Study: Tax Havens and Limited Regulation Increase Risk for Shareholders

Some large, publicly held companies are incorporated in tax haven countries, ostensibly to increase value for shareholders. But new research from North Carolina State University and the University of Arkansas finds that many such companies – particularly those headquartered in countries with limited shareholder protections – are more likely to engage in practices that benefit executives at the cost of their shareholders.

“Many of these companies are incorporated in one country – the tax haven – but headquartered in another,” says Christina Lewellen, an assistant professor of accounting at NC State and co-author of a paper on the work. “There’s long been a theory that being incorporated in a tax haven, such as the Cayman Islands, leaves a company open to theft from executives who could skim off the company’s tax savings.

“We’ve found that another key factor is the regulatory environment of the country where the company is headquartered,” Lewellen says. “Specifically, we found evidence that executives of tax haven-incorporated firms are more likely to siphon off tax savings if their companies are headquartered in so-called ‘weak governance’ countries.”

Weak governance countries, such as China, are deemed to have limited rules in place to protect shareholders.

To examine this issue, the researchers evaluated data on more than 14,000 publicly held companies. The data set included information on 1,127 companies that are incorporated in tax haven countries – of which 874 had their headquarters in weak governance countries.

One key finding was that although tax avoidance results in higher cash flows, which is generally associated with higher dividend payout, tax haven companies headquartered in weak governance countries paid an average of 83 percent less in dividends to their shareholders, as compared to other companies in weak governance countries with similar tax avoidance levels.

“That’s the opposite of what you’d expect,” Lewellen says. “Those tax haven companies should have more cash, since they pay fewer taxes – but shareholders don’t see that money. In contrast, we found that tax haven companies with headquarters in well regulated countries do pass on tax savings to their shareholders.”

The researchers also found that tax haven companies in weak governance countries do not see any benefit from the cash tax savings in terms of earnings performance. Those companies performed an average of 53 percent lower than other companies in weak governance countries with similar levels of tax avoidance.

“This tells us that the tax haven companies in weak governance countries were not investing their tax savings wisely, if at all,” Lewellen says. “And, again, tax haven companies in well regulated countries did not see this lapse in performance; their performance was comparable to their peers.

“One take-away here is that incorporating a company in a tax haven country can benefit shareholders, but is much less likely to do so if the company is headquartered in a country that doesn’t take steps to protect shareholder rights.”

The paper, “The Complementarity Between Tax Avoidance and Manager Diversion: Evidence from Tax Haven Firms,” is published in the journal Contemporary Accounting Research. The paper was co-authored by T.J. Atwood of the University of Arkansas.

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Note to Editors: The study abstract follows.

“The Complementarity Between Tax Avoidance and Manager Diversion: Evidence from Tax Haven Firms”

Authors: T.J. Atwood, University of Arkansas; Christina Lewellen, North Carolina State University

Published: June 12, Contemporary Accounting Research

DOI: 10.1111/1911-3846.12421

Abstract: We investigate whether tax avoidance and manager diversion are complementary when the costs of diversion are low by comparing dividend payouts, performance, and overinvestments of tax haven firms versus other multinational firms based in countries with weak and strong investor protections. Desai and Dharmapala (2006, 2009a, 2009b) and Desai et al. (2007) set forth a theory of tax avoidance within an agency framework (the D&D theory) based on the assumption that tax avoidance and manager diversion are complementary when the corporate governance system is “ineffective” (i.e., the manager’s expected costs of diversion are low). Studies developing the D&D theory provide indirect evidence consistent with the model’s predictions but do not directly test this complementarity assumption. Recent studies of U.S. firms find no complementarity or find evidence inconsistent with this complementarity. Tax haven firms are corporate groups whose parent firms are incorporated in tax haven countries that are not the countries where the groups’ headquarters or primary operations are located (i.e., their “base” countries). We argue that tax haven incorporation potentially lowers the costs of diversion for managers of firms based in countries with weak investor protections. Using a sample from 28 base countries, we provide evidence that manager diversion and tax avoidance are complementary for tax haven firms based in countries with weak investor protections but not for tax haven firms based in countries with strong investor protections. Our results are consistent with the complementarity assumption underlying the D&D model and provide additional insights into the potential impact of the decentralization of the global firm.