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Asian Review of Accounting
Privatization, tunneling, and tax avoidance in Chinese SOEs

Tanya Y.H. Tang
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Tanya Y.H. Tang , (2016),"Privatization, tunneling, and tax avoidance in Chinese SOEs", Asian
Review of Accounting, Vol. 24 Iss 3 pp. 274 - 294
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ARA
24,3
Privatization, tunneling, and tax
avoidance in Chinese SOEs
Tanya Y.H. Tang
274 Faculty of Management, University of British Columbia, Kelowana, Canada
Received 12 August 2014 Abstract

Revised 10 November 2014
30 December 2014
Purpose – The purpose of this paper is to investigate the effect of ownership structure arising from
Accepted 6 February 2015 China’s unique privatization process on listed firms’ tunneling activities and their interaction with
tax avoidance.
Design/methodology/approach – Using hand-collected data on the incompletely restructured state-
owned listed firms and their applicable tax rate, this paper conducts a multivariate regression to test
research questions. It also employs a triple differences method to examine whether the observed
interaction between tax avoidance and tunneling is mitigated for well-governed firms.
Findings – It documents that controlling shareholders’ tunneling increases as the percentage of
shares owned by state-owned enterprises (SOEs) increases. Evidence also shows that the magnitude of
tunneling increases when SOEs controlled by the central government engage in more tax avoidance,
suggesting that these firms use tax avoidance to facilitate wealth expropriation.
Social implications – These findings advance the understanding of the tunneling incentive behind the
tax avoidance behavior for a subset of Chinese SOEs and have implications for emerging capital markets
that are characterized by concentrated government ownership and weak corporate governance.
Originality/value – This paper is the first paper to investigate the effect of the incomplete
privatization process on tunneling and the interaction between tunneling and tax avoidance activities.
It extends prior studies by investigating the incentives behind SOEs’ tax avoidance from the
perspective of an agency problem and documenting that good corporate governance plays an
important role in deterring the diversionary tax avoidance.
Keywords Privatization, Tunneling, Corporate governance, Tax avoidance, Government ownership
Paper type Research paper
1. Introduction
This study investigates the effect of ownership structure arising from China’s unique
privatization process on listed firms’ tunneling activities and their interaction with tax
avoidance. The privatization of state-owned enterprises (SOEs) is one of the important
reforms in China in the past two decades, whereby many SOEs were restructured into
shareholding companies and some of which have been listed on stock exchanges[1].
On average, approximately 73 percent of listed firms spun off from restructured SOEs
prior to their initial public offerings (IPOs) and are either directly controlled by State
Asset Management Bureau (SAMB) or government institutions, or indirectly controlled
by prior parent SOEs (China Securities Regulatory Commission, 2005; Wang and Xiao,
2011). Although China’s SOE restructuring has led to a successful economic transition
and the world’s fifth-largest stock market by market capitalization, the government still
remains the dominance of ownership and retains substantial control over listed firms’
operations and CEO appointments.
Evidence has shown that government-owned firms exhibit low profitability and
efficiency, poor governance, and severe principal-principal agency conflicts relative to
Asian Review of Accounting non-government-owned firms (Chen et al., 2008; Fan et al., 2007; Liu and Lu, 2007).
Vol. 24 No. 3, 2016
pp. 274-294
While a number of studies have documented the prevalent expropriation of minority
© Emerald Group Publishing Limited
1321-7348
shareholders in China, whether these tunneling activities are associated with the
DOI 10.1108/ARA-08-2014-0091 incomplete privatization process remained unclear[2]. This paper examines how
ownership structure arising from the unique restructuring process of SOEs shapes the Tax avoidance
tunneling behavior of controlling shareholders and its effect on the interaction between in Chinese
tunneling and tax avoidance.
According to the China’s privatization process, I classify government ownership
SOEs
as SAMB (i.e. firms owned by the state agencies), SOELG (i.e. firms owned by
SOEs controlled by the local government), and SOECG (i.e. firms owned by SOEs
controlled by the central government). Although these firms are ultimately owned 275
by the government, as discussed in Section 2, they have different restructuring
processes that affect the incentives of the controlling shareholder[3]. Building on
prior studies ( Jiang et al., 2010; Aharony et al., 2010; Jian and Wong, 2010), I use the
related-party receivables owed by a parent firm and other related firms under control
of the same parent company to capture fund misappropriation by controlling
shareholders. I find that ownership structure stemming from the incomplete
restructuring process has a significant impact on the subsequent controlling

shareholders’ tunneling. Specifically, incompletely restructured firms (i.e. SOELG and
SOECG) engage in more tunneling as their shareholdings increase. On average,
a 1 percent increase in the SOECG (SOELG) ownership leads to a 6.1 percent
(5.6 percent) increase in tunneling.
I then investigate whether SOELG and SOECG firms avoid taxes to facilitate
tunneling. Prior literature suggests that tax avoidance activities may facilitate the
controlling shareholder to divert resource from minority shareholders (Desai and
Dharmapala, 2006; Kim et al., 2011; Chen et al., 2010). By and large, government-owned
firms are perceived to be not in favor of tax avoidance as the government (i.e. the
controlling shareholder) is more concerned about social and political goals than profit
maximization. However, it is worth noting that governmental tax revenue serves for
specific purposes (e.g. national defence, education, and welfare system) and its use is
under supervision of the National People’s Congress. In contrast, increased cash
flows and earnings from tax avoidance retained in the listed firm can be freely used
by the controlling shareholder and maximize the resources for tunneling. Hence,
SOELG and SOECG firms are likely to engage in tax avoidance to achieve tunneling
purposes. However, tax avoidance is not costless (e.g. tax audit risk, non-tax costs).
Therefore, whether these firms avoid taxes to facilitate tunneling appear to be an
empirical question.
The results show that SOECG firms experience more tunneling as they are tax
aggressive. However, I find no significant difference in tunneling between tax
aggressive and non-tax aggressive SOELG firms, suggesting that the cost-benefit
consideration affects the interaction between tunneling and tax avoidance. These
results are robust to various tax avoidance measures and after controlling for firm
characteristics, corporate governance factors, and year and industry fixed effects.
Additional tests show that the observed interaction between tax avoidance and
tunneling is attenuated for well-governed firms.
This paper contributes to the literature in several ways. First, it provides empirical
evidence that the ownership structure arising from the incomplete privatization process
is a determinant of controlling shareholders’ tunneling. The privatization of SOEs is
popular in most transitional economies (Yusuf et al., 2006). While China’s economic
restructuring is deemed to be a successful example for the market economy
transformation, its listed sector continues to be dominated by the government-owned
firms and subject to state intervention in corporate decision making[4]. As pointed out
by Yusuf et al. (2006), the full economic benefits of privatizing SOEs will not be realized
ARA until the state cedes control rights and fulfills its role of managing the market instead of
24,3 intervening it. The findings in this paper suggest that the incomplete privatization
process provides firms with incentives and ability to expropriate wealth from minority
shareholders, which should be partially responsible for the prevalent tunneling
activities in China.
Second, the results suggest that tunneling can be one of tax avoidance incentives,
276 which provides new insights into a long unsolved mystery of why SOEs avoid taxes.
The tax avoidance incentive for SOEs was less clear. For example, Shevlin et al. (2012)
posit that SOEs are likely to avoid more taxes as they obtain political connections that
reduce tax audit scrutiny. However, they find no evidence that SOEs engage in more
tax avoidance. Using confidential tax audit adjustment data, Chan et al. (2010) indicate
that firms with a higher percentage of government ownership are less tax compliant in
China although they do not provide any explanation on the result. This paper extends
their studies by investigating the incentives behind SOEs’ tax avoidance from the
perspective of an agency problem.
In addition, this study examines the impact of corporate governance mechanisms on
the tunneling-tax avoidance interaction. The results from the triple differences analysis
suggest that good corporate governance plays an important role in deterring the
diversionary tax avoidance.
Finally, this study aids foreign investors in better understanding listed SOEs’ tax
avoidance. As the largest emerging capital market, China has attracted numerous
market participants including foreign institutional investors and mutual funds. In the
meantime, increasing numbers of Chinese companies are cross-listed on the
New York, Singapore, and London Stock Exchanges[5]. The unique organizational
structure formed by incompletely restructured SOEs, the concentrated ownership,
and weak corporate governance mechanisms work together to create an environment
that is conducive to insider abuse. The findings in this study bring some
transparency to this environment by informing outside investors of an important cost
of tax avoidance for SOECG firms (i.e. the potential risk of expropriation from
minority shareholders). Liu and Lu (2007) indicate that tunneling is the most
important driver of the Chinese listed firms’ earnings management decisions. I extend
their study by revealing that tax avoidance is also associated with dominant
shareholder expropriation in some cases, suggesting that tax avoidance is not always
beneficial to investors.
The remainder of the paper is organized as follows. The next section discusses
the institutional background and develops testable hypotheses. Section 3 describes the
sample selection and the research design. Section 4 presents main results as well as
additional analyses. Section 5 concludes.
2. Hypothesis development
2.1 Institutional background and tunneling hypothesis
China established its Shanghai Stock Exchange in 1990 and Shenzhen Stock Exchange
in 1991 as a vehicle to recapitalize SOEs and improve their operating performance. In a
centrally planned economy, all enterprises were owned by the government, and so are
all profits and losses as well. With no operation autonomy and incentive systems, most
SOEs experienced heavy losses and debts which forced banks to issue excessive
amounts of currency and loans. The government suffered a huge deficit. To solve these
problems, the government decided to restructure SOEs and establish capital markets to
raise money through selling partial equity ownership to the public.
SOEs can be restructured in two ways. One method involves a complete Tax avoidance
restructuring process: the state reorganizes SOEs’ existing assets, injects new capital to in Chinese
repay their bank debts, and lays off excess work force so that the existing SOEs can
meet the listing requirements. In this case, the company goes public and is directly
SOEs
owned by the government or its agencies, such as the Ministry of Finance or the State
Council or SAMB at any level of government. Given that complete restructuring
requires numerous governmental inputs, only few of the former SOEs went through 277
this process. I denote these firms as SAMB firms. SAMB firms are typically managed
by civil servants who are appointed and paid by the government. The promotion of
these civil servants is largely dependent on how well they execute the instructions of
the government. They have no rights to use dividend revenue. The dividends and other
payouts by firms are remitted directly to the state treasury (Firth et al., 2006). In other
words, the state earns tax and dividend revenues as a return of prior input. Given the
direct government control and strong political purposes, this type of firms has
relatively weak incentives to tunnel (Chen et al., 2008).
Another method involves an incomplete restructuring process: the predecessor
SOE reorganizes its assets and transforms into a parent-subsidiary structure by
carving out its most profitable part for public listing. Typically, the existing
SOE consists of various units: profitable, unprofitable, and not-for-profit units
(e.g. hospital, community school, day care center). The parent SOE usually transfers
high-quality assets into the most profitable unit and allows it to compete for IPO,
leaving poor assets, excess labor, outstanding loans, and losses in other units. In this
case, the listed firm becomes the subsidiary of the predecessor SOE. In other words,
the IPO firm’s shares are indirectly owned by the government through the parent
SOE instead of a state agency. Most of the former SOEs went through this process.
I define these listed firms as SOELG (firms owned by existing SOEs controlled by
the local government) and SOECG (firms owned by existing SOEs controlled by the
central government). One major difference between completely and incompletely
restructured firms is whether there is a “parent SOE” in-between the government and
the publicly traded firm.
While the incomplete restructuring process is a less costly way of restructuring
for the Chinese Government, the parent SOE who bears the costs of restructuring
and keeps all policy burdens has an inherent incentive to siphon economic
resources back from the listed subsidiary to fund other unprofitable units
(see Figure 1). Under this restructuring structure, the parent SOE retains
substantial equity interests and control of the listed firm (in terms of deciding
operation strategies, CEO appointment, and CEO pay), which makes it easy to use
the listed firm as a vehicle to meet its goals at the expense of minority shareholders
(Liu and Lu, 2007; Firth et al., 2006).
One distinct difference between SOEs and private firms is that government-owned
shares are traded in a restricted manner. Due to its ideological aversion to capitalism,
the Chinese Government prescribes that all shares have the same voting rights and
cash flow rights, but all state-related shares are non-tradable. By doing so, the state
will retain absolute majority ownership and ultimate control over the listed firms
(Chen et al., 2008). As a result, the controlling shareholder of SOELG/SOECG firms
cannot benefit from price appreciation, which in turn motivates them to seek rents
through other channels ( Jiang et al., 2010). Another important difference is that SOELG
and SOECG firms may pursue social and economic purposes other than wealth
maximization only, such as, developing the regional economy, reducing bad debts of
ARA State State
24,3
Complete restructuring by
injecting money to existing SOEs
278
SOEs controlled by the SOEs controlled by the
Existing SOEs local government central government
become listed firms
directly owned by the
government agencies
(SAMB) Incomplete restructuring by carving-out

from existing SOEs
Listed firms owned by Listed firms owned by

predecessor SOEs predecessor SOEs
Weak
(SOELG) (SOECG)
tunneling
incentive
Figure 1.
Privatization process, Strong
organizational tunneling
structure, and the incentive
resulting tunneling
incentives
banks, preventing non-listed parent SOEs from bankruptcy to maintain local

employment, and social stability (Liu and Lu, 2007)[6]. Consequently, the controlling
shareholder of incomplete restructured SOEs has strong incentives to extract resources
from minority shareholders.
A number of studies have documented that government-owned firms use
intercorporate loans and related-party transactions as a means for tunneling
(Aharony et al., 2010; Jiang et al., 2010; Jian and Wong, 2010; Lo et al., 2010). By
analyzing 185 newly listed IPO firms during the period 1999-2001, Aharony et al. (2010)
find that parent SOEs prop up the earnings of the IPO candidate through increased
related-party sales in the pre-IPO period and tunnel their assets or profits back to the
unlisted parent SOEs via non-repaid corporate loans in the post-IPO period. Jian and
Wong (2010) find that government-owned firms exhibit more abnormal related-party
sales with their parent SOEs than non-state firms. They also find evidence that the local
governments prop up earnings of listed firms to meet the China Securities Regulatory
Commission (CSRC) requirements and this propping is associated with the transfer of
cash back to the controlling shareholder through related lending. These findings are
consistent with the story that the parent SOE gives a lending hand first in order to
siphon more wealth from the listed firm afterwards. While incompletely restructured
firms (SOELG and SOECG) have strong incentives for tunneling, the ability of
controlling shareholders to expropriate minority shareholders is subject to the degree
Tax avoidance
to which they control the firm. Therefore, I predict that the more shares these firms
hold, the more wealth they could tunnel. I develop the first hypothesis as follows: in Chinese
H1. Ceteris paribus, incompletely restructured SOECG and SOELG firms engage in SOEs
more tunneling activities as the percentage of shareholding increases.
2.2 Tunneling and tax avoidance interaction 279

The question of why SOE firms avoid taxes remains puzzling. Typically, SOE firms
are perceived to be not in favor of tax avoidance as they pursue social and political
objectives rather than maximizing shareholder value. Tax avoidance simply reduces
governmental revenue, which is inconsistent with the government’s interests.
However, as the largest shareholder, the government is the largest beneficiary of
post-tax return. Therefore, SOE firms have incentives to boost earnings and minimize
income tax so as to retain more resources under their control (Tang and Firth, 2011).
Using confidential tax audit adjustment data, Chan et al. (2010) find that firms with a
higher percentage of state ownership are less tax compliant in China. Shevlin et al.
(2012) examine tax-induced income shifting among consolidated group members by
Chinese B-share listed firms. As SOEs are politically connected and enjoy a low tax
avoidance cost, they propose that these firms avoid more taxes by shifting income
into lower-taxed subsidiaries. Yet, they find no evidence that high concentrations of
SOE ownership affect tax-induced income shifting. Unlike prior studies that
investigate the impact of government ownership on tax avoidance per se, I examine
whether the tax avoidance undertaken by incompletely restructured SOE firms
relates to their tunneling activities.
The linkage between tax avoidance and tunneling has been proposed by Desai
and Dharmapala (2006) who assert that tax avoidance could be used as a tool to
facilitate rent extraction. They contend that the complexity and opaqueness of
tax avoidance designed to prevent detection by taxing authorities enables managers
to hide their real intent of diverting rents. For example, claiming the transactions of
diverting profits to be for tax purposes. Kim et al. (2011) find that tax aggressive
firms have higher stock price crash risk. They interpret this result as evidence
that managers hide and accumulate bad news through tax avoidance activities,
which in turn increases future crash risk. SOEs are more concerned with
public images and social impact than private firms and hence they much desire
to conceal insider abuse to avoid the pressure from the media and public
investors ( Jiang et al., 2010). More importantly, paying less tax makes the firm
retain more cash flows and earnings under control and hence increases its ability to
expropriate funds afterwards.
While tax avoidance may facilitate tunneling, the tunneling-related tax avoidance
comes with costs. First, this type of tax avoidance may lead to a price discount due to
minority shareholders’ concern with the possibility of being extracted (Chen et al.,
2010). Second, tax audit risk and the resulting penalties will increase the costs of
tunneling. However, as discussed previously, SOE firms have a low tax avoidance cost
due to their political connections[7]. In addition, shares owned by the government
cannot be sold freely in the stock market. The price discount is not much of a concern
for these firms as the controlling shareholder cannot reap benefits from the
appreciation of share prices ( Jiang et al., 2010). While tunneling incentives are strong
and the tax avoidance cost is relatively low, SOELG and SOECG firms are likely to
avoid taxes to facilitate tunneling. As such, I expect to observe that the magnitude of
ARA tunneling for these firms to increase as their tax avoidance increases. Therefore, my
24,3 second hypothesis is as follows:
H2. Ceteris paribus, incompletely restructured SOECG and SOELG firms’ tunneling
increases as they avoid more taxes.
280 3. Sample and research design

3.1 Research design
To test the first hypothesis, I use the following model:
TUL ¼ b0 þ b1 SOECG þ b2 SOELG þ b3 SAMB þ b4 LEV

þ b5 ROA þ b6 SIZE þ b7 GROWTH þ e (1)

TUL is the amount of related-party receivables owed by a parent firm and other related
firms under control of the same parent company, divided by total assets. Prior studies
(e.g. Jiang et al., 2010; Aharony et al., 2010; Liu and Lu, 2007) use outstanding related-
party corporate loans (measured as other receivables) as a proxy for tunneling.
I include accounts/note receivable arising from related-party sales and other
receivables owed by the parent and related-party firms under the control of the
same parent company to capture fund misappropriation by controlling shareholders[8].
SOECG is the percentage of shares owned by a SOE controlled by the central
government as a controlling shareholder; SOELG is the percentage of shares owned
by a SOE controlled by the local government as a controlling shareholder. SAMB is
the percentage of shares owned by the state agencies. ROA is return on assets; LEV is
a ratio of total liabilities to total assets; SIZE is the natural logarithm of total assets.
GROWTH is the change in sales divided by total assets. These variables are included
to control for firm characteristics. In line with the first hypothesis, the coefficients on
SOECG and SOELG are expected to be positive to reflect that these firms engage in
more tunneling activities as the percentage of shareholding increases. H2 predicts
that SOELG and SOECG firms’ tax avoidance is associated with their tunneling
practices. To measure tax avoidance, I employ three proxies specific to Chinese
institutional and tax settings. Specifically, I construct two modified effective tax rate
measures to control for the country-wide tax rate differential effect: the modified
GAAP effective tax rate (METR), and the modified current effective tax rate
(MCETR). Unlike the US firms that are usually levied an identical statutory tax
rate, the tax rate applied to Chinese firms (i.e. ATR) is different from the statutory
tax rate and varies across industries, regions, and ownership structures due to a wide
range of preferential tax policies (Shevlin et al., 2012). One limitation of traditional
ETR measures is that a firm with a low ATR will lead to a low ETR in the absence of
any tax avoidance. As indicated in Table I, the means of ATR for NONSOE,
SOECG, SOELG, and SAMB firms are 18.8 percent, 14.3 percent, 21.1 percent, and
20.3 percent, respectively. To control for the effect of tax rate differentials, I use a
ratio of ETR to ATR (METR) and a ratio of CETR to ATR (MCETR) to measure tax
avoidance. To avoid some unreasonably large ETRs and CETRs arising from the
effect of relatively small values in the denominator, I follow Chen et al. (2010) and
constrain ETRs and CETRs to range from 0 to 1.
Similar to the spirit in Tang and Firth (2012), I also use an abnormal book-tax
difference (ABTD) measure[9]. ABTD is the residual estimated from the following
Variable NONSOE SOECG SOELG SAMB TOTAL
Tax avoidance
in Chinese
TUL 0.007 0.023 0.028 0.016 0.024 SOEs
ABTD 0.001 0.002 0.000 −0.003 0.000
METR 0.894 1.132 1.279 1.383 1.219
MCETR 0.946 1.142 1.282 1.415 1.229
ATR 0.188 0.143 0.211 0.203 0.197
ROA 0.055 0.048 0.043 0.056 0.046 281
LEV 0.462 0.498 0.462 0.396 0.465
SIZE 14.439 14.848 14.623 15.017 14.659
GROWTH 0.157 0.120 0.143 0.055 0.136
FIRSTSH 0.295 0.369 0.453 0.316 0.416
MVB 0.750 0.768 0.642 0.395 0.663
TOBIN’s Q 1.184 1.260 1.206 1.174 1.211
ROE 0.121 0.117 0.178 0.098 0.158

CEO_DIR 0.474 0.017 0.079 0.353 0.124
OUTDIR 0.456 0.380 0.466 0.539 0.454
CONCEN −0.020 0.167 0.323 0.213 0.255
BIG4 0.842 0.810 0.661 0.824 0.713
n 38 58 242 17 355
Notes: This table presents firm characteristics for the sample of 355 firm-year observations from 1999
to 2004. TUL is the amount of related-party receivables owed by a parent firm and other related firms
under control of the same parent company, divided by total assets; ABTD is abnormal BTD; METR is
ratio of GAAP ETR to ATR; GAAP ETR is measured as income tax expense divided by before-tax
profit; MCETR is the ratio of CETR to ATR; CETR is measured as current tax expense divided by
before-tax profit; ATR is the tax rate applicable to the listed firm after considering tax incentives.
ROA is return on assets; LEV is a ratio of total liabilities to total assets; SIZE is the log of total assets;
GROWTH is the change in sales divided by total assets; MVB is the ratio of market value of equity to
book value of equity; TOBIN’s Q is the sum of market value of equity and market value of net debt
divided by total assets; ROE is return on equity; CEO_DIR is coded as 1 if the company’s CEO is also
the chairman of the board and 0 otherwise; OUTDIR is the ratio of outside directors to all directors;
FIRSTSH is the percentage of shares held by the largest shareholder; CONCEN is the difference Table I.
between the percentages of shares held by the largest shareholder and the sum of the percentage of Descriptive statistics
shares held by the second to the tenth largest shareholders. BIG4 is coded as 1 if a firm is audited by of sample firms by
one of the Big Four firms and 0 otherwise ownership structure
cross-sectional equation by year and by industry:
BTDit ¼ b0 þ b1 DINVit þ b2 DREVit þ b3 TAX_DIFFit þ b4 BTDit1 þ b5 DACit þ eit (2)
BTD is pre-tax book income × applicable tax rate (ATR) – current tax expense, divided
by lagged total assets; ΔINV is the change in investment in gross property, plant and
equipment, and intangible assets from year t−1 to year t, divided by lagged total assets;
ΔREV is the change in revenue from year t−1 to year t, divided by lagged total assets;
TAX_DIFF is the difference between the consolidated company’s ATR and the average
tax rate of its consolidated subsidiaries; BTDt_1 is the lagged BTD for firm i in year
t−1, divided by lagged total assets; DAC is discretionary accruals estimated from the
across-sectional modified Jones model with return on assets by year and by industry
(Dechow et al., 1995). Given that ABTD controls for the effects of earnings management
and regulatory factors on book and taxable income, it captures tax aggressiveness
more effectively than ETR measures. Lower METR and MCETR, together with higher
ABTD, are consistent with greater levels of tax avoidance.
ARA To test the second hypotheses, I use the following cross-sectional equation:
24,3
TUL ¼ b0 þ b1 HTP þ b2 SOECG þ b3 SOELG þ b4 SOECGn HTP
þ b5 SOELGnHTP þ b6 LEV þ b7 SIZE þ b8 ROA
282 þ b9 GROWTH þ b912 CGcontrols þ e (3)

I include the interaction terms of SOECG*HTP and SOELG*HTP in Equation (3). HTP
is an indicator variable, coded as 1 if a firm is in the bottom METR (MCETR) quintile or
the top ABTD quintile, and 0 otherwise. The positive coefficients on SOECG*HTP and
SOELG*HTP support[10].
Good corporate governance mechanisms play an important role in protecting
investors against opportunistic behavior. I use the Big Four auditors, the board
structure, and its ownership concentration as proxies for governance. CEO_DIR is
coded as 1 if the company’s CEO is also the chairman of the board, and 0 otherwise;
OUTDIR is the ratio of outside directors to all directors; CONCEN is the difference
between the percentage of shares held by the largest shareholder and the sum of the
percentage of shares held by the second to the tenth largest shareholders. BIG4 is an
indicator variable coded as 1 if a firm is audited by one of the Big Four firms, and
0 otherwise. Prior literature has documented that Big Four auditors serve an important
role in monitoring management, improving overall corporate governance, and
protecting outside shareholders’ interests. The high-quality audits they provide help
verify a company’s disclosures about related-party transactions which makes it
difficult for controlling shareholders to conceal expropriation (Zerni et al., 2010).
As pointed out by Claessens et al. (2000), the more concentrated control is in the hands
of controlling shareholders, the more entrenched these shareholders are and the better
able they are to extract value from minority shareholders. Conversely, board structure
such as CEO independence and high percentage of outside directors can curb
controlling shareholders’ tunneling behavior. Correspondingly, I expect CONCEN and
CEO_DIR (BIG4 and OUTDIR) to be positively (negatively) related to TUL.
3.2 Sample selection

My sample consists of all non-financial Chinese B-share firms listed on Shanghai and
Shenzhen Stock Exchanges over a period from 1998 to 2004. I use B-share firms as a
sample based on several considerations. First, the ATR information is unavailable in
any database; I need to manually collect it from tax notes. Second, I hand collect data on
SOE classification by analyzing restructuring information and tracking ownership
back to the ultimate controlling shareholders. Third, B-share firms provide more
detailed disclosures as they are required to prepare financial reports in two languages
and under two sets of accounting standards: the Chinese-version under Chinese GAAP
and the English-version under International Accounting Standards (IAS) (Shevlin et al.,
2012)[11]. The IAS-based financial reports disclose detailed current tax expense, ATR,
and book-tax reconciliation information, avoiding measure errors resulting from tax
rate differentials across firms (Tang and Firth, 2012)[12]. In addition, weak accounting
standards and information disclosures may also facilitate tunneling activities. Using
B-share firms with dual accounting reporting systems and more sufficient disclosures,
I can alleviate the concern that the association between ownership structure and
tunneling is partially caused by these factors[13].
I choose the sample period because corporate governance data are not widely Tax avoidance
available before 1999. To make the data collection manageable, I focus on the period in Chinese
from 1999 to 2004[14]. Related-party receivables, corporate governance, and other
financial data are collected from the China Stock Market and Accounting Research
SOEs
(CSMAR) database[15].
I screen out firms with incomplete data (123 firm-years). As loss, net-operating loss
carry forwards, negative current tax expense, and negative income tax expense make it 283
difficult to interpret tax avoidance measures, I follow prior tax studies to remove these
firms (185 firm-years). I also exclude observations with zero ATR. This data screening
leaves me with a sample of 355 observations.
4. Empirical results
4.1 Descriptive statistics
Table I reports the descriptive statistics firms by ownership structure. During the
observation period, the sum of related-party receivable balances is 23.6 billion in RMB
(about US$3.87 billion), which amounts to 2.4 percent of total assets, 8.6 percent of sales
and 16.8 percent of cash flow from operations on average. As reported in Table I,
SOECG and SOELG firms exhibit more tunneling than others as measured by related-
party receivable. The means of TUL for SOECG and SOELG are 2.3 and 2.8 percent of
total assets, which are much higher than those for NONSOE (0.7 percent) and SAMB
(1.6 percent). T-tests and Wilcoxon signed-rank tests (untabulated) indicate that the
differences between SOELG (SOECG) firms and others are significant.
Among the sample firms, SOECG firms have the lowest ATR of 14.3 percent, which
is consistent with SOECG firms being granted tax privileges due to their strong
political connections (Shevlin et al., 2012). Not surprisingly, NONSOE firms engage in
more tax avoidance than other firms as measured by METR and MCETR. In contrast,
SAMB and SOELG firms appear to be less tax aggressive despite the fact that they are
taxed a relatively high ATR (20.3 and 21.1 percent). Interestingly, I find that SOECG
firms’ tax avoidance is higher than the sample means (as measured by ABTD, METR,
and MCETR) despite that they are taxed a very low ATR[16]. These results suggest
that Chinese firms’ tax avoidance decisions may be driven by other factors in addition
to tax burden considerations.
Parallel to prior studies, SAMB firms exhibit the lowest growth, ROE and MVB
and Tobin’s Q. Consistent with the nature of concentrated ownership, the shareholdings
of the largest shareholder account for 41.6 percent on average. Among our sample firms,
SOELG firms have the highest shareholding (45.3 percent) and the most concentrated
ownership (32.3 percent). SOECG and SAMB firms also have high shareholdings
(36.9 and 31.6 percent) but less concentrated ownership (16.7 and 21.3 percent).
Table II reports correlations among variables used in cross-sectional regressions.
The two effective tax rates (i.e. METR and MCETR) are highly correlated at 0.94. ABTD
is negatively correlated with METR and MCETR at 0.42 and 0.47, suggesting that
ABTD and ETR measures capture different aspects of tax avoidance. The correlation
analysis shows that TUL is positively correlated with SOELG (significantly) and SOECG
(insignificantly). There is a negative correlation between TUL and ROA, consistent with
controlling shareholders’ expropriation leading to poor performance of listed firms
( Jiang et al., 2010). The correlation coefficients between TUL and corporate governance
variables (e.g. CONCEN, BIG4, and GCG) are significant, suggesting that governance
mechanisms influence tunneling practices. All correlation coefficients among variables
are lower than 0.65, and thus multicollinearity is not a concern[17].
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Table II.
dependent,
control variables
independent, and
Correlations among
TUL 1 2 3 4 5 6 7 8 9 10 11 12 13 14
1. ABTD 0.03
2. METR 0.06 −0.42
3. MCETR 0.04 −0.47 0.94
4. SOECG 0.04 0.09 −0.03 −0.03
5. SOELG 0.13 −0.01 0.01 0.01 −0.52
6. SAMB −0.01 −0.10 0.02 0.03 −0.09 −0.28
7. LEV 0.08 0.00 0.08 0.09 0.05 −0.05 −0.04
8. ROA −0.10 0.41 −0.39 −0.40 0.07 −0.09 0.03 −0.33
9. SIZE −0.06 −0.18 −0.10 −0.11 0.08 −0.11 0.10 0.03 0.12
10. GROWTH −0.04 0.00 0.02 0.03 −0.01 0.03 −0.08 0.21 0.11 0.06
11. CEO_DIR −0.06 0.05 −0.11 −0.09 −0.12 −0.15 0.10 −0.17 0.19 −0.10 0.04
12. CONCEN 0.19 0.11 −0.05 −0.05 0.06 0.66 −0.05 −0.07 −0.03 −0.13 0.05 −0.09
13. OUTDIR 0.06 0.01 0.06 0.04 −0.16 0.13 0.13 0.03 0.07 0.09 0.01 −0.11 0.10
14. BIG4 −0.20 −0.16 −0.08 −0.06 0.11 −0.16 0.04 −0.40 0.23 0.19 −0.12 0.07 −0.09 −0.04
15. GCG −0.14 −0.16 0.00 0.04 −0.12 −0.20 0.14 −0.16 0.13 0.19 −0.09 −0.02 −0.32 0.24 0.61
Notes: TUL is the amount of related-party receivables owed by a parent firm and other related firms under control of the same parent company, divided by
total assets; ABTD is abnormal BTD; METR is ratio of GAAP ETR to ATR; GAAP ETR is measured as income tax expense divided by before-tax profit;
MCETR is the ratio of CETR to ATR; CETR is measured as current tax expense divided by before-tax profit; ATR is the tax rate applicable to the listed firm
after considering tax incentives. TUL is the amount of related-party receivables owed by a parent firm and other related firms under control of the same parent
company, divided by total assets; SOECG is the percentage of shares owned by a SOE controlled by the central government as a controlling shareholder;
SOELG is the percentage of shares owned by a SOE controlled by the local government as a controlling shareholder; SAMB is the percentage of shares owned
by the state agencies. ROA is return on assets; LEV is a ratio of total liabilities to total assets; SIZE is the log of total assets; GROWTH is the change in sales
divided by total assets; CEO_DIR is coded as 1 if the company’s CEO is also the chairman of the board and 0 otherwise; OUTDIR is the ratio of outside directors
to all directors; CONCEN is the difference between the percentages of shares held by the largest shareholder and the sum of the percentage of shares held by
the second to the tenth largest shareholders. BIG4 is coded as 1 if a firm is audited by one of the Big Four firms and 0 otherwise. GCG is coded as 1 for firms
whose auditors are one of the Big Four auditors, ownership concentration is below the lowest quintile of the sample, percentage of outside director is above the
highest quintile of the sample, and firms with no CEO duality. Italic font denotes the significance at the 1 and 5 percent levels (two-tailed)
4.2 Regression results Tax avoidance
I first examine whether SOECG and SOELG firms engage in more tunneling activities as in Chinese
they have a greater shareholding, given their strong incentives and ability to divert
resources to the unlisted parent company as discussed in Section 2. Table III reports the
SOEs
regression results. In Column (1), I estimate Equation (1) without controlling for firm
characteristics. Consistent with H1, Column (1) shows that the coefficients on SOECG
and SOELG are significantly positive above the 0.05 level. In Column (2), I include firm 285
characteristic controls. The inference that SOECG and SOELG firms with a great
shareholding experience more tunneling persists. On average, a 1 percent increase in
SOECG (SOELG) ownership leads to a 7.2 percent (6.5 percent) increase in tunneling on
average. The coefficient tests show no significant difference in TUL between SOECG and
SOELG in Table III. This finding is consistent with Lo et al. (2010) who find evidence that
government-owned firms engage in more tunneling as their shareholdings increase[18].
I find no evidence that SAMB firms engage in more tunneling.

Next, I test whether incompletely restructured SOELG and SOECG firms exploit tax
avoidance to help tunneling as predicted in H2. Table IV reports regression results on
the interplay of tax avoidance and tunneling using three tax avoidance measures.
In Columns (1)-(3), I estimate Equation (3) without controlling for corporate governance
factors. Consistent with H2, I find that the coefficients on SOECG*HTP are
significantly positive above the 0.05 level using ABTD (coefficient ¼ 0.173,
t-stat ¼ 3.14), METR (coefficient ¼ 0.113, t-stat ¼ 2.52), and MCETR (coefficient
¼ 0.145, t-stat ¼ 3.45). These results indicate that tax aggressive SOECG firms tunnel
more value than non-tax aggressive SOECG firms do as their shareholdings increase.
Ceteris paribus, the tunneling magnitude for high tax avoidance SOECG firms
increases by 17.3 percent than that for low tax avoidance SOECG firms (using ABTD),
suggesting that SOECG firms’ tax avoidance is associated with their tunneling
activities. These results are consistent with Desai and Dharmapala (2006) who suggest
that tax avoidance may facilitate tunneling. However, I find no significant difference in
Dependent variable (TUL) Predicted sign Column 1 Column 2
SOECG + 0.072 (2.56)** 0.072 (2.43)**

SOELG + 0.064 (3.23)*** 0.065 (3.23)***
SAMB ? 0.070 (1.30) 0.071 (1.31)
LEV ? 0.033 (1.39)
ROA ? −0.060 (−0.51)
SIZE ? −0.004 (−0.86)
GROWTH ? −0.017 (−1.19)
Intercept −0.007 (−0.64) 0.041 (0.63)
Industry fixed effect YES YES
Year fixed effect YES YES
n 355 355
Adjusted R2 0.022 0.030
Notes: This table presents results of Equation (1):
TUL ¼ b0 þb1 SOECG þb2 SOELG þ b3 SAMB þb4 LEVþ b5 ROAþ b6 SIZE þ b7 GROWTH þe
Table III.
All variables are defined as in Table II. All regressions include year and industry effects as well as The relation between
heteroskedastisticity-consistent standard errors that have been adjusted for clustering at the firm level. tunneling and
**,***Two-tailed statistical significance at the 5 and 1 percent levels, respectively ownership structure
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tunneling
Table IV.
between tax
avoidance and
The interaction
Predicted (1) (2) (3) (4) (5) (6)
Dependent variable (TUL) sign ABTD METR MCETR ABTD METR MCETR
HTP ? −0.006 (−0.71) 0.008 (0.71) 0.007 (0.57) −0.016(−1.54) −0.001 (−0.14) −0.002 (−0.16)
SOECG + 0.019 (0.80) 0.027 (0.97) 0.024 (0.91) −0.020(−0.62) −0.006 (−0.18) −0.009 (−0.29)
SOELG + 0.062 (2.82)*** 0.065 (2.94)*** 0.065 (2.93)*** 0.009(0.39) 0.018 (0.81) 0.017 (0.78)
SOECG*HTP + 0.173 (3.14)*** 0.113 (2.52)** 0.145 (3.45)*** 0.181(3.39)*** 0.118 (2.60)** 0.147 (3.24)***
SOELG*HTP + −0.029 (−1.21) −0.042 (−1.46) −0.044 (−1.43) −0.027(−1.19) −0.034 (−1.38) −0.039 (−1.52)
LEV ? 0.036 (1.50) 0.035 (1.44) 0.039 (1.57) 0.011(0.56) 0.013 (0.65) 0.016 (0.81)
ROA ? −0.069 (−0.63) −0.091 (−0.80) −0.101 (−0.90) 0.007(0.06) −0.030 (−0.27) −0.041 (−0.38)
SIZE ? −0.003 (−0.65) −0.002 (−0.52) −0.002 (−0.51) −0.000(−0.04) 0.000 (0.01) 0.000 (0.00)
GROWTH ? −0.012 (−0.81) −0.018 (−1.20) −0.017 (−1.14) −0.017(−1.09) −0.023 (−1.51) −0.023 (−1.45)
CEO_DIR + −0.005(−0.51) −0.004 (−0.42) −0.004 (−0.39)
CONCEN + 0.046(2.82)*** 0.040 (2.58)** 0.041 (2.65)***
OUTDIR − 0.010(0.40) 0.009 (0.33) 0.008 (0.31)
BIG4 − −0.035(−2.66)*** −0.033 (−2.58)** −0.033 (−2.58)**
intercept ? 0.020 (0.32) 0.010 (0.15) 0.008 (0.13) 0.033(0.50) 0.026 (0.37) 0.024 (0.35)
Industry fixed effect Yes Yes Yes Yes Yes Yes
Year fixed effect Yes Yes Yes Yes Yes Yes
n 355 355 355 355 355 355
2
adj. R 0.060 0.044 0.054 0.109 0.085 0.094
Note: This table presents the results for Equation (3):
TUL ¼ b0 þb1 HTPþ b2 SOECG þ b3 SOELG þ b4 HTPnSOECG þb5 HTPnSOELG
þ b6 LEV þb7 SIZE þb8 ROA þb9 GROWTHþ b912 CGcontrols þ e
HTP is coded as 1 if the size of ABTD (METR and MCETR) is at the highest (lowest) quintile of the sample. All variables are defined as in Table II. All
regressions include year and industry effects as well as heteroskedastisticity-consistent standard errors that have been adjusted for clustering at the firm level.
**,***Two-tailed statistical significance at the 5 and 1 percent levels, respectively
tunneling between tax aggressive and non-tax aggressive SOELG firms, indicating Tax avoidance
that SOELG firms’ tunneling does not vary with the tax avoidance level. in Chinese
While both SOECG and SOELG firms have strong incentives and ability to
expropriate, different political and tax audit risks may influence their tunneling-
SOEs
related tax avoidance practices. In contrast to SOELG firms that are monitored by
different provincial or municipal governments, SOECG firms are tied closely to the
central government and largely represent the image of the state. Their misbehavior is 287
more easily magnified by the press and easily triggers social dissatisfaction[19].
Given the political risk consideration, devices that conceal their tunneling and
reduce the likelihood of detection would be more favored by SOECG firms.
Furthermore, SOECG firms appear to have lower tax audit risks than SOELG firms
due to different levels of political connections and tax monitoring mechanisms
(Shevlin et al., 2012)[20]. In addition, the fact that SOECG firms are taxed a
significantly low ATR gives a misperception to the taxing authorities that SOECG
firms have no reason to be tax incompliant, which in turn substantially lowers
the risk of being audited and caught. The consideration of political risks and tax
avoidance costs may partially explain why SOECG firms couple tax avoidance with
tunneling while SOELG firms do not.
In Columns (4) and (6), I control for corporate governance factors and prior
results remain unchanged. As predicted, firms with high ownership concentration
exhibit a higher level of tunneling whereas Big Four auditors play a deterrent
role in tunneling. As a robustness check, I re-estimate Equation (3) by replacing
HTP with using a raw tax avoidance variable (TP). The results (untabulated)
show that the interaction term of SOECG*TP is positively (negatively) associated
with TUL based on ABTD (METR and MCETR). I continue to find no significant
relation between SOELG*TP and TUL, suggesting that SOELG firms are less
likely to avoid taxes for tunneling purposes. The overall results are substantially
similar to those in Table IV.
I use a continuous variable to measure ownership structure. In an additional test
(untabulated), I rerun Equation (3) using an indicator variable under which SOECG is
coded as 1 if the firm’s largest shareholder is a state-owned firm controlled by the
central government, and SOELG is coded as 1 if the largest shareholder is a state-
owned firm controlled by the local government. I find that prior results are qualitatively
similar. The coefficient on SOECG*HTP is positively associated with TUL based on
ABTD (coefficient ¼ 0.067, t-stat ¼ 2.50), METR (coefficient ¼ 0.054, t-stat ¼ 2.51), and
MCETR (coefficient ¼ 0.059, t-stat ¼ 2.55). The coefficient on SOELG*HTP continues
to be insignificant using three specifications. Overall, the fact that SOECG firms with a
greater level of tax avoidance extract more resources from minority shareholders is in
support of the interaction of tunneling and tax avoidance.
Liu and Lu (2007) find evidence that earnings management can serve for
expropriation purposes. To control for this effect on the tests, I include discretionary
accruals as a control variable in Equations (1) and (3). The results (untabluated)
indicate that the inclusion of DAC does not change prior inferences.
Finally, to control for the effect of normal operations on related-party receivable,
I employ an industry-adjusted TUL (ADJTUL) as an alternative tunneling
measure. ADJTUL is measured by the difference between firm-year level TUL and
the mean of industry-year TUL. I re-estimate Equations (1) and (3) with
this alternative measure and report the results in Table V. I find that prior results
do not qualitatively alter.
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Table V.
adjusted TUL
with the industry-
Robustness checks
Dependent
variable: (3) (4) (5) (6) (7) (8)
ADJTUL (1) (2) ABTD METR MCETR ABTD METR MCETR
SOECG 0.060 (2.27)** 0.061 (2.10)** 0.028 (1.15) 0.026 (0.92) 0.025 (0.93) −0.015 (−0.46) −0.012 (−0.33) −0.014 (−0.41)
SOELG 0.055 (2.98)*** 0.054 (3.04)*** 0.062 (3.02)*** 0.060 (2.97)*** 0.060 (2.96)*** 0.007 (0.33) 0.010 (0.48) 0.010 (0.44)
HTP −0.001 (−0.10) 0.006 (0.52) 0.004 (0.34) −0.010 (−0.99) −0.003 (−0.33) −0.004 (−0.39)
SOECG*HTP 0.135 (2.44)** 0.113 (2.57)** 0.137 (3.54)*** 0.142 (2.60)** 0.117 (2.63)*** 0.140 (3.37)***
SOELG*HTP −0.036 (−1.44) −0.031 (−1.08) −0.031 (−1.03) −0.033 (−1.36) −0.023 (−0.91) −0.025 (−0.97)
LEV 0.016 (0.85) 0.020 (1.03) 0.019 (0.96) 0.022 (1.10) 0.000 (0.01) 0.001 (0.08) 0.004 (0.26)
ROA −0.114 (−1.03) −0.117 (−1.12) −0.149 (−1.40) −0.155 (−1.46) −0.047 (−0.45) −0.089 (−0.87) −0.097 (−0.94)
SIZE −0.003 (−0.61) −0.002 (−0.51) −0.001 (−0.33) −0.002 (−0.35) −0.000 (−0.03) 0.000 (0.09) 0.000 (0.06)
GROWTH −0.009 (−0.90) −0.004 (−0.36) −0.008 (−0.76) −0.007 (−0.68) −0.009 (−0.74) −0.014 (−1.19) −0.013 (−1.12)
CEO_DIR −0.006 (−0.65) −0.005 (−0.58) −0.005 (−0.57)
CONCEN 0.048 (2.83)*** 0.043 (2.60)** 0.044 (2.70)***
OUTDIR 0.007 (0.28) 0.004 (0.17) 0.004 (0.16)
BIG4 −0.029 (−2.24)** −0.028 (−2.19)** −0.028 (−2.18)**
_cons −0.020 (−1.88)* 0.020 (0.32) 0.004 (0.07) −0.008 (−0.13) −0.007 (−0.12) 0.020 (0.32) 0.011 (0.17) 0.012 (0.18)
Industry and Yes Yes Yes Yes Yes Yes Yes Yes
year FE
n 355 355 355 355 355 353 353 353
Adj. R2 0.005 0.008 0.034 0.024 0.031 0.075 0.058 0.066
Notes: ADJTUL is measured as the difference between firm-year TUL and the mean of industry-year TUL. All variables are defined as in Tables II and IV.
All regressions include heteroskedastisticity-consistent standard errors that have been adjusted for clustering at the firm level. **,***Two-tailed statistical
significance at the 5 and 1 percent levels, respectively
4.3 The impact of corporate governance on tunneling and tax avoidance interaction Tax avoidance
In this section, I further examine whether the quality of corporate governance in Chinese
influences SOECG and SOELG firms’ tunneling-related tax avoidance activities.
The role of corporate governance in the link between tax avoidance and tunneling
SOEs
has appeared in recent studies. For example, Desai et al. (2007) suggest that managers
or controlling shareholders of firms in countries with weak governance find it easy to
engage in rent diversion activities and so have greater incentives to avoid 289
taxes. Wilson (2009) maintains that corporate governance is an important factor
in determining whether tax sheltering is associated with wealth creation or
managerial opportunism. He finds that poorly governed tax shelter firms
underperform the well-governed shelter firms. Current studies (e.g. Desai and
Dharmapala, 2009) suggest that poorly governed firms are more likely to use tax
avoidance to facilitate rent extraction.
If strong corporate governance enhances investor protection that limits insiders’

ability to acquire private control benefits, firms’ incentives of exploiting tax avoidance
to conceal and facilitate rent diversion will be mitigated. As such, the interaction
between tax avoidance and tunneling will be attenuated for well-governed firms. To
test the impact of corporate governance on SOE firms’ tunneling-related tax avoidance,
I limit the sample to SOELG and SOECG firms to ease the interpretation. I employ a
triple differences method by regressing TUL on GCG, SOECG*HTP and the interaction
term of GCG*SOECG*HTP. GCG represents well-governed firms and is coded as 1 if
firms have Big Four auditors, ownership concentration that is below the top quintile of
the sample, the percentage of outside director is above the bottom quintile of the
sample, and firms have no CEO duality[21].
As manifested in Panel A of Table VI, the coefficient on GCG*SOECG*HTP (β7) is
significantly negative, indicating that SOECG firms exhibit a significant decline in the
tunneling-related tax avoidance for well-governed firms than that for poorly governed
firms. The coefficient tests in Panel B further reveal that, when firms are poorly
governed, tax aggressive SOECG firms tunnel more than tax aggressive SOELG firms
(β6). However, there is no difference in the tunneling-tax avoidance interplay between
SOELG and SOECG firms for well-governed firms (β6 + β7 is positive but insignificant).
Furthermore, the interaction of tax avoidance and tunneling is weaker for well-
governed SOECG firms than that for poorly governed SOECG firms (β5 + β7 is
significantly negative). These results confirm that the quality of corporate governance
is an important factor that constrains controlling shareholders from using tax
avoidance to facilitate tunneling.
5. Conclusions
By analyzing the evolution and features of government ownership shaped by the
unique privatization process in China, this paper investigates whether ownership
structure affects firms’ tunneling and the interaction between tax avoidance and
tunneling. It also examines the impact of corporate governance mechanisms on
tunneling-related tax avoidance decisions. I find that SOELG and SOECG firms formed
by the incomplete restructuring process engage in more tunneling activities as their
shareholding increases. I further find that a subset of incompletely restructured firm
(i.e. SOECG) avoid taxes to serve for tunneling. While coupling tax avoidance with
tunneling may be subject to the cost-benefit consideration, the results from the triple
differences analysis indicate that good corporate governance plays an important role in
deterring the diversionary tax avoidance.
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corporate
Table VI.
The effect of
tunneling and tax

governance on the
avoidance interaction
Panel A: regression results
Dependent variable: TUL (1) (2) (3)
β ABTD METR MCETR
GCG β1 −0.017 (−1.34) −0.016 (−1.30) −0.017 (−1.35)
SOECG β2 −0.039 (−1.07) −0.029 (−0.71) −0.035 (−0.92)
HTP β3 −0.032 (−2.39)** −0.020 (−1.58) −0.025 (−1.85)*
GCG*HTP β4 0.030 (1.78)* 0.026 (1.63) 0.029 (1.72)*
GCG*SOECG β5 −0.035 (−0.82) −0.040 (−0.91) −0.035 (−0.82)
SOECG*HTP β6 0.292 (5.32)*** 0.169 (3.26)*** 0.215 (4.84)***
GCG*SOECG*HTP β7 −0.239 (−4.85)*** −0.108 (−1.70)* −0.155 (−2.76)***
CONTROLS Yes Yes Yes
Industry and year fixed effects Yes Yes Yes
n 300 300 300
adj. R2 0.059 0.019 0.034
Panel B: coefficient analysis between groups
ABTD METR MCETR
Test of coefficients β Difference F-stat p-value Difference F-stat p-value Difference F-stat p-value
HTP SOECG with GCG vs.
HTP SOELG with GCG β6 + β7 0.053 1.67 0.20 0.061 1.14 0.79 0.06 1.09 0.30
HTP SOECG with weak CG
vs. HTP SOELG with weak
CG β6 0.292 28.32*** 0.00 0.169 10.63*** 0.001 0.215 23.44*** 0.00
HTP SOECG with GCG vs.
HTP SOECG with weak CG β5 + β7 −0.274 61.39*** 0.00 −0.148 8.83*** 0.003 −0.19 19.83*** 0.00
Notes: This table presents the regression results of whether good corporate governance affects tunneling-tax avoidance interactions for SOECG and SOELG
firms. HTP is coded as 1 if the size of ABTD (METR and MCETR) is at the highest (lowest) quintile of the sample. All variables are defined as in Table II.
Control variables include LEV, ROA, SIZE and GROWTH. All regressions include heteroskedastisticity-consistent standard errors that have been adjusted for
clustering at the firm level. *,**,***Two-tailed statistical significance at the 10, 5 and 1 percent levels, respectively
The results of this study have several key implications. First, the findings of the Tax avoidance
interplay of tax avoidance and tunneling in SOECG firms advance our understanding in Chinese
of the incentives behind tax avoidance behavior and shed light on a long unsolved
mystery of why state-owned firms avoid taxes. Second, evidence on tunneling-related
SOEs
tax avoidance suggests that tax avoidance is not always beneficial to outside investors
and alters investors to the potential risk of being expropriated when they invest in
SOECG firms that exhibit a high level of tax avoidance. Third, the tunneling activities 291
by SOE firms in China are partially attributable to the design and implementation of
SOE reforms. The privatization experience from China may provide a valuable
reference for other emerging economies that are characterized by concentrated
government ownership and weak corporate governance mechanisms.
Notes
1. According to a national survey reported by Garnaut et al. (2005), 86 percent of SOEs had
been through restructuring (gaizhi) by the end of 2001, and 70 percent had been fully or
partially privatized. State entities, as the largest shareholder, hold an average stake of
65 percent of the listed firm in 2005 in the form of non-tradable shares (Green, 2003).
2. Following prior studies (e.g. Desai et al., 2007), tunneling is defined as the straightforward
looting of the firm and any actions benefiting controlling shareholders that are not in the
interests of minority shareholders, such as fund misappropriation, outright theft, loan
guarantees, and selling assets or products below market prices.
3. Prior tunneling studies examine the effect of government ownership without distinguishing
among these three types of ownership because their research questions are different from
this study. For example, Aharony et al. (2010) and Wang and Xiao (2011) only focus on
SOEs whereas other studies (e.g. Jian and Wong, 2010; Jiang et al., 2010) partition SOEs
into SOELG and SOECG firms.
4. Although China has experienced a series of SOE reforms in the past two decades,
approximately 50 percent of listed firms in China’s capital markets are still government-
owned by the end of 2011.
5. In the first 11 months of 2010, global IPO volume reached US$255.3 billion in 1,199 deals.
Among them, 422 deals (37 percent) which raised US$117.9 billion (46 percent) are issued by
Chinese companies. Global SOE privatization accounted for 82 IPOs worth US$78.3 billion.
Of 82 privatization deals, 63 deals from Chinese issuers. six of the top ten IPOs are former
SOEs (www.ey.com/Publication/vwLUAssets/Year- end_global_IPO_update_2010/$FILE/
2010_Year_End_Global_IPO_update.pdf).
6. Minimizing the bankruptcy of unlisted state-owned firms and state banks can help maintain
the employment rate and eliminate financial chaos.
7. Prior studies suggest that non-state firms are subject to more tax scrutiny and harsh
penalties than politically connected firms (proxied by government ownership) (Adhikari
et al., 2006; Chen et al., 2011).
8. A survey conducted by China Securities Journal reports that fund misappropriation by
controlling shareholders and other related parties has led to a large amount of outstanding
debts in listed firms which accounts for 57.5 billion RMB in 2003 (e.g., accounts receivable,
other receivables, and advance payments). I also use an industry-adjusted alternative to
control for the effect of normal operations on related-party receivables in a robustness test.
The results remain unchanged.
9. Tang and Firth (2012) include tax loss and tax loss utilized variables to test the impact of
book-tax differences on earnings persistence. As the purpose of this study is to test the
ARA tunneling and its interaction with tax avoidance, firms with a loss, net-operating loss carry
forwards, negative current tax expense, and negative income tax expense are removed.
24,3
10. To test H2, I exclude SAMB in Model (3) because my interest is focussed on whether incomplete
restructured SOE firms avoid taxes to facilitate tunneling. SAMB firms have the least
incentives for tunneling as discussed in Section 2 and Figure 1, and exhibits the lowest level of
tax avoidance (See Table I), which is not the group of interest. Also, including SAMB × HTP
292 may have the near singular metric concern since all SAMB × HTP variables are zero.
11. A-shares and B-shares are two types of publicly tradable shares on the China’s Stock
Exchanges. A-shares are traded in Renminbi (RMB) by domestic investors. B-shares are
traded in either US dollars on the Shanghai Exchange or Hong Kong dollars on the Shenzhen
Exchange, and held by foreign entities and foreign individuals. Chinese listed firms can issue
either A-shares or B-shares, or both. Among the sample, 83 percent of firm-years also issue
A-shares. As a result, the results from this sample are generalizable to A-share firms.
12. Almost all A-share firms use the tax payable method under Chinese GAAP and do not
provide book-tax reconciliation information. In contrast, all B-share firms are required to
adopt the tax effect method under IAS, allowing the current effective tax rate and book-tax
differences to be measured in a comparable way to those in the US studies.
13. While this advantage may compromise the sample size, I collect data of A-share firms from
2007 to 2012 and re-estimate Model (1). Because A-share firms adopted IFRS starting from
2007, similar results will suggest that the prior results from B-share firms can be applied to
A-share firms that also adopt a high-quality accounting standard and applied to the newest
period. I find the results are similar to those in Table III (untabulated).
14. As some lagged variables are required to estimate ABTD and DAC, the final sample
focusses on the period from 1999 to 2004.
15. The CSMAR database is commonly used in China’s research and incorporated in the
Wharton School’s WRDS platform.
16. The t-tests show that the mean of ATR for SOECG is significantly lower than that for
NONSOE, SAMB and SOELG.
17. Note that METR and MCETR are alternative measures for tax avoidance. They will not
appear in the model simultaneously.
18. Prior studies provide mixed evidence on the association between tunneling and government
ownership due in part to different measures of tunneling. For example, Jiang et al. (2010,
Table VI) use raw values of other receivables owed by controlling shareholders or their
affiliates. They find that SOEs are less tunneled by controlling shareholders than non-SOEs.
In contrast, Wang and Xiao (2011) measure tunneling as other receivables owed by
controlling shareholders only and find no significant relationship between SOEs and
tunneling. My tunneling proxy includes accounts/note receivable arising from related-party
sales to the parent company and its affiliates, as well as other receivables due to related-
party loans made to the parent company and its affiliates. I also use an industry-adjusted
alternative to control for the effect of normal operations on related-party receivables in a
robustness test. The results are qualitatively similar (see Table V). In addition, prior studies
use an indicator variable of SOE and do not exclude SAMB firms that have weak incentives
for tunneling due to the complete restructuring process as discussed in Section 2.1. In this
study, SOELG and SOECG firms are defined as incompletely restructured SOE firms.
19. Although there is no clear law to punish controlling shareholders’ expropriation, the severe
insider tunneling by state-owned firms has been continuously revealed and has caused harsh
criticism from the public. To maintain the government’s reputation, the Chinese Government
has to issue a series of regulations to stop the occurrence of related-party corporate loans and
induce repayment of outstanding debt by parent companies (see Aharony et al., 2010).
20. Politically connected firms obtain government privileges and are subject to less tax scrutiny Tax avoidance
(Adhikari et al., 2006). Among three government-owned firms, SAMB firms have the
strongest connection with the government, SOECG firms are in the middle, and SOELG
in Chinese
firms have the least connection. SOEs
21. These variables have been documented to be a proxy for good corporate governance and
affect tunneling in prior studies. For brevity, I construct GCG by integrating these variables.
This method is similar to some corporate governance studies that use a corporate governance 293
score (index) to test corporate-governance-related research questions (e.g. Render and
Gaeremynck, 2012).
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Corresponding author
Tanya Y.H. Tang can be contacted at: ttang@brocku.ca
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Asian Review of Accounting

Privatization, tunneling, and tax avoidance in Chinese SOEs

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Received 12 August 2014 Abstract

restructuring process has a significant impact on the subsequent controlling

(SAMB) Incomplete restructuring by carving-out

Listed firms owned by Listed firms owned by

banks, preventing non-listed parent SOEs from bankruptcy to maintain local

2.2 Tunneling and tax avoidance interaction 279

280 3. Sample and research design

TUL ¼ b0 þ b1 SOECG þ b2 SOELG þ b3 SAMB þ b4 LEV

þ b5 ROA þ b6 SIZE þ b7 GROWTH þ e (1)

ROE 0.121 0.117 0.178 0.098 0.158

cross-sectional equation by year and by industry:

BTDit ¼ b0 þ b1 DINVit þ b2 DREVit þ b3 TAX_DIFFit þ b4 BTDit1 þ b5 DACit þ eit (2)

þ b5 SOELGnHTP þ b6 LEV þ b7 SIZE þ b8 ROA

282 þ b9 GROWTH þ b912 CGcontrols þ e (3)

3.2 Sample selection

I find no evidence that SAMB firms engage in more tunneling.

Dependent variable (TUL) Predicted sign Column 1 Column 2

SOECG + 0.072 (2.56)** 0.072 (2.43)**

If strong corporate governance enhances investor protection that limits insiders’

tunneling and tax

income shifting: an empirical analysis of the transfer pricing behavior of Chinese-listed

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SOECG + 0.072 (2.56) 0.072 (2.43)