Ownership, tax and intercorporate loans in China

• DOI: https://doi.org/10.1108/IJAIM-09-2017-0114
• Date: 04 March 2019
• Pages: 111-129
• Published date: 04 March 2019
• Author: Wei Huang
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

Ownership, tax and intercorporate

loans in China

Wei Huang

University of Nottingham Ningbo, China

Abstract

Purpose –This paper aims to investigate the interconnections between corporate ownership, tax system

and controllingshareholder tunneling through intercorporateloans in an emerging market setting.

Design/methodology/approach –China’s Enterprises Income Tax reform in 2008 abolished its

previous multiple-tierstax system under which foreign direct investment (FDI) firmsenjoyed preferential tax

rates than domestic firms by introducinga new unified-rate tax system. Using difference-in-differencestests,

the author analyzes changes of controlling shareholders tunneling through intercorporate loans among

Chineselisted companies around this reform.

Findings –The author documents significant reductions of intercorporate loans after the reform. More

importantly, the author reveals that foreign-invested firms experienced larger reductions of intercorporate

loans than domestic firms. The author also showsthat state association matters for domestic firms’response

to the reform. In addition, the author documents positive stock market reaction to the tax reform

announcement for firms that exhibited higher level of tunneling prior to the reform, indicating market

expectationof reduced principal-principal conflict post-reform.

Research limitations/implications –The findings suggest effective corporate governance system is

warranted to constrain intercorporate fund transfers in emergingmarkets where tax incentives are used for

attracting inward foreign direct investments. Institutional reforms in emerging marketsaimed at removing

market frictions can alleviatethe problem of controlling shareholder expropriationsof minority interests or

tunneling.

Originality/value –This is a pioneering study that reveals the role of tax as a public governance

mechanismin weak minority investor protection environment.

Keywords China, Ownership structure, Tax, Intercorporate loans

Paper type Research paper

1. Introduction

China is now the world’s second largest economy. Its stock markets and institutional

environment for listed companies remain under strong political influence and significantly

less developed compared to the Western developed countries such as the USA (Jiang et al.,

2010;Liao et al.,2014).However, the legal system governing China’s enterprises has already

seen many developments in the recent decade. For instance, to regulate company behavior

and improve investor and creditor protection, China’sfirst company law was promulgated

in 1993 and subsequently modified in 1999, 2004, 2005 and 2013. One of the major legal

environment changes for Chinese enterprises in the recent decade has received much less

attention in the corporate finance and accounting literature is China’s Enterprise Income

Tax (EIT) Law reform in 2008 (or tax reform hereafter). Ever since its economic opening in

1979, China has launched its economic liberalization policy to attract foreign direct

investment (FDI) through carefully designed policy measures especially in the forms of

building a business-friendly environment and designing “preferential”treatments for

JEL classification –M4, G3, F38

Loans in China

111

Received29 September 2017

Revised26 November 2017

11January 2018

Accepted12 January 2018

InternationalJournal of

Accounting& Information

Management

Vol.27 No. 1, 2019

pp. 111-129

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-09-2017-0114

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

foreign investors. Previously, listed firms were governed by a tax law established in 1994

under which all domestic firms pay incometax at the flat tax rate of 33 per cent and foreign-

invested firms established in Chinaenjoyed 15 per cent preferential tax rate. In essence, tax

exemptions were used as one of the major incentivesfor attracting foreign direct investment

by Chinese central and local governments. On 13 March 2007, The National People’s

Congress passed a new EIT Law which took effect on 1 January 2008 and unified tax rates

for both types of firms to 25 per cent. Foreign-invested firms established prior to January

2008 were allowed a 5-yeartransition period during which they pay 18, 20, 22, 24 and 25 per

cent tax.

Cross-country studies by La Porta et al. (2002),Klapper and Love (2004) and Aggarwal

and Goodell (2009) suggestthat common law determines national financing preferences and

the legal and regulatory environment is a key determinant of controlling shareholder

expropriations of minorityinterests, which is often referred to as “Tunneling”(Johnsonet al.,

2000). This line of research hasfocused on legal protection for investors and enforcement of

laws whereas studies on tax laws and controlling shareholder tunneling are scant.

According to Xu et al. (2011), tax enforcementcan act as a corporate governance mechanism

and tax authorities play a positive role in decreasing agency costs in Chinese firms.

Although the tax reform is not a reform on corporate internal governance mechanisms,

firm’s response to the new tax regime is dependent on firm ownership and control. In a

similar vein, Wong et al. (2015) highlightthe interplay between ownership structure and tax

avoidance incentives in determining the economic consequences of related-party

transactions. Recent work by Huang (2016) has reported increased loan guarantees issued

by Chinese listed firms to their related parties after the 2008 tax reform. Moreover, studies

such as Liu and Lu (2007),Lo et al. (2010),Lo and Wong (2011),Shevlin etal. (2012) and Lin

et al. (2012,2014) have extensively documentthat China’s previous multiple-tier tax system

incentivizes earnings managementand related-parties sales which may facilitate tunneling.

Wong et al. (2015) further indicate that tax avoidance incentives often couple with

management’s rent extraction activities. Furthermore, Huang et al. (2018) report a negative

link between executivecash compensation and corporate tax aggressiveness amongChinese

firms. According to this most recent research, equity-based incentive compensation is not

widely adopted among Chinese firms and adverse selections by shareholders and creditors

pressure managers, whose compensation is mostly paid in cash, reduce firm risky tax

avoidance activities. Although tax avoidance activities may reduce group average tax

burden at the cost of government tax revenues,minority shareholders for listed subsidiaries

bear the cost of subsidizing non-listed subsidiarieswithin the same groups. The tax reform

therefore can potentially lead to improved corporate governance by reducing income-

shifting incentives by abolishing the old multiple-tier tax system that encourages intra-

group transfers of profits.

To our knowledge, the little evidence that has been documented in this line of research

shows that tax, as an exogenous factor, playsimportant role in determining firm tunneling

activities through extensively studied intercorporate loans (Jiang et al.,2010). This paper

fills this research gap by using the 2008 tax reform in China as an exogenous shock (or

natural experiment) to study tunneling.In addition, we also add to the understanding of tax

system and tunneling by conductingboth long-term event studies using accounting proxies

for tunneling and short-term event studies using excess returns associated with tunneling.

Neither An (2012) nor Huang (2016) analyzes short-term stock returns responses to the tax

reform. As long-termevent studies are often subject to other changes takingplace in China’s

dynamic economy, short-term studies on stock reactions adds valuable insights for

understanding market expectations of the reform outcomes. Short-term stock market

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