Do Multinational Corporations Engage in Transfer Pricing to Shift Income to Tax Havens?

In 2001, Enron made its mark on history as the largest bankruptcy in the United States to date — the result of fraudulent accounting practices. To this day, the American government loses large sums of potential tax income every year to corporations that maneuver to hide profits from taxation. Professor of Accounting David Harris and colleagues address this timely real-world problem in a paper recently published in the Journal of International Accounting Research. 

Co-authors Harris; Chao Chen ’16 M.S., ’16 Ph.D., developer at Salesforce; Linna Shi ’11 Ph.D., professor of accounting; and Nan Zhou, professor of accounting, both at the University of Cincinnati, focus on two issues. First, they examine whether multinational corporations shift U.S. income to their subsidiary corporations in tax haven countries. Second, they investigate whether this problem has been exacerbated by the growth of e-commerce. With their enhanced communication, automation, and remote supervision, internet businesses do not require the same kinds of staffed physical locations as mailbox companies of the past. 

The researchers created a mathematical model of the costs and benefits of such tax avoidance and studied how profitable and extensive it may become as the costs of this strategy go down.  

Each tiny tax haven company can only absorb a small amount of shifted profit before attracting too much notice from the IRS. Harris and his co-authors found that the more income a corporation shifted abroad, the more subsidiaries it had. Enron, for one, held more than 700 companies in the Grand Caymans but only some 240 in the U.K., with its higher taxes. 

“What are they doing with 700 subsidiaries in a tax haven where they can't do any real business?” Harris said. “We show that they're basically manipulating income and shifting it to a tax haven where they don't pay taxes.” 

The researchers did this by analyzing the extent to which the number of subsidiaries is associated with a decrease in U.S. reported income and an increase in foreign income. “Money is leaving the U.S., and approximately the same amount is showing up overseas,” Harris said. “It’s basically a zero-sum transaction.” 

As predicted, the ease of running e-commerce businesses led to a greater number of such operations and associated tax avoidance. An estimated $12 million per company, per year are flowing to foreign countries, for a total of at least $34 billion a year for the study’s sample. 

In follow-up research, Harris, Shi, and Jiahui Han, a current accounting Ph.D. student at Whitman, are considering the personal roles of U.S. corporate executives in income shifting to tax havens and whether and how much they are paid for implementing such “tax saving” income manipulations. 

Chen, C., Harris, D.G., Shi, L. and Zhou, N. “A Transaction Cost Model of Tax-Motivated Income Shifting into Dot-Sized Tax Havens and an Empirical Examination of E-Commerce Effects,” Journal of International Accounting Research, 2024.