How does management respond to tax risk? Evidence from the M&A setting

Abstract

Utilizing the M&A setting, I investigate whether and how a target firm’s tax risk impacts the acquirer’s decision-making. Using the ex-ante tax risk measure from Neuman et al. (2020), my overall findings suggest target firm tax risk is associated with increased effort in due diligence, but that these efforts do not appear to fully mitigate future adverse financial reporting consequences. I first examine the likelihood of withdrawal and find that operational tax risks are associated with an increased likelihood of withdrawal, concentrated in target firms with high organizational complexity. Next, I find that target firm tax risk is positively associated with longer due diligence periods and higher advisory fees paid, which is consistent with tax risk increasing due diligence efforts. This increased effort appears to be driven by target firm managerial tax risks, which arise when the target firm’s personnel lack sufficient tax knowledge or resources. Finally, I examine financial reporting consequences in the post-acquisition period and find that the likelihood of both tax-related misstatements and non-tax misstatements increases with target firm tax risk, driven by managerial risk. In cross-sectional analysis I find that the increase in tax-related misstatements is concentrated in deals that experienced overall workforce reductions after the acquisition and where the target firm has greater organizational complexity. My study provides evidence that acquirers recognize and respond to target firm tax risks, but that the response is not sufficient to mitigate future misstatements. My findings also suggest that a key source of tax risk in M&A stems from personnel knowledge and post-merger integration issues. The evidence in this study is consistent with assertions that tax risk is meaningful in management decisions and drives real outcomes in the M&A setting.