Research into the relationship between voluntary tax disclosure and tax aggressiveness: Can you judge a book by its cover?

Research into the relationship between voluntary tax

disclosure and tax aggressiveness: Can you judge a book

by its cover?

The recent public debate about tax avoidance has led to the investigation of how corporate social responsibilities influence tax avoidance. This study focusses on voluntary tax disclosures with regard to corporate social responsibilities. The voluntary tax disclosures researched in the study are: acknowledging tax as a responsibility and Country-by-Country reporting. The sample consists of companies that are listed on the FTSE 100 from 2010 to 2014. Legitimacy theory is used in trying to describe the expected behavior with regard to voluntary tax disclosures. The results found are inconclusive and further research is needed to explain the behavior of companies when looking at their disclosures. The credibility debate of voluntary disclosures arises. Therefore this study concludes that users of disclosures have to be careful when interpreting voluntary tax disclosures.

Keywords: CSR, Tax aggressiveness, Legitimacy theory, Voluntary disclosure, Tax disclosure, Country-by-Country.

Research into the relationship between voluntary tax

disclosure and tax aggressiveness: Can you judge a book

by its cover?

Name : W. J. (Winant) Zwinderman

Student number : S2295067

Date of Birth : 1 April 1993

E-mail address : w.j.zwinderman@student.rug.nl

University : University of Groningen

Faculty : Economics and Business

Study : MSc Accountancy and Controlling

Supervisor : dr. S. (Soojin) Lee

Table of Contents

1.

Introduction ... 7

2.

Theoretical Framework ... 10

2.1 Interpretation of the law ... 10

2.1.1 Abiding by the spirit of the law ... 10

2.1.2 Abiding by the letter of the law ... 11

2.2 Legitimacy Theory ... 12

2.2.1 Strategic Approach ... 12

2.2.2 Institutional Approach ... 13

3.

Hypotheses Development ... 15

3.1 Corporate Social Responsibility ... 15

3.2 Country-by-Country Reporting ... 16

4.

Research Method ... 19

4.1 Sample design and data collection ... 19

4.2 Measurement of variables ... 19

4.2.1 Dependent variable - Tax Avoidance ... 19

4.2.2 Independent variables ... 20 4.2.3 Control variables ... 20 4.3 Statistical model ... 20

5.

Findings ... 21

6.

Discussion and Conclusions ... 25

6.1 Limitations ... 27

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1.

Introduction

"Ethics is knowing the difference between what you have a right to do and what is right to do." – Potter Stewart Supreme Court justice

Currently, much debate is going on about the “fairness” of tax avoidance. With the use of transfer-pricing, corporate structures and financial transactions, companies can minimize taxes while complying with the letter of the law (Jenkins & Newell, 2013). Particularly for multinational corporations it is easy to avoid their taxes (Rego, 2003). Headlines shaming Google, Facebook, Netflix, Starbucks Vodafone and Amazon on their tax avoiding behaviors are just some examples indicating a growth of public discontent (Barford & Holt, 2013). A recent study of UK Commons’ Public Accounts Committee (2015) concluded that tax avoidance is promoted by professional service firms on an industrial scale. The Committee also states that the government has to take actions against the tax industry as they clearly cannot be trusted to control themselves. The Chairman of Google, Eric Smidt, responded, “I am very proud of the structure that we set up. We did it based on the incentives that the governments offered us to operate. “It’s called capitalism” (Daily Mail, 2012). He further argues that Google is following the rules and that if they have to pay more taxes the system should change (Daily Mail, 2012).

Whether Google is acting ethically is debatable. According to Friedman (1970) it is a business’s responsibility to increase its profits. Friedman argues that only people can have social responsibilities and that corporate responsibilities are often used as a disguise for actions that are justified on other grounds. The opinion that the sole responsibility of a corporation is to maximize financial returns is a typical shareholder view. Carroll (1991) argues that a company has to take several other stakeholders into account besides its shareholders. Carrol suggests that to reckon with all the stakeholders a company should be socially responsible. Corporate Social responsibility (CSR) consists of four kinds of responsibilities: economic, legal, ethical, and philanthropic. The four responsibilities are shown in figure 1, with a short description. Tax avoidance does not compromise legal responsibilities, since the UK Commons’ Public Accounts Committee report (2015) states that there is no legal violation when engaging in tax avoidance. However, during public debates the “morality”, “responsibility”, “reputation”, “fairness” and “relative deprivation” of tax avoidance are questioned. Thus tax avoiding companies do not seem to meet the ethical responsibility as stated by Carroll (1991).

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The recent public shaming of companies that avoid their tax indicates a shift in society’s expectations about the responsibilities of corporations. Therefore companies should not stand by and wait for governments to take action, but should take actions themselves (Jenkins & Newell, 2013). There are some ways for companies to take actions, like county-by-county reporting, abandoning transfer price manipulation and stopping the use of tax havens. According to Jenkins & Newell (2013) failure to do so can lead to decreased legitimacy claims in the same way as the abuse of workers or environmental disasters have affected companies in the past.

Recent studies about the role of CSR in tax avoidance show mixed results. In the study of Hoi, Wu, & Zhang (2013) a negative relation between CSR and tax avoidance was found. They suggest that the culture of a company defines its CSR practices. They conclude that companies that do engage in tax avoidance have a lack of CSR in their culture. Davis, Guenther, Krull, & Williams (2016) find however that there is a positive relation between CSR and tax avoidance, leading to the conclusion that tax avoidance is not seen by companies as part of the CSR. The study of Watson (2015) examines the relation between CSR and tax avoidance even further. In his study the impact of current and future earnings performance on the relation between CSR and tax avoidance is taken into account. It concludes that resource scarcity is an important moderator of the impact of CSR on firm behavior. The results of these recent studies investigating the relation between corporate disclosures and tax avoidance can therefore be deemed inconclusive.

Figure 1. The Pyramid of Corporate Social Responsibility

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At the moment the mandatory corporate disclosures about tax are limited. The tax returns of companies are confidential, which leads to discretion in disclosures about tax (Alexander, 2013). Besides the limited information in the presented accounts, the internal company codes rarely discuss tax obligations (Paine, Deshpande, Margolis, & Bettcher, 2005). Thus the mere compliance with tax regulation and accounting standards does not provide enough insight into the tax practices of a company. Some companies voluntary disclose their tax practices to enhance their transparency. In this paper the influence of the voluntary tax disclosures on the tax practices of a company will be investigated. An insight into the corporate social responsibilities with regard to tax of companies is given by examining their voluntary tax disclosures. This study contributes to the discussion of how CSR influences tax behavior.

The remainder of this paper is structured as follows. The next section reviews the literature on CSR and how it influences tax avoidance and describes the theoretical framework from a legitimacy perspective. In section three the hypothesis are being developed. The hypothesis are followed by the research method in section four. Section five presents the results, followed by a discussion and conclusion in the final section.

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2.

Theoretical Framework

When a company engages in CSR they accept ethical obligations, on top of their economic and legal obligations (Carroll, 1991). The Global Reporting Initiative (GRI) offers entities guidelines on reporting their responsibilities, but does not offer a clear definition of what this ethical obligation constitutes of. In practice there is a wide diversity of the activities labeled as CSR (Beddewela & Fairbrass, 2015). It ranges from community involvement (Muthuri, 2008; Seitanidi & Ryan, 2007) to establishing measures that consider the environment (Ingram & Frazier, 1980; Rondinelli & Carolina, 2000). Beddewela & Fairbrass (2015) argue that early CSR activities are mainly determined by the profits and values of their business owners, whereas today CSR activity requirements are influenced by other powerful stakeholders (Brammer & Millington, 2004; Veser, 2004), e.g. governments (Zhao, 2012). In the current literature a spectrum exists of what is deemed ethical with regard to tax avoidance. The spectrum ranges from the notion of “abiding by the spirit of the law” to “abiding by the letter of the law” (Dowling, 2014). As mentioned in the introduction, CSR’s influence on companies’ tax practices is subject of debate (A. K. Davis et al., 2016; Hoi et al., 2013; Watson, 2015).

2.1

Interpretation of the law

The two ways of interpreting the law as described by Dowling (2014) describe the extremes of the spectrum. Where the “spirit of the law” can be seen as the popular and political understanding of the law. When the law states that companies have to pay taxes on their accounting profits, companies that make a profit should pay taxes. This boils down to the understanding that companies owe a financial return to the state. The “letter of the law” does not make a distinction between the spirit of the law and the language of the law. Both are displayed in the words that are used in the legislation. The plain meaning of the words are directive in circumstances of ambiguity and can be resolved by court decisions. Arguments how to interpret the law are given below.

2.1.1 Abiding by the spirit of the law

Tax payments are a fundamental and easy measure of a company’s contribution to society (Dowling, 2014). Avoiding taxes causes harmful distortions in the market and leads to a shift in the tax burden from multinational companies to domestic-only companies (Rego, 2003). Avoiding taxes enables entities to become economic free-riders (Christensen & Murphy, 2004). Since multinationals are often cooperating with domestic-only companies, a multinational indirectly harms its stakeholders when avoiding taxes.

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According to Chen, Chen, Cheng, & Shevlin (2010) investors will also benefit from less aggressive tax planning. They suggest that tax aggressiveness is obscure in nature, which will make it easier for managers to hide rent extraction activities. Desai & Dharmapala (2002) see also the benefit of less aggressive tax practices for investors. A high degree of tax compliance can be a signal to investors of less value diversion, because managers of companies with high tax compliance are less likely to purchase tax shelter products.

Another downside of tax avoidance are the costs that go along with it (Dowling, 2014). A company has to invest time and effort to plan their taxes. Often it is argued that these costs are “earned” back through lower tax costs (Chen et al., 2010). However, there is a risk of a penalty from a tax authority. This is the product of the chance of being audited by a tax authority and the probability that they find the aggressive tax planning practices (Chen et al., 2010). Besides penalties, governments try to counter the clever tax avoidance practices. The aim of governments to counter these practices is to produce certainty, while in practice governmental intervention often leads to a more complex tax system. To comply with the new legislation and requirements, costs of compliance will increase.

Additionally, some specific tax planning strategies come at a cost like implicit taxes and book-tax conformity. The objective of these strategies is to lower the reported earnings, which in turn will reduce income taxes. Lower reported earnings will in turn lead to a decreased valuation of the company. Desai, Dyck, & Zingales (2007) found evidence that aggressive tax planning leads to lower valuations of firms. They studied Russian firms that where targeted by increased tax enforcement and therefore strongly complied with regulation. These firms increased in market value, suggesting that the tax aggressive benefits did not weight up against the potential cost reduction of their tax burden. Since there are drawbacks that go along with engaging in tax avoidance it might be wise for a company to “abide by the spirit of the law”. This depends on how the arguments apply to a company.

2.1.2 Abiding by the letter of the law

Directors often see it as their prime duty to act in the best interest of their shareholders. With the use of aggressive tax planning, directors can maximize performance on behalf of their shareholders (Christensen & Murphy, 2004). Taxes are significant costs and lead to a reduction in cash flow (Chen et al., 2010). Therefore, companies that avoid their taxes see avoidance as part of their financial responsibility (Erle, Hickey, Doherty, & Flexman, 2004). These savings will directly accrue to the shareholders and will reward managers for their efforts to effectively manage taxes.

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Another incentive for organizations to abide by the letter of the law is executive compensation. When executive’s compensation can be influenced through tax planning, managers might have an incentive for their personal gain. Compensation can be influenced directly through their salary or bonuses or indirectly through insider trading (Cheng & Warfield, 2005). The latter can arise when aggressive tax practices has an influence on temporary stock price fluctuations. These fluctuations can be known beforehand by managers and they can anticipate, to gain a personal benefit. When a company has incentives to reduce it taxes it will “abide by the letter of the law”.

2.2

Legitimacy Theory

To abide by the spirit of the law or by the letter of the law is for a company to choose. How a company chooses to behave can be described based on the legitimacy theory. Legitimacy is the generalized perception that actions of an entity are desirable, proper or appropriate within some socially constructed system of norms, values, beliefs and definitions (Suchman, 1995). In the research of Suchman (1995) a broad definition of legitimacy is given and two approaches to explain the phenomenon; the strategic and the institutional approach.

2.2.1 Strategic Approach

From a strategic approach legitimacy is seen as an operational resource, which organizations use to achieve their goals (Dowling & Pfeffer, 1975; Suchman, 1995). Dowling & Pfeffer (1975) examined organizational behavior with respect to legitimacy. Their legitimacy research can be categorized as the strategic approach to legitimacy. Dowling & Pfeffer (1975) state that companies with increased social pressure are motivated to change their behavior to retain legitimacy. Bansal and Roth (2000) find empirical evidence for the statement of Dowling & Pfeffer (1975). They find that companies increasingly pay attention to social and environmental externalities to build legitimacy from a strategic perspective. Patten (1991) argues that disclosure about CSR practices can increase the claim on legitimacy of a business, because their social legitimacy is not monitored by the marketplace but through the public-police arena. Therefore the extent of social disclosure is more closely related to public pressure variables than to profitability measures, giving firms an incentive to disclose their CSR practices. From a strategic approach a company also has an incentive to engage in philanthropic activities. These philanthropic activities are not for their economic return, but to maximize their political return (Su & He, 2010). The objective of political return is to reduce intervention or legislation of countries. Mismanagement in CSR strategy can therefore reduce legitimacy due to social and political pressure (Baron, 2001).

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Panwar, Hansen, & Kozak (2014) describe a framework of how problems with legitimacy arise. They connect the expectation gaps described by Wartick and Wood (1998) with the legitimacy gap explained by Sethi (1975, 1979). There are three types of expectation gaps (Wartick and Wood, 1998). This framework is shown in figure 1. The first is the factual gap, which is described by the differences between business and societal groups of the current state of affairs. The second is the Ideal gap, this is the differences between the relative positions of business to society with regard to the expected state of affairs. The last is the Conformance gap, this is the difference within the business between the current and desired behavior. In the social domain the legitimacy gap is the sum of the internally focused (conformance) gap and the externally focused (factual and ideal) gaps (Panwar, Hansen, et al., 2014).

2.2.2 Institutional Approach

The institutional approach tries to explain in which ways changes in corporate operations, structures or strategies are manifested in the wider social system (Dimaggio & Powell, 1983). Why corporations behave the way they do and the process by which behavior becomes institutionalized is the main research topic of institutional theorists (Scott, 1987). Therefore, institutional theory has been used frequently as a framework to study the reasons of why companies behave in a responsible way (Campbell, 2007; Gjølberg, 2009; Husted & Allen, 2006; Matten & Moon, 2004). Legitimacy is required in order for an institution to be created, transformed and diffused. Institutions gain legitimacy in a situation where alternatives are less appropriate, desirable or viable (Dacin, Goodstein & Scott, 2002). Social pressure can change legitimacy due to changing social norms and values associated with activities of the organization. Davis (1973) put it as the Iron Law of Responsibility: "in the long run, those who do not use power in a manner which society considers responsible will tend to lose it". (p. 314)

Figure 2. Diagrammatic representation of the

legitimacy gap and three types of expectational gaps.

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Institutional theory gives an insight in how consensus is build and how these concepts or practices are developed and diffused among organizations (Jennings & Zandbergen, 1995). Institutional theory mainly describes two phenomena: the first is how certain concepts or practices gain value and meaning, and the second describes how these concepts or practices become widespread and commonly accepted. There are three mechanisms through which the concepts and practices become commonly accepted (Dimaggio & Powell, 1983). The three mechanisms are: 1. coercive isomorphism that stems from political influence and the problem of legitimacy, 2. mimetic isomorphism resulting from standard responses to uncertainty and 3. normative isomorphism associated with professionalization. The mechanisms described by Dimaggio & Powell (1983) are called isomorphism and they argue that companies will start to look like one another when the concept or practice is getting commonly accepted. Institutional isomorphic processes do not always lead to enhanced effectiveness, but organizations will often be rewarded for being similar to other organizations (Dimaggio & Powell, 1983).

The three major sources for the institutionalization of norms or practices cover functional, political and social sources (Oliver, 1992). Political sources influence the effort companies make to resolve issues surrounding companies’ power distribution and the threat of failure or becoming obsolete. Functional sources influence the economic grounds on which companies activities are institutionalized. The pressure from social sources arises from a change in societal values or expectations and government laws which challenge the current activities. In this paper, the focus will be on the political and social sources. The issue of corporations behaving in a responsible way has become a familiar one among politicians (Buhr & Grafström, 2003). Not adhering to political pressures can endanger the legitimacy of organizations (Verhoest, Verschuere, & Bouckaert, 2007). Ignoring political pressure can decrease reputation and legitimacy in the eyes of stakeholders (Verhoest et al., 2007). Jenkins & Newell (2013) suggest that companies should not wait until government take actions but should take actions themselves in order to maintain legitimacy.

Besides the political sources there are also social sources described by Oliver (1992) that can lead to institutionalization. The social norms of business behavior have changed in the recent years. This led to an increasing number of companies behaving in a socially responsible way, implicitly conforming to the needs of society (Matten & Moon, 2008). When companies do not respond to the needs of society they may lose their social role and power (Davis, 1973). When a company does conform to social pressures, they have an incentive to disclose about their conformance in order to increase their claim on legitimacy (Chauvey, Giordano-spring, Cho, & Patten, 2015). Besides a stronger claim on legitimacy, reporting on CSR activities can help companies build reputational capital (Panwar, Paul, Nybakk, Hansen, & Thompson, 2014)

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3.

Hypotheses Development

3.1 Corporate Social Responsibility

Whether a company engages in CSR practices depends on the arguments they find most compelling. Some scholars argue that entities engage in CSR activities to protect the firm from political, regulatory and social sanctions in case of a negative event (Godfrey, 2005; Minor & Morgan, 2011). When being shamed by the press, tax avoidance can turn into one of these negative events. The negative effects of these events can be severe, like tax penalties, loss of firm reputation, consumer boycott and increased political pressure (Hanlon & Slemrod, 2009; Wilson, 2009). Therefore, from a risk management perspective CSR can be seen to enhance the reputation of a firm. Reporting about their CSR practices can enhance their reputational capital and their claim on legitimacy (Panwar, Paul, et al., 2014).

However, CSR, as described by Carroll (1991), is not intended to be a risk management tool. From Carroll’s perspective, CSR is about aligning business activities with the stakeholders’ needs. This includes the payment of taxes, since this is the most obvious and largest contribution firms make to non-employees and non-shareholders (Desai & Dharmapala, 2002). The GRI also emphasizes the importance of taxes as part of CSR. For example, in their G4 sustainability reporting guidelines (2015) they clearly state the importance of disclosing information that shows how an organization contributes to society.1

In 2014 and 2015 the Vereniging van Beleggers voor Duurzame Ontwikkeling (VBDO), a Dutch institute for investors with a focus on sustainability, investigated Multinationals in the Netherlands. Of the sixty-nine companies that were included in 2013, only 6% regarded tax as a CSR issue (VBDO, 2014). In 2014, the number grew significantly to 58% of companies accepting tax as their responsibility (VBDO, 2015). In their 2015 report they argue that companies should not see tax as a profit center, but they should take responsibility and pay their fair share of taxes. Yet, tax is often not integrated into CSR strategies. Companies still substantiate their tax policy from legal and technical perspective.

The perspective from which a company views its tax policy can be very different. Institutional theory tries to explain the different reasons for business behavior. The sector in which an organization operates is an important boundary for the institutional field (Dimaggio & Powell, 1983). Some sectors are, for example, more influenced by reputational harm (Hanlon & Slemrod, 2009). This can be due to the

1 _{“The underlying question of sustainability reporting is how an organization contributes, or aims to contribute in} the future, to the improvement or deterioration of economic, environmental and social conditions, developments, and trends at the local, regional or global level. Reporting only on trends in individual performance (or the efficiency of the organization) fails to respond to this underlying question.” (G4 sustainability reporting guidelines, 2015)

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different behavior of the Non-Governmental Organizations (NGO’s) and consumers in a sector. Therefore, some companies can benefit more by engaging in acknowledging tax as part of their responsibility than others (Apostolakou & Jackson, 2010). Besides NGO’s and consumers, governments also exercise pressure on companies to engage in a social responsible way (Campbell, 2006).

In current research the influence of CSR as a whole on tax avoidance is examined. CSR as a whole gives inconclusive results on how decisions are made by management regarding tax practices. Therefore this research makes a distinction between different social responsibilities. This study will focus on the social responsibilities that regard tax. Companies that face legitimacy threats will change their behavior in order to reduce the legitimacy gap. When companies change their behavior to retain their claim on legitimacy they have incentives to disclose their conformance (Chauvey et al., 2015). When companies engage in certain CSR activities like tax, competitors might have an incentive to mimic their actions. When imitating competitors, companies reduce their chance of non-conformance with stakeholder groups (Dimaggio & Powell, 1983). Therefore it is expected that there is a difference between companies that do disclose their tax responsibilities and those that do not. Accordingly, the first hypothesis is formulated as follows:

H1: When a company acknowledges taxes as a responsibility it is less likely to engage in aggressive tax practices.

3.2 Country-by-Country Reporting

In 2013 the G8 and G20 came together and discussed some of the problems surrounding tax avoidance. Together the involved countries agreed to start a project to tackle the base erosion and profit shifting (BEPS) problems. The Economic Co-operation and Development (OECD) was assigned by the G20 to come up with a plan to tackle the problem. This has led to an action plan of fifteen actions that could solve some of the BEPS problems. One of the proposed actions is documented in action 13: Guidance on the Implementation of Transfer Pricing Documentation and Country-by-Country Reporting (CbCR). This action plan consist of three components, (1) master file with standardized information, (2) local file regarding material transaction with regard to local taxpayers, (3) a CbC report containing information about the groups income and tax payments and certain indicators of the location of economic activity. This information remains confidential and does not have to be disclosed in a multinational’s report. Some multinationals will have to deposit CbC reports at the tax authorities of the countries where business is conducted from the first of January 2016.

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Although before 2016 deposits of the CbC reports are not mandatory, a company might have reasons to disclose the information anyway. What a company chooses to disclose is mainly affected by market forces (Jaggi & Yee, 2000; Zarzeski, 1996). Yet market forces alone are not always strong enough to meet all the requirements of the capital market (Prencipe, 2004). Regulation can increase and stimulate the information companies are willing to disclose (Einhorn, 2005; Holland, 2005). According to Holland (2005) companies will increase disclosure with norm elements and true elements. Norm elements are disclosures that satisfy external or market benchmarks for public corporate communications. The true elements are to provide additional information that give insight in the full value creation story. The norm elements will be disclosed to increase the quality of the disclosure, while the true elements are aimed to “paint the whole picture” (Holland, 2005).

Yet there is also some criticism on CbCR. Evers, Meier, & Spengel (2014) argue that the benefits of CbCR are largely uncertain since the national and international tax laws contain loopholes and gaps. Also there is no theoretical foundation for the expected benefits, while the costs are clear. Due to increased compliance costs poor countries and small companies may have difficulty complying (Gupta, 2008). The difficulty of complying with all regulations can lead to greater inequality. Besides greater inequality, Lash (2002) warns for too much transparency which can lead to information overload, misinformation and disinformation. For the benefits of increased transparency of CbCR, users of the information should be able to access and understand it (Mol, 2009). Due to information overload, enforcing the laws can also become a problem (Evers et al. 2014).

Although there is some criticism on the new CbCR regulations, companies increasingly voluntarily engage in CbCR. From a strategic approach of legitimacy companies will engage in voluntary disclosure to reduce the legitimacy gap. When reducing this gap companies have to make a cost benefit analysis. When complying with these pressures companies will voluntary disclose information to become more transparent and to reduce information asymmetry (Broberg, TorbjÖrn, & Collin, 2010). When reducing information asymmetry the agency costs can be reduced (Leuz & Verrecchia, 2000). Francis, Khurana, & Pereira (2005) have indicated that the cost of capital will be lower when a company engages in voluntary disclosure. Decreased information asymmetry and increased transparency comes at a cost. Besides the costs of gathering the information needed to enhance transparency there are costs of competitive disadvantages (Cormier, Magnan, & van Velthoven, 2005; Emmanuel & Garrod, 2004). Disclosing private information can be valuable for competitors. When the advantages outweigh the costs an entity will provide information voluntarily (Ness & Mikza, 1991).

The cost benefit analysis for every company will be different. For instance, the growing power of Civil Society Organizations (CSO) in different industries might play a role (Wójcik, 2015). These CSOs question multinationals how they exercise their power and the responsibilities that come along with

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their power (Christians, 2012). Beside the CSO’s other phenomena like: globalization, communication and technology, development of information and the changing role of sovereignty bring change to the information demand (Mol, 2010). For some companies the phenomena described by Mol (2010) play an important role on their reputational capital and therefore their behavior (Clark, Salo, & Hebb, 2008). At the time of this study CbCR disclosure is voluntary, so for companies that engage and provide information about CbCR the possible benefits outweigh the possible costs. Since tax avoidance is seen as unethical, it is expected that companies that are transparent about their tax practices will have less aggressive tax practices.

H2: When a company engages in CbCR less likely to engage in aggressive tax practices.

Even when engaging in CbCR there is still much room for improvements with regard to tax transparency according to the VBDO (2015). Besides the fact that, according to the VBDO, CbCR alone is not enough there is a debate going on in the literature about voluntary disclosure. The debate focusses on credibility (de Waard, 2011). The credibility of disclosures can be increased via two mechanisms. Assurance about the disclosed information can be provided through third-party intermediaries and through financial reporting itself (de Waard, 2011). Healy & Palepu (2001) argue that penalties can also be an efficient mechanism for ensuring credibility, since severe penalties can be imposed when disclosures are proven wrong. Penalties are a preventive mechanism for ensuring credibility since it may withhold organizations to report wrongly.

Doubts about credibility can also arise from an institutional perspective. When a company’s motivation to engage in CbCR stems from mimetic isomorphism questions can rise about their sincerity. Their intrinsic motivation might be low and they might only proceed with CbCR to manage risk. Therefore it is expected that companies who acknowledge taxes as their responsibility will have a higher intrinsic motivation to engage in CbCR and therefore are less likely to have aggressive tax practices.

H3: When a company acknowledges taxes as its responsibility and engages in CbCR, it is less likely to engage in aggressive tax practices.

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4.

Research Method

4.1 Sample design and data collection

This study examines the tax practices of FTSE100 listed companies from 2010 until 2014. Only companies which were listed on the FTSE100 for all 5 years have been taken into account. Organizations that had a tax exempt status, companies gone through a merger or companies with only loss years have been excluded. This has led to a sample of 69 companies. This sample contains 345 firm-year observations. The data used to measure the tax aggressiveness for the 345 firm-year observations consists of financial data and was collected through Orbis. The independent variables that measure the voluntary tax disclosures were manually collected from the annual reports, corporate responsibility reports and tax reports that were publicly available. The data for the control variables consist of financial data and was collected through the use of Orbis.

4.2 Measurement of variables

4.2.1 Dependent variable - Tax Avoidance

For the measurement of tax avoidance ideally the research of Hanlon & Heitzman (2010) will be followed. In this study two measurements of tax avoidance will be used. The GAAP effective tax rate (GAAP ETR) and the Cash effective tax rate (Cash ETR). Because there are limitations with regard to the data only the GAAP ETR can be used.

The GAAP ETR is calculated by the income tax expense divided by the pre-tax accounting income. Tax strategies that defers taxes are not captured by the GAAP ETR. Beside the limitation of not capturing these kind of strategies, the GAAP ETR can be influenced by changes in the tax contingency reserve or through changes is the valuation allowance. This is due to the fact that both the numerator and denominator of this measurement are accounting figures. This can lead to huge fluctuation among annual observations. Therefore the average GAAP ETR is calculated for the years were both independent variables are consistent. This will reduce the fluctuations and the impact of the change of the independent variables can be measured more accurate.

𝐺𝐴𝐴𝑃 𝐸𝑇𝑅 = Income Tax Expense

Pre − tax Accounting Income

𝐴𝑣𝑎𝑟𝑎𝑔𝑒 𝐺𝐴𝐴𝑃 𝐸𝑇𝑅 = ∑ Income Tax Expensen

n t=1

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4.2.2 Independent variables

Tax as a responsibility (TAXRES) - In the first hypothesis the influence of acknowledging tax as a

responsibility is tested on the aggressiveness of tax practices of an organization. Acknowledging responsibilities can be done in a variety of ways. Companies can discuss their responsibilities in their annual reports, CR reports and tax reports. The data is gathered through analyzing the available reports on the corporate website. When a company acknowledge tax as one of their responsibilities they are awarded with a 1, when they do now acknowledge tax as their responsibility they are awarded with a 0.

Country by Country Reporting (CBCR) – The second and third hypothesis involve CbCR. During the

period of 2010 to 2014 CbCR was voluntary. Some companies’ voluntary disclosed the information in their annual reports, CR reports or tax reports. When a company disclosed its financial information for each country apart, it is awarded with a 1 and it does not disclose this type of information it is awarded with a 0. The data for the annual reports from 2010 until 2013 is made available by Lee (2015) and is a piece of the dataset she used in her study. The additional information is been acquired through the other reports that are published by the companies itself.

4.2.3 Control variables

Control variables are included that are used in prior literature to control for our tax aggressive measure. The control variables will ensure that the results are not driven by differences fundamental to our sample. The first set of control variables are to control for profitability. The control variables are leverage (LEV) and return on assets (ROA) and are often used (Chen et al., 2010; Davis et al., 2016; Hoi et al., 2013; Watson, 2015). The next set of control variables will control for the differences in tax and book reporting which can influence the tax measurement. Plant property and equipment (PPE) and intangible assets (INTANG) will control for the difference in reporting (Chen et al., 2010; Davis et al., 2016; Hoi et al., 2013; Watson, 2015). Lastly there will be controlled for firm size (SIZE) because this may lead to difference in investments in tax favorable assets and recognition of expenses (Chen et al., 2010; Davis et al., 2016; Hoi et al., 2013; Rego, 2003).

4.3 Statistical model

To test the hypotheses linear multi regression models will be used. In table 1 an overview of the control, independent and dependent variables used in the models are given.

Model 1: ETRit= β0+ β1…nControls it+ εit

Model 2: ETRit= β0+ β1TAXit+ β2…nControls it+ εit

Model 3: ETRit= β0+ β1CbCRit+ β2…nControls it+ εit

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Table 1

Constructs of the variables

Variables Measurement

Control variables:

Size of the company SIZE Natural logarithm of the sales

Leverage of the company LEV Total debt / Total assets

Profitability ROA Return on assets

Plant property and equipment PPE Natural logarithm of the plant property and equipment

Intangible assets INTANG Natural logarithm of the

intangible assets

Independent variables:

Acknowledging tax as a responsibility TAXRES Dummy variable equal to 1 if company acknowledges tax as a responsibility, 0 otherwise Country-by-Country report CBCR Dummy variable equal to 1 if

company issues a Country-by-Country report, 0 otherwise

Dependent variable:

Effective tax rate GAAPETR Tax expense/Pre-tax income

5.

Findings

5.1 Descriptive statistics

Table 2 presents the descriptive statistics of the variables used in the regressions. The average ETR in the sample is 27 percent. This is above the statutory tax rate of 20 percent of the United Kingdom in which the FTSE 100 are enlisted. The sample has an average of 0,41 on the TAXRES. This means dat 41 percent of the companies acknowledges tax as part of their responsibility. The average CbCr of 0,32 means that thirty-three percent of the annual observation consist with CbC reporting. CbCr was voluntary during the sample period. The fact that thirty-three percent of the reports published by companies contain CbCr can be interpreted that companies see the benefit of disclosing (Ness & Mikza, 1991) a CbC report to communicate their tax position to their stakeholders. The ROA has a mean of 8,9 percent with a standard deviation of 7,96 percent. This shows that the companies in the sample have a great variability in their financial performance.

The annual GAAP ETR’s is winsorized between 1 and 0. This way loss years are set to 0 and outliers are set to 1. This way the data will be more meaning full when interpreted and outliers won’t excessively influence the analysis. Also all continuous variables will be winsorized at the 1st _{and 99}th _{percentile to}

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Table 2 Descriptive Statistics

N Minimum Maximum Mean Std. Deviation

GAAPETR 345 0 0,79 0,27 0,13 SIZE 345 14,4 21,7 17,2 1,79 LEV 345 0,1 1,3 0,68 0,20 ROA 345 -17,9 53,7 8,9 7,96 PPE 345 10,1 20,2 15,5 2,03 INTANG 345 0,0 18,5 13,1 4,93 TAXRES 345 0 1 0,41 0,49 CBCR 345 0 1 0,32 0,47

GAAPETR= effective tax rate, measured as tax expense/pre-tax income; Size=company size, measured as logarithm of sales; LEV=company leverage, measured as total debt/total assets; ROA=profitability, measured as return on assets; PPE=plant property and equipment, measured as logarithm of plant property and equipment; INTANG=intangible assets, measured as logarithm of intangible assets; TAXRES=tax as a responsibility, measured by ordinal variable from 0 (=no tax as a responsibility) to 1 (=tax as a responsibility); CBCR=country-by-country reporting, measured by ordinal variable from 0 (=no country-by-country report) to 1 (=country-by-country report)

5.2 Correlation analysis

To verify if there is an association between the variables a correlation analysis was performed. This analysis allows the identification of multicollinearity. Multicollinearity can lead to an underestimation of the coefficients. Table 3 shows the Pearson correlations of the variables used in the regression. The correlation analysis does not support our expectations regarding that acknowledging tax as a responsibility reduces their tax aggressiveness. Neither does it support our expectation that CbCr reduces a company’s tax aggressiveness.

The correlation analysis does not show a threat of multicollinearity since al Pearson coefficients are below 0,8. Beside the Pearson coefficients that may indicate multicollinearity during the hypothesis testing the VIF values will be analyzed. The VIF values are shown in table 4 and are consistent with the Pearson coefficient and do not indicate that multicollinearity forms a problem.

23 | P a g e Table 3 Correlations (1) (2) (3) (4) (5) (6) (7) (8) GAAPETR 1 SIZE 0,273 *** 1 LEV -0,048 0,452 *** 1 ROA -0,034 -0,511 *** -0,391 *** 1 PPE 0,214 *** 0,700 *** 0,245 *** -0,355 *** 1 INTANG -0,089 * -0.170 *** -0,046 -0,033 0,011 1 TAXRES 0,117 ** 0,359 *** -0,101 * -0,182 *** 0,253 *** -0,128 ** 1 CBCR 0,114 ** 0,363 *** -0,006 -0,131 ** 0,225 *** 0,035 0,486 *** 1

*** Correlation is significant at the 0.01 level (2-tailed). ** Correlation is significant at the 0.01 level (2-tailed). * Correlation is significant at the 0.01 level (2-tailed).

GAAPETR= effective tax rate, measured as tax expense/pre-tax income; Size=company size, measured as logarithm of sales; LEV=company leverage, measured as total debt/total assets; ROA=profitability, measured as return on assets; PPE=plant property and equipment, measured as logarithm of plant property and equipment; INTANG=intangible assets, measured as logarithm of intangible assets; TAXRES=tax as a responsibility, measured by ordinal variable from 0 (=no tax as a responsibility) to 1 (=tax as a responsibility); CBCR=country-by-country reporting, measured by ordinal variable from 0 (=no country-by-country report) to 1 (=country-by-country report)

5.3 Multivariate analysis

To test the hypothesis a multiple regression analysis is used. In table 4 the results of the multiple regressions are shown. The models of table 4 correspond with the statistical models given in the research method section. The results will be discussed per hypothesis.

H1: When a company acknowledge tax as a responsibility they are less likely to engage in aggressive tax practices. The regression analysis is negative but not significant. Just as the hypothesis stated a

negative relation was expected. The values from the analysis are stated in model 2 of table 3 (ß= -0,019 α<0,01). Therefore it cannot be concluded that acknowledging tax as a responsibility does reduce the likelihood for a company to engage in less aggressive tax practices.

H2: When a company engages in CbCr they are less likely to engage in aggressive tax practices. The

regression analysis of hypothesis 2 is negative but not significant. The negative relation shown in the results was expected. The results of the analysis are stated in model 3 of table 3 (ß= -0,095 α<0,01). It cannot be concluded that engaging in CbCr reduces the tax aggressiveness of a company.

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H3: When a company acknowledges taxes as their responsibility and engages in CbCR, they are less likely to engage in aggressive tax practices. It was expected that CbCR positive influences the

relationship between acknowledging tax as a responsibility and the tax aggressiveness of a company. The values of the basis relationship are shown in model 2 of table 3 (ß= -0,019 α<0,01). The values of the combined effect are stated in model 4 of table 3 (ß= -0,057 α<0,01). This combined effect is more negative than the basis relationship, just as expected. The analysis of hypothesis 3 is negative but not significant. Therefore it cannot be concluded that CbCr negatively influences the relationship between acknowledging tax as a responsibility and the tax aggressiveness of a company.

Table 4 Regression Results Variable (1) (2) (3) (4) Intercept -0,156 ** 0,168 * -0,166 * -0,169 * SIZE 0,028 *** 0,030 *** 0,029 *** 0,030 *** LEV -0,122 *** -0,132 *** -0,126 *** -0,132 *** ROA 0,002 0,002 0,002 0,002 PPE 0,002 0,002 0,002 0,002 INTANG -0,001 -0,001 -0,001 -0,001 TAXRES -0,012 -0,15 CBCR -0,006 -0,009 TAXRES*CBCR -0,012 Adjusted R-square 0,107 0,106 0,105 0,101 F Value 9,222 7,772 7,692 5,815 VIF 2,750 3,054 3,173 4,551

*** Correlation is significant at the 0.01 level (2-tailed). ** Correlation is significant at the 0.01 level (2-tailed). * Correlation is significant at the 0.01 level (2-tailed).

GAAPETR= effective tax rate, measured as tax expense/pre-tax income; Size=company size, measured as logarithm of sales; LEV=company leverage, measured as total debt/total assets; ROA=profitability, measured as return on assets; PPE=plant property and equipment, measured as logarithm of plant property and equipment; INTANG=intangible assets, measured as logarithm of intangible assets; TAXRES=tax as a responsibility, measured by ordinal variable from 0 (=no tax as a responsibility) to 1 (=tax as a responsibility); CBCR=country-by-country reporting, measured by ordinal variable from 0 (=no country-by-country report) to 1 (=country-by-country report); TAXRES*CBCR=combined effect of tax as a responsibility and country-by-country reporting, measured as tax as a responsibility times country-by-country reporting

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6.

Discussion and Conclusions

Following the academic debate between corporate responsibilities and tax practices (Davis et al., 2016; Hoi et al., 2013; Watson, 2015) this study has set out to give more insight in how voluntary tax disclosures influence companies’ tax behavior. Three hypothesis were tested to understand the relationship between voluntary tax disclosures and the tax aggressiveness of a company. None of the hypotheses could be accepted based on the analysis. The results demand further discussions and new questions arise. In this section the results, the difference between the results and what was expected and some recommendations for further research will be discussed.

The first hypothesis focused on verifying the relationship between acknowledging tax as a social responsibility and the aggressiveness of tax practices. The analysis provides some clues for the direction of the relationship, which indicates that acknowledging tax as a responsibility leads to a higher ETR, but there is no significant relation. The institutional perspective of the legitimacy theory might explain why this result is not statistically significant. Companies might just only acknowledge tax as a responsibility to mimic other organizations. Therefore, the intrinsic motivation to abide by the spirit of the law could be low. The main reason why companies are acknowledging tax as a responsibility from a mimic point of view is to reduce the chance of non-conformance. Another explanation of the results can be that companies use their disclosures as a risk management tool. Reporting about their responsibilities can increase their reputational capital (Panwar, Paul, et al., 2014). Because companies may have different incentives to report about their tax responsibilities their intrinsic motivation could be different.

The influence of CbCR on companies’ tax aggressiveness was tested in the second hypothesis. The statistical analysis could not confirm the expected relation. This leads to the conclusion that not all companies that disclose CbC information are less tax aggressive than companies that do not. CbCR is a fairly new way of disclosing tax information. Therefore it is still unclear how CbCR affects the behavior of companies. This study provides evidence that CbCR does not necessarily indicate that a company does not engage in tax avoidance. The objective of OECD plan 13 of BEPS is to counter tax avoidance through CbCR. While action plan 13 does not demand companies to disclose their CbC information publicly, they do have to deposit it at their local tax authorities. This is different from how CbCR is measured in this study. Since this study measures CbCR in a different way compared to action plan 13, nothing can be said about the effect of the new legislation. However the results could be indicative for the effect of the new legislation. To fully understand the impact of CbCR as described in action plan 13 further research is needed.

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In the last hypothesis the combined effect of acknowledging tax as a responsibility and CbCR was tested. It was expected that when disclosing tax as a responsibility as well as a Country-by-Country report a company would engage in less aggressive tax practices. Since CbCR is seen as the highest level of standard with regard to tax reporting. Acknowledging tax as a responsibility as well as CbCR signals that a company would use less aggressive tax strategies. The signals are not significant with regard to aggressiveness compared to companies that do not. This leads to the conclusion that the credibility debate about voluntary disclosure is relevant. The results of this study show that one has to be careful with the interpretation of voluntary tax disclosures.

In conclusion, none of the expected relations tested significant. This raises new questions on how disclosures do effect or should effect the tax practices of a company. Since the disclosures about tax researched in this study are voluntary the credibility debate arises. For voluntary disclosures to be useful they need to acquire credibility. Yet this study shows that the credibility of this type of disclosure is low. How this credibility can be enhanced is an important topic for companies with honest intentions and legislators alike. Also investors have a high interest in the credibility of disclosures, since it is one of their most important sources of information from which they acquire their knowledge about a company.

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6.1 Limitations

There are a few limitations in this research that might influence the results. First, the data used in this study comes from the FTSE100 of UK companies, which limits the generalizability of the results found in this study. In future research it is wise to include more companies of different counties. Second, one of the biggest limitations is the construct used for measuring the tax aggressiveness of the companies. In this research annual GAAP ETR’s are used, while Hanlon and Heinz (2010) point out the disadvantages of only using the GAAP ETR as a measurement value. They argue that using various measurements of tax aggressiveness is most effective, this way the results become more robust when the same result is found across the different measurements. The main reasons why this study only uses the GAAP ETR is because there where limitations in acquiring the necessary data. There was no access to the databases that contain such required data. In future research the use of different measurements would be useful in order to acquire robust findings.

With regard to the data acquiring for the independent variables improvements could be made. This data was collected manually from the reports available, because of this, the data could be affected by researcher bias. There is some form of subjectivity in the interpretation of the information disclosed by companies. In future research it can be useful to acquire the data with more researchers that can review each other’s data, which could decrease the bias in manually collected data..

Further research may show which types of voluntary tax disclosures do provide insights in a company’s tax practices. Future research could also make a distinction between multinationals that are required to follow action plan 13 of the BEPS project and those that are not. This way the effect of the action plan could be determined. Further research could also make a voluntary disclosure index about tax with multiple components that look into the extent of voluntary tax disclosures. This research only looks at two components of tax disclosures with dummy variables which have the disadvantage of being at the extremes of the continuum.

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