Unprofitable Affiliates and Income Shifting Behavior

Income shifting from high-tax to low-tax jurisdictions is commonly considered a primary method of reducing worldwide tax burdens of multinational firms. Extant research generally makes the high-tax and low-tax distinctions using statutory or aggregated effective tax rates. However, current losses also affect the marginal tax rates of affiliates. In the absence of carryback or carryforward provisions, an unprofitable affiliate has a marginal tax rate of zero. Thus, an unprofitable affiliate can alter the income shifting incentives and strategy of a multinational firm. We build upon prior estimation approaches to allow for the inclusion of unprofitable affiliates and test whether the reported pre-tax income of unprofitable affiliates deviates from the negative association with statutory tax rates observed in samples of profitable affiliates. We also estimate a marginal tax rate that takes into account factors such as loss carryback and carryforward. Results suggest that multinational firms with an unprofitable affiliate adjust their transfer pricing strategies to take advantage of losses and that the marginal tax rate is a determinant of observed pre-tax income. Our point estimates imply that an average-sized affiliate facing the average statutory tax rate alters its income shifting behavior by approximately $7.8M upon a change from profitability to loss.