Did FIN 48 increase companies’ tax payments? Trade-off between disclosure and tax burdens

Abstract

This article examines the effects of implementing FIN 48 on companies’ tax burdens. While the literature examines how FIN 48 impacts companies’ financial reporting, its effect on tax payments has not yet been explored. We find that FIN 48 likely increased larger companies’ tax burdens. Prior to the adoption of FIN 48, larger companies may have used their asymmetric information advantage over the tax authorities to maintain relatively aggressive tax positions. To the extent that such tax-saving strategies were possible only for larger companies, FIN 48 appears to have reduced the appeal of these more aggressive tax minimization strategies.

Keywords:

• FIN48
• tax burdens
• tax compliance

JEL Classification:

• H2
• M2
• M4

Acknowledgements

The authors appreciate comments from Molly Sherlock and also thank those in the IRS Large and Mid-Sized business economist group from providing useful comments and suggestions. Sangjik Lee was supported by Hankuk University of Foreign Studies Research Fund.

Notes

¹ Porterba et al. (2007) investigate deferred tax positions of large US companies between 1993, essentially the first year of implementation year of SFAS 109, and 2004. Using panel data on Deferred Tax Assets (DTAs) and Deferred Tax Liabilities (DTLs) of 100 FORTUNE 50 companies, they find that a higher proportion of companies have a net DTL. Their analysis also shows that the aggregate value of deferred tax liabilities is larger than that of deferred tax assets for US corporations.

² Only 0.8% of companies with assets less than $250 thousand were subject to IRS examinations in fiscal year 2007 (IRS, 2008).

³ Tax contingencies are reserves for uncertain tax positions. Tax contingencies are also known as tax cushions, tax exposures, reserves for uncertain tax positions and/or contingent reserves. While there are other types of tax reserves, including reserves for current taxes and reserves for deferred taxes, for the purposes of this article, we use the term tax reserves, specifically, to refer to reserves for tax contingencies.

⁴ The literature analyses the effect of FIN 48 on tax reserves. Blouin et al. (2007) find that tax reserve reductions were relatively common for large companies, as opposed to small companies, from 2005 through the first quarter of 2007. The authors conclude that their findings support the view of FIN 48 as a conformity tool. Blouin et al. (2008) examine whether companies with excess tax reserves were concerned with the increase in the probability of a tax audit after FIN 48. The authors hypothesized that this anticipation of FIN 48 may have altered companies’ strategies regarding tax reserves prior to its implementation. Blouin et al. (2008) show that companies with excess tax reserves tend to decrease their reserves prior to FIN 48's adoption, while other companies waited until adoption to increase tax reserves. The literature shows that the effects of FIN 48 on companies’ strategies vary by specific company characteristics such as company size and tax reserve levels.

⁵ Several other corporate tax planning issues have been explored in the literature: recent topics include inter-company finance (Overesch and Wamser, 2010), foreign direct investment (Wijeweera et al., 2007; Bellak and Leibrecht, 2009) and a tax reform and investment performance (Vergara, 2010).

⁶ The IRS Large and Mid-Sized Business (LMSB) Division Deputy Commissioner (International) stated on 4 January 2008 that the IRS is monitoring FIN 48 disclosures regarding transfer pricing related uncertainty and tax reserves (Bureau of National Affairs (BNA), 8 January 2008). While, the Deputy Commissioner stated that the IRS is closely observing these disclosures, the IRS has not changed its position or policy of restraint for tax work papers. As of December 2008, the IRS maintains a policy of voluntary restraint regarding the request for the calculations and documents in the work papers used to calculate the tax accrual including FIN 48 disclosures.

⁷ An official at H.M. Revenue and Customs (HMRC), the UK tax authority stated that HMRC has been monitoring FIN 48 disclosures closely. Not only has HMRC been monitoring to obtain additional information for tax audit purposes, the office stated that HMRC has been monitoring the effects of the disclosures on share prices, the market reactions to such disclosures, and financial analyst's use of disclosures (TMTPR, 4 December 2008).

⁸ Senator Carl Levin and the Senate Homeland Security and Governmental Affairs Permanent Subcommittee on Investigations have requested the work paper files surrounding FIN 48 and international transactions including transfer pricing. Senator Levin believed this policy of restraint to be ill-conceived and during 2007, this committee requested work paper files for an undisclosed set of companies regarding advanced pricing agreements and the values of unrecognized tax benefits (TMTPR, 11 September 2008).

⁹ One Ernst & Young director of Tax Accrual Services was not surprised with the diversity in FIN 48 disclosures. He remarked that since the analysis depends on the facts and circumstances, as well as a company's intentions in ultimately resolving the tax position, the results may be inconsistent between companies. One auditor at a Big Four firm anonymously stated that companies showed various ranges of FIN 48 responses. While some companies reported having an uncertain tax position, the company deemed certain positions as being immaterial for reporting purposes. Thus, the tax position was reported not to materially affect earnings or retained earnings (BNA, 22 May 2007).

¹⁰ The proportion of tax returns examined by the IRS by asset groups provides evidence to support this point. Only 3% of the tax returns in each asset groups with assets less than $10 million were examined in FY 2007. This probability increases dramatically once assets surpassed $10 million (18.5% of the tax returns in the 5 asset categories between $10 million and $1 billion were examined) and approximately doubles to 31.6% for the companies with assets between $1 billion and $5 billion. The probability of being examined again doubled to 62.9% for the companies with assets between $5 billion to $20 billion. All tax returns for companies with assets above $20 billion were audited.

¹¹ These are companies in the agriculture, forestry and fishing industry.

¹² Division J includes firms classified as being involved in Public Administration. Entities with SIC codes between 4300 and 4399 are classified as being a part of the United States Postal Service.

¹³ Further details on the construction of the dataset are provided in the Appendix.

¹⁴ The IRS Data Book provides the information on the proportion of audits by companies’ size. The data spanning 1999 through 2006 exhibit trends similar to what is observed here. Companies with less than $10 million in total assets generally had less than 10% audit rates. Companies with assets between $10 million and $250 million generally maintained 15% audit rate. Companies with assets greater than $250 million had an historic audit rate of approximately 30%.

¹⁵ Operating profit margin is (sales – total costs)/sales. It is a measure the profitability of the operations relative to sales revenues.

¹⁶ FIN 48 is effective for companies with fiscal years beginning after 15 December 2006. Technically, all companies with fiscal year end 16 December 2007 to 15 December 2008 would have their first mandatory experience with FIN 48. Preliminary analysis presented in Tomohara et al. (2010a, b) defines that FIN 48 is equal to one if the company's observations are for FYE 31 December 2007 or later. However, the fiscal year of many companies coincides with the calendar year, beginning on 1 January and ending on 31 December. Hence, most companies adopted FIN 48 for the 2007 fiscal year.

¹⁷ For most companies γ _jt is time invariant. However, it is not impossible for a company to change their focus and be reclassified into another SIC.

¹⁸ The analysis was also conducted using real Gross Domestic Product (GDP) and unemployment rates as macroeconomic variables. These variables did not explain trends of tax payments and, thus, were dropped from the analysis.

¹⁹ We introduce a difference-in-difference approach related to policy analysis. The preliminary analysis presented in Tomohara et al. (2010b) uses a simple before–after estimator.

²⁰ We recognize that non-Large companies are not exactly comparable to Large companies. In this sense, the analysis treats the former as a quasi-control group. The differences between the two groups are controlled through the use of the Large dummy and other firm specific control variables.

²¹ If the previous year's observation did not exist, we did not calculate the average level and simply utilized the FYE observation.

²² The LIFO reserves are the difference between the FIFO value of inventory and LIFO value. The LIFO reserves are a measure of the cumulative amount that a company's taxable income or financial statement pre-tax income has been reduced by using the LIFO method.