Tax avoidance of large corporations has been a topic of public and academic debate for decades. Major trends such as globalisation and the increasing importance of intangible assets have facilitated corporate profit shifting to low-tax jurisdictions. Some avoidance practices of multinationals were recently revealed in a series of leaks, reinforcing public pressure on policy makers to finally address the issue.
The OECD/G20 countries responded to this challenge with the Base Erosion and Profit Shifting (BEPS) project, and invited other countries to join. Today almost 140 countries are part of the initiative. One cornerstone of the BEPS project is the introduction of country-by-country reporting for multinational companies exceeding the revenue threshold of EUR 750 million or a local equivalent. Starting in 2016, the reporting framework provides information on the global activities of multinationals to tax authorities. The reports, however, are not made publicly available. The data contained in these reports include revenues, profits, and taxes paid at the country-level, as well as a list of all subsidiaries in the corporate group.
Providing additional information to tax authorities is supposed to increase the costs of profit shifting for companies with overly aggressive tax planning strategies, as it allows tax authorities to more effectively target their auditing efforts. However, there is skepticism about the effectiveness of non-public country-by-country reporting in curbing profit shifting. Critics argue that most tax avoidance is due to the complexity of the international tax system, allowing companies to exploit gaps and loopholes which are not closed by country-by-country reporting. Another frequent point of criticism is the non-public nature of the country-by-country reporting framework.
To assess the impact and success of BEPS country-by-country reporting, my recent working paper investigates firm responses to the reporting framework. It first looks at intended and unintended effects on companies within the scope of the country-by-country requirements, before examining avoidance of the disclosure obligation.
Effects of country-by-country reporting
To investigate the effects of country-by-country reporting on companies facing a reporting obligation, the first part of the paper compares companies above the reporting threshold versus companies below the reporting threshold. This differences-in-differences approach is based on firm-level data on over 11,000 companies for the years 2010-2018 from Bureau van Dijk’s Orbis database.
According to these estimations, effective tax rates of companies with country-by-country reporting obligations rise by about one percentage point after the introduction of the measure compared to the control group. The response is stronger for companies that experience a more pronounced increase in the expected cost of profit shifting, proxied, for example, by the listing status of companies, their reliance on intellectual property, and pre-reform tax aggressiveness. The estimations also reveal a decline in profit shifting at the subsidiary level, as the responsiveness of subsidiary profitability to corporate tax rates falls. In addition, the share of total profits remaining in high-tax jurisdictions increases. These results suggest that country-by-country reporting achieved its main goal and led to a reduction in profit shifting of large multinationals.
A widespread hope across tax authorities was that less profit shifting would also lead to rising tax revenues. In the absence of any other changes, a one percentage point increase in effective tax rates should translate into additional revenues of about EUR 30 billion for the OECD countries alone. This hope, however, remained unfulfilled. Tax payments of companies with country-by-country reporting obligations did not rise relative to the control group. Intuitively, this finding seems incompatible with the reported reduction in profit shifting and increased effective tax rates. While the paper does not provide conclusive evidence, this apparent paradox may be explained by lower economic activity of companies with reporting obligation and by the use of loss carryforwards. Such unintended reactions to country-by-country reporting seem to undermine the desired policy objective.
In addition, the increase in effective tax rates due to country-by-country reporting can trigger adjustments in the capital structure of companies. As interest payments are tax deductible, debt financing becomes relatively more attractive at higher tax rates. Apparently, companies respond to this change in incentives, as I find a relative increase in the leverage of treated companies, mirrored by a decrease in the equity ratio.
Avoidance of country-by-country-reporting
The second part of the paper investigates potential avoidance of the country-by-country reporting obligations. The fact that companies generally did not disclose the country-by-country information of their own volition before the BEPS program indicates that it is perceived as costly. This cost can be due to a number of factors, including lower profit shifting opportunities or the direct cost of preparing the reports. In any case, the costs of country-by-country reporting create an incentive for firms to avoid the disclosure obligation by adjusting revenues to a level just below the reporting threshold.
To identify such avoidance behavior, the distribution of companies in terms of revenues before country-by-country reporting is compared to the distribution after the introduction of the measure in 2016. This exercise shows an increase in density just below the reporting threshold. In 2018, 20 per cent more companies report revenues just below the threshold compared to the pre-reporting years. Additional tests provide further evidence that some companies avoid the obligation by adjusting their revenues. The avoidance response is stronger for companies with higher expected costs of filing a country-by-country report due to a stronger increase in effective tax rates as discussed above; and for companies with lower costs of adjusting revenues to a level below the threshold due to a smaller distance to the threshold before country-by-country reporting.
While the response found is sizable, it is still likely to be a lower bound estimation on the true extent of avoidance behavior since there are strategies for avoidance which are not visible in the data used. Such strategies include firm splits or the exploitation of leeway in country-by-country reporting legislation regarding the definition of revenues.
Discussion on the publication of the country-by-country reporting data
Decisions on disclosure obligations are always a trade-off between the benefits of increased transparency and the direct and indirect costs. By providing new insights on the effects of country-by-country reporting on company behavior, this study helps to evaluate the usefulness of the reporting framework as a weapon in the fight against corporate profit shifting. It also contributes to the ongoing debate on whether country-by-country data should be made publicly available.
Both costs and benefits are likely to differ between public and non-public country-by-country reporting frameworks. Public country-by-country reporting further reduces the attractiveness of excessive profit shifting by allowing for public scrutiny, potentially leading to reputational losses for tax aggressive firms. While this effect may be desirable, it might also reinforce the unintended effects including the reduction in economic activity and an increase in debt-financing. At the same time, the publication of country-by-country reports is likely to increase the costs of reporting to companies, for example, because sensitive business information becomes available to competitors. The results discussed above suggest that such an increase in the cost of country-by-country reporting would entail stronger avoidance of the reporting obligation.
Besides the immediate impact of the BEPS country-by-country reporting framework on corporate behaviour found in my paper, the reporting regime constitutes an important step towards the harmonisation of international corporate tax system. The data collected provides information on the extent of global corporate profit shifting and potentially facilitates political decision making on corporate tax reform in the future. The coordination mechanism established over the course of the BEPS program in general and for country-by-country reporting in particular can help to find the necessary multilateral solutions to the current challenges of the international corporate tax system.
Further reading
Hugger, F 2020, ‘The Impact of Country-by-Country Reporting on Corporate Tax Avoidance’, ifo Working Paper no. 304, Revised version, ifo Institute, Munich.
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