Sonja Olhoft Rego

Tax Reporting Aggressiveness and its Relation to Aggressive Financial Reporting

All authors are grateful to Thomson Financial for providing earnings forecast data, available through the Institutional Brokers Estimate System, as part of a broad academic program to encourage earnings expectations research. ABSTRACT: This study examines the relation between financial and tax reporting aggressiveness. Prior research has documented a growing gap between financial and taxable incomes since 1990. Over the same period, financial and tax regulators have documented an increase in tax shelter activity (aggressive tax reporting) and a concurrent increase in corporate accounting scandals (aggressive financial reporting). Consequently, this paper investigates whether the companies that engage in aggressive financial reporting are also the firms that engage in aggressive tax reporting. Our study is the first to predict and find that some firms tend to report aggressively for both book and tax purposes, while other firms tend to report more conservatively for both book and tax purposes. We use a system of equations to model the endogenous relation between financial and tax reporting decisions. The analysis controls for earnings management and tax planning incentives, and for rule differences between GAAP and tax law. Our bivariate and multivariate results both indicate firms that engage in aggressive financial reporting also engage in aggressive tax reporting. These results are important to both financial and tax regulators, and other stakeholders, who have a vested interest in understanding the interaction of financial and tax reporting decisions. Data Availability: The data used in this study are publicly available from the sources indicated.

Tax Avoidance Activities of U.S. Multinational Corporations

This paper investigates whether economies of scale and scope exist for tax planning. In particular, do multinational corporations avoid more taxes than U.S. domestic-only companies, resulting in lower effective tax rates? While the empirical results indicate that ceteris paribus, larger corporations have higher effective tax rates, firms with greater pre-tax income have lower effective tax rates. The negative relation between ETRs and pre-tax income is consistent with firms with greater pre-tax income having more incentives and resources to engage in tax planning. Consistent with multinational corporations being able to avoid income taxes that domestic-only companies cannot, I find that multinational corporations with more extensive foreign operations have lower worldwide ETRs than other firms do. Finally, in a sample of multinational corporations only, I find that higher levels of U.S. pre-tax income are associated with lower U.S. and foreign ETRs, while higher levels of foreign pre-tax income are associated with higher U.S. and foreign ETRs. Thus, large amounts of foreign income are associated with higher corporate tax burdens. Overall, I find substantial evidence of economies of scale and scope to tax planning.

Did FIN 48 Limit the Use of Tax Reserves as a Tool for Earnings Management

We utilize new income tax reserve disclosures required under FIN 48 to examine whether managers use discretion over this accrual to manage earnings to meet the consensus analyst forecast. We find that firms with pre-managed earnings (i.e., earnings before the change in the tax reserve) that are below the consensus analyst forecast are far more likely to reduce their tax reserves and thus report higher net income. In fact, we find that 37 percent of firm-years with pre-managed earnings below the consensus forecast meet the forecast when the change in the tax reserve is included in earnings. In contrast, only 9.8 percent of firm-years with pre-managed earnings above the consensus forecast increased their tax reserves to the extent that it caused them to miss the consensus forecast. This asymmetric result is consistent with managers using their discretion over tax reserves to meet consensus analyst forecasts. Using a proxy for changes in tax reserves developed by Blouin and Tuna (2007), we also document a decline in the use of tax reserves to meet the consensus analyst forecast following the adoption of FIN 48. Nonetheless, our results using both estimated and actual changes in tax reserves clearly suggest that managers continue to use their discretion over this account to meet the consensus analyst forecast, although at a lower rate of recurrence than during the pre-FIN 48 time period.

Does Greater Tax Risk Lead to Increased Firm Risk

A primary benefit of corporate tax avoidance is greater after-tax cash flows and therefore, increased shareholder value. However, in the accounting literature, some measures of aggressive tax avoidance have also been utilized as proxies for the level of a firm’s tax risk, since aggressive tax strategies involve uncertain future outcomes and can impose significant costs on the firm. This study evaluates the extent to which proxies for aggressive tax avoidance capture a firm’s tax risk, as measured by a positive association with the implied cost of equity capital. We find that the level of a firm’s reserve for income taxes is significantly, positively associated with the cost of equity capital, consistent with tax reserves capturing uncertainty surrounding a firm’s future after-tax cash flows. We also find that several other proxies for tax risk are not significantly associated with the cost of equity capital, including cash effective tax rates. We conclude that these tax metrics do not capture uncertainty surrounding a firm’s future after-tax cash flows.In this study we examine whether higher levels of tax risk are associated with increased firm risk, as perceived by capital market participants. Given the difficulties of measuring tax risk, we utilize four different proxies that prior research indicates capture greater tax-related uncertainty, including total unrecognized tax benefits (UTBs), current UTBs, discretionary permanent book-tax differences, and volatility in cash effective tax rates (ETRs). We provide robust evidence that discretionary book-tax differences and cash ETR volatility are positively associated with several measures of firm risk, while the UTB-based measures are either not associated with firm risk or negatively associated with firm risk. We also provide some evidence that low tax accrual quality drives the positive association between discretionary book-tax differences and firm risk. Our research increases our understanding of which tax metrics capture tax-related uncertainties that lead to assessments by investors and analysts of higher firm risk.

Conforming Tax Avoidance and Capital Market Pressure

In this study we develop a measure of corporate tax avoidance that reduces both financial and taxable income, which we refer to as “book-tax conforming�? tax avoidance. We use simulation analyses, LIFO/FIFO inventory method conversions, and samples of private and public firms, to validate our measure of conforming tax avoidance. We then investigate the prevalence of conforming tax avoidance within a sample of public firms. Results from the validation tests indicate that our measure of conforming tax avoidance successfully captures book-tax conforming transactions and thus, variation in conforming tax avoidance across firms. Consistent with expectations, we also find that the extent to which public firms engage in conforming tax avoidance varies systematically with the capital market pressures to which they are subject. For example, public firms that lack analyst following, do not issue equity securities, report lower sales growth, or smaller discretionary accruals engage in relatively more conforming tax avoidance and less nonconforming tax avoidance. Our study develops a new measure of conforming tax avoidance that should be useful in future research and provides new insights on the extent to which public firms are willing to reduce income tax liabilities at the expense of reporting lower financial income.

Who Invests in Corporate Tax Avoiders

We use data on individual investors’ stock holdings and retail trades to investigate whether corporate tax avoidance affects the willingness of individual investors to own stock. Consistent with corporate tax avoidance increasing the perceived risk of owning stock and the costs of processing financial information, we provide evidence that individual investors own less stock of firms that avoid more taxes and report more uncertain tax positions. We then examine whether investor sophistication and investment strategies impact individuals’ willingness to own stock in these firms. Our results suggest that more sophisticated investors and investors with shorter investment horizons own more stock in high tax avoidance firms, while more conservative investors own less. Overall, our findings are consistent with significant variation in how individual investors perceive corporate tax avoidance.

Supercharged IPOs: Rent Extraction or Signal of Future Firm Performance?

This study examines a new form of initial public offerings colloquially referred to as “Supercharged IPOs.” In a supercharged IPO, a series of transactions are performed as part of the IPO process that eventually generate new tax assets (i.e., greater future tax deductions) for the corporation. Unlike traditional IPOs, the creation of new tax assets also creates a tax liability for the pre-IPO owners. The benefits (i.e., future tax deductions) from the new tax assets are then split between the pre-IPO owners and the new IPO investors, who enter into a tax receivable agreement based on those assets. The net result of the transaction to the pre-IPO owners is the assumption of a certain tax liability in exchange for a contingent future benefit. As a result, we hypothesize, and find evidence consistent with, the decision to “supercharge” an IPO providing a signal regarding the future prospects of the firm. We document higher final offer prices and greater future financial performance for supercharged IPO firms compared to traditional IPO firms. We also examine future stock returns and do not find significant differences between traditional and supercharged IPO firms, consistent with the higher offer price for supercharged IPO firms not reversing. Our results contrast critics’ claims that tax receivable agreements allow pre-IPO owners and advisors to extract rents from new IPO investors.ABSTRACT This study examines a new form of initial public offerings, “supercharged” IPOs, where a firm-organized pre-IPO as a pass-through entity undergoes a series of transactions that steps-up th...