Investigating the Relationship between Tax Avoidance and Debt in Corporates Dr. Farzin Rezaei 1, Javad Rezazadeh 2 and Esmaeil Moradi 3,* 1 Assistant Professor, Islamic Azad University, Qazvin Branch 2 Associate Professor, Imam Khomeini International University of Qazvin 3 Master Student, Science and Research University of Qazvin ABSTRACT The trade-off theory in capital structure and taxes suggests that optimal taxation for firms is determined by balancing the benefits of debt against the costs of debt. Accordingly, one of the benefits of debt is that the costs resulting from debt usually include tax shield and on the other hand, high costs of debt may increase the risk of bankruptcy due to not fulfilling obligations. The benefits of debt are usually more than the costs of debt. Actually, the high cost of debt and anticipation of failure to pay debt on time make companies to use ways other than the cost of debt to pay less tax and thereby cash outflow; tax avoidance is one of the common methods in this regard; hence, the present research attempts to discover the conditions in which tax avoidance can be replaced with the use of debt; for this purpose, it investigates the relationship between substitution of tax avoidance and debt in companies listed on Tehran stock exchangeover a 10-year period (2002-2011)to answer whether tax avoidance can be substituted for the use of debt; also, it examines the impact of tax shields and costs of debt on the use of tax avoidance instead of debt. The results of this study indicate the absence of a positive relationship between tax avoidance of factors resulted from other than earnings management and debt as well as the presence of a positive relationship between tax avoidance and the loss of tax shields and the cost of debt. KEYWORD tax avoidance, financial leverage, debt substitution, tax shield A INTRODUCTION fundamental assumption in the literature of financial management is that each company is formed with the aim to maximize the wealth of its shareholders; and to achieve this objective, the management should take into consideration the factors of cash outflow and use while making decisions. The corporate income tax reduces its future earnings; so, one of the actions that can be done to *Corresponding Author: Esmaeil Moradi E-mail r: Telephone Number r: Fax. Number r: maximize corporate value and shareholders wealth is the use of strategies through which the tax payable is reduced THE PROBLEM STATEMENT Tax avoidance is defined as the strategy taken to reduce taxes allocated to the profits of a business unit; however, there is no scientific definition of tax avoidance accepted in accounting research. Anyhow, according to this definition, tax avoidance includes a series of strategic programs and activities which are completely legal and progressive in obtaining tax exemption and lead to an ambiguous space in providing financial and tax information and reports to people outside the organization. THE COST OF DEBT AND THE REASONS FOR USING IT The correct use of financing by debt is considered as one of the most important strategies in financial management of companies. Financial leverage is a tool used to describe the relationship between funds and reserves of shareholders and funds already set aside or borrowings or both. Funds already set aside include funds with the payment of interest and dividends before the common stockas well as the priority in principal receivables from the company when they become cash. 1. Financing through debt leads to tax savings due to interest payments; also, this way of financing is cheaper than financing through shareholders. In fact, financing through debt reduces the weighted average cost of capital even when interest rates are high, because the expected rate of return is greater than interest expense due to the higher risk and lack of tax savings. 2. The financial leverage puts pressure on managers to enhance the return of the company. Since they are aware of the fact that installments of loans must be paid, they try to have a detailed plan in relation to the factors of production. The obligation of debt repayment causes the management not to invest excess cash inflow-yield and low-value projects or acquire assets at a cost higher than their actual value.
THE RELATIONSHIP BETWEEN TAX AVOIDANCE AND THE COST OF DEBT According to Pastrick and Rico (2008), tax avoidance is defined as the legal use of tax system; however, it should be noted that tax avoidance is becoming a major concern in different countries. Understanding the consequences of tax avoidance is a very important topic which has been addressed in various studies, because one of the features of tax avoidance is to save cash outflow; this feature causes companies to increase the use of tax avoidance to reduce their need to outside financing for their projects (Xolbado, 2012). Thus, the lack of cash outflow and in general tax avoidance can be considered as the main factor of cost reduction or in other words, tax avoidance increases the rate of return for investors and owners. On the other hand, since the avoidance is applied legally, it increases the rate of return for shareholders and owners; as a result, it increases shareholders wealth and the flexibility of the company. According to Desai et al. (2009), the tax avoidance activity transfers wealth from the government to shareholders. THE RESEARCH LITERATURE Regarding the impact of tax on capital structure, Deangelo and Masulis (2000) demonstrate that optimal capital structure can be determined based on the balance between the tax benefits resulted from the creation of debt and the relevant financial risks. Financing through the creation of debt is occurred less in companies whose tax benefits resulted from the creation of debt are lower than the cost of risks (resulted from the creation of debt). Harrington and Smith (2012) investigated whether the use of long-term debt in capital structure affects tax avoidance or not. For this purpose, they used tax effective rate index (the ratio of tax expense to profit before tax). Their findings showed that companies using more debt in their capital structure have much higher financial leverage and tax avoidance in comparison to companies with lower financial leverage in their capital structure. Rezaei and Qanaeinejad (2013) studied the relationship between transparency in financial reporting and tax avoidance and corporate value. They measured the transparency using three criteria including quality of earnings, quality of auditing, and turnover. The results of this study showed that when tax avoidance is measured based on the effective rate of long-term cash tax as well as transparency in financial reporting is measured based on turnover and quality of auditing, the relationship between tax avoidance and corporate value will be inverse and there is no significant relationship between tax avoidance and transparency in financial reporting. Hashemi and Mehrabi (2008) conducted a study to identify the tax factors affecting the advantage of using debt to finance. They concluded that the amount of debt is simultaneously reduced by the reduction of tax rate as well as there is a direct relationship between non-debt tax shields and debt. THE RESEARCH HYPOTHESES The first hypothesis: there is a negative relationship between tax avoidance of factors resulting from other than earnings management and debt. The second hypothesis: substitution effect of tax avoidance is increased by the probability of losing the tax shield. The third hypothesis: substitution effect of tax avoidance is increased by increasing the cost of debt. THE METHODOLOGY A research were the relationship between two or more variables is measured is called a correlational research. Accordingly, the present study is also a correlational research, because it investigates the relationship between independent and dependent variables. After determining samples, the research hypotheses were tested using the independent and dependent variables, regression, the coefficient of determination ( ), and software E-Views (version 7) and SPSS (version 19). The research independent variable is tax avoidance and the dependent variables include the probability of losing the tax shield, the cost of debt, and debt. THE POPULATION, STATISTICAL SAMPLE, AND SAMPLING METHOD The research population consists of all companies listedon Tehran stock exchange during 2002-2011, from which the samples were selected To select samples, the screening method was used; in this method, the researcher defines conditions for the selection of samples; accordingly, members of the population which do not meet the conditions are removed and the remaining forms the statistical sample. Here, the conditions are as follows: 1. The companies must be part of manufacturing industry. Due to the nature of manufacturing companies performance, non-manufacturing companies such as insurance, investment, and holding companies, banks, financial intermediation, and so forth were excluded from the scope of the investigation. 2. The company s fiscal year should end on March 20. 3. The company must not have changed its fiscal year during the period of research (2002-2011). 4. Trading should not have been interrupted for more than 6 months. 5. The information should be accessible and complete. 6. The book value of equity should not be negative during the period of research. 7. The company should be active in stock exchange during 2002-2011 THE RESEARCH MODELS Model (3-1): Calculation of discretionary accruals 1
Dependent ICP Business, Economics and Finance Model (3-2): Calculation of discretionary accruals 2 Type of Varia ble Name of Variable Sy mbol Calculation Method Model (3-3): Calculation of tax avoidance Model (3-4): Model (3-5): the first hypothesis, model 1 Indep enden t Book- Tax Differen ces (Tax Avoidan ce) Financial Leverage : the book value of total interest-bearing debts of company at the end of year Model (3-6): the first hypothesis, model 2 : the total assets of company at the end of year Deprecia tion Expense Depreciation expense of company at the end of year Model (3-7): the second hypothesis, model 1 Financial leverage in the past two years : the book value of total interest-bearing debts of company in the past two years : the total assets of company in the past two years Model (3-8): the second hypothesis, model 2 Size of the company : the total assets of company at the end of year Model (3-9): the third hypothesis, model 1 Market- To-Book ratio (the market value of total assets) M TB Dividend Yield If the company pays dividends, it will be equal to 1; otherwise, it will be zero Model (3-10): the third hypothesis, model 2 Return on ROA : Net profit of company at the end of year : the total assets of company at the beginning of period THE INTRODUCTION OF VARIABLES AND THEIR MEASUREMENT METHOD Tab. 1. the introduction of variables Collatera l (rate of fixed assets of the compan) TFA: the total fixed assets of company at the end of year TA: the fixed assets of company at the beginning of period
Other Variables Other Variables Other Variables Other Variables ICP Business, Economics and Finance Effective Tax Rate Cost of Debt Total Accruals Changes in Revenue s :the tax expense of company in year : the operating income of company in year IE: interest expense of debts during the period AD: the average short-term and long-term debt during the period : the operating income of company in period :operating cash flow of company in period : revenues of the period : revenues of the previous period Avoidance other than EarningsMana gement Depreciation Expense 750 39.813 399.527 723 69.26 9 Tax Expense 750 0.165 2.84922 0.00015 585 0.233 96 Dividend 750 0.948 1 0 0.222 Yield Financial 750 0.251 0.663 0 0.151 Leverage Market-To- 750 7.92 34.01 0.297 8.84 Book Ratio (the ratio of market value to book value) Size 750 5.772 7.876 4.435 0.581 THE RESULTS OF TESTING THE FIRST HYPOTHESIS: There is a negative relationship between tax avoidance of factors resulting from other than earnings management and debt. Tab. 3. the results of testing the first hypothesis Changes in the company s accounts and receivabl es Tangible Fixed (property, plant and equipme nt) : accounts and receivables of the period : accounts and receivables at the beginning of period The tangible fixed assets (property, plant and equipment)of company in period Variables Coefficient Error Tax avoidance of factors resulting from other than earnings management Chow F- statistics Hausman Statistics Model (3-5) Model (3-6) Coefficient Error -0.194 0.13-0.205 0.108 271.102 (0.000) 6.68 (0.000) 332.99 (0.000) 292.79 (0.000) THE RESEARCH FINDINGS Table 2 shows the descriptive statistics of the research variables. Tab. 2. the descriptive statistics Variables Number of Observ ations Mean Maxim um Minimu m Stan dard Devi ation Total Accruals 750 0.028 0.398-0.329 0.138 Changes in 750 0.119 0.919-0.949 0.304 Revenues Fixed 750 0.329 1.17 0.013 0.25 and Equipment Return on 750 0.157 0.627 0.0035 0.114 Total Tax 750 0.012 0.251 0.00012 0.025 Avoidance Cost of Debt 750 0.250 0.663 0.001 0.151 Ratio of Fixed to Total 750 0.316 0.896 0.04 0.217 Discretionary Accruals 750-0.00000 9 0.00000 06 0.466-0.447 Tax 750 0.123 0.418-0.456 0.121 Type of Estimate Fisher s F- statistics The Coefficient of Determination 49.4 (0.000) 49.47 (0.000) 0.855 0.855 ANALYSIS OF THE RESULTS As previously discussed, the purpose of this hypothesis is to examine the relationship between tax avoidance of factors resulting from other than earnings management and debt in companies listed on Tehran stock exchange. In this regard, the values of coefficient for this variable respectively obtained equal to -0.194 and -0.205 in models (3-5) and (3-6). Also, the error levels are respectively equal to 0.13 and 0.108, which indicates that atacceptable error level of 5%, there is no significant relationship between tax avoidance of factors resulting from other than earnings management and debt in both models; hence, the hypothesis is rejected.
THE RESULTS OF TESTING THE SECOND HYPOTHESIS: Substitution effect of tax avoidance is increased by the probability of losing the tax shield. Tab. 4. the results of testing the second hypothesis Model (3-7) Model (3-8) Variables Coefficient Error Coefficient Error Reversed Tax -2.06 0.006-2.05 0.006 Expense Tax Avoidance of Factors (resulting from other than earnings management) Chow F-statistics 6.58 (0.000) 6.58 (0.000) Hausman Statistics 289.87 (0.000) 289.86 (0.000) Type of Estimate Fisher s F-statistics 43.51 (0.000) 43.57 (0.000) The Coefficient of Determination 0.841 0.841 ANALYSIS OF THE RESULTS As previously discussed, the purpose of this hypothesis is to examine whether the substitution effect of tax avoidance is increased by the probability of losing the tax shield in companies listed ontehran stock exchange or not. In this regard, the values of coefficient for variable reversed tax expense tax avoidance of factors resulting from other than earnings management respectively obtained equal to -2.06 and -2.05 in models (3-7) and (3-8). Also, their error level is reported equal to 0.006, which indicates that atacceptable error level of 5%, there is a negative and significant relationship between reversed tax expense tax avoidance of factors resulting from other than earnings management and debt in both models; hence, the hypothesis is confirmed. THE RESULTS OF TESTING THE THIRD HYPOTHESIS: Substitution effect of tax avoidance is increased by increasing the cost of debt. Model (3-9) Model (3-10) Variables Coefficient Error Coefficient Error Interest Expense 0.064 0.006 0.064 0.006 Interest Expense Tax Avoidance of -3.42 0.066-3.44 0.064 Factors (resulting from other than earnings management) Chow F-statistics 6.64 (0.000) 6.64 (0.000) Hausman Statistics 287.39 (0.000) 287.19 (0.000) Type of Estimate Fisher s F-statistics 48.55 (0.000) 48.61 (0.000) The Coefficient of 0.856 0.856 Determination ANALYSIS OF THE RESULTS As previously discussed, the purpose of this hypothesis is to examine whether the substitution effect of tax avoidance is increased by increasing the cost of debt in companies listed on Tehran stock exchange or not. In this regard, the values of coefficient for variable interest expense tax avoidance of factors resulting from other than earnings management respectively obtained equal to -3.42 and -3.44 in models (3-9) and (3-10). Also, their error levelsare respectively reported equal to 0.066 and 0.064, which indicates that at acceptable error level of 10%, there is a negative and significant relationship between interest expense tax avoidance of factors resulting from other than earnings management and debt in both models; hence, the hypothesis is confirmed. CONCLUSION Every corporation tries using legal loopholes to play a role in increasing the wealth of its shareholders; for this purpose, on the one hand it has to properly manage costs and reduce them to a minimum and on the other hand, decrease cash outflow paid for taxes.as observed, the present study investigated to discover to what extent tax avoidance can besubstituted for the use of debt so that using its benefits, the company can pay less tax. The results of this study showed that there is no significant relationship between substitution of tax avoidance and debt, but the corporation can substitute tax avoidance for the use of debt through reducing tax shields and increasing the costs of debt. THE RESEARCH SUGGESTIONS 1. It is recommended to take into consideration the identified factors, which affect the advantage of using debt, in studies investigating the variable of tax (such as testing the theories developed on capital structure). 2. The government shouldgive special attention to the identified factors, which affect the advantage of using debt, to adopt the optimal tax policies forinfluencing companies finance. SUGGESTIONS FOR FUTURE STUDIES 1. To perform similar studies considering the dynamics of tax laws to achieve a more accurate measurement regarding the influence of factors which have similar characteristics such as the exemption of developmental designs or the exemption of capital increase. 2. To identify the non-tax characteristics of revenue sources and non-tax benefits of using debt. THE RESEARCH IMITATIONS 1. 1-Limitations in measuring tax avoidance based on the provided model, which can be considered as a limit for the accurate calculation of tax avoidance. 2. 2- Limitations in calculation of tax avoidance, which caused diagnostic tax to be used due to the lack of access to definitive tax.
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