Corporate tax avoidance has significantly increased at both the state and federal level over the past three decades. As an important tax avoidance strategy, U.S. firms extensively use intangible assets to shift taxable income from high-tax areas to low-tax areas to reduce income taxes. Therefore, patents and other intangible assets create significant tax benefits for firms.
Governments around the world have adopted various measures to combat such income-shifting behavior and crackdown on tax avoidance. For example, more than twenty U.S. states have adopted addback statutes that specifically target tax-motivated income-shifting transactions using intangibles. Addback statutes require firms within the adopting state to add back to their state taxable income intangible-related expenses paid to related parties in other states. The goal of these provisions is to limit a firm’s ability in avoiding state income taxes by using intangible assets to shift income across states. However, the crackdown on tax-motivated income-shifting transactions using intangibles could unintentionally discourage firms from engaging in innovative activities by reducing the projected after-tax net present value (NPV) of such projects.
Our recent study examines whether such addback statutes impede corporate innovation in a large sample of U.S. firms. We take an output approach to measure a firm’s innovation based on the count of utility patents and the total number of citations that a firm receives on its patents. These measures comprehensively capture both observable and unobservable inputs into innovation. To identify the effect of addback statutes on corporate innovation, we study staggered adoptions of addback statutes by different states. After controlling for other determinants of corporate innovation as well as state, firm, and year fixed effects, we find that the adoption of an addback statute by a state leads to a 4.77% decrease in the number of patents filed by a firm with material subsidiaries in that state. Similarly, after a state adopts an addback statute, the total number of citations received on patents filed by affected firms also significantly decreases by 5.12%. Therefore, the addback statutes have an economically significant negative effect on corporate innovation.
We also provide several other tests on the economic value of the “disappearing patents.” First, the adoption of the addback statutes significantly decreases the patents’ aggregate stock market value. Second, when we classify patents into two groups based on whether a patent has any citations, we find that the addback statutes reduce both patents with and without citations. Third, we do not find a significant change in the average number of citations per patent after the adoption of addback statutes. Thus, the “disappearing patents” do not seem to be of lower quality than other patents.
We also consider the location of patents. Several U.S. states (i.e., Delaware, Nevada, Wyoming, and Michigan) do not tax intangible income. Prior to the adoption of addback statutes, a firm could lower taxes by assigning patents to those states and shifting income using those patents from high-tax states. Addback statutes limit firms’ ability to avoid paying taxes in the high-tax state by assigning a patent to a zero-tax state. By identifying the location of patent assignees from the United States Patent and Trademark Office (USPTO)’s patent assignment data, we find that the adoption of an addback statute reduces the number of patents that the firm assigns to subsidiaries in states with no taxes on intangible income. In contrast, we do not observe a significant change in the number of patents that the firm assigns to other non-zero-tax states. These findings lend further support to the argument that the addback statutes limit firms’ use of patents in zero-tax states for tax-motivated income shifting.
Overall, our findings suggest that the crackdown on corporate tax avoidance could impede corporate innovation. We believe that our study informs policymakers who are interested in the consequences of policies that constrain tax-motivated income shifting using intangibles and prevent income base erosion. The Tax Cuts and Jobs Act (TCJA) of 2017 also included anti-base-erosion provisions similar to addback statutes, which aimed to constrain tax-motivated income shifting by U.S. multinational firms to foreign countries with low taxes. Specifically, a U.S. firm’s global intangible low-taxed income (GILTI) became taxable in the U.S. beginning December 31, 2017. GILTI is calculated as the excess (if any) of the shareholder’s global income over 10% of the qualified tangible assets minus certain expenses. Also, the base erosion and anti-abuse tax (BEAT) provision imposes an alternative minimum tax on a modified taxable income, which is calculated by adding back royalties and other expenses paid to foreign related parties to the firm’s regular domestic taxable income. Thus, the TCJA reduces U.S. firms’ ability to avoid U.S. taxes by shifting income overseas using intangible assets. Our study may help policymakers understand the net benefits of these tax policies. We encourage future research to directly examine the effect of the TCJA provisions on corporate innovation.
Shuai (Mark) Ma is an Assistant Professor of Business Administration at the Katz Graduate School of Business, University of Pittsburgh.