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E-MailMichelle Hanlon is the Howard W. Johnson Professor and a Professor of Accounting at MIT Sloan School of Management; Rodrigo Verdi is the Nanyang Technological University Professor of Accounting at MIT Sloan School of Management; and Benjamin Yost is an assistant professor of accounting at Boston College Carroll School of Management. This post is based on their recent paper.
Whether firms care about shareholder-level taxes is a longstanding question in the academic literature. In the context of acquisitions, target shareholders potentially face capital gains tax liabilities upon the sale of their shares, leading early researchers to predict that investor-level taxes should influence the acquisition price as well as the deal structure (i.e., cash versus stock payment). Despite the clear theoretical predictions, it was not until fairly recently that studies found supporting empirical evidence. In particular, the findings in two papers by Ayers, Lefanowicz, and Robinson (2003, 2004) indicate that higher capital gains tax rates on individual shareholders are associated with higher acquisition premiums as well as a higher likelihood of tax-deferred deals. Although these findings represent important advancements in our understanding, it is plausible that the results would obtain even if managers do not really consider outsider shareholders’ taxes but rather consider primarily their own taxes. Motivated by recent literature examining the effects of individual executives on firm performance and activity, we expect insiders to care about shareholder-level taxes primarily when they bear those taxes themselves. In addition, we posit that tax-bearing insider shareholders are in a better position to take individual tax liabilities into account when negotiating a deal. Thus we extend upon and contribute to the earlier research by considering the impact of insiders’ tax liabilities on acquisition outcomes.
We begin our paper by replicating the main results in Ayers et al. (2004) during the time period 1996 to 2016, which includes three major federal capital gains tax rate changes. As in Ayers et al., we find that periods of high capital gain tax rates are associated with a higher likelihood of tax-deferred deals, and that this relation is mitigated when tax-exempt institutions hold a large fraction of the firm. Next we construct a measure of insider ownership by combining the CEO’s direct and indirect holdings in the firm as reported on SEC Forms 3, 4, 5, and 144, which insiders are required to file when they trade in their companies’ stock. Upon modifying the regression specification to capture target insiders’ tax liabilities, we find that the link between individual capital gains tax rates and acquisition structure becomes stronger as target insider ownership increases. In fact, the new evidence suggests that that the structure of acquisitions is influenced by the personal tax incentives of the target company’s insiders, and that the effect of target shareholders only exist when insiders own a relatively large proportion of the firm.
Next we examine the effects of state capital gains tax rates on acquisition structure. One advantage of the state tax setting over the federal setting is that there is substantially more variation in state tax rates during the sample period than in federal tax rate (both in the cross-section as well as over time). A second benefit of the state setting is that it helps address the concern that our tax rate variable reflects the incentives of outside shareholders, because a given state’s capital gains tax rates apply only to shareholders who reside in that state. Thus, while a state’s taxes are likely to apply to employees of the firm, including insiders, who tend to reside near the firm’s headquarters, they will not apply to investors who live in other states. We find that the positive relation between state-level tax rates and the likelihood of a deal being structured as a tax-deferred transaction becomes stronger as insider ownership increases, reinforcing our conclusion that acquisition structure is a function of the personal tax incentives of the target company’s insiders.
We perform a similar set of analyses with respect to acquisition premiums. We begin by replicating the main results in Ayers et al. (2003), finding a positive relation between federal capital gains tax rates and acquisition premiums among taxable deals. After modifying the regression specification to capture target insiders’ tax liabilities, we find that the link between individual capital gains tax rates and premiums becomes stronger as target insider ownership increases. We also perform an analysis using state tax rates and find that the relation between state taxes and acquisition premiums increases as inside ownership increases. Similar to our findings with regard to acquisition structure, the new evidence suggests that acquisition premiums are influenced by the personal tax incentives of the target company’s insiders, and that the effect of target shareholders only exist when insiders are a significant owner in the firm.
In additional analysis, we consider the tradeoff between adjusting acquisition structure and premium for public and private acquirers. Our rationale for this analysis follows from the observation that public acquirers can respond to target insider tax liabilities in two ways: adjust the structure to a tax-deferred deal by offering stock as payment, or offer cash in a taxable deal but pay a higher premium. In contrast, private firm acquirers rarely engage in stock deals, meaning that they can only accommodate tax liabilities via acquisition premiums. Consistent with this reasoning, we find that public acquirers are more likely to adjust the acquisition structure (i.e., offering stock in a tax-deferred deal), but not the premium as a function insiders’ tax liabilities. Private acquirers, however, do the reverse—they do not adjust acquisition structure (presumably because this is not an option) but instead compensate insiders for their tax liabilities by increasing the acquisition premium.
Finally, because our findings suggest that targets (and indirectly the acquirers) take tax liabilities into consideration when structuring the deal, we investigate the question of whether this would affect the likelihood of the deal taking place at all. Our results indicate that insiders’ tax liabilities reduce the unconditional likelihood of an acquisition occurring. Further, we find that the effect of tax considerations on the likelihood of a deal taking place only exists for private acquirers, but not for public acquirers. This result suggests that while public acquirers can take into account target insider tax liabilities by changing the form of payment for the deal, private acquirers incur an explicit cost of the tax liabilities via a higher premium and are more likely to abandon the deal if these costs get too high.
Overall, our findings suggest that although shareholder-level taxes seem to influence acquisition outcomes, they primarily do so when firm insiders are the shareholders bearing the tax.
The complete paper is available for download here.
