Involvement in Offshore Financial Centers and Audit Fees

Involvement in offshore financial centers and audit fees: Evidence from U.S. multinational firms

• European Accounting Review ISSN 0963-8180
• Involvement in offshore financial centers and audit fees: Evidence from U.S. multinational firms
• Authors: Wenxia Ge,Jeong-Bon Kim,  Tiemei Li ,  Sanjian William Zhang
• Article publication date: February 2022
• DOI to Review Research Article

Over the past three decades, a growing number of multinational enterprises (MNEs) have established affiliates or subsidiaries in offshore financial centers (OFCs). As defined by the International Monetary Fund (IMF) (2000), OFCs are countries or jurisdictions with low or zero taxation, moderate or loose financial regulations, and/or banking secrecy, where a relatively large number of financial institutions engage primarily in business with nonresidents. Some more famous examples include places such as the British Virgin Island, Bermuda, as well as a few tourist attractions, such as Singapore, and Switzerland. Attracted by these institutional features, U.S.-based MNEs often create multi-tiered corporate structures and use complex tax-avoidance transactions to shift income to OFC affiliates or subsidiaries. According to a report by Professor Zucman at U.C.Berkeley in 2014, about 20% of all U.S. corporate profits are booked in OFCs, a tenfold increase since the 1980s. The transfer-pricing practices of U.S. MNEs through OFCs have triggered heated debates and a series of congressional investigations in recent years. However, despite the extensive media coverage of OFCs and the growing concerns about the lack of transparency of OFC operations, there is little empirical evidence on whether auditors price their audit services differently to clients with foreign operations in OFCs and those in non-OFCs.

We construct a sample that includes 1,530 U.S. MNEs with affiliates or subsidiaries in OFCs (labeled as OFC firms hereafter) (7,420 observations) and 2,177 U.S. MNEs with foreign operations in non-OFCs (labeled as non-OFC firms hereafter) (8,213 observations) from 2004 to 2016. We use three measures to capture the extent of a firm’s involvement in OFC operations: (i) an indicator variable, Offshore, that equals 1 if a firm has at least one affiliate or subsidiary located in an OFC in a given year, and 0 otherwise; (ii) the percentage of affiliates and subsidiaries in OFCs (OFC_Subsidiary_Ratio); and (iii) the weighted average of Masciandaro’s (2008) offshore attitude index for the host countries of a firm’s affiliates or subsidiaries (OFC_Index), which captures the intensity of a firm’s operations in OFCs with offshore attributes. We find that all three measures of involvement in OFC operations are positively and significantly associated with audit fees after controlling for commonly known audit fee determinants. This result indicates that auditors charge higher audit fees to OFC firms than to non-OFC firms and that among OFC firms, those with a greater extent of OFC operations pay higher audit fees. We also perform analyses to shed light on whether the auditor-provided tax services affect the OFC–audit fee relation. Our results indicate that the knowledge spillover effect of auditor-provided tax services is weaker for OFC firms than for non-OFC firms and that auditor-provided tax services are associated with a higher audit fee premium for firms with more intensive OFC operations, which is consistent with the litigation risk explanation. We also use available data to establish two new measures, regulatory arbitrage opportunity and secrecy protection level of host countries for MNC subsidiaries. We find that auditors perceive audit risk to be higher when regulatory arbitrage opportunity is greater and an audit client’s foreign operating environment is opaque due to OFC secrecy policies. For all the results above, we perform multiple robustness tests and results are all robust under these additional tests.

Our study makes several contributions. First, it extends the literature on the economic consequences of OFC operations. Prior studies have examined the effect of OFC operations on firm value, the value of foreign cash-holding, firms’ earnings management, tax avoidance, executive compensation, bank loan contracting terms, loan syndicate structure, and management forecasts. Unlike previous studies, our research adopts the auditor’s perspective and documents a positive effect of OFC involvement on audit risk and audit fees.

Second, our study extends a growing body of literature on how business strategy or location affects audit fees. Prior studies find that clients following a prospector strategy (i.e., rapidly changing their product market mix to be innovative market leaders) pay higher audit fees and that internationalization, cross-listing location, and domestic headquarters location affect audit pricing. We find that OFC involvement has incremental explanatory power for audit fees after controlling for business strategy, traditional internationalization measures, such as the “ratio of foreign assets” and “business complexity”, and tax aggressiveness. This finding suggests that our measures of OFC operations are separate constructs providing incremental information content over and beyond these traditional measures. Our study complements this line of research by documenting the geographic location of a firm’s foreign affiliates or subsidiaries as an important audit fee determinant. We also provide new evidence that auditors incorporate risk related to regulatory arbitrage opportunities and information opacity of OFCs, a factor that has not been picked up in prior studies, into the pricing of their assurance services.   

Finally, it is important to point out that OFC is not equivalent to tax shelter since the former is a specific country or location, while the latter is “a financial arrangement made to avoid or minimize taxes”, according to the Concise Oxford English Dictionary. An excellent example of tax shelter is the sale-in-lease-out transaction in the well-cited Wells Fargo & Co. v. United States No. 2010-5108, where a bank finances various infrastructure expenditures at U.S. tax-exempt agencies for a significant tax deduction. This case involves $150 million in depreciation from 26 transactions (tax shelters), while 17 out of 26 counterparties were U.S. domestic transit agencies (NOT any of the international 33 OFCs is involved here). The remaining nine transactions were equipment-related financial leases, also no transactions happened in any OFC. In sum, past tax shelter literature is completely different in underlying concept and scope.