CEO Inside Debt Incentives and Corporate Tax Sheltering

• Author: SABRINA CHI,JUAN MANUEL SANCHEZ,SHAWN X. HUANG
• DOI: http://doi.org/10.1111/1475-679X.12169
• Date: 01 September 2017
• Published date: 01 September 2017

DOI: 10.1111/1475-679X.12169

Journal of Accounting Research

Vol. 55 No. 4 September 2017

Printed in U.S.A.

CEO Inside Debt Incentives

and Corporate Tax Sheltering

SABRINA CHI,

∗SHAWN X. HUANG,

†

AND JUAN MANUEL SANCHEZ

∗

Received 1 August 2014; accepted 1 December 2016

ABSTRACT

This paper examines the relation between CEO inside debt holdings (pen-

sion benefits and deferred compensation) and corporate tax sheltering. Be-

cause inside debt holdings are generally unsecured and unfunded liabilities

of the firm, CEOs are exposed to risk similar to that faced by outside creditors.

As such, theory (Jensen and Meckling [1976]) suggests that inside debt hold-

ings negatively impact CEO risk-appetite. To the extent that corporate tax

shelters are likely to result in high cash flow volatility in the future, we expect

that inside debt holdings will curb CEOs from engaging in tax shelter trans-

actions. Consistent with the prediction, we document a negative association

between CEO inside debt holdings and tax sheltering. Additional analyses

suggest that the effect of inside debt on tax sheltering is more (less) pro-

nounced in the presence of high default risk and liquidity threats (cash-out

options in pension packages). Overall, our results highlight the importance

of investigating the implication of CEO debt-like compensation for corporate

tax policies.

∗Texas Tech University; †Arizona State University.

Accepted by Philip Berger. This paper has benefited from the comments by an anonymous

referee, Cory Cassell, David Kenchington, Linda Myers, James Myers, Morton Pincus, and

workshop participants at Texas Tech University and the University of Arkansas, and partici-

pants at the 2015 American Accounting Association Annual Meeting. We thank the anony-

mous referee for generously sharing the tax shelter score measure constructed based on

Lisowsky’s [2010] model with us, and Ed Owens for sharing and explaining the data on the

probability of debt covenant violation. We also thank Laurie Corradino, Hal Elkins, Savan-

nah Guo, Min Kim, Blair Marquardt, and Jason Talakai for their excellent research assistance.

We gratefully acknowledge financial support from W. P. Carey School of Business and Rawls

College of Business.

837

Copyright C, University of Chicago on behalf of the Accounting Research Center,2017

838 S.CHI,S.X.HUANG,AND J.M.SANCHEZ

JEL codes: H25; H26; M41; M52

Keywords: inside debt; deferred compensation; incentives; executive com-

pensation; tax sheltering; tax shelters

1. Introduction

In Scholes and Wolfson’s[1992] framework, effective tax planning requires

managers (as tax planners) to consider the implications of tax strategies

for all parties involved in the tax planning process. As compared to other

parties (i.e., shareholders and the government), managers themselves have

received relatively little attention with respect to their impact on tax plan-

ning. Focusing on managerial fixed effects, Dyreng, Hanlon, and Maydew

[2010] show that individual managers are responsible for a significant por-

tion of the variation in tax strategies across firms, but such variation cannot

be explained by managers’ backgrounds. Providing further insight into in-

dividual managers’ impact on tax strategies, subsequent research points to

managerial incentives, especially those arising from employee stock options

or equity stocks. Both Rego and Wilson [2012] and Armstrong, Blouin, and

Larcker [2012] document a positive relation between managerial equity

(risk) incentives and aggressive tax planning, indicating that equity com-

pensation induces managers (including tax directors) to pursue aggressive

tax positions in an attempt to boost their option values.1These studies focus

primarily on the benefits of engaging in aggressive tax activities for man-

agers.2Despite the aforementioned findings, we still have an incomplete

understanding of why some managers are less aggressive in tax planning

than others. That is, are there any potential constraints to managers them-

selves of being tax aggressive? The existence of “internal” constraints can

potentially explain why some managers voluntarily choose, rather than be-

ing driven by external pressure, to be less aggressive in corporate tax poli-

cies. In this study, we focus on a specific constraint imposed on managers

that arises from an important component of their own compensation, in-

side debt holdings, and examine its impact on corporate tax sheltering.3

1In an early study, Desai and Dharmapala [2006], however, find that increases in equity

incentives for the top five paid executives lead to lower levels of tax sheltering. They attribute

their findings to agency costs of tax management and suggest that managers whose interests

are aligned with shareholders’ tend to be less aggressive in tax strategies.

2Extant literature also examines whether religion and gender affect managers’ risk prefer-

ence and thus their incentive to be aggressive in tax planning (Boone, Khurana, and Raman

[2013], Francis et al. [2014]). However,these studies do not investigate whether aggressive tax

strategies impose costs on managers.

3In general, pension plans, including supplemental executive retirement plans (SERPs),

are defined benefit plans that pay an executive a fixed amount per year after retirement.

Deferred compensation, on the other hand, refers to defined contribution plans in which

specific contributions are made to a retirement plan in the form of either deferred employee

compensation or employer contributions. Throughout the remainder of the paper, following

CEO INSIDE DEBT INCENTIVES AND TAX SHELTERING 839

Paying managers with debt-like compensation is a common practice in

the United States (Sundaram and Yermack [2007]). In general, managers

work in exchange for promises from their firms to pay them fixed amounts

of cash after retirement. Wei and Yermack [2011] find that 84% of chief

executive officers (CEOs) in their sample have inside debt with an aver-

age holding of more than $10 million.4Because CEO inside debt holdings

are generally unsecured and unfunded liabilities of the firm, CEOs are ex-

posed to default risk similar to that faced by outside creditors (Sundaram

and Yermack [2007], Edmans and Liu [2011], Wei and Yermack [2011]).

As such, theory suggests that inside debt holdings incentivize the CEO to

manage the firm more conservatively (Jensen and Meckling [1976], Ed-

mans and Liu [2011]), which is in contrast to the risk-seeking incentive

implied by equity-based compensation (Guay [1999], Rajgopal and Shevlin

[2002], Coles, Daniel, and Naveen [2006]). Consistent with theory, prior

research finds that firms with CEOs having high levels of inside debt imple-

ment more conservative investment and financing policies (Cassell et al.

[2012]), face lower default risk (Sundaram and Yermack [2007]), enjoy

lower costs of debt capital (Wang, Xie, and Xin [2010a], Anantharaman,

Fang, and Gong [2013]), report earnings more conservatively (Chen, Dou,

and Wang [2010], Wang, Xie, and Xin [2010b]), and have higher levels

of earnings quality (He [2015]). Together, the evidence suggests that CEOs

with large inside debt holdings become more risk averse in order to protect

the value of their holdings.

In examining the implication of inside debt for corporate tax policies, we

focus on the most aggressive form of tax minimization strategies, corporate

tax sheltering. Conceptually, corporate tax strategies can be considered as

a continuum, from tax avoidance to tax aggressiveness to tax sheltering

(Hanlon and Heitzman [2010], Lisowsky [2010]). In some cases, tax incen-

tives are not first-order drivers behind strategies along the tax minimization

continuum. For benign tax avoidance such as depreciation and stock op-

tions, capital investment and incentive alignment are more likely to have

a first-order effect than tax considerations (Lisowsky [2010]). Even for tax

aggressiveness, tax incentives are not likely to be the only driver. For exam-

ple, Hanlon and Heitzman [2010] argue that financial reporting incentives

can also significantly affect disclosures of tax reserves under Financial Inter-

pretation No. 48 (FIN 48), which potentially reduces the informativeness

of FIN 48 disclosure about tax aggressiveness. Different from the afore-

mentioned forms of tax strategies, corporate tax sheltering has little or no

Jensen and Meckling’s [1976] terminology,we refer to the sum of cumulative defined pension

benefits and deferred compensation as total inside debt holdings.

4In spite of its widespread use, disclosure on inside debt holdings was very limited be-

fore 2006, which hindered researchers’ ability to investigate this compensation component.

However, effective for 2006 fiscal year-ends, the Securities and Exchange Commission (SEC)

started to require firms to disclose their CEOs’ inside debt positions related to CEO pension

benefits and deferred compensation, including the actuarial net present value and annual

increase of such balances.