In a new paper, we examine the extent to which cross-border M&A is influenced by tax avoidance motives and quantify the resulting tax savings.
Firms employ tax avoidance strategies like profit shifting or the relocation of their tax residence to minimize their global tax bill. For example, let’s say a firm has operations in a tax-haven like Ireland and a non-haven like the UK, with 10 percent of its sales attributable to its operations in Ireland and 90 percent to its UK operations. Given the differences in corporate tax rates – 12.5 percent in Ireland and 25 percent in the UK, such a firm would have an incentive to shift some of its UK profits to Ireland. These activities are conducted on a large scale, with estimates of the total amount of corporate tax avoidance ranging from $212 billion (Tørsløv et al., 2022) to $600 billion (Crivelli et al., 2015). Moreover, Tørsløv et al. (2022) document that 36 percent of multinational profits are shifted to tax havens globally. As such, it seems likely that tax avoidance motives might affect corporate policies that traditionally have been outside the scope of public economics, such as M&A.
In our paper, we examine 13,307 tax-haven M&A deals worth $4.1 trillion from 1990-2017. These are deals where the acquirer or target is tax resident in a tax haven. Given the stark differences in GDP, we distinguish between the five large havens (Hong Kong, Ireland, the Netherlands, Singapore, and Switzerland) and the remaining small havens (e.g., Bermuda or the Cayman Islands). Our analysis is more comprehensive than other studies for two reasons. First, we include deals involving small havens, which many other studies ignore. In addition, we utilize novel tax-residence data from Meier and Smith (2023), which results in more firms that are haven residents and thus more haven M&A deals.
Summary statistics alone suggest that cross-border M&A involving tax havens are significant. For a non-haven country, the ratio of domestic deal value to cross-border deal value is 2:1. For a large tax haven, this ratio is 1:3, and for a small haven, it is 1:12.
To quantify the extent to which cross-border M&A activity in havens is “abnormal,” we run an econometric specification that estimates how much M&A volume is attributable to tax havens given their tax status compared with what would be predicted based on non-tax factors. Specifically, we estimate a gravity model following Silva and Tenreyro (2006) on a country-pair level panel. The dependent variable is the amount of deal value in a given year between an acquirer and target country. The independent variables of interest are tax haven dummies, and the control variables are factors known to affect the flow of M&A across countries, including GDP, GDP per capita, and geographic proximity. The results are striking; country pairs with a large- (small-) haven acquiror have 112 percent (508 percent) more deal value than predicted based on non-tax factors, and country pairs with a large- (small-) haven target have 66 percent (344 percent) more deal value. The corresponding total abnormal dollar values are $1,536 and $826 billion for large and small havens, respectively, resulting in a total of $2.4 trillion.
Next, we estimate the tax savings from these deals. There are two ways that a deal can result in tax savings, depending on whether the acquirer or target is resident in a haven. We refer to deals when the target is in a haven as “haven purchases.” Establishing a presence in a haven through a haven purchase facilitates tax avoidance strategies like profit shifting or the relocation of the firm’s tax residence. Deals when the acquirer is in a haven and the target is in a non-haven are referred to as “asset building deals.” Expanding once located in a tax haven grows the asset base subject to lower taxes. Using estimates from a firm-year panel regression, we find significant tax savings from haven purchases. For example, for a U.S. firm with no prior cross-border, large-haven M&A history, buying an Irish firm worth 5 percent of its total assets would reduce its cash effective tax rate by 3.32 percentage points. Aggregating across all firms, the total annual dollar amount of savings from haven purchases is $20.2 billion. Asset building results in further savings of $10.6 billion, bringing the total amount of tax savings from tax-haven M&A to $30.7 billion per year.
To assess the validity of our tax savings estimates, we run an M&A event study where we correlate the market response to the deal on our measure of projected tax savings. The results indicate that savings equivalent to a one percentage point drop in the acquirer’s effective tax rate is associated with a 0.30 percentage points higher cumulative announcement return. This shows that the market responds positively to our measure of projected tax savings, which gives us confidence in our approach.
We also look into channels underlying our results. First, we find that the tax savings from haven purchases are stronger when the target is in the pharmaceutical industry. This makes sense given that the pharmaceutical industry is a heavy user of patents, and transfer pricing on intellectual property such as patents is a well-known tax avoidance strategy (Hebous and Johannesen, 2021). This is consistent with the idea that one of the ways haven purchases facilitate tax avoidance is through transfer pricing.
The relocation of the firm’s tax residence is another tax avoidance strategy that M&A facilitates. Specifically, we document that firms are more likely to relocate their tax residence to tax havens following small- and large-haven acquisitions.
Based on our findings, we interpret tax haven M&A as a facilitator of established tax avoidance techniques, such as inversions and transfer pricing on intellectual property.
We address a number of alternative explanations. First, we examine a 2004 U.S. tax-law change that made it more difficult for U.S. firms to move their tax residence abroad and find resultant changes in M&A flows consistent with tax-avoidance motives. We also rule out the concern that a majority of the haven M&A deal value is driven by shell companies in havens. The results in the paper are driven by firms that are tax resident in havens due to having headquarters in havens, as opposed to just being incorporated there. The results are also not explained by firms seeking the secrecy and anonymity offered by havens. Tax avoidance is legal, so firms are not using haven M&A for this purpose. Lastly, the results are robust in various subsamples and to the inclusion of numerous controls.
Overall, our results show that tax avoidance is an important determinant of cross-border M&A. We are the first to document that havens affect the actual ownership of assets on a large scale and not just on paper. Moreover, the novel tax-residence data and extensive manual-data work results in a much larger and more complete sample of haven M&A than in prior work, allowing us to more accurately assess the magnitude of abnormal deal activity and the resulting tax savings. We expect this analysis to be of interest to policy makers trying to increase taxes paid by multinationals, including the recent OECD initiative to institute a global minimum tax.
Crivelli, E., R. D. Mooij, and M. Keen (2015). Base Erosion, Profit Shifting and Developing Countries. Working Paper.
Hebous, S. and N. Johannesen (2021). At your service! The role of tax havens in international trade with services. European Economic Review 135, 103737.
Meier, J.-M. and J. Smith (2023). Improving the Measurement of Tax Residence: Implications for Research on Corporate Taxation. Working Paper.
Silva, J. S. and S. Tenreyro (2006). The Log of Gravity. Review of Economics and Statistics 88(4), 641–658.
Tørsløv, T. R., L. S. Wier, and G. Zucman (2022). The Missing Profits of Nations. Review of Economic Studies. Forthcoming.
This post comes to us from Professor Jean-Marie Meier at The Wharton School of the University of Pennsylvania and the University of Texas at Dallas’ Naveen Jindal School of Management and from Jake Smith at the U.S. Securities and Exchange Commission. It is based on their recent paper, “Tax Avoidance through Cross-Border Mergers and Acquisitions,” available here. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or commissioner. This article expresses the authors’ views and does not necessarily reflect those of the commission, the commissioners, or other members of the staff.