The influence of governance infrastructure and corporate governance on profit shifting

Abstract

In this article we develop a conceptual model to examine the influence of quality of country-level governance infrastructure and corporate governance effectiveness on profit shifting. We empirically test propositions derived from the model with a unique firm-level data set and using multiple indicators of governance infrastructure quality and corporate governance mechanisms. We estimate that on average about 6% of total pre-tax income is shifted out of foreign-owned firms in India. We show that governance infrastructure that improves collective action and transparency in both the foreign- and host-country reduces shifting. On the other hand, secure property rights and efficient contracting in the foreign country increases shifting. We also find that monitoring by foreign institutional investors restricts shifting.

Abstract

Dans cet article, nous développons un modèle conceptuel pour étudier l'influence de la qualité de l'infrastructure de gouvernance d’un pays et de l'efficacité de la gouvernance d'entreprise sur le transfert des bénéfices. Nous testons empiriquement des propositions dérivées du modèle avec un ensemble de données uniques concernant des entreprises  et utilisons différents indicateurs de la qualité de l'infrastructure de gouvernance et des mécanismes de gouvernance d'entreprise. Nous estimons qu’en moyenne environ 6 % du revenu total avant impôt sont transférés par les entreprises étrangères en Inde. Nous montrons que l'infrastructure de gouvernance qui améliore l'action collective et la transparence, à la fois dans le pays étranger et dans le pays d'accueil, réduit le transfert. D'autre part, les droits de propriété sécurisés et l’efficacité de la contractualisation dans le pays étranger augmentent le transfert. Nous constatons également que le contrôle par les investisseurs institutionnels étrangers limite le transfert.

Abstract

En este artículo desarrollamos un modelo conceptual que permite examinar a nivel país la influencia que tiene la calidad de la infraestructura de gobernabilidad y el gobierno corporativo en la transferencia de utilidades. De manera empírica hemos probado proposiciones que fueron derivadas del modelo con datos únicos al nivel de la empresa, y se usaron múltiples indicadores de calidad en la infraestructura de gobernabilidad y mecanismos de gobierno corporativo. De acuerdo a nuestras estimaciones, cerca del 6% de las ganancias totales antes de impuestos es transferido de las compañías extranjeras en India. Hemos demostrado que la infraestructura de gobernabilidad mejora la acción colectiva y la transparencia, tanto en el país extranjero como en el país de origen, reducen la transferencia. Por otro lado, la seguridad en derechos de propiedad y la contratación eficiente en países extranjeros incrementan la transferencia. También encontramos que el monitoreo llevado a cabo por parte de inversionistas institucionales extranjeros restringe la transferencia.

Abstract

Neste artigo, nós desenvolvemos um modelo conceitual para examinar a influência da qualidade da infraestrutura de governança do país e da eficácia de governança corporativa na transferência de lucros. Nós testamos empiricamente proposições derivadas do modelo com um conjunto único de dados de empresas e usando múltiplos indicadores de qualidade da infraestrutura de governança e de mecanismos de governança corporativa. Nós estimamos que, em média, cerca de 6% do faturamento antes dos impostos é remetido para o exterior em empresas de propriedade estrangeira na Índia. Nós mostramos que a infraestrutura de governança que melhora a ação coletiva e a transparência, tanto no país de origem quanto no destino, reduz as transferências. Por outro lado, a garantia de direitos de propriedade e a eficiente contratação no país estrangeiro aumentam as transferências. Nós também concluímos que o monitoramento por investidores estrangeiros institucionais restringe transferências.

Abstract

在这篇文章里我们开发了一个理论模型用来检验国家层面治理基础设施质量与公司治理效力对利润转移的影响。我们结合一个独特的企业层面数据集, 利用基础设施治理质量与公司治理机制的多重指标, 对从模型中导出的命题进行了实证分析。我们估测平均约6%的总税前收入从在印度的外国企业移出。我们指出提高外国和东道国的集体行动及透明度的基础设施治理能减少转移。而另一方面, 在外国的财产权保障和有效契约则会增加转移。 我们还发现外国机构投资人的监督可约束转移。

APPENDIX

A Simple Model of Optimal Profit Shifting

Refer to Table 7 for all variable/parameter definitions used here. We start with a model of corporate governance in the presence of corporate income tax (Desai et al., 2007) in Eq. (A1).

We develop this base model by including the effect of: (a) the foreign country tax rate f, (b) the cost to shifting due to governance infrastructure C _g (s), and (c) the costs of shifting due to corporate governance C _cg (s). We assume a quadratic cost function such that:

Such that, for a wholly owned firm, when λ→1, the cost due to monitoring by other principals also vanishes, C _cg (s)→0. Further we assume that only a fraction ρ (0<ρ<1) of the post-tax shifted profits s(1−f)ρ is available to the foreign owner. In the model we use parameter ρ to proportionately represent the foreign country institutional quality of property rights and contract enforcement, such that when the quality of these institutions improves, ρ approaches 1 (ρ→1).

Incorporating these additional terms in Eq. (A1), we define the value of firm to the foreign owner as:

Equation (A2) is the same as Eq. (1) in the article. The foreign owner would limit profit shifting to a level such that total value V _f is maximized. We obtain this optimal level of shifting s′ from the first order condition (∂V _f /∂s)=0):

Equation (A3) is the same as Eq. (2) in the article. A valid range of values for s′ is 0⩽s′<1, we can define the range of model parameters ρ, γ and μ to satisfy this condition. To ensure that s′ is confined within the valid range, without loss of generality, we scale ρ to:

Propositions and Proofs

Proposition 1:

• For a firm with controlling foreign ownership stake (λ) in a relatively high-tax host country, increase in host-country corporate tax rate (t) increases outward profit shifting, and increase in foreign country (f) tax rate decreases outward profit shifting(s′), ceteris paribus.

Proof:

• Differentiating s′ with respect to t and f:

  

  Therefore the optimal outward shifting s′ increases with higher host-country tax rate t and decreases with higher home-country (foreign country) tax rate f. □

Proposition 2:

• For firms with controlling foreign ownership stake (λ) in a relatively high-tax (t) host country, higher foreign ownership increases outward profit shifting (s′), when the host-to-foreign country tax difference (Δt) is greater than a threshold(Δt _TH ).

Proof:

• 

  Profit shifting increases with higher foreign ownership if:

  

  For the case of relatively high-tax host country, 0<f<t<1, this derivative is positive when the following condition is met:

  

  Rearranging the terms we get:

  

  where

  

  Thus for a given foreign country tax rate, f, higher foreign ownership increases outward profit shifting when the host-to-foreign country tax difference, Δt=(t−f), is greater than threshold Δt _TH =(1−f)(γ+μ(1−ρ))/(γ+μ).

  Rewriting the condition for (∂s′/∂λ>0) in Proposition 2, in terms of host-country tax t we get:

  

  Such that, the maximum host-country tax rate t _max beyond which shifting increases with increasing foreign ownership (∂s′/∂λ>0) is:

  

  Equation (A5) is the same as Eq. (3) in the article. Therefore the sub-region in the space that satisfies Eq. (A5) is bound by a line segment with intercept=((γ+μ(1−ρ))/(γ+μ)) or =(γ/(γ+μ)|ρ→1), hence we call this term as the “governance infrastructure cost fraction.” The slope of which is =(μρ/(γ+μ)) or=(μ/(γ+μ)|ρ→1), which we denote as the “corporate governance cost fraction.” Where the sum of parameters=(γ+μ) represents total cost of profit shifting and ρ→1 is typical of tax haven countries with secure property rights. □

Proposition 3(a):

• In firms with controlling foreign ownership (λ), higher costs of income shifting due to superior quality of governance infrastructure restricting negative externalities (γ), negatively moderates the extent of profit shifting (s′) from the focal firm.

Proof:

• Costs of income shifting due to host and foreign country GI that restricts negative externalities is represented in the model by γ. Let g _γ be a measure of the quality of foreign country GI restricting negative externalities. If we assume that γ is a monotonically increasing function F _γ of g _γ such that,

  

  Differentiating s′ with respect to γ:

  

  Therefore

  

  Hence profit shifting is negatively moderated by g _γ or higher quality of GI in the host and foreign country that restricts negative externalities. □

Proposition 3(b):

• In firms with controlling foreign ownership (λ), lower costs of profit shifting due to superior quality of governance infrastructure (ρ), supporting economic activities and transactions in the foreign country, positively moderate the extent of profit shifting (s′) from the focal firm.

Proof:

• We represent the quality of GI supporting economic activities and transactions in the foreign country by ρ in the model. Let g _ρ be a measure of quality of foreign country GI supporting economic activities and transactions by securing property rights and efficient contracting. If we assume that ρ is a monotonically increasing function F _ρ of g _ρ such that,

  

  Differentiating s′ with respect to ρ:

  

  Therefore

  

  Hence profit shifting is positively moderated by increasing g _ρ or with higher quality of GI supporting economic activities and transactions in the foreign country. □

Proposition 4:

• In firms with controlling foreign ownership (λ), better corporate governance achieved through monitoring by vigilant other principals (λ _CG ) negatively moderates the extent of profit shifting (s′).

Proof:

• In the model of optimal profit shifting, μ represents the costs introduced by corporate governance. Let λ _CG be the share of vigilant other shareholders of the firm. If we assume that the cost to shifting due to monitoring, μ, is a monotonically increasing function F _CG of λ _CG such that,

  

  Differentiating s′ with respect to μ:

  

  From Eq. (A4) we have

  

  The condition implies that

  

  and

  

  Therefore

  

  Hence earnings outflow is negatively moderated by higher ownership stake of vigilant minority shareholders. □