Tax Law Asymmetries and Income Shifting: Evidence from Japanese Capital Keiretsu

Abstract

While the asymmetric treatment of positive and negative income creates clear tax incentives to shift income among a group of closely related corporations, attempts to document the impact of such behavior on economic outcomes are relatively sparse. We aim to provide evidence on tax-motivated transfers from a large dataset of Japanese corporate groups. Using company level data on 33,340 subsidiary time pairs from 1988, 1990, and 1992, we consider testable implications of income shifting in a theoretical model tailored to the Japanese institution of the early 1990s and empirically examine the spread of the profitability distribution, the attrition rate of loss-making subsidiaries, and the propensity to report zero profit. The findings suggest that income shifting was pervasive when Japan had not adopted a formal allowance for group-level tax. The result underscores the importance of accounting for the inter-relatedness of companies, in designing a corporate income tax.

Unprofitable Affiliates and Income Shifting Behavior

“…14 Because the presence of a loss affiliate can alter the income shifting incentives of relatively low-tax profitable affiliates, this omission may have a profound effect on measurement of income shifting. Although Klassen et al (1993) discuss the difficulty in measuring the tax incentives of unprofitable firms and the potential confounding effect losses have on taxmotivated income shifting behavior, to our knowledge, only Gramlich et al (2004) and Onji and Vera (2010) attempt to test the effect of loss affiliates on reported profits. 15 Both Gramlich et al (2004) and Onji and Vera (2010) find that members of Japanese keiretsu groups (member firms) appear to alter their transfer pricing behaviors in the presence of loss members.…”

“…Although Klassen et al (1993) discuss the difficulty in measuring the tax incentives of unprofitable firms and the potential confounding effect losses have on taxmotivated income shifting behavior, to our knowledge, only Gramlich et al (2004) and Onji and Vera (2010) attempt to test the effect of loss affiliates on reported profits. 15 Both Gramlich et al (2004) and Onji and Vera (2010) find that members of Japanese keiretsu groups (member firms) appear to alter their transfer pricing behaviors in the presence of loss members. Although these results support loss-related income shifting, their data sets do not 14 Much of the tax-motivated income shifting research excludes unprofitable foreign affiliates or unprofitable foreign groups from analysis.…”

“…This is consistent with firms altering their traditional response to income-shifting incentives in the presence of loss-making affiliates and provides further evidence that the existence of loss affiliates disrupts the traditional pattern of income shifting. This paper is in the spirit of Gramlich, Limpaphayom, and Rhee (2004) and Onji and Vera (2010), who both study income shifting among Japanese keiretsu members. Both papers document a lower incidence of losses in affiliated members relative to unaffiliated members, suggesting affiliated groups band together to save keiretsu-level income taxes.…”

Loss Expectation and Income Shifting.

“…2 As a result, focus has turned toward investigating the features of loss affiliates and their effects on the income-shifting behavior of MNCs. Gramlich, Limpaphayom, and Rhee (2004) and Onji and Vera (2010) are the first study that attempt to examine the income-shifting strategy of loss firms. They find evidence of inward income shifting from profitable members to unprofitable members in Japanese Keiretsu groups.…”

Inflexibility in Income Shifting: Implications, Detection and Remedies

“…Gramlich et al (2004) and Onji and Vera (2010) analyze income-shifting behavior within domestic Japanese trusts ("keiretsus") and find that net operating losses in some affiliates are balanced by shifting income from profitable affiliates. In addition, Onji and Vera (2010) point out that this behavior most likely is driven by tax motives because the Japanese corporate income tax did not allow for consolidation of the keiretsus' overall profitability. De Simone et al (2017) study the link between unexplained income of loss affiliates and tax-related factors.…”