The Corrosive Effect of Offshore Financial Centers on Multinational Firms’ Disclosure Strategy

Courtesy of Walid Ben Amar, Luo He, Tiemei Li, and Michel Magnan

Establishing subsidiaries in offshore financial centers (OFCs), such as the Bahamas, Bermuda, and the Cayman Islands, has become increasingly common for multinational corporations. For multinationals headquartered in the U.S., the primary (or at least ostensible) purpose of creating OFC subsidiaries is to reduce taxes. However, the effect of OFCs on multinationals goes far beyond tax avoidance. Our study suggests that the use of OFCs may also have a corrosive effect on firms’ transparency and market oversight capabilities.

In our paper, The Corrosive Effect of Offshore Financial Centers on Multinational Firms’ Disclosure Strategy, we investigate whether U.S. multinational companies with subsidiaries located in OFCs are more likely to be opaque in their voluntary information disclosure than U.S. multinationals without such subsidiaries. As defined by the International Monetary Fund (IMF), OFCs refer to countries or jurisdictions that provide some or all of the following three services: low or zero taxation, loose financial regulation, and banking secrecy.¹ Globally, OFCs serve as the domicile for over two million on-paper companies and thousands of banks, funds, and insurers.² They have become channels for at least one-third of all international lending and global foreign investment.³ According to the IMF definition, there are around 40 OFCs in the world, many of which are small islands, with those clustered in the Caribbean accounting for more than half of all OFC financial transactions.⁴

Known for the services they provide for ‘clean as well as dirty money,’ OFCs are controversial due to their use of money-laundering ⁵ and tax-dodging activities.⁶ In recent years, the opacity of firms with OFC operations has attracted increased attention. The U.S. Senate has held hearings examining the tax avoidance activities of multinational corporations conducted through OFC subsidiaries. At the G20 meeting in 2013, the Organization for Economic Co-operation and Development unveiled a global plan to close OFC related tax loopholes. More recently, in November 2017, responding to the leak of the Paradise Papers, the finance ministers of European Union countries vowed to take action against tax sheltering through OFCs.⁷

Tax avoidance underlies the motivation of U.S. multinationals to set up subsidiaries in OFCs and also explains these countries’ rapid growth. Zucman (2014) reports that today, around 20% of all U.S. corporate profits are booked in OFCs, a tenfold increase since the 1980s.⁸ Many OFCs (e.g., Bermuda and the Cayman Islands) offer a very low, or zero, tax rate to attract foreign investment. Besides low taxation, we also explore the effects of two other OFC characteristics, namely lax regulation and secrecy policies, on disclosure strategy. Most OFCs (e.g., the Bahamas and the British Virgin Islands) feature light financial regulation.⁹ In addition, many OFCs such as Switzerland, Luxembourg and the Cayman Islands have secrecy policies, particularly for firms’ bank accounts and beneficial ownership information, making it difficult for regulators to detect or decipher firms’ offshore operations.¹⁰ Examining all three characteristics shared by most OFCs, we posit that it is not tax shielding opportunities alone, but the intertwining of all three elements that leads to the corrosive effect of OFCs.

Prior studies suggest that tax avoidance reduces corporate transparency for two reasons.¹¹ First, implementing intricate tax strategies usually increases a firm’s financial and organizational complexity. Second, managers often refrain from communicating such complexity to outsiders since tax avoidance implies that firms obscure their activities from tax authorities. Thus, firms pursuing tax avoidance have more opaque information environments, as captured by larger bid-ask spreads, larger analyst forecast errors and dispersion, and higher stock price crash risk.¹²

Facing the issue of opacity, do managers of U.S. multinationals exercise discretion in an efficient or opportunistic manner in their disclosure? Within the efficiency view, managers maximize firm value by employing transparency-enhancing disclosure practices to compensate for the higher opacity caused by tax avoidance. Prior research documents that better disclosure and higher transparency lead to lower cost of capital, higher share prices, and higher market liquidity.¹³ Alternatively, the opportunism view predicts that managers adopt disclosure policies that maintain or even exacerbate opacity because a more transparent information environment likely inhibits managers from maximizing their expected utility. Research suggests that managers take advantage of firm opacity to obtain benefits for themselves, such as higher compensation, greater job security, more freedom of action, perquisite consumption, or even diversion of corporate funds.¹⁴

Among a firm’s disclosure strategies, we examine voluntary disclosure as reflected in management earnings forecasts (MEFs), a key mechanism through which managers of U.S. firms voluntarily provide private information to outsiders. For voluntary MEF disclosures, managers have considerable discretion in deciding their practices. They have control over whether to provide a forecast, how frequently to issue it, whether and how frequently to release a bad news forecast, and how precise or vague the disclosed forecast is.

Our sample comprises 21,391 observations of U.S. multinationals with OFC subsidiaries (i.e., offshore firms) and those without such subsidiaries (non-offshore firms) from 1999 to 2013. We employ three testing variables to measure the overall OFC effect: (1) a simple indicator variable, (2) a ratio for the number of offshore subsidiaries, and (3) a subsidiary-weighted offshore attitude index. The results turn out to be highly consistent across all three measures. We find that offshore firms are less likely to issue earnings forecasts and issue forecasts less frequently than non-offshore firms. Additionally, offshore firms are more likely to withhold bad news forecasts, which are forecasts lower than the prevailing market expectations. Furthermore, earnings forecasts released by offshore firms are less precise/specific than those released by non-offshore firms.¹⁵ Hence, offshore firms are less forthcoming in providing value-relevant information to outsiders. In addition, we construct measures for the three characteristics of OFCs (low taxation, light regulation, and secrecy policies) and find that each of the three is associated with offshore firms’ opaque disclosure practices. Our results are robust to various sensitivity tests, including propensity score matching analyses, the change sample tests, and different model specifications.

Why does the use of OFCs have a negative effect on firms’ MEF disclosures? A cost-benefit analysis underlies managers’ decisions on voluntary MEF disclosures for all firms. Possibly, setting up subsidiaries in OFCs, even if initially for tax reduction purposes, changes the cost-benefit structure for managers of offshore firms. Desai (2005) proposes that tax avoidance is often intertwined with earnings manipulation and managerial expropriation.¹⁶ In other words, managers of offshore firms may be more likely to manipulate earnings and conduct expropriation in the course of seeking tax avoidance. As disclosures of MEFs are likely to cast light on or increase attention to all three types of activities, which managers go to great lengths to hide, the expected cost of disclosure increases for managers of offshore firms.

Our findings are consistent with the view that U.S. multinational firms pursuing tax avoidance using OFCs exhibit managerial opportunism in their disclosure strategy. Managers of those firms adopt MEF disclosure practices that exacerbate, instead of reducing, opacity that already to some extent plagues companies seeking to minimize taxes. It appears that all three elements forming OFCs’ unique institutional environment play a role in facilitating the opportunistic disclosure strategy.

Our extensive control variables and rigorous regression models, combined with the robust results from a battery of sensitivity tests, give us confidence that endogeneity is not a serious concern for this study. However, given that the independent variable (to use OFCs or not) is a choice of the firm, we cannot completely rule out the possibility that there may be some missing firm characteristic which jointly determines MEF attributes and the use of OFCs. We acknowledge this as a limitation of the study.

Our study has policy implications for regulators in the U.S. and other major economies. Our findings suggest that tax avoidance via OFCs engenders problems beyond the scope of taxes. It appears that for U.S. multinational corporations, establishing subsidiaries in OFCs has a corrosive effect on their voluntary information disclosure. In other words, the secrecy policies and lax regulations of OFCs seem to migrate upward to parent organizations, reducing the capability of investors and other market participants to monitor management and undermining the governance and ethical foundations of multinationals. Hence, for regulators, it is imperative to consider the implications for governance and market information dynamics from companies’ use of OFCs.

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1. International Monetary Fund (IMF). (2000). Offshore financial centers: IMF background paper. Retrieved from http://www.imf.org/external/np/mae/oshore/2000/eng/back.htm
2. The Economist. (2013a, February 16). Storm survivors. P. S.3–S.5.  About the “on-paper companies”, for example, Ugland House, a moderate-sized building in the Cayman Islands, is the registered address for over 18,000 firms. (The Economist. 2013b, February 16. The good, the bad and the Ugland; The OFCs’ economic role. P. S.6–S.7)
3. The Economist. (2013c, February 16). Enduring charms. P. S.5.
4. Gonzalez, M., & Schipke, A. (2011). Bankers on the beach. Finance and Development, 48(2), 42–45.
5. For example, in the Stroh case indicted by the U.S. Department of Justice, Jose Stroh, a Colombian fugitive, pled guilty to conspiring to launder over $129 million for multiple drug cartels in Colombia. By opening bank accounts and creating shell companies in Panama (an OFC), Stroh operated a money laundering organization to convert millions of dollars of narcotics proceeds generated in the U.S. and Mexico into Colombian pesos and subsequently transfer them to the drug traffickers in Colombia. (The U.S. Department of State. 2001. Money laundering and financial crimes. Retrieved from https://www.state.gov/j/inl/rls/nrcrpt/2000/959.htm
6. The Economist. (2013a, February 16). The good, the bad and the Ugland; The OFCs’ economic role. P. S.6–S.7.
7. The Paradise Papers are 13.4 million leaked documents from two offshore service providers and corporate registries in 19 secrecy jurisdictions. The leak exposes the tax engineering via OFCs of over one hundred multinational corporations and reveals offshore interests of many political leaders, celebrities, and extremely wealthy individuals. For more information, visit https://www.icij.org/investigations/paradise-papers/.
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15. In the empirical tests, we use the measure Precision, which equals four if the latest MEF that a firm issues during year t is in point format (e.g., $0.15 per share), three if range (e.g., $0.10 to $0.20 per share), two if open-ended (e.g., maximum $0.20 per share), and one if qualitative (e.g., expect high profits). If a firm does not issue any MEF, this variable equals zero. (The results remain qualitatively the same if we exclude observations where Precision equals zero.)
16. Desai, M. (2005). The degradation of reported corporate profits. Journal of Economic Perspectives, 19(4), 171–192.