Controlling shareholders' tax incentives and related party transactions

Abstract

This study examines whether the tax incentive of controlling shareholders affects firms' engagement in related party transactions (RPTs) by using the introduction of a tax law in Korea that imposes gift taxes on the controlling shareholders of firms generating profits from excessive related party sales. As the amount of new taxes is calculated based on firms' related party sales, firms face incentives to reduce related party sales to decrease the tax burden of controlling shareholders. We use a difference-in-differences approach to examine the change in firms' related party sales around the introduction of the tax law between firms whose controlling shareholders are likely to be subject to the gift tax (i.e., treatment firms) and those without such controlling shareholders (i.e., control firms). We find that the treatment firms exhibit a significant decrease in related party sales in the post-tax law period, while there is no significant change in related party sales for the control firms. Test results suggest that the new tax law seems to be effective in deterring abnormal parts of RPTs (e.g., potentially related to opportunistic RPTs) without a significant loss of efficiency gains from RPTs.