Dual Class Ownership and Tax Avoidance. Sean McGuire Mays Business School Texas A&M University. Dechun Wang Mays Business School Texas A&M University

Transcription

1 Dual Class Ownership and Tax Avoidance Sean McGuire Mays Business School Texas A&M University Dechun Wang Mays Business School Texas A&M University Ryan Wilson Tippie College of Business The University of Iowa November 2011 Abstract: This study investigates whether the agency conflicts inherent in a dual class ownership structure are associated with the level of firms tax avoidance. Dual class ownership presents a unique agency problem because insiders voting rights (i.e., insiders ability to control the firm) exceed their cash flow rights (i.e., insiders claim on the cash payouts of the firm). Thus, insiders control a majority of the votes of a firm despite having claims to a minority of the firm s cash flows. We examine the level of risky tax avoidance for a sample of dual class firms. Among dual class firms, we find that the extent of risky tax avoidance is declining as the difference between voting rights and cash flow rights increases. We also compare the level of tax avoidance of dual class firms to other publicly traded firms and continue to find that dual class firms engage in lower levels risky tax avoidance as the wedge between insiders voting rights and cash flow rights increases. These findings are consistent with the view that dual class managers avoid risky tax planning to minimize scrutiny from outside regulators. It is also consistent with the theory that dual class managers are willing to forgo tax benefits to avoid any potential price discounting by non-controlling shareholders who may view tax avoidance as a means of rent extraction by insiders. We thank Andrew Metrick for providing data on firms with dual class stock. We appreciate helpful comments from Anwer Ahmed, Ben Ayers, Justin Hopkins, Stacie Laplante, Ed Maydew, Tom Omer, Sonja Rego, Doug Shackelford, Terry Shevlin, the University of Texas tax readings group, and workshop participants at Texas A&M University, the University of North Carolina, and the 2011 Journal of the American Taxation Association Conference. McGuire and Wang gratefully acknowledge funding from the Mays Business School. Wilson gratefully acknowledges funding from the Tippie College of Business.

2 I. Introduction Dyreng, Hanlon, and Maydew (2008) document significant variation in cash effective tax rates both across firms and across time. 1 In fact, they find that more than a quarter of the firms they examine maintain a ten-year cash effective tax rate below 20 percent during the period from These results suggest significant variation in the extent to which firms pursue tax avoidance strategies. To date, researchers have developed only a limited understanding of the cross-sectional determinants of corporate tax avoidance. Non-tax costs associated with tax avoidance are likely an important cause of the observed variation. Recently, prominent researchers (Desai and Dharmapala 2006; Hanlon and Heitzman 2010; Scholes et al. 2009) have called for more research examining the role of non-tax costs arising from agency conflicts in determining the extent of firms tax avoidance activities. In this paper we examine whether the presence of a control-enhancing mechanism is associated with firms tax planning decisions. Specifically, we focus our analysis on a set of firms with an extreme form of antitakeover provision: dual-class stock. Firms with dual class ownership structures exhibit high insider ownership as well as the marked separation of voting rights from cash flow rights (Francis et al. 2005). Gompers, Ishii, and Metrick (2010, p. 2) report that dual-class firms represent about 6% of U.S. publicly traded companies. The typical dual-class firm has two classes of stock: an inferior class and a superior class. 2 The inferior class of stock is publicly traded stock and has one vote per share. The superior class of stock is typically not traded publicly and has multiple votes (typically ten) per share (Gompers et al. 2010). The superior class of stock is usually owned primarily by the firm s officers and directors (i.e., insiders) and allows them to control a majority of the votes despite having claims to a 1 Dyreng, Hanlon, and Maydew (2008) examine 2,077 firms from 1995 through Some firms have more than two classes of common stock. Consistent with Gompers et al. (2010), we refer to multiclass firms as dual class. 1

3 minority of the firms cash flows (Gompers et al. 2010). 3 Dual-class stock makes it almost impossible for these firms to be subject to a hostile takeover and creates a significant conflict of interest between controlling shareholders (insiders) and non-controlling shareholders. Such an arrangement increases the probability that insiders will begin shirking, empire-building, or extracting private benefits (Bebchuk and Cohen 2005). Dual class stock presents a unique agency problem because the separation of cash flow rights (i.e., insiders claim on the cash payouts of the firm) and voting rights (i.e., insiders ability to control the firm) allows insiders to avoid the pro rata shareholder wealth consequences of their decisions (Francis et al. 2005). Consistent with dual class ownership creating agency conflicts, Gompers et al. (2010) find that the presence of a dual-class ownership structure reduces firm value. Masulis et al. (2009) find evidence suggesting managers of dual class firms are more likely to pursue private benefits as the wedge between their voting rights and cash flow rights increases. They show that as the wedge increases, CEOs enjoy significantly higher compensation, make more value-destroying acquisitions, and capital expenditures contribute less to shareholder value. In accounting specific settings, prior research finds that dual class firms have less informative earnings, exhibit less conservative accounting practices, and have lower levels of disclosure (Francis et al. 2005; Khurana et al. 2011; Tinaiker 2008). Together, these studies suggest managers of dual class firms are able to take advantage of the dual class ownership structure to divert resources from the firm to themselves. We expect that the agency problems present in dual class ownership will influence firms level of tax avoidance. Firms trade off the expected benefit of tax avoidance with the expected costs (Chen et al. 2010). The benefit of tax avoidance is greater tax savings that potentially 3 For example, Ralph Lauren, the founder and CEO of Polo Ralph Lauren Corporation, owns 100 percent of the superior shares of stock during our sample period, but only 2.7 percent of the inferior shares of stock. Mr. Lauren owns 88 percent of voting power of all common stock. 2

4 increase cash flow and reduce the tax expense on the financial statement. The costs of tax avoidance include potential IRS scrutiny and shareholders discounting of firms stock price (Chen et al. 2010). We expect that managers of dual class firms become more sensitive to the potential costs of tax avoidance as the difference between voting rights and cash flow rights increases. As described above, prior research suggests that managers consume firm resources for private benefits as the gap between voting rights and cash flow rights widens (Masulis et al. 2009). Prior research (Hanlon et al. 2011) finds that scrutiny by tax authorities influences financial reporting practices, which suggests that tax authorities can act as a potential monitoring mechanism of corporate insiders. Accordingly, managers of dual class firms likely avoid tax strategies that potentially increase IRS scrutiny because IRS monitoring could lead to scrutiny of other activities that relate to managerial rent extraction. In addition, Chen et al. (2010) hypothesize that investors are likely to discount a firm s stock price if they perceive that managers are using risky tax avoidance strategies to extract rents. Gompers et al. (2010) note that dual class firms are already subject to a price discount because investors expect direct rent extraction or weaker firm performance. Because managers of dual class firms are already suspected of rent extraction, they likely avoid risky tax strategies that could be interpreted by investors as a signal of rent extraction in an effort to avoid an even greater price discount of their firms stock price. In combination, the costs of risky tax avoidance are likely to be high for dual class firms. Therefore, we expect that the difference between voting rights and cash flow rights is associated with lower levels of risky tax avoidance. At the outset, however, it is not clear whether the separation of voting rights and cash flow rights will result in less tax avoidance. As noted above, Desai and Dharmapala (2006) suggest that aggressive forms of tax avoidance can facilitate managers ability to expropriate 3

5 shareholder wealth (i.e., extract private benefits) because they are complex and designed to obscure the underlying economics of a transaction. Francis et al. (2005) note that a dual-class structure encourages rent extraction because it allows insiders to simultaneously extract private benefits and avoid the related cash flow consequences. Thus, it is possible dual-class firms may engage in higher levels of tax avoidance because insiders view tax avoidance as a means to expropriate wealth from shareholders. Because the purpose of our analysis is to provide insight into whether the dual class ownership structure provides managers with an incentive to reduce the types of tax avoidance that could result in increased scrutiny or investor concerns about managerial wealth extraction we focus on proxies that we expect to reflect risky and likely complex tax avoidance. 4 We begin our analysis with three measures of non-conforming tax avoidance activities (i.e., activities that generate a difference between book and taxable income). Our first two proxies, the effective tax rate and the cash effective tax rate reflect aggressive tax planning through permanent book-tax differences. We begin with these measures because they can be easily calculated by investors and the effective tax rate is a required disclosure in the annual report. Consequently, we believe these are measures of tax avoidance that regulators and investors are likely to fixate on if they are looking for evidence of wealth extraction by managers. Nonetheless, both measures are designed to reflect both clearly legal and highly uncertain forms of tax planning. 5 For this reason, we include a third measure of non-conforming tax avoidance, the level of discretionary book-tax 4 Consistent with Hanlon and Heitzman (2010), we view tax avoidance on a continuum. This continuum of avoidance includes clearly legal transactions, such as investments in municipal bonds that lower explicit taxes, on one end, to more aggressive forms of tax avoidance, such as tax sheltering where the legality of the transaction is less certain (i.e., more risky), on the other end. 5 See Hanlon and Heitzman (2010) for a complete discussion of the advantages and disadvantages of common measures of tax avoidance. 4

6 differences, which is specifically designed to detect the most aggressive forms of tax avoidance. 6 Our first three proxies of tax avoidance capture non-conforming tax avoidance activities However, Hanlon and Heitzman (2010) note that focusing solely on non-conforming tax avoidance paints an incomplete picture of a firm s overall tax avoidance because some firms may choose to engage in strategies that simultaneously reduce book income and taxable income (i.e., conforming tax avoidance). Therefore, we use two additional measures of tax avoidance designed to detect both conforming and non-conforming avoidance activities. Specifically, we use a measure of firms marginal tax rates and the cash ratio defined as cash taxes paid over cash flow from operations. We use Gompers et al. s (2010) sample of dual class firms from 1995 to 2002 to examine the association between the separation of voting rights and cash flow rights and tax avoidance. In our first set of tests, we examine whether the wedge between insiders voting rights and cash flow rights is associated with lower levels of risky tax avoidance for a sample of dual class firms after controlling for factors that prior research suggests are associated with tax avoidance and insiders decision to issue dual classes of stock. Consistent with our predictions, we find that the difference between voting rights and cash flow rights is associated with higher effective tax rates, cash effective tax rates, cash ratio, marginal tax rates, and lower levels of discretionary book-tax differences which suggests that managers with excessive control rights engage in significantly less risky tax avoidance. In our second set of tests we compare the tax avoidance activities of dual class firms to a set of propensity score matched single class firms during our sample period. Consistent with expectations, when we include the matched single class firms we 6 In supplemental analysis we also examine uncertain tax benefits as an alternative measure of risky tax avoidance. However, because firms were not required to disclose the balance of the reserve for uncertain tax benefits until 2007 we are unable to directly match this data to our sample of dual class firms. We discuss this analysis in more detail in Section V. 5

7 continue to observe a negative association between excessive control rights and risky tax avoidance. This study contributes to two distinct streams of research. First, we contribute to the recent literature examining the determinants of tax avoidance activities (e.g., Chen et al. 2010; Dyreng et al. 2008). Hanlon and Heitzman (2010) note that the literature is not able to explain the variation in tax avoidance well and call for, among other things, a more detailed examination of the effect of agency costs and ownership structure on tax avoidance. This study answers the call, at least in part, by examining the association between tax avoidance and an ownership structure that creates extreme agency costs. Our study also contributes to research that examines the effects of the agency issues present in dual-class ownership structures (e.g., Gompers et al. 2010). We extend recent research that explores the influence of a dual class ownership structure on corporate behavior (e.g., Masulis et al. 2009; Francis et al. 2005) by examining the association between risky tax avoidance and the divergence of voting rights and cash flow rights. This evidence suggests that as the separation of voting rights and cash flow rights increases, managers of dual class firms engage in less risky tax avoidance in an effort to reduce the risk of government scrutiny and to avoid the potential price discount associated with investors suspicion of managerial rent extraction. The remainder of the paper is structured as follows. In the next section we discuss prior literature and develop our hypotheses. Section 3 describes our research design. Section 4 describes our sample selection and results. Section 5 provides our sensitivity analyses and section 6 concludes. 6

8 I. Prior Literature and Hypothesis Development The benefit of increased tax avoidance is greater tax savings that potentially reduce the tax expense on the financial statements and increase cash flow. However, the costs of risky tax avoidance can be substantial. For example, Wilson (2009) reports that for a sample of identified tax shelter firms interest (penalties) assessed against firms investing in tax shelter activities comprised 40 (9.26) percent of the total tax savings. Hanlon and Slemrod (2009) document a significant negative price reaction to initial news that firms are engaged in tax shelter activity. In addition, consistent with tax avoidance masking opportunistic behavior, Kim et al. (2011) find risky tax avoidance is positively associated with firm-specific stock price crash risk. They note that the final revelation of the tax shelters employed by Dynegy from September of 2000 through April of 2002 resulted in a 97% decline in the firm s market value. Firms engaged in significant tax avoidance can also come under politically motivated scrutiny. For example, the Citizens for Tax Justice publish a series of studies reporting firms effective tax rates and identifying firms that are not paying their fair share of taxes. Masulis et al. (2009) find managers are more likely to pursue private benefits as the difference between their voting rights and cash flow rights increases. This result is consistent with the argument that the agency costs between controlling and non-controlling shareholders of dual class firms increase as the separation between voting rights and cash flow rights increases. Managers incur less of the wealth consequences of any value destroying actions such as empire building or rent extraction as their cash flow rights decline. We expect that as the wedge between voting rights and cash flow rights increases managers will engage in less risky tax avoidance because they are consuming more firm resources and, as a result, the cost of increased scrutiny 7

9 related to detected tax avoidance will be higher. 7 Hanlon et al. (2011) find the probability of IRS audits is positively associated with measures of accrual quality. They conclude that higher tax enforcement is associated with improved financial reporting quality. Their findings support the theory developed by Desai et al. (2007) that tax authorities can provide a monitoring mechanism for corporate insiders. As such, we predict that increased scrutiny from tax authorities could lead to scrutiny of other activities by managers related to the extraction of firm resources. Chen et al. (2010) point out that another cost of risky tax avoidance is the potential price discount imposed by shareholders if they perceive that managers are using risky tax avoidance strategies to extract rents. They note that the complementarity of risky tax avoidance and rent extraction combined with the obscurity of tax transactions make it very difficult for investors to disentangle the two incentives (i.e. genuine attempts to reduce the firm s tax burden and rent extraction). Consequently, they expect investors will price protect themselves by bidding down the price of the firm s stock if they observe signals the firm is engaged in risky tax avoidance. Desai et al. (2007) find that in Russia firms experience a price increase when targeted by increased tax enforcement. This finding suggests investors believe a reduction in tax avoidance activity will limit manager s ability for self-dealing. Prior research suggests that investors are especially likely to impose a price discount on dual class firms. Smart et al. (2008) find that, relative to their fundamentals, dual class firms trade at lower prices relative to single class firms both at the time of their IPO and in the 7 We acknowledge that managers of dual class firms likely hire a tax director to perform the actual work of reducing the firm s tax liability. However, Dyreng et al. (2010) find that top executives (e.g., the CEO) influence firms level of tax avoidance, which suggests that top management is responsible for setting the tone for the firm s tax planning practices. Consistent with our expectation, recent research suggests that tax directors compensation packages influences the level of firms tax avoidance in terms of the effective tax rate (Armstrong et al. 2011). Likewise, Robinson et al. (2010) find that the overall objective of the tax department (i.e., profit center versus cost center) influences firms level of tax avoidance. Accordingly, we expect that managers of dual class firms provide guidance to the tax director about the amount of uncertainty or risk that is acceptable in the firm s tax planning strategies and establish a compensation package that aligns the incentives of the tax director with those of top management. 8

10 following five year period. Consistent with dual class firms receiving a price discount, Gompers et al. (2010) find that firm value (i.e., Tobin s Q) decreases as the difference between voting rights and cash flow rights increases, which suggests that the likelihood of price discounting increases as the gap between voting rights and cash flow rights becomes larger. Because of the significant agency conflict between controlling and non-controlling shareholders in dual class firms, we expect non-controlling shareholders are more likely to be skeptical of risky tax avoidance and impose a related price discount as the wedge between insiders voting rights and cash flow rights increases. In combination, the costs of risky tax avoidance are likely to increase as the separation of voting rights and cash flow rights grows. Consequently, we expect managers will be less likely to engage in risky tax avoidance when the wedge between voting rights and cash flow rights is large. This leads to the following hypothesis: H1: The difference between voting rights and cash flow rights is associated with lower levels of risky tax avoidance. Despite incentives for dual class managers to engage in less risky tax avoidance; it is possible dual class stock could lead to greater levels of risky tax avoidance activity. Shleifer and Vishny (1997) argue that managerial entrenchment increases the likelihood managers will expropriate shareholder wealth. Adelphia Communications Corporation is a highly publicized example that provides anecdotal evidence in support for this argument. The dual-class structure at Adelphia protected the founding Rigas family from a hostile takeover allowing for the expropriation of corporate funds from the company for the family s personal use. Desai and Dharmapala (2006) argue that because tax shelters are intentionally designed to obscure the economic substance of a transaction, they can provide a shield for managers to engage in 9

11 opportunistic behavior. They contend that the complexity associated with tax avoidance schemes allows managers to conceal rent extraction activities. 8 If managers of dual-class firms are expropriating wealth from shareholders of inferior classes of stock, risky tax avoidance is a possible vehicle for executing such expropriation. II. Research Design a. Measures of Tax Avoidance Prior research views tax avoidance as a continuum that ranges from clearly legal transactions, such as investments in municipal bonds that lower explicit taxes, to more aggressive forms of tax avoidance, such as tax sheltering where the legality of the transaction is less certain (Hanlon and Heitzman 2010). The focus of our analysis is on the more uncertain or risky forms of tax avoidance. However, we also want to use measures of tax avoidance that investors are most likely to examine in making inferences about firms tax avoidance activities. For this reason we use five alternative measures of tax avoidance. Specifically, we estimate firms effective tax rate, cash effective tax rate, discretionary permanent book-tax differences, the ratio of cash taxes paid to pre-tax cash flows, and the marginal tax rate. The effective tax rate, ETR, is our first measure of avoidance and is measured over a oneyear period. ETR is defined as total tax expense (Compustat TXT) in year t divided by pre-tax book income (Compustat PI) less special items (Compustat SPI) in year t (Dyreng et al. 2008). 9 ETR represents tax avoidance activities that directly affect net income (Robinson et al. 2010) and is a commonly used by both investors and executives as measure of a firm s tax burden and 8 Desai and Dharmapala (2006) cite Dynegy Inc. as an example of a company that used an opaque, tax-motivated transaction to mislead the capital markets. In the case Dynegy managers employed a tax shelter developed by Arthur Anderson to artificially inflate operating cash flows for financial reporting purposes. Chen et al. (2010) note that improved financial reporting data can benefit managers through higher bonuses or short term increases in stock price. 9 Unless otherwise noted, all data items are measured on an annual basis. 10

12 overall level of tax avoidance (e.g., Dyreng et al. 2010; Rego 2003; Rego and Wilson 2010; Robinson et al. 2010). However, ETR does have limitations. First, tax avoidance activities that generate temporary differences (i.e., those that defer cash taxes paid to later periods) are not reflected in ETR (Hanlon and Heitzman 2010). Second, financial accounting rules also affect ETR. For example, changes in valuation allowances and changes in tax contingency reserves affect total tax expense (Hanlon and Heitzman 2010). Thus, ETR is the product of both tax avoidance activities and financial accounting rules. Prior research suggests that a lower value of ETR reflects an increased level of tax avoidance (e.g., Gupta and Newberry 1997; Rego 2003; Zimmerman 1983). The cash effective tax rate (CASHETR) is our second measure of tax avoidance. Dyreng et al. (2008) posit that firms that engage in effective tax planning are able to maintain a low CASHETR. We measure CASHETR over a one year period and define it as cash taxes paid (Compustat TXPD) in year t divided by pre-tax book income (Compustat PI) less special items (Compustat SPI) in year t (Dyreng et al. 2008; 2010). Unlike ETR, CASHETR is not biased by changes in tax accounting accruals (Dyreng et al. 2008). Furthermore, CASHETR reflects tax avoidance activities that defer cash taxes paid (i.e., temporary differences) as well as those that directly affect net income (i.e., permanent differences). Thus, CASHETR reflects any activity that reduces cash taxes paid in the current period, many of which may not affect net income (Dyreng et al. 2008). Consistent with prior research, lower values of CASHETR represent higher levels of tax avoidance (Dyreng et al. 2008; 2010) Cash taxes paid represents the actual taxes paid by the firm during a given year, and as a result could include estimated tax payments associated with the prior year s income. This potential mismatch between the timing of cash payments to tax authorities and when the tax is incurred will introduce measurement error into both our CASHETR and CASHRATIO measures. 11

13 We estimate ETR and CASHETR because financial statement users likely fixate on these measures of tax avoidance if they are looking for evidence of wealth extraction by managers via complex tax planning. Nonetheless, both ETR and CASHETR reflect tax planning strategies that are clearly legal as well as tax strategies that are more risky. Accordingly, our third proxy for tax avoidance is Frank et al. s (2009) measure of discretionary permanent book-tax differences, DTAX. Conceptually, DTAX captures tax avoidance activities that are aggressive in nature and directly affect net income through a reduction in total tax expense. Consistent with this notion, Frank et al. (2009) find that DTAX is positively associated with the probability that a firm is currently engaging in a tax shelter. Following Frank et al. (2009), we estimate DTAX as the residual of a regression of permanent book-tax differences on various non-tax planning determinants such as current state tax expense, change in net operating loss, and minority interest. Consistent with Frank et al. (2009), larger values of DTAX represent higher levels of tax avoidance. ETR, CASHETR, and DTAX capture only tax avoidance activities that generate a difference between book income and taxable income (i.e., non-conforming activities). Hanlon and Heitzman (2010) argue that focusing solely on non-conforming tax avoidance strategies paints an incomplete picture of a firm s overall level of tax avoidance because firms can avoid income taxes using strategies that reduce book income and taxable income simultaneously (i.e., conforming activities). Because prior research has not developed an accepted measure of conforming tax avoidance, we estimate two additional measures of tax avoidance that are designed to capture a firm s overall level of tax avoidance (i.e., a firm s conforming and nonconforming tax avoidance activities). Accordingly, our fourth proxy for tax avoidance is the ratio of cash taxes paid to pre-tax cash flows (CASHRATIO). Dyreng et al. (2008) and Hanlon and 12

14 Heitzman (2010) note that the ratio of cash taxes paid to cash flows from operations conceptually captures conforming as well as non-conforming tax planning because the tax burden is measured relative to a firm s economic activity (cash flow) instead of accounting earnings. 11 Similar to ETR and CASHETR, we measure CASHRATIO over a one year period and define it as cash taxes paid (Compustat TXPD) in year t divided by pre-tax cash flows (Badertscher et al. 2011). Consistent with Badertscher et al. (2011), we define pre-tax cash flows as cash flow from operations (Compustat OANCF) plus cash taxes paid (Compustat TXPD) less extraordinary items (Compustat XIDOC). Consistent with ETR and CASHETR, lower values of CASHRATIO represent higher levels of tax avoidance. Our final measure of tax avoidance is the Blouin et al. s (2010) simulated marginal tax rate, MTR. 12 The marginal tax rate represents the present value of taxes paid on an additional dollar of taxable income (Blouin et al. 2010). Consistent with Baderstcher et al. (2011), our analyses are based on MTRs calculated after taking interest expense into account in order to capture the effects of debt financing. Although, MTR is not typically used as a measure of tax avoidance, it does capture both conforming and non-conforming tax avoidance strategies (Hanlon and Heitzman 2010). In addition, Hanlon and Heitzman (2010) note that MTR is potentially useful when comparing firms that potentially place different weights on the importance of financial accounting earnings (e.g., dual class versus single class firms). Consistent with ETR and CASHETR, lower values of MTR represent higher levels of tax avoidance. 11 One example of conforming tax planning that would likely result in a lower CASHRATIO would be the use of the LIFO method of inventory accounting. U.S. tax rules require that if LIFO is used for tax purposes, the external financial statements must also use LIFO. Relative to the FIFO method, LIFO typically results in a higher cost of goods sold and thus lower pre-tax book and taxable income. By lowering firms taxable income LIFO would reduce the tax expense, but would not affect pre-tax cash flow from operations resulting in a lower CASHRATIO. 12 We thank Jennifer Blouin, John Core, and Wayne Guay for making their simulated marginal tax rates publicly available. 13

15 b. Sample Selection Bias and Endogeneity We test our hypothesis on two separate samples. First, we test our hypothesis on a sample that contains all available firm-year observations with a dual class ownership structure in order to examine whether the difference between voting rights and cash flow rights is associated with lower levels of tax avoidance after holding the ownership structure of the firm constant. Second, we test our hypothesis by comparing dual class firms to single class firms to examine whether the difference between voting rights and cash flow rights in dual class firms influences tax avoidance relative to single class firms. However, Gompers et al. (2010) find that firms with a dual class ownership structure differ significantly from firms with a single class structure, which suggests that a firm s ownership structure is endogenous. Prior research suggests that insiders choose a dual class ownership structure when the private benefits of control are likely to be significant (Gompers et al. 2010; Masulis et al. 2009). Consequently, our tests that use a sample of dual class firms only potentially suffers from selfselection bias because the sample of firms is not chosen randomly from the overall population (Heckman 1979). To address this concern, we estimate a two-equation Heckman (1979) model. Our first stage regression follows the dual class prediction model developed by Gompers et al. (2010) and is designed to predict whether insiders will choose a dual class ownership structure at the date of a firm s initial public offering (IPO). Gompers et al. (2010) predict that insiders will choose a dual class ownership structure when the private benefits of control are likely to be high. Following Gompers et al. (2010), we estimate the following probit regression to model the initial choice to use a dual class ownership structure (firm and time subscripts are omitted for convenience): 14

16 ( ) (1) where all variables are measured in the year prior to each firm s IPO and defined in the Appendix. Gompers et al. (2010) argue that each of the above independent variables proxy for the potential private benefits of control available to insiders if they are able to protect themselves from takeover. 13 Specifically, Gompers et al. (2010) argue that insiders are more likely to choose a dual class ownership structure when the founding family has a personal stake in the business (FAMILYNAME), when the firm is a member of the media industry (MEDIA), and when the firm has a significant local presence (%FIRMSINREGION, %SALESINREGION, and LOCALMKRTSHR). In addition, Gompers et al. (2010) predict that insiders are less likely to choose a dual class ownership structure when they are headquartered in a state with antitakeover laws (STATELAW) and when the firm is older because the founder is less likely to be involved in the firm s operations. Consistent with Gompers et al. (2010), we proxy for firm age by calculating the percentile rank of the IPO-year sales of the firm relative to all other IPO firms in the same year (SALERANK). 14 Finally, we follow Gompers et al. (2010) and control for overall profitability (PROFITRANK) to control for the costs and benefits of control that are associated with firm profitability. In addition, we augment the Gompers et al. (2010) model by including a measure of market value of equity at the beginning of the year (SIZE) to control for the magnitude of potential ongoing private benefits. Consistent with Heckman (1979), we use the 13 Please see Section 2 of Gompers et al. (2010) for a more detailed discussion of the independent variables in equation (1). 14 We acknowledge that this is an indirect proxy. Gompers et al. (2010) argue that firm age is likely to be positively associated with firm sales at the time of the IPO. Gompers et al. (2010) note that the probability that a founder is actively involved with the company likely decreases with the age of the company. 15

17 coefficient estimates from equation (1) to construct an inverse Mills ratio (INVMILLS), which we include as a control variable in equation (2). Our tests that examine whether the difference between voting rights and cash flow rights in dual class firms influences tax avoidance relative to single class also suffer from endogeneity. Accordingly, we follow Masulis et al. (2009) and employ propensity score matching to control for the fact that a firm s ownership structure is endogenous. Specifically, we remove the annual fixed effects and estimate equation (1) on an annual basis to estimate the probability that insiders will choose a dual class ownership structure. We estimate the selection equation on an annual basis to ensure that each dual class firm has a match firm that experiences the same macroeconomic events that take place in a given year. Based on our annual estimations of equation (1), we obtain a propensity score for each firm-year that represents the likelihood that insiders will choose a dual class ownership structure. We then match (without replacement) each dual class firm-year observation to the single class firm with the closest propensity score. Thus, our final sample consists of dual class and single class firms that possess similar characteristics at the time of the ownership structure decision. Because data availability differs across each measure of tax avoidance, we perform this matching procedure separately for each measure of tax avoidance. c. Multivariate Model To examine the association between tax avoidance and dual-class ownership, we estimate the following OLS regression: (2) where all variables are defined in the Appendix and discussed below. The dependent variable (TAXAVOID) is one of the five proxies of tax avoidance discussed above. As described 16

18 above, we estimate equation (2) on a sample that consists solely of firms with a dual class ownership structure and on a propensity matched sample that contains both dual class and single class firms. To examine our hypothesis, we analyze the coefficient on WEDGE. For dual class firms, we define WEDGE as the difference between the voting rights and cash flow rights of a firm s insiders (Claessens et al. 2002; Villalonga and Amit 2006; Gompers et al. 2010). Consistent with Gompers et al. (2010), we define insider voting rights is as total insider voting rights divided by total voting rights for all shareholders and insider cash flow rights as total insider cash flow rights divided by total cash flow rights for all shareholders. 15 For single class firms, we follow Gompers et al. (2010) and define WEDGE as zero. 16 We examine the association between non-conforming tax avoidance and the divergence of voting rights and cash flow rights. We predict that the difference between insiders voting rights and cash flow rights is associated with lower levels of tax avoidance as managers of dual class firms attempt to protect themselves from unnecessary risks. Therefore, we expect a positive (negative) association between WEDGE and our measures of non-conforming tax planning, ETR and CASHETR (DTAX). Our expectation for the association between WEDGE and our measures of overall tax avoidance, CASHRATIO and MTR, is less clear because overall tax avoidance consists of both conforming and nonconforming tax strategies. To the extent that managers of dual class firms 15 We also measure WEDGE as the ratio of voting rights to cash flow rights (e.g., Lemmon and Lins 2003; Masulis et al. 2009). Specifically, we redefine WEDGE as the ratio of the percentage of a firm s voting rights controlled by insiders to the percentage of a firm s cash flow rights controlled by insiders. Inferences remain the same using this alternative specification. 16 Consistent with prior research (e.g., Francis et al. 2005; Masulis et al. 2009; Gompers et al. 2010), we focus on the magnitude of the difference between voting rights and cash flow rights in our tests that compare dual class firms to a sample of propensity matched single class firms. Gompers et al. (2010) note that dual class status does not have uniform implications across firms because some dual class firm only have a small difference between voting rights and cash flow rights. Accordingly, our analysis focuses on WEDGE in an effort to fully capture the agency costs present in dual class firms. In untabulated analysis, we replicate our analysis using an indicator variable to compare dual class and single class firms. Our inferences remain the same across all tax avoidance proxies (including the alternative proxies discussed below) except that the association between dual class status and CASHETR and CASHRATIO is no longer statistically significant. 17

19 prefer conforming tax planning strategies because they are insulated from capital market pressures and conforming strategies lower detection risk, we expect a negative association between WEDGE and both CASHRATIO and MTR. However, if dual class managers are concerned about potential scrutiny resulting from tax avoidance they may avoid all forms of tax avoidance, which would result in a positive association between WEDGE and both CASHRATIO and MTR. In addition to our variable of interest, we control for other factors associated with tax avoidance to examine whether ownership structure is incrementally associated with tax avoidance. Rego and Wilson (2011) find that the equity risk incentives of CEOs are positively associated with higher levels of risky tax avoidance strategies. To control for the possibility that managers of dual class firms have different equity incentives to pursue tax avoidance strategies relative to managers of single class firms we follow Rego and Wilson (2011) and control for CEO equity risk incentives (CEORISKINC) and CEO pay-for-performance sensitivity (CEOSLOPE). Prior research also suggests that economies of scale and firm complexity are associated with additional tax planning opportunities (e.g., Mills et al. 1998; Rego 2003). Accordingly, we control for firm size (SIZE), income from foreign operations (FORINC), leverage (LEV), capital intensity (CAPINT), and research and development activities (R&D). In addition, the need to avoid income taxes varies across firms (Chen et al. 2010; Rego 2003). Consequently, we control for firm profitability (ROA), net operating loss carryforwards (NOL and NOL), and the number of pre-tax losses that a firm experienced over the previous four years (LOSSINT) In untabulated sensitivity analysis, we control for abnormal accruals because the pressure to manage earnings likely differs across dual class and single class firms. Our inferences remain unchanged (i.e., WEDGE remains significantly associated with each of our tax avoidance proxies). 18

20 We include income related to the equity method of accounting (EQINC) to control for differences in financial and tax accounting treatment that influence our measures of tax avoidance (Chen et al. 2010; Frank et al. 2009). We also control for firms growth opportunities (MTB) because Chen et al. (2010) note that rapidly growing firms potentially invest in more taxfavored assets. In addition, we use the coefficient estimates from equation (1) to estimate an inverse Mills ratio (INVMILLS) and include it as an additional variable in our tests that consist solely of dual class firms to control for potential self-selection bias (Heckman 1979). Finally, we include industry fixed effects because prior research documents that tax avoidance varies by industry. 18 III. Sample and Results a. Sample Selection We obtain our sample of dual-class firms from Gompers et al. s (2010) sample of dual class firms. The Gompers et al. (2010) sample begins in 1995 and ends in 2002 and initially contains 3,609 dual class firm year observations. Our initial sample contains both dual class and single class firms with data available on both Compustat and Execucomp during the 1995 to 2002 time period. For a firm-year observation to be included in our sample, it must have sufficient data to calculate the variables described in equations (1) and (2). In addition, we eliminate all firms with negative pre-tax income because our focus is on firm-years where tax avoidance is likely to be a priority. The sample used to estimate equation (1) contains 718 dual class firm-year observations and 11,296 single class firm-year observations. Thus, dual-class firms make up approximately six percent of all firm-year observations, which is consistent with 18 We do not include the determinants of insiders decision to form a dual class ownership structure in equation (2) because we do not expect them to directly influence firms level of tax avoidance. However, in untabulated analysis, we include all variables from equation (1) as control variables in equation (2). In general, the determinants of dual class ownership are not significantly associated with our proxies of tax avoidance. In addition, our inferences remain unchanged (i.e., WEDGE remains significantly associated with each of our tax avoidance proxies). 19

21 Gompers et al. (2010). The final sample used to estimate equation (2) varies based on the data requirement of each tax avoidance proxy. b. Descriptive Statistics Table 1, Panel A provides the descriptive statistics for our sample of dual class firm-year observations. The means and medians of our measures of non-conforming tax avoidance are consistent with prior research. 19 Specifically, the mean (median) ETR is (0.367) while the mean (median) CASHETR is (0.314). Consistent with Dyreng et al. (2008), CASHETR is lower than ETR. In addition, the mean (median) of DTAX is (0.001). The mean (median) of CASHRATIO is (0.239) while the mean (median) MTR is (0.342). 20 Panel B of Table 1 describes the distribution of dual class firm-years in our sample across the 38 Fama-French (1997) industry classifications. Consistent with prior research (e.g., DeAngelo and DeAngelo 1985), the largest concentration of dual class firms is in the media industry (i.e., printing and publishing). The distribution of dual class firms across the industries underscores the importance for controlling for industry-related effects in equations (1) and (2). Table 1, Panel C presents univariate correlations for our sample of dual class firm-year observations with Pearson (Spearman) correlations reported above (below) the diagonal. Consistent with expectations, the Pearson correlations suggest that WEDGE is positively and significantly associated with ETR, CASHETR, and CASHRATIO. However, we do not find a significant correlation between WEDGE and MTR and DTAX. In addition, we find that WEDGE is positively and significantly correlated with CEORISKINC, which underscores the importance 19 We winsorize (reset) all control variables at the 1 st and 99 th percentiles. We winsorize our tax avoidance ratios (ETR, CASHETR, CASHRATIO, and MTR) to be between zero and one. 20 We note that in many respects tax law is very much like the cash basis of accounting. As a result, if we divide cash taxes paid by cash flow (taxable income) we should get back the statutory tax rate. However, we do not get the U.S. statutory tax rate (35%), instead our median CASHRATIO is 25.9%. We believe this difference likely occurs because of rate differences (on foreign source income), credits, and differences in the consolidated group for financial reporting purposes versus tax reporting purposes. 20

22 of controlling for CEO equity risk incentives in equation (2). All control variables are correlated with our measures of tax avoidance in a manner that is broadly consistent with prior research. Panel D of Table 1 provides univariate tests of the differences between our dual class firms and a propensity matched sample of single class firms. 21 Consistent with managers of dual class firms controlling a majority of the available voting rights of the firm, we find that the median percentage of voting rights (VOTE_RIGHTS) of dual class managers is approximately 56 percent and exceeds the percentage of voting rights of single class managers (p-value < 0.01). In untabulated analysis, we also find that dual class managers voting rights significantly exceeds the cash flow rights (p-value < 0.01), which is consistent with the marked separation of voting rights from cash flow rights that is present in dual class firms (Francis et al. 2005). Consistent with dual class firms exhibiting high levels of insider ownership (Francis et al. 2005), we find that the percentage of a firm s cash flow rights (CASH_RIGHTS) distributed to the managers of dual class firms is significantly greater than the percentage of cash flow rights distributed to the managers of a sample of propensity matched single class firms (p-value < 0.01). Specifically, the median percentage of cash flow rights for managers of dual class firms is approximately 26 percent compared to 1.2 percent for managers of single class firms We allow the sample used in our primary analysis to vary based upon the availability of each tax avoidance measure. Table 1, Panel D presents univariate comparisons for the sample that uses ETR as the proxy for tax avoidance. Our conclusions remain the same when the propensity matched samples for the other tax avoidance proxies are used. 22 We also examine the dividend payout ratio of the superior shares of dual class stock relative to the dividend payout ratio of both the inferior shares of dual class stock and single class stock. We define the dividend payout ratio as total dividends paid for a specific class of stock in year t to total assets in year t. Within our sample of dual class firms, we find that the median dividend payout ratio of the superior class of dual class stock is 0.4 percent of total assets compared to 1.5 percent for the inferior class of dual class stock. Univariate analysis reveals that difference in the dividend payout ratio between the superior and inferior shares of dual class stock is statistically significant (pvalue < 0.01). We also find that the dividend payout ratio for our sample of propensity matched single class firms (0.7 percent of total assets) is not statistically different from the dividend payout ratio of the superior shares of dual class firms (p-value > 0.70). However, the median overall dividend payout ratio of dual class firms (i.e., the dividend payout ratio across both superior and inferior shares) is two percent of total assets, which is significantly greater than the median dividend payout ratio of the propensity matched single class firms (p-value < 0.01). This 21

23 In addition, the analysis in Table 1, Panel D suggests that CEOs at single class firms possess larger equity incentives relative to CEOs at dual class firms. Specifically, we find that the median level of both CEORISKINC and CEOSLOPE are significantly higher for single class firms relative to dual class firms (both p-values < 0.01). We also find that the median percentage of CEOs total compensation that is comprised of equity incentives (%STOCKCOMP) is significantly higher for single class firms relative to dual class firms (p-value < 0.10). 23 Finally, univariate analysis suggests that dual class firms engage in lower levels of tax avoidance relative to single class firms when ETR, CASHETR, and CASHRATIO serve as proxies for tax avoidance (all p-values < 0.01). In addition, we find that the dual class and single class firm-year observations are similar in terms of performance (ROA), leverage (LEV), income from foreign operations (FORINC), research and development expenditures (R&D), loss intensity (LOSSINT), growth opportunities (MTB), and firm size (SIZE) (all p-values > 0.10). These results suggest that our propensity matching procedure is effective and identifies single class firms with similar characteristics. c. Results of Selection Equation Table 2, Panel A presents the results of equation (1), our selection model. The area under the ROC curve is 0.79, which suggests our selection model has acceptable discriminatory power (Hosmer and Lemeshow 2002). The coefficients on the industry and year fixed effects are not reported for the sake of brevity. The results of our selection model are generally consistent with those reported by Gompers et al. (2010). Specifically, we find that FAMILYNAME, MEDIA, STATELAW, and the firm s local presence (%FIRMSINREGION) are positively and significantly result is consistent with dual class firms paying a higher rate of dividends in an effort to entice investors to purchase the inferior class of stock. 23 In untabulated sensitivity analysis, we find that our results are robust to controlling for %STOCKCOMP (i.e., the coefficient on WEDGE remains the same in terms of its sign and statistical significance across all measures of tax avoidance). 22