Unprofitable Affiliates and Income Shifting Behavior

Unprofitable Affiliates and Income Shifting Behavior

By Lisa De Simone, Kenneth J. Klassen, Jeri K. Seidman
May 29,2015Working Paper No. 3266

Income shifting from high-tax to low-tax jurisdictions is considered a primary method of reducing worldwide tax burdens of multinational firms. Extant research generally makes the high-tax and low-tax distinctions using statutory or aggregated tax rates. However, current losses also affect income-shifting incentives. We extend prior approaches to allow for the inclusion of unprofitable affiliates and test whether the unexpected profit of unprofitable affiliates deviates from the negative association with tax incentives observed in profitable affiliates. Results suggest that multinational firms alter the distribution of reported profits to take advantage of losses. Our point estimate for profitable affiliates implies that an increase of one standard deviation in the tax rate incentives of an affiliate with average return on assets of 13.3 is associated with a lower return on assets of 0.5 percentage points. The same tax incentive of an unprofitable affiliate is associated with an increase in its return on assets of approximately 0.7 percentage points, holding assets, labor, productivity and other factors constant. We further document a larger responsiveness to rates between profitable and unprofitable affiliates in high-tax jurisdictions, consistent with predictions.