldwide tax systems are also less tax aggressive compared to their industry peers within foreign affiliate countries. More in particular, they find that subsidiaries owned by investors from worldwide tax systems (like the U.S.) have a higher average GAAP effective tax rate (ETR) compared to subsidiaries owned by foreign investors from countries with a territorial tax system. This finding is consistent with the claim in Scholes et al. (2015) that the incremental repatriation tax under a 1 The sample includes 27 out of the 28 EU Member States as Italy has a regional tax that is based on the value of all produced goods. In this case, the standard proxies for tax avoidance, e.g. the effective tax rate, cannot be interpreted. 2 We focus on GAAP ETR because the majority of our sample firms, especially private firms, do not publish cash flow statements. 3 worldwide tax system reduces the incentive of worldwide parent companies to be tax aggressive in foreign subsidiaries. In the current paper, we further build on the MNC parent-subsidiary tax avoidance associations to investigate whether and if so to what extent MNCs achieve lower consolidated GAAP ETRs by local tax avoidance or rather shift income across countries. In particular, we study abnormal GAAP ETRs defined as deviations from country-industry-year average GAAP ETRs for both MNC groups and subsidiaries as our main proxy for tax avoidance. Then, we identify the proportion of MNC group level tax avoidance that stems from subsidiary-level local tax avoidance. Empirically, we regress the abnormal ETR of the group on the (pretax-income) weighted abnormal ETR of all its subsidiaries. This approach is attractive because it can distinguish between tax avoidance that is realized entirely via income shifting (where the association is predicted to be zero) and tax avoidance that originates from 100% local strategies (where the association would equal one) or from a combination of both (where the association is between zero and one). 3 Because of the paucity of insights in parent and subsidiary country local tax avoidance, we start our analyses by gauging the relative importance of MNC time-invariant factors that can explain subsidiary local tax avoidance behavior. After these descriptive insights, we investigate the time-series pattern as well as the cross-sectional determinants of subsidiary local tax avoidance. First, we find that MNC time-invariant fixed effects explain almost 80% of the total explained variation in subsidiary abnormal GAAP ETR, which is far above the 6% (27%) that stems from the MNC parent country (parent/subsidiary country pairs) fixed effects. We interpret these results as evidence that MNC origin and MNC-affiliate country bilateral relationships only 3 We explain our research method and design in more detail in Sections 3.1 and 3.2. 4 capture a fraction of the subsidiary tax avoidance and that it is rather the MNC fixed effect (i.e., the “corporate style”) that is largely responsible for the design and orchestration of subsidiary local tax avoidance behavior. In further analyses on the association between MNC group and subsidiary-level local tax avoidance, we find that after controlling for the standard GAAP ETR determinants identified in prior tax research, tax avoidance of the average MNC is positively related to the local subsidiary tax