A number of firm-level characteristics are suggested to be associated with corporate tax avoidance, as discussed below.
Firm size
Firm size is the most widely recognised firm-level characteristic related to corporate tax avoidance. However, no consensus has been achieved in the literature regarding whether firm size exerts a positive or negative effect on tax avoidance. Those proposing a positive firm size effect argue that, compared with small companies, large companies have greater incentives and ability to engage in corporate tax avoidance activities that are costly to plan and establish. Siegfried (1972) shows that larger companies have greater power to influence political process for their interest and undertake tax planning to achieve optimal tax savings than do their smaller counterparts. Mills, Erickson and Maydew (1998) find that tax planning costs decrease as firm size increases, suggesting the existence of economies of scale in tax planning. Studies proposing a negative firm size effect on corporate tax avoidance argue that large companies are subject to greater scrutiny and regulatory actions, and subsequently incur higher political costs, such as taxes, than do small companies (e.g. Omer, Molloy & Ziebart 1993; Watts & Zimmerman 1978; Zimmerman 1983).
The empirical results in the literature are also mixed. While a number of studies document a negative (positive) relation between firm size and ETR (corporate tax avoidance) (e.g. Harris & Feeny 2003; Tran & Yu 2008; Tran 1997), some report a positive relation (e.g. Davidson & Heaney 2012). Moreover, the studies by Gupta and Newberry (1997); Holland (1998); and Richardson and Lanis (2008) produce mixed results. The studies by Stickney and McGee (1982); and Wilkinson, Cahan and Jones (2001) find no significant
relation between firm size and ETR. Although these different results may be attributable to different proxies used for firm size, different study periods, and different sample companies, the relation between firm size and ETR may warrant further investigation.
Profitability
Similar to firm size, the influence of profitability level on corporate tax avoidance is not consistently documented in prior studies. Wilkie (1988) and Wilkie and Limberg (1993) find a positive, though not linear, relationship between pre-tax accounting profit and ETR. However, since the two studies do not control for firm size (a factor closely related to profitability), the findings may be confounded by the firm size effect. Recognising this correlation, Rego (2003) argues that, when holding firm size constant, more profitable companies engage in more tax avoidance activities than their less profitable counterparts because of the lower costs of tax avoidance they face. In line with her argument, Rego (2003) documents a negative relation between profitability and ETR, after controlling for firm size. Manzon and Plesko (2002) concur that more profitable companies are in a better position to efficiently use tax deductions, tax credits and tax exemptions than are less profitable companies.
Nevertheless, several studies simultaneously considering firm size and profitability show a positive relation between profitability and ETR (e.g. Chen et al. 2010; Gupta & Newberry 1997; Richardson & Lanis 2008). It should be noted that, in these studies, the relation between firm size and ETR is not consistently strong across different sample periods and across models with different ETR measures. Therefore, it is questionable how profitability captures an aspect of firm-level characteristics different from firm size in terms of influencing ETR.
Foreign entities and foreign operations
Having subsidiaries or branches located in foreign countries with different (especially lower) tax rates offers an opportunity for companies to reduce their worldwide tax liabilities through the aforementioned cross-border profit shifting arrangements, such as intra-group transfer pricing. This opportunity is not available to domestic-operating companies. Previous studies, especially those in the U.S., recognise a positive relation between foreign operations and corporate tax avoidance. Anecdotal evidence—such as the case of Wachovia Bank discussed in McGill and Outslay (2004), and the case of Enron discussed in Bankman (2004)—clearly demonstrates the use of foreign entities for
corporate tax avoidance. Mills, Erickson and Maydew (1998) report that U.S. companies with foreign operations have greater investment in tax planning.
Empirical studies employ different measures of foreign operations, including, but not limited to, a foreign operation indicator that takes the value of 1 if the company has foreign operations (foreign income) and 0 otherwise (e.g. Frank, Lynch & Rego 2009), the extent of foreign operations expressed as the ratio of foreign income (or sales) to total income (or sales) or assets (e.g. Chen et al. 2010; Huseynov & Klamm 2012; Lisowsky 2010), and subsidiary location indicators (e.g. Rego 2003). Despite the different measures, the positive relation between foreign operations and corporate tax avoidance is widely recognised in U.S. studies.
Leverage
Leverage or debt financing is a way to avoid tax; however, the effect of leverage on ETR is not clear cut. Theoretically, leverage should not be an ETR determinant because interest expense is deductible for both accounting and tax purposes. Thus, adopting a highly leveraged capital structure is a book-tax conforming tax avoidance method. However, a number of studies reveal a negative relation between leverage and ETR (e.g. Frank, Lynch & Rego 2009; Markle & Shackelford 2012; Rego & Wilson 2012; Xian, Sun & Zhang 2015).12 The explanations offered for the empirical results vary. Graham (2003) argues
that companies may use debt financing because of the tax deductibility of interest expense, and would subsequently have higher leverage ratios. Mills, Erickson and Maydew (1998) view leverage as a proxy for a company’s financial transaction complexity that provides an opportunity for tax avoidance. There are also studies finding no significant effect of leverage on ETR (e.g. Richardson & Lanis 2008).
Although not directly affecting ETR, leverage can be related to corporate tax avoidance in an alternative way. Several studies view issuing debt as one of the competing corporate tax avoidance mechanisms that take advantage of the tax deductibility of particular expenditures, such as depreciation and investment credits. DeAngelo and Masulis (1980) develop a model that predicts a negative relationship between the level of debt and level of available non-debt tax shields. Trezevant (1992) concurs and demonstrates that highly leveraged companies may have less need for non-debt tax shields. Graham and Tucker
12 Frank, Lynch and Rego (2009) employ corporate tax avoidance proxies other than ETR, such as BTD.
(2006) propose that companies engaging in tax shelters would use less debt financing (lower leverage) to the extent that the tax shelters reduce tax.13 Based on a sample of 44 tax shelter cases, Graham and Tucker (2006) find supporting evidence for the tax shelter substituting for use of debt. Wilson (2009) and Lisowsky (2010) also indicate that tax shelter use is negatively associated with leverage.
Thus, the relation between leverage and corporate tax avoidance measured by ETR requires further investigation. It is plausible that leverage per se does not affect ETR, yet shapes ETR by affecting other factors that are directly related to ETR.
2.6
Summary
This chapter provides a brief review of the corporate tax avoidance literature, mainly in the accounting discipline. Publicly listed companies typically adopt book-tax non- conforming tax avoidance arrangements that can largely be captured by ETR and its variants. For MNEs, intra-group transfer pricing and thin capitalisation (which are book- tax conforming tax avoidance) also appeal, and may be more potent than book-tax non- conforming tax avoidance. Moreover, prior studies document a number of firm-level characteristics that may affect corporate tax avoidance, such as firm size, profitability, foreign operations and leverage.
It should be noted that most prior studies are conducted using U.S. data. However, as will be discussed in the next chapter, the tax system in the U.S. differs from that in Australia, which may render some of the theories and findings in the U.S. studies not applicable in the Australian context.
13 A tax shelter is defined by the U.S. Congress as an arrangement designed for the purpose of avoiding tax,