57 2.5.3.5 Interaction Effects: Tax Variables 58 10

[Implicit taxes reflect the extent (if any) to which tax-favored assets bear lower pretax returns than do tax-disfavored assets of similar risk. Prior research on implicit taxes has met with mixed results, particularly in equity securities, because of the difficulty in separating tax effects from effects caused by cross-sectional differences in risk. We avoid problems of risk by essentially comparing each security to itself before and after an unexpected change in the manner in which dividends are taxed to corporate investors. We find strong evidence of implicit taxes in preferred stocks. Extensive testing using the same event date indicates that no similar implicit tax effect exists in common stocks.]

We analyze the effect of tax-based transaction structure on the acquisition price of corporate subsidiaries. For a sample of 200 subsidiary stock acquisitions, the evidence weakly supports the conclusion that acquisition premiums are higher in transactions accompanied by an I.R.C. §338(h)(10) election. We find that the tax benefits generated by the §338(h)(10) election are positively correlated with acquisition premiums. Overall, this study indicates that the tax structure of a subsidiary sale influences the price paid in the transaction, and the tax structure selected is a function of a divesting parent's tax basis in the subsidiary's stock and net assets.

We investigate whether acquiring firms attempt to increase their stock price prior to a stock for stock merger in order to reduce the cost of buying the target. In a sample of stock for stock mergers completed between 1985 and 1990, we find that acquiring firms manage earnings upward in the periods prior to the merger agreement. Our results also indicate that the degree of income increasing earnings management is positively related to the relative size of the merger.

Scholes et al. (2005) predict that S corporations, and other conduit entities such as partnerships and LLCs, can sell for a tax-driven purchase price premium relative to C corporations. We test this conjecture by comparing purchase price multiples in a sample of taxable stock acquisitions of S corporations to purchase price multiples for a matched set of taxable stock acquisitions of privately held C corporations. Consistent with Scholes et al.'s (2005) predictions, we find evidence that the organizational form of the target influences acquisition tax structure and acquisition price. Specifically, the evidence supports the conclusion that conduit entities (S corporations) fetch a taxbased purchase price premium relative to similar C corporations. Furthermore, our estimates indicate that average tax benefits in S corporation acquisitions are equal to approximately 12–17 percent of deal value.

We investigate the backdating of stock option exercises. Before SOX, we find evidence that some exercises were backdated to days with low stock prices. Consistent with a tax-based incentive, these suspect exercises are more likely when the personal tax savings from backdating are higher. However, suspect CEO exercises generate average (median) estimated tax savings of 96,000 (7,000). These savings appear modest relative to the costs insiders and firms face. We find that the likelihood of a suspect exercise increases in the likelihood of option grant backdating. This suggests that agency problems associated with backdating permeate option compensation in some firms.

Abstract The purpose of this study is to investigate whether and how shareholder‐level taxes affect earnings response coefficients (ERCs). Our tests indicate that when the tax rate on dividends increases, ERCs decrease for firms with high levels of dividend yield and whose marginal investor is likely to be an individual. For firms with high levels of share repurchase yield and whose marginal investor is likely to be an individual, an increase in dividend tax rate has no discernible effect on ERCs. These results are consistent with the notion that the tax penalty on dividends, relative to capital gains, reduces the earnings‐return relation.

Hybrid securities, Trust preferred stock, Financial reporting, Tax incentives