Agency Costs of Moving to Tax Havens: Evidence from Cross‐border Merger Premia

• Published date: 01 July 2017
• Date: 01 July 2017
• Author: Burcin Col
• DOI: http://doi.org/10.1111/corg.12177

Agency Costs of Moving to Tax Havens: Evidence

from Cross-border Merger Premia

Burcin Col*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper explores the valuation effects of the tradeoff between tax avoidance and corporate

governance through tax haven M&As. Firms can achieve tax savings by selling to an acquirer based in a tax haven, making

the newly created multinational a haven resident. Changing a f‌irm’s tax homethrough a 100 percent acquisition is also accom-

panied by a change in legal system and corporate governance. Therefore, tax savings could come at the expense of corporate

governance degradation making the value implications of such tax avoidance attempts an important empirical issue.

Research Findings/Insights: Using an international sample of cross-border M&As from 1989 to 2012, we f‌ind value evidence

supporting the agency costs hypothesis. For 100 percent M&As, a lower target premium is associated with those transactions

where the tax haven acquirer has weaker investor protection than the target.

Theoretical/Academic Implications: Our f‌indings provide value evidence regarding the agency costsof tax-motivated M&As

as a result of the secrecy laws and limited investor protection of tax havens.

Practitioner/Policy Implications: This study provides a perspective for executives of multinational f‌irms to take into account

the value consequences associated with secrecy laws and weak investor protection while considering a possible relocation to

tax havens. It also offers further insight to policymakers concerning the costs of limited investor protection and lack of

transparency.

Keywords: Corporate Governance, Tax Haven, Cross-Border Mergers, Tax Avoidance

JEL classif‌ication: G3, H2; G34, G38, H26

INTRODUCTION

Globalization has encouraged a growing number of f‌irms

to take advantage of tax havens by transferring their

headquartersand effectively changingtheir tax homes to these

jurisdictions. Most of these corporate actions are conducted

through mergers and acquisitions (M&As) (Deschryvere,

2009; Voget, 2010). Desai and Dharmapala (2010) report the

increasing number of acquisitions of US targets by foreign

f‌irms based in tax havens and argue for tax motivations as

the documented increase is not necessarily confounded by

the growth in cross-border M&As per se over time nor by

the non-tax differences between foreign countries.

Tax savings should generally enhance shareholder wealth.

In an agency framework,however, recentresearch argues that

opportunisticmanagers employ the methods of tax avoidance

to advance managerial, rather than shareholder, interests

(Desai & Dharmapala, 2006, 2009a, 2009b; Desai, Dyck &

Zingales, 2007). Therefore, agency costs may partially offset

the savings derived from tax avoidance transactions, making

the value implications of these tax avoidance attempts an

important empirical issue. In this paper, using a sample of

tax-motivated cross-border M&As that involve tax haven

f‌irms, we explore the valuation consequences of the tradeoff

between tax savings and the degradation of corporate gover-

nance. We follow previous studies and calculate the valua-

tion effect on merger premia as the targets’cumulative

abnormal return around the announcement date and com-

pare them to a control sample of acquisitions. We control

for other factors identif‌ied by past studies as determinants

of the premium to isolate the value effects for our variables

of interest.

Cross-border M&As conducted by tax haven acquirers

offer a unique setting to study the valuation implications

regarding the agency costs of tax avoidance. For tax pur-

poses, the newly created multinational is resident in the ac-

quiring or parent cou ntry. However, when the parent f‌irm

moves to a foreign jurisdiction, as prescribed by interna-

tional law, it also adopts acquirer country laws pertaining

to disclosure and corporate governance, especially when

the transaction is 100 percent. Using the evidence from

*Addressfor correspondence:Burcin Col, Lubin Schoolof Business, Pace University,One

Pace Plaza,New York, NY 10038, USA. E-mail:bcol@pace.edu

© 2016 JohnWiley & Sons Ltd

doi:10.1111/corg.12177

271

Corporate Governance: An International Review, 2017, 25(4): 271–288

cross-border merger premia, studies show that for 100 per-

cent acquisitions, the transfer of corporate governance laws

through cross-border transactions has signif‌icant valuation

consequences (Bris & Cabolis, 2008; Martynova &

Renneboog, 2008). If the shareholder rights and disclosure

practices of the haven jurisdiction are weaker than those of

the former nation (which is likely the case as haven jurisdic-

tions are known for their lax laws), then the tax benef‌its will

come at a cost of worsening corporate governance, which is

likely to be ref‌lected in the merger premium.

1

One major example is the 1997 merger between Tyco Inter-

national Ltd, a New Hampshire-based company, and ADT

Ltd that was headquartered in Bermuda. The transaction

was structured so that it allowed the new parent company

to pay corporate taxes at Bermuda rates. As a result, Tyco’s

average tax rate fell from 36 percent to only 23 percent

(Symonds, 2002). Yet, the company was later associated with

one of the worst corporate governance scandals in the US

where the chief executive, L. Dennis Kozlowski, and his team

looted the f‌irm of hundreds of millions of dollars behind the

tax scheme.

Using an international sample of M&As from 1989 to 2012,

we f‌ind value evidence supporting the agency costs hypothe-

sis. Regardless as to the potential tax savings, the average

merger premia is not signif‌icantly different for targets

acquired by haven f‌irms compared to those in acquisitions

by non-havenf‌irms.

2

The target premiaare signif‌icantly lower

for transactions where the tax haven acquirer has weaker in-

vestor protection than the target. Our f‌indings provide value

evidence for potential agency costs as they especially hold

for transactions where corporate governance regulations of

the haven-based acquirers are a major concern including 100

percent acquisitions and those after which the target f‌irm is

listed in the stock exchange of the acquirer.

There are two possible concerns associated with the cross-

border M&A setting. First, the decision to sell to a tax haven

acquirer is an endogenous choice and the sample selection

bias may affect our results. Thus, we run two-stage treatment

regressions, where the probability of a f‌irm selling to a tax

haven acquirer rather than to any other foreign acquirer is

f‌irst estimated. In addition to tax considerations, f‌irms are

likely to have other motivations for undertaking merger-

related transactions. Therefore, we explicitly control for those

potential determinants of M&As, such as operational syner-

gies that are shown to affect the announcement returns.

Additionally, we differentiate tax havens with real economic

activity from those that usually host shell companies for

tax savings or other litigation-related reasons. Finally, we

address sample related concerns and employ alternative

def‌initions of tax havens.

The main contributions of our study are threefold. First

and foremost, it contributes to the emerging literature on

the “corporate governance view of taxation,”which includes

several recent studies, such as those by Desai et al. (2007) and

Desai and Dharmapala (2006, 2009a, 2009b). These studies

focus on f‌irm-level governance in conjunction with the

agency costs of tax avoidance, while we focus on the institu-

tional aspects by analyzing the differences in country-level

mechanisms. Our cross-border M&A setting allows a simul-

taneous exploration of changes in tax regimes and corporate

governance and it follows that corporate governance should

be an important determinant for the valuation of overall

potential tax savings. In addition, tax motivations are shown

to affect M&A decisions, as well as the returns to targets and

acquirers. In a recent study, Huizinga and Voget (2009) f‌ind

that the parent-subsidiary structure of multinational f‌irms

created by cross-border M&As is affected by the prospect

of international double taxation. Countries with high interna-

tional double taxation attract a smaller number of parent

f‌irms. Huizinga, Voget, and Wagner (2008) determine that

takeover premia fully ref‌lect non-resident dividend with-

holding taxes that are imposed by the target country after

the merger. Alternatively, they f‌ind that the premia ref‌lect

corporate income taxation by the acquiring country less than

fully. Our study focuses on the merger premia for cross-

border M&As that involve tax haven f‌irms. These are cases

where tax motivations are clearly the most evident (Desai

& Dharmapala, 2010). Finally, our study builds and extends

on the previous literature regarding the valuation conse-

quences of corporate governance transfers via cross-listings

and cross-border M&As.

The “bonding hypothesis”introducedby Coffee (1999) and

Stulz (1999) suggests that f‌irms from countries with poor

investor protection use cross-listing as a way to signal their

desire to improve shareholderrights with tougher regulations

and greater transparency.

3

Cross-border M&As also offer a

venue for changes in corporate governance where the target

f‌irm usually adopts the governance structure of the acquirer

by internationallaw (Bris & Cabolis, 2008) providing contrac-

tual convergence similar to bonding through cross-listings

(Rossi & Volpin, 2004). Following this argument, a number

of studies f‌ind positive value associated with target f‌irms’

adopting better governance standards through a stronger in-

stitutional environment of the acquirernation (Bris & Cabolis,

2008; Col & Errunza, 2015; Martynova & Renneboog, 2008).

Our study extendsthis in three ways. First,while these studies

focus on the positive side of the transfers, where the target is

adopting better governance regulations of the acquirer, we

f‌ind evidence for the value consequences of negative spill-

overs. In addition, instead of general cross-border M&As,

our focus is on those M&As with tax haven f‌irms. This al-

lows us to explore the value effects of these transfers in the

context of tax savings vs. the agency costs tradeoff. As corpo-

rate governance costscould be large enough to outweigh any

potential tax savings, our results shed light on the extent of

the economic signif‌icance and help to advance our under-

standing of the valuation consequences of corporate gover-

nance. Moreover, while international law requires the target

f‌irm to adopt an acquirer’s legal and institutional framework

upon completion of a 100 percent cross-border M&A, in

cases where the target chooses to list in an exchange other

than the acquirer’s, it could also be subject to other country’s

laws. We go a step further and also run our analysis for

transactions where the target lists in the acquirer’sexchange

upon completion of the merger. Our results conform to those

of the prior studies.

The paper is organized as follows.The next section develops

a testable hypothesis based on a simple model of the agency

costs of tax-motivated M&As. The data and methodology

are provided in next section and the empirical results follow.

The f‌ifth section provides the robustness checks followed by

our conclusions.

272 CORPORATE GOVERNANCE: AN INTERNATIONAL REVIEW

© 2016 JohnWiley & Sons LtdVolume 25 Number 4 July 2017