Discussion Papers In Economics
And Business
Taxes, corporate takeovers, and steptransactions
Kazuki Onji and Roger H. Gordon

Discussion Paper 21-16

November 2021

Graduate School of Economics
Osaka University, Toyonaka, Osaka 560-0043, JAPANTaxes, corporate takeovers, and step transactions
Kazuki Onji and Roger H. Gordon∗
October 2021

Abstract
Taxes affect the size of a corporate takeover market in theory; the extant empiricalstudies from the US data offer limited such evidence. We consider Japan after 2001,
which offers an alternative setting in which a tax system implicitly subsidizes mergers
that follow a particular sequence of steps (“step transactions”). We construct a novel
dataset on step transactions from a list of takeover deals from 1996 through 2013 andexamine their utilization rates before and after Japan’s tax reform of 2001. We find astatistically and economically significant discontinuity across the two regimes. We also
examine tax payments using a panel dataset of firms from 1997 through 2013 and find astrong association between unexplained falls in tax payments and step transactions. The
Japanese tax system provided subsidies to marginal as well as infra-marginal mergers
among domestic corporations: we estimate tax expenditure to be ¥172.3 billion.
JEL Classification: H25, H26, G34, H32
Keywords: Tax Avoidance, M&A, Corporate Restructuring∗Onji (corresponding author): Graduate School of Economics, Osaka University; Gordon: Department of
Economics, University of California at San Diego. Email addresses: kazuki.onji@econ.osaka-u.ac.jp (Onji),rogordon@ucsd.edu (Gordon). We thank Joel Slemrod, Jim Hines, Ron Masulis, Julie Cullen, and seminar
participants at UMich, UCSD, UNSW, ANU(RSE, AJRC), SWET 2016, and Policy Research Institute at MoF(Japan), for comments and suggestions. Research School of Asia and the Pacific at ANU and JSPS KAKENHI(15K03510, 25885050) provided financial supports. Kōji Asano and Masashi Tanaka provided excellent research
assistance. All remaining errors are ours.

1

Introduction

Corporate takeovers are an important means through which productive resources are reallocated (Andrade et al., 2001; Holmstrom and Kaplan, 2001; Martynova and Renneboog, 2008).
The role of taxes in the takeover market are of long-standing interest (Butters and Lintner,
1951; Mandelker, 1974); takeover deals often involve considerable payout, and thus, the efficiency consequences can be enormous if taxes influence deal formations.1 The seminal empiricalstudies by Auerbach and Reishus (1986, 1988b) find no effect of taxes on the size of a takeovermarket. While subsequent studies report significant influences (Ayers et al., 2007), the prevailing view in the literature is that taxes are probably of secondary importance in deal formationand constitute windfall gains or losses (Shackelford and Shevlin, 2001; Betton et al., 2008;
Hanlon and Heitzman, 2010).2
The literature adopts this view from studies mainly on the US economy in which the tax law
limits tax benefits from takeovers. If an acquirer could fully carry over the net operating loss
(NOL) of a target and offset that NOL against its own profits, then the acquirer’s valuationof target with a large NOL would be higher by the amount of tax saving compared to its
valuation absent carryover. However, the US institution sets limits to the carryover of NOL
upon ownership changes (Scholes and Wolfson, 1990), and Devos et al. (2009) find tax benefits
to be a minor component of takeover premia. The lack of findings on the effects of NOL after
the Tax Reform Act of 1986 (TRA1986) in the US could be due to the legal environment which
restricts carryover of NOL. More generally, tax incentives in the US might have been too small
for statistical analysis to detect.
We consider an alternative setting, Japan, where a Supreme Court ruling in 2016 foundthere has been large tax incentives favoring mergers.3 Japan differs from the US not justin terms of specific tax laws but also in terms of the legal tradition and attitude of the tax
enforcement agency. We show that in Japan, acquirers can reduce after-tax costs of takeoverpremium substantially by applying takeover schemes developed in response to the tax reformof 2001: the net-of-tax cost of an additional dollar spent on an acquisition can be as low
as a quarter by applying one of the schemes. The 2001 reform overhauled tax treatments
For example, a landmark deal between AOL and Time Warner in 2000 amounted to $164 billion.
Certainly, the literature has found influences on other aspects of takeover deals, providing evidence thattax considerations affect takeover premiums and forms of transactions.
3
Appendix provides details of this case involving Yahoo! Japan.
121

of shareholders and acquiring firms by instituting explicit conditions that apply for tax-freetransactions, including carryover of NOL. Tax avoidance schemes developed in response to the2001 reform involve merging in two steps to fulfill the conditions necessary for preferable tax
treatment: the acquirer first purchases shares in the target firm from the firm’s shareholders,
and then merges with the target firm.
The goal of this study is to provide evidence that is relevant in assessing the impacts oftaxes in the market for corporate takeovers. Two-step mergers can reduce the effective pricesof target companies. In theory, a reduction in price induces deals at the margin of realization
to form, increasing merger activity. The option of a two-step merger however can induce inframarginal deals, or parties that would have merged directly absent tax motives, to opt to merge
in two steps if the latter has tax advantages. Distinguishing between these two responses isimportant, but since the utilization itself is not well understood beyond the aforementioned
court case, our study takes a first step toward filling this gap in knowledge.
The key challenge is then to identify the frequency with which mergers are preceded bymajority acquisitions of the target firm’s shares. We employ a list of adopters of tax avoidance
schemes constructed from a dataset on takeover deals by focusing on key observable featuresof the schemes, that is, that those schemes involve two steps. We employ a list of mergers andacquisitions (M&As) compiled by a private M&A consultant firm, RECOF, to obtain a subsetof mergers that involve prior acquisitions. We find 507 cases completed from 2001 through 2010
in a sample of large domestic takeover deals. Durations between steps does not appear longenough for acquirers to make substantial operational adjustments in targets in many cases:
one-quarter of the two-step mergers cases involve durations between steps of seven months orless.
We analyze two aspects of tax avoidance schemes: the utilization rate and tax payment.
First, we examine the probability that a majority acquisition precedes a merger between independent domestic firms in a sample of third-party mergers, and test whether the probabilities
differ before and after the 2001 reform. The sample period for the baseline analysis is 1997–
2010. The RECOF list begins in 1996 and determines the beginning year of the sample periodthat is not affected by left-censoring. A tax change in 2010, which closed one of the schemes,
determines the ending year. We apply regression discontinuity (RD) design and estimate lin-2

ear probability models to examine if there is a discontinuity in 2001. We find a statisticallyand economically significant discontinuity, particularly for the information and communication
technology (ICT) sector. The finding is robust to various specification checks: varying sample
periods, specification of the running variables, and definition of two-step mergers.
Second, we check whether acquiring firms in two-step mergers pay “unusually” small amountsof corporate tax. Specifically, do firms that engage in two-step mergers exhibit an unexplained
fall in tax payments during financial years when two-step mergers take place? We obtain financial information from NEEDS-Financial Quest to construct a panel dataset of 5,496 publicly
traded firms spanning 1997–2013 and augment the dataset with the list of two-step mergers.
We find a statistically and economically significant reduction in tax payments after two-stepmergers. The total savings from 2001–2013 is ¥172.3 billion and the sample of publicly tradedfirms saved nine times as much taxes as that documented in the court case.
Our study contributes to investigations into the effects of tax attributes of target firms on
takeover activities by providing evidence from a setting in which the legal environment differ
markedly from that of the US (Auerbach and Reishus, 1988b,a; Hayn, 1989; Plummer andRobinson, 1990; Scholes and Wolfson, 1990; Erickson, 1998; Moore and Pruitt, 1987; Henning etal., 2000; Devos et al., 2009; Chiang et al., 2014; Steffens, 2015). While a Japanese legal scholar
predicted an increase in tax-preferred forms of transaction soon after the 2001 reform (Kimura,2002), we are not aware of any attempt to test that prediction; we provide documentation in
support of this prediction.
The rest of the paper is organized as follows. Section 2 reviews the related literature withemphasis on studies dealing with NOLs. Section 3 describe the tax provisions on mergers inJapan and their changes over time, while relegating technical details to the appendix. Section
4 describes the data. Section 5 presents the analysis, which has two main parts. The firstpart considers the incidence of two-step mergers relative to direct mergers. The second part
investigates tax payments of firms conducting two-step mergers, and considers the amount oftax expenditures in aggregate. The last section concludes.

3

2

Literature review

Main tax considerations in corporate takeovers are target companies’ tax attributes, target
shareholders’ capital gains tax liabilities, and step-up in basis. Since our study primarily
focuses on the role of target companies’ tax attributes, particularly NOLs, this section firstreviews studies related to NOLs and then briefly covers other tax considerations.

2.1

NOLs

Policy debates in the 1980s motivated researchers to examine the importance of targets’ tax
attributes in mergers beyond what anecdotes suggest.4 Evidence from early studies in the US
is mixed. Auerbach and Reishus (1988b) estimate tax benefits in mergers from 1968 to 1983
and find that, in a significant minority of cases, tax benefits appear large enough. However,in the authors’ subsequent study comparing pairs of merged firms with control pairs that did
not merge, they find little difference in NOLs between merged and control pairs (Auerbach
and Reishus, 1988a). Likewise, Plummer and Robinson (1990) find no difference in cumulative
abnormal return (CAR) for taxable acquisitions with targets with and without NOLs for asample of taxable acquisitions from 1970 to 1982 in the US. By contrast, Hayn (1989) examine
a sample of taxable and tax-free mergers from 1970–1985 and conclude that targets’ NOLs
and tax credits are important in explaining CAR. Scholes and Wolfson (1990) consider thecomposite effects of tax changes under TRA1986, and argue that the reduced takeover activities
are attributable to the reform. While the evidence is mixed, reviews assessing earlier studies
suggest NOLs do not constitute a strong motive in takeovers (Shackelford and Shevlin, 2001;
Betton et al., 2008), which is in line with the results from later studies (Henning et al., 2000;
Erickson, 1998).
Despite the general consensus from the early studies, academic interest in the role of NOLs
persist, perhaps prompted by the practical relevance.5 In a review article, Hanlon and Heitzman(2010) refer to the Wachovia takeover turmoil of 2008, when an unexpected lifting of the loss
limitation rule seemingly increased the price offered to takeover a troubled financial institution
by more than sevenfold. A theme emerging from a series of recent studies is the role of the loss
4
5

For example, refer to “Penn central in talks on merger with Colt,” The New York Times, July 21, 1981.
See, for example, an unequivocally titled newsletter by Bottomlee et al. (2009).

4

limitation rule in the US, known as the Section 382 Rule, as emphasized earlier by Moore andPruitt (1987) and more recently by Steffens (2015).6 Consistent with this reasoning, Chiang
et al. (2014) find in the main specification that NOLs do not increase acquisition prices in asample for 1997–2006.7
Overall, the loss limitation rule, in conjunction with the judicial anti-avoidance doctrines,
would have limited—although probably not eliminated—mergers motivated by NOLs in the US,
rendering statistical detection difficult with US data. Under more “lenient” legal institutions,then, the influence of NOLs could be discernible.

2.2

Capital gains tax and international taxation

In a taxable transaction, target firm’s shareholders lose an option to defer their capital gains
tax liability, and might demand compensation in the form of additional takeover premium,as conjectured by Mandelker (1974). In light of a broader literature on lock-in effects (e.g.
Feldstein and Yitzhaki, 1978), the conjecture seems reasonable, particularly given recent studies
that employ more accurate information on tax bases.8 Betton et al. (2008) interpret early
evidence from corporate takeovers as mixed (Huang and Walkling, 1987; Franks et al., 1988;
Hayn, 1989).9 While the measurement of capital gains tax liabilities in studies of takeovers
is not as finely measured as in recent studies on lock-in effects, later evidence suggests that
acquirers pay compensation to target firms’ shareholders (Erickson and Wang, 2000; Ayers etal., 2003).
M&As are a large component of foreign direct investment (FDI), representing 82% of inward
FDI into OECD countries for the 1987–2001 period (Head and Ries, 2008). While FDI includes
6

In estimating tax benefits, Devos et al. (2009) consider interest shields as the sole source of tax benefits
and do not to consider NOLs in the first place, observing that the loss limitation restriction would have limited
the value of NOLs to acquirers. Devos et al. (2009) estimate synergy gains in mergers by comparing thepresent value of cash-flow forecasts for firms before mergers with that for combined entities, and decompose
their synergy estimates into operational, market, and tax components employing a sample of 264 large mergers
during 1980–2004. They find interest shields contributed 1.64 percentage points in additional value, or about
16.4% of the overall synergy gains on average, and conclude that tax benefits are a minor component of overall
gains.
7
We take the main specification (Table 3) in their study as the most informative estimate, since anotherspecification, which distinguishes NOLs by the length of time to expiry, produces an estimated NOL effect thatis outside the plausible range. The value of 1 dollar of NOL to an acquirer with a marginal tax rate of 40%
should be at most 40 cents absent any loss restriction.
8
For example, Ivković et al. (2005) measure capital gains directly by employing monthly-positions of individual investors. By contrast, a common strategy has been to construct a proxy measure with a recent stock
price before a takeover announcement and the lowest stock price within 5 years.
9
See also Henning et al. (2000) and a discussion by Erickson (2000).

5

greenfield investments, the effects of taxes on FDI, particularly FDI into and out of developed
countries, should provide insights into how taxes affect corporate takeovers. A large body ofinvestigations, as reviewed by Gordon and Hines (2002), show that tax rates, home-country
tax regimes (i.e., territorial and worldwide systems), and sub-national taxes affect the levels
and locations of FDI. A growing body of recent literature focuses on M&As and provides direct
supporting evidence, drawing on transaction-level data (e.g. Di Giovanni, 2005; Huizinga andVoget, 2009; Feld et al., 2016). The main emphasis of these studies has been on differentials
in tax rates across locations. Our study differs by examining tax incentives generated withina country’s tax system.

3

Japanese Institution

By the late 1990s, developed counties had specific rules for tax-free reorganization, viewing
tax discouragement to reorganization as inefficient (Vanistendael, 1998). Typically, a taxable
merger triggers capital gains tax for a target firm’s shareholders and corporate tax on any gains
realized by the target firm while an acquiring firm cannot carry over the target firm’s NOL
and credits, although the acquirer may benefit from increased depreciation deduction fromstepping up asset basis. Tax-free mergers lessens these disincentives by allowing transacting
parties to defer realization of gains and sometimes carryover credits with conditions. To prevent
abuse, tax rules around the world place conditions requiring the continuity of interests andbusiness activities. Vanistendael (1998) characterizes these broad approaches as placing specificeligibility conditions and requiring the existence of business purposes. Japan was comparably
late in adopting explicit rules for tax-free reorganization, although in practice, even before
the adoption of the Tax System for Corporate Reorganization (TSCR), companies could defer
capital gains upon merger. This section describes how the Japanese rules governing tax deferralchanged in 2001, and considers how the Japanese approach to the continuity requirement leftroom for abuse, drawing from a discussion by Kimura (2002).

6

3.1

Tax rules for reorganization: 1990–2000

The Japanese tax system before 2001 was relatively more permissive in allowing deferral of
capital gains upon mergers than the TSCR was. In Japan, the main requirement was thatthe transacting parties exchange stock-for-stock and transfer a target’s assets in book value(Mizuno, 1997). Under these conditions, the target firm’s shareholders could defer capitalgains tax.10 Although statistics are not available, practitioners from the 1990s observe thattransacting parties in mergers typically choose to defer gains (e.g. Kawamoto, 1998). However,unlike under formal tax-free reorganization, an acquiring firm cannot carry over a target firm’s
NOL.11
Tax deferral for the acquisition of shares became available in 1999. Like the tax-free reorganization for stock acquisition in the US, a target firm’s shareholders can defer capital gains
tax by exchanging their shares in the target for an acquirer’s share.12 While a target firm’s
NOL in the US is subject to the loss transfer restriction imposed on substantial changes inownership interests, the Japanese law does not impose such a restriction.13

3.2

After the reform: 2001–2010

The Japanese economy had been stagnating at the turn of the century, and a series of measures
had been implemented to facilitate restructuring of businesses, particularly banks. The TSCR,
enacted in May 2000 and enforced from April 2001, was part of that effort to lesson tax
disincentives for reorganization.14 Compared to the previous regime, the TSCR had narrower
eligibility but provided more generous treatment of NOLs for qualifying mergers.
To qualify for a tax-free treatment since 2001, a merger must fulfill various conditions thatare intended to ensure continuity, as summarized in Figure A1 in the appendix. The foremost
condition is that the payment must be in shares. The new regime improves flexibility byallowing shares of a parent firm to be used in payment, but is more restrictive than the US
10

Between 1989 and 2003, capital gains on shares were taxable at 26% or 1% of sales proceeds.
The rule permitted accounting for a target’s NOL as goodwill, to be amortized over 5 years, but with some
limitations (Kawamoto, 1998).
12This is called the Section 368(b) reorganization. See Scholes et al. (1992) for details.
13
Scholes and Wolfson (1990) concisely summarize the Section 382 limitation in the appendix to their study.
Japan introduced a transfer limitation upon acquisition in 2006, but this limitation only applies in cases inwhich target firms have been non-operational.
14
Between 2003 and 2010, the capital gains tax rate on shares of publicly traded companies was 10%.
11

7

institution, which allows some cash payments.15 The TSCR requires additional restrictions.
Mergers are tax-free almost automatically among related parties, particularly with whollyowned subsidiaries, but an additional test applies between a pair with less than 50% ownershipparticipation. This test (“joint-venture test”) includes five requirements, such as the similarityof business operations of two firms.
Tax-free mergers may or may not qualify for carryover of a target firm’s NOLs, as summarized in Figure A2 in the appendix. A qualifying merger between unrelated parties carries overa target’s NOL, but a qualifying merger between related parties must pass a test, similar but
slightly different to the joint-venture test described above. This test (“deemed joint-venturetest”) has similar individual requirements to the joint-venture test, but a merger needs only
pass a subset of the requirements in order to carry over losses. Importantly, therefore, this test
for NOL carryover is less restrictive than the test for tax-free treatment.16 For a merger that
does not satisfy all the required elements of the joint-venture test, transacting parties have
incentives to conduct a two-step merger as in the court case mentioned in the introduction involving Yahoo! Japan (YJ) summarized in the appendix (see also Hironaka et al., 2015). Notethat firms may acquire the majority of shares in another firms prior to merging for non-tax
reasons, such as to control risks of unobserved liabilities and to squeeze out shareholders who
are unwilling to sell out.
To illustrate the impact of a two-step merger, Panel (a) in Figure 1 shows YJ’s income
tax payments and before-tax accounting profits in billion yen from unconsolidated accounting
statements since the company’s founding in January 1996 until financial year 2014. Earnings
increased rapidly and steadily in the 2000s, reaching ¥190 billion in 2013. The tax payments
exhibit a similar increase except when YJ conducted a two-step merger in financial year 2008
which exhibits an apparent dip; the tax payment falls by ¥25 billion or 50% of the payment
made in financial year 2007. Panel (b) shows the ratio of the two variables, indicating a generaldecline with an apparent dip in financial year 2008.
Other types of step transactions can generate substantial tax incentives for merger. Appendix describes a scheme, involving a taxable merger, that was available from 2001 to 2010,
demonstrating with a simple accounting model that, in effect, the government subsidizes cor15
16

See Scholes et al. (1992) for details of Section 368 (a) and (c).
For a discussion of fine differences between these two tests, see, for example, Adachi (2011).

8

porate mergers. In a baseline scenario without NOLs, an acquirer obtains tax benefits of 26
cents per 1 dollar spent on acquiring targets’ stock. The implicit subsidy can be much larger;
with a large NOLs, tax benefits are as much as 76 cents in a dollar under certain condition.

3.3

US-Japan Comparison

The YJ case highlights several characteristics of the Japanese tax system that are distinct
from the US tax system. First, US judicial doctrines restrict the type of step transaction
integral to the YJ scheme. The time span between YJ’s acquisition and merger is only 34
days, a speed reminiscent of the landmark Gregory case of 1935, in which the transaction
included the creation and closure of a company within 6 days (Likhovski, 2004). As a common
law country, the judicial tradition in the US includes the step transaction doctrine whereby aseries of transactions are deemed a single integrated event in assessing tax liability. Althoughprecedents also influence judicial decisions in Japan, as a civil law country, codified statutes
weigh heavily. Until the YJ case, tax practitioners had regarded the scheme as permissible inJapan.17 Therefore, codified statues restrain the Japanese tax enforcement agency to a greater
degree than in the US.
Second, the statute on NOLs carryforward in ownership changes is less restrictive in Japan
than in the US (Kimura, 2002). Section 382 of the US Internal Revenue Code of 1986 limits
carryforward in events of ownership changes, including stock acquisition. As an illustration,
had the same limitation existed in Japan, it would have limited the amount of income YJ
could offset with NOLs to at most ¥2.25 billion per year.18 Since Japanese corporate incometax (CIT) does not have an equivalent restriction, NOLs were passed on in full upon thisacquisition. The lack of the Section 382 limitation in Japan may in part be explained by theearly expiration of NOLs (7 years) compared to 20 years in the US.19
17
Various pieces of qualitative evidence support this conjecture: while YJ adopted a complex tax avoidance
scheme, its essence is the same as one that appears in a tax-saving guidebook (Adachi, 2009). The tax
affairs division of YJ initiated the scheme. An executive director of an up-and-coming information technology
firm commented that NOLs were an important consideration in a takeover he conducted, and that he madeconsiderable tax savings (Nihon Keizai Shimbun, April 4, 2009, p. 17, morning edition).
18
In general, the use of NOL is limited to the value of a company before the change multiplied by a long-term
tax-exempt interest rate. We assume the value of the target firm to be ¥45 billion. We follow Bottomlee et al.
(2009), whose discussion is based on the US case, and assume the long-term tax-exempt interest rate to be 5%.
19
The expiration was 5 years until the tax reform of 2004, which extended expiration on losses generated atand after financial year starting on April 2001. Tax reforms extended expirations to 9 and 10 years in 2015 and2016 respectively.

9

4

Data

The data source is the MARR Database published by RECOF Co., an M&A consulting firm.
RECOF Co.’s subsidiary gathers information on deals from sources, such as the press, disclosurestatements, and press releases, and as such, this data source mostly covers M&A deals involving
large companies.20 Studies on M&As in Japan employ this data source for its accessibility(Fukao et al., 2005; Arikawa and Miyajima, 2007).21 The MARR Database is not the universeof M&A deals in Japan but is a selected list that disproportionately samples deals that involve
prominent companies. The strength of this data source is its coverage of economically significant
deals. However, if smaller firms were tax aggressive, a sample drawn from this source would
produce an underestimate. The dataset contains characteristics of transacting parties such as
names, industry, and location. The records classify deals by the degree of prior ownership andthe extent of change in ownership.22 Information on deals includes various dates, deal amounts,
and levels of ownership before and after, but with some variation in coverage. The appendix
describes the construction of a list of two-step mergers in detail.
Figure 2 presents the distribution of the number of months between acquisitions and mergers. The sample comprises two-step mergers in which merger transactions took effect from2001 through 2010. We find 507 cases during this period. The distribution is skewed to theright; the 25th percentile is 7 month, with a median of 16 month, indicating that the majorityof two-step transactions are completed within 2 years. Table 1 provides summary statistics on
the cross-section of deals.
20

The proportion of companies that are publicly traded in all entries from January 1996 to September 2013
(N=45,701) are 45% and 17% for acquirers and targets, respectively.
21
While mergers need to be reported to the Ministry of Justice (MoJ), stock acquisitions need not be, andMoJ does not make the information publicly available.
22
The types of deals include mergers, acquisitions (stock purchase that brings ownership in excess of 50%),
division sales, stock participation (stock purchase in an unrelated-party transaction that does not exceed 50%
ownership), and ownership increase (stock purchase in a related-party transaction that does not exceed 50%
ownership).

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5

Analysis

5.1

Theoretical prediction

In theory, for parties to reach an agreement in a takeover deal, the value of assets to a buyer
must be higher than the reservation price of the target’s shareholders. We expect that, forsome pairs of companies, deals generate surpluses large enough so that those deals would takeplace regardless of tax considerations (“compatible match”). However, most matching between
companies, particularly for pairs conducting distant activities, makes no business sense, so that
deals would not be possible regardless of tax motives (“incompatible match”). In between thisspectrum of matchings, there should be pairs that are on the margin of agreement (“marginal
match”).
The discussion in Section 3 shows that the institution after April 2001 in effect provide
a subsidy when an acquirer obtains a target’s shares prior to merger. Therefore, we expectthat the incidence of two-step mergers to increase after the policy change along three channels.
First, in compatible matches, parties would choose a two-step merger over a direct merger if
doing so increases surplus from trade. Note that direct mergers should still be advantageous
in various circumstances. For example, a direct merger between two similar-sized independent
firms in the same industry may qualify for the deferral of capital gains and NOL carryover.
In other words, we expect some, but not all, infra-marginal cases to take the form of two-stepmergers after 2001. The extent to which transacting parties adopt two-step mergers is anempirical question. Second, agreement may be reached in some takeover deals only if two-stepmergers generate sufficient surplus, leading to realization of marginal matches. Third, the tax
avoidance motive may induce some firms in incompatible matches to merge. The last twochannels, but not the first, increases the quantity traded in the market for corporate takeover.

5.2

Incidents of two-step mergers

5.2.1

Graphical analysis

To test this prediction, we examine the incidence of two-step mergers relative to mergers
without prior acquisition of controlling stakes (“direct merger”). Non-tax factors primarily
determine the pool of potential matches and realized mergers at a given point in time, since11tax motives likely affect incentives at the margin.23 We pool direct and two-step mergers tocontrol flexibly for those non-tax factors. Recall that, in direct mergers, NOLs survive intransactions that fulfill certain conditions before and after the 2001 reform. If anything, this isa conservative approach since the 2001 reform might have induced additional direct mergers.24
Panel A in Figure 3 presents the share (solid line) and number (dashed line) of two-stepmergers for 1997–2010. Our baseline analysis defines two-step mergers as deals in which thedurations between stock and asset acquisitions are 12 months or less. The choice of the firstyear of this plot is to avoid a mechanical under-identification of two-step mergers that have
durations between transactions shorter than 1 year. The first year which this left censoring
does not affect identification is 1997, since the record begins on January 1996. We choose thelast year to avoid the 2010 reform, that closed the scheme involving capital losses. The tax
bureau’s lawsuit against YJ would have affected practitioners’ perceptions on the applicabilityof the general anti-avoidance clause. “Year” is the April–March fiscal year.
The share of two-step mergers is visibly different across the tax regimes. Between 1997 and2001, 5% of the sample before 2001 involve two-step mergers; in and after 2001, the share is23%. Fitted regression lines for corresponding periods highlight possible discontinuity acrossthe two regimes. The numbers of cases per annum fluctuate from around 70 to 110; the higher
numbers in 2005–2007 are in line with the world-wide expansion in liquidity while the decline
from 2008 reflects the global financial crisis. Panel B widens the sample of two-step mergers;
the duration between steps is 24 months or less. The gap before and after 2001 becomes lesspronounced with the additional sample, suggesting that non-tax reasons dominate mergers thattake a longer time to complete. Overall, the graphical analysis suggests that the 2001 reform
increased adoptions of two-step mergers. The analysis also shows that direct mergers remain
dominant, which is indicative of tax and non-tax reasons for merging directly.
23

Non-tax factors include macroeconomic condition and industry-specific growth as well as age-dependent
preferences of the founder-owner and regulatory environment.
24
We pool observations based on the dates when mergers took place legally, assuming similar lead times forthe two types of mergers. We restrict attention to two-step mergers of relatively short duration to ensure thisassumption is reasonable. Switches from direct to two-step mergers do not overstate the impact by double
counting, since one addition of a two-step merger from this channel leaves the denominator unchanged, unlike
for the ratio of the number of two-step mergers to the number of direct mergers. Strictly speaking, of the threechannels discussed in the previous section, the switches would have larger impacts since an addition due tothe realization of marginal matching increases the denominator, but possible differences appear quantitatively
minor: with N=25, a switch has only a 0.15 percentage point larger effects than an addition does.

125.2.2

Regression analysis

To analyze, we implement sharp RD design albeit with caution. The sharp RD design identifies
local average treatment effects by utilizing a cut-off point at which observations on one side
receive treatment but those on the other side do not, and a before–after analysis is a special casein which the running variable is time (Lee and Lemieux, 2010). In a standard RD design, in
which a running variable, for example, is the geographical distance from a border, the outcome
should differ sharply across the border. In our setting, responses may occur with some delay.
While tax consultants understood the new policy within months of its passage, they would
have faced uncertainty as to how the tax bureau would react to the scheme. Since a postreform time trend captures some of those delayed responses, sharp RD under-identifies the full
extent of behavioral response. We report the validity checks of the RD design, including thebalance of covariates across the cut-off point and the manipulation of the running variable, in
the appendix.
The following is the baseline linear probability model:

yj = αl + γAF T ERj +P
X[βlp (T IM Ej − T IM E0 )pp=1+ βrp AF T ERj (T IM Ej − T IM E0 )p ] + δ1 P U BLICAj + δ2 P U BLICTj + κk + uj . (1)Outcome variable yj is a dummy variable indicating that deal j is a two-step merger withup to 12 months between transactions. AF T ERj is a dummy variable indicating deal j was
finalized at or after the second quarter of 2001. T IM Ej is the running variable in quarter.
The order of polynomial (P ) is 1 in the baseline model since the linear specification performed
best in terms of the Akaike information criterion (AIC). The specifications allow for different
time trends (βlp and βrp ) across the cut-off point as recommended by Lee and Lemieux (2010).
P U BLICAj and P U BLICTj are a dummy variable for publicly traded acquirers and targets, respectively. For a two-step merger, the status of the target is as at the time of acquisition.
The specification includes industry dummies of acquirers (κk , 5 categories). The base industry
is manufacturing.
Columns 1–4 in Table 3 presents results from a sample consisting of direct mergers and twostep mergers with duration between transactions at or less than 12 month. The coefficient on
13

AF T ER is statistically significant at the 5 and 10 percent level for, respectively, the linear andquadratic specification. The linear specification performs better in terms of AIC. The coefficientfrom the quadratic specification implies that the probability of two-step merger increases by
8.3 percentage points; this coefficient implies that the probability more than doubles from 5
percent in the pre-2001 period.
The dummy for financial companies is negative and statistically significant at the 1% level,
indicating that financial companies rarely employ two-step transactions. A regulatory factor
drives this finding: the majority of financial companies in the estimation sample are credit
unions and credit cooperatives, which cannot, as a general rule, hold more than 10% of voting
shares in other corporations. Since a large fraction of the estimation sample are credit unions
and credit cooperatives (11%), the aggregated response likely understate responses amongfirms not constrained by this ownership regulation. To allow for heterogeneity across sectors,
Columns 3 and 4 present an extended model that replaces AF T ER with interaction terms
between each industry dummy and AF T ER. The coefficients on these interaction terms indicate substantial heterogeneity. The impacts are statistically significant and large for the ICT
and retail/wholesale industries (increases of 26 and 17 percentage points, respectively) but thecoefficients are not statistically different from zero for the remaining categories.
The dummy for publicly traded acquirers is positive and statistically significant, whereasthat for publicly traded targets is negative and statistically significant. Since publicly traded
companies on average are larger, the set of variables likely capture the size effects. Columns 4–6
in Table 4 present results from the sample that extends two-step mergers to those completed
within 24 months. The overall estimates are qualitatively similar.

5.2.3

Sensitivity analysis: RD design

The analysis thus far employs observations far from the cut-off point in identifying policy effects.
Since we expect delayed impacts due to learning, inclusion of those distant observations hasan advantage. The key disadvantage is that subsequent policy changes may confound theresults. Table 2 provides a chronological list of institutional changes related to corporate
restructuring. To examine the sensitivity of estimates, we focus on the extended model thatallows for sectoral heterogeneity and estimate models on the sub-sample in the neighborhood

14

of the cut-off point. Table 4 presents key estimates from sub-samples ranging from ±4 to 16
quarters from the second quarter of 2001. We present both linear and quadratic specifications
for each sub-sample; the linear specification generally performs better in terms of the AIC.
For the sub-sample of ±16 quarters, the coefficient estimates for retail/wholesale and ICT arerobust for both linear and quadratic specifications. For the ± 12- and 8-quarter sub-samples,the linear specification produces qualitatively similar estimates, although with larger standard
errors; the results are sensitive for quadratic specifications. For the ±4-quarter sub-sample,
none of the coefficients in the table are statistically significant. The last result is consistent
with the conjecture that transacting parties responded with a delay. The identification in anyof these subsamples does not employ variation after the second quarter of 2005 and there do
not seem to be policy changes that could favor two-step transactions in the meantime. Overall,other policy changes do not appear to confound the results.

5.3

Tax payment

To investigate further, we examine what happens to tax payments when firms conduct two-stepmergers. If the tax consideration were relevant in adopting two-step transactions, as the court
found in the YJ case, tax payments should have fallen, perhaps as sharply as in that case.
We obtain financial statement information for publicly traded companies from the NEEDS
Financial Quest Database and merged the sample of two-step mergers using the numericalticker symbols of acquirers. This procedure restricts the sample to publicly traded companies,
but publicly traded acquirers are the majority of the two-step merger sample (79%).
We estimate the following two-way fixed-effects regression model. The idea is to examine
whether we observe a dip in tax payment for the financial year in which a company completes
a two-step merger.

cit/assetit = β0 + β1 stepit + β2 prof it/assetit + β3 prof it/assetit × stepit + vi + wt + uit (2)citit is taxes currently owned, an income statement item that combines CIT and regional
taxes owed by firm i for its taxable income from financial year t. A securities report discloses
the stand-alone account of the parent company and the consolidated account which combines15the parent and its subsidiaries. We employ figures from stand-alone accounts in the estimation
to capture the impacts of gross tax savings. In some two-step mergers, targets merge withsubsidiaries of acquirers. Those subsidiaries are typically not listed companies and we cannot
observe their tax payments. While a consolidated account should capture gross tax savings at
a subsidiary, any taxes triggered at a target that becomes part of a consolidated group would
render detection of net tax savings difficult. To proceed, we employ stand-alone data and focus
on transactions in which acquirers of shares, rather than their subsidiaries, merge with theirtarget firms. Since corporations vary in sizes, we normalize tax payments with gross assets andconsider the ratio of the two, cit/assetit .25 We apply a winsorization of 5 basis points at eachtail.
stepit is a dummy variable indicating that, during financial year t ∈ [2001, 2013], company imerged with a target acquired previously (“merger dummy”). First, in case another subsidiaryof company i merged with a target acquired previously, stepit is 0. Second, the contemporaneous specification captures the effects of NOLs or capital losses for years of mergers, andignores future tax savings. We consider lagged impacts, which can arise through unused NOLs
or goodwill amortization, in an extension. Third, the baseline specification employs a merger
dummy that takes 1 for any duration between stock acquisition and merger. This specification
can capture tax savings from cases in which an acquiring firm did not initially plan to merge(“unplanned”) as well as cases in which an acquisition was only an intermediate step before
merger (“planned”). In an extension, we make a distinction by durations between transactions.
Finally, stepit takes the value 0 in cases in which the algorithm does not identify matching pairs
in the data source but are in fact two-step mergers. Mergers that do not take place in two
steps cannot be classified as two-step mergers in the algorithm. Since any misclassification
would lead to stepit being classified as 0, but not as 1, any measurement errors would lead toattenuation bias (Hausman, 2001).
prof it/assetit is defined as follows:

prof it/assetit = max(0,25\opprof itit − N
OLit),assetsit(3)

We attempt to normalize tax payments with turnover (tax/saleit ); the variation of this variable is larger
and the model fit is lower (R2 is 0.28 for the baseline specification). The results are qualitatively identical.

16\where opprof itit is an operating profit of firm i at time t and N
OLit is an estimate of net
loss carry over (NOL).26 prof it/assetit therefore captures variation in cit/assetit associatedwith variations in operating profits, allowing for i ’s NOL, and leaves variation arising from
non-operating expenses and NOL from targets. The coefficient on prof it/assetit (β2 ), shouldbe the tax rate approximately.27
The remaining variation includes the effects of two-step transactions: NOL inherited fromtargets, which is tax credit, and capital loss, which is a deductible expense accounted for among
other non-operating expenses. The coefficient on the interaction term between prof it/assetit
and stepit is the average difference in effective tax rates (ETR) between a subset of firm-year
observations with stepit equal to 1 and the rest of the sample, and captures those sources ofvariation. Under the tax-saving hypothesis, this coefficient should be negative.
vi is the time-invariant characteristics of company i. wt is the calendar-year fixed-effects.
uit is an error term. We cluster standard errors within panel units in the estimation. Table 5
provides summary statistics on the panel of 5,496 firms, omitting observations that have fiscal
year lengths other than 12 month.
5.3.1

Estimation results

Column 1 in Table 6 presents estimates from the baseline specification excluding the merger
dummy. With adjusted R2 of 0.65, the model fit is reasonable. Positive operating profits explain
much of the variation in tax payments, reflecting the accounting relationship. The coefficientis statistically significant at the 1% level, and its magnitude implies that ¥100 of additional
operating profit increases tax payments by about ¥40. The model in Column 2 incorporates
the merger dummy. The coefficient on the interaction term is statistically significant at the 1%
level and is economically substantial: the ETR is lower by 9.8 percentage points.28
Column 3 incorporates one merger dummy for shorter durations between transactions(within 12 months) and another for those that took longer. The coefficient on the shorter
26

To estimate NOL, we employed net accounting profit and assumed carry back of one year, carry forwardof 5 years, and no stock of NOL for initial sample year.
27
The statutory rates, inclusive of regional taxes, have fallen from 50 percent in 1996 to 34.6 percent in2014. We have tried a specification with interaction terms between prof it/assetit and tax regime dummies
in a preliminary analysis. This extended model produces similar results to the baseline model so we report aparsimonious specification.
28
A concurrent study by Steffens (2015) examines ETR at times of takeovers for international as well as
domestic deals from around the world. He finds targets of tax-aggressive acquirers’ ETR is eight percentage
points lower on average.

17

duration is slightly larger than that on the longer duration but a test of equality of these twocoefficients does not reject the null hypothesis of no difference. While the estimated coefficientssuggest that, on average, step transactions with short duration between transactions reduce
tax payments, mergers of subsidiaries are associated with lower tax payments.

5.3.2

Sensitivity analysis: panel regression

One concern with the analysis in the previous subsection is that relative to the number ofobservations, the number of two-step mergers is small: the sample contains 234 firm-year
observations on two-step mergers, which is 0.31% of the sample size. If YJ was an outlier (after
all, the YJ lawsuit was a prominent case), that observation may be driving the correlation.
Another concern is that the interaction term may capture some pre-existing trends, causing a
spurious correlation.
To check for influential observations, we obtain jackknife estimates of coefficients by leavingout each panel unit that engaged in two-step mergers (i.e. all observations on one firm). A
large difference between the coefficient from the full sample and that from the sample excluding
ith firm flags an influential observation. To examine the second concern about the time-varying
shocks, we added to the model leads of the merger dummy of up to 3 years, which shouldcapture shocks that extend over a few years.
Panel A in Table 7 presents the coefficients on interaction terms from a specification withlead dummies of up to 3 years. The first column shows the estimated coefficients. The second
and third columns present the ranges of coefficients obtained from the jackknife procedure. The
coefficient on the contemporaneous interaction term is statistically significant at the 1% level
and this test is not sensitive to influential observation, as the magnitudes of the estimations
remain well above the standard error. The coefficient on the 1-year-lead term is statisticallysignificant at the 10% level but this test is sensitive to removal of observations, which reduces
its magnitude by 42% as shown in the second column. The rest of the lead terms are notsignificant statistically. This exercise shows that the main estimate is not sensitive to influential
observations and we find no evidence of pre-existing trend.
As an extension, Panel B considers possible lagged impacts of step transactions that canarise from unused NOL or amortization of goodwill. The specification incorporates lag dummies18

of up to 3 years into the baseline specification. The estimated coefficient on the contemporaneous interaction term is still statistically significant but falls to about three-quarters ofthat from the model without lags. Lagged terms are negative and 1- and 2-year lag terms
are negative and significant at the 10% and 5% levels, respectively. While the test result forthe 1-year lag term is sensitive to influential observation, the result for the 2-year-lag term isrobust, indicating some evidence of delayed impacts.
Another concern involves some time-varying shocks that generate gaps between tax payments and operating profits during merger years unaccounted for by control variables in thebasic specification. To address this concern, we estimate a specification with industry-specificand prefecture-specific time effects, and corporate age. The result is robust to the addition ofthese controls.29
Finally, we consider the effects of mergers between independent parties that do not involve
any step transactions, and provide a discussion in the appendix. Briefly, the main result isrobust to the inclusion of a direct merger dummy and its interaction with positive operating
profits. We find no robust evidence indicating unusual falls in tax payments upon direct
mergers.

5.3.3

Tax expenditure

We consider an initial estimate of tax expenditure in a parsimonious model based on equation
2 but without the interaction term. By multiplying the coefficient on the merger dummy
from this specification and the average assets of acquirers in the years of two-step mergers,
an estimate of the average gross tax savings per two-step merger is ¥736.4 million. With 234
firm-year observations, total savings during 2001–2013 are ¥172.3 billion. The court foundthat YJ unlawfully avoided paying tax of ¥20 billion. Therefore, our estimate indicates thatthe sample of publicly traded firms saved 8.6 times the amount of taxes that YJ did. Thus,
while the YJ case is not representative of other cases, it is the tip of the iceberg.
We also consider tax savings by length of duration between transactions. For short duration
29

Since a merger increases the gross assets of an acquirer (assuming a target own assets of positive value),the denominator of the dependent variable increases; there may be concern that this generates a mechanicalcorrelation between the dependent variable and merger dummy. The baseline model includes a control variable
scaled by assets (ratios of operational profits to assets), which should absorb some of the mechanical correlation,
if any, but the non-linearity in the profit variable may leave some influence unaccounted. We attempted to use
assets from previous period to scale tax payments and operating profits but the result is qualitatively similar.

19

(N=83), the average savings are ¥1066.0 million with total savings of ¥88.5 billion; roughly
one-half of tax savings is attributable to shorter duration. For longer duration (N=152), theaverage is ¥563.9 million with total savings of ¥85.7 billion.

6

Conclusion

This study analyzes tax incentives in the corporate takeover market during the 2000s in Japan.
We utilize a unique policy environment after 2001, which enables acquiring firms to reduce
their corporate tax liabilities by acquiring large stakes in targets prior to merging. This setting
allows us to consider the role of NOL and other tax motives in takeover deals. We find thatmerger transactions that involve prior acquisitions, or two-step mergers, are not rare events;
our sample of domestic takeover deals involving large firms contains 507 cases completed from2001 through 2010. Durations between steps do not appear long enough for acquirers to makesubstantial operational adjustments in targets in many cases; one-quarter of the cases of twostep mergers involve durations between steps of 7 months or less. Consistent with the tax
incentives, we find that the probability of two-step mergers discontinuously increases after thepolicy change of 2001, particularly in the ICT sector. We also estimate an accounting modelof tax payments on profitability and find strong correlation between unexplained reductions in
tax payments and incidences of two-step mergers.

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23

Table 1: Summary statistics: Cross section data of deals
Sub-sample

1 year or lessbeforeafter
diff.

beforeTwo-step transaction=1

0.047(0.211)0.231(0.422)0.184**[7.91]

0.062(0.241)0.308(0.462)0.246**[9.71]

Acquirer public= 1

0.323(0.468)0.379(0.485)0.056[1.83]

0.321(0.467)0.389(0.488)0.068+[2.28]

Target public= 1

0.123(0.329)0.163(0.369)0.040[1.75]

0.121(0.327)0.147(0.354)0.025[1.18]

Manufacturing= 1

0.148(0.356)0.145(0.353)-0.003[-0.12]0.148(0.356)0.150(0.357)0.002[0.08]

Finance= 1

0.244(0.430)0.197(0.398)-0.047[-1.81]0.240(0.428)0.182(0.386)-0.058*[-2.35]Retail Wholesale= 1

0.348(0.477)0.271(0.445)-0.076*[-2.66]0.345(0.476)

0.274 -0.071+(0.446) [-2.52]

Info. & Comm.= 1

0.085(0.279)0.140(0.347)0.055*[2.67]

0.089(0.285)0.145(0.353)0.057*[2.73]

Other industry= 1

0.175(0.381)0.246(0.431)0.071*[2.69]

0.178(0.383)0.249(0.433)0.071*[2.74]

365

792

1,157

371

880

1,251

Observations

2 year or less
after
diff.

Notes: This table shows the summary statistics of the cross-section of merger deals. Standard deviations in parentheses. t-statistic in brackets. The sample period is 1997Q1–
2010Q1. “1 year or less” and “2 year or less” sub-samples include two-step transactions
with up to 12 and 24 months between transactions, respectively. “before” and “after” indicates the sample period before and after April 2001, respectively. The third and sixth
columns ( “diff.”) show differences between the two periods. **, *, and + denote statistical significance at the 1%, 5%, and 10% levels, respectively.

24

Table 2: A chronological list of major institutional changes

Effective
06/1997
06/1997
10/1997
10/1999

Enacted05/1997
06/1997
06/1997
03,08/1999

01/2001
04/2001

05/2000

07/2002

04/2002

04/2003

03/2003

04/2002

03/2002

01/2003

03/2001

04/2004

03/2003

10/2006

04/2006

05/2007

07/2005

10/201003/2010

Description
Relaxed restrictions on share repurchase
Removed a ban on holding companies
Simplified merger procedures
Introduced the stock swap and stocktransfer system that defer capital gains
realization
Relaxed restrictions on repurchase further
Introduced the Tax System for Corporate Restructuring
Introduced an option for consolidated
filing of corporate income tax. Applicable from tax year ending 03/2003
Reduced dividend tax for small individual shareholders (less than 5% ownership)
Increased taxable dividend received
by corporations form unrelated parties(owns less than 25%). Applicable for financial years ending after 03/2003
Reduced, in effect, the capital gains tax
rate on individuals for gains less than11%
Introduced the size-based enterprise tax,
applicable for fiscal year starting after
04/2004
Unified stock transfer and stock swap
into the Tax System for Corporate Restructuring
Permitted an acquirer to use its parent
company’s stocks as payment to target
shareholders
Introduced a new taxation of corporategroupsArea of law
Commercial
AntitrustCommercial
Commercial,
Tax
Commercial
Tax
CIT

PIT

CIT

PIT

CIT
gional)(Re-

CIT, PIT

Commercial

CIT

Note: PIT and CIT refer to personal income tax (shotokuzei ) and corporate income tax(hōjinzei ), respectively.

25

Table 3: Baseline regression: probability of two-step transactions
Dep. var.: Indicator for two-step merger
two-step sample:
1 year or less
(1)
(2)
(3)

(4)

(5)

2 year or less
(6)
(7)

(8)

After 2001Q2

0.083*
0.089+
0.079*
0.072(0.034)(0.050)(0.038)(0.057)
Acquirer public = 1
0.243** 0.243** 0.237** 0.237** 0.260** 0.260** 0.254** 0.254**(0.033)(0.033)(0.033)(0.033)(0.031)(0.031)(0.031)(0.031)
Target public = 1-0.413** -0.413** -0.410** -0.410** -0.492** -0.492** -0.488** -0.487**(0.031)(0.031)(0.031)(0.031)(0.029)(0.029)(0.029)(0.029)Finance = 1-0.127** -0.126** -0.102* -0.102* -0.176** -0.175** -0.131** -0.131**(0.033)(0.033)(0.046)(0.046)(0.035)(0.035)(0.048)(0.048)Retail Wholesale = 1-0.031-0.031 -0.125** -0.127** -0.052-0.052 -0.142** -0.143**(0.035)(0.035)(0.044)(0.045)(0.036)(0.036)(0.047)(0.047)
Info. & Comm. = 1
0.038
0.038
-0.125** -0.123**
0.034
0.033
-0.087-0.086(0.043)(0.043)(0.047)(0.046)(0.043)(0.043)(0.064)(0.064)
Other industry = 1
0.001
0.001
-0.056-0.056-0.013-0.013-0.057-0.056(0.038)(0.038)(0.054)(0.054)(0.039)(0.039)(0.058)(0.058)Manufac. x after = 1
0.023
0.037
0.041
0.045
(0.060)(0.069)(0.063)(0.075)
Finance x after = 1-0.021-0.007-0.036-0.032(0.036)(0.049)(0.040)(0.056)Ret.&Whole. x after = 1
0.166** 0.182**
0.174** 0.179**(0.043)(0.056)(0.045)(0.062)
Info.& Comm. x after = 1
0.241** 0.254**
0.199**
0.202*(0.054)(0.064)(0.071)(0.081)Other industry x after = 1
0.105+
0.119+
0.103
0.106(0.059)(0.070)(0.064)(0.078)(0.039)(0.048)(0.045)(0.050)(0.043)(0.055)(0.049)(0.058)Observations
1,157
1,157
1,157
1,157
1,251
1,251
1,251
1,251
Adjusted R-squared
0.195
0.194
0.204
0.202
0.241
0.240
0.247
0.246
Polynomial order (P )
1
2
1
2
1
2
1
2
AIC
793.0
796.8
784.6
788.4
1069
1073
1063
1067
Notes: This table presents estimates of linear regressions. The dependent variable is the indicator for mergers inwhich acquirers obtained controlling shares prior to merging targets. Columns 1–4 employ a sub-sample with up
to 12 months between acquisitions and mergers. Columns 5–8 employ a sub-sample with up to 24 months between
acquisitions and mergers. The estimated models include a P th order polynomial in quarter. The base industry
category is manufacturing. Robust standard errors in parentheses. **, *, and + denote statistical significance atthe 1%, 5%, and 10% levels, respectively.

26

Table 4: Sensitivity analysis: Sample periods around 2001Q2
Dep. var.: Indicator for two-step merger
Specification:
linear quadratic
Quarters to/since ‘01Q2:
16
16
(1)
(2)
Manufacturing x after = 1

linear12(3)

quadratic
12(4)linear8(5)quadratic
8(6)

linear4(7)

quadratic
4
(8)

0.014
(0.076)
Finance x after = 1-0.022(0.040)Retail Wholesale x after = 1 0.191**(0.055)
Info. & Comm. x after = 1
0.284**(0.075)
Other industry x after = 1
0.081(0.075)-0.023(0.089)-0.064(0.059)0.150*(0.072)0.254**(0.080)0.043(0.085)0.063(0.086)-0.026(0.046)0.157*(0.063)0.245**(0.088)0.085(0.087)0.042(0.104)-0.050(0.071)0.131(0.086)0.218*(0.097)0.065(0.092)0.114(0.103)-0.026(0.053)0.212**(0.075)0.243*(0.095)0.047(0.101)0.084(0.129)-0.059(0.089)0.173(0.107)0.203+(0.113)0.007(0.111)-0.040(0.142)-0.113(0.083)0.161(0.107)0.127(0.105)-0.009(0.121)-0.128(0.211)-0.197(0.190)0.083(0.198)0.045(0.200)-0.083(0.197)

Observations
Adjusted R-squared
AIC

684
0.173
331.4

537
0.146
250.9

537
0.147
252.2

389
0.185
159.5

389
0.189
159.5

242
0.160
121.9

242
0.159
123.9

684
0.173
329.4

Notes: This table presents estimates of linear regressions by different sample lengths (quarters around April 2001).
The base specification corresponds to Columns 3 and 4 in Table 3. The dependent variable is the indicator for mergers in which acquirers obtained controlling shares prior to merging targets, and two-step mergers are those with 12
months between acquisitions and mergers. The estimated models include controls for trend, public dummies, industry
dummies, and a constant. Robust standard errors in parentheses. **, *, and + denote statistical significance at the
1%, 5%, and 10% levels, respectively.

27

Table 5: Summary statistics: Panel of firms(1)
Others(= 0)0.0184(0.0258)(2)
2 step Diff.
(= 1)
0.0200 -0.002(0.0232)

Positive operating profit/assest (prof it pos)

0.0430(0.0544)0.0568 -0.014**(0.0580)[0.004]Year

2003.9(4.769)2007.1(3.164)[0.312]

Total assets (totassets, billion)

122.6(502.0)160.1 -37.5(465.0)[32.9]

Operating profit (op prof )-0.0575(0.432)-0.0186 -0.039(0.382)[0.028]Sample(stepit )Tax payment/asset (cit a)(Fraction)
Mining agriculture construction
Light manufacturing
Heavy manufacturing
Finance
Services
Retail and wholesale
Info. and comm.
Utility and transportation

0.056
0.053
0.340
0.047
0.212
0.177
0.077
0.038

0.026
0.017
0.184
0.077
0.175
0.312
0.184
0.026

Observations

75,146234(3)
Std. Err.
[0.002]-3.198**0.031+
0.036+
0.156**-0.030*0.037-0.135**-0.107**0.012[0.015][0.015][0.031][0.014][0.027][0.025][0.017][0.012]75,380Notes: This table presents summary statistics of the panel of firms. The time period is the
fiscal year ending January 1997 to December 2013. Column 1 is for firm-year observations
in which firms did not conduct two-step mergers (stepit = 0). Column 2 is for firm-year
observation in which firms engaged in two-step mergers (stepit = 1). Standard deviations
in parentheses. Standard errors in brackets. **, *, and + denote statistical significance atthe 1%, 5%, and 10% levels, respectively.

28

Table 6: Tax payments and two-step mergers
Dep. var.: Ratio of tax payments to assets (cit a)(1)
Positive operating profit/assest (prof it pos) 0.3920**(0.0041)
Merged after acquisition = 1 (step)
step x prof it pos(2)
0.3923**(0.0041)0.0009(0.0011)-0.0979**(0.0258)

step = 1 & duration ≤ 12 (short)(3)
0.3923**(0.0041)0.0015(0.0019)-0.1030**(0.0373)0.0006(0.0014)-0.0936**(0.0351)

short x prof it pos
step = 1 & duration > 12 (longer)longer x prof it pos

Firm fixed effects
Year fixed effects

YES
YES

YES
YES

YES
YES

Observations
Number of id
Adjusted R-squared

75,3805,496
0.654875,3805,496
0.655375,3805,496
0.6553

Notes: This table presents estimates of panel regressions of tax payments. The
dependent variable is the tax payment divided by asset. The model includes constant terms. Standard errors are clustered at firm level and are shown in parentheses. **, *, and + denote statistical significance at the 1%, 5%, and 10% levels,
respectively.

0

.6
.5
CIT/PROFIT
.4

0

.3

20

CIT (billion yen)
40
60

50
100
150
B/F Tax Profit (billion yen)

80

200

Figure 1: Notes: Yahoo! Japan’s tax payments and before-tax accounting profits

2000
CIT (billion yen)

2005
2008 2010
fiancial year

2015

.2

1995

1995

B/F Tax Profit (billion yen)(a) Tax and profit

2000

2005
fiancial year

2008

2010

2015

(b) Ratio

Panel (a) shows YJ’s tax payments and before-tax accounting profits (billion yen). Panel (b) shows the ratio ofthese two variables. The dashed vertical line indicates the financial year during which YJ acquired and mergedwith Softbank IDC Solutions.

29

Table 7: Leads, lags, and jackknife estimates

Panel A
step x prof it poslead x prof it pos
lead2 x prof it pos
lead3 x prof it pos
Panel B
step x prof it pos
lag x prof it pos
lag2 x prof it pos
lag3 x prof it pos

Coefficient

Jackknifemax
min-0.1194**(0.0345)-0.0428+(0.0223)-0.0168(0.0123)0.0077(0.0143)-0.0981-0.1302-0.0246-0.0488-0.0122-0.01960.01330.0014-0.0683-0.0947-0.0224-0.0423-0.0404-0.0599

0.0066-0.0231-0.0870**(0.0257)-0.0334+(0.0193)-0.0517*(0.0201)-0.0115(0.0221)

Notes: This table presents selected coefficients from equation 2 augmented with leads and lags. The dependent
variable is tax payment divided by asset. Panel A incorporates leads of up to 3 years and their interaction termwith prof it pos. Panel B incorporates lags of up to three
years and their interaction term with prof it pos. Columns
2 and 3 show the range obtained from the jackknife procedure described in the text. Standard errors are clusteredat firm level and are shown in parentheses. **, *, and +denote statistical significance at the 1%, 5%, and 10% levels, respectively.

30

60

Figure 2: Time between stock and asset acquisition: Domestic companies, in months

0

20

number of cases
40

sample: 2001 - 2010
median: 16.0
25th percentile: 7.0
observations: 507

0

12

24

36

48

60
72
84
months till merger

96

108

120

132

Notes: This figure presents the distribution of the number of months between acquisition and merger. The
sample comprises two-step mergers in which the merger transaction took effect from 2001 to 2010. The bin sizeis 3 months.

120

.4

2005

2010

1995

fiscal year
two-step share (left scale)fitted value-after

110
70

0

60
2000

80

.1

.2

80
90
total cases
70

.1
.05
1995

90
100
total cases.3.25
Before (N=315 )mean: 0.05
After (N=862)
mean: 0.23

.15

.2

Before (N=321 )mean: 0.07
After (N=964)
mean: 0.32

100

.3

110

Figure 3: Share of two-step mergers in mergers

2000

2005

2010

fiscal year
fitted value-before
cases (right scale)

two-step share (left scale)after(a) Duration of 12 month or lessbeforecases (right scale)(b) Duration of 24 month or less

Notes: This figure presents the share of two-step mergers in all mergers in the sample, along with fitted lines
for before and after the policy change of 2001 (left scale, solid line). Data are aggregated over a fiscal year,
which spans April–March. The dashed vertical line indicates the timing of the TSCR. The figure also presents
the total number of mergers including direct and two-step mergers (right axis, dashed line). In panel (a), thesub-sample of two-step mergers is restricted to deals in which the durations between stock and asset acquisitions
are 12 months or less. The sub-sample for panel (b) is for duration of 24 months or less.

31Online appendix for “Taxes, takeovers, and step transactions”
Kazuki Onji and Roger H. Gordon

A

Case studies

A.1

Yahoo! JapanA Supreme Court case involving Yahoo! Japan (YJ) highlights the relevance of net operating
losses (NOLs) as a motivating factor in mergers in Japan.1 YJ is a profitable joint venture ofYahoo! (US) and SoftBank, a large telecommunications company.
The case involves two separate litigations, but for brevity, we focus on the main one. On
February 24, 2009, YJ acquired 100% of SoftBank IDC Solutions (IDCS), a 100% subsidiaryof SoftBank, for ¥45 billion. On March 30, a month later, YJ merged with IDCS in a merger
that qualified as a tax-free transaction. This merger also fulfilled the requirements to carryover the target’s NOLs; YJ obtained ¥54.2 billion in NOLs and saved ¥20 billion in taxes in
the fiscal year ending March 31, 2009. Table A1 shows the timeline of the case.
Note first that a merger between a parent and a 100% subsidiary qualifies as a tax-freemerger, provided the payments do not include cash, and the merger on March 30 qualifies for
tax-free treatment (see Figure A1). However, since the parent became a majority owner of thetarget within 5 years of the merger, additional requirements must be met for the target’s NOLs
to survive. YJ satisfied the deemed joint-venture test by assigning its executive director as an
executive vice-director of IDCS on December 24, 2008 (see Figure A2 for the requirements forthis test).
Note also that a direct merger can qualify for tax-free treatment and for NOL carryover if
the transaction satisfies requirements under the joint-venture test. However, the joint-venture
test has more requirements than the deemed joint-venture test does. For example, YJ would
have had to retain 80% of IDCS’s employees to meet the joint-venture test.
After the Tokyo Regional Taxation Bureau (TRTB) received YJ’s tax return, which wasdue by June 1, the bureau engaged with YJ to revise the tax return.2 On June 30, 2010,
1
2

Hironaka et al. (2015) provide an English-language summary of this court case.
The transaction involving these prominent corporations was covered by a major financial newspaper, Nihon

1

YJ received a formal letter of reassessment from the TRTB, which invoked the general antiavoidance clause in the Tax System for Corporate Reorganization (TSCR) for the first timeand denied carryover of NOLs. The case eventually went to the Supreme Court, which ruledin favor of the government in February 2016.

A.2

HOYA

The takeover of Pentax, a precision instrument producer popularly known for its single-lensreflex cameras, by HOYA, another precision instrument producer, is a case in which tax savings
might have played a pivotal role in tipping the balance in favor of a takeover. This section outlines the HOYA-Pentax merger, and section G describe the technical details of the transaction
scheme.
According to a press report, as early as 2004, the then CEOs of the two companies had
discussed possible business cooperation (Matsuzaki, 2008). Pentax had competitive advantage
in medical equipment, particularly endoscopes, and HOYA had interest in Pentax’s technology
to complement its own medical instrument production. In late 2006, the two companies publicized their merger agreement. The direct merger involved a merger ratio of 1 Pentax sharefor 0.158 HOYA shares. Given HOYA’s stock price in late 2006, the valuation of one Pentax
share was about ¥720 per share. HOYA’s stock price fell by more than 10% by March 2007,
and the then second largest shareholder of Pentax, a foreign-based investment trust, warned
that it would cast a dissenting vote at an upcoming shareholders’ meeting. Apparently, Pentax’s executives were not unanimously in favor of the merger, and after a boardroom coup,
Pentax’s new CEO canceled the merger agreement. However, the then largest shareholder ofPentax, a domestic investment trust, disagreed with the cancelation, submitting an agenda
for the upcoming shareholders’ meeting to reinstate the former CEO, who was in favor of themerger. Eventually, Pentax’s CEO agreed to a “friendly” takeover bid (TOB), which was astock acquisition unlike the asset acquisition in the previous deal. In summary, the merger
negotiation between the two companies went through twists and turns.
HOYA’s disclosure statement suggests that the company was able to offer a higher pricewithout a substantial cost hike by switching from a direct merger to a step transaction. HOYA
Keizai Shimbun, as early as April 4.

2

initiated its TOB on July 3, 2007, offering ¥770 per share or about ¥50 per share more than theinitial offer. HOYA completed its TOB on August 6, obtaining 90.5% of Pentax. Shareholders
who accepted the TOB realized capital gains. The tax rate on capital gains under personal
income tax was 10% for publicly traded stocks around the time. The two companies mergedon March 31, 2008, the last day of financial year 2007, paying ¥770 per share in cash for theremaining shares. The merger was a taxable transaction. In its financial year 2007 Securities
Report, HOYA reported writing off ¥18.1 billion in capital loss as a result of the merger with
Pentax; total tax savings would had been ¥7.3 billion assuming an effective corporate tax rateof 40%, implying tax savings of ¥59.3 per share.3 Under the 2006 merger agreement, thiscapital loss would not have arisen, since the transaction was a direct merger. This estimate oftax savings per share is similar in magnitude to the difference in the offer price; more than 80%
of tax savings would have accrued to the target’s shareholders, which is in line with previous
studies that reported that most of the tax benefits are captured in the premium. Although
HOYA offered higher compensation to Pentax’s shareholders, its own net-of-tax cost of stock
would not have changed much from the initial offer. Thus, the tax benefit of ¥59.3 per share
would have facilitated the formation of this agreement.

B

Current value of net assets imputed for tax purposes

This section provides details on how firms impute current values of assets for tax purposes.
The TSCR does not specify an exact procedure to compute the current value of net assets, andpractitioners generally refer to a circular notice (tūtatu), issued by the National Tax Agency(NTA) for another purpose (Adachi, 2009).4 The circular, by design, does not specify all
details, and leaves room for discretion within the bounds of acceptable corporate accounting
practices.5 The primary adjustment to book value stipulated by the circular is a revaluation of3

The denominator is the number of outstanding common stocks (12,792.5 million) minus Pentax’s own
holding (13.8 million) plus common stocks that would have been granted upon maturation of convertible bonds(768.45 million).
4
The Corporation Tax Basic Circular Notice 12: 3-2-1 was issued in February 2003. This circular notice
explains how a firm should assess current values of assets upon electing to file a consolidated tax return.
Formally, the Corporation Tax Basic Circular Notice is a set of guidelines issued by the NTA commissioner toregional commissioners at regional tax bureau on how to implement Japan’s Corporation Tax Act.
5
A circular notice need not be comprehensive: the preface of the circular notice published in 1964 after an overhaul states that its purpose is to guide flexible implementation of the Corporation Tax Law
that respects appropriate accounting practices and individual situations and therefore, avoids overregulation (https://www.nta.go.jp/shiraberu/zeiho-kaishaku/tsutatsu/kihon/hojin/zenbun/01.htm, accessed March3

tangible assets, especially land, and of securities. This corporate income tax circular provides
the following guidelines by types of assets.

B.1

Tangible depreciable asset

The current value of a depreciable tangible asset is its estimated replacement value depreciatedfor the number of years since the initial purchase, employing the declining balance method.

Intangible depreciable asset
The current value of a depreciable intangible asset is its purchase price depreciated for thenumber of years since the initial purchase using the straight line method. The circular does
not specify how to treat intangibles generated in-house; this omission leaves room for discretion.

Land
Transaction prices of nearby land, if available, provide the basis to assess land values. If suchtransactions are unavailable, government-published figures on land values (kōji kakaku) provide
the basis.6

Securities
Stocks of publicly traded companies are valued at the market price. Otherwise, the value of asecurity is imputed from, for example, traded prices of the same security from within 6 months,
and traded prices of corporate stocks issued by companies similar to the issuer of the security
in question. Guidelines for the purpose of inheritance and gift tax detail methods for valuing
stocks of non-traded companies and provide another basis that practitioners can follow.

Accounts and notes receivable
The computation of the bad debt allowance under the accounting rule is different from that
under the tax rule. For the purpose of assessing the market value of outstanding credits, the31, 2016).
6
The Land, Infrastructure and Transportation Ministry provides assessments on selected addresses (23,380
points across Japan in 2015), revised annually on January 1.

4

circular requires computation based on the tax rule, which generally results in a higher value
than that based on the accounting rule (i.e., the tax rule is more stringent than the accounting
rule in allowing deductions for bad debts).

Deferred assets
A deferred asset is expenditure undertaken in advance and provides a flow of service beyond 1
year. The tax law specifies that expenditure can be counted as deferred assets for tax purposes;
examples include expenditure for paving public roads, down payments for consultation, andthe costs of producing a signboard for display at a (third-party) car dealer. The circularspecifies the current values to be the book values (or remaining values after applying statutory
depreciation).

C

Sample construction

This section describes the construction of the sample of corporate mergers preceded by stockacquisitions (“two-step mergers”). The procedure consists of two main components. The firstis a selection of a pool of observations on transactions from the data source. The second is analgorithm for pairing observations from the pool.

C.1

Sub-sample of takeover deals

The data source is RECOF’s MARR Database for the period January 1996 to July 2013. RECOF gathers information on transactions though published information, such as news releases
by acquirer companies and the press. The database does not comprise administrative data anddoes not contain the universe of transactions. Since the database records YJ’s merger IDCS
in a note to an entry on YJ’s acquisition of IDCS, rather in a separate entry, we make anadjustment by creating a separate entry.7 We make few corrections to date variables in casesof large inconsistencies in these variables (published dates and effective dates of transactions).
The original sample consists of 457,001 entries.
7

This should not affect the two analyses in the main text. First, the analysis employing the regression
discontinuity identifies the policy effects around April 2001, and YJ’s case occurred in financial year 2008.
Second, the analysis of tax payments includes a sensitivity analysis, which leaves out a panel of firm one at a
time.

5

Our goal is to identify pairs of entries in which mergers were preceded by acquisitions ofcontrolling interest. Recall that YJ and HOYA obtained 100% and 90.5% of targets’ stocks
prior to the mergers, respectively. To identify step transactions that possibly were influenced by
tax considerations, ideally, we should pinpoint acquisition-merger pairs in which acquirers helda large fraction of control prior to the mergers. Unfortunately, the database does not containcomplete information on acquirers’ ownership of targets. However, the database does classify
as “acquisition” stock purchases that increases ownership above 50%.8 Other classifications
include “equity participation” and “expansion in equity participation.”9 Given the data limitation on post-acquisition ownership levels, we employ entries classified as “acquisition” as acounterpart to merger entries. Retaining transactions classified as “merger” and “acquisition”
leads to elimination of 21,811 entries (Table A2).
We further drop 445 entries that mostly are cases in which negotiations did not lead to final
agreement, but we include a few cases in which RECOF made corrections. Since the research
focus is on Japanese laws and to abstract from international tax issues, we drop internationaltransactions. We keep transactions with RECOF codes as “IN-IN,” which are transactions
among “Japanese” companies, and delete 3,639 entries. Since companies registered outside
Japan but financed by Japanese-owned capital are classified as Japanese companies in the
M&A database, we further delete 799 entries of this type. This selection leads to a base sample
of 430,307 transactions.

C.2

Algorithm for identifying two-step mergers

The aim of the algorithm is to pair an acquisition entry in time t1 with a merger entry int2 > t1 based on the identities of a target and acquirer.
The M&A database does not contain company identifiers that allow us to match companies
unambiguously across entries. The algorithm instead employs company name and headquarter
location (prefecture) for identification. Mismatch is possible in theory. Until May 2006, theCommercial Code restricted new corporations from choosing the same company name of an
8

Even if ownership is less than 50%, if an acquirer effectively controls a target after the transaction, including
a case in which parties related to the acquirer hold the target’s shares, RECOF classifies the transaction as an“acquisition”
9“Equity participation” refers to purchases—by acquirers with no ownership stakes in targets—of stocks
that lead to less than 50% ownership. “Expansion in equity participation” refers to additional stock purchasesby companies that already hold less than 50% stakes, and excludes additional purchases beyond 50%.

6

existing corporation from the same municipality. The Company Code, in effect from May
2006, removed that restriction. A close inspection of the result suggests that the matches are
genuine. Since selecting an existing name risks triggering anti-competitive lawsuits and theoriginal source draws from the press reports, which disproportionably cover cases involving
large companies, the two variables are sufficient identifiers in the current context. If anything,
the algorithm under-identifies cases owing to name changes and headquarter relocations.
In searching for matches, the algorithm employs target-based information on name and location. Not conditioning on acquirer name enables the identification of mergers by subsidiaries
of acquirers, and not just by acquiring companies themselves. We use acquirer name to distinguish between mergers as companies that acquired stocks and those whose subsidiaries did
so. To ensure that we do not treat the case of a target that merges into a third party as a
two-step merger, the algorithm requires that a merger be conducted within a corporate group;
an indicator variable provides such information.
In a minority of cases, target names appear more than twice. One type involves a sequenceof transactions, ordered by time, {A1 , A2 , M }, where A and M denote acquisition and merger,
respectively. This type occurs when a target changes hands before being merged. The algorithm
takes (A2 , M ) as a pair for this type. Another type is {A1 , M1 , M2 }. This type occurs whenan acquirer spins off a target after a merger and calls the new company by its previous name.
(A1 , M1 ) is a pair for this type.
RECOF records transactions that each involve multiple targets in one entry. This occurs,for example, in the case of a merger of multiple auto distributors in nearby regions. To illustrate
how the algorithm deals entries with multiple targets, consider the example of Table A3. Row
0 indicates that an acquirer obtained controlling stakes in three companies X, Y, and Z. Rows
1–7 shows possible subsequent entries on mergers. In Row 1, for example, the acquirer merged
the three companies. If only one of Rows 1–7 appears in the subsequent sample, that merger istreated as one pair, regardless of the number of companies involved. If mergers are in separate
entries (e.g., the acquirer merged X and Y on different dates), the algorithm augments Row 0
so that Rows 2 and 3 each have a counterpart.

7

D

Validity checks for the regression discontinuity design

We examine the balance of the covariates across 2001 to check the validity of applying theregression discontinuity (RD) design. Figures A3 and A4 present time-series plots of control
variables for the samples with short and long step transactions, respectively. No break isvisible in most covariates, although the fractions of the retail and wholesale industry and the
publicly traded acquirers appear to exhibit discontinuities. We estimate a seemingly unrelated
regression in which each equation represents a different covariate and conduct a joint test of
discontinuity gaps, as recommended by Lee and Lemieux (2010). The test results do not reject
the null hypothesis, suggesting RD design is valid.
One of the key identifying assumption in the RD design is that subjects do not manipulaterunning variables. Otherwise, any discontinuities in outcomes confound the effects of sample
selection. In the present context, there may be concern that transacting parties could haveadjusted the timing of takeover deals, particularly since the TSCR was passed in May 2000, but
enforced only about 1 year later. We inspect for evidence of timing adjustments by plotting
the number of observations by quarter, but find no such evidence. Since takeovers tend tooccur during the second and fourth quarters, Appendix Figure A5 shows a seasonally adjusted
number of cases from 1997 to 2009, indicating no pattern of withholding prior to the second
quarter of 2001. This lends support to the assumption that non-tax factors largely determine
the broad timing of takeover deals.

E

Influential observation

We examine the sensitivity of the effective tax rate (ETR) estimate in a parsimonious model,
which omits the interaction term from the main specification but allows for difference in thelength of time between transactions.

cit/assetit=

β0 + β1 shortit + β2 longerit + β3 prof it/assetit + vi + wt + uit (1)Figure A6a presents the differences in coefficients, or DFBETA, as a proportion of the8coefficient estimate from the full sample. The x-axis is the industry code on the Tokyo Stock
Exchange. The figure excludes panel units with deviations of less than 0.5% for visibility. Panel(a) is for the coefficient on shortit . The most influential company is, perhaps as expected, YJ(ID: 30102); the company increases the magnitude of coefficient by 13.4 percentage points.
YJ is not the only influential observation, however; several others from the information andcommunication technology (ICT) industry have high values of DFBETA. Panel (b) is for thecoefficient on longerit . The industry classification for the most influential observation is realestate, but the acquirer is originally from the ICT industry.

F

Direct mergers

On average, should we expect a lower effective tax rate (ETR) among firms that merge directly?
The theoretical prediction is ambiguous. On one hand, some direct mergers generate tax
benefits, manifesting in low ETR for some acquirers, both before and after the 2001 reform.10
On the other hand, if non-tax considerations primarily drive majority of direct mergers, ETR
would not be systematically lower for the group.
The empirical finding reflects this ambiguity. We identify 245 firm-year observations thatcompleted a direct merger during the sample period, and create a dummy variable (dirmerit ),which takes the value 1 in the case of a firm that has completed one or more direct mergers
during year t. For two cases in which a firm has completed a direct merger and a two-stepmerger in the same year, we set the variable to 0. Column 1 in Table A4 shows the coefficientestimates from a model augmenting equation (8) from the main text with dirmerit and its
interaction term with prof it/assetit . The coefficient on the interaction term is as large as thatfor the two-step merger, and is statistically significant at the 1% level. Since the direct mergers
pre- and post-2001 can result in different tax consequences, Column 2 distinguishes direct
mergers from the two periods. The coefficient for the pre-period is about half the magnitude ofthat from the post-period, although they are not statistically distinguishable. Column 3 shows
the results for a model that incorporates lead terms of up to three periods. The coefficienton the interaction term is statistically significant at the 5% level. The coefficient on the lead
10

After 2001, qualified acquirers could carry over targets’ NOLs in tax-free mergers. Before 2001, although
to a limited extent, acquirers could do so likewise through the informal institution, as discussed in the main
text.

9

term, which is statistically significant at the 5% level, may be capturing costs of raising capitalfor takeovers or some pre-existing trend. These results appear to suggest that direct mergers
resulted in lower tax payments, particularly after 2001.
However, this result is sensitive to influential observations. The last two columns report
the maximum and minimum of coefficients obtained from the jackknife procedure, this time
excluding, one at a time, firms engaged in two-step mergers or direct mergers. At one extreme,
the magnitude of the coefficient on the interaction term with dirmerit falls by more than 40%
and becomes close to the size of the standard error. Therefore, few observations on direct
mergers carry significant weight in the estimation of the coefficient on dirmerit . This suggeststhat tax savings are large in few cases but not so in the majority of direct mergers. Importantly
for our purpose, the coefficients on step transactions are not sensitive to inclusion of the direct
merger dummy.

G

Step transaction with a taxable merger

A step transaction need not involve a tax-free merger to generate tax benefits. Parties may
adopt other transaction structure, as in the case study of Hoya, which involved a taxable
merger. This section examines a step transaction scheme involving a taxable merger discussed
in a tax guidebook by Adachi (2009) based on the 2001 institutional environment.11 We employ
a simple accounting model to show that, in effect, the government subsidizes corporate mergers;in the baseline scenario, the tax system reduces merger cost by 20–30%.
Suppose first that an acquirer first obtained a% (where a > 50%) of a target company’s
shares in a takeover bid (TOB), and then merged that target company in a taxable merger
by paying cash after 6 months. For simplicity, assume that the target’s shareholders were allindividuals, were identical and faced dividend tax (τ d ) and capital gains tax (g). The acquirer
paid p yen per share in the TOB and taxable merger. The target had no NOLs or built-in
gains or losses on tangible assets. The acquirer was profitable and generated sufficiently large
profits during the financial year at and after the merger.
The following concepts are based on tax law, rather than accounting. C is the target’s
total capital stock, which is a component of shareholders’ equity paid in by shareholders and11

A later edition of the book, published after the 2010 amendment, removes this strategy (Adachi, 2011).

10

does not include retained earnings.12 c(= C/n) is capital stock per share, where n is the total
number of outstanding shares issued by the target. b is the average basis for each shareholders(average price paid when purchasing shares in the target firm). t is the corporate tax rate.

G.1

Target shareholder

At the shareholder level, both transactions (TOB and merger) trigger the realization of capitalgains on shares since they involve cash payments. In taxing capital gains (p − b), which
are taxed lightly compared to dividends, the Japanese tax law classifies capital gains into
two components.13 One component is a portion attributable to deferred dividend payments,
referred to as “deemed dividend.” Deemed dividend is the difference between the share price(p) and capital stock per share (c). Since capital stock does not include retained earnings,(p − c) captures deferred distribution of profits. The capital gains tax applies to the remainder(c − b).
The sum of shareholders’ tax liability from the sales of a% of shares at the time of acquisition
and the sales of the remaining (1-a)% of shares at the time of merger is[g(c − b) + τ d (p − c)]n.

G.2

(2)

Target company

In addition to the shareholder-level tax, the merger triggers the realization of capital gains on
assets at the target-company level. Capital gains are a part of gross revenue under the CIT,
and NOLs can offset those capital gains. Since the target in this example does not have NOLs,
upon asset sales to the acquirer, the target is liable to pay the difference between the receipt(P = pn) and book value of net assets (Abv ) based on the tax rule.

(P − Abv )t.
12(3)

In other words, C equals the book total assets minus total liabilities under the tax rule, minus retained
earnings.
13
Currently, the tax rates on dividends and capital gains are both 20.315% so that the tax advantage ofcapital gains is mainly the deferral of tax payments. Historically, capital gains were not taxable in principle for
1953–1989, while dividends could be taxed at the top personal rate during this period.

11

The tax definition of the book value of net assets is similar to the accounting concept of a book
net asset, or shareholders’ equity; book-tax differences arise from, for example, the treatment
of depreciation and inventories.

G.3

Acquirer

A taxable merger may create various sources of tax savings for the combined firms in addition
to any possible step-up in the basis for depreciable assets.14
The acquirer books an intangible asset that can be amortized over 5 years. The present
value of goodwill amortization is
5X
j=1(1 − δ)j−1

P − Acv
t = zt(P − Acv ),5(4)where Acv is the current value of net assets imputed for tax purposes.15 δ is the discount rateand z is the present value of amortization deductions per yen.
At the time of merger, the acquirer owns shares in the target. The tax law in 2001 treatedthe acquirer as both a buyer and seller of the target’s share; as a buyer of the target share,
the acquirer obtained a% of the shares in the target and was deemed to have made a paymentof p per share on shares worth c per share. Since the amendment in 2010, however, acquirers
cannot realize losses on this type of transaction and instead adjust balance sheet items undershareholders’ equity. The total amount of tax saving from this deduction isa(P − C)t.

(5)

As a seller, the acquirer is deemed to have realized a gain of a(P − C), which is treatedas a dividend. As long as the acquirer has held the target’s shares for more than 6 months(the period needed for the target to be a related company for the tax purpose), the dividend
is excluded from the acquirer’s taxable income.
14

We follow the treatment of Adachi (2009) and ignore the step-up of tangible assets.
Net assets are assets minus liabilities, where assets include depreciable assets as well as non-depreciable
assets and intangible assets.
15

12

G.4

Accounting model

The discussion so far highlights benefits and costs to different parties. Positive total gains
increase the (private) surplus from a takeover and would facilitate deal making. Consider the
total tax gain (S):S = a(P − C)t + (P − Acv )zt − (P − Abv )t − [g(c − b) + τ d (p − c)]n(6)

The first two terms represent acquirer-level deductions and are the capital loss and goodwill
amortization, respectively. These tax benefits arise only when the acquirer has taxable income.
The third term is the target-level realization of capital gains. This tax cost arises if the target
has positive net income and is zero if the target has NOLs as large as this term. The last itemis the shareholder-level tax. The capital gains tax rate (g) and dividend tax rate (τ d ) dependon the identity of shareholders.
To understand the scheme better, let s = S/n and differentiate s with respect to p to obtainds= t(z + a − 1) − τ d .
dp(7)

Since p is the payment to target shareholders, 1 − ds/dp represents an after-tax cost of anadditional takeover premium.
Table A5 summarizes after-tax premium costs by identities of shareholders. The first row
shows the case for dispersed shareholders who face a 10% dividend tax rate, as in the baseline
scenario. In this case, the scheme generates tax benefits of 26 cents per 1 dollar spent on
acquisition so that the effective cost of an additional 1 dollar of premium is 74 cents. The
second row shows the case involving large individual blockholders. An individual must combine
dividend income with other income if s/he holds more than 5% of shares,16 and we assume suchindividuals face the top marginal personal income tax rate of 43%. An additional premiumincreases tax payment by 7 cents so that the effective cost is greater than a dollar; parties would
likely prefer a tax-free transaction to defer shareholder-level tax in such cases. Founder-owners
often create proxy corporations known as asset-management companies, which hold shares andreceive dividends on their behalf. If a corporate owner holds more than 25% of the stake, the16

The threshold was reduced to 3% in 2011.

13

dividend received is not taxed in order to mitigate double taxation of corporate income.17 The
third row shows that the marginal cost is the lowest (0.64) in that case. If a corporate ownerholds less than a 25% stake, half of the dividend is excluded from the tax base and the rest
is taxed along with other income.18 The marginal cost is still less than a dollar (0.84) in thiscase.
The second column in Table A5 shows a similar computation, assuming that the target had
NOLs greater than the target-level capital gains. As the third (negative) term in equation (6)drops out, the marginal costs are lower and all less than 1, with a minimum of 0.24 in the caseof related corporate shareholders. This finding highlights that NOLs in targets are valuable
even when parties do not qualify for tax-free mergers.

References
Adachi, Yoshiyuki, M&A and Corporate Reorganization Schemes for Reducing Tax Costs(Zeimu cosuto wo yūri ni michibiku M&A soshiki saihen no sukı̄mu sentaku), first ed., Tokyo:
Seibunsha, 2009. (in Japanese).
, M&A and Corporate Reorganization Schemes for Reducing Tax Costs (Zeimu cosuto woyūri ni michibiku M&A soshiki saihen no sukı̄mu sentaku), second ed., Tokyo: Seibunsha,
2011. (in Japanese).
Hironaka, Akihiro, Michito Kitamura, and Masaki Noda, “Japan,” in Simon Whitehead, ed., Tax Disputes and Litigation Review—The Third Edition, London: Law BusinessResearch Ltd., 2015, pp. 227–239.
Kakihara, Yoshimi, “Issues surrounding the interpretation and application of the generalanti-avoidance clause under corporate reorganization (Soshiki saiheisei ni kakaru koui keisanhinin kitei no kaishaku tekiou wo meguru shomondai),” Zeimu Daigakko Ronsō, 2015, 82,
1–126. (in Japanese).
Lee, David S and Thomas Lemieux, “Regression discontinuity designs in economics,”
Journal of Economic Literature, 2010, 48 (2), 281–355.
17
18

There is provision for a debt-financed avoidance scheme.
This has applied since 2002, and from 1991 to 2001, 80% was excluded.

14

Matsuzaki, Takashi, “HOYA’s TOB of Pentax: Backstage view,” Nikkei BP Online 2008.
http://www.nikkeibp.co.jp/style/biz/feature/news/070828_hoya/index1.html, accessed May 23, 2016, (in Japanese).

15

Table A1: Timeline of Yahoo! Japan Corp.’s tax-avoidance case
Date
2008
2009

2010
2014
2016

Event
Executive Director of YJ was appointed as Executive Vice-Directorof IDCS
Feb 2
IDCS span off IDCF
Feb 20IDCS sold all of IDCF to YJ at ¥11.5bn
Feb 24
YJ acquired 100% of IDCS from SoftBank at ¥45bn
Mar 30
YJ merged IDCS and carried over NOLs worth ¥54.2bn
June 30
TRTB challenged YJ
Mar, Nov The District and High Courts ruled against YJ
Feb 29The Supreme Court supported the earlier decisions
Dec 26

Notes: Authors’ compilation from Kakihara (2015) and other sources. Yahoo! Japan (YJ),
SoftBank IDC Solutions (IDCS), SoftBank IDC Frontier (IDCF), Tokyo Regional Tax Bureau(TRTB).

Table A2: Sample selection

Number ofobservations

Notes

deletions

457,001
21,811
445
3,639
799
430,307

Original sample with corrections
Drop transaction types other than merger and acquisition
Drop dissolved and corrected entries
Drop market type other than IN-IN
Drop if parties located overseas
Base sample for identification

Table A3: An example to illustrate the algorithmrowtype target
0 acquisition X,Y,Z
1merger X,Y,Z
2
mergerX
3
mergerY
4mergerZ
5mergerX,Y6mergerX,Z7
mergerY,Z

16

Table A4: Tax payments and direct mergers

Dep. Var.: Ratio of tax payments to assets (cit a)step x profit pos

(1)

(2)

(3)

-0.0985**(0.0260)-0.0984**(0.0260)-0.1205**(0.0352)-0.0435+(0.0225)-0.0175(0.0126)
0.0070(0.0141)-0.0973*(0.0454)-0.0410*(0.0195)-0.0369(0.0267)-0.0087(0.0280)

step lead x profit pos
step lead2 x profit pos
step lead3 x profit pos
dirmer x profit pos-0.0990**(0.0328)

dirmer lead x profit pos
dirmer lead2 x profit pos
dirmer lead3 x profit pos
dirmer after x profit pos-0.0981-0.1315-0.0253-0.0495-0.0128-0.0204

0.01260.0007-0.0565-0.1195-0.0295-0.0474-0.0158-0.0447

0.0077-0.0299-0.1123**(0.0405)-0.0501*(0.0244)

dirmer before x profit pos
Observations
Number of id
Adjusted R-squared
Firm fixed effects
Year fixed effects

Jackknifemax
min75,3805,496
0.6555YES
YES

75,3805,496
0.6555
YES
YES

59,0405,362
0.6497YES
YES

Notes: This table presents selected coefficients from equation 1 augmented with thedummy for direct mergers (dirmer) and a set of interaction terms. The dependent
variable is the tax payment divided by asset. The last two columns show the range
obtained from the jackknife procedure for the model in Column 3. Standard errors
are clustered at firm level and are shown in parentheses. ***, **, and + denotestatistical significance at the 1%, 5%, and 10% levels, respectively.

17

Table A5: After-tax marginal costs of an additional premium
Shareholder typeτdBaseline
Dispersed individuals
0.1
0.74
Individual blockholders 0.43
1.07
Related companies
00.64
Unrelated companies
0.2
0.84

Target has NOLs
0.34
0.67
0.24
0.44

Notes: Figures are based on equation (7). τ d is the tax rate on dividend income for each shareholder typeunder the assumptions described in the text. We assume z is approximately 1, a is 0.9, and t is 0.4 in thiscomputation.

18

Figure A1: Eligibility for tax-free merger under the TSCRNo
No cash payment
Yes
Yes

𝐴 directly owns
𝑇 in fullNo
𝐴 indirectly
owns 𝑇 in full

Yes

Yes

𝐴 continues to
own 𝑇 in fullNo

Taxable merger

YesNo
𝐴 owns at ormore than 50%
of 𝑇 indirectly
No

No

Yes

The majority
ownership
continues
No

Yes

Satisfies both of thefollowings
1. Over 80% of target
Yes
workers remains
employed
2. Merged company
continues 𝑇’s main
operation

Tax-free mergerNo

𝐴 owns at ormore than 50%
of 𝑇 directlyNo

The “joint-venture test”
1. The business operations of 𝐴 and 𝑇 are related.
2. The business sizes are not lopsided, or an executive of 𝐴 is
involved in the operation of 𝑇. Specifically, a ratio of sizes,
measured in terms of sales, employee, or paid-in capital, does
note exceed five.
3. At or over 80% of target employees is expected to remain
employed at the merged company.
4. The merged company continues 𝑇’s main operation.
5. The continuity of shareholding test (for 𝑇 with less than 50
shareholders).

Yes

Note: This flowchart summarizes the eligibility for tax-free merger under the TSCR. This flowchart is basedon the authors’ translation of (Adachi, 2009, p.32).

19

Figure A2: Eligibility for NOL carryover under the TSCRNo

No carryover

Qualify as a tax-free transaction
Yes
Acquirer owns at or more than 50%
TargetNo

Yes
No

A restriction applies

Yes
Deemed joint-venture test:
Satisfies 1, 2, 3, & 4, or 1 & 5
1. The business operations of Acquirer
and Target are related.
2. The business sizes are not lopsided.
3. At or over 80% of target
employees is expected to continue
working at a new company
4. Merged company continues running
Target’s main operation
5. The executive involvement testYes

No carryover restriction

𝐴’s ownership in 𝑇 commenced within
5 years of the merger

No

No

Prior to 𝐴’s ownership involvement in
𝑇, 𝑇 had an unrealized net capital gains
exceeding the amount of 𝑇’s NOL atthat time

Yes

Note: This flowchart summarizes the eligibility for a carryover of targets’ NOLs under the TSCR. This flowchart
is based on the authors’ translation of (Adachi, 2009, p.55).

20

Figure A3: Discontinuity in covariates: A sample with short step transactions.5

Finance.5

Manufacturing

.3
.2
.1

.1

.2

.3

.4

Means
Before: 0.24
After: 0.20

.4

Means
Before: 0.14
After: 0.14

1995

2000

2005

2010

1995

2000

Fiscal Year

2005

2010

Fiscal Year

Retail and Wholesale

Infomation and Communication.5(b) Finance.5(a) Manufacturing

Means
Before: 0.36
After: 0.27

.1

.1

.2

.2

.3

.3

.4

.4

Means
Before: 0.08
After: 0.14

2000

2005

2010

1995

2000

Fiscal Year2005
Fiscal Year(c) Retail and wholesale(d) Information and communication.5

Other industry

.2

.3

.4

Means
Before: 0.18
After: 0.25

.1

1995

1995

2000

2005
Fiscal Year(e) Other industry

21

2010

2010

(continued from the previous page).5

Public target.5

Public acquirer
Means
Before: 0.13
After: 0.16

.1

.1

.2

.2

.3

.3

.4

.4

Means
Before: 0.34
After: 0.38

1995

2000

2005

2010

1995

Fiscal Year

2000

2005

2010

Fiscal Year(f) Acquirer is a public company(g) Target is a public company

Note: This figure presents time-series plots of control variables employed in the regression
discontinuity analysis on the sample restricted to step transactions with intervals of up to 12
months. All these control variables are dummies, and the vertical axis measures the
proportions with a value of 1. The bin size is 1 year, which spans April to March.

22

Figure A4: Discontinuity in covariates: A sample with longer step transactions.5

Finance.5

Manufacturing
Means
Before: 0.24
After: 0.18

.1

.1

.2

.2

.3

.3

.4

.4

Means
Before: 0.14
After: 0.15

1995

2000

2005

2010

1995

2000

Fiscal Year

2005

2010

Fiscal Year

Retail and Wholesale

Infomation and Communication.5(b) Finance.5(a) Manufacturing

Means
Before: 0.36
After: 0.27

.1

.1

.2

.2

.3

.3

.4

.4

Means
Before: 0.08
After: 0.14

2000

2005

2010

1995

2000

Fiscal Year2005
Fiscal Year(c) Retail and wholesale(d) Information and communication.5

Other industry

.2

.3

.4

Means
Before: 0.18
After: 0.25

.1

1995

1995

2000

2005
Fiscal Year(e) Other industry

23

2010

2010

(continued from the previous page).5

Public target.5

Public acquirer
Means
Before: 0.12
After: 0.15

.1

.1

.2

.2

.3

.3

.4

.4

Means
Before: 0.34
After: 0.39

1995

2000

2005

2010

1995

2000

Fiscal Year

2005

2010

Fiscal Year(f) Acquirer is a public company(g) Target is a public company

Note: This figure presents time-series plots of control variables employed in the regression
discontinuity analysis on the sample restricted to step transactions with intervals of up to 24
months. All these control variables are dummies, and the vertical axis measures the
proportions with a value of 1. The bin size is 1 year, which spans April to March.

5

10

15

count
20

25

30

Figure A5: Deseasonalized cases of takeovers by quarters

1997q3

2000q3

2003q3time (quarter)

2006q3

2009q3

Notes: This figure presents the number of takeovers after removing quarterly seasonality. The sample isrestricted to step transactions with intervals of up to 12 months. The dashed vertical line indicates the introduction of the TSCR.

24

10
91290
37030

31196
20077
3864
5591
12105
30249
7691
30795
16109
12077
9447
16173
16225
30577
21787
30149
30594
22355
7635
30212
5652

16681
22756

1668
1737
30145

5

30297
4155
7089
18413
1901
36921
30185
30625
1846

30886
30862
31432
1766
31145
30299
16284
30248
30539
24545
22976
31504
2104
28356
31345

14649
28635
114

Deviation (%)
-5
0

1538
16636

806
8126
123023956
18144
14649
31401
11908
31463
30094
487
728
4109

30968

26762

23927
29850
30543
31358
4459
30414
30481
30102
31009
1846
30906
30710
5962
30201
30930
30581
30044
30250
30185
35429
25165
30492
4111
30909
29271
31423
16022
31549
30608

7691
7140
30920
5241
1701
36007
18901
30505
11361
25244
22321
1724
24491
30127
8167
1721
7684
27482
16178
631225

1803
30730
12947

30886
35013
16344
30058
30254
13583
8935
4000
24042
30248
30271
30811
31043
37892
22305
9278

31157

28639
16369
30971

12203
30744
1711
1637
18380
18374

17848
2020
7688
21265
22355
16318
9425
30541
13255
30083
29845
31483
30328

30183
31504
22756

-15

-15

31009
30102

service

ICT

retailreal estateservice-20

retail

-20

ICT

30064
532
525 13451
30130
14007
18227
15045
1536
1111
16188
30206
8955
8387
16077
1251
368
5298732567141278

-10

30930
30906
30710
30201
5962

-10

Deviation (%)
-5
0

5

10

Figure A6: Sensitivity of coefficient estimates to excluding a firm

2000

4000

6000
Industry code

8000

10000

2000

4000

6000
Industry code

8000

10000

(b) longer (duration ≥12)(a) short (duration <12)Notes: This figure presents differences in estimates from the full sample and those from a sub-sample that
excludes one panel unit at a time. The Nikkei Company Identification Code labels indicate an excluded unit
for each iteration. Panels (a) and (b) show the coefficients on short and longer, respectively. The y-axis shows
percentages. The x-axis shows the industry code adopted by the Tokyo Stock Exchange. The figure excludes
panel units with deviations less than 0.5% for visibility.

25