Management Incentives for Optimal Investment Decisions under Formula Apportionment

We investigate how the interplay between taxation under formula apportionment (FA) and management compensation schemes impacts investment decisions of managers. More precisely, we aim at answering the following research question: How should managers be incentivized in order to make optimal investment decisions under FA?

Under the tax allocation system “FA” profits of multinational enterprises (MNEs) are allocated to the single group entities on the basis of a certain apportionment formula, which depends, for example, on the factors assets, labor and sales. FA has frequently been discussed as a universal solution to dampen profit shifting activities of MNEs. It increasingly gains importance for international business taxation: the European Commission proposed a harmonized tax system for EU countries, which is based on formula apportionment, the FA-related profit-split-method is more and more applied as one of the transfer pricing methods and, last but not least, many countries already established country-by-country reporting in the course of the OECD BEPS project, which is also based on the idea of FA.

In contrast to separate accounting, FA can distort locational investment decisions such that profitable investments, from a pre-tax perspective, need not necessarily be profitable from an after-tax perspective as well. The pre-tax profits of an investment can be overcompensated by tax payments that result from a shift of tax base from a low-tax to a high-tax country. Consequently, FA violates the neutrality claim for tax systems.

Against this background, it is important to assess how managers need to be incentivized in order to ensure that they make investment decisions in line with shareholders’ preferences. The incentive system hinges to a great extent on management compensation, in particular the performance measure used. Common practice of German DAX-30 companies is to use some variant of reported or pro-forma profits as one central performance measure. Accordingly we analyze compensation schemes that are distinguished along two different dimensions: management compensation based on pre-tax versus after-tax profits, and management compensation based on single entity profits versus group level profits. Thus we analyze four stylized performance measures, which cover the main aspects of a substantial range of empirically observable measures.

Preliminary results indicate that none of the currently (under the allocation system separate accounting”) applied profit definitions for management compensation are appropriate to incentivize managers for optimal investment decisions under FA. We demonstrate how these compensation schemes lead to over-investment or under-investment from the shareholders’ perspective. The ultimate goal of this project is to derive conditions for performance measures that incentivize optimal investment decisions under FA.