Corporate Tax Avoidance Impact

1.0 Introduction

Corporate tax avoidance (CTA) is an effective strategy to transfer wealth from governments to corporations to enhance firm value (Hanlon and Heitzman, 2010). However, corporate tax avoidance (CTA) has some costs which include the risk of potential punishment, the risk of losing the firm’s reputation and customers and implementation costs (Armstrong et al., 2015). According to the argument of agency theories, different corporate governance strategies and mechanisms are closely related to tax avoidance activities of an organization (Khan et al., 2016). Desai et al. (2007) argued that the lack of transparent taxation activities might hamper the firm’s values and goodwill. Hence, big corporations always compare the costs and benefits during tax planning in order to enhance the firm’s values and profitability. Therefore, the purpose of this research is to examine the impact of corporate tax avoidance on the values of FTSE 100 companies listed at London Stock Exchange (LSE) by reviewing relevant literature and empirical research in this area.

Evidence from current empirical research suggests mixed results of the consequences of corporate tax avoidance whether the organizations are enhancing firms values through corporate tax avoidance or firm’s values are increasing. The literature suggests that corporate tax avoidance is an effective strategy through which an organization aims to enhance its profitability and subsequent firm value (Reidel, 2018). Ayers et al. (2009) argued that an organization’s information content of income tax reduces due to corporate tax avoidance. However, evidence suggests that the impact of corporate tax avoidance on the enhancement of firm’s value is not significant for the low level of institutional ownership in an organization while the effect is significant where the level of institutional ownership is high (Desai and Dharmapala, 2009). However, Desai and Dharmapala (2009) argued that CTA enhances firm’s values by transferring government’s wealth to the shareholders of an organization while it reduces firm’s value by creating agency conflicts among the management teams. How the market reacts to the news of corporate tax avoidance is still limited and requires further research (Hanlon and Slemrod, 2009). Wang (2010) reported that corporate tax avoidance increases the firm’s stock price since investors are willing to invest into the firm but this increases the overall opacity of the corporation and thus the firm subsequently sees a decline in share price. However, the conflicts in research findings may arise due to the differences in the measure of corporate tax avoidance, effects of the CTA on the cash flow and profitability, and the firm’s agency costs. At the same time, aggressive CTA leads to complex business transactions, lower transparency and decreasing the firm’s values indirectly (Desai and Dharmapala, 2009). Hence, business environment and operations also play an indirect role in understanding the effects of CTA on the values of the firms. Therefore, this research will examine the CTA and its impact on the firm value of FTSE 100 companies by considering recent dataset starting from 2012 to 2016 through regression analysis by reviewing relevant literature to address the research question.

1.1 Objectives

i. To critically evaluate the literature and theories of corporate tax avoidance.

ii. To empirically investigate the impact of corporate tax avoidance on firm value.

2.0 Literature review

The purpose of tax planning in an organization is to enhance the firm value, financial profitability and to maximize the return of the investor. Through CTA strategies, an organization aims to pay less tax and increase the firm’s value. However, literature has shown mixed evidence of the motivation and outcome of CTA by the big organizations. The seminal work of Scholes and Wolfson (1992) called “Taxes and Business Strategy: A Planning Approach” is consistent with the modern corporate finance theory which aims to maximise shareholder’s wealth (Ross et al., 2013). However, agency theory creates a conflict when the managers are likely to increase own personal benefit through increasing managerial compensation, bonuses or benefits, or by investing free cash flow in unprofitable and unfeasible projects (Jensen and Meckling, 1976). CTA increases a firm’s cash flow which can increase firm’s values and shareholder’s wealth but agency theory predicts that managers are likely to engage in activities that maximize their own benefits rather than the shareholder's wealth. This type of agency behaviour is detrimental to the growth and sustainability of the organization since the shareholders are likely to invest into monitoring activities that will increase overall costs and reduce firm’s value in order to align the activities of the managers with the interest of the shareholders (Bosse and Phillips, 2016). In absence of strong corporate governance mechanisms such as independent directors, auditors, monitoring agencies, strong institutional ownership and transparent information exchange, managers still find a way to indulge in self-interest maximizing activities (Coumo et al., 2016). The problem gets complicated when transparency within an organization reduces and the transaction becomes complex due to CTA activities of an organization. How owners address these issues, reduce the gaps and take measures to depend on the most feasible options to restrict the agency conflicts through either increasing monitoring activities or offering remuneration and performance-based bonus to the shareholders (Khan et al., 2016). The implementation of the mechanisms and their effectiveness will align the managerial interest with the shareholder’s interest as well as will protect the interest of the minority shareholders (Cuomo et al., 2016). Therefore, agency theory predicts that instead of increasing a firm’s value of an organization, CTA may reduce the firm value of an organization by increasing information asymmetry and reducing transparency.

There are two general perspectives on the consequences and motivations of CTA identified by Hanlon and Heitzman (2010). According to the mainstream perspective of CTA, the aim is to transfer the government’s wealth to the shareholders by paying less tax and increasing firms’ values. Therefore, shareholders are in favour of CTA avoidance practices. The alternative perspective coined by Desai et al. (2007) argues that managers engage in CTA activities in order to maximize self-interest rather than maximizing the values of the shareholders as predicted by the agency theory. Desai et al. (2007) further argued that shareholders support managerial tax planning activities to avoid attention from the authorities. However, this has negative consequences on the firms with lower institutional and minority shares. Desia et al. (2007) found that shareholders activities are more aligned with the interest of the government than the interest of the managerial activities by investigating Russian firms, the market values increases when tax enforcement is stronger. Prior to these findings, Desai and Dharmapala (2006) found that firms with strong corporate governance mechanisms discourage managers to indulge in tax avoidance activities since firms are more likely to be better governed and transparent. The literature has been developing considering the effect of CTA activities on the firm values. Literature has identified that CTA can create wealth for the organization or can enhance managerial opportunistic activities (Wahab and Holland, 2012). Wilson (2009) investigated CTA activities by collecting information from the annual reports which are the beginning of CTA activities. Wilson (2009) reported that firms exhibit higher returns during the tax avoidance period than the period prior to or after tax avoidance when corporate governance mechanisms are strong. This finding was consistent with the findings of Desai and Dharmapala (2009). However, in terms of the studies in the UK, Wahab and Holland (2012) reported that CTA activities reduce the firm’s values. This implies that the corporate governance mechanisms and shareholders do not appreciate CTA of the managers. However, Wahab and Holland (2012) stated that there might be inefficiency in the corporate governance elements of the UK and tax related information for the contradictory findings.

CTA has some costs and benefits which can either enhance the net value of an organization or can eventually reduce it by increasing irregularities and corporate failure. Therefore, the question arises; does corporate tax avoidance increase firms’ value? There are mixed findings regarding the relationship between CTA and firm values in the empirical literature. The impact of CTA on the firm value is positive in the USA according to the findings of Desai and Dharmapala (2009). Wilson (2009) also reported a positive association between CTA and firm values in the USA. The researcher further found that in absence of strong corporate governance mechanisms, managers are getting benefitted from CTA instead of transferring wealth to the shareholders. The findings are consistent with the findings of Desai and Dharmapala (2009). Chen et al. (2014) reported a positive association between CTA and firm value in the context of China by considering dataset during the period of 2001-2009. However, by applying the methodology of Desai and Dharmapala (2009), Chen et al. (2014) further found that CTA and firm values are negative in the context of China. The results are not explicitly compared with the degree of corporate governance transparency. Leite Santa and Rezende (2016) also found a negative relationship between CTA and firm’s value considering the case study of Brazil during the period of 2006 to 2012. Wahab and Holland (2012) reported a negative association between CTA and firm value by considering the case study of the UK. Therefore, this research will investigate the context of the UK by applying an updated dataset to investigate whether CTA enhances firms value or not. Based on the findings above, the following hypothesis has been formulated.

H1: Corporate tax avoidance has an impact on the firm’s value.

H1(a): Corporate tax avoidance increases firm’s value.

H2(b): Corporate tax avoidance reduces firm value.

3.0 Research Methodologies

Research methods are the strategies how the research has been conducted and how the research instruments have been utilised by the researcher to collect and analyze data to meet the objectives of the research (Morse, 206). The research methods are discussed below

3.1 Research methods

Qualitative, quantitative and mixed research methods are the three popular research methods (Bell and Bryman, 2018). Quantitative research methods follow the branch of numeric data analysis while qualitative research methods follow the analysis of data that are non-numeric in nature (Mayer, 2015). Mixed research methods follow the strategy of both qualitative and quantitative using which the researcher aims to answer the question of the research by numeric data analysis and qualitative data interpretation (Bell and Bryman, 2018). The researcher will follow a quantitative research method in this research in order to examine the impact of tax avoidance on the value of the firm FTSE 100 companies at LSE. The rationale for the choosing the quantitative research method is that statistical analysis of the tax avoidance activities will help the researcher to enhance understanding and gain an in-depth knowledge of the impact of tax avoidance on the firm values. This will help the researcher to answer questions why listed companies adopt corporate tax avoidance strategies and solve the long-debated puzzle using the latest information from the financial statement of the listed FTSE 100 companies at LSE.

3.2 Research approaches

Research approaches guides the researcher to answer the research questions and develop new theories or test existing theories through data collection and analysis (Creswell, 2017). Inductive and deductive approaches are the two research approach that guides researchers (Saunders, 2011). The inductive approach helps the researcher to formulate a new theory by analysing data. This process also includes a collection of qualitative information to construct an appropriate theory. The deductive approach follows the approach of testing existing theories and hypothesis by collecting and analysing recent and situation specific data (Saunders, 2011). This research will follow a deductive research approach and the justification for following a deductive approach is that this research will help the researcher to test the hypothesis that has been formulated from the existing literature and theoretical framework by analysing FTSE 100 companies’ tax avoidance information and its impact on firm value. The proposed research will compare the outcome of this research with the existing theory to validate or contrast the findings.

3.3 Data collection techniques

Data collection and data analysis are the most important aspect of any research to answer the research objectives and questions (Matthews and Ross, 2010). Primary, secondary and mixed data collection methods are the most popular strategies of data collection (Bell and Bryman, 2018). Primary data collection consists of collecting information directly from the source for the purpose of the research (Smith, 2015). According to Neuman (2013), primary data is reliable since there has been no prior processing and data manipulation even though the cost of primary data is high and involves significant time in collecting and organizing the data. Questionnaire, observations, interviews, experiments and focus group are some of the most popular techniques of primary data collection (Saunders, 2011). Secondary data collection method involves in utilising the information from a reliable source (Quinlan et al., 2018). Secondary data is cost effective and requires minimum time; however, consideration of the quality of information is essential in secondary data since the quality of the research outcome is dependent on the quality of information (Saunders, 2011). The research will collect information on the secondary sources. The rationale for choosing secondary data is that the company publishes the required information on the annual reports and financial statements which are publicly available on their respective websites. Information released in financial statements is reliable since this information is audited information. Hence, this will enhance the outcome of the research. The sample for the research will be from the year 2012 to 2017 of the FTSE 100 listed companies at LSE. The rationale for choosing this sample period is that the research will investigate the topic after the publication of Wahab and Holland (2012) who also investigated the research in the UK but found mixed evidence. This research will test the theories and literature and their relevance by analyzing the latest information. Therefore, data will be collected from the FTSE 100 companies’ annual reports during the period of 2012 to 2017.

3.4 Research Model

The researcher will follow the following econometrics model to study the impact of tax avoidance on the firm value of FTSE 100 companies in the UK.

Firm value = 0 + 1 Tax avoidance + 2 Total accruals+ 3 Return on Assets + B4 Firm Size + µ

Dependent variable: The dependent variable for the model is firm value. There are several instruments of measuring firm value; however, the researcher will use TobinQ following the research of Chen et al. (2014) to measure firm value.

Independent variable: The independent variable in this research model is Tax avoidance. Tax avoidance has been measured from a different perspective due to the lack of a single measure of tax avoidance in the literature. The first perspective follows the difference of book-tax difference (BTD) as the measure of tax avoidance (Manzon and Plesko, 2002) while Desai and Dharmapala (2006) follows the measure of book-tax difference but adding total accruals since BTD doesn’t explain the variance. Hence, book-tax difference and total accruals are the measures of independent variables.

Control variable: Firm’s performance measured by return on assets and firm size has been used as the control variable in this research to account for the variations caused by firm performance and firm’s size.

3.5 Data analysis

In order to investigate the impact of corporate tax avoidance on the firm value, the researcher will estimate the model following a multiple panel data regression model. This will reveal the impact of CTA on the firm value where the impact is significant and consistent with the theory and literature. The researcher will further analyze the standard errors and heteroskedasticity due to variance in tax avoidance across years (Petersen, 2009).

References

Armstrong, C.S., Blouin, J.L., Jagolinzer, A.D. and Larcker, D.F. (2015). Corporate governance, incentives, and tax avoidance. Journal of Accounting and Economics, 60(1), pp.1-17.

Ayers, B.C., Jiang, J. and Laplante, S.K. (2009). Taxable income as a performance measure: The effects of tax planning and earnings quality. Contemporary accounting research, 26(1), pp.15-54.

Bosse, D.A. and Phillips, R.A. (2016). Agency theory and bounded self-interest. Academy of Management Review, 41(2), pp.276-297.

Chen, X., Hu, N., Wang, X. and Tang, X. (2014). Tax avoidance and firm value: evidence from China. Nankai Business Review International, 5(1), pp.25-42.

Creswell, J.W. and Creswell, J.D. (2017). Research design: Qualitative, quantitative, and mixed methods approaches. Sage publications.

Cuomo, F., Mallin, C. and Zattoni, A. (2016). Corporate governance codes: A review and research agenda. Corporate governance: an international review, 24(3), pp.222-241.

Desai, M.A. and Dharmapala, D. (2006). Corporate tax avoidance and high-powered incentives. Journal of Financial Economics, 79(1), pp.145-179.

Desai, M.A. and Dharmapala, D. (2009). Corporate tax avoidance and firm value. The review of Economics and Statistics, 91(3), pp.537-546.

Desai, M.A., Dyck, A. and Zingales, L. (2007). Theft and taxes. Journal of financial economics, 84(3), pp.591-623.

Hanlon, M. and Slemrod, J. (2009). What does tax aggressiveness signal? Evidence from stock price reactions to news about tax shelter involvement. Journal of Public Economics, 93(1-2), pp.126-141.

Jensen, M.C. and Meckling, W.H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of financial economics, 3(4), pp.305-360.

Khan, M., Srinivasan, S. and Tan, L. (2016). Institutional ownership and corporate tax avoidance: New evidence. The Accounting Review, 92(2), pp.101-122.

Leite Santa, S.L. and Rezende, A.J. (2016). Corporate tax avoidance and firm value: from Brazil. Revista Contemporânea de Contabilidade, 13(30).

Mayer, I. (2015). Qualitative research with a focus on qualitative data analysis. International Journal of Sales, Retailing & Marketing, 4(9), pp.53-67.

Mayer, I. (2015). Qualitative research with a focus on qualitative data analysis. International Journal of Sales, Retailing & Marketing, 4(9), pp.53-67.

Riedel, N. (2018). Quantifying international tax avoidance: A review of the academic literature. Review of Economics, 69(2), pp.169-181.

Scholes, M.S., Wilson, G.P. and Wolfson, M.A. (1992). Firms' responses to anticipated reductions in tax rates: The Tax Reform Act of 1986 (No. w4171). National Bureau of Economic Research.

Wahab, N.S.A. and Holland, K. (2012). Tax planning, corporate governance and equity value. The British Accounting Review, 44(2), pp.111-124.

Wilson, R.J. (2009). An examination of corporate tax shelter participants. The Accounting Review, 84(3), pp.969-999.