Tax Avoidance and Geographic Earnings Disclosure

The following post comes to us from Ole-Kristian Hope, Professor of Accounting at the University of Toronto; Mark (Shuai) Ma of the Department of Accounting at the University of Oklahoma; and Wayne Thomas, Professor of Accounting at the University of Oklahoma.

Multinational firms can avoid taxes through structured transactions among different jurisdictions (e.g., Rego 2003), such as reallocating taxable income from high-tax jurisdictions to low-tax ones (Collins et al. 1998). This type of income shifting significantly reduces tax revenues of governments in high-tax jurisdictions and potentially hinders domestic economic growth and other social benefits (e.g., GAO 2008; U.S. Senate 2006). Policy makers around the world, including the United States, European Union, and Canada, have either enacted or are considering regulations related to multinational firms’ cross-jurisdictional income shifting and tax avoidance behavior. However, relatively little is known about multinational corporate tax avoidance behavior (Hanlon and Heitzman 2010), though such knowledge provides a basis for making and enforcing related rules. Further, the relation between firms’ tax avoidance and financial disclosures is not well established. In our paper, Tax Avoidance and Geographic Earnings Disclosure, forthcoming in the Journal of Accounting and Economics, we investigate how geographic earnings disclosure in firms’ financial reports relates to multinational firms’ tax avoidance behavior.

Prior to Statement of Financial Accounting Standards No. 131 (SFAS 131), geographic earnings (along with geographic sales and assets) were required to be disclosed by all multinational firms. However, after implementation of SFAS 131 in December 1998, firms that define primary operating segments by industry are required to disclose only geographic sales and assets; disclosure of geographic earnings is voluntary. Given that the vast majority of firms report operating segments by industry classification, disclosure of geographic earnings is voluntary for most firms, and most firms choose to no longer disclose (Herrmann and Thomas 2000).

We expect that managers wanting to conceal tax avoidance behavior from financial statement users would likely avoid voluntarily disclosing any information related to these activities. Geographic earnings relate directly to firms’ income shifting behavior, and under SFAS 131 they are now a voluntary disclosure for most firms. Disclosing abnormally high earnings in lower-tax jurisdictions is generally perceived as tax avoidance (Sullivan 2004; Christian and Schultz 2005) and potentially imposes reputational damage on the firm (e.g., Chen et al. 2010), attracts criticism from policy makers (e.g., Houlder 2010), angers citizen groups (e.g., Publish What You Pay 2010; Tax Justice Network 2003; Shaheen 2011), and could generate scrutiny from foreign tax authorities (e.g., Drucker 2010; Bergin 2012). None of these groups have access to corporate tax filings and therefore they must rely on published financial information (e.g., geographic earnings) to detect tax avoidance activities. Given that prior research provides evidence that managers have the ability to influence their firm’s tax avoidance (Dyreng, Hanlon, and Maydew 2010) and their firm’s disclosure (Bamber, Jiang, and Wang 2010; Yang 2012), we predict a relation between tax avoidance and non-disclosure of geographic earnings in the post-SFAS 131 period.

We also consider the impact of changes in tax reporting requirements on the relation between non-disclosure of geographic earnings in the financial reports and tax avoidance. In December 2004, Schedule M-3 became a required part of the annual corporate tax filing. Schedule M-3 requires significant additional tax reporting details, including information related to the profitability of foreign entities that are included in financial net income but excluded from taxable net income. Prior to Schedule M-3, many complained that tax reports (e.g., Schedule M-1) failed to provide the information necessary to tax authorities to help identify complex business transactions associated with helping firms avoid taxes (Mills and Plesko 2003; Boynton, DeFilippes, Lisowsky, and Mills 2004; Boynton and Mills 2004; Boynton and Wilson 2006). This deficiency led to calls for improvement in tax reporting, eventually leading to implementation of Schedule M-3 (Mills and Plesko 2003). Donohoe and McGill (2011, 36) describe Schedule M-3 as “one of the most important new sources of information for the U.S. Treasury and IRS in the last 40 years.” The information provided in the Schedule M-3 plays an important role in determining which firms will be audited (Boynton, DeFilippes, and Legel 2008). Thus, beginning in 2004, firms’ ability to hide profits from the IRS in low-tax geographic regions or through other tax avoidance schemes should be substantially reduced by the additional reporting requirements of Schedule M-3. Accordingly, we expect that the relation between tax avoidance and non-disclosure of geographic earnings in the financial report will diminish after implementation of Schedule M-3.

Using a sample of 13,831 firm-year observations for the 16 years surrounding the adoption of SFAS131 and Schedule M-3 (1993-2008), we compare effective tax rates in the pre- SFAS 131 period (January 1993 to November 1998), post-SFAS 131 period (December 1998 to November 2004), and post-M-3 period (December 2004 to December 2008) to test our predictions. We find that firms no longer disclosing geographic earnings in the post-SFAS 131 period have current effective tax rates (cash effective tax rates) that are 4.2 (5.3) percentage points lower than do firms that continue to disclose geographic earnings, controlling for many firm-level factors and fixed effects for year and industry. However, prior to implementation of SFAS 131 (when all firms were required to disclose geographic earnings in financial reports), eventual non-disclosers’ effective tax rates were not significantly different from those that continued to disclose geographic earnings. Overall, the results are consistent with managers perceiving non-disclosure of geographic earnings as making their firms’ tax avoidance behavior less transparent.

We further find that, after implementation of Schedule M-3 (when all firms were required to reconcile with the IRS the profitability of foreign entities not included in the consolidated tax group), the difference in non-disclosers’ and disclosers’ effective tax rates diminished. This finding is consistent with improvements in tax reporting to the IRS constraining firms’ tax avoidance behavior. These conclusions are robust to controlling for a number of firm characteristics, employing matched-sample designs, using a constant sample of firms between the different reporting regimes, assessing long-term effective tax rates as alternative measures of tax avoidance, and controlling for differences in foreign and domestic pretax profit margins. We also find that the relation between non-disclosure of geographic earnings and tax avoidance is more pronounced in the post-SFAS 131 period for firms that are more intangible-intensive, that report more geographic segments immediately prior to SFAS 131, or that have a lower probability of an IRS audit.

We provide some additional tests to better understand firms’ income shifting behavior. First, we find an increase in the number of tax havens for non-disclosers in the post-SFAS 131 period. Tax havens provide greater opportunity for firms to shift both domestic and foreign profits to lower-rate foreign jurisdictions. Second, we document an increase in non-disclosers’ ratio of foreign pretax income to total pretax income in the post-SFAS 131 period relative to that of disclosers. These results are consistent with greater domestic-to-foreign income shifting for non-disclosers. The increase in non-disclosers’ foreign-to-total pretax income in the post-SFAS 131 period is then mitigated in the post-M-3 period, consistent with reduced domestic-to-foreign shifting. Finally, we find that non-disclosers’ foreign effective tax rates fall in the post-SFAS 131 period, and this decline partially reverses in the post-M-3 period. As we discuss in more detail in our paper, one interpretation of these results is that non-disclosers engaged in more domestic-to- foreign profit shifting in the post-SFAS 131 period. To the extent that firms shift domestic profits to foreign jurisdictions that have tax rates lower than those of their other foreign jurisdictions, the foreign effective tax rate is expected to decline. After Schedule M-3, the decline in the foreign effective tax rate partially reverses, as the IRS is better able to detect and prevent domestic-to-foreign shifting. However, Schedule M-3 is not provided to foreign tax authorities, and firms may continue to shift profits from high-tax foreign jurisdictions to low-tax ones. As such, non-disclosure of geographic earnings remains associated with firms’ foreign tax avoidance behavior. These shifting activities are interesting issues for future research to explore further.

The full paper is available for download here.

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