The Effect of Shareholder Scrutiny on Corporate Tax Behavior: Evidence from Shareholder Tax Litigation

What are the causes and consequences of shareholder tax litigation? The annual frequency of shareholder tax litigation has nearly tripled in recent years, but little is known about why certain firms get targeted with this kind of litigation and how this litigation affects not only the sued firm but also its industry peers. Our recent paper examines these questions.

Further motivating our study, shareholder tax litigation can create substantial economic and reputational risks for firms and their stakeholders as shown by the recent securities class action against Pall Corporation. Validating this risk, recent research has also shown that director and officer (D&O) liability insurers price tax litigation risk into firms’ D&O insurance policies. Additionally, while shareholder tax litigation is still relatively rare, despite its significant increase in frequency in recent years, its effects may spill over to sued firms’ industry peers. As a result, shareholder tax litigation has the potential to broadly influence corporate tax planning and reporting, which can aid related efforts by the Internal Revenue Service (IRS) and Securities and Exchange Commission (SEC) to curb aggressive tax avoidance and misleading tax reporting and disclosures.

We examine shareholder tax litigation from 1996 through 2018. Because allegations in shareholder tax litigation commonly involve both tax avoidance strategies and tax financial reporting, we use several proxies to capture different aspects of tax avoidance. In the analyzed time period, there were 123 shareholder tax-related cases filed against public firms. These cases have resulted in $950 million in settlements with 21 cases still pending, although total litigation cases likely exceed $1.2 billion after adding defense costs. The appendix in our paper provides several examples of shareholder tax litigation and the different types of tax-related allegations involved.

We first examine the association between several lagged tax measures and the likelihood of shareholder tax litigation filings. We find shareholder tax litigation is more likely when firms exhibit higher levels of tax avoidance and greater tax uncertainty.

We next examine whether sued firms reduce tax avoidance after the filing of shareholder tax litigation. We expect that litigation increases the cost of future tax avoidance for sued firms, due to increased reputational risk for managers and the firm itself and the threat of additional related scrutiny from tax authorities and regulators, and thus may decrease the equilibrium level of tax avoidance. Due to the endogenous nature of litigation, we use a matched sample in these tests of firms targeted with shareholder tax litigation (i.e., treatment firms) and firms targeted with non-tax shareholder litigation (i.e., control firms). We thus hold shareholder litigation constant across our sample and use entropy balancing to ensure firms are similar on all observable dimensions. Using a difference-in-differences design, we find that sued firms decrease tax avoidance activities after the litigation.

Furthermore, we investigate potential spillover effects since firms often mimic peers’ tax strategies. We similarly use a difference-in-differences design with a matched sample and entropy balancing in these tests. We compare high litigation risk industry peers of the sued firm (i.e., treatment firms) to low litigation risk industry peers (i.e., control firms). We thus hold industry-wide economic factors constant, but only treatment firms are expected to respond to changes in tax litigation risk as control firms face minimal risk of being sued. We find that treatment firms decrease tax avoidance and tax uncertainty after the sued firm’s shareholder tax litigation. Thus, shareholder tax litigation exhibits a strong spillover effect.

Finally, we exploit cross-sectional variation to test if the spillover effects are strongest where theory predicts results to be concentrated. We focus on two partitions of our sample. We first examine sued firms that are product market leaders versus other sued firms since peers are more likely to mimic the tax strategies of industry leaders. We also examine sued firms that experience higher abnormal media coverage around the tax litigation filing versus other sued firms since greater media coverage increases the visibility of the alleged tax misconduct. In both cases, we find that peers increase their tax avoidance when the sued firm is a product market leader or has high abnormal media coverage around the litigation filing date and minimal spillover effects for other sued firms.

We conduct a number of tests to minimize concerns that we are capturing the effects of non-tax shareholder litigation or tax-related SEC comment letters. Specifically, we separately re-estimate our tests after excluding shareholder tax litigation triggered by tax authorities or other government actions (e.g., IRS audits) or followed by regulatory actions (e.g., SEC enforcement) and after controlling for the receipt of a tax-related SEC comment letter. We obtain similar results across all specifications, indicating that our results are not due to these alternative explanations. We also conduct tests to ensure that the parallel trends assumption underlying our difference-in-differences test appears reasonable.

In conclusion, our study contributes to the academic literature in several ways. First, we extend the literature on the determinants and consequences of litigation to examine tax-related litigation. In contrast to most non-tax litigation (e.g., securities class actions), tax litigation could curtail a legal, but risky, value-maximizing activity simply due to differences in managers’ and investors’ risk preferences. Second, we contribute to the literature on how scrutiny of tax issues affects corporate tax behavior by showing a direct mechanism by which shareholders can monitor corporate tax behavior. Third, we inform prior research on the spillover effects of tax scrutiny. Given recent evidence that internal resource constraints have negative effects on IRS tax enforcement and SEC monitoring, our results indicate that shareholder tax litigation can play an increasingly important role in complementing the IRS’ and SEC’s tax-related enforcement. Finally, we contribute to the literature on reputation effects of tax avoidance since our results indicate that firms perceive shareholder scrutiny as increasing the reputational costs of tax avoidance.

Dain Donelson is a Professor in the Accounting Department of the Tippie College of Business and the College of Law at the University of Iowa

Jennifer Glenn is an Assistant Professor of Accounting & Management Information Systems at the Ohio State University Fisher College of Business 

Sean McGuire is an Associate Professor at the Texas A&M University Department of Accounting

Christopher Yust is an Associate Professor at the Texas A&M University Department of Accounting

This post is adapted from their paper, “The Effect of Shareholder Scrutiny on Corporate Tax Behavior: Evidence from Shareholder Tax Litigation,” available on SSRN.

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