In our recent paper, we provide strong empirical evidence that banks play an active role in shaping borrowers’ tax planning. Our evidence is drawn from a comprehensive analysis of the impact of debt covenant violations on corporate tax avoidance.

Covenants must be maintained while the debt is outstanding and are tripwires for trouble. A violation of a covenant can put the borrowing firm into technical default and lead to the transfer of control rights to creditors, who then step in and exert strong influence over managerial decisions.

Using a large sample of covenant violations by U.S. public firms between 1997 and 2007 and a regression method called regression discontinuity design,, our main analysis shows that firms significantly increase moderate forms of tax avoidance after a violation of debt covenants. Economically, our estimates suggest that, all other things being equal, a violating firm’s cash effective tax rate (ETR) is lower by about 3 percent. We find similar results by using alternative measures of tax avoidance: ETR-based and book-tax difference based.

Further analysis indicates that the increased tax avoidance can be attributed to enhanced bank monitoring after covenant violations. In theory, corporate tax avoidance is the tradeoff between direct tax expenses and agency costs aggravated due to the opaque nature of tax reduction activities. Specifically, while tax avoidance yields direct cash tax savings that can improve solvency and increase after-tax cash flow, it could also induce managerial rent diversion and information hoarding. In particular, as tax avoiding activities are often hidden, managers could take advantage of reduced tax liabilities for their personal gain at the expense of other stakeholders.

To the extent that creditor governance enhances monitoring and mitigates manager rent extraction from reduced tax liability, investors will benefit from a higher level of tax avoidance. Some also argue that better corporate governance can encourage managers to engage in tax planning. When properly monitored and designed, moderate tax avoidance improves cash flows with limited risk.

Empirically, we find strong support for the above points. We show that the increased tax avoidance (in less aggressive form) is more pronounced among firms that had high agency costs before entering technical default. This heterogeneous reaction to covenant violation is consistent with the argument that poorly governed firms benefit more from enhanced bank monitoring. Put differently, after shareholders delegate monitoring to banks following covenant violations, the marginal impact of creditor governance in lowering agency cost and boosting tax efficiency is bigger among firms that were under scant monitoring from their equity holders.

We also find that the effectiveness of creditor intervention in increasing tax avoidance depends on the relative bargaining power between the firm and its lender. In particular, we explore the cross-sectional variation in violators’ bargaining power during debt renegotiations following covenant violation. We use the number of different banks from which loans were granted in the past five years as a proxy for a firm’s bank dependence and thus its bargaining power during renegotiation. We find that the increase in tax efficiency following a covenant violation is more pronounced when the borrower has an inferior bargaining position, i.e., having fewer relationships with banks in the past. This result highlights that the effectiveness of creditor governance also relies on lenders’ relative bargaining power.

Importantly, firms’ heterogeneous responses in tax planning following covenant violations suggest that banks’ incentive to influence borrowers’ tax avoidance behavior is not merely to preserve cash and protect their stake in a violating firm. Instead, banks’ active involvement in governance mitigates agency problems associated with tax avoidance, therefore allowing some firms to benefit more from improved tax efficiency. Our core findings in the paper are also insensitive to a number of further robustness tests.

Furthermore, turning to the more aggressive and riskier end of the spectrum of tax manipulation, we find that strengthened creditor governance has a mitigating effect on tax sheltering. Using the estimated tax sheltering probability, we show that, while creditor intervention leads to an increase in moderate forms of tax avoidance (measured by ETRs and book-tax differences in our baseline analysis), it curbs high-risk tax sheltering. This result suggests that banks don’t believe the benefits of aggressive forms of tax avoidance are worth the risks.

Taken as a whole, our study is among the first to provide comprehensive evidence of how the intervention of creditors affects corporate tax avoidance. We provide new evidence for the real effect of creditor governance following covenant violations on corporate tax policy. Recent studies on covenant violations find that, following a covenant violation, actions taken by banks are effective in curbing agency problems and in increasing the value of violating firms This study sheds new light on how creditors actively exercise their control rights granted by debt contracts to improve tax efficiency. As properly managed tax strategies increase after-tax cash flows, the findings add to the literature by identifying a new value-enhancing channel of the re-allocation of control rights in technical default.

We also identify active creditor intervention as a new determinant of corporate tax avoidance behavior. Recent studies have underlined the distinct monitoring and governance roles played by a firm’s other stakeholders in mitigating agency problems related to tax avoidance, resulting in corporate tax policies shaped by family owners, labor unions, dual-class shareholders, institutional equity investors, and hedge fund activists. However, the role of creditor governance has been largely overlooked. We show that creditor intervention prompts borrowers to reduce tax liabilities in moderate ways.

This post comes to us from professors Chi Wan and Yijia Zhao at the University of Massachusetts, Boston. It is based on their recent article, “Do Creditors Actively Influence Corporate Tax Planning? Evidence from Loan Covenants,” available here.