Investor Valuations of Japan's Adoption of a Territorial Tax Regime: Quantifying the Direct and Competitive Effects of International Tax Reform

Abstract

Despite an extensive literature on the normative implications of different international tax regimes and an empirical literature addressing individual specific predictions, there exists little evidence encompassing the broad range of effects of taxing corporations' foreign-source income on a worldwide or territorial basis. This paper takes a more comprehensive quantitative approach by examining stock market reactions surrounding three events over the course of which Japan's 2009 adoption of a dividend exemption system was developed into proposed law. Using an event study methodology which leverages individual firm characteristics and accounts for contemporaneous financial market developments, we find that Japanese firms with less foreign exposure and fewer opportunities for tax avoidance experienced relatively larger abnormal returns, while differences in firms' foreign and domestic effective tax rates accounted for an aggregate capitalization effect of ¥4.1 trillion. We attribute these gains to a combination of enhanced opportunities for international expansion among smaller domestic firms, direct tax savings on official estimates of existing undistributed foreign earnings, and general cultural biases against tax planning in an environment of largely unchanged anti-abuse provisions.

Territorial Tax Reform and Profit Shifting by US and Japanese Multinationals

“…In column (6), the coefficient on Af ter t ×T ax it is -0.74 and statistically significant at the 5% level, suggesting that the tax semi-elasticity for large US-owned subsidiaries increased by 0.74 from 2008 to 2014. Comparing the coefficients on this interaction terms between columns (3) and (6), I find that the tax semi-elasticity for large Japanese-owned subsidiaries increased more (by 1.51) from 2008 to 2014 than did that for large US-owned subsidiaries (0.74), which is consistent with the hypothesis and the finding of Figure 4.…”

“…Following the METI's report, the proposals for adopting a territorial tax regime were sequentially approved and released by the Government Tax Commission on November 28, 2008, the Liberal Democratic Party (the ruling party in the Japanese House of Representatives) on December 12, 2008, the Ministry of Finance on December 19, 2008, and the Cabinet on January 23, 2009. Finally, the legislative bill including the territorial tax reform was passed into law on March 27, 2009 and came into effect on April 1, 2009(Bradley et al, 2018. 11 The Japanese version of a territorial tax regime, which is referred to as a dividend exemption system, exempts 95% of dividends paid by Japanese-owned foreign subsidiaries to their parents from home-country taxation under the tax reform of 2009.…”

“…Columns (4)- (6) of Table 5 present the estimation results for all US-owned subsidiaries, small US-owned subsidiaries, and large US-owned subsidiaries, respectively. In column (4), the coefficient on T ax it is -0.70 and statistically significant at the 5% level, whereas the coefficient on Af ter t × T ax it is close to zero (-0.02).…”

“…Thus, under this system, multinationals care more about the tax rates of the host countries and have stronger incentives to shift more profits to low-tax jurisdictions to reduce their foreign tax liabilities than is the case under a worldwide tax system. Although many studies attempt to estimate the extent of profit shifting by multinationals in response to corporate tax rates, 6 very few studies examine the impact of a switch in the international tax system on multinationals' profit shifting. The exceptions are Markle (2016) and Liu et al (forthcoming).…”

“…6 As surveyed by Dharmapala (2014), the seminal works on this topic are by Grubert and Mutti (1991) and Hines and Rice (1994), followed by Huizinga and Leaven (2008) Dharmapala and Riedel (2013) invent the alternative approach in which they identify profit shifting by investigating how exogenous positive earnings shocks to the parent firm propagate to its own affiliates in low-tax countries (relative to those in high-tax countries). 7 Motivated by the territorial tax reforms of Japan and the UK in 2009, several studies have examined the impacts of the territorial tax system on the activities of multinationals other than profit shifting, including profit repatriation (Egger et al, 2015;Hasegawa and Kiyota, 2017), cross-border mergers and acquisitions (Feld et al, 2016), domestic investment and dividend payouts (Arena and Kutner, 2016), foreign investment (Liu, forthcoming), foreign cash holding (Xing, 2018), and firm value (Bradley et al, 2018). 8 Consistent with the finding of Liu et al (forthcoming), Langenmayr and Liu (2019) find that the profitability of UK-owned foreign subsidiaries located in low-tax countries increased after the territorial tax reform.…”