Income Shifting, Ownership, and R&D Density of Japanese Multinationals

Most countries scrutinize their taxation systems in order to prevent the leakages in their tax revenue from multinationals. Tax authorities depend on transfer pricing methods which help in deterring transfer pricing manipulations by multinationals intracompany transactions. In practice, the pricing methods are based on number of economical ratios of profits of comparable transactions of unrelated parties. However, tax authorities lack of ability in detecting the true market price of multinationals internal trade transactions (e.g., R&D, patents, royalties and services) is acquaint in transfer pricing literature. We analyze the impact of the tax rate differential and R&D expenditures, which are mainly driven by the high tax rate in the home country, on the income shifting activities. The empirical investigation is carried out by exploiting firm-level data on Japanese foreign direct investment activities during the period 2000 to 2009. The results infer that Japanese wholly owned multinationals with high R&D programs are more responsive to income shifting since their traded transactions are group-specific, unperceived and precisely incalculable by tax authorities. Moreover, the wholly owned affiliates of Japanese parent companies which employ low R&D expenditures and are located in high tax jurisdictions, are more sensitive to host countries’ corporate income tax rates.