A researcher at the University of Iowa has found companies in China lower their tax bills by taking advantage of a government policy designed to promote economic development in targeted regions such as high-tech development zones.

The companies use a technique called income shifting to move money from the books of a subsidiary in one part of the country to a subsidiary in another to take advantage of lower tax rates. Ryan Wilson, assistant professor of accounting in the Tippie College of Business, says his new study with colleagues from the University of Washington and the University of British Columbia-Kelowna shows us how Chinese businesses are managed in a way that hadn't been previously documented.

"Since we know little about the tax planning activities and incentives of Chinese firms, any insight into these issues will be interesting," says Wilson.

Wilson says the income shifting takes advantage of a Chinese government policy that lowers tax rates to businesses located in regions of the country targeted by the government for economic development. The results suggest that corporations with subsidiaries located across the country are using accounting maneuvers to move profits from the books of subsidiaries located in higher tax regions to the books of subsidiaries in the target zones.

Unlike in the United States, where companies are taxed on the combined profits of all their subsidiaries, Chinese firms are taxed on a subsidiary-by-subsidiary basis. Wilson and his co-authors looked at the annual reports of 320 publicly traded Chinese domestic firms between 1999 and 2004. They found the average firm has a 23 percent point difference in the tax rates applied to their subsidiaries, which Wilson says gives them a strong tax incentive to shift income to the lower-performing subsidiaries.

He says spotting income shifting is difficult in any circumstance, but even more so in China because its tax laws, accounting procedures, and political considerations make it hard to decipher financial records. But he and his co-authors discovered a footnote in the firms' annual reports that helped provide insight into firms' income shifting activity. The disclosure represents the difference between the taxes that would have been paid if the subsidiary's income had been taxed at the parent company's tax rate. They found that most every firm they studied shifted at least some income to subsidiaries in the lower tax rate zones, although he says they were not able to determine how much of that shifting was done for tax reasons.

The research has real implications, because income shifting is mostly a bookkeeping maneuver based on accounting-based transfer pricing and so doesn't indicate actual increased business income by the subsidiaries in the government's target regions, he says. Further, firms use transfer pricing information to make business decisions and if tax incentives lead firms to use misleading transfer prices this could result in less efficient business decisions.

They also found that income shifting increases with the level of a firm's intangible assets, such as proprietary data or intellectual property. Thus, software companies have an easier time shifting income than, say, heavy construction companies. Wilson says this finding is consistent with managers taking advantage of discretion in setting transfer prices for intangible assets to shift income in a way that minimizes their taxes.

Wilson's paper, "Domestic Income Shifting by Chinese Listed Firms," is co-authored by Terry Shevlin of the University of Washington and Tanya Tang of the University of British Columbia-Kelowna. It will be published in a forthcoming issue of the Journal of the American Taxation Association. It's available online at papers.ssrn.com/sol3/papers.cfm?abstract_id=1808140.