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1. Introduction
Taxes constitute one of the largest items of expense for most firms, reducing net income and after-tax cash flow, thereby giving firms a strong incentive to reduce their tax burden by a practice known as tax avoidance. This should not imply that tax avoidance is necessarily something improper (Dyreng et al., 2008) or illegitimate, rather, it refers to all attempts by a firm to reduce its taxes. At first glance, tax avoidance would seem to be beneficial to the firm and its shareholders, because it saves resources that are needed for investment or shareholder distributions. Conversely, tax avoidance may induce further costs to the firm. Specifically, tax avoidance could be a source of tax risk (Neuman et al., 2014). Tax risk can arise from the firm’s tax planning strategies independently from overall operating risk (Guenther et al., 2017). If positions taken in corporate tax returns are challenged or overturned by the fiscal authorities, a firm may have to face additional tax payments, interest and fines. Thus, tax avoidance can be seen as “one of many risky investment opportunities available to management” (Armstrong et al., 2015, p. 2). Empirical and anecdotal evidence suggests that many firms are very successful at avoiding taxes without incurring substantial disadvantages (Dyreng et al., 2008), making it less clear whether tax avoidance is inherently risky.
Shareholders might benefit from tax avoidance through either higher dividends or higher share prices. The perspective of shareholders on tax avoidance has been the subject of extensive research over the past ten years (Wilde and Wilson, 2018). Among others, Desai and Dharmapala (2009) find evidence that tax avoidance can have a positive effect on firm value. Although evidence is not entirely unambiguous, many studies find that tax avoidance is beneficial to shareholders, as long as firms have strong corporate governance institutions in place. However, equity is not the only source of financing. Debt is the second major source of funds on which many firms rely. Debtholders differ from shareholders in several ways. Instead of having residual claims, debtholders have fixed claims and, therefore, bear only the downside risk of tax avoidance (Shevlin et al., 2013). If a firm successfully avoids paying taxes, the benefits accrue to the shareholders...