ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX PLANNING OUTCOMES

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behavior in Sweden.

“CEO Personal and Corporate Tax Behavior Consistency” explores whether and how CEOs’ personal tax preferences relate to corporate tax avoidance outcomes.

“CFO’s Role and Corporate Tax Outcomes” investigates whether corporate tax outcomes can be explained by CFO’s role as defined in the firm.

“Corporate Tax Outcomes and Executive Turnover: Evidence from Sweden”

examines which executive, a CEO or a CFO, is perceived to be primarily re- sponsible for corporate tax outcomes, and what tax outcomes are preferred by corporate boards.

“Auditors and Tax Avoidance in Micro Firms” evaluates how the Swedish regulatory change of 2010 that allowed Swedish micro firms to opt out of audit affected their tax planning behavior.

is a researcher at the Department of Accounting at Stockholm School of Economics.

ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX

PLANNING OUTCOMES

ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX PLANNING OUTCOMES

ISBN 978-91-7731-105-8

DOCTORAL DISSERTATION IN BUSINESS ADMINISTRATION STOCKHOLM SCHOOL OF ECONOMICS, SWEDEN 2018

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This thesis consists of four empirical papers investigating corporate tax behavior in Sweden.

“CEO Personal and Corporate Tax Behavior Consistency” explores whether and how CEOs’ personal tax preferences relate to corporate tax avoidance outcomes.

“CFO’s Role and Corporate Tax Outcomes” investigates whether corporate tax outcomes can be explained by CFO’s role as defined in the firm.

“Corporate Tax Outcomes and Executive Turnover: Evidence from Sweden”

examines which executive, a CEO or a CFO, is perceived to be primarily re- sponsible for corporate tax outcomes, and what tax outcomes are preferred by corporate boards.

“Auditors and Tax Avoidance in Micro Firms” evaluates how the Swedish regulatory change of 2010 that allowed Swedish micro firms to opt out of audit affected their tax planning behavior.

is a researcher at the Department of Accounting at Stockholm School of Economics.

ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX

PLANNING OUTCOMES

ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX PLANNING OUTCOMES

ISBN 978-91-7731-105-8

DOCTORAL DISSERTATION IN BUSINESS ADMINISTRATION STOCKHOLM SCHOOL OF ECONOMICS, SWEDEN 2018

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Essays on the Non-Financial Determinants of Corporate Tax

Planning Outcomes

Milda Tylaitė

Akademisk avhandling

som för avläggande av ekonomie doktorsexamen vid Handelshögskolan i Stockholm

framläggs för offentlig granskning fredagen den 7 december 2018, kl 13.15,

sal 750, Handelshögskolan, Sveavägen 65, Stockholm

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Essays on the Non-Financial Determinants of Corporate Tax

Planning Outcomes

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Essays on the Non-Financial Determinants of Corporate Tax

Planning Outcomes

Milda Tylaitė

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Dissertation for the Degree of Doctor of Philosophy, Ph.D., in Business Administration

Stockholm School of Economics, 2018

Essays on the Non-Financial Determinants of Corporate Tax Planning Outcomes

ISBN 978-91-7731-105-8 (printed) ISBN 978-91-7731-106-5 (pdf) Front cover illustration:

ARCTISTIC/Photo: Nicklas Gustafsson Printed by:

BrandFactory, Gothenburg, 2018 Keywords:

Tax planning, behavioral consistency, upper echelons theory

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To my family

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Foreword

This volume is the result of a research project carried out at the Department of Accounting at the Stockholm School of Economics (SSE).

This volume is submitted as a doctoral thesis at SSE. In keeping with the policies of SSE, the author has been entirely free to conduct and present her research in the manner of her choosing as an expression of her own ideas.

SSE is grateful for the financial support provided by Jan Wallanders and Tom Hedelius Foundation as well as Torsten Söderberg Foundation which have made it possible to carry out the project.

Göran Lindqvist Johnny Lind

Director of Research Professor and Head of the Stockholm School of Economics Department of Accounting

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Acknowledgements

A PhD journey would not have been possible without the support of many people. First of all, I want to express my deepest gratitude to my main advisor Henrik Nilsson for teaching me how to do research, providing insights into the making of academic future, and always making sure that all is good both within and beoynd the SSE walls. I could not have expected to have a better advisor.

I am also grateful to my advisory committee members Juha-Pekka Kal- lunki and Ryan Wilson for guiding me during these years and for showing me not only how research is done, but also how it is communicated. These lessons and your overall support are invaluable.

During these six years my academic mindset has been shaped by numerous discussions with and insights by present and former colleagues at the Department of Accounting, in particular Kenth Skogsvik, Niclas Hellman, Walter Schuster, Ebba Sjögren, Henrik Andersson, Tomas Hjelström, Malin Lund, and Derya Vural. I am looking forward to continuing these discussions.

I am particularly grateful to Mattias Hamberg for generously providing me with some of the data used in this dissertation. I am hoping to be able to return the favour in the future.

Special thanks go to the participants of the Financial Analysis Brown Bag series: Péter Aleksziev, Ting Dong, Florian Eugster, Mariya Ivanova, and Hanna Setterberg. Research is always more exciting when discussed with great company (and with reasonably good coffee!).

This dissertation has also benefited from the comments and suggestions by fellow PhD students Patrik Tran and Kai Krauss. Thank you for being supportive colleagues in matters ranging from framing a research question to formatting page breaks.

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Tsujita Stephenson, and Elena Braccia for the administrative, organizational, and moral support during these years. You are magicians in what you do.

It turns out that PhD studies also have some unexpected social perks. I would therefore like to thank Tina Sigonius and Emilia Cederberg for their patience and encouragement when I was struggling with my first sentences in Swedish; Per Åhblom, Johan Graaf, and Shruti Kashyap for their delight- ful company, particularly after-hours; Christoph Schneider for, among other things, lovely promenades; and Egle Karmaziene for her advice, support, and no-nonsense Lithuanian attitude that made me see things more clearly.

Finally, I am immensely grateful to my family for their love and uncon- ditional support during the PhD journey. Despite having been exposed to extended research monologues as babies, my daughters Lina and Greta still appear to be my biggest fans. And I cannot thank my husband Karolis enough. Your patience, support, and reality checks have helped me to write this book and not lose my mind in the process. I could not have made this without you.

Stockholm, October 10, 2018 Milda Tylaitė

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Chapter 1

Introduction and Overview of the Dissertation

1.1. Introduction

What shapes corporate tax planning outcomes? And why do some firms ex- hibit more aggressive tax planning than others? These questions are growing in importance due to increasing public attention to corporate tax behavior and changing perceptions of how such behavior should look like. In this dissertation, I investigate the non-financial determinants of corporate tax planning behavior in a Swedish setting. The dissertation consists of the following papers:

• Paper I: CEO Personal and Corporate Tax Avoidance Consistency

• Paper II: CFO’s Role and Corporate Tax Outcomes

• Paper III: Corporate Tax Outcomes and Executive Turnover: Evi- dence from Sweden

• Paper IV: Auditors and Tax Avoidance in Micro Firms

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The main theme in this dissertation is the notion that corporate tax behavior is shaped by a multitude of factors that go beyond purely financial considerations. Thus, the first paper (Paper I)¹ investigates whether personal tax preferences of the CEOs in listed Swedish firms during 1999-2007 can explain the corporate tax avoidance outcomes of their firms. Indeed, the findings suggest that executives that are personally more tax conscious run companies that have higher levels of tax avoidance; moreover, such association appears to be a result of a CEO imprint in the firm rather than firms choosing the CEOs that best match their tax planning preferences.

In the second paper (Paper II), I turn to the CFO’s role and its associa- tions with tax planning outcomes which I investigate using the same sample of Swedish listed firms during 1999-2007. This study is based on the proposition that CFO’s involvement is critical for the implementation of tax planning strategies (Feller & Schanz, 2017), and the observation that CFO’s role can take a variety of forms. Two main observations emerge from this study.

First, I show that the CFO’s functional scope (with, I suggest, reflects the degree of attention paid to tax planning) and the CFO’s power (which arguably reflects the CFO’s ability to influence corporate outcomes) are signifi- cantly related to corporate tax outcomes. Second, and related to Paper I, I find some evidence that the CFO’s role and CEO preferences can function as substitutes in achieving (arguably) optimal corporate tax behavior. These two papers therefore show how managerial preferences and organizational structures can explain corporate tax outcomes.

In the third paper (Paper III), I investigate what kinds of tax planning outcomes are preferred by the corporate boards that are expected to guide their firms with shareholder interests at heart. I thus investigate whether CEO and CFO turnover in Swedish listed firms during 2000-2007 can be related to foregone shareholder value creation opportunities, tax-related reputational damage, and tax-related risk. I find that forced executive turnovers are preceded by extreme low tax avoidance levels which may be indicative of foregone shareholder value creation opportunities. I also find that executives

1 Co-authored by Tomas Hjelström, Juha-Pekka Kallunki, and Henrik Nilsson.

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are punished for high tax risk which yields uncertainty about future tax outcomes and therefore may also reduce shareholder value. However, I find no support for the proposition that executives are punished for extreme high (but arguably legal) tax avoidance. Instead, I find some evidence that executives are rewarded, either via promotions or compensation, for such behavior. Such finding contrasts the previous literature and the proposition that high levels of tax avoidance yield reputational costs, which then may be re- flected in executive dismissals. I discuss potential reasons for these differences in findings in the paper summaries at the end of this chapter as well as in Paper III further in this book.

The final paper (Paper IV)² investigates the role of the auditor in corporate tax planning behavior. To that end, we utilize the sample of micro Swe- dish firms during 2006-2014 and investigate how audit regulation change that took place in 2010 affected corporate tax planning behavior. The key finding emerging from this study suggests that auditors, in efforts to retain their clients following the regulation change, provide additional advice on tax planning opportunities available to those clients.

The four empirical papers that comprise this dissertation thus shed some additional light on what role managers, organizational structures, and auditors play in corporate tax planning outcomes. However, tax planning outcomes can take multiple forms, whereas corporate tax planning in itself is a complex, multi-layered process. The key purpose of this introductory chapter is therefore twofold. First, this chapter is intended to provide a review of the outcomes that corporate tax planning processes may yield, and discuss the empirical measures used to capture those outcomes. Further in the dissertation, I investigate the drivers of these different types of tax outcomes. The second aim of this chapter is to provide a broader unifying view on how and why specific approaches to corporate tax planning emerge in the firm. To that end, I utilize the three-hurdle tax planning framework developed by Feller and Schanz (2017). As per this framework, corporate tax planning strategies are subject to three sequential hurdles (availability, desirability, and implementability) that determine whether a specific tax planning strategy will

2 Co-authored by Ting Dong and Ryan Wilson.

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be adopted in the firm. The three-hurdle framework therefore suggests a hi- erarchical view on corporate tax planning, and provides a structured way to reconcile some of the empirical findings in corporate tax planning literature.

It also provides a conceptual basis for the methodological choices made in this dissertation; I discuss some of these choices in Section 1.4.

I thus structure this chapter as follows. First, I provide a broader overview of the extent of corporate tax avoidance taking place internationally. To provide basis for the discussion of tax research, I then review the common approaches to identifying and quantifying tax planning behavior. Next, I present the three-hurdle framework of tax planning behavior (Feller & Schanz, 2017). I use this framework to review the contemporary corporate tax planning literature as well as highlight the positioning of the present dissertation in this literature. Finally, I discuss the Swedish setting on which this dissertation is based, and provide an extended summary of the papers that comprise this book. In the final section, I discuss the contributions as well as limita- tions of this dissertation, and offer some suggestions for further research.

1.2. Increasing Public Awareness and

Regulatory Efforts to Curb Tax Avoidance

During the recent years, corporate tax avoidance and evasion have received unprecedented public exposure. In 2014, the International Consortium of Investigative Journalists revealed that tax rulings in Luxembourg facilitated substantial income tax savings for the multinational firms incorporated in this country. LuxLeaks, as they were popularly called, caused public outrage, even though advance tax rulings that the investigation revealed were (arguably) legal and contained no risk for the firms named in those rulings. Soon after, in early 2015, another journalistic investigation revealed a giant tax evasion scheme set up for private and corporate clients alike by the Swiss sub- sidiary of HSBC, a British-origin multinational bank. In 2016, the Panama Papers leak made information about offshore entities in Panama public, and revealed how some of these offshore companies were used for financial fraud, tax evasion, and other illegal purposes. Finally, in 2017, the Paradise

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Papers leak revealed information about the use of offshore companies and tax avoidance schemes from 19 tax havens.

In light of the extent at which both personal and corporate tax avoidance appears to take place, it is no surprise that the recent decades have seen numerous political and regulatory initiatives aimed at limiting such practices.

For instance, in the US, firms³ are since 2007 required to provide greater disclosure on their tax reporting choices, including uncertain tax benefits as defined in FIN 48 (Wilde & Wilson, 2018). Organization for Economic Co- operation and Development (OECD) has also oriented its actions towards curbing international corporate tax avoidance via information exchange, introduction of country-by-country tax reporting requirements, and transfer pricing regulations aimed at limiting income shifting (OECD, 2013). Individ- ual countries also gradually modify their local regulations so as to reduce international tax avoidance: for instance, Sweden has in 2009 introduced so- called interest stripping restrictions and in 2019, new regulation limiting interest deductibility is about to come into effect. At a local firm level, tax authorities have also started making more use of the technology in efforts to limit corporate tax avoidance at small and medium enterprises (SMEs), where such behavior often takes simple, but difficult to prevent forms, such as un- derreporting of sales, or over-reporting of expenses.

As a result of these developments, contemporary corporate decision makers appear to be subject to different types of pressures related to tax planning outcomes. On the one hand, firms are expected to create shareholder value, thus implying low desired tax expenses. On the other hand, regulatory initiatives make tax avoidance costlier; finally, actual and perceived reputational pressures create additional risks related to tax planning. Corpo- rate tax planning is thus becoming an increasingly demanding activity that must address compliance, profitability, and risk dimensions of stakeholder expectations (Donohoe, McGill, & Outslay, 2014).

As firms, regulators, and society at large perceive corporate tax planning activities and their outcomes as increasingly important, academic research has also responded to such developments by investigating why and when

3 Initially only public firms; currently, the requirement applies to all firms reporting under GAAP.

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firms engage in corporate tax avoidance, how stakeholders perceive various types of corporate tax behavior, and how such behavior can be identified.

Numerous factors, such as firm level characteristics, governance structures, regulations, managerial intentions, as well as external stakeholders’ pressures, have been related to corporate tax planning outcomes. I review this literature using the three-hurdle tax planning framework developed by Feller and Schanz (2017) further in this chapter, see Section 1.4.

1.3. Defining and Measuring Corporate Tax Planning

Before discussing the three-hurdle framework of corporate tax planning, it is crucial to define what the concept of tax planning represents. Any firm subject to tax obligations also has a naturally developed or explicitly formulated tax planning strategy⁴. Such tax planning strategy covers all activities and considerations related to assessing the amount of income taxes to be reported and paid. Tax planning is therefore an overarching concept that includes corporate tax goals as well as approaches to achieving those goals.

Corporate tax goals vary greatly across firms. The goal of tax planning that receives most attention from practitioners and academics alike is tax avoidance. Other goals of tax planning can be, for instance, tax risk management (i.e. maintaining the variation and uncertainty of tax outcomes at a certain level), or tax compliance, i.e. ensuring that the firm fully complies with all tax reporting requirements. In certain cases, tax planning goals can also extend towards other business considerations. For instance, certain firms treat their tax obligation as a part of corporate social responsibility, and thus communicate their tax payments as reflective of their societal engagement.

At a more operational level, tax planning techniques can also be used to en- sure sufficient financial liquidity. In this dissertation, I concentrate on tax avoidance and tax risk dimensions of tax planning.

4 Further in the dissertation, I refer to tax planning strategy and tax planning inter- changeably.

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Following Dyreng, Hanlon, and Maydew (2010), I define corporate tax avoidance as any behavior that reduces the corporate tax bill. Importantly, such definition of tax avoidance does not imply that tax avoidance is illegal;

rather, it suggests that firms use various legal tools that are available to them in order to reduce their tax burden. To differentiate between legal and illegal corporate tax avoidance behavior, I refer to the latter one as tax evasion.

Contemporary literature identifies two main types of corporate tax avoidance: conforming and non-conforming tax avoidance. Non-conforming tax avoidance⁵ is defined as the deviation of corporate tax position from the one that is expected based on the book pre-tax income and the statutory tax rate.

It is the type of tax avoidance that is typically investigated in accounting and taxation literature. The primary reason behind such approach has to do with the type of firms investigated in such literature. Contemporary studies primarily investigate the tax behavior of listed firms that are likely to prioritize this kind of tax avoidance. Listed firms’ aim is to achieve certain level of earnings; in the tax context, such outcome can be achieved by utilizing the differences in financial and tax reporting rules. The firm thus may aim to report high pretax (book) income and low taxable income; the outcome of this kind of behavior is thus referred to as non-conforming tax avoidance.

Conforming tax avoidance behavior, on the other hand, refers to situa- tions when firms choose to report lower performance (i.e. by lowering reported revenue and/or increasing reported expenses) in both their financial statements and tax filings with the goal of reducing their income tax burden.

Such behavior is more likely to be observed in private firms where capital market pressures are low and owners are well informed (Badertscher, Katz, Rego, & Wilson, 2017). This type of behavior is thus conceptually different from non-conforming tax avoidance since the need to report high book earnings does not play a (significant) role in such tax decision making; as a result, it is not captured by standard tax measures which mostly are designed to describe non-conforming tax avoidance. Recently, an effort has been made to back out the level of conforming tax avoidance from tax burden, operating

5 The term of non-conformity is used in this setting since deviation from statutory tax rate arises due to differences (or non-conformity) between financial and tax reporting.

Due to differences in there reporting requirements, the pre-tax income reported in the financial statements and taxable income reported in tax filings often are not the same.

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performance, and degree of non-conforming tax avoidance (Badertscher et al., 2017). This is the approach I also use in this dissertation.

Finally, corporate tax risk refers to the uncertainty of tax outcomes. Such uncertainty can arise either from volatility of tax outcomes (e.g. when effective tax rate is unpredictable), or from tax positions that are likely to be dis- puted by the tax authorities, thus yielding tax fines⁶ and, in extreme cases, impaired corporate reputation. Notably, tax risk emerging from the volatility of tax outcomes (as opposed to tax fines) does not necessarily mean that the firm is inefficient in its tax management. Such volatility can emerge from using ad hoc tax saving opportunities that are not questionable (Blouin, 2014)⁷; the risk, however, arises when shareholders do not have access to tax planning information and thus may perceive such uncertainty negatively.

In Table 1.1, I review the empirical proxies for tax avoidance and tax risk most frequently used in contemporary corporate tax literature. Based on this review, I highlight several observations about the empirical use of tax planning measures. First, in line with the fact that most studies during the recent decades have aimed to identify the levels of non-conforming tax avoidance, the number of proxies intended to capture this type of behavior is highest.

During the last decade, the discussion about tax risk has intensified; as a result, a spectrum of proxies for this construct has also been broadening. Sec- ond, most proxies are developed in the studies investigating U.S. firms’ tax behavior. This imposes a limitation on the use of certain mesures in an international setting, particularly when they are based on the U.S.-specific regulation (such as FIN 48 disclosure requirements), or U.S.-based estimates (such as tax shelter score calculation). Finally, several studies investigate how various proxies of tax planning behavior are related, but their findings yield

6 Which typically result in larger effective tax rates. For instance, SCA AB, a Swedish listed company, because of a lost dispute with a Swedish Tax Agency, has reported the effective tax rate of 42% in 2016. In comparison, its effective tax rate in 2014 and 2015 was 24.3% and 27.4%, respectively. See Table 1.1 for a review of other tax risk proxies.

7 For instance, in a Swedish setting, cash tax payments can be temporarily reduced by allocating up to 25% of taxable income to untaxed reserves. Such approach contains no legal risks.

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mixed results (Dyreng, Hanlon, & Maydew, 2008; Dyreng, Hanlon, &

Maydew, 2018; Guenther, Matsunaga, & Williams, 2016).

These observations also guide the choice of tax planning outcome proxies in this dissertation. Since different measures appear to capture slightly different dimensions of tax planning behavior, investigations of broad tax avoidance or tax risk may benefit from the use of several proxies capturing that kind of behavior. Indeed, many studies, including Rego and Wilson (2012), Chyz and Gaertner (2018), Chyz (2013), and Armstrong et al. (2012), use multiple proxies to capture tax planning outcomes. In this dissertation, I also use multiple measures to identify tax avoidance (and thus use effective tax rates, book-tax differences, and conforming tax avoidance measures) and tax risk (and thus use ETR volatility and tax peak indicators). Second, as proxies of specific tax behavior, such as tax sheltering, are based on the U.S.

firms, studies of the outside-the-U.S. markets should either develop their own measures for that behavior or rely on more general tax avoidance proxies. Thus, as this dissertation focuses on Swedish firms’ tax behavior, I primarily rely on general proxies for corporate tax behavior outcomes.

However, when specific measures for personal tax behavior (Papers I and II) and corporate tax strategies (Paper IV) are required, they are developed based on the Swedish regulation and using Swedish data. These approaches are therefore expected to provide a robust view on a multifaceted phenomenon of corporate tax behavior.

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Table 1.1. Overview of empirical proxies for tax planning outcomes ^M^e

asureConstruction Motivation CommentsExamples of use Non-conforming tax avoidance Total effective tax rate (GAAP ETR) Total tax expense over pre-tax income (book) Captures the permanent part of non-conforming tax avoidance; directly affects reported net income and is therefore an important measure for firms subject to external market pressures.

Scaling by pre-tax income which is has relatively high volatility distorts the measure and may disguise the economic significance of tax planning outcomes. Difficult to interpret for pre- tax loss years.

Rego (2003); Chyz ( Cash effective tax rate (CASH ETR)

Cash tax paid over pre-tax income (book) Captures both permanent and temporary parts of tax avoidance. Likely to be distorted when a firm has tax loss carry-for- wards, as tax payable is reduced; otherwise same comments as for GAAP ETR.

Chyz, Gaertner, Kaus and Watson (2018) Long run CASH ETR Rolling average of CASH ETR for a se- lected number of years

One-year CASH ETR is highly volatile and only has limited predictive ability for long term tax avoidance outcomes; using longer period CASH ETRs also limits the loss-year biases in esti- mating the extent of corporate tax avoidance.

Use limited when extensive longitudinal data is not available or short- term ef- fects are to be evaluated.

Dyreng (2008), Rego and Wilson (2012 Graham et al. (2014 Industry-year adjusted GAAP ETR

GAAP ETR, demeaned by industry-year Deviation from industry-year averages is indicative of abnormal tax behaviour. Identification of compara- ble industry peers is not always straightforward.

Chyz and Gaertner Armstrong et al. (2015

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Measure Construction Motivation CommentsExamples of use Industry-year ad- justed CASH ETR CASH ETR, demeaned by industry-year Deviation from industry-year averages is indicative of abnormal tax behaviour. Identification of compara- ble industry peers is not always straightforward.

Chyz and Gaertner Book-tax differ- ence (BTD) Difference between expected tax expense, based on statutory tax rate, and reported tax expense. Scaled by lagged assets (or market capitalization, or similar measure capturing firm size)

Unlike ETRs, book-tax differences directly describe the tax avoidance effect relative to the statutory tax rate. It captures the economic extent of tax avoidance behavior better since the measure is scaled by a stable firm-level characteristic, rather than relatively volatile pre-tax income. Is directly interpreta- ble for loss years Relevant statutory tax rate is unclear when a firm has international operations. Variations may include other tax items, such as cash tax paid, of current portion of total tax only.

Mills (1998) Chyz, Gaertner, Kaus and Watson (2018) TS-Score (tax shelter) Likelihood that a firm is using tax shelters. Esti- mated using an empirical model based on actual tax sheltering cases

Certain firm characteristics serve as indicators that the firm may engage in tax sheltering activity.

U.S.- based empirical models, international generali- zability questionable.

Wilson (2009); Lisowsky (2010); Kim, Lu, and Zhang ( Rego and Wilson (2012 Armstrong et al. (2012 Graham et al. (2014 DTAX (discretionary permanent BTD)

Discretionary permanent differences. Esti- mated as residuals of a regresssion that elimi- nates non-distretionary sources of permanent book-tax differences from the total permanent differences Temporary book-tax differences reflect earnings management via pre-tax accruals. Be- cause of the same reason, short-term cash ETRs are spuriously related to book-tax differences. Temporary portion of tax avoidance thus needs to be eliminated from the tax avoidance measure.

A measure based on U.S. setting and regulation, highly specific in its purpose (investigation of association between earnings management and tax avoidance). However, used more broadly in citing studies.

Frank, Lynch, and Rego (2009); Rego and Wilson (2012

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Measure Construction Motivation CommentsExamples of use Abnormal BTDA part of book-tax difference that is not at- tributable to accounting accruals Captures managerial discretion under the hypothesis that tax avoidance is used to mask managerial diversion.

Developed as a proxy for tax sheltering activity before tax shelter models were developed.

Desai and Dharma (2009; 2006); Chen e (2010) Conforming tax avoidance CONFTAX Estimated as a part of total tax burden (total cash tax paid over total assets) that is not explained by non-conforming tax strategies and operating performance

Certain firms (such as firms subject to low capital market pressures) may choose to reduce their tax burden by simultaneously reducing their book performance. Such tax avoidance strategy is not captured by non- conforming tax avoidance measures.

Economic significance is im- possible to infer. Describes behavior only relative to peers, not a descrip- tion of absolute behavior.

Badertscher et al Tax risk Volatility of CASH ETR Rolling volatility of CASH ETREffective tax rate volatility represents tax-related uncertainties arising from firm operations, transactions, and financial reporting decisions.

May not be related to tax avoidance levels (Blouin, 2014); Dyreng, Hanlon, Maydew (2018). Measure may be distorted by loss years.

Hutchens and Rego Guenther, Matsunag and Williams (2016

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Measure Construction Motivation CommentsExamples of use Observed and predicted settlements with Tax Authorities Instances of settlements, or CASH ETR peaks Tax settlements indicate unsuccessful tax avoidance behavior that represents outcome uncertainty to the shareholders.

More likely to capture tax evasion; biased as only captures uncovered and denied tax strategies.

Bauer and Klassen Saavedra (2013) Uncertain Tax Benefits reserve (levels and addi- tions)

Uncertain tax benefits (i.e. claims that may not be ap- proved by the IRS) that are reported under FIN 48 Uncertain tax positions indicate the extent of tax planning and, as a pooled measure, is easy to observe. Excessive UTBs may repre- sent substantial tax-related risks as eventual tax outcome is unknown at the time of reporting.

U.S.- specific measure. Inher- ently discretionary. Hanlon, Maydew, S vedra (2017); Armstrong al (2015); Hutchens Rego (2015); Dyreng Hanlon, Maydew (201

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1.4. The Three-Hurdle Corporate Tax Planning Framework

Just as many other corporate processes, tax planning is a complex activity that is simultaneously shaped by a multitude of internal and external factors.

Thus, to understand how and why corporate tax planning activities take place in the firm, it is instrumental to have a broader conceptual view not only on what factors affect corporate tax behavior, but also how these factors interact in shaping the outcomes that the public, regulatory bodies, and researchers eventually observe. To that end, I utilize the three-hurdle tax planning framework developed by Feller and Schanz (2017). This framework identifies three sequential hurdles of corporate tax planning: availability, desirability, and implementability of corporate tax strategies.

The availability of tax planning strategies refers to the regulatory and ob- jective firm level determinants of corporate tax outcomes, such as taxation system in which the firm operates, as well as the complexity, financing, and income structure of the firm. In other words, the hurdle of availability refers to whether business characteristics facilitate or constrain the use of certain tax planning strategies. The second hurdle, the desirability of corporate tax planning, refers to the values and priorities of the firm, including managerial preferences and operational constraints. Finally, the implementability refers to the firm’s ability to actually implement tax planning strategies and relates to the managerial responsibilities and power in the firm. As per this framework, for a certain tax planning strategy to be implemented, all three hurdles need to be passed; likewise, the fact that one of the hurdles is jumped over does not mean that tax planning activity will take place, if conditions implicit in the remaining hurdles are not met.

I further review each of these hurdles in more detail and discuss how the findings of previous literature can be viewed through the three-hurdle tax planning framework.

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Figure 1.1. The three hurdles of tax planning

1.4.1. Hurdle 1: Availability of Tax Planning Opportunities

Whether and what tax planning strategies are available for a firm to a large extent depends on the firm-level characteristics and the regulatory environ- ment of the market(s) that the firm operates in. Previous literature provides ample evidence on how various regulatory principles and initiatives guide tax planning behavior; specific firm-level characteristics, such as size, type of operations, or financing structures, are also related to such behavior. The purpose of this section is to provide an understanding how these country- and firm-level characteristics shape the availability of tax planning strategies. In this section, I therefore provide an overview of research on several international reporting principles that guide reporting behavior for tax purposes, and discuss the literature investigating firm-level characteristics related to the availability of certain tax planning strategies.

Adapted from Feller and Schanz (2017)

Hurdle 1: availability Hurdle 2: Desirability Hurdle 3: Implementability

All conceivable tax planning methods

Available tax

planning methods Desirable tax

planning methods Implemented tax planning methods

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Territorial vs. worldwide taxation system

The broadest regulatory principle related to the tax planning strategies’ availability for a firm with international operations is the territorial vs. worldwide taxation system that is in place in the country of the firm’s incorporation.

Under the territorial taxation system, income earned in a specific country is taxed at the local tax rate. In contrast, under the worldwide taxation system, the tax rate of the domicile is applied to all income regardless of where it has been earned, as soon as it is repatriated. Thus, under the worldwide taxation system, whether the firm is able to engage in tax planning is largely dependent on the type and structure of its operations as well as its financial position.

For instance, De Simone, Piotroski, and Tomy (2017) show that U.S international firms react to expected repatriation tax deductions by accumulating cash in foreign subsidiaries; and, more generally, firms exposed to repatriation taxes tend to avoid repatriation by accumulating cash outside domicile’s jurisdiction (Foley, Hartzell, Titman, & Twite, 2007). In other words, firms that have sufficient financial flexibility may choose to leave their financial resources unemployed so as to reduce their total tax costs, or chose to invest, possibly inefficiently, in jurisdictions where the cash is trapped (Hanlon, Lester, & Verdi, 2015). Overall, when it comes to the availability of tax planning strategies in relation to the type of taxation system, Markle (2016) shows that income shifting activity is lower in firms subject to worldwide income taxation, likely because potential complications related to such activity limit the attractiveness of such tax planning strategy.

Thin capitalization rules

Corporate tax reporting principles typically allow deducting debt interest from taxable income. This provides a loophole via which firms with international operations can reduce the group-level income tax expense. OECD countries during the recent decades have taken measures to limit such behavior by introducing thin capitalization rules. Thin capitalization rules, that are now a part of the tax regulation in more than two thirds of the OECD countries (but not Sweden; see Section 1.5.2.), regulate tax avoidance activity by defining how much of the corporate debt, relative to equity, is subject to

ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX PLANNING OUTCOMES

ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX

PLANNING OUTCOMES

ESSAYS ON THE NON-FINANCIAL DETERMINANTS OF CORPORATE TAX

PLANNING OUTCOMES

Essays on the Non-Financial Determinants of Corporate Tax

Planning Outcomes

Milda Tylaitė

Akademisk avhandling

Essays on the Non-Financial Determinants of Corporate Tax

Planning Outcomes

Essays on the Non-Financial Determinants of Corporate Tax

Planning Outcomes

Milda Tylaitė

Foreword

Acknowledgements

Contents

Chapter 1

Introduction and Overview of the Dissertation

1.1. Introduction

1.2. Increasing Public Awareness and

Regulatory Efforts to Curb Tax Avoidance

1.3. Defining and Measuring Corporate Tax Planning

1.4. The Three-Hurdle Corporate Tax Planning Framework