Private Equity and Taxes

We study companies’ tax avoidance behavior after being acquired in a private equity transaction. We find that target companies’ effective tax rate decreases by 16.14% relative to the unconditional mean. This finding is in line with the hypothesis that private equity investors create shareholder value by extracting money from the government. While our evidence further suggests that firms engage more heavily in profit shifting, we do not find direct evidence in support of a tax-motivated leverage channel. We further show that those target firms that become more tax efficient experience significantly lower asset and employment growth than target firms with no or moderate tax savings after the buyout. This finding indicates that tax savings are not used to finance investment but are directly transferred to shareholders.

With more than USD 3 trillion assets under management as of 2017 and growing, private equity will soon be the largest alternative asset class. This growing importance leads regulators to ask how private equity firms create shareholder value. The bright side view argues that targeted companies increase in value through operating efficiencies and better aligned incentive contracts. The dark side view points towards value extraction from other stakeholders, such as employees or the government. While there are studies on the effect of private equity transactions on employees, there is little evidence on value extraction from the government. Our analysis supports the claim that private equity firms transfer money from the government to shareholders by significantly reducing the target firms’ effective tax rate (ETR).

Through tax claims, national and local governments are a significant stakeholder in private firms. Reducing the overall tax bill provides one important way of transferring money from the government to shareholders. We identify three major channels by help of which private equity target firms can engage in tax avoidance. First, general tax efficiency. This category subsumes, for example, generating additional tax deductions, making use of tax consolidation at the business group level, and general tax aggressiveness. A second potential channel is profit shifting. Firms can engage in internal trade with other subsidiaries and thereby shift profits into low-tax countries. Third, target firms can benefit more from the interest tax shield that allows firms to deduct their interest payments from the taxable income. Private equity firms are notorious for the extensive use of debt financing, which increases the value of these tax shields. Exploiting rich data on financial accounts of public and private firms in Europe and evaluating transaction data on 11,305 private equity deals between 2001 and 2016, we document a substantial increase in target firms’ general tax efficiency after being acquired by a private equity firm. We further find supportive evidence for profit shifting, while financial leverage seems to play a secondary role for target firms’ tax avoidance. In a last step, we look at the cross-section of private equity deals to investigate how target firms use their tax savings. We find that investments in assets and human capital are significantly lower for high tax avoidance deals.

To address concerns that private equity ownership is endogeneous, we perform a matched sample difference-in-differences estimation with the acquisition as treatment. In addition to an exact matching on five different discrete variables, including firms’ country, year, and industry, we perform a nearest-neighbor matching on six continuous variables. These variables are carefully selected in accordance with the private equity and tax literature. They comprise the effective tax rate, ROA, cash ratio, growth, size, and financial leverage. The large pool of more than 50 million potential control observations assures a good matching quality. In the first part, we analyze how the target’s effective tax rate and overall tax payments develop after an acquisition. We then use triple-differences estimation to investigate additional channels. Last, we conduct a sample split to look at firms’ investment outcome depending on their level of tax avoidance.

First, we investigate companies’ tax avoidance by analyzing the effective tax rate and total tax payments after the acquisition. We find an immediate drop in the effective tax rate of 1.62 percentage points directly following the acquisition. Three years after the deal, these firms report effective tax rates that are 3.01 percentage points lower than those of control firms, which represents a 16.14% decrease relative to the unconditional sample mean. We then investigate whether target firms engage in profit shifting. Firms that belong to a multinational group can use transfer pricing to shift pre-tax income to low-tax countries. We hypothesize that target firms which have subsidiaries in tax haven or incentives stemming from tax rate differentials in the same business group are more susceptible to engage in such a behavior. Our findings show that target firms’ pre-tax income growth is significantly lower if such profit shifting opportunities exist prior to the deal. In our third set of tests, we analyze target firms’ financial leverage after the acquisition. We find moderate increases in target firms’ net leverage ratio. In the year of the acquisition, leverage decreases slightly and then increases until it is about 5 percentage points higher than the leverage of control firms. This finding contrasts the common notion of excessive debt financing during private equity buyouts. It is possible, however, that the increase in leverage is concentrated in intermediate holding companies and thereby does not show up in the garget firms’ financial accounts. Then, we test whether this leverage increase is related to tax considerations. We do not find heterogeneous treatment effects contingent on the target country’s tax law, such as allowing for pre-tax income consolidation with other group firms or restricting the tax deductibility of interest payments. Our third findings, therefore, do not support the notion that private equity leverage is driven by tax considerations.

Our last set of results presents target firms’ investment outcome with respect to their tax savings. We find that target firms with above median tax savings invest 2.64 and 2.32 percentage points per year less in assets and human capital than target firms with below median tax savings. When splitting the data with respect to quartiles in the tax savings distribution, the effects are exacerbated to an annual 4.03 and 4.06 percentage points decline in assets and employment growth, respectively. These findings show that private equity transactions after which target firms engage in substantial tax avoidance also have adverse effects on stakeholders other than the government through lower investments and less employment.

Our study contributes to both the finance and tax literature. Our study is the first to fully explore the tax effects of private equity transactions. Results suggests that tax efficiency is an outcome of private equity investments and that the most tax efficient private equity transactions seem to be those that are less growth- but more cost-cutting oriented.

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