Discussant Comments: Early Evidence on the Determinants of Unrecognized Tax Benefits. Ed Outslay Michigan State University

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1 Discussant Comments: Early Evidence on the Determinants of Unrecognized Tax Benefits Richard Cazier, Sonja Rego, Xiaoli Tian, and Ryan Wilson University of Illinois Symposium on Tax Research XI October 2, 2009 Ed Outslay Michigan State University Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 1

2 Purpose of the Research This study examines the association between disclosures of unrecognized tax benefits under FIN 48 (ASC ) and existing measures of tax avoidance. Premise: Prior research suggests that managers use the tax contingency reserve (UTB) to meet key earnings targets. Question: Will FIN 48 mitigate this behavior? Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 2

3 Purpose of the Research Answering the question: Investigate the association between levels of UTB balances at yearend (2007) to firm characteristics found to be associated with tax avoidance activity. Investigate the association between current year (2007) tax positions to firm characteristics found to be associated with tax avoidance activity Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 3

4 Purpose of the Research Provide descriptive evidence on the association between FIN 48 disclosures and existing measures of tax avoidance and tax aggressiveness Accounting ETR Cash TR Total book-tax differences Permanent book-tax differences Discretionary permanent book-tax differences Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 4

5 Findings of the Research Findings UTB balances associated with: Profitability (positive) Foreign operations (positive) R&D (positive) Leverage (positive) Sales growth (negative) Results are consistent with prior research that finds significant associations between these firm characteristics and tax avoidance activity. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 5

6 Findings of the Research Incremental explanatory power of tax avoidance measures: UTB balances: Only the 5-year average cash tax rate (negative) UTB balances that affect ETR: 5-year cash tax rate and permanent book-tax differences Firms with lower 5-year cash TRs have larger liabilities for unrecognized tax benefits. Potential significance: Cash TR only measure not affected if tax benefits are not recognized on the financial statement Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 6

7 Contribution of the Research These results suggest initial FIN 48 disclosures provide some information about the magnitude of firms tax avoidance activity. Caveat: Because of existing measures of tax avoidance all suffer from measurement error it would be difficult to conclude that a lack of association (if any) between these measures and FIN 48 disclosures is solely the result of the new disclosures not providing useful information about tax avoidance activities. {Query: Would the reverse also be true?} More caveats: not clear from these tests whether these disclosures provide financial statement users with new information about tax avoidance activity or whether they will be helpful to tax authorities in the audit process. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 7

8 Motivation for FIN 48 FIN 48 was motivated by the FASB s concern that diverse accounting practices have developed resulting in inconsistency in the criteria used to recognize, derecognize, or measure benefits related to uncertain tax positions. This diversity in practice results in noncomparability in reporting income tax expense that is not discernible by the users of the financial statements. [Exposure Draft] Most corporations used a best estimate approach to estimating the tax contingency reserve under FAS 5. Under the best estimate approach, the tax contingency reserve should be the amount that ultimately will be paid ( settled ) upon resolution of the litigation or appeals process. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 8

9 Motivation for FIN 48 Typical disclosure of FAS 5 tax contingencies With limited exception, the company is no longer subject to U.S. federal, state and local or non-u.s. income tax audits by tax authorities for years through The years subsequent to 2000 contain matters that could be subject to differing interpretations of applicable tax laws and regulations as it relates to the amount and/or timing of income, deductions and tax credits. Although the outcome of tax audits is always uncertain, the company believes that adequate amounts of tax and interest have been provided for any adjustments that are expected to result for these years. IBM Corporation 2006 Annual Report Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 9

10 Motivation for FIN 48 Atypical disclosure of tax contingencies The accruals associated with U.S. federal tax issues such as the tax benefits from the FSC / ETI tax rules, the amount of research and development tax credits claimed, deductions associated with employee benefit plans, U.S. taxation of non-u.s. earnings, and valuation issues regarding charitable contributions claimed were $841 at December 31, 2006, and $771 at December 31, The accruals for domestic state tax issues such as the allocation of income among various state tax jurisdictions and the amount of state tax credits claimed were $88 at December 31, 2006 and $98 at December 31, 2005, net of federal benefit. The accruals associated with taxation of non-u.s. earnings were $31 at December 31, 2006 and Boeing Company 2006 Annual Report Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 10

11 Motivation for FIN 48 The issues addressed by the Exposure Draft were reflected in speeches given by members of the SEC. My second point is that income tax contingencies also fall within the scope of Statement [FAS] 5. In other words, the accounting and disclosure requirements of Statement 5 apply to items of tax cushion. Statement 109 provides additional disclosure requirements for income tax items that arise as a result of temporary differences. Some of you no doubt are thinking, If we follow that guidance, and comply with the disclosure requirements in Statements 109 and 5 we d be providing a virtual roadmap for the IRS. This issue has been with us for some time. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 11

12 Motivation for FIN 48 A company s concern about maintaining confidentiality in this area is understandable, but it has to be balanced with the need for the company s investors, analysts, and regulators to gain a clear understanding of liquidity and the financial position and results of operations. Moreover, compliance with GAAP and SEC disclosure requirements is a responsibility a company voluntarily takes on when it decides to access the public markets. Confidentiality concerns do not excuse violations of GAAP or the SEC s disclosure rules. Scott A. Taub Deputy Chief Accountant of the SEC May 2004 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 12

13 Motivation for FIN 48 The FASB noted in its May 10, 2006 minutes that: The staff is not attempting to provide decision-useful information to taxing authorities in their roles as regulators. The staff simply believes that information which users have asserted is decision useful should not be withheld because of concerns that a regulator will have more information to do its job. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 13

14 Motivation for FIN 48 The [corporate finance] division now has more accountants than attorneys for the first time in its history, which means we re looking at lots and lots of financial statements. The concern in the UTP area is over whether there is enough transparency in that area and how much is enough without stepping over the line of confidentiality and where you re in a position where you re harming the company rather than helping investors understand, and it s a very fine line and we agree with that. Carol Stacy Chief Accountant SEC Division of Corporate Finance February 9, 2006 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 14

15 Motivation for FIN 48 Contrary to popular beliefs, FIN 48 was not written to provide a roadmap for the taxing authority. While it might have the ancillary impact of providing some additional information, that wasn't why the accounting standard setters went about writing it. It was written from the perspective of trying to provide the information that an investor would need to make an informed decision. So we certainly don't expect a company to go through each position and put together a whitepaper in the financial statements as to all of the facts, the technical authorities, and the tax code relied upon. I am not sure that is even meaningful to the average investor. What we are looking for though is somewhat transparent disclosures about the magnitude and type of exposures in either direction either positive or negative that might in fact have a material impact in the near term on either the company's cash flows, results of operations, or financial position, so that the investor has that information at his disposal. Joseph Ucuzoglu, Office of the Chief Accountant Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 15

16 FIN 48 Constituencies What do investors get out of this? First, FIN 48 provides much better comparability between companies. When looking at companies financial statements, there will be a higher likelihood that their tax expense and recorded assets and liabilities are recorded on a comparable basis. However that basis may not reflect the ultimate, or even the most likely, outcome. In addition, the disclosures will help investors understand the potential variability in income tax cash flows and possible future volatility in GAAP income tax expense. Bear, Stearns & Co. Equity Research Analysis July 2006 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 16

17 FIN 48 Constituencies What do investors get out of this? The added transparency provided by FIN 48 might cause companies to eventually pay more in taxes due to an increased risk of audit, and less aggressive applications of the tax code, it may reduce companies ability to manage earnings through the tax reserve and it may uncover tax risks that investors were not previously aware of. If investors learn that a company actually bears more risk than was known before, that could have an impact on their estimates of future cash flows and the return that investors would demand (i.e., increased tax risk should increase the cost of capital), which could affect valuations. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 17

18 FIN 48 Constituencies We expect FIN 48 will result in more volatile effective tax rates, and as a result, more volatile earnings (unless of course companies decide to become more conservative with the tax positions they take), increasing tax liabilities reported on the balance sheet and, most important, the added transparency might cause companies to eventually pay more in taxes due to an increased risk of audit, and less aggressive applications of the tax code, may reduce companies ability to manage earnings through the tax reserve and may uncover tax risks that investors were not previously aware of. Credit Suisse Equity Research Peeking Behind the Tax Curtain: FIN 48 Reveals Tax Risk May 18, 2007 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 18

19 FIN 48 Constituencies What do regulators get out of this? It will become common for tax return figures to diverge, sometimes quite dramatically, from the corresponding amounts reported in the financial statements and these differences, which will henceforth be known as unrecognized tax benefits, ought to provide, although this was certainly not the primary reason for the change in financial accounting that the Financial Accounting Standards Board (FASB) has recently wrought, the I.R.S. with something of a roadmap with respect to the enterprise s most controversial positions and, in the process, enable that agency to conduct more efficient audits of affected taxpayers. Robert Willens Lehman Brothers July 2006 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 19

20 FIN 48 Constituencies We view the FIN 48 disclosures as a compass for the IRS. It can point the IRS and other tax authorities in the right direction, helping to identify uncertain tax positions. The tax accrual workpapers are the roadmap. Credit Suisse Equity Research Peeking Behind the Tax Curtain: FIN 48 Reveals Tax Risk May 18, 2007 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 20

21 FIN 48 Footnote Disclosure The Seigel Tax Reserve Report, 4th Q public companies: Median tax reserves was $55 million Median to revenues: 0.9%; to assets: 0.7% Median impact on adopting FIN 48 was $100,000 The amount of a company s tax reserves is loosely correlated with its size 39 companies with revenues > $50 billion: $64,666 million ($1,700M) 372 companies with revenues $2-$5 billion: $15,928 million ($43M) Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 21

22 FIN 48 Footnote Disclosure So what has emerged from the murk? Generally, FIN 48 statements are not really meaningful in shedding light on risk analysis, (Deborah Butler, IRS associate chief counsel (procedure and administration) said, because the disclosure made by taxpayers on the forms tend to be fairly broad and potential risks are lumped together. But the disclosures may highlight for the IRS areas of further inquiry on the tax return Accounting Workpapers Generally Not Meaningful, Officials Say Tax Notes Today, Nov. 10, 2008 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 22

23 Thoughts on the Paper Timely, thoughtful, well-done, well-written, and thorough! Focus on investors is appropriate. What we learn: UTB balances correlate with prior measures of tax aggressiveness and are negatively correlated with cash ETRs What we would like to know: Has FIN 48 changed analysts risk assessment of corporations with high/low UTB balances (is this new information or more transparent information)? Has FIN 48 changed managers risk preferences for tax avoidance transactions? Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 23

24 Thoughts on the Model Equation 1 Do you need an auditor variable? Firms with increases / decreases to UTB in 2007 were not randomly distributed across CPA firms! END_UTB: Should it be measured based on absolute size or scaled? Somewhat like the budget deficit $1.7 trillion or as a percentage of GDP? Very different picture. ETR variable: Would structural ETR be a better measure? ETR +/- discrete items? Firms usually focus on the structural ETR. Five year average cash TR : Post Enron, Sarbanes much more emphasis on TRM; settlements related to tax shelters; shifting income to low-tax jurisdictions Need an industry variable? Credit Suisse finds that 11 industry groups accounted for over 60% of UTB. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 24

25 Thoughts on the Model How overstated is the UTB balance? Do you subtract correlative adjustments not netted with the gross UTB balance? The amount of unrecognized tax benefits at December 31, 2008 determined in accordance with the provisions of FIN 48 increased by $804 million in 2008 to $3,898 million The additions to the unrecognized tax benefits related to the current and prior years are primarily attributable to various transfer pricing and related valuation matters, certain tax incentives and credits, acquisition related matters and other non-u.s. and state matters... The liability at December 31, 2008 of $3,898 million can be reduced by $532 million of offsetting tax benefits associated with the correlative effects of potential transfer pricing adjustments, state income taxes and timing adjustments. The net amount of $3,366 million, if recognized, would favorably affect the company s effective tax rate. IBM 2008 Form 10-K Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 25

26 Thoughts on the Model Using a measure of UTB that includes only unrecognized tax benefits that affect the effective tax rate: good idea! Excludes tax benefits from stock option planning Might obscure aggressive tax planning with cost sharing As a result of the Court s (Xilinx) ruling, Cisco will record a one-time tax charge of approximately $130 million $150 million, with an impact of approximately $0.02 $0.03 per share, to GAAP net income during its current fourth quarter of fiscal Further, this matter will result in a reduction of approximately $310 million $320 million to additional paid-in capital. There will be no impact to cash flows for the fourth quarter of fiscal Additionally, Cisco does not believe this matter will have a material impact on its future results of operations, cash flows, or financial position. Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 26

27 Thoughts on the Model Thoughts on addressing issues of risk assessment Credit Suisse Securities measures of tax risk UTB / 5-year average cash taxes paid UTB / market capitalization UTB / cash flow from operations UTB / total liabilities Z score: average of 4 ratios; average = 0 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 27

28 Thoughts on the Results Factors associated with UTB balances: New information? As of December 31 and January 1, 2008, the total amount of unrecognized tax benefits was $1,453 and $1,272, of which $1,171 and $1,032 would affect the effective tax rate, if recognized. These amounts are primarily associated with U.S. federal tax issues such as the tax benefits from the Foreign Sales Corporation/Extraterritorial Income (FSC/ ETI) tax rules, the amount of research and development tax credits claimed, U.S. taxation of foreign earnings, and valuation issues regarding charitable contributions claimed. Also included in these amounts are accruals for domestic state tax issues such as the allocation of income among various state tax jurisdictions and the amount of state tax credits claimed. Cash tax rate: 15% ETR: 33.6% Boeing 2008 Form 10-K Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 28

29 Thoughts on the Results Negative correlation between PRIOR_UTB and SETTLE Consistent with firms that reduce unrecognized tax benefits due to settlements simultaneously rebuilding their tax reserves to facilitate future earnings management. Not all settlements are in cash (negotiated positions) Settlements can be for past and future years Does it depend on open years? Under-reserved or over-reserved? Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 29

30 The Moral of the Story Footnotes in 2006 and prior years tell you general tax information about a company Footnotes in 2007 and forward will tell you more but it will take an educated reader to know exactly what the more really means. Deloitte FIN 48 Why So Much Uncertainty over Accounting for Uncertainty in Income Taxes? Webcast, 2007 Outslay2009 Discussant Comments - Cazier, Rego, Tian, and Wilson 30