Tax Haven Incorporation and the Cost of Capital*

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.

Aggressive Tax Planning and Labor Investments

“…First, we examine institutional ownership as an internal governance mechanism. Second, prior literature suggests that financial analysts act as an external monitoring mechanism and help mitigate information risk (e.g., Dyck et al, 2010; Hong et al, 2014) and Lewellen et al (2021) provide evidence that low analyst following exacerbates information risk associated with aggressive tax avoidance. Thus, we also examine how our results vary with high and low analyst following.…”

“…While traditional notions of tax planning suggest that corporate tax avoidance results in a simple transfer of wealth from the government to shareholders, more recent literature puts aggressive tax planning in an agency framework (e.g., Desai & Dharmapala, 2006). Consistent with this theory, studies find evidence that aggressive tax planning is associated with a higher cost of capital (e.g., Hasan et al, 2014;Lewellen et al, 2021), financial reporting opacity (Balakrishnan et al, 2019), and agency problems (e.g., Armstrong et al, 2015;Desai & Dharmapala, 2006). Thus, this stream of literature provides evidence that aggressive tax planning can create opacity, and it proposes that managers can use this opacity to further their own personal wealth at the cost of shareholder wealth, resulting in suboptimal firm decisions.…”

The Debt and Non-Debt Tax Shields Trade-Off: A Review

“…Yet, at a firm level, different type of tax avoidance activities may have different effect on the expected cost of capital. Lewellen et al (2021) show that group incorporation in a tax haven is positively associated with the cost of equity capital, suggesting that shareholders perceive aggressive level of tax avoidance as potentially detrimental for their expected level of return. Specifically, the negative relationship provided by the Authors is enhanced in presence of risks, including: (i) tax risks; (ii) informative risks; (iii) legal and country-specific risks.…”