It is well established that multinational corporations (MNCs) reduce their tax load by shifting income from higher-tax countries to those with lower tax rates, including tax havens, as part of their tax planning.
To prevent the resulting loss of tax revenue, particularly in times of uncertainty, deficits and high inflation, governments invoke various policies to strengthen business tax rules and enforcement. One recent initiative has been to tax the country-level income of the largest MNCs at a minimum rate globally. Spearheaded by the Organisation for Economic Co-operation and Development (OECD), the initiative (currently being implemented by around 55 jurisdictions) is forecast to increase governments’ tax take by a combined US$220bn a year.
Metrics such as EBIT are used for both internal assessment and local tax calculations
Unexpected consequences
In the dynamic international tax system, MNCs frequently change their tax planning strategies in response to shifting circumstances. Using affiliate data from MNCs based in 21 European countries, we recently conducted a study (Klassen and Valle Ruiz, 2023) into whether these changes in income-shifting strategies altered affiliate managers’ internal reporting behaviour (see the AB article ‘Tax rate changes impact income timing’).
Beyond the potential distortion to internal decision-making, the types of internal reporting decisions we studied contribute to a business’s overall earnings management because they are not eliminated with consolidation.
Financial performance metrics such as earnings before interest and taxes (EBIT) are frequently used internally for evaluating the performance of affiliate managers. International corporate tax planning strategies add complexity to the task of headquarters in setting targets for affiliates and evaluating the performance of affiliate managers.
This complexity arises because metrics such as EBIT are used for both internal assessment and local tax calculations. Economic theory and empirical findings support an equilibrium in which the financial performance targets of affiliates are generally set with the impact of income-shifting activities already incorporated into the affiliates’ income.
But what happens when there is a change in the income-shifting strategy of the business and some affiliates receive more profit as a result while others receive less? Corporate headquarters do not have perfect, timely information on the dynamic income-shifting activities, particularly on their effects on affiliates’ performance metrics, as illustrated in the typical timeline shown below.
How it works
Let’s take the example of an MNC headquartered in France with an affiliate in Ireland. France, with a corporate tax rate of 25%, represents the higher-tax country within the business, while Ireland, with a corporate tax rate of 12.5%, represents the lower-tax country. As a result, the income-shifting strategy aims to transfer income from France to Ireland, using, for example, the transfer prices on intercompany transactions.
At the beginning of 2024 (year t in the above graphic), targets and incentive parameters for managers in both the French headquarters and Irish affiliate are established on the basis of EBIT and other data from 2023 (year t-1). Assume that, during 2024, the French government tightens its income-shifting regulations. In response, the MNC’s tax department reduces the income shifted from France to Ireland to avoid tax scrutiny, and potentially additional tax and penalties. The change in transfer prices results in less income being shifted, lowering income in Ireland.
It may not be possible to adjust manager incentives following changes in tax plans
Within the performance assessment system, once affiliate-level targets are approved, they are rarely modified – a result of limited information flows from the tax group to the assessment group, or other structural features of the incentive system. Consequently, managers responsible for setting incentive parameters may be unable or unwilling to adjust them following changes in tax plans, leaving the Irish affiliate’s targets at the level set prior to the change in transfer prices.
Meanwhile, the Irish managers have some control over their financial performance metrics such as EBIT and may strategically report additional income to meet targets, necessitated in this case by less income resulting from the change to the tax planning.
Managing up earnings
Previous studies have indicated that managers manage earnings upward if they fall below their internal targets. We therefore assert that if affiliate targets do not adapt to the business’s evolving tax plans, managers in countries with reduced income shifting (such as Ireland in the above example) may compensate for the loss of income by artificially inflating local earnings to achieve their predetermined targets.
In our study, we empirically tested this scenario. Our findings confirm the effects of changing regulations on income shifting by MNCs. Overall, affiliates in low-tax jurisdictions (Ireland in our example) report higher EBIT on average, while affiliates in high-tax jurisdictions (France in our example) report lower EBIT on average, taking into account the expected profits of each affiliate. Our findings also confirm that changing regulation reduces these tax-motivated distortions to income.
Earnings manipulation rises in countries losing shifted income
However, a different picture emerges when we explore the discretionary reporting of the affiliates. In equilibrium, the evidence suggests that, if anything, discretionary reporting follows the income shifting (ie affiliates in low-tax jurisdictions report even more income). However, when a high-tax country tightens its income-shifting regulations (in our example, France) and businesses adjust their tax strategies so that low-tax affiliates (Ireland) report less income, this adjustment prompts the low-tax affiliates to strategically increase their earnings to meet their targets. Therefore, with changing tax planning, the earning management reaction of the low-tax affiliate offsets the change from the income-shifting strategy.
In short, while our empirical findings initially suggest that the tightening of income-shifting regulations achieves its intended objective, it does so with unintended consequences. Specifically, there is an increase in earnings manipulation by countries losing shifted income. Our study highlights the importance for central managers to consider the additional pressures on financial performance reporting when tax planning significantly reduces the profits of specific affiliates.
