Debtor-Creditor Relationship and Corporate Tax Planning: Evidence from Initiation of Credit Default Swaps Trading

Abstract

This study investigates the effect of the debtor–creditor relationship on firms’ tax planning decisions. We explore the initiation of credit default swaps (CDS) as a shock to the debtor–creditor relationship that attenuates the concavity of creditors’ payoff function and reduces their incentives to closely monitor debtors and to protect their claims. As a result, debtors engage in more tax avoidance. Less price protection by creditors also reduces debtors’ marginal cost of tax avoidance and thus increases debtors’ level of tax avoidance. Using a differences-in-differences regression, we find that borrowing firms significantly increase their level of tax avoidance when there are CDS trading on their debts. This effect is more pronounced when the debtor–creditor relationship is characterized by continuous monitoring prior to CDS trade initiation, when creditors suffer lower reputation losses if they reduce monitoring post-CDS, and when the CDS market is more liquid.

Keywords: Credit Default Swaps, Tax Planning, Debt Renegotiation

JEL Classification: H25, H26, G14