U.S. companies with board directors who have connections to well-known island tax havens of the Bahamas, Bermuda and the Cayman Islands exhibit significantly greater tax avoidance than other companies, according to a novel study that includes two University of Kansas School of Business professors and one alumnus.
In their recent Management Science article, researchers found that the presence or arrival of a board director with those ties—deemed an island director—would reduce a company's effective tax rate by approximately one to three percentage points, on average. They also observed a significant increase in the use of tax haven subsidiaries after the arrival of an island director.
"The reduction in effective tax rates translates into millions of dollars in increased earnings for shareholders owning stock," said co-author Tom Kubick, associate professor of accounting.
Researchers have devoted a lot of attention to tax policy and U.S. corporations' tax outcomes, but scholars have paid relatively less attention to whether individual directors can influence corporate tax policy within companies.
"Nobody has paid attention to the fact that companies were systematically acquiring this tax avoidance expertise," said co-author Jide Wintoki, associate professor of finance. "In this broader debate, nobody was realizing that companies were reducing their tax rates by 1 to 3 percentage points just by having directors that had connections to these tax havens."
Their co-authors were Chao Jiang, KU graduate and assistant professor of finance at the University of South Carolina, and Mihail Miletkov, associate professor of finance at the University of New Hampshire.
A company's level of tax avoidance does not constitute anything illegal, but the practice of tax avoidance in recent years has received significant criticism from the media, regulators and some politicians who often raise questions as to whether U.S. companies are shouldering an equitable share of the tax burden. The issue can also be a reflection of the competitiveness of U.S. tax policy, the researchers said.
To conduct the study, they identified a set of U.S. directors and senior executives who serve or had served for foreign companies domiciled in the Bahamas, Bermuda and the Cayman Islands.
Then they examined what happened to the tax outcomes—the effective tax rates—of U.S. companies after the arrival of an island director to their board. Their sample covered years 1994 through 2010 and included 29,191 company-year observations, of which 2,140 had a clearly identifiable island director.
During that time they observed consistent evidence of a significant increase in tax avoidance following the appointment of an island director. The average book effective tax rate before the island director was 34.5 percent, and once the island director arrived, that dropped to 31.5 percent. Similarly, the average cash effective tax rate fell more than two percentage points from 25.6 percent to 23 percent.
Another key contribution of the study is the implication that a board director's affiliation with a company can be more important than it appears.
"It's very challenging to disentangle the effect of one specific board member," Kubick said. "In particular, it's difficult to identify whether there is some sort of information flowing through a network simply because U.S. companies share board members."
The innovation in how they structured the data involved not comparing board members between U.S. companies but instead looking at the arrival of a board member from an island tax haven to measure how specific expertise that could affect the U.S. company's tax outcomes and level of tax avoidance.
"We think another important aspect of this is that we're also documenting a phenomenon that may have been underestimated, which is how much being connected to tax havens matters," Wintoki said.
The island directors are able to utilize tax avoidance expertise and transfer it into corporate policies, he said.
"This expertise has a really significant effect on U.S. companies, even if they are not located themselves in island tax havens," Wintoki said.
Kubick said one caveat of the study is the researchers obviously cannot observe every detail and dynamic within the board.
"We're looking at this from a distance, but in spite of that, the results seem to be pretty compelling because we are controlling for a number of important characteristics," he said.
This type of research could also be significant depending on what happens in Congress in wake of last year's federal tax overhaul, especially if Democrats regain power in Washington and seek to roll back some of the recent changes.
"If Congress increases tax rates, we're losing competitiveness in terms of the rate difference between U.S. and foreign nations, and we might see companies being more aggressive," Kubick said.
For investors and policymakers looking at companies, examining the makeup of boards and board member's social and network connections could provide a key new piece of insightful data.
"Directors, it turns out, are important in influencing corporate policy. It's not just that every company has a script and everybody does the same thing," Wintoki said. "Directors matter, and this is a clear, tangible example of the fact that directors elected by shareholders are actually important."
Explore further: Companies located near an IRS office more likely to face an audit, avoid more taxes
Chao Jiang et al. Offshore Expertise for Onshore Companies: Director Connections to Island Tax Havens and Corporate Tax Policy, Management Science (2017). DOI: 10.1287/mnsc.2017.2776