Talk softly but carry a big stick: transfer pricing
penalties and the market valuation of Japanese
multinationals in the United States
Lorraine Eden
1
, Luis F Juarez
Valdez
2
and Dan Li
1
1
Department of Management, Texas A&M
University, College Station, TX, USA;
2
Department of Accounting and Finance,
Universidad de las Americas-Puebla, Cholula,
Mexico
Correspondence:
Professor L Eden, Department of
Management, Texas A&M University,
4221 TAMU, College Station,
TX 77843-4221, USA.
Tel: þ 1 979 862 4053;
Fax: þ 1 979 845 9641;
Received: 12 February 2004
Revised: 1 September 2004
Accepted: 4 October 2004
Online publication date: 19 May 2005
Abstract
Corporate income tax law in OECD countries requires multinational enterprises
(MNEs) to set their transfer prices according to the arm’s length standard. In
1990 the United States (US) government introduced a transfer pricing penalty
for cases where MNEs deviated substantially from this standard. More than two
dozen other governments have followed suit. Our paper uses event study
methodology to assess the impact of the US transfer pricing penalty on the
stock market valuation of Japanese MNEs with US subsidiaries in the 1990s. We
find that the penalty caused a drop in their cumulative market value of $56.1
billion, representing 12.6% of their 1997 market value.
Journal of International Business Studies (2005) 36, 398414.
doi:10.1057/palgrave.jibs.8400141
Keywords: transfer pricing; tax penalty; event study; market value; ADR; Japanese
multinationals; IRS
Introduction
Nobody wants to pay taxes. No wonder, then, that so many companies spend so
much effort trying to avoid them. Almost every big corporate scandal of recent
years, from Enron to Parmalat, has involved tax-dodging in one form or
another. (The Economist, 2004, 71)
Corporate income tax law in all OECD countries requires multi-
national enterprises (MNEs) to set their transfer prices according to
the arm’s length standard; that is, the external market or arm’s
length price that two unrelated firms would set for the same or
similar product traded under the same or similar circumstances, as
the product traded within the MNE (Eden, 1998, 2001). In 1990,
the United States (US) government introduced a transfer pricing
penalty Internal Revenue Code y6662 for cases where MNEs
engage in transfer price manipulation (TPM), setting a transfer
price that deviates significantly from the arm’s length price. The US
Congress approved the y6662 penalty partly in response to the
widespread perception that foreign-owned, particularly Japanese,
MNEs were paying little US tax (Inoue, 1990).
When first introduced, the penalty was broadly condemned by
other OECD tax authorities, but over the past few years the policy
has begun to spread. Ernst & Young (2004), for example, document
the international tax policies of 46 countries in 2003; 27 of the
Journal of International Business Studies (2005) 36, 398414
&
2005 Academy of International Business All rights reserved 0047-2506 $30.00
www.jibs.net
countries now have explicit transfer pricing penalty
legislation modeled on the US legislation.
How important an issue is transfer pricing? In
Ernst & Young’s (2003, 7) most recent global
transfer pricing survey, 86% of MNE parent and
93% of subsidiary respondents stated that transfer
pricing was the most important international tax
issue they currently face. The respondents noted
that almost half their MNEs had been audited since
1999, and two-thirds expected to be audited within
the next 2 years (Ernst & Young, 2003, 10). Of the
MNEs that had been audited, one-third of the
audits concluded with an adjustment (that is, the
MNE owed more tax to the national tax authority).
Tax penalties were threatened in one-third of these
cases and actually imposed in one-sixth of them
(Ernst & Young, 2003, 7). To quote Ernst & Young
(2003, 15): ‘If an MNE is subject to an adjustment as
the result of a transfer pricing examination, there is
almost a one-in-three chance of being threatened
with a penalty, and a one-in-seven chance of
actually having one imposed.’
Global dollar estimates for TPM are hard to come
by. The US Department of the Treasury (1999, 3)
estimated the annual loss in US income tax revenue
due to TPM at $2.8 billion. Manufacturing
accounted for one-half the estimated tax loss,
followed by wholesale and retail trade; over half
the estimated loss came, not surprisingly, from
large corporations (US Department of the Treasury,
1999, 13). In terms of actual, not estimated, tax
dollars, in fiscal year 2002, the US Internal Revenue
Service (IRS) recommended $5.56 billion in transfer
pricing adjustments (that is, additional income tax
owed by the MNEs) and spent $15 million on direct
examination costs (US Department of the Treasury,
2003, 10). Estimates of the impacts of the transfer
pricing penalty are not available, but a recent IRS
survey revealed that 31% of US MNEs were spend-
ing between $100,000 and $1 million dollars
annually preparing the contemporaneous transfer
pricing documentation required as a precondition
to avoid being hit by the y6662 penalty (US
Department of the Treasury, 2003). Moreover, even
the threat of transfer pricing adjustments and
penalties can affect a multinational’s market valua-
tion. Swatch, for example, saw its stock price drop
by 11% on the Zurich stock exchange when two
employees claimed to the US Labor Department
that the Swiss MNE had used transfer price
manipulation through its British Virgin Islands
subsidiary to evade millions of dollars in taxes
(Lopez, 2004).
These numbers suggest that both the threat and
the reality of transfer pricing penalties should
affect the strategies and market valuation of
MNEs. The purpose of our paper is to address
exactly that question: How do transfer pricing
penalties affect the behavior and profits of multi-
nationals? We develop a theoretical model analyz-
ing the penalty’s impact on MNE after-tax profits.
We hypothesize that MNEs that engage in TPM
should respond to the transfer pricing penalty
either by continuing their existing pricing policies
(and therefore risking being hit with the penalty),
or by setting government-approved arm’s length
prices (and therefore paying more income taxes).
We outline the circumstances under which MNEs
would choose one or the other of these alternatives.
In either case, the MNE’s cash flows should fall,
having a negative impact on the firm’s stock market
valuation.
We test our model using an event study of the
stock market prices of American Depository
Receipts (ADRs) of all Japanese multinationals with
US subsidiaries over the 1990s. A brief history of the
US transfer pricing penalty legislative process from
1989 to the present is used to isolate the critical
dates for our event study. We follow the rigorous
research methodology design for event studies laid
out in MacKinlay (1997), McWilliams and Siegel
(1997) and McWilliams et al. (1999).
Our results show a strong negative reaction to the
penalty for Japanese stock market returns in the US,
providing support for our theoretical model, even
though there has been only one major penalty case
to date. We estimate the impact of the y6662
legislation on the market value of the Japanese
ADRs between 1990 and 1997 to be a cumulative
loss of $56.1 billion (an average $7 billion dollars
per year), which is 12.6% of the ADRs’ market value
at the end of the period. This drop in market value
can be compared with US Treasury estimates,
mentioned above, of $2.8 billion in annual forgone
tax revenues due to TPM and $5.56 billion in
recommended tax adjustments in 2002. Thus, the
market value impact on Japanese MNEs alone
appears to be larger than the US Treasury’s esti-
mates of forgone tax revenues.
We therefore conclude that the transfer pricing
penalty and even the threat of the penalty can
be punitive for targeted firms. The penalty dis-
courages transfer price manipulation and reduces
the MNEs’ market value. Talking softly but carrying
a big stick does encourage tax compliance, albeit at
a very high cost in terms of lost market value.
Talk softly but carry a big stick Lorraine Eden et al
399
Journal of International Business Studies
Literature review
Economic theory suggests that MNEs will maximize
global after-tax profits by shifting revenues to low-
tax, and deductions to high-tax, jurisdictions
(Horst, 1971). Manipulation of transfer prices is
widely believed to be the primary route for such
income shifting. There has been a large theoretical
literature on transfer pricing responses to income
tax differentials (Horst, 1971; Halperin and Srinid-
hi, 1987; Eden, 1998). Empirical studies by Grubert
et al. (1993), Harris (1993), Harris et al. (1993),
Klassen et al. (1993), Jacob (1996), Clausing (1998)
and Collins et al. (1998), among others, suggest that
high tax rates negatively affect volume and location
of foreign direct investment (FDI), and encourage
aggressive transfer pricing techniques. Hines (1999,
318) concludes that international tax avoidance is a
‘successful activity’, limited only by ‘available
opportunities and the enforcement activities of
governments’.
Most of the empirical work on this topic has been
macroeconomic in nature, using US foreign direct
investment data. An alternative approach is to
analyze the impact of tax policy changes on stock
market prices, using event study methodology.
Schipper et al. (1987), Cornett and Tehranian
(1990), Malatesta and Thompson (1993), Barth
et al. (1995) and Harper and Huth (1997), for
example, measure the impacts of government tax
and regulatory changes on firms’ abnormal returns.
As policy changes typically provide many possible
event dates, it is critical to select those dates that (i)
provide major new information and (ii) are unanti-
cipated by the markets.
Three recent surveys of event study research
(MacKinlay, 1997; McWilliams and Siegel, 1997;
McWilliams et al., 1999) argue that past researchers
often paid inadequate attention to theory and
research design issues, leading to spurious, overly
optimistic results. The authors outline the
necessary components of a ‘good’ event study
design. In our paper, we follow the steps outlined
by these authors, using event study methodology to
provide an ‘inverse test’ of transfer price manipula-
tion.
If foreign MNEs did manipulate transfer prices in
order to artificially shift profits out of the US, then
introduction of the penalty should reduce their
incentive to manipulate transfer prices, causing a
drop in cash flows and generating negative cumu-
lative average returns (CARs). We therefore expect
the market valuation of foreign MNEs with US
subsidiaries to fall in response to the introduction
of penalty legislation, and to fall furthest for
those MNEs using aggressive transfer pricing tech-
niques.
Theory development
We hypothesize that a transfer pricing penalty has
two key effects: a direct effect and an indirect effect.
The first effect is the penalty itself, which is an
extra, nondeductible tax levied as some percentage
a of the MNE’s profits. The penalty is not auto-
matic, but depends on the extent of TPM as defined
by the tax authority: that is, by the gap between the
MNE’s transfer price p and the tax authority’s arm’s
length transfer price W
ˆ
, multiplied by the volume
of intrafirm trade X. The regulated transfer price, in
practice, is not a single price but an arm’s length
range; however, in the interests of simplicity, we
assume W
ˆ
is a fixed price.
The penalty is levied on top of the corporate
income tax rate t on the MNE’s profits. There is
some probability U of a penalty being levied: the
larger the extent of TPM, the more likely the
assessment of a penalty. For simplicity, assume the
penalty is triggered by a transfer pricing gap that
exceeds some known percentage k of the arm’s
length price W
ˆ
. The transfer pricing penalty T is
therefore
T ¼ Fatðp
^
WÞX ð1Þ
which is positive if U40 and (pW
ˆ
)XkW
ˆ
, and zero
if U¼0orif(pW
ˆ
) okW
ˆ
. Equation (1) suggests that
the penalty will be larger, the higher the probability
of assessment U, the higher the penalty tax rate a
and corporate income tax rate t, the greater the
degree of transfer price manipulation (pW
ˆ
), and
the larger the volume of intrafirm trade X.
Second, if a penalty is assessed, the tax authority
replaces the MNE’s transfer price p with the arm’s
length price W
ˆ
and restates the MNE’s profits with
the new transfer price.
1
The indirect effect of the
penalty is the reassessment of income tax based on
substituting the arm’s length price W
ˆ
for the MNE’s
transfer price p. The indirect effect also depends
positively upon U, t and X.
Where the MNE’s chosen transfer price p differs
from the regulated price W
ˆ
, the MNE pays an
additional tax if the tax authority audits the MNE
and finds that the transfer pricing differential
exceeds the minimum allowable gap. By staying
inside the arm’s length range set by the tax
authority, the MNE avoids the penalty but reduces
its profits from manipulating the transfer price.
Talk softly but carry a big stick Lorraine Eden et al
400
Journal of International Business Studies
Thus, the penalty reduces the MNE’s marginal after-
tax profitability. Our first hypothesis therefore is:
H1: The transfer pricing penalty reduces the net
profitability of the MNE.
In the absence of the penalty, the MNE would
simply overinvoice its transfer price whenever the
US corporate income tax rate was higher than
the foreign tax rate. With the penalty, however, the
incentive to manipulate the transfer price is
reduced for two reasons. First, as U rises, the MNE
is less willing to take chances with its transfer
pricing policy. Second, the higher the penalty
rate a the less likely the MNE is to overinvoice
because the cost of the penalty rises. In effect, the
MNE balances the tax-saving gains from transfer
price manipulation against the probability and
size of the penalty. The penalty provides an
additional constraint on the MNE’s transfer
pricing range, reducing its overall net profitability
from transfer price manipulation. Our second
hypothesis is:
H2: The higher the probability of penalty assess-
ment and/or the higher the penalty rate, the less
likely is the MNE to engage in transfer price
manipulation.
There is a third effect to the transfer pricing
penalty. Most tax authorities also require the MNE
to contemporaneously collect transfer pricing
documents, in both primary and secondary forms,
and to make these available to the tax authority on
request. Contemporaneous documentation is a
necessary, but not sufficient, condition to avoid
the penalty. Therefore, there are administrative
costs attached to the penalty regulations, which
should be included in a full model.
2
Let C
D
represent the administrative costs of complying
with the penalty regulations, and assume C
D
is
negatively related to the probability of the
penalty. The MNE’s optimal transfer price is now
affected because documentation reduces the
probability of the penalty being levied, all other
things being equal, and thus permits a higher
transfer price: that is, documentation reduces
the likely penalty costs and encourages greater
transfer price manipulation. This suggests our third
hypothesis:
H3: Because contemporaneous documentation
reduces the probability of a tax penalty, it has the
unintended consequence of encouraging transfer
price manipulation.
A brief history of the y6662 transfer pricing
penalty
Tax penalties have been part of the US income tax
code for many years, but they were aimed at severe
cases of tax evasion, and were seldom levied.
Congress, cognizant of the IRS’s apparent reluc-
tance to levy tax penalties, consolidated all the
different penalties on 19 December 1989 into
y6662. In 1990 the US government introduced
added an accuracy-related penalty for cases where
the MNE’s transfer prices deviated significantly
from IRS-approved arm’s length transfer price.
3
The transfer pricing penalty was introduced for
two reasons. The first rationale was IRS experience
in transfer pricing audits (Lowell et al., 1994, 352).
The Service had found that most taxpayers had no
documentation, and were unable to explain their
transfer prices at the time of an audit, causing
increased time and costs for the Service. The IRS
believed that taxpayer compliance would improve
if an inaccuracy penalty were introduced.
4
A second reason was the widespread perception
that foreign MNEs were underpaying their US taxes.
The Wall Street Journal (Wall Street Journal,
20
February 1990) interviewed an IRS official who
noted that, while inward FDI and sales revenues
had surged in the 1980s, US tax payments by
foreign-owned subsidiaries had not grown (Stout,
1990). (Underlined events are considered signifi-
cant and tested in the event study below.) He also
noted that more than 36,000 foreign-owned com-
panies filing US tax returns reported negative
taxable income, and that the IRS was stepping up
its surveillance of foreign-owned MNEs. This was
documented on
10 July 1990, when the US Ways
and Means Committee conducted hearings (known
as the Pickle hearings after its chair) into tax
compliance by foreign subsidiaries in the US. An
IRS report, based on an investigation of 36 large
foreign-owned subsidiaries, concluded that most
had paid little or no US taxes over a 10-year period
(Heck, 1990; Inoue, 1990). About half the subsidi-
aries had Japanese parents. The study concluded
that inflated transfer prices for goods purchased
from foreign parents and the performance of
functions not fully charged to foreign parents were
the main causes for the low US taxes. A former US
Treasury official was quoted as saying, ‘For most
Japanese firms operating in the US, it’s a question of
when, not if, they’ll be audited and investigated by
the IRS’ (Inoue, 1990).
These events provided support for congressional
critics who contended that foreign firms were
Talk softly but carry a big stick Lorraine Eden et al
401
Journal of International Business Studies
manipulating their books to avoid paying US tax.
As a result, Congress developed legislation for a
new transfer pricing penalty (Schmedel, 1990). On
5 November 1990, as part of the Revenue Reconci-
liation Act, y6662(e) was added to the Income Tax
Code, creating a penalty for transfer pricing mis-
valuations. The 1990 legislation differentiated
between a substantial valuation misstatement
(SVM) and a gross valuation misstatement (GVM).
With a US federal tax rate of 34%, the penalty raised
the effective US tax rate to 41% for an SVM
(1.2 34) or 48% for a GVM (1.4 34). An escape
clause from the penalty was provided in y6664(c),
requiring the taxpayer to show that there was
reasonable cause for the underpayment and that
the taxpayer had acted in good faith with respect to
the transfer price. As part of RRA ‘90, Congress
directed the IRS to develop regulations to imple-
ment the y6662 legislation.
The IRS issued its first tax penalty regulations,
covering everything but the transfer pricing penalty
on
4 March 1991, with essentially unchanged final
regulations issued on 30 December 1991. However,
it took the IRS until
13 January 1993 to prepare
and release its proposed transfer pricing penalty
regulations for y6662(e).
5
Issued along with the
revised y482 temporary transfer pricing regulations,
the penalty caused immediate controversy among
US and foreign transfer pricing professionals. The
most controversial issue was the ‘reasonable cause
and good faith’ exemption in y 6664(c). To qualify
for the exemption, the taxpayer had to meet two
tests: (i) contemporaneously document the transfer
pricing methodology by the time taxes were filed,
and provide the documentation to the IRS within
30 days of a request; and (ii) prove that the transfer
pricing result, more likely than not, would be
sustained on its merits in a transfer pricing audit.
6
On 2 February 1994, the IRS issued temporary
y6662 regulations to take into account the changes
introduced by RRA ‘93. The changes tightened the
rules, introducing two classifications of documents
(principal and background) required for contem-
poraneous documentation, and requiring the tax-
payer to use a transfer pricing methodology that
met the best method test of y482. On
17 March
1994, the temporary regulations were amended to
raise the disclosure standard from ‘not frivolous’ to
‘reasonable basis’, as required in RRA ‘93. On
8 July
1994 the y6662 regulations were updated to con-
form to the IRS final y482 regulations. The key
change was to provide a complete list of all the
principal and supporting documents required for
contemporaneous documentation. This was the last
major change in the y6662 regulations.
7
The IRS
formalized the penalty process by establishing a
penalty oversight committee to ensure uniform
application of y6662, on
11 March 1996.
The first y6662 non-transfer pricing penalty
(company unnamed) under the pre-1994 rules was
announced by the IRS at a conference on 8 June
1996. The first transfer pricing penalty was
announced on
17 September 1997. The one, major
transfer pricing penalty case to date has been DHL,
8
filed on 30 December 1998, where the US Tax
Court levied a 40% penalty for the undervaluation
of DHLs sale of its trademark to a foreign related
corporation, and a 20% penalty for failing to charge
for the use of its trademark in earlier years. The
total amount of y 6662 penalties was $162.5 mil-
lion.
9
Thus, nine years elapsed between December
1989, when Congress first consolidated the tax
penalties into y6662, and December 1998 when the
first significant transfer pricing penalty was upheld
in Tax Court. Since that time there have been no
publicly discussed, major transfer pricing penalties
announced by the IRS. Our historical analysis
therefore stops with the DHL case.
Data and methods
As our historical review shows, Japanese MNEs were
perceived by the IRS and US Congress to be the
most serious tax underpayers in the 1990s.
10
Japanese firms were targeted in the Pickle hearings
in 1990. Hufbauer and van Rooij (1992, 116–117)
calculated that the 1990 net return on sales in the
US was 3.4% for US MNEs, but only 0.1% for
Japanese MNEs. Eden (1998, 373) reported an
operating profit to gross income ratio of 7.1% for
US majority-owned foreign affiliates in Japan
compared with 0.2% for Japanese affiliates in
the US. In the early 1990s, the IRS launched several
transfer pricing cases against Japanese MNEs in the
US, including Epson, Fujitsu, Hitachi, NEC, Nissan,
and Yamaha (Borkowski, 1997, 31). Therefore, we
expect that, even though the transfer pricing
penalty should have negatively affected all foreign
MNEs with cross-border intrafirm trade, the penalty
should have most strongly and negatively affected
the stock market prices of Japanese MNEs with US
affiliates because the y6662 legislation was targeted
primarily at these MNEs.
Japanese MNEs with US affiliates over the 1990s
are therefore selected as the appropriate sample for
testing our hypotheses. We collected data on the
ADRs of all the Japanese MNEs with US affiliates
Talk softly but carry a big stick Lorraine Eden et al
402
Journal of International Business Studies
over this period. The ADRs must have been listed
on the NYSE and NASDAQ stock markets for a
minimum of 255 days between 1989 and 1999. In
all, 24 Japanese MNEs met these criteria and were
included in our study. They are listed in Table 1.
Using Eventus version 6.2 and CRSP data, we
employ event study methodology to test whether
y6662 negatively affected the stock market returns
of foreign MNEs with US subsidiaries, using the 10
underlined dates in our history section. We care-
fully checked our event windows and did not find
evidence of confounding events.
11
As outlined in McWilliams and Siegel (1997, 628),
we compute the standardized abnormal returns,
where the abnormal return is standardized by its
standard deviation.
12
The standardized returns are
then cumulated over 2-day (1, 0) and 3-day (1,
þ 1) event windows
13
to derive measures of the
cumulative abnormal return (CAR), as a percentage,
for each firm.
14
Assuming markets are efficient, the
event contains significant information that is
unanticipated, and there are no confounding
events, the test statistic Z provides a good test of
whether the CARs are statistically significant.
15
Another important issue raised by McWilliams
and Siegel (1997, 635–636) is the presence of
outliers, which are important in small samples
typical of event studies. We compute two non-
parametric tests to test for outliers: the ratio of
positive to negative returns (PRNEG), and the
binomial Z statistic, which tests whether PRNEG
is statistically significant (McWilliams and Siegel,
1997, 634–635).
The next stage of our research design, following
McWilliams and Siegel (1997), tests our hypotheses
about the time-series and cross-sectional variation
in abnormal returns using three post hoc analyses,
two tests using multiple regression techniques and
a third looking at the impact of the penalty on the
Tokyo stock market. We employ additional regres-
sion diagnostics and bootstrapping methods as
further tests for small sample bias and outliers. In
the last stage of the research design, we conclude by
estimating the cumulative wealth impact of the
transfer pricing penalty, as discussed in McWilliams
et al. (1999).
Empirical results
Event study results
Table 2 summarizes the impacts of y6662 on
Japanese MNEs’ abnormal returns for our selected
event dates. The table reports CARs, as a percen-
tage, for two windows (1, 0) and (1, þ 1), along
with their Z scores, ratio of negative to positive
returns, and binomial Z scores.
As the table shows, our event study results closely
follow their predicted signs, with the impacts being
negative and significant for almost all event dates.
In addition, both the y6662 penalty regulations
(13 January 1993, 2 February 1994) and their
accompanying contemporaneous documentation
requirements (2 February 1994, 8 July 1994) have
significant, negative impacts on CARs. This
provides empirical support for H1 (the penalty
reduces MNE profitability) and H3 (documentation
requirements reduce profitability). The policy
impacts are also larger at the beginning of the
period; as the surprise factor should deteriorate over
time, one would expect the CARs to be smaller for
later dates.
There are three anomalies where H1 is not
confirmed by the empirical results. The Pickle
hearings (10 July 1990) had no effect on CARs.
Event study methodology depends on surprise: an
event affects abnormal returns only if it is a surprise
Table 1 Japanese multinationals with ADRs and subsidiaries in
the United States, 1990–1999
No. PERMNO TICKER Company name
1 21152 CANNY Canon Inc.
2 26060 CSKKY CSK Corp.
3 28303 DAIEY Dai Ei Inc.
4 37867 FUJIY Fuji Photo Film
5 46085 IYCOY ITO Yokado Ltd
6 46309 JAPNY Japan Air Lines
7 47897 KNBWY Kirin Brewery Ltd
8 51087 MKTAY Makita Electric W
9 51131 SNE Sony Corp.
10 53727 MC Matsushita Electric
11 54579 MITSY Mitsui & Co Ltd
12 55782 NIPNY NEC Corp.
13 57681 NSANY Nissan Motors
14 59344 KUB Kubota Corp.
15 59424 PIO Pioneer Electronic
16 59555 HMC Honda Motor Ltd
17 61778 KYO Kyocera Corp.
18 64231 HIT Hitachi Limited
19 64362 TDK TDK Corp.
20 68823 SANYY Sanyo Electronic
21 75811 MBK Mitsubishi Bank
22 76428 TKIOY Tokyo Marine & Fire
23 76655 TOYOY Toyota Motor Corp.
24 81331 WACLY Wacoal Corp.
Talk softly but carry a big stick Lorraine Eden et al
403
Journal of International Business Studies
to investors. Although the hearings were widely
publicized, within the Japanese MNE community
this would not have been ‘new news’, so the lack of
market reaction is to be expected. The disclosure
standard was raised on 17 March 1994, but this
event was also either ignored or anticipated by the
market. Lastly, the DHL penalty (30 December
1998), although widely reported in the financial
press, was not reflected in CARs, presumably
because there was no surprise factor attached to
the penalty announcement.
We therefore conclude that the empirical evi-
dence provides strong support for our hypotheses.
Subgroup analysis
We now turn to the second stage of our analysis.
Following the research methodology laid out in
McWilliams and Siegel (1997), we perform three
post hoc tests to further explore the relationship
between tax penalties and MNE profits.
The first test is a subgroup analysis of all the
dates, separating our 24 Japanese MNEs into two
groups: automotive and electronics (A&E, eight
firms) and all other firms. The A&E group were
heavily targeted during the 1990 Pickle hearings as
the foreign firms most heavily engaged in transfer
price manipulation and underpayment of US taxes.
Table 2 Impact of y6662 on the abnormal returns of US ADRs by Japanese multinationals
Results Window Actual effect on CAR
Date Event Predicted
by
theory
Actual
results
(Z o5%)
CAR Z Pos:Neg Binomial Z
20 Feb 1990 IRS audits foreign MNEs for tax
underpayment.
(1,0) 2.87% 6.22*** 0:24 4.40***
(1,+1) 5.12% 9.02*** 0:24 4.4.0***
10 Jul 1990 Pickle hearings on underpayment of
US tax by foreign MNEs.
+(1,0) 0.57% 1.17 16:8 2.04*
(1,+1) 0.91% 1.48
w
18:6 2.86**
4 Mar 1991 y6662 proposed penalty regulations
issued (except for transfer pricing section).
(1,0) 4.96% 7.47*** 0:24 4.57***
(1,+1) 6.66% 8.05*** 0:24 4.57***
13 Jan 1993 y 6662 proposed transfer pricing
penalty regulations. Documentation
required for ‘reasonable cause and good
faith’ exemption.
(1,0) 1.99% 3.47*** 2:22 4.05***
(1,+1) 1.76% 2.59** 3:21 3.64***
2 Feb 1994 y6662 temporary regulations outline penalty
and documentation requirements.
(1,0) 0.19% 0.30 10:14 0.29
(1,+1) 1.87% 3.00** 6:18 1.93*
17 Mar 1994 y6662 temporary regulations raise
disclosure standard, impose cost burden.
0(1,0) 0.40% 0.71 12:12 0.56
(1,+1) 0.35% 0.67 9:15 0.68
8 Jul 1994 y6662 temporary regulations
provide documentation list, clarify
requirements.
(1,0) 1.19% 2.38** 5:19 2.50**
(1,+1) 0.57% 0.78 9:15 0.87
11 Mar 96 Transfer pricing penalty oversight
committee created to coordinate
penalties.
(1,0) 1.07% 1.81* 6:18 2.27*
(1,+1) 1.06% 1.40
w
9:15 1.05
17 Sep 1997 First y6662 transfer pricing penalty
announced.
(1,0) 1.31% 3.10*** 7:17 2.10*
(1,+1) 0.45% 1.03 10:14 0.87
30 Dec 1998 40% transfer pricing penalty against
DHL Corporation is sustained by
US Tax Court.
0(1,0) 0.25% 0.38 15:9 1.46
(1,+1) 0.04% 0.18 11:13 0.18
Asterisks show significance levels using a two-tailed test, where
w
o0.10, *o0.05, **o0.01, ***o0.001.
Talk softly but carry a big stick Lorraine Eden et al
404
Journal of International Business Studies
Therefore, these firms were the most likely targets
for y6662.
Table 3 reports CARs by subgroup for the seven
significant event dates from Table 2. Although both
groups show negative, significant Z, and binomial
Z scores for most dates, two items are noteworthy.
First, the negative CARs are larger for the non-A&E
group. Second, the A&E CARs are significant only
in the early years, whereas the non-A&E CARs are
significant in all time periods. Paired means tests of
the CARs for the two groups show significant
differences between the two groups, using either a
2-day (po0.0328) or 3-day (po0.0518) window or a
combined window (po0.0012).
The most likely explanation for the differences
between the two subgroups is the lack of policy
surprise for the A&E firms. As the A&E group has
been audited continuously since the late 1980s, and
several A&E firms were in tax court by the mid-
1990s, the penalty proposals would not have been a
surprise for these firms. The group most surprised
by y6662 should have been the non-A&E group,
which accords with our event study results in
Table 3, and our paired means comparison test. In
practice, the actual penalties levied on the A&E
group might be higher, but event study methodol-
ogy does not measure the actual income lost, only
the impact on market valuations when investors are
surprised.
Cross-section and panel data tests
Cross-section tests
Our second post hoc test examines the cross-
sectional variation in CARs within our sample. H2
suggests that the penalty should have the most
negative impact on MNE after-tax profits in cases
where the probability of the penalty is high and the
penalty is likely to be large. These two cases are
most likely where the MNE has large intrafirm sales,
is highly profitable before tax, pays little or no US
taxes, and is a member of the A&E group.
Our dependent variable is CAR3, the 3-day
cumulative abnormal returns. In the absence of
firm-level data on intrafirm sales, we use the
natural log of total sales, LNSALE, as a proxy for
intrafirm sales. LNSALE also proxies for size of the
MNE, which would accord with the hypothesis that
large MNEs are more likely to attract attention from
Table 3 Subgroup analysis of abnormal returns
Actual effect on CAR
Autos & electronics group (n¼8) All other Japanese MNEs (n¼16)
Date Event Window CAR Z Pos:Neg Binomial Z CAR Z Pos:Neg Binomial Z
20 Feb 1990 IRS audits foreign MNEs
for tax underpayment
(1,0) 2.72% 3.55*** 0:8 2.58** 2.94% 5.11*** 0:16 3.57***
(1,+1) 5.02% 5.43*** 0:8 2.58** 5.16% 7.21*** 0:16 3.57***
4 Mar 1991 y6662 proposed regulations (1,0) 4.04% 3.76*** 0:8 2.65** 5.42% 6.49*** 0:16 3.73***
(1,+1) 5.31% 3.96*** 0:8 2.65** 7.34% 7.06*** 0:16 3.73***
13 Jan 1993 y6662 proposed transfer
pricing regulations
(1,0) 1.86% 2.13* 0:8 2.77** 2.06% 2.74** 2:14 3.00**
(1,+1) 2.32% 2.03* 1:7 2.06* 1.48% 1.73* 2:14 3.00**
2 Feb 1994 y6662 temporary regulations (1,0) 0.86% 0.78 5:3 0.89 0.72% 0.92 5:11 0.99
(1,+1) 1.16% 1.23 4:4 0.18 2.23% 2.80** 2:14 2.51**
8 Jul 1994 Document list (1,0) 1.46% 1.68* 1:7 2.04* 1.06% 1.73* 4:12 1.62
w
(1, +1) 1.03% 0.98 3:5 0.63 0.34% 0.27 6:10 0.62
11 Mar 1996 Transfer pricing oversight
committee
(1,0) 0.12% 0.24 3:5 0.63 1.55% 2.05* 3:13 2.34**
(1,+1) 0.02% 0.04 5:3 0.79 1.58% 1.69* 4:12 1.84*
17 Sep 1997 First y6662 transfer pricing
penalty
(1,0) 0.39% 0.65 3:5 0.62 1.77% 3.34*** 4:12 2.13*
(1,+1) 0.27% 0.21 3:5 0.62 0.81% 1.42
w
7:9 0.63
Asterisks show significance levels using a two-tailed test, where
w
o0.10, *o0.05, **o0.01, ***o0.001.
Talk softly but carry a big stick Lorraine Eden et al
405
Journal of International Business Studies
the IRS. We expect a negative relationship between
LNSALE and CARs.
PPM, the pre-tax profit margin, and the Berry
ratio (BERRY) are used as measures of pre-tax
profitability. The Berry ratio is a well-known profit-
ability measure used by transfer pricing profes-
sionals and the IRS as possible evidence of transfer
price manipulation; it is the ratio of sales minus
cost of goods sold, divided by selling and general
administrative expenses.
16
TXASSET, the ratio of total US taxes paid divided
by total assets, is used as a proxy for taxes paid. Low
tax/asset ratios have been used by the IRS as
evidence of transfer price manipulation (e.g. Heck,
1990; Eden, 1998). Low tax/asset ratios should
trigger investigations by the IRS, raising the prob-
ability of the transfer pricing penalty. We therefore
expect a positive relationship between TXASSET
and CARs. Lastly, a dummy variable A&E is added
for firms with primary SIC code in the automotive
and electronics sectors.
Our model is therefore of the form
CAR3 ¼a
0
þ a
1
LNSALE þ a
2
PPM þ a
3
BERRY
þ a
4
TXASSET þ a
5
A&E þ x ð2Þ
Table 4 reports our results for the cross-section
tests, by event date. Data for the independent
variables are taken from Compustat’s ADR set for
1990–98. Where variables are missing, the firm is
deleted from our data set: thus the number of firms
varies for each of the regressions. In addition, a
pooled time-series, cross-section test is conducted
for the 19 firms with complete information for all
years. All variables, including the dependent vari-
able,
17
are centered at mean zero and the resulting
variance inflation factors (VIFs) for all regressions
are close to 1.0 so that multicollinearity is not a
problem (except in the moderator analysis where
high VIFs are inevitable). We use the REGRESS
ROBUST technique in STATA/SE 8.0. This technique
uses the Huber/White/sandwich estimator of var-
iance in place of traditional OLS estimators: this
generates ‘consistent standard errors even if the
data are weighted or the residuals are not identi-
cally distributed’ (STATA, 2003, Vol 3, 328).
Although we do have predictions for the direction
of expected effects, we use a conservative two-tailed
t-test.
The general fit of our model is very good, with all
equations having significant F statistics. Looking
first at the individual cross-section events, the most
consistent result is firm size; LNSALE is negative
and significant in three of the six dates, as
hypothesized. The A&E variable is positive for all
years, but significant on only one date (13 January
1993), contrary to our original expectations, but in
accordance with our subgroup analysis. BERRY is
negative and significant for two dates, but positive
and significant for a third (13 January 1993);
Table 4 Cross-section time-series analysis of cumulative abnormal returns
Pooled dates
20 Feb
1990
4 Mar
1991
13 Jan
1993
2 Feb
1994
11 Mar
1996
17 Sep
1997
(1) (2) (3)
LNSALE 0.0167
w
0.0002 0.0165* 0.0323
w
0.0038 0.0230 0.0093
w
0.0089 0.0086
A&E 0.0146 0.0186
w
0.0025 0.0000 0.0157 0.0015 0.0107
w
0.0114
w
0.0113
w
BERRY 0.0005 0.0008** 0.0007
w
0.0011 0.0007 0.0026*** 0.0001 0.0067* 0.0101**
PPM 0.0221 0.0776 0.2766* 0.0670 0.0389 0.3008 0.0189 0.0301 0.0360
TXASSET 0.1973 0.4348* 1.0544** 0.7751** 0.3064 0.9554
w
0.0661 0.4279 0.7150*
BERRY TXASSET 0.2733* 0.4106**
PPM TXASSET 3.3724
w
YR90 0.0474*** 0.0492*** 0.0498***
YR91 0.0568*** 0.0585*** 0.0588***
YR93 0.0082 0.0091 0.0095
YR94 0.0107 0.0136 0.0152
YR96 0.0002 0.0001 0.0019
Constant 0.0316*** 0.0414*** 0.0111** 0.0061 0.0120* 0.0183* 0.0205*** 0.0109 0.0027
Number of obs. 22 22 22 21 21 23 114 114 114
R
2
0.3321 0.5167 0.4871 0.2245 0.1645 0.3818 0.4267 0.4400 0.4517
F statistic 4.42* 65.53*** 4.23* 14.72*** 2.87
w
9.41*** 9.85*** 9.13*** 9.21***
F DIST 5.20* 6.26**
Asterisks show significance levels using a two-tailed test, where
w
o0.10, *o0.05, **o0.01, ***o0.001.
Talk softly but carry a big stick Lorraine Eden et al
406
Journal of International Business Studies
interestingly, that is the only date where PPM is
significant, suggesting that a moderator effect may
be at work. TXASSET is significant in four of the six
years; however, its sign switches (positive for two
years, negative for two), so that no clear relation-
ship emerges between CARs and the tax/asset ratio.
In addition, we ran a series of regression diag-
nostic tests (DFITS, Cook’s Distance, WELSCH
distance) to check for possible confounding effects
from outliers (STATA, 2003, Vol 3, 373–377); none
appeared. As the number of firms in our cross-
section regressions is small (N¼ 22 or 23), we also
employed bootstrapping techniques (STATA, 2003,
Vol 1, 112–127; Mooney and Dulal, 1993).
18
Setting
the number of replications at 1000, we found that
the bootstrap bias estimate relative to the observed
standard error, for each independent variable in
each regression, was always a small percent of the
bootstrapped standard error, and that our observed
standard error always lay within the bootstrapped
confidence interval. We therefore concluded that
the underlying distribution was approximately
normal and our results were not affected by the
small sample size.
Pooled cross-section time-series tests
In the pooled cross-section time-series regression,
column 1 simply repeats the individual year
regressions, with the addition of year dummy
variables. Only two variables are significant:
LNSALE (negative) and A&E (positive), which is
consistent with our individual date results. In
column 2 we add one moderator term, BER-
RY TXASSET, to test our hypothesis that high
profitability, coupled with low tax payments, is a
better predictor of abnormal returns than either
variable separately. Owing to the multicollinearity
induced by adding the moderator term, the signs
on the individual variables are somewhat suspect.
However, it is interesting to note that both BERRY
and the moderator variable BERRY TXASSET are
negative and significant, suggesting that MNEs
with high profits and low taxes earned negative
abnormal returns over the six-event period. The F
DIST test is also significant (F¼5.20), implying that
there is a moderator effect at work. The F DIST test
is even stronger in column 3 when we add
PPM TXASSET as a second moderator. TXASSET
now becomes significant and negative, with a
weakly positive moderator term. In all the three
pooled regressions, the 1990 and 1991 year dummy
variables are highly significant, suggesting that
earlier event dates had more impact on abnormal
returns than later dates. This coincides with our
expectations: because the surprise factor and the
relative significance of the policy changes decline
over time, we expect a greater impact earlier on.
19
Looking across the nine regressions, some pat-
terns are evident. Abnormal returns are negatively
related to LNASSET and BERRY, as expected. CARs
are also positively (not negatively) related to A&E,
contrary to our original predictions but in accor-
dance with our subgroup analysis. TXASSET is a
significant predictor of CAR, but its sign varies; one
reason may be that TXASSET moderates the
relationship between the profitability ratios and
abnormal returns. The two earliest event dates (20
February 1990 and 4 March 1991) are negatively
and significantly related to abnormal returns,
whereas later dates are not statistically significant.
This accords with event study methodology where-
by surprise is critical to the generation of abnormal
returns.
We conclude that our post hoc analyses provide
strong support for our hypotheses. Cumulative
abnormal returns are affected by the size of the
firm (), membership in the A&E group ( þ ), and
pre-tax profitability (). MNEs with high profits
and low tax-asset ratios earned negative abnormal
returns. The impact of the penalty on CARs was
strongest at the beginning of the 1990s, and
became less important as the element of surprise
disappeared.
As final checks on our cross-section, time-series
regressions, we ran regression diagnostic tests for
outliers, without finding any problems. We also
employed bootstrapping techniques (number of
replications¼1000) and concluded that our results
were robust to sample size.
Market valuation of Japanese parents
As a third test, we examined the impact of US
transfer pricing penalty announcements on the
stock market returns of the Japanese parent firms,
using daily stock prices on the Tokyo Stock
Exchange.
20
While we expected the major impact
of the US penalty to be on the abnormal returns of
Japanese subsidiaries in the US (and therefore
reflected in their US ADRs), there was some
possibility, albeit remote, that US tax penalties
could have negatively affected the market returns
of Japanese parent firms on the Japanese stock
market.
Using EVENTUS, external datasets were required
to perform event studies with non-CRSP data. We
retrieved the daily stock prices and market indices
Talk softly but carry a big stick Lorraine Eden et al
407
Journal of International Business Studies