Asymmetric Information between the Taxpayer and the Tax Authority – Income Shifting via Patents

Abstract

We examine whether, when, and to what extent asymmetric information between a multinational corporation (MNC) and the local tax authority over how to value intra-firm royalty payments facilitates tax-motivated income shifting via patents. As the value of patents is often firm specific, the local tax authority lacks information on comparable transactions when assessing an MNC's transfer-pricing strategies. Using a sample of affiliates of European MNCs and employing the relative share of patents held by an MNC as a measure, we show that tax-motivated income shifting increases in the level of asymmetric information. We also find that more external comparable information available to the local tax authority and stricter tax enforcement mitigate this relation. In contrast, more extensive transfer-pricing documentation requirements are less effective in this setting. Overall, our results suggest that the level of comparable information is an economically important determinant of tax-motivated income shifting via patents. The effectiveness of tax-policy measures in curbing income shifting critically depends on their ability to increase the set of comparable information.