Tax Avoidance as an R&D Subsidy: The Use of Cost Sharing Agreements by US Multinationals

We use administrative corporate tax data from the IRS to study a particular form of tax avoidance for US multinational corporations (MNCs). This strategy relies on cost sharing agreements (CSAs), which govern joint R&D efforts conducted with foreign affiliates and allow US MNCs to shift profits by moving intellectual property abroad. We analyze an unexpected 2005 Tax Court ruling that additionally allowed MNCs with CSAs to engage in cost shifting: by excluding employee stock option compensation costs from CSAs, the ruling allowed MNCs to allocate these formerly-shared costs entirely to their US parent corporations. This in turn increased the domestic tax deduction associated with R&D expenses, generating a tax shield that lowered the after-tax cost of domestic R&D. We show that the regulatory change increased market value, R&D investment, and cost shifting margins among US MNCs with CSAs following the ruling. Our results demonstrate how tax minimization strategies can translate into real changes in innovative economic activity.