The Moderating Role of Internal Control in Tax Avoidance

• In Event: Continental Breakfast & Research and Education Forum
  In Paper Session: Table 2: Internal Control and/or Internal Audit

Abstract

To fully understand the mechanism through which internal control affects tax avoidance, we investigate whether the relation between internal control and tax avoidance resembles the nonlinear pattern uncovered for corporate governance in Armstrong et al. (2015) or exhibits the linear pattern documented for internal control in Bauer (2016). First, we perform quantile regressions to take into account the entire tax avoidance distribution. Second, we use a comprehensive COSO-based index that covers a firm’s internal controls over operations, financial reporting and compliance for all public firms in China. Supporting the results in Armstrong et al. (2015), we find a nonlinear relation between internal control and tax avoidance with internal control playing a moderating role on tax avoidance. Specifically, we find that internal control quality has a significantly positive impact on tax avoidance for under-sheltered firms in the left-tail of the tax avoidance distribution, indicating that effective internal control may enhance firm value through prudent tax planning for these firm inactive in tax saving activities. We also find that internal control quality has a significantly negative impact on tax avoidance for over-sheltered firms in the right-tail of the tax avoidance distribution, suggesting that effective internal control may lower reputational, legislative and enforcement risks by curtailing tax aggressiveness for these firms active in tax avoidance. These findings suggest that high-quality internal control can weigh the benefits and costs of tax avoidance, balancing between performing prudent tax planning for under-sheltered and curbing aggressive tax sheltering for over-sheltered firms.

Authors

• Hanwen Chen, University of International Business and Economics

• Daoguang Yang, University of International Business and Economics

• Xinmin Zhang, University of International Business and Economics

• Nan Zhou, State University of New York at Binghatmon