Globally, tax authorities have recognised that the use of tax haven has contributed to a reduction in taxes payable by firms as evidenced by a decline in effective tax rates and an increase in the difference between accounting and taxable income. Tax havens are typified by a lack of information exchange, secrecy in disclosures and regulatory, legal and financial arbitrage, and a nil or very low corporate tax rate.
Oxfam (2016) reports that Australian investments in tax havens were estimated at US$56.4 billion in 2009. This increased to US$79.1 billion in 2014. Some of the more well-known tax havens used by Australian firms include the Cayman Islands, Vanuatu and the British Virgin Islands.
Australian firms may also have subsidiaries located in other offshore financial centres with lower levels of corporate taxes such as Switzerland.
Tax havens and related-party transactions
The Australian Taxation Office (ATO) has embarked on several reforms since 2014 which are designed to improve tax transparency and tax risk management of firms. This includes requiring large businesses to self-report any uncertain tax positions.
The Tax Avoidance Taskforce was also established to assist firms in examining tax arrangements such as the use of tax haven jurisdictions. Between July 2016 and June 2021, some AU$12.7 billion had been collected in tax adjustments relating to tax arrangements of Australian multinational enterprises.
Related-party transactions (RPTs) involve the transfer of funds or other resources between related entities (for example, between parent and subsidiary companies), regardless of whether a payment is involved or the terms and conditions of such a payment.
RPTs may include non-arm’s length or non-commercial transfer pricing arrangements including funds transfers and price setting. These arrangements could be augmented through tax havens given the secrecy and lack of transparency involved.
More related-party transactions in firms that use tax havens
Based on a sample of 300 publicly-listed Australian firms (2008–2019), we find that related-party transactions are significantly higher in those firms that have affiliates located within tax haven jurisdictions. We also find that related party transactions are more profound in firms that manipulate their earnings, in those firms that have a high ownership concentration, and in firms that do not have an advanced pricing agreement (APA) with the ATO.
Firms facing a high tax burden may use RPTs to reduce taxable income and to assist in treasury or capital management. RPTs can be used as a mechanism to transfer income out from Australia to tax haven jurisdictions and to move funds from a corporation to its owners and shareholders. In fact, Doo and Yoon (2020) provide evidence that RPTs can be used as a tool to shift funds to lower-taxed tax havens with the objective of reducing income tax payable.
Further, Desai, Foley and Hines (2006) show that tax haven affiliates sell more of their products to related parties than their counterparts. De Simone, Mills and Stomberg (2019) also find that many inter-company transactions involve transfers of inventory, which provides management with the opportunity to sell at a lower than market price to a subsidiary in a tax haven jurisdiction. The tax haven subsidiary can then resell the transferred inventory to outside parties at a higher price. These transactions increase the profit margin allocated to the tax haven jurisdiction affiliate and lower the profit allocated to the Australian parent entity.
Previous research finds that firms use RPTs as part of earning management to improve credit ratings or to distort their tax position. Indeed, Wang and Yuan (2012) find that firms that engage in non-arm’s length transactions are opportunistic in nature and this reduces the quality of financial reporting. We find that firms that manage earnings and use tax haven jurisdictions generate more RPT sales and engage in more RPT manipulation.
Further, firms with high levels of shares being owned and controlled by few large institutional investors could use RPTs as a tool to shift resources from minority to majority shareholders. We find that firms with both tax haven utilisation and ownership concentration are indeed more likely to manipulate sales with related parties.
We also find that firms with an advanced pricing agreement with the ATO are less likely to engage in transfer pricing manipulation, while firms without are more likely to do so. The association is negative and significant between tax haven use and RPTs for firms that have an advance pricing agreement. Our data show that only 7% of firms in our sample entered into an advance pricing agreement with the ATO.
According to PwC, an advance pricing agreement is “a contract, usually for multiple years, between a taxpayer and at least one tax authority specifying the pricing method that the taxpayer will apply to its related-company transactions”. These agreements “are designed to help taxpayers voluntarily resolve actual or potential transfer pricing disputes in a proactive, cooperative manner”, without the need to go to the traditional examination process.
Implications
The study has several implications. Tax havens play a role in reducing the tax burden of corporations and can assist in facilitating various treasury and capital management arrangements. In particular, RPTs can be used as a tool to shift funds to and from lower-taxed tax havens with the objective of reducing income tax payable. Hence, tax haven use can assist a corporation in their objective to achieve shareholder wealth maximisation but may attract a number of risks around tax and financial opacity.
Journal article
Almutairi, A., Eulaiwi, B., Evans, R., & Taylor, G. (2023). Tax Haven Use and Related‐Party Transactions: Evidence from Australia. Australian Accounting Review, 33(4), 352-374.
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