Tax Motivated Income Shifting and Korean Business Groups (Chaebol)

Abstract

This paper examines tax-induced income shifting behavior among the affiliated firms in the Korean business groups (chaebol). Korean corporate income tax law does not require consolidated tax returns, and business groups with a large number of affiliated member firms have incentives to shift income across member firms to reduce overall taxes of the group. Korean chaebols provide a good experimental setting to explore within-jurisdictional income shifting because, under the peculiar governance structure of chaebol firms, business decisions for each affiliated firm are coordinated by the controlling owner-manager of the group, so a coordinated strategy among the affiliated firms can be utilized to reduce overall tax burdens for the group as a whole. For a large number of Korean companies that are subject to external audits, we perform univariate and multivariate regression analyses on income shifting behavior of chaebol firms compared with non-chaebol control firms. Our evidence supports tax-motivated income shifting activities of chaebol firms. The extent of income shifting is found to depend on its effect on nontax cost factors such as earnings, leverage, and cash flow rights of the controlling shareholders. We also find that income shifting occurs mainly through operating rather than nonoperating income, suggesting that transfer pricing could be a likely channel for income shifting. Furthermore, we do not find much difference in income shifting activities across chaebol groups, and the endogeneity test supports the chaebol's income shifting activities even after controlling for the variables endogenous to the chaebol affiliation. Our study provides some insights on the within-jurisdictional income shifting activities where research is limited.