Taxation of multinational companies (MNCs) has received increasing attention from politicians, the media, regulators, and academics. While the popular press provides considerable anecdotal evidence that large MNCs pay lower taxes than their domestic counterparts, academic research provides mixed evidence on how multinationality affects taxation. Although foreign operations provide additional cross-border tax avoidance opportunities, such as income-shifting to low tax rate jurisdictions, the existing empirical studies find that MNCs do not have significantly lower effective tax rates than purely domestic firms. As more U.S. firms become multinational by engaging in offshore activities to serve foreign markets and moving production overseas, further research on the tax impacts of offshore activities is needed to understand the taxation of U.S. firms, especially MNCs. In this paper, we shed more light on this issue by examining how offshore activities of serving foreign markets and overseas production relate to corporate tax avoidance for U.S. MNCs.
It is unclear how offshore activities affect tax avoidance. On one hand, moving operations overseas, such as establishing subsidiaries in tax haven countries, facilitates income-shifting to low tax rate jurisdictions. On the other hand, serving overseas markets increase the exposure to the risks of aggregate demand of the global economy. To sell its output in a foreign country, a company needs to pay a significant sunk cost and incur a fixed cost to maintain operations in the foreign country. The offshore sales are sensitive to the aggregate demand of the foreign country, which is correlated with the aggregate demand of the global economy. When aggregate demand decreases, foreign sales decrease, and the business in the foreign country will suffer a loss because of the fixed operating cost. In this case, the company faces a dilemma. The company can avoid the loss from the foreign country by quitting the market. However, the company will need to pay the entry cost again if they want to enter the foreign market in the future. The higher the entry cost, the more likely the company is willing to absorb the loss. Therefore, an aggressive tax avoidance strategy that shifts income from the foreign country to a low tax rate jurisdiction may actually increase the tax burden when the business in the foreign market makes a loss. For example, Xerox implemented the “Project Global” strategy that restructured its European business to shift income to Ireland, a low tax rate jurisdiction (Bandler and Maremont 2001). The strategy rested on an assumption of 15% annual growth in pretax profits. However, this strategy eventually led to an increased effective tax rate for Xerox due to the unexpected operating losses that occurred both worldwide and in Ireland. The reason lies in the fact that the loss in a low tax rate jurisdiction brings lower tax benefits than a loss in a high tax rate jurisdiction. The tax avoidance literature also suggests firms that take aggressive tax avoidance strategies have lower tax benefits when making a loss. More generally, uncertainty in taxable income makes tax avoidance strategies less effective and reduces the incentives of firms to take these strategies. Therefore, offshore activities may reduce tax avoidance incentives by intensifying the uncertainty in future taxable income. We refer to this channel as the uncertainty channel.
We provide evidence supporting the uncertainty channel using the text-based measure of offshore activities developed by Hoberg and Moon (2019). Specifically, we measure the intensity of sales in foreign markets (offshore output activities) by the counts of the keywords that indicate sales of output mentioned alongside foreign countries in the firm’s 10-K filing. We measure the intensity of overseas production (offshore input activities) by the counts of the keywords that indicate purchases/production of inputs mentioned alongside foreign countries. Compared with measures based on geographic segment disclosures, the text-based measures provide a more complete picture of offshore activities and better identify the location of the activities.
We find a significantly positive association between the intensity of offshore output activities and cash effective tax rates (ETR), based on a sample of U.S. MNCs between the period of 1997-2017. An inter-quartile increase in offshore output activities is associated with an increase in cash ETR of 0.8%, or about 3.3% of the sample mean. Moreover, overseas production has higher sunk entry costs and fixed operating costs than domestic production, and therefore leverages the risk exposure brought by overseas sales. Thus, if overseas sales increase cash ETR through the uncertainty channel, the effect should be stronger for those via overseas production than those via domestic production. To test this hypothesis, we deconstruct the measure of offshore output activities into two parts. The first part measures the foreign sales via overseas production, and the second part captures the foreign sales via domestic production. We find that cash ETR has a greater positive association with offshore output activities via offshore production than that via domestic production.
We proceed by conducting several cross-sectional tests to highlight the uncertainty channel. The uncertainty channel predicts several positive relationships between ETR and the offshore output activities (especially the output activities via overseas production). First, the relation should be stronger when the outputs are sold in the counterparty countries with higher economic and political uncertainty. This is because offshore output activities expose the firm to a larger shock. Second, the relation should be stronger when the firm has a lower ability to pass on the shocks to other business parties, such as customers or suppliers. This is because the same magnitude of raw negative shock brought by offshore output activities should result in a smaller net shock to the firm, and is less likely to result in a loss. Third, the relation should be stronger when the firm has lower flexibility to adjust its tax avoidance strategies in response to the shocks. In an extreme case, if a firm can sufficiently and quickly adjust its tax avoidance strategy after knowing its taxable income, the shock should result in no effect.
The evidence from our cross-sectional analyses strongly supports these predictions. First, we find that the positive association between the offshore output activities and ETR is greater when the offshore sales are in the counterparty countries with higher World Uncertainty Index (WUI) – developed by Ahir, Bloom, and Furceri (2019) – and when the counterparty countries have lower GDP growth. Second, firms with greater product market power have a greater ability to pass on shocks. We find that the positive association between the offshore output activities and cash ETR is weaker when the market power is stronger. Third, income-shifting based on transfer pricing of intangibles has greater flexibility to adjust. We construct a composite measure of intangible intensity to measure the flexibility to adjust tax avoidance strategies. We find that the positive association between ETR and the offshore output activities is weaker for firms with higher intangible intensity. Importantly, we find that the moderating effects of the uncertainty of counterparty countries, the ability to pass on shocks, and the ability to flexibly adjust tax strategies mainly manifest in the association between ETR and the offshore output activities via overseas production, but not the offshore output activities via domestic production.
Finally, if offshore output activities impede tax avoidance by increasing the uncertainty of taxable income, the firms with more intensive offshore output activities face higher tax uncertainty in order to achieve the same level of tax avoidance. The higher tax uncertainty should result in a higher reported unrecognized tax benefits related to current-year tax positions. We find that a firm with low ETR has higher unrecognized tax benefits related to current-year tax positions when the firm has more intensive offshore output activities, especially those via overseas production.
Our paper contributes to the literature on the relation between offshore activities and tax avoidance. Foreign operations facilitate cross-border income-shifting that helps reduce the tax burden. Nevertheless, MNCs with more intensive foreign activities do not have lower tax rates than domestic firms. This suggests that overseas activities may also affect tax avoidance through other channels in addition to facilitating income-shifting. We show that foreign sales and overseas production jointly affect tax avoidance through the uncertainty channel.
Zhihong Chen is an Associate Professor at Hong Kong University of Science and Technology
Ole-Kristian Hope is a Deloitte Professor of Accounting at University of Toronto, Rotman School of Management
Qingyan Li is a Professor at Wuhan University, School of Economics and Management
Yongbo Li is an Assistant Professor at Wuhan University
This post is adapted from their paper, “Offshore Activities and Corporate Tax Avoidance” available on SSRN.
