The Effect of Changes in Income Shifting on Affiliate Managers' Internal Reporting Decisions*†

Abstract

This study examines the interplay between tax and internal reporting incentives among affiliates of multinational corporations (MNCs). MNCs face limited information flows that may prevent affiliates' performance metrics to be responsive immediately to changes in the firm's tax planning. Using granular data of affiliates belonging to MNCs from 21 European countries, our study provides new empirical evidence of affiliate internal reporting responses induced by changing tax plans. When high-tax-rate countries tighten income shifting rules, we first document that income shifting is reduced and low-tax-rate affiliates have less income. Second, we predict and document that managers of these low-tax-rate affiliates offset this decrease in profits by managing upwards a key performance metric: affiliate earnings. Our results are consistent with firms not quickly adjusting the affiliate managers' incentives in the face of changing tax planning strategies, and affiliates managing reported earnings to offset the effect of changes in the tax planning of the firm. Cross-sectional analyses provide further evidence consistent with the theory underlying the main tests. The results support the policy of tightening income shifting rules when the objective is to reduce income shifting, and firms' central management would benefit from considering the implications of changing tax plans on the assessment of local managers.

Tax Strategy and International Financial Management of Multinational Companies

“…The tax strategy of MNCs focuses on tax planning, i.e., arranging a variety of tax methods and structures to minimize the company's tax under the international tax system. Tax planning includes strategies such as direct investment, moving money and profits, and utilizing tax treaties to help MNCs reduce their burden [4][5][6]. Direct investment is one of the most important tools in the tax strategy of MNCs.…”