Tax Havens Can Have Hidden Costs for Corporations

While companies incorporate in tax havens to reduce their tax burden and improve their bottom lines, a recent study finds investors are leery of the risks associated with tax havens.

Concerns about those risks can drive up a firm’s cost of equity capital, which is the expected rate of return the shareholders require to invest in the company.

“Basically, when a company is riskier, shareholders demand a higher expected rate of return, which could be through higher dividends or expected future growth in the company’s stock price,” says Christina Lewellen, corresponding author of the study and an assistant professor of accounting in North Carolina State University’s Poole College of Management. “A higher cost of equity capital could deter investors if they are not sure that the return on their investment will be high enough to compensate them for the level of risk. Therefore incorporating in a tax haven could curtail the benefits of moving to a tax haven in the first place.”

At issue are tax havens: countries with very low tax rates and laws that are conducive to corporate secrecy.

“The research is all over the place in terms of risks associated with incorporating a company in a tax haven,” Lewellen says. “Some studies find significant risks, others find little or no risk. We wanted to see what actual shareholders think, and what that might mean for the company’s constraints on raising capital.”

To address these questions, Lewellen and her collaborators drew on data from more than 7,500 publicly traded, multinational companies incorporated in 23 countries that are not tax havens. They then compared this information with data from more than 500 companies that are based in the same 23 countries, but that are incorporated in one of 20 tax haven countries. Altogether, the researchers compiled 41,480 firm-years of data from between 1990 and 2013.

“Basically, we found that investors view tax havens as having additional risks,” says Lewellen. “Because of this, the cost of equity capital of companies incorporated in tax havens is higher than other companies.

“For example, if you had two identical companies but one was incorporated in the U.S. and the other was incorporated in a tax haven, investors would likely choose to invest in the U.S. company – unless the tax haven company could promise higher dividends and/or higher stock price growth to compensate for the additional risks.”

Ultimately, the researchers found that this means companies incorporated in tax havens face a higher cost of raising equity capital of between 5% and 19%.

The perceived effect was enhanced by three types of risk: tax risk, information risk and legal risk. Tax risk is the risk that a company’s efforts to reduce its tax burden end up running afoul of tax law in other countries, resulting in the payment of back taxes and financial penalties. Firm-level information risk is a risk to investors stemming from the fact that some tax havens have laws that allow a company to be less transparent with its shareholders. Country-level legal risk is another risk to investors, caused by the absence of legal mechanisms in some tax havens for enforcing responsible behavior on the part of corporate leadership.

“In short, we found that there is a pretty significant cost of raising capital associated with incorporating in tax havens,” Lewellen says. “That tells us investors have concerns with tax havens. And it suggests that those concerns may be enough to deter corporate relocations to tax havens – it may not be worth the risk of substantially increasing the cost of raising capital.

“For accountants, it also highlights the importance of disclosing risks associated with incorporating in a tax haven. If investors are aware of the risks, heightened transparency could be one way to address those concerns.”

The paper, “Tax Haven Incorporation and the Cost of Capital,” is published in the journal Contemporary Accounting Research. The paper was co-authored by Landon Mauler of Florida State University and Luke Watson of Villanova University.

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Note to Editors: The study abstract follows.

“Tax Haven Incorporation and the Cost of Capital”

Authors: Christina M. Lewellen, North Carolina State University; Landon Mauler, Florida State University; Luke Watson, Villanova University

Published: June 5, Contemporary Accounting Research

DOI: 10.1111/1911-3846.12703

Abstract: Incorporating the firm’s corporate parent in a tax haven is a major decision that receives significant attention from many stakeholders, yet certain implications of this corporate strategy remain unclear. While tax haven incorporation offers tax savings, it also imposes risks that are potentially costly and hence important to consider. We predict and find a higher cost of equity capital in firms with parent companies that are incorporated in tax havens but that are primarily based in nonhaven countries. We also predict and find that the observed cost of equity premium is more pronounced in firms with greater tax risk, firm-level information risk, and country-level legal risk. We also employ corporate inversions in a difference-in-differences test and again find a positive relation between tax haven parent incorporation and the cost of capital. Our findings imply that an increased cost of capital is a material cost of tax haven parent incorporation. We contribute to the literatures on valuation of tax haven use, tax and nontax costs of corporate tax strategies, corporate inversions, and the relation between taxes and the cost of capital. Our study provides evidence on the tax and nontax risks of a uniquely observable tax strategy (i.e., tax haven parent incorporation) that could factor into firms’ decisions about whether to incorporate in a tax haven and policymakers’ efforts to deter such activity.

This post was originally published in NC State News.