Boon or Bane? Advance Tax Rulings as a Measure to Mitigate Tax Uncertainty and Foster Investment

Abstract

Politicians and tax practitioners often claim that tax uncertainty negatively affects investment. In many countries, firms can request fee-based advance tax rulings (ATRs) to mitigate tax uncertainty. We analyse theoretically the circumstances under which investors request ATRs, how tax authorities should price them and how they can affect investment. We assume that tax authorities integrate investors’ reasoning into their decisions. We find that in special cases the optimal fee tax authorities should charge is prohibitively high, thus firms will refrain from requesting ATRs. However, we find that revenue-maximising tax authorities offer ATRs if the ruling enables them either to significantly reduce their tax audit costs or to increase the probability of detecting ambiguous tax issues. Under certain circumstances, ATRs may effectively foster investment and potentially benefit both the tax authorities and taxpayers. Our results provide new explanations for why taxpayers that face high levels of tax uncertainty often do not request ATRs, even when the fee is rather low. Our results also hold when the tax authority maximises social wealth instead of its revenues. Regulatory changes in ATR requirements might serve as a natural quasi-experiment for an empirical study of our predictions regarding investment decisions.

Acknowledgements

We would like to thank the guest editor Richard Sansing and two anonymous reviewers for very valuable comments and suggestions. Moreover, this paper has benefited from helpful comments from the participants of the European Accounting Association Annual Meeting in Rome 2011 and the Tax Research Network Conference in London 2012 on an earlier version of this paper and the participants of the CETAR Young Researcher Workshop 2013, the CETAR meets Practice Tax Workshop in 2014 in Paderborn and the 2016 Spring conference of the Section Business Taxation in the German Academic Association for Business Research (VHB) in Mannheim, as well as the valuable suggestions of Martin Jacob, Jens Müller, Rainer Niemann, Regina Ortmann and Jack Stecher, two anonymous referees for the Annual Congress of the European Accounting Association 2014 and three anonymous referees for the Annual VHB Conference 2014. Any remaining errors or inaccuracies are, of course, our own. Earlier versions of this paper were entitled ‘Do investors request advance tax rulings to alleviate tax risk (and do tax authorities provide them)? A joint taxpayers’ and tax authorities view on investment behavior’ (2014) and ‘Economic Analysis of Advance Tax Rulings’ (2011).

Notes

¹See § 89 Abgabenordnung (German General Tax Code) and § 34 Gerichtskostengesetz (German Court Fees Act).

²See § 189 Bundesabgabenordnung (Austrian General Tax Code), KPMG (2014).

³ICIJ’s (2014) documentation includes 548 tax rulings that have been approved by Luxembourg officials with a stamped and signed confirmation letter. ICIJ further outlines:

In addition, ICIJ is publishing 16 other documents such as corporate tax returns related to companies in Luxembourg. On December 9, 2014, ICIJ released on this database a small new batch of Luxembourg tax rulings. ICIJ received the documents after the publication of the first installment of stories on Nov. 5. The new documents are Luxembourg tax rulings sought by a variety of accountancy firms on behalf of corporate clients from around the world. The files cover the period from 2003 to 2011. ICIJ is only publishing the rulings that were reported on by ICIJ and its media partners and that bear evidence that they were approved by Luxembourg authorities.

 

⁴See the critical considerations on revenue maximisation by Slemrod and Yitzhaki (2002).

⁵Our model offers several possible interpretations. In the first interpretation, the best alternative investment has a net cash flow of zero. In our second interpretation, the best alternative investment has a positive net cash flow. Then we interpret as the additional after-tax net cash flow generated by the underlying investment. More explicitly, let denote the after-tax cash flow of the investment and one of the alternative investments, then . For example, the alternative investment might be a financial investment that is subject to a tax that is non-stochastic, that is, certain. In the third interpretation, the investor has the possibility either to invest in the domestic country or in a tax haven, that is, in a country with a very low tax rate. The after-tax net cash flow in the domestic country is while it is in the tax haven. We then interpret as the difference In other words, the investor must decide whether to invest in the tax haven. Cash flow denotes the saved taxes due to the tax differential. We can emphasise that in the third case, that is, in settings in which the benefit of the investment is generated exclusively by the tax treatment, it is likely that an unfavourable tax treatment might render the investment disadvantageous. The unfavourable treatment, for example, might be due to the non-deductibility of outflows or double taxation.

⁶Similar to Mills et al. (2010, p. 1726), who also give an example for the discrete nature of tax disputes.

⁷The parameter can be interpreted as follows. The tax authority might treat part of the expenditures as non-deductible for tax purposes. Explicitly, let , where is non-deductible. Then, the after-tax cash flow changes to . We define Then, in case of a favourable interpretation of the tax case, the investor receives , and if is non-deductible, .

⁸While results from offsetting earnings against expenses and accruals, tax disputes typically focus on operating expenses or accruals (e.g. depreciation allowances), such that, for example, even for , a huge tax liability may arise. Obviously, is typically not a function of .

⁹Although the fee for an ATR in most countries is or will be tax deductible, it is not necessary to model this deductibility explicitly. The fee can be interpreted as a net fee for the taxpayer (gross fee net of tax savings resulting from tax deductibility) and net revenues for the tax authorities (net of lost revenues due to the deductibility of the fee).

¹⁰Implicitly, we assume that the probability of a negative outcome of the ATR is the same as the probability of a negative interpretation of the tax code in a setting with no ATRs.

¹¹This tax ambiguity can be operationalised, for example, by FIN 48 reserves (cf. e.g. Lisowsky et al. (2013). For an overview of potential additional operationalisations of tax risk, cf. Neuman, Omer, and Schmidt (2015).

¹²Slemrod and Yitzhaki (2002) note that revenue maximisation is a common assumption in the literature (see, for example, p. 1452) but suggest that revenue maximisation is suboptimal from a normative standpoint under social utility maximisation. In a first step, we abstract from these long-term effects and concentrate on ATR settings that are potentially able to increase public revenues. We relax this assumption in Sec. 5.2.4.

¹³In the case of our third interpretation (footnote 5), the formulas would slightly change. However, the main insights remain valid.

¹⁴The ex ante probability of losing cash flows due to fewer investments equals the probability of additional cash flows due to more investment. This result depends critically on the assumption that is uniformly distributed.

¹⁵An interior solution, as in the above example, cannot always be derived. Thus, for the parameters ; we obtain

Additional information

Funding

Caren Sureth-Sloane gratefully acknowledges support by the German Research Foundation (DFG) [grant number SU 501/4-2].