Craig Doidge and Alexander Dyck
Taxes and corporate policies: Evidence from a quasi-natural experiment
Journal of Finance | Volume 70, Issue 1 (Feb 2015), 45-89

Nobel Laureate Eugene Fama recently stated that the big open challenge in corporate finance remains to produce evidence on how taxes affect market values and thus optimal financing decisions (ARFE, 2011). We document important interactions between tax incentives and corporate policies using a “quasi natural experiment” provided by a surprise announcement that imposed corporate taxes on a group of Canadian publicly traded firms. The announcement caused a dramatic decrease in value although prospective tax shields partially offset the losses, adding 4.6% to firm value. In response to changing tax incentives, firms subsequently adjusted corporate policies. They increased leverage to gain interest tax shields and reversed changes in other policies made to capitalize on tax benefits. Because we document changes in valuations and in several intertwined corporate policies, our evidence is supportive of the view that taxes are important for corporate finance.

Income trusts and the tax policy change

The tax policy change we exploit is officially known as the Tax Fairness Plan (TFP) but is unofficially referred to as the “Halloween Massacre” because it took place after markets closed on October 31, 2006. The TFP affected a large number of publicly traded Canadian firms called income trusts. Similar to Real Estate Investment Trusts (REITs), firms that adopted the income trust structure could avoid paying almost all corporate taxes while retaining the advantages of the corporate structure. The trust structure, which arguably had no nontax rationale, allowed trusts to pass all income through to investors who were then taxed at the personal level. In contrast, income earned by public corporations is taxed twice, once at the corporate level and again at the shareholder level when income is distributed. Thus, income generated by trusts faced fewer and lower taxes than income generated by corporations, with the tax gain from holding a trust depending on the investor's personal tax status.

The trust market grew rapidly in the early 2000s. Established publicly traded corporations from a broad cross-section of industries converted to the trust structure and new firms went public as trusts. At its peak just prior to October 31, 2006, the trust market included 216 trusts from a wide variety of industries worth $165 billion (Canadian dollars) and four corporations worth another $88 billion had announced plans to convert but had not completed the conversion. In total, these firms accounted for almost 13% of the market value of the Toronto Stock Exchange. The widely held view at the time was that the tax-advantaged status of income trusts was here to stay.

Not only was the plan to tax trusts a surprise to the market, the tax change was dramatic (the corporate tax rate increased from 0% to 31.5%), and was not contaminated by other information or policy changes. It effectively eliminated the tax advantage of the income trust structure (REITs were exempted). Existing trusts were given a four-year transition period and could retain their preferential tax status through January 1, 2011. Following the TFP, funds stopped flowing into the trust sector and most trusts made new organizational choices.

Taxes and the value of corporate policies

Figure 1 shows the cumulative abnormal returns on a value-weighted portfolio of trusts around the TFP announcement. It confirms that the TFP announcement was a complete surprise and shows the dramatic decrease in trust values after the announcement. On average trust values fell by 15% although there was substantial variation across trusts. We use this variation to provide new market-based evidence on the value of tax shields and the extent to which taxes reduce firm value.

1: Returns around the Tax Fairness Plan announcement
This figure shows cumulative abnormal returns on portfolios of trusts and REITs from September 26 to December 29, 2006 (days -25 to +40 around the October 31 announcement). It also shows cumulative returns on a value-weighted portfolio of corporates.

The trust structure provided a tax shield until it expired at the end of 2010. After that, trusts could use debt or nondebt tax shields to lower their taxes. We expect the value drop following the TFP should be smaller for trusts with access to more potential tax shields. To test this idea, we regress each trust's value drop on its prospective tax shields, measured as the sum of debt and nondebt tax shields used by corporations in the same industry. We also control for other factors that could influence the value drop, including the value of the four-year transition period for each trust. In these regressions, we focus on the 149 trusts with complete data. As expected, trusts with more prospective tax shields were less affected by the TFP. Our estimates imply that a trust that is fully affected by the TFP and has mean prospective tax shields is worth 4.6% more compared to a trust with no prospective tax shields.

The tax gain from holding a trust was greatest for tax exempt investors (e.g., investments held in individual investors' retirement accounts and pension funds) and smallest for taxable Canadian investors. Therefore, trusts that have a marginal investor with a lower personal tax rate should be more affected by the TFP and have a greater value drop. We include a well-known proxy for the tax status of the marginal investor (the Elton-Gruber (1970) ex-dividend day drop ratio) in our regressions and find that this is the case. With this proxy, we can also test whether the value of prospective tax shields differs depending on the tax status of the marginal investor. We find that prospective tax shields are worth more if the marginal investor has a lower personal tax rate.

Finally, because the TFP was a change in the corporate tax rate (from 0% to 31.5%), we can directly measure the net impact of this change on firm value. Our estimates, which control for a variety of factors including the transition period and tax shields, imply that firm value fell by 17.5%.

Taxes and changes in corporate policies

Our evidence shows that taxes significantly reduce value. Thus, firms should be willing to change their corporate policies or organizational structure to seek advantageous tax treatment. If the benefits from advantageous tax treatment are large enough, firms should be willing to incur costs on other margins to gain preferential tax treatment, as long as there is a net benefit. This view suggests an interconnected nature across a range of corporate policies. The same predictions go in reverse if the preferential tax treatment is eliminated.

If the tax advantage of trust status provided incentives to alter corporate policies, the effects should be observable before the TFP as firms converted from corporate to trust status and after the TFP when trusts lost their tax advantage. We start with leverage, an important corporate policy with clear tax incentives. Prior to the TFP, debt had no value as a tax shield for trusts. As expected, we find that trusts had lower leverage than when they were organized as corporates. With the loss of the trust tax shield due to the TFP, trusts could increase leverage to create an alternate source of tax shields. To identify a change in leverage in response to the TFP, we estimate regressions that compare year-to-year changes in leverage for trusts relative to corporates from 2007 to 2010. After controlling for observable and unobservable firm characteristics, plus industry and year effects, we find that trusts increased their leverage by six percentage points relative to corporates, an economically significant change given that the average debt-to-value ratio was about 20% in 2006.

We also examine other policies more closely tied to the specific trust tax rules. To fully capture the tax benefits of the trust structure, trusts had to pay out all earnings. This made it costly to build up cash holdings and to use these holdings to finance investment. Therefore, trusts had a tax incentive to increase payout and decrease cash holdings, and to the extent that external finance is costly, they had a disincentive to invest. The evidence is consistent with these predictions. Prior to the TFP, trusts had higher payout, lower cash holdings, and lower investment than when they were organized as corporates. After the TFP, they reversed these changes by reducing payout, increasing cash holdings, and increasing investment relative to corporates. Although the changes in these policies depend on specific income trust tax rules, our analysis suggests that managers are willing to make substantial, and potentially costly, accommodations to a number of corporate policies to access preferential tax treatment. Most interesting are the investment results as investment policy is central to value creation.

As a final test of the interactions between tax incentives and corporate policy choices, we examine acquisitions. Prior to the TFP, trusts' tax-advantaged status increased their value relative to corporates. We predict that trusts were more likely to be acquirers and less likely to be targets compared to corporates. Similarly, with the loss of the tax advantage due to the TFP, we predict that trusts were more likely to be acquired after the TFP as takeovers are one channel that can change organizational form and potentially offer more tax shields. The results are consistent with these predictions.


We offer new market-based evidence on the value of tax shields as well as new evidence of interactions between tax incentives and corporate policy choices. The combination of event study and time-series evidence that we provide is difficult to reconcile with nontax explanations. The increase in leverage after the TFP is consistent with the importance of debt tax shields while the results for investment and acquisitions highlight the potential for tax incentives to alter value-relevant policy choices. To the extent that trusts made potentially inefficient and costly changes to their investment policies, the net tax benefit of being a trust was likely worth less than the potential gross benefit of 31.5%. The idea that firms are willing to make costly changes to important policies to gain preferential tax treatment is consistent with all our other evidence that suggests taxes have an important impact on corporate decision-making.