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New Study Sheds Light on Corporate Tax Shelters
December 19, 2004
DURHAM, N.C. -– A study by researchers from Duke University and Pace University found that use of corporate tax shelters not only allows organizations to avoid billions of dollars in annual tax payments, it may also help companies artificially enhance their attractiveness to investors by reducing levels of debt.
The study also explores some commonly used tax shelters and the characteristics of firms that have employed these shelters.
Finance professors John R. Graham of Duke’s Fuqua School of Business and Alan L. Tucker of Pace’s Lubin School of Business collected the largest known sample of tax shelters utilized by corporations during the past 25 years.
“We have a unique sample of corporations that have sheltered taxes, and find that these firms have different types of corporate policies relative to non-sheltering firms,” Tucker said. “Since shelters lower taxes, writing off interest from debt becomes less useful to companies. When companies choose to use tax shelters instead of debt, they appear less risky to investors and their share values can be inflated.”
Graham and Tucker’s sample consists of 44 firms that have been involved in government litigation related to tax shelters and/or have been served a Notice of Deficiency by the Internal Revenue Service related to an alleged tax shelter. The sample includes such companies as BB&T Corp, Colgate-Palmolive Company, Compaq, Fleet Boston Financial Corp., Microsoft, United Parcel Service and Winn-Dixie. The tax shelters were devised or brokered by firms including Goldman Sachs, Merrill Lynch and Twenty First Security Corporation.
“This process identifies 43 publicly traded corporations (involving 44 total instances of sheltering) that have been alleged or proven by the government to have illegally sheltered taxable income,” the researchers note in their paper. “In 29 of these 44 cases the taxpayer brought litigation against either the Commissioner or the United States in an attempt to preserve the tax treatment sought. The filing/docketing of the litigation is a matter of public record and thereby permits us to identify the firms accused of sheltering as well as the tax years involved.”
The paper presents an overview and analysis of eight common tax shelter strategies used by the companies in the sample. Many of the strategies involve use of foreign partners or subsidiaries, or corporate-owned life insurance plans.
The researchers demonstrated that sheltering firms have debt-to-total asset ratios that are one-third lower than comparable firms that do not use tax shelters. Because they have less debt, companies that use tax shelters look healthy to investors. According to the researchers, this reduced debt can lead to better debt ratings, cheaper borrowing rates and less risk of violating corporate covenants.
The median tax shelter led to tax deductions of about $1 billion per year.
“To put this number in perspective, to achieve that level of tax savings via debt would require the typical company to increase its debt ratio to 90 percent of asset value, an unheard-of number,” Graham said. “The tax shelters we investigated are very large, reduce the need for debt and artificially prop up the user’s financial statements.
“Our study sheds light on the age-old question of why some large, profitable firms appear to use such a small amount of debt,” Graham added. “Previous research has implied that many firms pay more tax than they have to because they apparently have so few interest deductions. Our study shows that in fact many of these firms obtain huge deductions from tax shelters that aren’t visible to the IRS or investors, and in fact they pay little in corporate income tax.”
Graham and Tucker also identified the characteristics of firms most likely to use tax shelters. The researchers found large firms, firms with foreign operations and those with substantial research and development expenses were most likely to use tax shelters. This analysis should help investors, or the IRS, identify the types of firms that might be likely to use tax shelters.
The low debt levels utilized by these sheltering firms gives the appearance that they exhibit less financial leverage or risk, which may cause investors to bid up the firms' share values,” Tucker said. “For example, it has been estimated that through sheltering, Tyco may have increased its market capitalization (share price times the number of shares outstanding) by about $5 billion. That's a big number. If sheltering is widespread, then we may be looking at some very tenuous share values.” Graham and Tucker’s paper, “Tax Shelters and Corporate Debt Policy,” is available at http://www.ssrn.com/abstract=633042.