Avoiding inheritance taxes in family firms

• Author: Hojong Shin
• Published date: 01 December 2020
• Date: 01 December 2020
• DOI: http://doi.org/10.1111/fima.12308

DOI: 10.1111/fima.12308

ORIGINAL ARTICLE

Avoiding inheritance taxes in family firms

Hojong Shin

College of Business, California State University,

LongBeach, Long Beach, California

Correspondence

HojongShin, College of Business, California State

University,Long Beach, 1250 N Bellflower Blvd,

LongBeach, CA 90815.

Email:hojong.shin@csulb.edu

Abstract

This article documents a novel wayto transfer control in family firms

while avoiding inheritance taxes: intragroup mergers. I provide evi-

dence that avoiding inheritance taxesis the motivation behind intra-

group mergers in Korea. In 1999, Korea initiated a tax reform that

bumped up personal inheritance taxes by 25 percentage points. In

the posttax-reform period, I find that family firms increase stock-for-

stock intragroup mergers involving targets owned by heirs. Specifi-

cally, firms with heavy inheritance taxesacquire affiliates owned by

heirs, who then convert private target shares into acquirer shares

while avoiding inheritance taxes.

1INTRODUCTION

In exchangefor these financial contributions, prosecutors say,Ms. Choi colluded with Ms. Park to ensure government

backing for several deals, most notably a controversial merger of two Samsung affiliates in 2015 that helped Mr.Lee

consolidate his hold over Samsung Electronics. The merger changed Samsung’s intricate cross-holding structure and,

prosecutors said, allowed Mr. Leeto avoid a steep inheritance-tax bill as he sought to succeed his father at the top of

the conglomerate (WallStreet Journal, August 25, 2017).1

This anecdote illustrates how,i n practice,family firms indirectly transfer control to heirs through intragroup merg-

ers.2When controlling families transfer their control through direct ownership inheritance, heirs must pay an inheri-

tance tax. This is generally what we expect when talking about transferring control in family firms. However, because

of the heavy inheritance taxes, heirs are exposedto ownership dilution risk. Thus, controlling families are incentivized

to minimize inheritance taxes to ensure that the heirs maintain sufficient control over the entire business group. A

common strategy to avoidheavy inheritance taxes is for family firms to acquire smaller affiliates owned by heirs. Then,

the heirs convert the target shares into acquirer shares. Throughthis stock-for-stock intragroupmerger,3heirs obtain

large controlling stakes in a keystrategic firm owned by the controlling family while avoiding the inheritance tax.

c

2020 Financial Management Association International

1Eun-Young Jeong, “Samsung Heir Lee Jae-Yong Convicted of Bribery, Gets Five Years in Jail,” Wall Street Journal (August 25, 2017), https://www.wsj.

com/articles/samsung-heir-lee-jae-yong-convicted-of-bribery-1503642785.

2Theintragroup merger between two Samsung group affiliates is detailed in Appendix B.

3Becauseheirs’ shares are converted into acquirers’ shares, any intragroup merger that uses cash as payment should be irrelevant.

Financial Management. 2020;49:1051–1082. wileyonlinelibrary.com/journal/fima 1051

1052 SHIN

Family firms comprise more than 80% of firms worldwide,4and succession largely determines their fate. Only 30%

of family firms last into a second generation, 12% into a third, and 3% into a fourth generation or beyond.5Given

the importance of succession in family firms, it has attracted significant attention in the recent literature.6However,

there is scant evidence documenting the effect of personal inheritance tax on family succession and its implications for

control-transfer processes in family firms. I fill this gap by studying one wayto transfer control: intragroup mergers.

Using a natural experiment, I provide causal evidence that avoiding inheritance taxes is the motivation behind

intragroup mergers. This natural experiment exploits Korea’s major tax reform initiativeundertaken in 1999, which

suddenly increased the maximum personal inheritance tax rate by 25 percentage points. Exploiting this unexpected

increase in inheritance taxes and using a difference-in-differences (DiD) estimation, I examine how firms respond to

the tax change when transferring control shares. Specifically,I compare how firms with high and low expected tax bur-

dens before the 1999 tax reform use intragroup mergers to transfer control shares after the tax reform. My findings

shed light on (a) the inheritance tax-savingbenefits of controlling families,(b) the transaction costs of intragroup merg-

ers, and (c) the way the overallownership structure of family firms is rebalanced.

The final data comprise 2,422 firm-year observations from the 24 largest Korean chaebols7from 1997 to 2004

(sample years). I use Korean chaebol data because Koreanchaebols have reported highly detailed interfirm ownership

information among their affiliates to the Korean Fair TradeCommission (KFTC) since the mid-1990s. Public access to

this type of information is limited in most countries but is available in Korea.8Giventhat family ownership is prevalent

around the world, my results haveimportant implications for many countries in addition to Korea.9

I first document that the number of stock-for-stock intragroup mergers increases with personal tax burdens. Next,

using the 1999 tax reform, I estimate the causal effect of the expected inheritance taxes on intragroup mergers. The

results show that the difference in intragroup mergers between firms with high and low personal inheritance taxes is

2.3 times more likelyto increase after the tax shock. I also find that among firms with high tax burdens, stock-for-stock

intragroup mergers are concentratedin (a) central firms,10 (b) firms located in the upper layer of the pyramid,11 and (c)

firms within a circular ownership chain, that is, firms where heirs can consolidate their indirect control over the entire

businessgroup. This result highlights that the ownership network of group affiliates determines which firms with heavy

inheritance taxes initiate intragroupmergers. However, this result does not hold for non-intragroup mergers.

4Chase Peterson-Withorn, “New Report Reveals the 500 Largest Family-Owned Companies in the World,” Forbes (April 20, 2015), https://www.forbes.

com/sites/chasewithorn/2015/04/20/new-report-reveals-the-500-largest-family-owned-companies-in-the-world/#6eccd1423602.

5FamilyBusiness Alliance, http://www.fbagr.org/index.php?option=com_content&view=article&id=117&Itemid=75(accessed June 2014).

6Pérez-González(2006) and Bennedsen, Nielsen, Pérez-González, and Wolfenzon (2007) document that family chief executive officers (CEOs) perform worse

than nonfamily CEOs. Mehrotra,Morck, Shim, and Wiwattanakantang(2013) also show that firms run by nonbiological heirs outperform firms run by either

biological heirs or professional managers. Bunkanwanicha, Fan, and Wiwattanakantang (2013) show that a network marriage between a controlling family

memberand a member of a prominent business or political family is followed by increasing stock prices.

7Family-ownedlarge business conglomerates in Korea are generally called “chaebols.”

8KFTCrequires only select Korean chaebols to divulge their ownership status information. Because of limited access to ownership data, the sample does not

includesmaller business groups.

9Theliterature shows that controlling families siphon resources out of member firms for their private benefit (Johnson, La Porta, Lopez-de-Silanes, & Shleifer,

2000). Similar tax-saving tactics likely benefit controlling families in other institutional contexts. For example,Asian casino king Stanley Ho implemented

similarintragroup transactions to avoid inheritance taxes.

10These companies are connected to many other member firms in the ownership network. Therefore, the controlling family can indirectly control affiliated

firmsthrough strategic firms in a pyramidal business group. Following Almeida, Park,Subrahmanyam, and Wolfenzon (2012), the centrality of firm iis measured

asthe average percentage difference in the control rights of the controlling family across all group member firms except the firm itself after excludinga specific

firmifrom the group. In this article, I refer to firms with a high centrality value as “central firms.”

11The upper layer of the pyramid is an indicator that equals 1 if a firm’s position is smaller than the average of all chaebol firms, and 0 otherwise. Position

refers to the distance between the controlling family and a firm in the group. A value of 1 indicates that the firm is directly controlled bythe founding family.

In a simple pyramidstructure with two firms, firm iin the upper layer (Chain 1) has a position value of 1, and firm jin the lower layer (Chain 2) has a position

value of 2. In this case, the position of firm ican be measured by the weighted averageof Chains 1 and 2, whose importance is weighted by the cash flow the

familyreceives. Cash flow comprises direct cash flow from firm iand indirect cash flow from firm jthrough Chain 2. Group firms that are directly owned by the

controllingfamily have a low position value, whereas those that are indirectly owned have a high position value. See Almeida et al. (2012) for additional details

aboutownership metrics.

SHIN 1053

Next, I test whether a reduction in personal taxes decreases intragroup merger activities. I find that intragroup

mergers are rarely pursued by firms that have heavy inheritance taxes and are indirectly owned by private founda-

tions exempt from gift taxes.A difference-in-difference-in-differences (DiDiD) estimation of Korea’s 1999 tax reform

confirms that unusual surges in stock-for-stock intragroup mergers occur primarily because firms aim to avoid inheri-

tance taxes through intragroup mergers.12 I find that this sudden increase in intragroupmergers after the tax reform

is not prompted by the Asian financial crisis. In other words, it is not due to the sudden drop in Korea’s capital market

value during the precrisis era or postcrisis restructuring.

Furthermore,I investigate ownership reallocation by identifying target firm characteristics in relation to intragroup

mergers. I find that heirs of chaebol families receive large dividends from their private firms in which they have large

ownership stakes. These firms become the targets of intragroupmergers. Heirs can take these dividends because they

have substantial voting rights, which they use to determine corporate policies in target merger firms. Because heirs

own only their target firms that are merged with central firms, they prefer short-term wealth gains over long-term

investment commitments. However,this behavior is not necessarily found in male relatives in the current chair’s gen-

eration,for whom succession process has officially ended. Overall, these results suggest that to avoid inheritance taxes,

heirs first prefer to own private firms where they can cash out corporate resources quickly and then reallocate their

ownership to central firms through intragroupmergers.

Although controlling-family heirs are likely to benefit from this reshuffling, the ownership network becomes more

distorted as central firms expand their boundaries with additional circular shareholding links. Minority shareholders

suffer losses from these tax-motivated mergers, which have few operational synergies. Forinstance, the 2-day cumu-

lative abnormal return (CAR)drops 32.3% more when an intragroup merger is announced than when a non-intragroup

merger is announced. Overall, this evidencesupports the tunneling view of business groups discussed i nthe literature

(e.g., Johnson et al. 2000).

This article is related to several strands of literature, including studies on the effect of taxeson firms. Early stud-

ies emphasize the effects of corporate income taxes on the right-hand side of the balance sheet, such as capital

structure (Miller, 1988; Modigliani & Miller,1958, 1963) and dividend policy (Auerbach, 1979; Bradford, 1981; King,

1974). Recent studies explore topics such as the effects of tax reforms on organizational forms (Desai & Hines,

1999; Desai, Foley, & Hines, 2004) and the effects of inheritance laws on investment decisions (Ellul, Pagano, &

Panunzi, 2010; Tsoutsoura, 2015). My article connects these two recent topics by exploring ownership networks

among group affiliates. Ownership networks are a key component of the inheritance tax channels through which

firms with heavy inheritance taxes initiate intragroup mergers, which in turn cause distortions in the ownership

network.

My findings also contribute to the literature on tunneling in emerging markets. Tunneling is more prevalent in

emerging economies, where controlling shareholders exercise their discretionary power to extract private benefits

by transferring assets and profits out of firms (Johnson et al., 2000). The literature documents tunneling in business

groups under a pyramidal ownership structure by highlighting conflicts of interest between controlling shareholders

and minority shareholders (Almeida & Wolfenzon, 2006a, 2006b; Bae, Kang, & Kim, 2002; Bertrand, Mehta, & Mul-

lainathan, 2002; Chang, 2003). Recent studies introduce several forms of tunneling practicesand their consequences

(Cheung, Rau, & Stouraitis, 2006; Jian & Wong, 2010; Jiang, Lee, & Yue,2010). In such cases, minority shareholders

suffer losses from negative firm outcomes. I explore a form of tunneling in which intragroup merger activities aim to

avoid inheritance taxesbut r esultin negative market consequences. Similar tax-saving schemes employed by control-

ling families for their own benefit likely crop up in manyother institutional contexts.

This article is organized as follows: Section 2 introduces the institutional background of inheritance tax reform.

Section 3 describes the data and sample summary statistics. Section 4 discusses the main results. Section 5

concludes.

12An example of avoiding inheritance taxesthrough intragroup mergers in pyramids is detailed in Appendix C.