Income Shifting and Management Incentives

Abstract

The tax literature shows that income shifting within multinational enterprises collides with optimal incentivization of managers in subsidiaries. The different modes of income shifting have received different attention, however, and the incentive implications of internal debt shifting have not yet been investigated. We analyze the different impacts of tax—efficiently setting intercompany prices for the use of intangibles (royalties) and debt shifting on incentivization of affiliate managers. Different from most other studies, we focus on endogenous, unobservable managerial effort and the firm's optimal design of the (linear) compensation contract. For EBIT(DA) as performance measure, we find that internal debt shifting does not have a direct effect on management incentives, but has an ambiguous indirect effect via its positive effect on investment. In contrast, tax—motivated royalty payments have a clearly negative incentive effect that is fully offset, however, by an higher compensation rate. Hence, the adjustment of the compensation payment reveals the firm's aggressiveness in income shifting via intangibles. There is no confounding indirect effect from tax—motivated royalty payments because these royalty payments do not affect investment.