Iftekhar Hasan, Chun-Keung (Stan) Hoi, Qiang Wu, and Hao Zhang
Beauty is in the eye of the beholder: The effect of corporate tax avoidance on the cost of bank loans
Journal of Financial Economics | Volume 113, Issue 1 (Jul 2014), 109-130

Tax savings from avoiding taxes are a real benefit to corporations. Since shareholders care deeply about after-tax profits, it is reasonable that many corporations are active and even aggressive in undertaking activities to reduce corporate taxes. Nevertheless, not all firms avoid taxes. In fact, a well-known empirical regularity is that many US firms apparently do not avail themselves of tax avoidance opportunities. Weisbach (2002) coined this phenomenon the “under-sheltering puzzle”. This study provides an answer to the “under-sheltering puzzle” by examining how debt holders, particularly banks, perceive tax avoidance activities. We argue that if debt holders perceive tax avoidance as engendering significant risks, they will price the risks into loan and bond contracts, leading to higher borrowing costs, which, in turn, moderate the incentive to engage in tax planning activities.

Why debt holders? What risks?

Debt holders are fixed claimants. They care about downside risk but face limited up-side potential. Accordingly, debt holders are naturally less sensitive to the tax savings from avoiding taxes and more sensitive to the risks engendered by corporate tax avoidance than do shareholders. Focusing on the perspective of debt holders therefore provides an empirical setting that is well-suited for the following queries. Does corporate tax avoidance engender risks? If so, do debt holders price these risks engendered by corporate tax avoidance into debt contracts? Relying on prior literature, we argue that corporate tax avoidance engenders information risk, agency risk, and IRS audit risk. The idea that corporate tax avoidance would increase the IRS audit risk is intuitive. Mills (1998) and Mills and Sansing (2000) provide early evidence on it. More recently, Desai and Dharmapala (2006, 2009) and Kim, Li, and Zhang (2011) argue and find that corporate tax avoidance engenders significant information risk and agency risk. The premise of their argument is as follows. Tax avoidance activities are necessarily complex, obfuscated, and opaque to minimize the risk of detection by the tax authorities. But if firms are hiding information from the tax authorities, they would also need to hide the same information from outside investors, shareholders, and bond holders. This peculiar characteristic of tax avoidance activities exacerbate information risk by reducing firm information quality and they give managers greater latitudes to divert corporate resources for private benefit consumption, leading to greater agency risk.

Tax-avoiding firms face higher bank loan cost

To investigate whether debt holders price risks engendered by corporate tax avoidance into debt contracts, we use a comprehensive sample of around 17,000 bank loans issued to U.S. public firms in the period 1985-2009. We focus on more aggressive tax avoidance practices because they are likely to engender greater risks. We use two book-tax difference measures (Manzon and Plesko, 2002; Frank, Lynch, and Rego, 2009) and cash effective tax rates as the main measures of aggressive tax avoidance. Across all three measures, we find a positive and significant relation between aggressive tax avoidance and loan spread after controlling for known determinants of loan spread.

We use two quasi-experiments to establish the causal effects of tax avoidance on bank loan spreads. The first involves the implementation of Financial Accounting Standards Board (FASB) Interpretation No. 48, hereafter FIN 48. FIN 48 was introduced in 2007 and it affects only those firms that undertake uncertain tax positions to avoid taxes. After FIN 48, these affected firms are required to report tax reserves related to the uncertain tax positions they have taken. However, firms with no uncertain tax position would naturally have no tax reserves to report pursuant to FIN 48. Using a difference-in-differences analysis, we find that firms that disclose a positive FIN 48 tax reserve during a three-year window immediately after FIN 48 incur significantly larger increases in loan spreads when compared to match firms that never report a positive FIN 48 tax reserve in that same period. This result indicates that banks use the tax reserves disclosed in affected firms to infer the firm's tax aggressiveness in terms of uncertain tax position.

The other experiment involves firms that are publicly scrutinized for their engagements in tax shelters. We find, in this setting, that firms affected by tax shelter news have significantly higher increases in bank loan spreads after tax shelter news when compared with match firms without tax shelter news. This result indicates that tax shelter news provides banks incremental information about the firm's tax aggressiveness, which, in turn, causes banks to increase the firm's loan spreads after its tax-sheltering activities became a publicly disclosed news event.

. . . and then some

Banks can adjust nonprice loan terms such as collateral and covenant requirement to mitigate avoidance-induced risks. Accordingly, we examine the effects of aggressive tax avoidance on the likelihood of a collateral requirement and the intensity of covenant requirement. We find that banks tighten collateral and covenant requirements when lending to firms that exhibit greater tax avoidance.

Just as banks would price avoidance-induced risks into loan contracts, so should public bond holders when issuing bonds. In fact, bond holders should be more sensitive to avoidance-induced risks than do banks because they are arms-length lenders. Using an exhaustive sample of bond issuing firms during the same sampling period 1985-2009, we find that firms with greater aggressive tax avoidance incur higher at-issue yield spreads when issuing public bonds. More important, the results indicate that tax avoidance has significantly larger incremental effects on interest spreads of bonds than on those of the bank loans, providing some evidence that public bond holders are more sensitive to avoidance-induced risks. Additionally, based on the combined sample of bond-issuing firms and loan-initiating firms over the same sampling period, we find that firms with greater tax avoidance prefer bank loans over public bonds when seeking debt financing. This latter result is consistent with Bharath, Sunder, and Sunder (2008).


Taken together, the findings on bank loan spreads, at-issue bond yields, nonprice loan terms, and firm debt financing preference for bank loans over public bonds paint a fairly consistent picture of how aggressive tax avoidance affects a firm's cost of debt capital in general. The results show that aggressive tax avoidance has multi-faceted effects on debt contracting and uniformly increases the cost of debt capital, regardless of whether the firm seeks debt financing from private bank loan market or public bond market.

These findings contribute to two under-explored issues in the tax avoidance research. First, they advance the understanding of the “under-sheltering puzzle”. Our findings suggest that, all else equal, a tax avoiding firm could incur a higher cost of debt, which, in turn, moderates the firm's incentive to engage in tax avoidance, providing a potential explanation for the “under-sheltering puzzle”. Second, Hanlon and Heitzman (2010) call for more research to explore how lenders, investors and consumers perceive corporate tax avoidance activities. Our study answers their call, and our findings show that debt holders, including banks and bond holders, view corporate tax avoidance negatively as they perceive tax avoidance as engendering significant risks.