How Companies Worked Around a Law Aimed at Keeping U.S. Tax Dollars from Going Overseas

Legislation aimed at preventing large companies from avoiding U.S. taxes by shuttling money to foreign subsidiaries hasn’t worked as well as anticipated. A new study reveals how companies are responding to the provisions – and the potential costs associated with their tax avoidance strategy.

The Tax Cuts and Jobs Act, which went into effect in 2018, included base erosion and anti-abuse tax (BEAT) provisions designed to discourage companies from circumventing U.S. tax law. Historically, some companies have created subsidiaries outside the U.S. in countries that had lower tax rates. And doing business with those subsidiaries has the effect of allowing the parent companies to avoid higher U.S. taxation. The BEAT provisions – which apply only to large companies – essentially disincentivize this loophole by adding an additional surtax to payments companies make to foreign subsidiaries.

However, actual BEAT tax collections have been less than half of what was predicted. Why?

“One way a company can potentially avoid the BEAT provisions and reduce its tax liability is by reclassifying the payments it makes to foreign subsidiaries,” says Christina Lewellen, co-author of a paper on the work and an associate professor of accounting in North Carolina State University’s Poole College of Management. “For example, one type of payment not subject to the BEAT provisions is classified under the category of ‘cost of goods sold.’”

Cost of goods sold is a broad category that covers the overall costs attributable to the production of the goods or services a company sells. Cost of goods sold includes direct costs, such as the cost of feedstock used in manufacturing. But it also includes indirect costs, such as product design, management, and sales and marketing services.

“If a company says that the payments it makes to a foreign subsidiary are for services covered under cost of goods sold, it can avoid the BEAT provisions,” Lewellen says. “That raises two questions.

“First, are companies actually reclassifying payments to foreign subsidiaries as cost of goods sold? Second, if companies are reclassifying these payments to subsidiaries, how is that affecting the companies?”

To address these questions, the researchers looked at data from 24,982 foreign subsidiaries incorporated in 48 countries. Only 9,944 of those subsidiaries are subsidiaries of companies that are subject to the BEAT provisions, with the remainder serving as a control group. Specifically, the researchers looked at financial data for those subsidiaries from 2011 through 2018 – the seven years prior to the implementation of the BEAT provisions, and the year the BEAT provisions took effect.

“Companies don’t disclose a detailed breakdown of how they distribute their cost of goods sold, so we had to identify a proxy that would give us a clear idea of whether companies were shifting some cost-of-goods-sold expenses to foreign subsidiaries,” Lewellen says. “One way to do this is to measure whether there was an increase in sales by foreign subsidiaries when the BEAT provisions took effect – and there was.

“On average, sales for foreign subsidiaries subject to the BEAT provisions were 6.8 percent higher than the control group in the year that the provisions took effect,” Lewellen says. “This suggests that companies were, indeed, reclassifying payments as cost of goods sold expenses in order to avoid paying the BEAT. We estimate that this reclassification allowed the companies in our sample to avoid paying approximately $6 billion in U.S. taxes.”

So why wouldn’t every company do this? Well, that’s because the researchers found that the reclassification process has costs of its own.

“For one thing, we found that the reclassification process can require a significant overhaul of the company’s internal accounting processes,” Lewellen says. “That is a significant task in itself, but modifying these processes can also result in managers across the company having to make decisions with lower quality data. This is more likely to be the case if the true cost of goods sold varies significantly from the way cost of goods sold is being reported for tax reasons.”

The researchers also found that companies whose foreign subsidiaries reported a marked increase in sales when the BEAT provisions took effect were also more likely to disclose higher levels of uncertainty about their tax positions in financial statements.

“That means those companies were required to maintain higher tax reserves in case the IRS overturns those tax positions,” Lewellen says. “It also means those companies are likely to face greater scrutiny from the IRS in the first place.”

The paper, “‘Just BEAT it’ do firms reclassify costs to avoid the base erosion and anti-abuse tax (BEAT) of the TCJA?,” is published in the Journal of Accounting and Economics. Corresponding author of the paper is Daniel Lynch of the University of Wisconsin-Madison. The paper was co-authored by Stacie Kelley at Wisconsin and David Samuel of Singapore Management University.

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Note to Editors: The study abstract follows.

“‘Just BEAT it’ do firms reclassify costs to avoid the base erosion and anti-abuse tax (BEAT) of the TCJA?”

Authors: Stacie O. Kelley and Daniel P. Lynch, University of Wisconsin-Madison; Christina M. Lewellen, North Carolina State University; David M.P. Samuel, Singapore Management University

Published: Nov. 9, Journal of Accounting and Economics

DOI: 10.1016/j.jacceco.2023.101648

Abstract: This study empirically examines whether firms reclassify related-party payments to avoid the base erosion and anti-abuse tax (BEAT) of the Tax Cuts and Jobs Act (TCJA). We leverage the BEAT filing threshold and use both a difference-in-differences design among U.S. firms and a triple-difference design utilizing the parent company’s location to provide evidence that firms reclassify related-party payments to avoid the BEAT. This effect is stronger in firms with greater pre-TCJA income shifting incentives. We estimate a $6 billion aggregate reduction in U.S. taxes for our sample firms in 2018. We also examine the consequences of reclassifying related-party payments and find some evidence of an increase in tax reserves and a reduction in internal information quality for firms that engage in cost reclassification to avoid the BEAT. These findings help explain observed BEAT collection shortfalls, contribute to the current policy debate about international tax reform, and document spillover effects of tax policy.

This post was originally published in NC State News.