In 2021, 136 nations signed a groundbreaking pact to abolish tax havens and force large multinational companies to declare their profits in the countries where they do business. The agreement, masterminded by the Organization for Economic Cooperation and Development (OECD), includes a 15 percent minimum effective corporate tax rate and would generate $150 billion annually in new taxes.
This global effort to get companies to pay their fair share of taxes has yet to be implemented. And while the deal focuses on the lengths corporations go in pursuit of lower taxes, it does not consider when companies first adopt tax avoidance strategies.
In a new paper, Rebecca Lester reveals that many U.S. companies begin complex tax planning during the IPO process, suggesting that international tax policy is focused on only one part of the corporate life cycle. “The OECD is trying to police companies when they are already public, but we also need to focus on incentives that push companies into these tax structures in the first place,” says Lester, an associate professor of accounting at Stanford Graduate School of Business and a faculty fellow at the Stanford Institute for Economic Policy Research (SIEPR).
Along with Christine L. Dobridge of the Federal Reserve Board and Andrew Whitten of the Department of the Treasury, Lester found that completing an initial public offering correlates with the implementation of strategies to shield income from high-tax countries. Around the time they go public, U.S. firms expand their presence in offshore tax havens, transfer intangible assets to foreign subsidiaries, and increase their cross-border payments to these overseas entities — moves that point toward income-shifting rather than routine intercompany transactions.
Lester and her coauthors found that private U.S. firms that complete an IPO are 57 percent more likely to own a subsidiary in a tax haven after they go public. And in the period after a stock offering, they found a doubling in the incidence of cost-sharing agreements, which enable firms to source revenues to lower-taxed jurisdictions after moving their intellectual property offshore.
IPOs trigger tax avoidance largely because they increase the scrutiny companies face from capital markets, including prospective shareholders. More disclosure, in turn, pushes soon-to-be public firms to ramp up their tax-planning strategies to align with other public corporations. “Companies are responding to capital market pressures for tax avoidance,” Lester says.
“It’s also a revelation of information about the value of assets which pushes companies to implement these tax-planning strategies,” she says. “When a company is private, it doesn’t have a sense of what their assets are worth, beyond some signals from private equity or venture capital investors.”
Assets on the Move
Lester and her coauthors’ study sheds new light on the centrality of IPOs in corporate finance. The authors obtained confidential U.S. corporate tax returns from 1994 to 2018. They controlled for other external financing events, isolating the distinct impact of going public on tax planning.
Foreign tax planning is most common among firms that spend more on research and development and therefore have more intangible assets, which can be shifted offshore more easily. Professional tax advisors also play a key role in a firm’s decision to engage in tax avoidance. Lester’s study shows that international tax planning is greatest among companies that switch to using an experienced tax advisor in the three years leading up to an IPO.
The paper uncovered little evidence of domestic tax planning among U.S. firms. Although it found large decreases in domestic effective tax rates post-IPO, this was largely attributed to increased stock option deductions, which decrease taxable income. “They also manage the earnings upward to make the firm look better to investors. They are changing financial income, not necessarily tax income,” Lester says.
The U.S. levies an “exit tax” on companies that transfer assets offshore, based on their value. That pushes firms to strategically time asset transfers before an IPO, as a public listing makes those values known to tax collectors, and may even increase them if the stock price pops.
These findings have important implications for the current debate on international tax policy, which is reaching a fever pitch. Since foreign tax planning begins relatively early in company lifecycles, policies that target profit-shifting may be most effective if they address not only the biggest multinationals but also young, growing firms with high levels of R&D spending.
Lester says that incentives to keep intangible assets in the U.S. may be particularly effective in stemming the tide of foreign asset transfers. She cites the United Kingdom, where the “patent box” scheme enables companies to pay a lower effective corporate tax rate of 10 percent (instead of 19 percent) on profits from domestic patents. The U.S. implemented a similar policy, known as the Foreign-Derived Intangible Income incentive, in 2017.
“That seems to be exactly the type of policy that would directly motivate companies to keep their intangible assets in the U.S.,” she says.
This story was originally published by Stanford GSB Insights.