How Do Managers and Shareholders Respond to Taxation? An Analysis of the Introduction of the UK Real Estate Investment Trust Legislation

Corporate finance decisions, measurement of accounting profits and market valuations are invariably made within the framework of a taxation system(s). Previous research indicates both ambiguity over the influence of taxation on managers’ behavior and limitations in the ability of shareholders to process tax information. The establishment of the UK’s Real Estate Investment Trust (REIT) regime in 2006 allowed quoted companies to opt out of company level taxation. We examine the reasonableness of managers and shareholders’ responses i.e. their ability to process information. When compared with shareholders, managers demonstrated a greater knowledge of the legislation, and of its applicability. For example, managers appeared to pre-empt the effects of the legislation. This should also act as a warning of the potential downside of increased cooperation between tax policy makers and taxpayers in trying to make more appropriately formed legislation. Further, managers appeared to be willing to trade off the interests of shareholders for their own personal gain which is surprising given the visibility of the REIT conversion process. Although shareholders were willing to pay less in such instances, their apparent inability to prevent this behavior illustrates the limitation of shareholder control over managers’ behavior. We find shareholders can accurately assess the general effects of the legislation but were unable, when combined with company information, to identify specific companies likely to benefit from the legislation. Without any increase in shareholder sophistication, concerns exist over the effectiveness of shareholders in acting as monitors of managers’ tax decision making and decision making more generally.