The Relationship Between Tax Avoidance and Corporate Bankruptcy Risk

This report investigates the relationship between corporate tax avoidance and the risk of bankruptcy, drawing on a literature review of ten relevant journal articles. The report begins with an executive summary outlining the scope, objectives, and methodologies employed. It then provides a background on the topic, highlighting the significance of tax avoidance in corporate finance and its potential impact on bankruptcy risk. The main objective is to identify and analyze the relationship between tax avoidance activities and corporate bankruptcy risk, supported by critical reviews of the selected articles. The report summarizes key findings from the literature, discussing the benefits and costs of tax avoidance and its effects on financial constraints and cash savings. The discussion section compares and contrasts the views of different authors, supported by logical arguments and empirical evidence. It explores how tax avoidance affects bank loan costs, corporate tax aggression, debt, and bankruptcy risk. Methodological aspects are critically evaluated, with specific attention to the frameworks, sample selections, and regression controls used in the studies. The report also identifies gaps in the existing literature and concludes by summarizing the analysis results. Overall, the report provides a comprehensive overview of the relationship between tax avoidance and corporate bankruptcy risk, offering valuable insights for students of finance.

Running head: HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
How tax avoidance affects corporate bankruptcy risk
Name of the Student
Name of the University
Author Note

1HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
Executive summary:
The report is prepared for identifying and evaluating the relationship between corporate tax
avoidance and corporate bankruptcy risk by reviewing literature sourced from ten relevant
articles. Report demonstrates the critical view presented by different authors in terms of
comparing and contrasting their views. Methodologies used in research papers have been
critically evaluated and later part of report highlights the research gap identified while
viewing literature review. In the conclusion part, several results of analysis have been
depicted and the gaps in literature review have been addressed.

2HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
Table of Contents
Introduction:...............................................................................................................................3
Background of topic:..................................................................................................................3
Main objective of report:............................................................................................................3
Findings summary from literature review:.................................................................................3
Discussion:.................................................................................................................................4
Focused discussion on topic with logical arguments and Comparing and contrasting views of
different authors:........................................................................................................................4
Criticizing aspects of methodologies used:................................................................................6
Identification of gaps in literature review:.................................................................................8
Conclusion:................................................................................................................................8
References list:...........................................................................................................................9

3HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
Introduction:
Background of topic:
The chosen topic for assessment of literature review is “how tax avoidance activities
affect corporate bankruptcy risks”. Analysis of relationship is done by reviewing ten journal
articles selected from relevant sources that would depict different views of different authors.
There have been number of studies that deal with the avoidance of tax activities and tax
planning with the corporate bankruptcy risks. The literature on corporate tax avoidance in this
regard does not come with any study that explicitly examines the relationship between cost of
debt and tax avoidance and ultimately to bankruptcy risk that further leads to the application
of agency perspective to the relationship. Since more than third of profit of firms are taken
away by government through taxes, it is quite understandable about the incentive to avoid
paying taxes. The bankruptcy risk of firms can be increased if the capital structure involves
more proportion of debts compared to equity and make investment in assets generating riskier
cash flow (Al‐Hadi et al. 2017). Therefore, it is required to empirically as well as
theoretically examine the level of sheltering the firms to default probability and debt level in
its capital structure for assessing the impacts of these two bankruptcy risks aspects.
Main objective of report:
The main objective of report is to ascertain and identify the relationship between tax
avoidance activities of firms to their corporate bankruptcy risks. Identification of relationship
is done critically reviewing ten journal articles from different relevant sources for supporting
the arguments presented by different authors. Furthermore, the objective of report is compare
and contrast views of different authors on the concerned topic.
Findings summary from literature review:
The findings generated from research paper on the given topic helps in adding to
literature by highlighting importance of different parameters in establishing relationship
between tax planning or avoidance and corporate bankruptcy risks. Empirical findings
generated from one research paper provides strong evidence of negative relationship between
leverage and tax sheltering that is considered importance for high risk firms. Tax avoidance
can be looked in terms of both benefits and costs to company (Business.unsw.edu.au 2018).

4HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
Current cash flow of organization is increased when company avoids tax payment and
this would have positive expected value for firms. On other hand, tax position of firms will be
challenged that results in higher future payment of penalties and tax and thereby making tax
position risky and firms at bankruptcy risk. Other research paper comes with findings that
increase in level of tax avoidance, there is increase in level of financial constraints and this
increases level of firm cash savings (Erepository.uonbi.ac.ke 2018).
Discussion:
Focused discussion on topic with logical arguments and Comparing and contrasting
views of different authors:
This particular section of report illustrates findings from several journal articles
extracted from different sources. Views of authors are supported by presentation of logical
arguments that helps in explaining the relationship between corporate bankruptcy risk and tax
avoidance. An article extracted from sciencedirect,com published on July, 2014 named “ The
effect of corporate tax avoidance on bank loan costs” depicts that firms with greater tax
avoidance have to incur high spreads when they require loans from bank (Jalan 2016). It is
perceived by lenders such as banks tax avoidance engenders significant risks.
Another article extracted from sciencedirect.com on corporate tax aggression and debt
provide a trade off model of capital structure that consider leverage to be a function of choice
of firm of tax aggressiveness. Implications of model are tested empirically and the
relationship between corporate tax aggression and debt use is considered economically
important. It has been found that for most of the firms, debt use is inversely related to
corporate tax aggression. Firms that have scored higher prediction score of tax shelter exhibit
that substitution effect is evident of the fact of such relationship. Tax aggression and debts are
considered complements for the most profitable firms (Kubick et al. 2016).
A paper on debt, corporate tax aggressiveness and bankruptcy extracted from finance
group of a business school. The theory used in the analysis predicted that there is inverse
relationship between tax sheltering and bankruptcy cost of managers and leverage. Results of
empirical test are consistent with theoretical predictions. Tax sheltering has been found to be
negatively related to bankruptcy risk and leverage and for riskier firms, such negative effects

5HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
of debt and bankruptcy risks are stronger. The findings are opposite for weaker firms as the
negative effects between such variables are not strong. In order to depict that findings of
research paper are robust to endogeneity concerns, authors have used two changes to
bankruptcy law (Nesbitt et al. 2017).
A paper on role of debt and corporate tax aggressiveness intended to study the impact
of leverage on tax aggressiveness. Study was conducted with the development of simple two
date and one period model for capturing incentives of managers to avoid income tax
sheltering and money diversion from taxable income. Evidences have been found that
depicted negative relationship between tax aggressiveness and leverage. The developed
single period model is based on intuition that bankruptcy is costly for managers (Akamah et
al. 2016).
According to Richardson et al. (2014), the examination of relationship between tax
avoidance and equity incentive to managers depicts that higher incentive compensation
reduces tax avoidance. On other hand, it has been found by Isin (2018), that tax
aggressiveness and equity risk incentives have a positive association between tax
aggressiveness and equity risk incentives. However, corporate governance at firm level does
not influence such relationship.
In a research paper, extracted from parsproje.com on maturity structure of debt and
corporate tax aggressiveness that investigated the association between corporate debt
maturity and tax aggressiveness. It was found that tax aggressive firms have shorter debt
maturity and tax aggressiveness is viewed as risky activity by lenders and this restricts the
debt maturity structure of debt providing monitoring mechanism for debt contracts with
borrowers who are tax aggressive (Crane and Matten 2016).
One of the articles named reviewing research on leverage puzzle and corporate tax
aggressiveness extracted from the journal of Australian tax research association. In this
article, previous research was reviewed on relationship between leverage and corporate tax
aggressiveness depicts that puzzle remained unsolved. Engagement of firms to avoid taxation
requires use of deductibility of debt interest and therefore high debt ratio is considered as part
of tax aggressive schemes (Sbs.ox.ac.uk 2018). This makes it challenging to conclude that
there is a casual relationship between leverage and tax aggressiveness. Moreover, it has been
proposed in the table that companies that are successful in avoiding payment of taxation has

6HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
the possibility of sustaining large difference between taxable income and book value. This in
turn would lower the associated bankruptcy risks.
In an article extracted from onlinelibrary.wiley.com on “taxes and credit ratings-the
effect of book tax differences on credit ratings of firms”. This paper is prepared for
examining whether information contained in the taxable and credit analysts in analyzing the
credit risks of firms utilize book income. An increase in book tax differences signals the
changes in off balance sheet financing of firms, decreased quality of earnings, and are such
changes are considered informative (Donohoe 2015). It has been found there is considerable
negative association between any positive changes in book tax differences. Less favorable
rating changes have been witnessed when there are large negative changes in book tax
differences.
An article extracted from semanticsscholar.com that is about empirical analysis on
debt policy and corporate tax aggressiveness. It has been found that there exists negative
correlation between level of debt and tax aggressiveness. In addition to this, negative
correlation has been observed proportion of outside directors on board and level of debt. For
monitoring the management, corporate debt plays a consequential role and thereby helps in
reducing agency costs. While examining the relationship between monitoring mechanism
and debt level, it was found that there exists correlation between them; however, the nature of
relationship is not clear (Graham et al. 2017).
One of the research papers on debt equity and taxation bias extracted from
ec.europa.eu by Serena Fatica and Thommas hemmelgarn discusses the debt bias
consequences in relation to taxation payment. It has been found that under most corporate
income tax system, the tax deductibility interest payments do not have any measure to be
foreseen for financing equity and this creates distortion in financing decision of organization.
Corporate tax bias might lead to high degree of leverage in companies and thereby increasing
systematic risks (Bayar et al. 2016).
Criticizing aspects of methodologies used:
The methodology used in analysis of relationship between debt, corporate tax
aggressiveness and bankruptcy make use of simple framework. Such framework helps
researcher in obtaining close form solution for presenting comparative statistics and optimal
level of sheltering of firms. It has been assumed in this particular research paper that debt

7HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
level is exogenous and it derives the levered firm optimal level of sheltering. A two stage
least square methodology is used as the negative relations are regarded as robust for making
adjustments for endogeneity. Negative relation has been found between bankruptcy risk and
tax sheltering in cross sectional analysis (Richardson et al. 2014).
Methodology used in research paper for identifying relationship between debt
maturity structure and corporate tax aggressiveness is about selection of samples and
measurement of corporate tax aggressiveness. Sample used in the study is derived from the
intersection of execucomp and compustat database through 2012 and the measure of tax
aggressiveness is done by measuring the likelihood of tax sheltering. This is so because the
most aggressive form of tax aggressiveness is captured by the likelihood of tax sheltering.
Regression control used for the analysis purpose does not completely capture the activities of
tax avoidance of firms. It has been found that shorter debt maturity is associated with higher
tax avoidance level. The emerging streams of literature receive contribution from such results
that helps in investigating the tax aggressiveness consequences. Results complement the work
of Hasan et al. (2014) that lenders into loan spreads price the risk of tax aggressiveness and
evidence is provided in supply favor forces in negative relationship between leverage and tax
aggressiveness.
Research methodology involved in capital structure measurement, tax planning
involves determining the panel of dataset, and the main sources of data collection were
income statement and balance sheet of companies (Hsu et al. 2016). In this particular study,
samples have been selected from companies listed on Malaysian stock exchange and the
companies that do not have proper data are excluded from sample.
The empirical analysis of tax avoidance is considered highly challenging due to
concealment of activities and perhaps social shame and threat of punishment makes
companies unwilling to accurately respond to surveys conducted. Research work has
exploded two research designs that is analysis of kinks and notches in policy and regression
discontinuity (Efmaefm.org 2018).
Research methodology adopted in determination of firm value due to effects of tax
planning of company involves formation of research design, data collection and sampling
process. Secondary data for the analysis purpose were sourced from websites of company and
it involved panel of data. Data collected were described using descriptive model in terms of
standard deviations and mean scores. Results were interpreted by examining the level of tax

8HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
planning of firms using median and mean values (Dhaene et al. 2017). Data analysis was
performed using panel data regression techniques.
Identification of gaps in literature review:
Gaps in literature review concerning with identification of relationship between
bankruptcy risks and tax planning was ascertained in terms of lack of availability of data on
tax avoidance or tax sheltering of companies that was selected in the sample. Moreover, there
is no proper disclosure of the planning method of taxation of companies and appropriate and
authentic data for the analysis was difficult to obtain. It made it difficult for researcher to
create a proper linkage between corporate bankruptcy risk and tax avoidance and tax
sheltering of companies (Faccio and Xu 2015).
Data gathered for the analysis of relationship between these two identified variables in
research paper were extracted from two more sources. A number of methods are used by
researchers for accounting the endogeneity concerns in examination of tax related effects
(Hasan et al. 2014). Therefore, it is very essential to address the problem of endogeneity for
studying the relationship between bankruptcy risk and tax aggressiveness. It is required to fill
the gaps in literature by extracting the data from several other relevant sources and hence, it
can be regarded that gap exist in terms of uniformity of data while conducting research.
Furthermore, data gathered are searched from two or more than two sources might create
skewed data in results of research paper (Chen et al. 2017). However, data are sourced from
several sources for creation of data integrity.
Conclusion:
Identification of relationship between tax avoidance and bankruptcy risk has been a
topic of research to academics in accounting, finance and taxation. From the analysis of
research paper in identification of relationship between tax avoidance by organization and
corporate bankruptcy risk, it can be inferred that there exist negative relationship bankruptcy
risk or debt level and tax avoidance. Nevertheless, other relevant articles came with
conflicting conclusion that corporate tax avoidance is associated positively with debt
holdings. Second line of report gives a conclusion of negative association between leverage
and tax aggressive activities. While some other studies and research paper shows
insignificant and mixed findings in respect of leverage or bankruptcy risk and tax aggressive
of firms. However, four main issues are suggested from literature review and it involves bi

9HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
directional or casual relationship between bankruptcy risk associated with debt level of firms
and tax avoidance, cost of debt level and measures of debt level, proxies used for engagement
of firms in tax aggressive activities and endogeneity of corporate tax status. The contribution
of empirical and theoretical results is to show that bankruptcy risks due to presence of debt in
the capital structure is regarded as a crucial determinant of income sheltering and thereby
reducing tax sheltering of corporations. It has also been highlighted by results that tax
sheltering reduces the introduction of likelihood of bankruptcy by serving as monitoring
mechanism.
The puzzle of leverage and tax aggressiveness are faced with a number of issues that
requires further examination and explanation in future research. It is considered essential to
determine the most relevant proposition having the dominant effect since arguments and
competing theories supports positive and negative relations between bankruptcy risk and
corporate tax avoidances. Attempt of future research might be to document the association
between debt for each level of tax aggressiveness and tax avoidances.

10HOW TAX AVOIDANCE AFFECTS CORPORATE BANKRUPTCY RISK
References list:
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Tax Outcome Variability.
Al‐Hadi, A., Chatterjee, B., Yaftian, A., Taylor, G. and Monzur Hasan, M., 2017. Corporate
social responsibility performance, financial distress and firm life cycle: evidence from
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Bayar, O., Huseynov, F. and Sardarli, S., 2017. Corporate Governance, Tax Avoidance, and
Financial Constraints. Financial Management.
Business.unsw.edu.au. (2018). [online] Available at:
https://www.business.unsw.edu.au/About-Site/Schools-Site/Taxation-Business-Law-Site/
jattavolumes/JATTA-2016-Nguyen.pdf [Accessed 20 Mar. 2018].
Chen, N.X., Chiu, P.C. and Shevlin, T., 2017. Do Analysts Matter for Corporate Tax
Planning? Evidence from a Natural Experiment. Contemporary Accounting Research.
Crane, A. and Matten, D., 2016. Business ethics: Managing corporate citizenship and
sustainability in the age of globalization. Oxford University Press.
Dhaene, J., Hulle, C., Wuyts, G., Schoubben, F. and Schoutens, W., 2017. Is the capital
structure logic of corporate finance applicable to insurers? Review and analysis. Journal of
Economic Surveys, 31(1), pp.169-189.
Donohoe, M.P., 2015. The economic effects of financial derivatives on corporate tax
avoidance. Journal of Accounting and Economics, 59(1), pp.1-24.
Efmaefm.org. (2018). [online] Available at:
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