Do Managers Reduce Related-Party Sales to Counter the Enforcement of Gift Taxes on the Benefits Tunneled through Abnormal Related-Party Sales?

Prior studies present the competing hypotheses for the role of related-party transactions (RPT). “Efficiency enhancing view” argues that firms engage in RPT with intent to reduce transaction costs in an imperfect market. On the other hand, “tunneling view” posits that RPT is a viable channel for transferring the wealth within a business group into the ultimate shareholders. From the tunneling view, the Korean regulators have had long concerns over abnormal levels of related-party sales (RPS), and enforced gift taxes on the benefits tunneled through these transactions in 2012, which are levied to the ultimate individual controlling shareholders. Since such taxes increase with the ratio of RPS to total sales above 30%, the sellers (beneficiary firms) whose shareholders are expected to pay the gift taxes may have incentives to reduce RPS after 2012. However, this tax incentive may conflict with the purpose to enhance business efficiencies through RPS. Using 1,456 firm-year observations over 2010-2013 and employing a difference-in-differences approach, I find that beneficiary firms are likely to reduce their RPS transactions after 2012, compared with non-beneficiary firms. However, this phenomenon is pronounced solely in the abnormal components of RPS estimated based on Jian and Wong’s (2010) methodology, not in its normal components. In addition, it is documented that the tendency of beneficiary firms to reduce RPS is more prevalent when they are in competitive markets than in non-competitive markets, or when the individual controlling shareholders have a higher percentage of ownership. These results suggest that gift taxes on RPS seem to induce managers of beneficiary firms to reduce RPS transactions, especially when the resulting non-tax costs of losing business efficiencies (the following tax savings) are expected to be lower (higher).