Dual Holding: The Hidden Strategy Driving Tax Avoidance
In some companies, investors wear two hats – as both creditors and shareholders. Research by Professor Liang Xu, a professor of Finance at SKEMA Business School, shows that this setup tends to favor tax avoidance.
This phenomenon has been studied in the United States, but its implications can be applied to Europe and France. It’s a trend that comes in handy for companies, helping them reduce their tax bills. This setup is known as a “dual holding.”
In short, it’s a structure in which investors—particularly institutional ones—act as both creditors and shareholders of a company. Our study, based on a sample of U.S. companies including Microsoft, Procter & Gamble, and Walt Disney, listed between 1987 and 2017, shows that firms in this situation are more likely to pursue tax avoidance strategies, effectively adopting an aggressive approach to lowering their taxes.
On average, these companies report an effective tax rate 1.1% lower than their peers, translating into annual savings of roughly $3.63 million per company.
Conflict of interest between shareholders and creditors
Why does tax avoidance differ when creditors are also shareholders?
Corporate tax avoidance carries both benefits and risks. Shareholders, as residual claimants, favor tax avoidance because they can enjoy the upward benefits while shifting the risks to creditors. Creditors, by contrast, are fixed claimants who bear the downside consequences of the higher risks associated with tax avoidance, such as regulatory and litigation risks, but cannot fully share in the rewards. For that reason, creditors often demand higher borrowing costs from firms that engage in more tax avoidance.
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With dual holders present, the shareholder-creditor conflict is mitigated. In this case, dual holders reduce creditors’ concerns about risk shifting, because the risk is merely transferred within the same investor’s portfolio from left pocket to right pocket. At the same time, dual holders enjoy the benefits of tax avoidance like other shareholders, which gives them strong incentives to support such strategies. As a result, the conflict between shareholders and creditors becomes less pronounced, and creditors have fewer incentives to constrain firms from engaging in tax avoidance. Consistent with this mechanism, evidence shows that firms with dual holders have lower effective tax rates and achieve substantial tax savings.
Aggressive Tax Strategies
How do dual holders drive firms toward greater tax avoidance?
Like many other corporate policies, tax avoidance is ultimately decided by managers on behalf of shareholders. Managers may sometimes choose not to engage in tax avoidance to reduce their risk exposure or workload, but their decisions largely depend on incentives. When CEOs are rewarded based on after-tax performance, they are more likely to adopt aggressive tax strategies. Evidence shows that firms with dual holders are more likely to include after-tax accounting-based rewards in CEO compensation, encouraging executives to treat tax savings as performance goals and thereby fostering greater tax avoidance.
In addition to influencing incentives, dual holders also bring tax expertise, as many of them are banks with the capability to support their corporate clients’ tax planning. While pure creditors might be reluctant to help firms avoid taxes due to risk-shifting concerns, dual holders, as both creditors and shareholders, have clear reasons to do so. By channeling tax expertise into the firms they invest in, dual holders enable firms to discover overlooked ways to reduce taxes and implement more sophisticated tax-saving strategies.
Impacts on Policy and Society
What happens to creditors’ views of tax avoidance under dual holding?
Credit markets usually view tax avoidance as risky, prompting creditors to demand higher borrowing costs to compensate. When dual holders are present, however, this perception shifts. Creditors may then perceive certain tax-saving activities as less risky, as reflected in the lower cost of debt for firms with dual holders. These results suggest that dual holding at least partially eases creditors’ concerns about tax avoidance risks, making the tax-saving benefits more appealing.
The rise of dual holders has broad implications. For firms, it lowers the cost of tax avoidance by easing creditors’ concerns, which makes aggressive tax planning appealing and feasible. For investors, it reduces perceived risks associated with such strategies and strengthens their influence over managerial decisions, allowing them to shape corporate policies toward greater tax savings. For governments and society at large, however, it translates into lower tax revenues, limiting the capacity to fund essential public goods.
While this study focuses on U.S. firms, the issue extends far beyond the United States. In Europe, nearly all universal banking groups combine lending with asset management, and in emerging markets such as China and Thailand, commercial banks are even permitted to hold equity stakes in firms. These examples show that dual holding structures are widespread across global financial systems, giving the findings worldwide significance.
