Deciphering Tax Avoidance: Evidence from Credit Rating Disagreements

Abstract

This study investigates the role of tax avoidance in the credit-rating process and whether differences exist in how rating agencies account for the risk relevance of tax avoidance. Using a sample of initial credit ratings assigned to public debt issuances during 1994-2013, our evidence is consistent with Moody's Investors Service and Standard & Poor's assessing the costs and benefits associated with tax avoidance differently from one another, resulting in more frequent and pronounced rating agency disagreement. Rating agency disagreement over tax avoidance is most evident when it is accompanied by relatively high levels of uncertain tax positions, foreign activities, research and development activities, or tax footnote opacity. We also find evidence that decreases (increases) in tax avoidance or tax footnote disclosure opacity are positively (negatively) associated with the convergence of split ratings. This suggests that firms can exacerbate or mitigate rating agency disagreement subsequent to bond issuance. Our study complements prior research by examining why sophisticated information intermediaries disagree about the risk relevance of tax avoidance. It also sheds light on how firms can influence rating agencies' understanding of tax avoidance.impôts dans les etats financiers est en relation positive (n egative) avec la convergence des diff erentes notes attribu ees, ce qui semble indiquer que les soci et es peuvent accentuer ou att enuer les divergences des agences de notation a la suite de l' emission d'instruments d'emprunt. L' etude vient compl eter les recherches pr ec edentes grâce a l'analyse des raisons pour lesquelles des agents chevronn es de transmission de l'information ne s'entendent pas quant a l'incidence de l' evitement fiscal sur l' evaluation du risque. Elle jette egalement un nouvel eclairage sur la mani ere dont les soci et es peuvent influencer la compr ehension de l' evitement fiscal qu'ont les agences de notation.

Does credit rating conservatism matter for corporate tax avoidance?

“…Hasan et al (2014) show that banks impose higher bank loan cost when lending to firms with greater tax avoidance and use both price and non-price loan terms to mitigate avoidance-induced risks. Bonsall et al (2017) show that CRAs have greater disagreement in ratings when rated firms have higher levels of tax avoidance, suggesting that CRAs have difficulties in interpreting more complex and uncertain tax-avoidance activities. It implies that, in the presence of rating conservatism, the risk of rating downgrade is higher when a firm uses more tax avoidance.…”

“…For example, tax avoidance-related transactions could induce agency risk (e.g., Desai et al, 2007), the risk of being audited by tax authorities and penalties and fines for disallowed tax-avoidance practices (e.g., Wilson, 2009), and information risk (e.g., Kim et al, 2011). The risks and costs of tax avoidance might damage the credit quality of firms (Shevlin et al, 2020) and heighten financial distress costs (Bonsall et al, 2017). Hasan et al (2014) show that banks impose higher bank loan cost when lending to firms with greater tax avoidance and use both price and non-price loan terms to mitigate avoidance-induced risks.…”

“…On the other hand, there are opposite arguments against the use of more tax avoidance when CRAs become conservative. Tax-avoidance activities could enhance firm value but could also engender risks that induce debt contracting costs and credit rating downgrades (Guedhami and Pittman, 2008;Crabtree and Maher, 2009;Hasan et al, 2014;Bonsall et al, 2017;Isin, 2018;Shevlin et al, 2020). Firms facing rating conservatism may not perceive tax avoidance as an appealing financing strategy because of its associated costs.…”

“…Third, our study enriches the literature on the determinants of corporate tax avoidance. Prior literature has focused mainly on the impact of tax avoidance as a risk factor in credit rating assessment (e.g., Bonsall et al, 2017;Shevlin et al, 2020), while there is limited research on the impact of rating properties on tax avoidance. Our study extends this line of research by identifying the conservative rating behaviour of CRAs as a determinant of tax avoidance.…”

Tax Haven Incorporation and the Cost of Capital*

“…Specifically, tax haven incorporation itself could signal aggressive earnings stripping (i.e., shifting income from the base country to low tax countries), prompting tax authorities to investigate tax haven firms more aggressively, which may produce future tax-related payments for settlements, interest, and penalties. Since firms attempt to obfuscate their tax positions to avoid tax authorities' scrutiny, capital market participants may face difficulty accurately estimating a firm's tax risk (Bonsall et al 2017). However, investors can infer earnings stripping from low effective tax rates (ETRs) and ETR reconciliations found in the footnotes to the firm's financial statements, which highlight permanent tax reductions such as lower tax rates applicable to foreign income.…”