taxes and transper-pricing5162019 income shifting and the volume of intra-firm transpers

Taxes and Transfer Pricing: Income Shifting and the Volume of Intra-Firm Transfers John Jacob Taxing authorities have often alleged that multinationals shift income between different ge

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NORTHWESTERN UNIVERSITY

TAXES AND TRANSFER~PRICING:

INCOME SHIFTING AND THE VOLUME OF INTRA-FIRM TRANSFERS

A DISSERTATION SUBMITTED TO THE GRADUATE SCHOOL

IN PARTIAL FULFILLMENT OF THE REQUIREMENTS

for the degree DOCTOR OF PHILOSOPHY Field of Accounting and Information Systems

Copyright 1995 by

Jacob, John All rights reserved

UMI Microform 9614764

Copyright 1996, by UMI Company All rights reserved This microform edition is protected against unauthorized copying under Title 17, United States Code

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Copyright by John Jacob 1995 All rights reserved

ii

Taxes and Transfer Pricing:

Income Shifting and the Volume of Intra-Firm Transfers

John Jacob

Taxing authorities have often alleged that multinationals shift income between different geographic regions to minimize global

are also consistent with firms using legitimate operational measures

discriminate between these alternate explanations by using data derived from the geographical segment disclosure in annual reports

of firms about the volume of firms' inter-geographic area transfers Firms with large amounts of intra-firm international transfers are hypothesized to have greater opportunities to shift income through the use of transfer prices

The dissertation also examines whether the pattern of income shifting through transfer prices has changed subsequent to the Tax

iii

transfer pricing regulations that followed, considerably increased

the incentives for firms to use transfer prices to shift income also increased significantly because of the change in firms' foreign tax

effects predominates by testing for income shifting in both periods

shifting through transfer prices in both the pre- and the post- Tax

geographic area transfers are found to pay lower global taxes than

area transfers appear to have paid lower U.S taxes than other similar firms prior to the Tax Reform Act of 1986 and higher U.S

U.S and in the foreign region are also found to be suggestive of

results are robust to the use of different formulations for the variables

Lv

I would like to thank the chairman of my dissertation committee, Professor Thomas Lys for encouraging me to pursue this topic and for his comments and suggestions on various drafts of this

Professor Carla Hayn for her many comments and recommendations which

for his advice and the insights I gained from sitting in on his

Thiagarajan for his suggestions and advice

I would like to acknowledge the assistance of Ernest Aud of International Business Services at Ernst & Young's Chicago office

in providing me with reference material and some insights into the

International Business Services at Ernst & Young's Chicago Office for many useful conversations on the subject of this dissertation Financial support frem the Accounting Research Center at the Kellogg Graduate School of Management is gratefully acknowledged

Most of all, I thank my wife Blizabeth and daughter Neha (Miriam) for sharing my joys and sorrows and for putting up with my

long absences and unorthodox hours while this dissertation was in progress

Finally I would like to thank my fellow doctoral students - Julia D'Souza, Jowell Sabino, Bjorn Jorgenson, Linda Vincent, Peqgy Bishop, Rita Czaja, Roby Lehavy, Mark Soczek, Byoung Ho Kim, Eric Weber, Rachel Schwartz and SongKyu Sohn for their companionship and

encouragement

vi

Research Question and Hypotheses

Sample Selection and Research Design

Descriptive Statistics and Univariate Tests

Correlation Matrix of the Variables

Regression Results for Global Taxes Paid

Regression Results for U.S Taxes Paid

Regression of Difference of Profitability

Between Regions

Regression of Reported U.S Profitability

Regression of Foreign Profitability

Tests for Differences in Income-Shifting Into

and Out of the U.S

Regression of Difference of Operational

Profitability Between Regions Regression of Difference in Non-operational

Profitability Between Regions Tests for Differences in Income Shifting Between

Table 13:

Table 14:

Table 15:

Tests for Differences in Income Shifting Between the

Regression of Difference in Profitability Between

Regression of Difference in Profitability Between Regions: Dependent Variable Scaled by Sales in the

LIST OF APPENDICES

Tax Rates Using Income Tax

INTRODUCTION

transfer-prices to shift income from high to low tax countries

the annual tax revenue loss to the U.S due to transfer-pricing

transfer pricing problem ranks on a scale equivalent to the S & L bail-out '"?

minimization plays a relatively minor role in the determination of

evaluation are of equal, if not greater, importance

Transfer pricing between related parties is governed, in the U.S., by Section 482 of the Internal Revenue Code which constrains taxpayers who are owned or controlled by the same interests to deal

*Pp.D Quick and M.L Levey in the Journal of European Business Jan/Feb 1992

2

Address to the National Tax association-Tax Institute of America symposium, 1991 quoted in the National Tax Journal 1991

-

2

with each other at arm's length The arm's length standard requires that related tax payers, when dealing with each other, establish a transfer price comparable with the price that would be charged in

comparable transaction between unrelated parties is often difficult Companies are alleged to have exploited the resulting ambiguity to their advantage, choosing the price for intra-firm transactions

corporations and the IRS Section 482 "has undoubtedly created more uncertainty and disputes with the IRS involving greater amount of tax dollars than any other part of the law."‘ For example, as of

April 30, 1991, the IRS had recommended increases to income of $13.1

billion for section 482 cases involving either foreign or U.S

* Tax notes (December 16, 1985) quoted in "Taxes and Business Strategy"

(Scholes & Wolfson)

5 Figures from "International taxation: Problems persist in determining tax effects of intercompany prices," GAO report, June 1992.

that a large, and growing, proportion of world trade is conducted

publication® stated that approximately 40% of imports in the United States in 1974 and 50% of United States exports in 1970 were within

these percentages have not fallen in the interim period

Shifting of income between geographical areas through transfer

manipulation of transfer prices distorts the measurement of income,

subject is particularly relevant at this time because the FASB is currently reviewing the guidelines for industry and geographic

formulators of tax policy because of the tax revenue effects of geographical income shifting

Prior research in accounting suggests that firms shift income

of income from one geographical location to another to minimize

geographical income shifting have established the existence of links

Transnational Corporations in World Development: A re-examination, United Nations, 1978, page 43.

4

between the tax rates that companies face in various countries and the income they report and the taxes they pay in these countries {see for e.g Harris, Morck, Slemrod and Yeung (1993), Grubert, Goodspeed and Swenson (1993) and Klassen, Lang and Wolfson (1993)) While this is a possible outcome of the management of transfer prices, the possibility that this could be the result of legitimate

been entirely discounted.’

This study extends the research by linking, for the first time, the level of global taxes paid by firms and the profits they report in various geographical areas to the volume of inter-

using transfer prices for goods transferred internationally to minimize their global taxes, it seems reasonable to assume that the greatest opportunities and incentives for such manipulation should exist for firms with large amounts of international intra-firm sales

the hypothesized relationships between the level of taxes paid, incomes reported in various regions and the volume of international transfers provides more direct evidence on the use of transfer

Such operating decisions could be, for instance, locating more profitable activities in low tax jurisdictions and responding to changes in tax rates

by altering the location or volume of businesses Legitimate tax planning

by managers in making such operating decisions could also lead to the existence of links between tax rates and income reported and taxes paid.

prices to decide the location of income than has been available from prior research

The analysis is performed using publicly available data which

is primarily from the geographic segment and tax footnotes to the financial statements of companies.’ The advantage of using publicly available data (as opposed to using confidential tax return data)

is that, because such data is reported on an on-going basis, the results of the study are verifiable by other researchers

This study also investigates whether the pattern of income shifting through transfer prices has changed in recent years relative to years prior to the Tax Reform Act of 1986 (TRA '86) The regulations governing transfer pricing and their enforcement have become more restrictive in most major trading countries in the

income through transfer prices appear to have increased since a

See Collins and Shackleford (1992) for a description of the foreign tax credit.

6

through transfer prices was prevalent in both the pre- and the post-

also appears to be related to the difference in tax rates firms face

suggest that transfer-prices are the means through which the income

is shifted

The impact of the income-shifting through transfer prices on the U.S taxes paid by the sample U.S multinationals appears to differ between the two periods It appears to result in a reduction

of U.S taxes paid in the pre-TRA'86 period and an increase in U.S taxes paid in the post-TRA'86 period.™

The results also suggest that while there were no major differences in the use of transfer prices to shift income between large and small firms in the pre-TRA'86 period, such a difference

using transfer prices to shift income to a greater extent than large

Alternatives to transfer prices as means to manage the location of reported income include managing the location of debt and expenses

“An increase in U.S taxes paid is a possible consequence of income shifting if it is a result of tax rates in foreign countries exceeding the U.S tax rate This would motivate firms to shift income into the U.S., presumably increasing U.S taxable income.

firms in the post TRA'86 period This could be a consequence of the greater scrutiny of transfer prices by the IRS and other taxing

on larger firms

These results are robust to the use of a variety of proxies for the difference in the tax rates firms face in their U.S and

not appear to be driven by the data for any particular year within

justified in their assertions that transfer prices are being manipulated by firms that have intra-firm international transactions

to reduce taxes

describes the changes brought about in this by TRA'86 and narrates the evolution of the transfer pricing regulations in the U.S

question and develops the hypotheses while Chapter V describes the

empirical results and chapter VII summarizes the conclusions Appendix III develops a theoretical model of the incentives for

8

firms to shift income across locations and attempts to motivate the hypotheses

INSTITUTIONAL BACKGROUND

II.1 U.S Taxation of International Income

There are two main systems that countries use to tax foreign

"world-wide" system of taxation, i.e they tax the worldwide income

of resident corporations Others (e.g France) use the "territorial" system, taxing only income that resident corporations earn within the country

In the U.S., income from foreign sources is not, in general,

portion of their income which is from U.S sources

U.S multinationals operate abroad either through branches or

U.S taxes on the foreign income of U.S multinationals that operate through branches are payable as they are realized and losses can be

22 The exceptions are passive foreign income which is taxable when realized under sub-part F and the income of foreign branches

9

10

subsidiaries is generally only taxable when repatriated to the U.S but losses cannot be used to reduce domestic taxable income

U.S multinationals operating abroad also pay taxes to foreign

taxation that results because the U.S taxes global income, the U.S allows its resident corporations a credit, called the foreign tax credit, equal to the foreign taxes paid, against the U.S taxes

taxes actually paid and U.S taxes which would otherwise have been

tax rate faced by U.S corporations on income earned outside the U.S is the higher of the U.S and foreign tax rates However, because U.S taxes on income earned abroad are only due when the income is repatriated to the U.S., foreign income from low-tax countries benefits from the deferral of U.S taxes

Firms with foreign tax-credits in excess of the limitation can

credits are calculated in different income "baskets" (categories of

income) and within a basket a firm is allowed to average foreign income that is taxed at a rate in excess of the U.S tax rate with foreign income that is taxed at a rate below the U.S tax rate

Firms with average foreign tax rates greater than the U.S statutory tax rate will typically generate foreign tax credits in excess of

computations

is the direct credit, is a credit for foreign taxes paid directly

treatment include withholding taxes imposed by foreign countries on dividends, interest and royalties paid to the U.S parent and the

credit for the foreign income taxes paid in the past on income which

is now being repatriated, usually in the form of dividends, to the

U.S

multinationals from indefinitely deferring the payment of taxes on

provision allows the deferral of U.S taxes only on that portion of foreign income which is invested in "active" foreign businesses.¥

4 Active businesses are those in which the firm materially participates and

is distinguished from portfolio investment.

12 II.2 TRA'86 Provisions Relevant to International Transfer Pricing The changes brought about by the Tax Reform Act of 1986 that had implications for international transfer pricing are described

in the following sections

II.2.1 Number of Baskets in which the Foreign Tax Credit is Computed

In general, the foreign tax credit limitation is calculated as

Foreign taxable income

Worldwide taxable income U.S tax on worldwide income

This computation is performed in each of the baskets into which

the amount of foreign taxes that could be credited by adding five additional baskets in which the foreign tax credit calculation is

foreign tax credit is computed, the lower is the probability that all foreign taxes paid can be successfully credited

II.2.2 Change in the Top U.S Statutory Tax Rate

TRA'86 reduced the top U.S statutory tax rate on corporate

income, which is a factor in calculating the foreign tax credit

foreign tax credit position of a number of firms and a shift in the relative attractiveness of reporting income in the U.S as opposed

to foreign countries

II.2.3 Rules for Allocating Expenses to Foreign Sources

As described earlier, the allowable foreign tax credit is

of foreign taxable income and the amount of expenses allocated to this income are important in determining the foreign tax credits

permitted the manipulation of income and expenses to inflate foreign

allocation of expenses to foreign sources

Prior to TRA'86, firms could reduce the expenses allocated against foreign-source income by applying the expense-allocation

debt incurred by a subsidiary that had only U.S income or assets would be entirely allocable to U.S source income, independent of

multinationals could avoid having any of their interest expense allocated to foreign source income by locating their debt in

proportion of U.S and foreign gross income as an alternative to allocating these expenses based on the proportion of U.S and

14

being manipulated (for e.g., through the use of transfer prices), firms could manage the interest expense allocated to foreign sources

Subsequent to TRA'86, the interest expense of an affiliated group cf& corporations must be apportioned into U.S and foreign sources on the basis of all the assets of the group In addition, gross income cannot be used to compute the portion of the interest

necessarily to be performed on the basis of the location of assets These developments had the effect of reducing foreign source income and thus decreasing the foreign taxes that firms could offset against their U.S tax liabilities

Prior to TRA'86, firms were not required to report identical transfer prices to the U.S customs authorities and to the IRS Firms coulda conceivably have reported lower transfer prices to the customs authorities (to reduce customs duty) and a higher price te the IRS to reduce taxes One of the provisions of TRA'86 was that importers were not permitted to claim a higher transfer price for income tax purposes than was claimed for U.S customs valuation

II.3 History of the U.S Transfer Pricing Regulations

The earliest predecessor of Section 482 of the Internal Revenue Code, which governs transactions between related parties,

Internal Revenue Service (IRS) to allocate income among related parties in order to prevent tax evasion or to clearly reflect the

was incorporated into the 1928 Revenue Act and the Commissioner's authority to make adjustments to transfer prices was expressly based

on his responsibility to deter tax avoidance and to ensure that the

issued in 1935 specified that the arm's length standard was the

of the predominantly domestic character of U.S business in this

multinational affiliates, the impact of these provisions was

limited

multinationals operated changed substantially by the early 1960s The Treasury Department recommended in 1961 that significant modifications be made in the regulations governing the taxation of

that Section 482 was not effectively protecting U.S tax interests

16

This prompted the House ways and Means Committee in 1962 to propose legislation which specified, in greater detail, directives for

Senate version of the bill however reaffirmed the existing Section

482 and the Conference Committee asserted that the purpose of the proposed legislation cculd be achieved by an amendment of the

that, in the main, governed international transfer pricing till recent years

These regulations described the circumstances under which

continue to cover) five specific types of intercompany transactions: The sale of tangible property

The use of tangible property

The transfer or use of intangible property

The performance of services

Loans or advances

The regulations described various methods that could be used

methods (listed in the order of priority) were:

- The comparable uncontrolled price method which uses the price of the same or a similiar product exchanged between unrelated parties as the arm's length price

- The resale price method which is intended to determine an

is determined by measuring the value of the distribution function through an examination of gross profit margins earned on the distribution of the products in question

- The cost-plus method-which is typically used to determine an arm's -length price for components or unfinished goods that will be subject to substantial additional manufacturing, processing or assembly prior to final distribution

- The fourth method which was to be used if none of the preceding three methods could be used to determine an arm's length

determining an arm's length price, one of them being the reasonable rate of return method

In addition to these recommended approaches to determining an arm's length price for tangible assets, the regulations provided guidance on the treatment of loans and advances betweeen related

arm's length rate of interest was defined as the rate that would

independent transactions with, or between, unrelated parties under

similar circumstances

The regulations described in the previous paragraphs remained

18

multinational companies do not pay their fair share of taxes prompted Congress and the U.S Treasury, in the last decade, to enact a number of measures to make tax avoidance through transfer

transfer-prices for the transfer of intangible assets from one related party to another had to be commensurate with the income that

the act also mandated that the IRS conduct a comprehensive study of rules governing inter-company transactions to examine whether

in October 1988 with "A Study of Inter-company Pricing," commonly referred to as the "White Paper."

The White Paper argued that several deficiencies exist in the

noted that the regulations rely heavily on finding comparable

addition, the White Paper asked Congress to examine whether existing

“ It was felt that intangible assets were less likely than tangible assets

to have exact comparables to validate the transfer prices.

penalties are sufficient to deter taxpayers from setting overly aggressive transfer prices and to compel them to provide accurate information about the methods used to compute them

In response to the concerns voiced in the White Paper, the

Reconciliation Act of 1990 introduced mandacory record keeping

acts also increased the penalties for substantial misstatements of

"earnings stripping" rules which limits the deductions that firms can claim for certain excess related party interest and restricted the ability of firms to reduce the taxable income of a U.S subsidiary through excessive interest payments

In January 1992, the IRS issued the proposed Section 482 regulations which incorporated many of the suggestions made in the

“comparable profit interval" The comparable profit interval is a range of profits earned by companies in the same industry as the

comparable profit interval was to be used to examine the arm's length validity of transfer prices and royalty rates determined under any method other than when a exact comparable transaction

could be found.

20

criticized by companies who felt that it imposed unfairly high data requirements and deviated from the arm's length standard which had

"comparable profit interval," in particular, was not well received Responding to this criticism, the IRS in January 1993 issued the

proposed regulations employ a more flexible approach than the regulations suggested in January 1992 and allow tax payers greater freedom to tailor methods to determine appropriate transfer prices

regulations also require that tax payers document the methods by which they determined the transfer price and disclose these to the IRS when requested

increasingly concerned about the use of transfer-prices by related

"proposed regulation," the trend, over time, has been to wake the rules more restrictive, increase the documentation requirements and the penalties for misstatements of transfer-prices

11.4 Transfer Pricing Regulations in Other Countries

The regulations governing international transfer pricing in

most industrialized countries are directed by the "arm's length"

outlined in "Transfer Pricing and Multinational Enterprises," a report compiled by the 0.E.C.D committee on fiscal affairs in 1979

influential guiding factor in determining international transfer prices and contains suggestions to operationalize these principles

in specific instances

The following sections briefly describe the transfer pricing regulations in some of the major trading partners of the U.S.! Canada

Subsection 69(2) of the Income Tax Act prescribes that when the amount owed by a Canadian taxpayer to a related nonresident is greater than a resonable arm's length amount, the deduction is

to amounts charged by the Canadian firm to its related foreign customer for goods and services

Germany

The German Foreign tax law (section 1) recommends that the income of related parties be reallocated if income has been shifted abroad through transactions that would not have been entered into

i This material is adapted from "International Transfer Pricing," (Ernst

& Young, 1991)

22

by unrelated parties

Japan

Japanese transfer pricing rules are largely based on the U.S

payments for inventory, services, interest or royalties should be

determine the arm's length price and the order of priority of their use are very similar to the U.S regulations

United Kingdom

Section 770 of the 1988 Taxes Act permits the United Kingdom Inland Revenue to adjust the taxable income of the U.K party to the amount that would have been reported if the transaction had been between unrelated parties

As international taxation is, to some extent, a zero sum game, the major trading partners of the U.S have responded to the more restrictive regulations in the U.S by increasing the stringency of

strengthened their transfer pricing regulations during the nineteen eighties include Canada, Japan, Korea and the EEC countries in Europe *

Roger Tang, Management Accounting, February 1992

Transfer prices, by their nature, are guarded by companies as

systematic differences between transfer and arm's-length prices for transferz to the U.S from many oil-exporting countries However, their results do not indicate that taxes were the reason for these deviations from arm's length prices.”

Ikawa (1989) uses average transfer prices in various product categories to examine whether transfer prices for international product transfers between related parties are correlated with tax

7 Due to political instability in some major oil producing countries in the period covered by their study, taxes may not have been the major incentive to shift income

23

24

uses Department of Commerce data for 1982 which contains average prices for transfers of goods into the U.S in various product categories, separately for transactions between related parties and between unrelated parties He finds that the deviations of prices for transfers between related parties from those for transfers between unrelated parties were significantly associated with all of the hypothesized variables and in a direction which implies shifting

of income through transfer prices

The limitations of Ikawa's study were that the data he used was for inbound transfers only (i.e., transfers into the U.S.)

used was aggregated so that no firm specific inferences could be

therefore the generalizability of his results to other years is not

evident

A number of papers address the problem using proxies to detect

on a cross-section of 33 countries, Grubert and Mutti (1991) analyze

in the countries these affiliates operate in and find that these

predict that a drop in the statutory tax rate from 40 percent to 20 percent leads to an increase in the ratio of after tax profits to sales from 5.6 percent to 12.6 percent, which is more than the increase that would be predicted by the decrease in tax rates These results are consistent with tax-motivated income-shifting Hines and Rice (1990) also analyze country-level aggregate data for 1982 on the majority-owned foreign affiliates of U.S

on the location of these firms’ pre-tax operating profits, interest

correlations between host country tax rates and the aggregate profitability measures that they use

Statements

Harris, Morck, Slemrod and Yeung (1993) investigate whether the U.S taxes paid by U.S based multi-nationals are related to the

results show strong negative (positive) correlations between U.S taxes and presence in low (high) tax jurisdictions In other words, firms that have subsidiaries in low tax countries pay lower U.S

26

taxes which is consistent with them shifting income from the U.S

in high tax countries are found to pay higher U.S taxes which is consistent with them shifting income from these high tax countries

motivated income shifting

differing in the relative emphasis they place on minimization of

a premium on the minimization of explicit taxes are likely to use

a portfolio of approaches including locating businesses in low tax

possessions corporations and using other tax saving devices in the

levels of explicit taxes but perhaps, higher levels of implicit taxes by way of infrastructural costs and lower pre-tax rates of

higher levels of explicit taxes and lower levels of implicit taxes

productivity and explicit taxes are high (for e.g., Japan and

shelters within the U.S to the same extent as the other set of

firms Such a scenario would also lead to the results that Harris,

Morck, Slemrod and Yeung report, i.e., firms with subsidiaries in

subsidiaries in high tax countries pay higher U.S taxes than otherwise similar firms

the corporate tax rate from 46% to 34% and simultaneously decreased

increased the incentives for multi-nationals to shift income into the U.S and deductions out of the U.S using transfer-prices and

random sample, but the results for a sub-sample identified as more sensitive to TRA's changes are consistent with the hypothesis

Grubert, Goodspeed and Swenson (1993) study foreign domiciled

of foreign corporations, they find that these corporations pay significantly less tax than either U.S domestic companies or U.S

domestic firms and other ‘factors that could cause legitimate differences in profitability, they are able account for part of the