Earnings, institutional investors, tax avoidance, and firm value: Evidence from Taiwan

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<ul><li><p>Journal of International Accounting, Auditing and Taxation 22 (2013) 98 108</p><p>Contents lists available at ScienceDirect</p><p>Journal of International Accounting,Auditing and Taxation</p><p>Earnings, institutional investors, tax avoidance,and rm</p><p>Ling-Linga Department ob Department o55812, United c Department o</p><p>a r t i c </p><p>Keywords:Foreign instituDomestic instiFirm valueTransfer pricinTax avoidanceTax havens</p><p>1. Introdu</p><p>Prior stuticularly in important ito attract fovalue (Douk</p><p> CorresponE-mail add</p><p>1 +886 2 282 +886 2 33</p><p>1061-9518/$ http://dx.doi.o value: Evidence from Taiwan</p><p> Changa,1, Fujen Daniel Hsiaob,, Yann-Ching Tsai c,2</p><p>f Accounting, Ming-Chuan University, 250 Sec. 5, Zhong Shan N. Road, Taipei 111, Taiwanf Accounting, Labovitz School of Business and Economics, University of Minnesota Duluth, 1318 Kirby Drive, Duluth, MNStatesf Accounting, National Taiwan University, No. 1, Sec. 4, Roosevelt Road, Taipei 106, Taiwan</p><p>l e i n f o</p><p>tional investortutional investor</p><p>g audit regulation</p><p>a b s t r a c t</p><p>This study examines the valuation of earnings from China and Taiwan by foreign anddomestic institutional investors across a sample of Taiwanese electronics rms. We furthercompare the valuation of rm earnings reported in tax havens and non-tax havens, andwhether these rms have changed tax avoidance activities since 2004 when the Taiwanesegovernment enacted stricter auditing of transfer pricing regulation.</p><p>Our ndings show that both operating income from the home country and investmentincome are positively associated with rm value. Operating income from China, however, isnot signicantly related to rm value when institutional ownership of the rm exceeds ftypercent. This result indicates that operating income is valued differently, depending on thelocation from which the income was generated. Non-operating income enhances rm valueregardless of the revenue source. We also report that foreign institutional investors favoroperating income from domestic and investment sources over earnings generated fromnon-domestic sources and other non-operating income. Furthermore, our results suggestthat rms rearrange reported prots from subsidiaries located in tax havens to afliatesin other countries following the transfer pricing audit guide Taiwan implemented in 2004.Results also indicate rms may have been shifting prots to other low-tax-rate countries,or to countries which do not require rms to pay taxes, even if they are not doing businessin that country.</p><p> 2013 Published by Elsevier Inc.</p><p>ction</p><p>dies document that foreign institutional investment affects rm value more than domestic investment, par-emerging markets. Gillan and Starks (2003, p. 15) argue that foreign institutional investment has become annuence in emerging equity markets, and rms may be motivated to improve their corporate governance in orderreign capital. Internalization theory assumes foreign direct investment (hereafter FDI) increases a rms marketas &amp; Travlos, 1988; Fatemi, 1984; Kim, 2000). For example, Bodnar and Weintrop (1997) nd that rm earnings</p><p>ding author. Tel.: +1 218 726 7454; fax: +1 218 726 8510.resses: llchang@mail.mcu.edu.tw (L.-L. Chang), fhsiao@d.umn.edu (F.D. Hsiao), yanntsai@ntu.edu.tw (Y.-C. Tsai).824564.661118.</p><p> see front matter 2013 Published by Elsevier Inc.rg/10.1016/j.intaccaudtax.2013.07.001</p></li><li><p>L.-L. Chang et al. / Journal of International Accounting, Auditing and Taxation 22 (2013) 98 108 99</p><p>association coefcients are more constant and have a greater impact on incremental foreign earnings than domestic earningsdue to relative growth opportunities overseas. Garrod and Rees (1998) document that earnings and net assets are valuedmore highly for multinational rms than for purely domestic rms because of international expansion opportunities. Usinga sample of U.S. multinationals, Callen, Hope, and Segal (2005), however, assert that domestic earnings more accuratelyexplain themultinationdomestic or</p><p>MNCs hmaximizingtion. Tax autransactionto continue</p><p>This studinvestmentrms have bIn particulaoperations tax prots. insights int</p><p>The rstinvestors, wexamine ththird objectto Taiwane</p><p>Using a from 2000 ttied to signinvestmentpercent) anating incomregardless oincome frofrom Chine</p><p>Results iregulation countries thmultinationcontributesunderstandhost countrguidelines f</p><p>The remses. Sectionconcludes w</p><p>2. Literatu</p><p>In emerginvestors plbefore allocoverbuy anleading us t</p><p>Taiwan ipassed repuTaiwanese et from a rms. Accoelectronics discussion variance of unexpected returns than do foreign earnings. In light of inconclusive results from evaluating U.S.al companies (hereafter MNCs), it remains unclear whether rm valuation will vary due to its composition of</p><p> foreign institutional investment, or domestic earnings and foreign earnings from emerging markets.ave incentives to use transfer pricing arrangements to shift income to lower tax countries or tax havens, thus</p><p> after-tax prots (Sikka &amp; Willmott, 2010). This type of tax avoidance by MNCs has received considerable atten-thorities have responded with stricter audits on transfer pricing arrangements for MNCs, particularly involvings with afliates or related parties in tax havens. This audit response raises the question of whether MNCs are able</p><p> tax avoidance activity.y uses high-tech electronics rms in Taiwan to examine the variation in rm value associated with institutional</p><p> within emerging markets. A unique feature of the Taiwanese sample is that almost all Taiwanese electronicsusiness operations in both China and Taiwan, which attracts both foreign and domestic institutional investment.r, many of these rms, with multiple geographic business operations, derive signicant foreign earnings fromin tax havens. Thus transfer pricing arrangements for tax avoidance are a common strategy to maximize after-Additionally, the setting of these Taiwanese rms, unique from other emerging markets, may provide signicanto rm valuation.</p><p> objective of this study is to examine differences in valuation of earnings by foreign and domestic institutionalhen comparing operating income from China and operating income from Taiwan. The second objective is toe differences in rm value when operating income is reported from tax havens or non-tax havens. Finally, aive is to investigate whether rms have changed reported earnings due to tax avoidance activities subsequentse stricter audit regulation on transfer pricing effective in 2004.sample of Taiwanese electronics rms that includes 1346 rm-years of observation spanning a six-year periodo 2005, we nd evidence supporting an incremental increase of rm value related to each component of earningsicant foreign institutional ownership (more than twenty percent). However, domestic operating income and</p><p> income enhance rm values only for rms with signicant domestic institutional ownership (more than twentyd with majority institutional ownership (more than fty percent). The ndings suggest that the value of oper-e differs depending on where the operating income originated, but non-operating income enhances rm valuef revenue source. Therefore, operating income from Taiwan has a greater impact on rm value than operating</p><p>m other locations, including from China. The results also indicate that rms which disclose operating incomese operations are valued differently by foreign and domestic institutional investors.ndicate that operating earnings from tax havens decreased after the change in Taiwanese transfer pricing auditin 2004. This nding suggests that Taiwanese electronics rms have shifted income from tax havens to otherrough afliated transactions in response to new government audit guidelines. Thus, our study of Taiwaneseal rms adds to the extant literature on the impact of institutional ownership on rm value of MNCs, and</p><p> to accounting practices within the global business environment. Secondly, this paper contributes to a greatering of rms transfer pricing arrangements to shift income for tax avoidance. Lastly, our empirical ndings supporties accounting policies that include stricter government audit regulations on rms transfer pricing and suggestor MNCs operating in emerging markets.ainder of this paper is organized as follows: Section 2 presents recent literature for review and develops hypothe-</p><p> 3 includes sample selection and research design. Section 4 presents empirical results and analysis. Section 5ith a brief summary.</p><p>re review and hypotheses development</p><p>ing markets, foreign investment has become an important channel to raise capital. In general, foreign institutionalay an important role in the market. They spend considerable time analyzing the fundamentals of their investmentating substantial capital into emerging markets. FDI strategies regarding foreign institutional investors thatd oversell information have often been followed by domestic institutional investors or individual investors,o explore this valuation behavior as well.s among the most economically-charged emerging markets, and the electronics rms located there have unsur-tations for high quality manufacturing and productivity (Ernst, 2003; Lowe &amp; Kenney, 1999). On the other hand,rms operating in China, one of the biggest markets in the world, provide good business opportunities that ben-common language and similar cultures. Thus, China has become the main investment location for Taiwaneserding to the Investment Commission of Ministry of Economic Affairs in Taiwan (hereafter MOEA), the high-techindustry represents the majority of outward investments in Taiwan. These considerations are relevant to ourof rm valuation behavior of various institutional investors of Taiwanese rms with operations in China.</p></li><li><p>100 L.-L. Chang et al. / Journal of International Accounting, Auditing and Taxation 22 (2013) 98 108</p><p>2.1. Earnings and rm valuation</p><p>The relationship between ownership structure and rm value is important to corporate governance. Gillan and Starks(2003, p. 15) argue that foreign institutional investment has become an important inuence in emerging equity markets, andrms may be motivated to improve corporate governance in order to attract foreign capital. Shleifer and Vishny (1986) arguethat large shareholders have greater incentives to monitor the actions of managers and can benet minority shareholdersin order to limit agency problems. Chung, Firth, and Kim (2002) nd that a prevalence of institutional ownership reducesopportunistalso revealsHartzell &amp; S</p><p>Internalin knowledvalue. For epersistent tmore highlydomestic eaprevious reare expecteinstitutionainvestmentindustry.</p><p>TraditionStatistics frrms has mplays an imlocation forin 2006, of rst hypoth</p><p>H1. Foreigtic and fore</p><p>2.2. Tax hav</p><p>The TaiwinvestigatioAccording tbecame thebetween 20industry: adjusting st2004). Taiwto shift incopricing, MNincome, or itax of the h</p><p>The Orgtaxes, protepaper, a taxinformation38 jurisdictthose listedstate of Nevbut not tranincorporati</p><p>Rousslanand Yeung (in high-tax</p><p>3 During theic earnings management. Some empirical evidence on the monitoring role played by institutional investors that institutions have greater inuence on executive compensation contracts (Bertrand &amp; Mullainathan, 2001;tarks, 2003).ization theory (Buckley &amp; Casson, 1976) assumes a rms proprietary ownership of rm-specic advantages (FSAs)ge and products, extends across international boundaries of the enterprise, thus FDI will enhance a rms marketxample, Bodnar and Weintrop (1997) argue that the earnings coefcient is higher for foreign income and morehan the coefcient for domestic income. Garrod and Rees (1998) assert that earnings and net assets are valued</p><p> for multinational rms than earnings and net assets of rms that are strictly domestic. Callen et al. (2005) claimrnings are more important than foreign earnings in explaining the variance of unexpected returns. However,search did not address valuation by different kinds of institutional investors. Empirically, institutional investorsd to monitor the company and are more concerned about the operating income of each component. While foreignl investors more carefully weigh fundamental analysis than domestic institutional investors when evaluatings in developing countries, domestic investors tend to be more familiar and have a greater comprehension of local</p><p>ally the Taiwanese stock market is dominated by many individual investors that own small numbers of shares.om the Taiwan Stock Exchange (TSE), however, show that foreign equity ownership of Taiwanese electronicsore than doubled in recent years, increasing from 15.2% in 2000 to 32.9% in 2006.Thus, foreign ownershipportant role in Taiwans stock market. According to the MOEA, China has become the predominant investment</p><p> the Taiwanese electronics industry. Investment of Taiwanese rms into China reached approximately $12 billionwhich approximately 40.8% was directed toward the electronics-related industry. This discussion motivates ouresis:</p><p>n and domestic institutional investors value earnings components differently, especially when comparing domes-ign operating income.</p><p>ens and income shifting</p><p>anese electronics industry enjoys an important position as the countrys economic backbone, which justiesn of its behavior in response to the Transfer Pricing Audit Regulation issued by the Taiwanese government.o the MOEA, Taiwans investment in tax havens (such as Bermuda, Cayman Islands, and British Virgin Islands)</p><p> most popular outward investment for the electronics industry, representing around 50% of outward investment00 and 2006. During this period, outward investment of the electronics industry is second to only one othernance. Electronics rms, heavily dependent on the international market, are expected to be more nimble whenrategies in response to export demands and rapidly changing economic environments (Guerrieri &amp; Pietrobelli,anese electronics rms locate a signicant portion of their foreign operations in tax havens, providing the abilityme from high-tax countries to low-tax countries to maximize after-tax prots. By using tax havens and transferCs can avoid or defer corporate taxes. For example, a corporation may use a tax haven subsidiary to accumulatet may use transfer pricing to shift income from high-tax countries to tax havens to postpone or avoid the corporateome country.anization for Economic Co-operation and Development (OECD) applies three key factors (no or only nominalction of personal nancial information, and lack of transparency) to identify a jurisdiction as a tax haven. In this</p><p> haven is dened as a country that imposes no taxes, even though it is transparent, exchanges personal nancial, or requires substantial activity in the country. The OECD issued a black list of tax havens in 2000 which includedions (OECD, 2000). For our research purposes, we dene 40 countries and regions as tax havens. In addition t...</p></li></ul>

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