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

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  • Journal of International Accounting, Auditing and Taxation 22 (2013) 98 108

    Contents lists available at ScienceDirect

    Journal of International Accounting,Auditing and Taxation

    Earnings, institutional investors, tax avoidance,and rm

    Ling-Linga Department ob Department o55812, United c Department o

    a r t i c

    Keywords:Foreign instituDomestic instiFirm valueTransfer pricinTax avoidanceTax havens

    1. Introdu

    Prior stuticularly in important ito attract fovalue (Douk

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    1 +886 2 282 +886 2 33

    1061-9518/$ http://dx.doi.o value: Evidence from Taiwan

    Changa,1, Fujen Daniel Hsiaob,, Yann-Ching Tsai c,2

    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

    l e i n f o

    tional investortutional investor

    g audit regulation

    a b s t r a c t

    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.

    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.

    2013 Published by Elsevier Inc.


    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 & Travlos, 1988; Fatemi, 1984; Kim, 2000). For example, Bodnar and Weintrop (1997) nd that rm earnings

    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.

    see front matter 2013 Published by Elsevier Inc.rg/10.1016/j.intaccaudtax.2013.07.001

  • L.-L. Chang et al. / Journal of International Accounting, Auditing and Taxation 22 (2013) 98 108 99

    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

    MNCs hmaximizingtion. Tax autransactionto continue

    This studinvestmentrms have bIn particulaoperations tax prots. insights int

    The rstinvestors, wexamine ththird objectto Taiwane

    Using a from 2000 ttied to signinvestmentpercent) anating incomregardless oincome frofrom Chine

    Results iregulation countries thmultinationcontributesunderstandhost countrguidelines f

    The remses. Sectionconcludes w

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    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

    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

    after-tax prots (Sikka & 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

    tax avoidance activity.y uses high-tech electronics rms in Taiwan to examine the variation in rm value associated with institutional

    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.

    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

    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

    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

    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-

    3 includes sample selection and research design. Section 4 presents empirical results and analysis. Section 5ith a brief summary.

    re review and hypotheses development

    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 & 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 inves