Flexibility in Income Shifting under Losses

Abstract

This study examines the flexibility of multinational firms to adjust their income-shifting strategies—whether using transfer pricing or internal debt—during the tax year to react to affiliates' operating losses. We develop the concept that under flexibility, multinationals can adjust their inter-affiliate payments ex post (i.e., after financial outcomes are revealed, but before the end of the tax year) to minimize worldwide tax payments. Without flexibility, multinationals must commit to their affiliates' income-shifting strategies ex ante (i.e., before financial outcomes are revealed). Our central prediction is that under ex post income shifting, loss affiliates report lower transfer prices and internal leverage than profitable affiliates; under ex ante income shifting, affiliates report the same transfer prices and internal capital structure, regardless of making losses. Using novel data on direct transfer payments and internal debt of Norwegian affiliates, we find empirical evidence that transfer pricing, particularly related to user fees, but not internal debt, provides flexibility to adjust income shifting ex post. In additional tests, we confirm that our results reflect flexibility rather than loss affiliates' poor performance. Our study should interest tax policymakers and researchers by identifying how various mechanisms allow multinational firms to shift income when they face losses. JEL Classifications: F23; H25; H87.

On the Interdependency of Profit Shifting Channels and the Effectiveness of Anti-Avoidance Legislation

“…This substitution could explain why studies looking at the effect of each profit shifting strategy separately find that anti-avoidance legislation has a strong effectiveness but little or no effect on investment responses. Our question links to Hopland et al (2017) who investigate the flexibility of adjusting transfer pricing and debt shifting strategies within each year to react to changing benefits (due to losses) at given costs. Similar to de Simone (2016) we study how institutional changes affect firms' decisions on profit shifting strategies.…”

“…In this context, survey studies provide crucial insights into what has been called the "black box" of profit shifting (Hanlon and Heitzman, 2010) Due to the nature of internal corporate decision-making processes, this question is difficult to answer with archival data. Nonetheless, recent studies by Hopland et al (2017), de Simone (2016, and Kim et al (2015) address the call from Shackelford and Shevlin (2001) to move beyond merely documenting income shifting to better explaining, understanding and predicting it.…”

“…(e.g. survey evidence by Klassen et al, 2017, Hoopes et al, 2015, evidence from archival data by Hopland et al, 2017, de Simone, 2016, Kim et al, 2015.…”

“…This speed of adjustment is shown to be heterogeneous and is, for example, higher for multinational firms. Hopland et al (2017) also look at the adjustment of profit shifting decisions and in particular investigate firms' flexibility in terms of using income shifting strategies within a single tax year to react to operating losses. They consider transfer prices and debt as profit shifting strategies which can potentially be adjusted to shift profits into group entities making a loss either ex-post (after the fiscal year), or ex-ante (before the current year).…”

“…Due to the nature of firms' internal decision-making processes, this question is difficult to answer with archival data. Nonetheless, recent studies by Hopland et al (2017), de Simone (2016, and Kim et al (2015) show that specific research designs, reform settings and 1 For the effect of anti-avoidance legislation on the debt channel see, for example, Buettner et al, 2012, Blouin et al, 2014. For the effectiveness of transfer pricing regulations see, for example, Klassen and Laplante, 2012, Blouin et al, 2010, Lohse and Riedel, 2013, Beer and Loeprick, 2015, Saunders-Scott, 2015 estimation techniques make it possible to draw inferences on the formation of profit strategies even from archival data.…”