Territorial Tax Reform and Profit Shifting by US and Japanese Multinationals

Abstract

In 2009, Japan began to exempt dividends paid by Japanese-owned foreign subsidiaries to their parent firms from home-country taxation. This tax reform switched Japan's corporate tax system to a territorial tax system that exempts foreign income from home-country taxation. In this paper, I examine the impact of the territorial tax reform on the profit-shifting behavior of Japanese multinationals. I analyze the change in the sensitivity of the reported profits of Japanese-owned foreign subsidiaries to host countries' corporate income tax rates after the tax reform, using US-owned foreign subsidiaries as a comparison group. I find that, on average, the profits of US-owned foreign subsidiaries are more sensitive to host countries' tax rates than are those of Japanese-owned foreign subsidiaries over the whole study period from 2004 to 2016 and over the subperiod from 2004 to 2007, when both countries used the worldwide tax system. However, the sensitivity of the pre-tax profits of Japanese-owned foreign subsidiaries, particularly large subsidiaries, to host countries' corporate tax rates significantly increased from 2008 to 2012 in response to the 2008 announcement of the implementation of the territorial tax regime, relative to that of the US-owned foreign subsidiaries. This suggests that the introduction of the territorial tax system encouraged profit shifting by Japanese multinationals.