Taxes, keiretsu affiliation, and income shifting

Abstract

This paper provides evidence that keiretsu group member firms are subject to lower effective tax rates than independent firms in Japan. As one explanation for this phenomenon, we develop a hypothesis that keiretsu firms strategically shift financially reported income among affiliates in order to reduce overall effective tax rates. Empirical evidence supports this income-shifting hypothesis since the positive relationship between pretax return on firm value and marginal tax rate status is significantly mitigated by keiretsu membership. Further, it appears that keiretsu income shifting activities intensify when Japanese firms face economic recession, contrasting conjecture of weakening strength of keiretsu affiliation during this period. We also find evidence supporting the view that benefactors of shifted income are compensated via increased dividends.

Propping through related party transactions

“…However, the opportunistic incentives arise not from compensation as in Healy (1985) but from capital market pressures that have an impact on insiders' wealth. Finally, we extend the income-shifting literature by providing evidence of earnings management through related transactions for purposes other than taxation (Gramlich et al 2004;Klassen et al 1993). …”

Business groups and profit redistribution: A boon or bane for firms?

“…Redistribution can also occur because of the benefits accruing to controlling shareholders (and family members) and the principle of solidarity within the business group to keep struggling firms afloat. Another reason for profit redistribution is put forward by Gramlich et al (2004). They argue that business groups will engage in income-shifting activities among affiliated firms in order to benefit from reduced combined tax liabilities.…”

Multinationals, Minority Ownership and Tax-Efficient Financing Structures

“…They do not find support for compensatory dividends between keiretsu members (table 6). The results by Gramlich et al (2004) are not backed by a theoretical model and are sometimes lacking explanations, e.g., they confess on page 223, that "there may be other vehicles beyond dividends for compensating income shifting among the keiretsu member firms. "…”

“…Gramlich et al (2004) study how pre-tax profits in such affiliates are affected, compared to independent firms, and they define a keiretsu as a (diversified) industrial grouping sharing the same financial institutions or being organized around the same main bank. Though not dealing with internal debt in detail, Gramlich et al (2004) show that a higher leverage significantly decreases taxable income (table 4). Moreover, pre-tax income decreases more sharply the closer the affiliation to a keiretsu (p. 221).…”

“…Moreover, we have shown that compensating dividends from the lending to the borrowing affiliate are not necessary, as the tax-savings, and therefore the return on taxavoidance accrues in the borrowing affiliate. Thus, the more profit-shifting in the keiretsu that is done by internal debt, the weaker and the more insignificant should the results on compensating dividends in Gramlich et al (2004) be expected to be.…”