Are financial derivatives tax havens? Evidence from China

Abstract

PurposeThe purpose of this study was to examine whether the use of financial derivatives by business enterprises can avoid taxes and whether tax authorities can detect and effectively enforce measures regarding this emerging tax avoidance method.Design/methodology/approachUsing panel data from the Shanghai and Shenzhen Stock Exchange listed companies from 2008 to 2019, this study used the Heckman self-selection two-stage model and a cross-sectional analysis to test a total of 22,578 samples. Moreover, propensity score matching (PSM), instrumental variable and Heckman MLE methods were conducted in the robustness test.FindingsThe results showed that enterprises could use financial derivatives to avoid taxation. The greater the tax effort is, the more obvious the effect of the company's use of financial derivatives for tax avoidance, which proves challenging for tax authorities to identify and manage.Originality/valueThis study expands on research on corporate tax avoidance and provides a new perspective for the study of financial derivatives. Moreover, it improves relevant research in the field of tax regulation, offering practical guidance for tax authorities to govern the use of financial instruments to prevent potential risks effectively.

Are financial derivatives related to intra‐entities' tax aggressiveness? UK evidence

“…Particularly, the coefficients for FVDA/TA t−1 and FVDL/TA t−1 in our regression are 10.44 and 2.771, respectively, both of which are significantly positive at the 1% level. These outcomes corroborate the ongoing literature arguing that firms use derivatives to lower their cash taxes paid through the unrealized gains from the derivatives themselves rather than classically managing total tax expenses in the income statement (see Chen, 2021;Donohoe, 2015a).…”

“…Offshore financing is more important for MNEs compared to the cost of internal financing, a finding leading to the prediction that hedging solutions are effective in resolving these issues for their allowance to increase the value of holden founds and result in decreasing the possibility for MNEs in affiliating to capital markets around the world. Some firms utilize financial derivatives as a sort of strategic tax arbitrage investment to gain an advantageous tax position or even to take part in tax avoidance practices (Chen, 2021). Some firms can control and monitor their taxable income, despite differing taxation, with the use of FDIs (Donohoe, 2015a(Donohoe, , 2015bWang, 2016;Zeng, 2014).…”

“…Such a scheme will put the firm into a short-term price change risk situation and give it the latitude to differ its tax liabilities (Chen, 2021). In off-shore or cross-border transactions, related firms or derivative contractors could extract gains regarding the differentiation of the derivatives earnings from period to period and depending on the type of transaction.…”

“…Over the last two decades, many fields of research have highlighted the dramatic growth and acceleration in derivatives management (Aretz & Bartram, 2010; Graham & Rogers, 2002; Scholes et al, 2015; Taylor et al, 2015; Zeng, 2014) related to several reasons, including hedging risks, reducing costs related to financial constrained situations and decreasing the volatility of pretax income and thus reducing tax expenses. However, only a limited part of accounting and finance literature has investigated the association between derivatives instruments and tax avoidance practices based on a sample of individual firms (Afza & Alam, 2011; Ben Khediri, 2010; Donohoe et al, 2012; Donohoe, 2015a, 2015b; Chen, 2021; Geyer‐Klingeberg et al, 2019). These studies provide evidence that companies use financial derivative instruments (FDIs) as a device to avoid tax expenses and by replicating some complex economic positions allowing them to create an appealing way to aggressively avoid taxes.…”

“…In this, T. Tang et al (2017) note that tax authorities have the power to monitor corporate tax avoidance practices in line with the principle that ‘the essence is more important than the form’. Additionally, tax supervision of tax authorities means that firms have endured tax audits of their tax avoidance practices (Cheong et al, 2020; Ye & Liu, 2011), simply put classic tax avoidance practices have risen to the notice of tax authorities (Chen, 2021). However, the use of derivatives in tax aggressiveness schemes seems to be an effective, safer, obscured and effectively substitutional solution for tax evaders due to their complexity, their lack of identification and the difficulty of tax authorities in identifying them.…”