Thomas R. Kubick Assistant Professor University of Kansas [email protected] Daniel P. Lynch* Assistant Professor
University of Wisconsin –Madison [email protected] Michael A. Mayberry Assistant Professor University of Florida [email protected] Thomas C. Omer Professor of Accounting University of Nebraska-Lincoln [email protected] August 2014 Abstract:
This study examines the tax avoidance behavior of firms prior to the issuance, and following the resolution, of tax-related SEC comment letters. We find that firms engaging in higher levels of tax avoidance are more likely to receive a tax-related SEC comment letter. In order to resolve SEC comment letter issues, firms must address the comments and increase disclosure quality to satisfy the SEC’s demands. If the costs of the new disclosures exceed the benefits of the higher tax avoidance, we predict firms will decrease tax avoidance following a tax-related comment letter. Supporting this conjecture we find firms subsequently reduce their level of tax avoidance following the resolution of the SEC comment letter. This is consistent with increased disclosure quality increasing the expected costs of tax avoidance ultimately leading to a decrease in tax avoidance. We also present evidence that investors positively value within-firm increases in tax avoidance but assign lower valuations after receipt of a tax-related comment letter, consistent with investors anticipating additional tax-related costs from regulatory scrutiny. Overall, these results illustrate the interplay between increased financial statement disclosure quality and tax avoidance.
*Corresponding Author
The Effects of Increased Financial Statement Disclosure Quality on Tax Avoidance: An Examination of SEC Comment Letters
I. Introduction
The disclosure of tax-related information in financial statements has undergone dramatic changes in recent years. From the enactment of FIN 48 (ASC 740) in 2007, requiring all public firms to make financial statement disclosures of aggregated reserves for uncertain tax positions, to recent calls for corporations to publicly disclose tax returns and report information on a country by country basis, firms are under pressure from regulators and standard-setters to increase disclosures of tax-related information in their financial statements.1 Although prior research has examined the impact of changes in mandatory disclosures, the literature provides little evidence on the impact of firm-specific changes in disclosure on firms’ tax avoidance behavior and investors’ reaction to these new disclosures.2 This study contributes to the ongoing public discussion by examining the tax outcomes of firms before the issuance of and following the resolution of tax-related Securities & Exchange Commission (SEC) comment letters to investigate the relation between increased tax-related financial statement disclosure quality and tax avoidance, as well as, investors’ responses to an increase in disclosure quality.
The SEC examines publicly traded companies’ 10-K filings at least once every three years (SOX: Section 408) and comment letters are issued for deficient disclosures. Firms are required to respond to comment letters within ten days.3 Firms’ responses include additional information, disclosures, and a commitment to adjust future filings, or restating previously issued
1http://www.bloomberg.com/news/2011-10-06/on-corporate-taxes-put-the-public-in-publicly-traded-view.html 2 This is in contrast to studies that consider the effects of mandated, general disclosure standards of tax information. See Donohoe and McGill (2012), Abernathy et al. (2013), Ciconte et al. (2014), De Simone et al. (2014), and Robinson and Schmidt (2013) for information regarding the disclosure of tax information through new standards. 3 The SEC examines filings other than the 10-K (e.g. 8-Ks), but concentrates its resources on these critical disclosures. Thus, in this study we focus on SEC comment letters on 10-K filings.
filings (Cassell et al. 2013). When the matter is resolved, SEC comment letters and firms’ responses to them are posted on the SEC’s web site, revealing new firm-specific information.
To proxy for firm-specific, tax-related disclosure quality and increases in disclosure quality, we use tax-related SEC comment letters and their ultimate resolutions. The primary reason for tax-related SEC comment letters is a lack of disclosure and clarity in the income tax footnote related to items such as undistributed foreign earnings, uncertain tax positions and valuation allowances (Deloitte 2012; PWC 2013). Thus, we first examine whether firms with higher levels of tax avoidance, and presumably higher costs related to disclosure, are more likely to receive a tax-related SEC comment letter. We then investigate if, subsequent to increases in disclosure quality (i.e., the resolution of disclosure issues cited in SEC comment letters), firms engage in lower levels of tax avoidance. We next examine how investors change their
expectations about the probability of losing tax avoidance strategies by considering the valuation of tax avoidance preceding and subsequent to the disclosure of tax-related SEC comment letters.
Prior research documents inconsistent results with respect to the association between tax avoidance and mandatory disclosure quality. Consistent with a proprietary cost explanation, some prior research documents an association between higher levels of tax avoidance and
decreased disclosure quality (Hope, Ma, and Thomas 2013; Robinson and Schmidt 2013; Dyreng et al. 2014). However, Towery (2012) documents that firms complying with new tax return disclosure requirements do not reduce tax avoidance in response to these increased private disclosures to the IRS but instead alter their financial reporting of potentially sensitive tax positions. Additionally, concurrent research suggests higher tax avoidance is associated with greater financial complexity, leading to reduced corporate transparency (Balakrishnan et al. 2012, Neuman et al. 2013).This reduction in disclosure quality results in firms attempting to
increase the volume of their disclosures in order to offset the reduction in transparency but without a corresponding increase in the quality of their tax disclosures (Balakrishnan et al. 2012, Neuman et al. 2013). Given the mixed results concerning the complex relation between tax avoidance and disclosure quality, we focus on tax-related SEC comment letters as an exogenous shock to firms’ tax disclosures that allows us to use the firm as its own control, potentially ruling out alternative explanations and providing a stronger test of the impact of increased tax-related financial statement disclosure quality on tax avoidance.
There are costs to disclosing tax-related information in the financial statements. Indeed, strong corporate opposition to new disclosures is consistent with managers’ belief that disclosing tax information in financial statements is informative to both the IRS and competitors (Graham et al. 2012). Thus, increasing the disclosure quality of tax information can increase detection risk, thereby increasing the expected costs of tax avoidance. Tax authorities could use improved financial statement disclosures to target companies for audit and to target particular tax planning strategies for examination during audit. We argue that increases in disclosure quality potentially reveal sensitive tax information, thereby increasing the expected cost of tax avoidance by increasing detection risk. All else equal, higher expected costs of tax avoidance related to improved disclosure quality should result in a new, lower level of tax avoidance.
Using a sample of firm-years from 2004-2011, we find a positive association between higher levels of tax avoidance and the propensity to receive a tax-related SEC comment letter.4 This is consistent with firms’ tax-related disclosures obfuscating information which may result in additional costs from revealing their tax planning activities to tax authorities. In our primary analysis, we find that following the resolution of the disclosure issues cited in the SEC comment
4 We use textual and manual analyses to examine SEC comment letters for the references to disclosure issues related to tax matters.
letters, firms engage in lower levels of tax avoidance. Specifically, our estimates suggest that firms report higher GAAP effective tax rates and smaller total/discretionary permanent book-tax differences following comment letter resolution. This is consistent with increased financial statement disclosure quality of tax-related information leading to a decrease in tax avoidance. Finally, we find that investors appear sensitive to the receipt of tax-related comment letters. Prior to the resolution of a comment letter, tax avoidance is positively related to stock returns.
However, we document a significant attenuation of this positive relation following a comment letter, suggesting SEC scrutiny is related to heighten concern over the loss of value-enhancing tax planning.
We also perform a number of supplemental tests. First, we confirm using a firm fixed effects specification, which controls for unobservable time-invariant firm characteristics and help rule out alternative explanations. Second, we employ a difference-in-difference design using propensity-score matching where we match each firm receiving a tax-related comment letter to a control firm based on company and industry characteristics including prior period tax avoidance and other variables that could impact the likelihood of receiving a tax-related comment letter. Inferences generally remain unchanged or become stronger. Finally, we document that tax avoidance is positively related to the length of correspondence between the firm and the SEC, suggesting that tax avoidance is also related to the severity of the comment letter.
The impact of tax-related financial statement disclosures on tax avoidance is important for several reasons. First, tax authorities potentially use financial statement disclosures (or lack of disclosures) in determining which firms to target for examination and the scope of subsequent audits. Second, although the SEC and IRS are both governmental entities, in the past minimal
coordination and information sharing has occurred between the two agencies.5 This study documents a material “spill-over” effect from improving financial reporting quality that favors additional revenue collection. Thus, we inform legislators and regulators on the potential benefits of better cross agency allocation of resources. Third, by investigating investors’ responses to increased disclosure for firms engaging in greater levels of tax avoidance, we provide evidence on the market’s perception of increased disclosures and the value of firms’ tax avoidance.
This study contributes to several lines of literature. First, we contribute to the literature investigating the determinants (Cassell et al. 2013; Ettredge et al. 2011) and consequences (Johnston and Petacchi 2012; Robinson, Xue, and Yong 2011) of SEC comment letters. We expand the scope of the literature to include tax-related topics, which represent a unique tension between the interests of regulators that favor full disclosure of tax information and investors that may prefer less disclosure to facilitate an increase in after-tax cash flows through tax avoidance. Second, we extend studies examining the effect of disclosure on tax avoidance (Robinson and Schmidt 2013; Gupta et al. 2014; Donohoe and McGill 2011; Abernathy et al. 2012) by focusing on firm-specific disclosures rather than newly mandated standards. This approach allows us to investigate the variability of individual firm disclosures rather than attempting to assess the impact based on an assumed complete or uniform compliance among firms. Third, we contribute to the literature on the consequences of regulatory scrutiny (Hanlon et al. 2014; Hoopes et al. 2012). We document a ‘spill-over’ effect where the actions of the SEC benefit the IRS and potentially increase tax collections.
The remainder of this paper proceeds as follows: Section II provides background on the SEC comment letter process along with a discussion of prior research and develops the research
5See https://www.sec.gov/info/municipal/sec-irs-mou030210.pdf for an exception where the SEC and IRS worked together regarding tax-exempt bonds and municipal securities.
hypotheses. Section III discusses the methodology and empirical procedures, Section IV discusses the results, Section V provides a discussion of additional analyses performed, and Section VI concludes.
II. Related literature and hypotheses development SEC Comment Letters and Disclosure
Under Section 408 of the Sarbanes-Oxley Act (SOX), the SEC is required to review each registrant’s 10-K at least every three years (Cassell et al. 2013). Comment letters are issued when a registrant’s filing is materially deficient or if the filing requires additional clarification (SOX Section 408). Registrants are required to respond to comment letters within ten days and responses typically include supplemental information addressing the deficiency or providing additional clarification.6 In some cases, firms are required to restate the reviewed filing, but typically the firm commits to providing the requested information in future disclosures.7
Prior literature has modeled the determinants of SEC comment letters. Cassell et al. (2013) examine SEC comment letters related to 10-K disclosures during 2004-2009 and find that lower profitability, higher complexity, weaker corporate governance, and retaining a non-Big 4 auditors are all positively associated with the likelihood of receiving a SEC comment letter. Boone et al. (2013) find that firms subject to rule-based standards and standards that require subjective accounting estimates are positively associated with the propensity to receive SEC comment letters. Additionally, Johnston and Petacchi (2012) find that firms with a history of amended filings and restatements are more likely to receive comment letters.
6 Although the SEC comment letter process is advisory in nature, research shows the firms modify disclosures in response to the receipt of SEC comment letters (Bozanic et al. 2013; Brown et al. 2013).
7 Johnston and Petacchi (2012) report that more than 17% of firms amend filings to resolve SEC comment letters during the 2004-2006 time period.
Given the determinants and consequences of comment letters, prior research has used SEC comment letters as a measure of disclosure quality to examine the consequences of the SEC review process. Ettredge et al. (2011) use SEC comment letters to identify firms failing to
disclose bad news (i.e., circumstances of auditor changes) and find that identified firms had weaker corporate governance and relied less on external creditors. Robinson, Xue and Yong (2011) use SEC comments on mandatory compensation disclosures to document a positive association between defective disclosures and excess CEO compensation as well as prior media criticism of CEO compensation, suggesting excessive compensation incentivized managers to withhold information for private benefit. Further, Johnston and Petacchi (2012) document an increase in earnings response coefficients (ERCs) and a reduction in return volatility and trading volume around earnings announcements following the resolution of comment letters suggesting that investors are cognizant of comment letters and that the additional disclosure from the resolution of the comment letter process results in a decrease in information asymmetry.
Appendix B provides two examples of tax-related comment letters. In the first example, General Motors Inc. (GM) receives a tax-related comment letter related to its 2010 10-K filing in which the SEC asks for clarification regarding GM’s assumptions related to permanently
reinvested earnings (PRE). In response, GM claims that the liquidity needs of the firm can be met by using foreign cash through intercompany loans and pledges to make this disclosure in future filings. While the SEC deemed GM’s response to be satisfactory to comply with tax footnote disclosures, the particular tax information disclosed in this exchange potentially increases the probability of IRS scrutiny. The use of intercompany loans can be treated as a deemed dividend under section 956 of the Internal Revenue Code. Thus, the disclosure necessary to satisfy the SEC potentially exposed GM to costs in the form of higher expected tax costs.
In a second example, Apple, Inc. (Apple) received a comment letter regarding its foreign tax structure in which the SEC asks for additional risk factor disclosures and clarification on the location of PRE. In response, Apple refers the SEC to existing disclosures and further discloses that the majority of PRE are located in Ireland. Notably, Apple withheld a pledge to materially change future disclosures to include Ireland. The SEC did not deem this private disclosure to be acceptable and then issued a second comment letter asking for a change in disclosures which specifically references Ireland and the risks associated with changes in tax rates. Apple requested confidential treatment of this second comment letter, suggesting that even revealing such
mundane details as the location of PRE is proprietary information that can hamper tax avoidance activities. The SEC ultimately denied Apple the ability to withhold information regarding Ireland and tax risks from their disclosures, releasing this information to the public. Notably, in each of these examples it appears that the firm reveals new information related to its tax avoidance activities.
Disclosure Quality and Tax Avoidance
Because of the separation of ownership and control in most large U.S. corporations, external shareholders are exposed to loss through self-interested managers diverting resources for their own private benefit (Jensen and Meckling 1976; Healy and Palepu 2001). Disclosure of private information is one potential, yet complicated, avenue to alleviate the agency costs
associated with the separation of ownership and control. However, the means of obtaining the optimal level of firm-level disclosure is not straightforward.
Market forces can motivate the disclosure of information. Grossman’s (1981) analysis of disclosure suggests an ‘unraveling’ phenomenon where investors punish managers for failure to disclose information by discounting share prices. All but the poorest quality firm discloses
information to avoid being characterized by shareholders as the worst. This disclosure pattern allows investors to infer that a lack of disclosure represents bad news and effectively reveals private information to the market. In addition to Grossman’s (1981) work, the management forecast (Bamber and Cheon 1998; Hirst, Koonce, Venkataraman 2008) and voluntary disclosure (Verrecchia 1990; Leuz and Verrecchia 2000) literature suggest that managers reveal private information without being compelled through regulation.
In contrast, another means of improving disclosure is through regulation. Proponents of disclosure regulation view disclosure as a public good in which firms do not reap sufficient firms-specific benefits from disclosure and thus underinvest in disclosure from a social-welfare maximizing perspective (Beaver 1998). Because of the socially suboptimal level of disclosure resulting from this free-rider problem, regulators must mandate higher levels of disclosure rather than rely on market forces.
Proponents of regulation also point to a number of issues complicating the unraveling result of Grossman (1981). First, in addition to complications with respect to disclosing bad news, proprietary costs can also hinder the disclosure of good news (Verrecchia 1983;
Verrecchia and Weber 2006). If the disclosure of good news erodes a firms’ competitive position by allowing competitors to gain vital information that can be used to alter competitive behaviors, managers might optimally select non-disclosure and withhold information from the market. For example, firms in more competitive industries are more prone to request that the SEC allow them to withhold information regarding material contracts, presumably to keep competitors from learning sensitive price and quantity information (Thompson 2013). Second, the potential existence of proprietary costs provides managers a credible explanation for withholding information that exposes agency costs (Bens et al. 2011; Berger and Hann 2007; Hope and
Thomas 2008). Rather than disclose information demanded by investors that would reveal managerial self-dealing, managers can assert disclosure would harm investors by revealing sensitive information to competitors and potentially avoid discounts on firm value associated with agency costs (Berger and Hann 2007). For example, empirical evidence suggests managers withheld the disclosure of segment information primarily when segment performance was low and would reveal unresolved agency costs (Berger and Hann 2007).
Third, Dye (1985) explains private information might be uncertain, meaning managers with an incentive to fully disclose information may not possess the information to disclose to the market, further complicating the unraveling result of Grossman (1981). If this is the case, the failure to disclose information does not imply withholding of information and investors are therefore unsure of how to assess management actions. Investors are therefore unable to fully punish firms that withhold information through discounting share prices to accommodate agency costs. In summary, a lack of disclosure may represent (1) the optimal withholding of information to protect firm value from proprietary costs, (2) agency costs of managerial self-dealing, or (3) the lack of actual information.
Prior literature investigating the relation between disclosure quality and tax avoidance focuses on mandated disclosures and offers mixed evidence. One line of literature is consistent with tax avoidance leading to a decrease the level of disclosure quality. Hope et al. (2013) find that firms engaged in higher levels of tax avoidance exploited discretion in segment reporting to hide foreign segments, presumably to withhold information from taxing authorities. Robinson and Schmidt (2013) find that FIN 48 disclosure quality is inversely related to tax avoidance and that investors rewarded firms with poor disclosure quality. Dyreng et al. (2014) find that firms that fail to comply with mandatory subsidiary disclosures in the United Kingdom (U.K.) had
higher levels of tax avoidance and that firms subsequently increase ETRs after pressure from social activists to disclose a complete list of subsidiaries, consistent with firms withholding tax information to prevent consumer backlash.8
In contrast to the literature suggesting that tax avoidance incentivizes managers to withhold information, some literature suggests that managers do not withhold information regarding tax avoidance. Balakrishnan et al. (2012) find that managers of firms engaging in higher levels of tax avoidance attempt to offset the obfuscation resulting from higher tax avoidance by increasing their disclosure quantity. Lennox, Lisowsky, and Pittman (2013) find that firms engaged in higher levels of tax avoidance are less likely to receive an Accounting and Auditing Enforcement Release, suggesting tax avoidance does not incentivize managers to distort information on mandated financial statements and potentially implying a lack of incentive to withhold tax-related information from disclosure in general.
Given the results of some prior literature supporting a positive association between tax avoidance and poor disclosure quality and the nature of the issues cited in tax-related SEC comment letters such as uncertain tax positions, foreign tax planning, etc. we contend that higher levels of tax avoidance result in lower disclosure quality. We therefore hypothesize:
H1: The receipt of tax-related comment letters is positively associated with prior
period tax avoidance.
Increases in Disclosure and Tax Avoidance
If the disclosure of new information reveals sensitive tax information, the relative costs and benefits of tax avoidance should change. All else equal, increased regulatory scrutiny should
8 Both Dyreng et al. (2014) and Robinson and Schmidt (2013) focus on the presence of a specific, required disclosure. In contrast, the use of SEC comment letters allows us to examine both the presence and precision of specific disclosures. Additionally, we contribute to the literature by examining the impact of regulatory scrutiny of disclosures rather than pressure from a non-governmental entity (Dyreng et al. 2014)
increase the expected cost of detection and thus the expected cost of tax avoidance. Evidence on mandated disclosure regulation is consistent with this conjecture. Gupta et al. (2014) find a reduction in multistate tax avoidance following the implementation of FIN 48. Similarly, Blouin et al. (2010) find that firms reduced tax reserves prior to the implementation of FIN 48,
consistent with a change in the costs of financial reporting of uncertain tax positions eliciting a firm-level response. Moreover, our previously-discussed examples identified in Appendix B provide anecdotal evidence consistent with this intuition. Subsequent to the disclosure of intercompany loans, GM’s GAAP ETR increased from 9% in 2010 to 27% in 2012.9 Following their comment letter regarding the tax risks of having material PRE located in Ireland, Apple’s GAAP ETR increased from 13.8% to 18.2% and cash ETR increased from 25.2% to 26.2%.10
However, we should not observe a change in tax avoidance behavior to the extent that comment letters do not require the revelation of new, sensitive tax information. Indeed, in a non-tax context, extant research finds that not all SEC comment letters are equally important and some fail to produce stock price reactions, consistent with at least some comment letters
revealing no new information (Ryans 2014). Similarly, in a non-tax setting, Robinson, Xue, and Yu (2011) fail to find changes in executive compensation following SEC comment letters on the quality of compensation disclosures, suggesting that even for comment letters which might reveal sensitive information, the newly incurred costs from disclosure may not exceed the benefit of current corporate policies. In a tax context, previous studies examining newly mandated tax disclosures do not consistently find evidence of disclosures producing novel information. Dunbar et al. (2009) finds only limited evidence that FIN 48 reduced Federal tax avoidance activities,
9 GM had negative tax expense in 2011.
10 In the Apple example a potential confounding factor is the Senate subcommittee hearings on May 21st, 2013 where Apple testified on its foreign tax planning strategies.
consistent with a mandated disclosure of tax information not eliciting a change in taxpayer behavior. Hasegawa, Hoopes, Ishida, and Slemrod (2013) fail to detect changes in tax avoidance for Japanese firms following new, public disclosure guidelines for corporate tax returns. Similar to mandated disclosures, SEC tax-related comment letters may represent mundane or boilerplate issues that provide no new information to investors.
While there are counter-arguments, eliciting scrutiny from the SEC appears to be a material event. First, tax-related comment letters are targeted to specific firms and therefore have a greater likelihood of producing additional information compared to generic, one-size-fits-all disclosure standards. Second, empirical evidence confirms that firms responded to comment letters concerning non-tax subjects by materially altering disclosures (Bozanic et al. 2013; Brown et al. 2013). Therefore, we hypothesize in the alternative form:
H2: The resolution of tax-related comment letters is negatively associated with future
tax avoidance.
Stock Market Response to SEC Comment Letters
We examine investors’ responses to changes in disclosure quality to consider whether investors appear sensitive to changes in the expected cost of tax avoidance due to the receipt of tax-related comment letters. If managers are hesitant to disclose tax-related information because of costs relating to increased detection by taxing authorities, then the scrutiny from the SEC comment letter should decrease shareholders’ valuation of tax avoidance. Donohoe and McGill (2011) and Abernathy et al. (2012) find negative abnormal stock returns surrounding key Schedule M-3 and Schedule UTP dates, respectively. Similarly, Frischmann et al. (2008) find negative price reactions to Congressional inquiries about specific firm’s FIN 48 disclosures. These negative stock returns suggests shareholders expected a potential loss of tax benefits
resulting from the increases in the mandated disclosure of tax information and is consistent with an increased cost explanation.
However, Frischmann et al. (2008) also find no evidence of abnormal returns for tax aggressive firms around key FIN 48 dates, suggesting that disclosure standards either do not produce useful information or that regulators do not use all tax-related information contained in disclosures. Moreover, Frischmann et al. (2008) find investors responded favorably to the initial disclosures of FIN 48 for certain types of firms. Given prior research’s lack of consensus, we hypothesize in the null form:
H3: The resolution of a tax-related comment letter does not change the valuation of
tax avoidance.
III. Methodology Sample
We use the intersection of Compustat Annual files and Audit Analytics databases to construct an initial sample comprised of 16,061 firm-year observations for the period 2004-2011. We begin our sample in 2004 because this is when the SEC began publicly disclosing comment letters and end in 2011 because of data limitations.11 Consistent with prior research, we remove firms in the financial and utilities industries because of their unique regulatory and institutional structures. We also exclude firms with missing total tax expense (Compustat TXT), missing cash taxes paid (Compustat TXPD), or negative pretax book income before special items (Compustat PI - Compustat SPI) because these firms are in a different tax planning position compared to firms traditionally examined in this line of research (Dyreng et al. 2008). We require each observation to have each of our four tax avoidance proxies discussed in the next section. Table 1
11 Prior 2005, comment letters were only available via Freedom of Information Act requests (Johnston and Pettachi 2012).
presents the sample breakdown by fiscal year and industry. We note a slight decrease in the annual distribution of firms in Panel A that is likely due to the omission of loss firms in our sample during years in which the Financial Crisis occurred.
To identify firms that receive a tax-related comment letter, we begin with the Audit Analytics Comment Letter database. Panel B reports the annual distribution of comment letters, including tax-related comment letters, and depicts a fairly even distribution across time. From here, we differentiate tax from non-tax-related comments by searching the text of the letter for the words “Tax”, “FAS 109”, “FIN 48” and “ASC 740.” Our search methodology captures variations of these keywords, including the usage of lowercases and the usage of “SFAS” in lieu of “FAS.” Panel C reports the annual distribution of tax-related comment letters. Similar to the general comment letter distribution in Panel B, tax-related comment letters are fairly evenly distributed across time. Finally, Panel D reports the industry distribution (one-digit SIC) of our tax-related comment letter sample.
Measures of tax avoidance
Following Hanlon and Heitzman (2010) and related tax research, we define tax avoidance as the reduction in a firm’s explicit tax liability. Accordingly, we employ four commonly used proxies to measure tax avoidance: two based on effective tax rates and two based on book-tax differences. First, we use annual GAAP and cash ETR measures. The GAAP ETR (ETR) is computed as the ratio of total income tax expense (TXT) to pretax income (PI) and reflects tax avoidance activities that generate permanent book tax differences and thus impact accounting earnings. In contrast, the cash ETR (CETR) is the ratio of cash taxes paid (TXPD) to pretax income (PI) and represents the effects of both permanent and temporary tax planning strategies. Following prior literature, we winsorize our effective tax rate measures to lie between zero and
one to ensure a valid economic interpretation. Both effective tax rate measures (ETR and CETR) are decreasing in tax avoidance.
Second, we also use two measures of book-tax differences. Permanent book-tax
differences (BTD) are the differences between book and taxable income that do not reverse over time, scaled by lagged total assets (AT). Book income equals the difference between pretax income (PI) and minority interest in earnings (MII). Taxable income equals the sum of federal (TXFED) and foreign taxes (TXFO) less deferred taxes (TXDI) divided by 35%. Finally, as a proxy for potentially more aggressive forms of tax avoidance, we measure discretionary permanent BTDs (DTAX) following Frank et al. (2009).12 By controlling for common
determinants of permanent BTDs and using the residual, we hope to capture more aggressive tax planning activities (McGuire, Omer, and Wang 2012; Armstrong, Blouin, and Larker 2012). Both book-tax difference measures (BTD and DTAX) are increasing in tax avoidance.
The association between tax avoidance and disclosure (H1)
To examine our first hypothesis (H1) regarding the relationship between tax avoidance and disclosure quality, we estimate a probit model to predict the issuance of a tax-related comment letter:
TAXCOMMLETTi,t = 0 + TAXi,t + 2SIZEi,t + 3ROAi,t + 4ACCi,t + 5LEVi,t + 6FOREIGNi,t + 7RESTRUCTUREi,t + 8MERGERi,t + 9PRIORLITi,t + 10Gi,t + 11RESTATEi,t-1 + 12TAXICWi,t + 13NONTAXICWi,t + 14TAXHAVENi,t + 15NUM_CL_INDi,t + t +i
+ i,t (1)
12 We specifically follow Frank et al. (2009) and measure DTAX as the residual from regressing (by two-digit SIC and fiscal year) permanent book-tax differences on intangibles, unconsolidated earnings, non-controlling interest in earnings, state income tax expense, change in NOL, and lagged permanent book-tax differences. Following Frank et al. (2009), we require at least 15 observations for each industry-year group in order to estimate DTAX.
Our model is in the spirit of Cassell et al. (2013) whom estimate the factors that influence the issuance of a comment letter. However, we augment this model to incorporate necessary tax-related factors that influence the issuance of a tax-tax-related comment letter.13 The dependent variable (TAXCOMMLETT) is an indicator variable equal to one if the firm receives a tax-related SEC comment letter for the 10-K filing for the fiscal year ended and zero for firms that do not received a tax-related comment letter. Our primary variable of interest, TAX, is one of the four previously defined tax avoidance proxies. A negative coefficient on TAX for ETR and CETR as well as a positive coefficient on BTD and DTAX would suggest that firms engaging in higher levels of tax avoidance are more likely to receive a tax-related comment letter, consistent with H1.
We also include a number of factors that we believe have predictive ability in the issuance of a tax-related comment letter. We include the natural log of the lagged market value of equity (PRCC_F*CSHO) to control for size (SIZEt-1). We include the ratio of pretax income (PI) to lagged total assets (AT) to control for profitability (ROA). Discretionary accruals (ACC) are performance-matched discretionary accruals calculated as in Frank et al. (2009).14 Leverage (LEV) is the ratio of long term debt (DLTT) to assets (DLTT/AT).
We include a number of variables that represent the complexity of disclosure. FOREIGN equals one if firms report a foreign currency translation adjustment (FCA). RESTRUCTURE equals one if firms report non-zero restructuring costs (RCP). MERGER equals one if firms
13 In supplemental analyses, we use this model to form matched-pairs using propensity score matching in order to estimate our difference-in-difference regressions to test H2. We set TAXCOMMLETT to missing if the firm has ever received a tax-related comment letter in a different year. This safeguards the integrity of our difference-in-difference estimation in that we are ensuring our control firms have never received a tax-related comment letter.
14 We specifically follow Frank et al. (2009) and require at least 10 observations for each industry-year group in order to estimate pretax discretionary accruals (ACC).
engage in any merger or acquisition activity during the fiscal year (AQC). PRIORLIT equals one if the firms’ 10-Ks indicate any litigation within the last five years.15
Prior literature finds that monitoring and internal accounting systems are related to receiving comment letters. Accordingly, we include an indicator variable (BIG4) that equals one when firms retain a Big 4 auditor and zero otherwise. RESTATE is an indicator equaling one if firms experienced a restatement in prior years and zero otherwise. We include indicator variables for whether firms reported a tax or non-tax-related internal control weakness (TAXICW and NONTAXICW, respectively). We separate tax from non-tax internal controls because prior literature finds differential effects for tax internal control weaknesses versus non-tax weaknesses on tax avoidance (Bauer 2014; Lynch 2014). We also include an indicator variable that tracks whether firms disclose material operations in a known tax haven (TAXHAVEN).16 Finally, we control for the number of tax-related comment letters issued for a given industry-year in order to capture the possibility that the SEC may be scrutinizing tax-related disclosures among certain
industries (NUMBER_CL_INDUSTRY).17 Industry (t ) and year fixed effects (I ) are also included and robust standard errors are clustered at the firm level.
The impact of disclosure improvements on tax avoidance (H2)
To examine our second hypothesis (H2), regarding the effects of resolving a tax-related comment letter, we estimate the following ordinary least squares (OLS) regression, in the spirit of Chen et al. (2010):
TAXi,t = 0 + TAXCLFIRMi + 2POSTi,t + k Controlsk + t +i + i,t (2)
15 To capture prior litigation (PRIORLIT), we use the Stanford University lawsuit database.
16 Data procedures used to identify tax haven operations are described in Dyreng and Lindsey (2009). We thank Professor Scott Dyreng for generously sharing this data on his faculty website.
The dependent variable is one of our four tax avoidance measures, defined previously. TAXCLFIRM is an indicator variable equaling one if a firm received a tax-related comment letter at any point during our sample period and zero otherwise. POST is an indicator variable equaling one for periods after the resolution of a tax-related comment letter, only among firms that have ever received a tax-related comment letter. Given that we estimate Model (2) over a pooled sample, observations that have a zero value for TAXCLFIRM must have a zero value for POST. Thus, POST serves as an implicit interaction and represents the effect that receiving a tax-related comment letter has on firms’ tax policies, controlling for the level of tax avoidance before receiving the comment letter. We expect a positive (negative) and significant interaction (POST) when using ETR and CETR (BTD and DTAX), consistent with firms decreasing their tax
avoidance following the resolution of a tax-related comment letter because of the costs of additional disclosure.
We include a vector of controls (CONTROLS) previously identified in related tax research as determining firm-level tax avoidance. EQINC equals the ratio of the equity method income in earnings (ESUB) to lagged total assets (AT) to control for book-tax differences related to income received from unconsolidated entities (Dyreng, Hanlon, and Maydew 2010). INTAN equals intangible assets (INTAN) scaled by lagged total assets (AT) and controls for differing treatments of intangibles for book and tax purposes. We control for depreciation tax shields (PPE) by including the ratio of property, plant, and equipment (PPENT) to lagged total assets (AT) (Stickney and McGee 1982; Gupta and Newberry 1997). We also control for net operating losses by including NOL, an indicator variable equal to one if firms report a positive tax loss carryforward (TLCF) during the year and the change in NOL scaled by lagged total assets
We include the lagged market-to-book ratio (MTB), calculated as the ratio of the market value of equity (PRCC_F*CSHO) to the book value of equity (CEQ) to control for differences in growth opportunities. In addition, we control for leverage, LEV (DLTT/AT), and research and development, R&D (XRD/AT), to control for the effect of debt usage and R&D on tax outcomes, respectively. Finally, we control for free cash flow (FCF), defined as operating cash flows (OANCF) net of capital expenditures (CAPX), because prior research finds firms with greater levels of cash holdings engage in greater tax avoidance (Dhaliwal, Huang, Moser, and Pereira 2011). We include year and industry fixed effects as well as adjust standard errors for clustering by firm and by year.
The stock market response to SEC comment letters (H3)
We investigate our third hypothesis (H3) relating to changes in the valuation of tax avoidance by using the following firm-fixed effects model:
RETi,t = 0 + POSTi,t + 2TAXi,t + 3TAX*POSTi,t + 4 TAX*TAXCLFIRM,t +
5ROAi,t + 6SIZEi,t-1 + 7MTBi,t-1 + 8LEVi,t + µi + t + i,t (3) The dependent variable (RET) is the firm’s buy and hold annual return, inclusive of
dividends. POST equals one for years after receipt of a tax-related comment letter. TAX equals one of four measures of tax avoidance described earlier. Each specification is estimated using firm fixed effects, allowing for a test of investors’ reaction to within firm changes in tax avoidance before and after receipt of a tax-related comment letter and controlling for
unobservable time-invariant firm characteristics. This firm fixed effect specification provides a test of investors’ valuation of within-firm changes in tax avoidance both before and after receipt of a tax-related comment letter relative to firms that have never received a tax-related comment letter.
The coefficient on TAX captures investors’ average valuation of within-firm changes in tax avoidance, regardless of whether the firm has a received a tax-related comment letter or not. We control for any incremental differences in valuation that exist before the receipt of a tax-related comment letter by including the interaction TAX*TAXCLFIRM, which captures the average valuation effect of tax avoidance for firms that will receive a tax-related comment letter at some point in our sample. Note that we do not include the main effect TAXCLFIRM in our model as this is collinear with the firm fixed effects.
Our primary variable of interest is the interaction between TAX and POST. This
interaction captures investors’ valuation of changes in tax avoidance after receipt of a tax-related comment letter. A negative coefficient is consistent with an additional cost of disclosure
explanation and suggests shareholders assign an incrementally less positive value to tax planning following a tax-related comment letter consistent with a concern regarding the potential loss of value-enhancing tax benefits.18 The remaining variables are previously defined. We include ROA in the model in order to distinguish between investors’ reaction of changes in tax avoidance from changes in profitability. We control for SIZE, MTB, and LEV as these are common controls from prior asset pricing research (Fama and French 1992, 1993).
18 Model (3) also allows us to test whether or not investors perceive the withholding of tax-related information as indicative of agency costs. Desai and Dharmapala (2006) assert that tax avoidance necessarily requires a level of obfuscation in order to be successful. Depending upon the nature of incentive contracting and corporate governance, self-interested managers may exploit this obfuscation for their own private benefit. To the extent Desai and
Dharmapala’s (2006) claims hold in our context, we would expect to find a positive and significant interaction between TAX and POST in Model (3), consistent with shareholders expecting lower agency costs associated with tax avoidance due to greater regulatory scrutiny. However, given that Desai and Dharmapala (2006) do not assert such an effect to hold generally across all firms and recent empirical evidence questioning its validity (Blaylock 2011; Seidman and Stomberg 2012), we omit such arguments from our paper as they are out of the scope of our research question. Subsequent results presented in Table 5 are inconsistent with an agency based explanation of our findings as we find tax avoidance is, on average, positively valued and that decreases in tax avoidance following a tax-related comment letter are less positively valued.
IV. Results Descriptive Statistics
Table 2 presents our descriptive statistics. Consistent with tax accruals, on average, increasing reported tax rates, the average ETR is 0.302 and is higher than the average CETR of 0.252. Permanent BTDs average 3.7% of assets, of which 3% remain unexplained and appear in the average value of DTAX. Approximately 44% of our samples receive a SEC comment letter regarding any topic. However, only 7.6% of our sample received a tax-related SEC comment letter. Overall, our descriptive statistics are broadly consistent with prior literature (Chen et al. 2010; Kubick et al. 2015).
Univariate Tests
Figure 1 contains a graphical representation of our tax avoidance measures before and after the resolution of a tax-related comment letter. The first graph pictures the change in
effective tax rates while the second illustrates the change in book-tax difference-based measures. Consistent with H2, we find that ETR increases from approximately 29% to approximately 30% following the resolution of a comment letter (p< 0.05). Similarly, we find significant decreases for BTD (from 0.045 to 0.035, p < 0.05) and DTAX (0.03 to 0.015, p < 0.05). We fail to find a significant increase for CETR, though the direction is consistent with H2. Collectively, these patterns provide preliminary evidence consistent with firms decreasing tax avoidance following the resolution of a tax-related comment letter and supporting H2.
Multivariate results – H1
We present the results of estimating Model 1 in Table 3. In each specification, the area under the ROC curve is over 0.70 which suggests that our probit models have reasonable
discriminate power (Hosmer and Lemeshow 2000).19 We find that receipt of a tax-related
comment letter is negatively related to book effective tax rates (ETR, Column (1)), and positively related to book-tax differences (BTD and DTAX, Columns (3) and (4), respectively). These results support our first hypothesis (H1) that tax avoidance is positively associated with receipt of a tax-related comment letter. In contrast, we do not find a relation between the cash effective tax rate (CETR, Column (2)) and receipt of a tax-related comment letter, suggesting that the SEC is less concerned with disclosures related to tax issues that do not affect reported earnings. Overall, tax avoidance appears to impair tax-related disclosure quality and thus positively
predicts tax-related comment letters, consistent with an additional cost of disclosure explanation.
Multivariate results – H2
Table 4 contains the results of estimating Model (2) for the pooled sample. The negative and significant coefficient on TAXCLFIRM in the ETR specification (p < 0.05) indicates that firms receiving a tax-related comment at some point in the sample period engaged in a higher level of tax avoidance and the positive and significant coefficients on TAXCLFIRM in the BTD and DTAX specifications (p < 0.01) support this result. Moreover, consistent with H2, we find that firms decrease their level of tax avoidance following the resolution of a tax-related comment letter. In particular, we find a positive and significant coefficient on POST in the ETR
specification (p < 0.05). We also find negative and significant coefficients on POST in the BTD and DTAX specifications (p < 0.01). We fail to find significant results in the CETR specification.
Multivariate results – H3
Our third hypothesis (H3) considers whether the receipt of a tax-related comment letter affects investors’ valuation of changes in tax avoidance. Table 6 reports the results from testing
19 We note a smaller sample (N = 11,770) in these specifications because zero values for the dependent variable (TAXCOMMLETT) only captures firms that have never received a tax-related comment letter.
H3 with the specification in Model (3). Consistent with tax avoidance increasing after-tax cash flows and increasing firm value, we find stock returns are decreasing in ETR and CETR (p < 0.01) and increasing in BTD and DTAX (p < 0.01). Moreover, we find no evidence that investors differentially value tax avoidance of firms before receiving comment letters because the
interaction between TAX and TAXCLFIRM is insignificant in all four specifications. However, consistent with investors lowering the value of firms’ tax avoidance following tax-related
comment letters, we find negative interactions between TAX and POST in the CETR specification and positive interactions in the BTD and DTAX specifications (p < 0.05). Accordingly, we reject hypothesis H3 in favor of a decreased valuation of tax avoidance. We fail to find a significant interaction between TAX and POST in the ETR specification. Overall, results suggest investors discount the tax avoidance of firms subsequent to an increase in tax-related disclosure quality (i.e., the resolution of a tax-related comment letter).
V. Additional analyses Firm fixed effects
To mitigate the possibility that our results are sensitive to unobservable firm
characteristics, such as firm culture or tax technologies, we re-estimate Model (2) using a firm fixed effects specification. We continue to find support for our hypothesis H2 under this methodologically restrictive design. Specifically, we continue to find firms engaged in
significantly higher levels of tax avoidance before the receipt of a tax-related comment letter (p < 0.05) and that, following the disclosure of tax information through the resolution of a tax-related comment letter, firms significantly decrease their level of tax avoidance.
Difference-in-difference regressions using propensity score matching
In addition to Model (2), that uses a pooled sample, we also estimate a refined model using propensity score matching. We first generate the expected probability of receiving a tax comment letter using our probit specification in Model (1). We then match, on a one-to-one basis, firms receiving a tax-related comment letter (treatment firms) to firms never receiving a tax-related comment letter during the sample period with the closest propensity score (control firms). Then, using this matched-pairs sample, we modify Model (2) to accommodate the following research design:
TAXi,t = 0 + TAXCLFIRM,t + 2POSTi,t + 3TAXCLFIRM*POSTi,t +
k Controlsk + t +i + i,t (4)
The dependent variable of Model (4) continues to be one of our four tax avoidance measures, defined previously. Given that this sample is generated through propensity score matching, control firms have POST equal to one in the same year in which their matched treatment firm receives a tax-related comment letter. An interaction between TAXCLFIRM and POST is therefore necessary to determine the effect of tax-related comment letters and serves as our difference-in-difference estimator. Accordingly, our variable of interest, and only
modification from Model (2), is the interaction between TAXCLFIRM and POST
(TAXCLFIRM*POST). We expect a positive (negative) and significant interaction when using ETR and CETR (BTD and DTAX), consistent with firms decreasing their tax avoidance following the receipt of a tax-related comment letter.20
20 We require firms to have valid pre and post data in order to be considered for Model (1). Furthermore, firms that have received a tax-related comment letter in a different year are not considered as a potential control for the current fiscal year. These additional constraints reduce our sample size for Model (4), relative to the pooled OLS model in Model (2), and thus serves as a more powerful test of H2.
Table 6 contains the results of estimating Model (4) over our propensity-score matched sample. Panel A reports the probit regression of Model (1). Results confirm H1, namely that firms with lower book effective tax rates (ETR) are more likely to receive a tax-related comment letter. Panel B reports univariate differences in control variables between treatment and control firms to ensure that our matching procedures are sound. Panel C contains our estimation of Model (4). We find even stronger results in support of hypothesis H2. The coefficients on the interaction of TAXCLFIRM and POST are positive and significant in both the ETR and CETR specifications (p < 0.05) and negative and significant in the BTD and DTAX specifications (p < 0.05).21 These findings are consistent with firms decreasing their level of their tax avoidance following the resolution of a tax-related comment letter and supports our notion that the
disclosure of additional tax information in the comment letter process changes the expected costs and benefits of tax avoidance such that tax avoidance is relatively more costly.
Severity of Comment Letter Process
Prior literature acknowledges variation in the severity of comment letters and commonly employs the number of rounds of communication between the SEC and the registrant firm as a proxy for severity (Cassell et al. 2013). As additional analysis, we consider the extent to which tax avoidance affects the severity of comment letters. We modify Model (1) such that the dependent variable equals the natural log of the number of rounds in which taxes are referenced in a comment letter thread.
We present our results on the severity of the comment letters in Table 7. We find evidence consistent with tax avoidance being positively related to the severity of the comment letter. In particular, we find negative and significant coefficients on ETR and CETR (p < 0.05)
and positive and significant coefficients on BTD and DTAX (p < 0.01). Not only does tax avoidance appear to impair the tax-related disclosure quality of firms, higher levels of tax avoidance also appear to produce greater scrutiny by the SEC.
Uncertain Tax Benefits
We also examine changes in uncertain tax benefits (UTBs) surrounding tax-related comment letters to help triangulate our overall findings. If managers believe that the comment letter reveals sensitive tax information and elicits regulatory scrutiny, managers should increase the cumulative likelihood of sustaining these positions under audit and accordingly lower the maximum tax benefit that is more likely than not to be realized. We replace the dependent variable of Model (2) with UTB, equaling the ratio of uncertain tax benefits (TXTUBEND) to total assets (AT).22 Our sample decreases to 6,223 observations. In untabulated results, before receipt of a tax-related comment letter we find an insignificant coefficient on TAXCLFIRM (p = .564) suggests no difference in UTB balances. However, consistent with our expectations, we find a positive coefficient on POST, suggesting firms increase their total disclosed UTBs following the resolution of a tax-related comment letter (p < 0.05).
VI. Conclusion
We examine the relation between increases in firm-specific disclosure quality and tax avoidance using SEC comment letters. Consistent with firms attempting to limit the disclosure of information which would incur proprietary costs, we find the probability of receiving a tax-related SEC comment is increasing in tax avoidance. We further document that the level of tax avoidance decreases following the resolution of the SEC tax-related comment letter. This finding is consistent with the release of tax-related information increasing the expected costs of tax
22 Consistent with Lisowsky, Robinson, and Schmidt (2013), we omit firms with missing UTB balances due to Compustat’s poor coverage of UTB variables.
avoidance and firms responding by lowering their average level of tax avoidance. Moreover, we find that investors assign an incrementally less-positive value to tax avoidance following the resolution on a tax-related comment letter, consistent with investors increasing the expected costs associated with tax avoidance following regulatory scrutiny. We perform a battery of tests to verify the robustness of our finding, including a firm fixed effect design, using propensity-score matching to control for the underlying determinants of receiving a tax-related comment letter, and examining the severity of the comment letters.
This study expands our knowledge regarding the costs of tax avoidance and our
understanding of why shareholders may not demand full disclosure of information in all settings. Our findings are important to legislators as we document evidence of a spillover of benefits from a securities regulator to the tax regulator. Moreover, our findings inform legislators that the comment letter process mandated by the Sarbanes-Oxley Act appears to be impacting firm behavior in a tax context. Our conclusions also inform tax regulators, suggesting that targeting firms with poor disclosure quality in their tax footnote for audit should aide in the proper identification of firms engaged in potentially aggressive tax avoidance behavior. Finally, our evidence on investor responses to comment letters suggests that shareholders could prefer a higher level of tax avoidance rather than complete compliance with current disclosure standards.
APPENDIX A Variable Definitions Tax Avoidance Measures (TAX)
ETR Book effective tax rate: computed as total tax expense (Compustat TXT) divided by pretax book income less special items (Compustat PI - SPI) constrained between the [0,1] interval.
CETR Cash effective tax rate: Computed as cash taxes paid (Compustat TXPD) divided by pretax book income less special items (Compustat PI - SPI) constrained between the [0,1] interval.
BTD Permanent book-tax differences: Computed as pretax income, less minority interest in earnings (Compustat PIi,t – MIIi,t), minus the sum of federal and
foreign tax expense less deferred taxes (Compustat TXFEDi,t + TXFOi,t –
TXDIi,t), scaled by 35%, all scaled by lagged total assets (Compustat ATi,t-1).
DTAX Discretionary permanent book-tax differences: constructed following Frank et al. (2009).
SEC Comment Letter Variables
TAXCOMMLETT Equal to 1 if the firm has resolved an SEC comment letter which upon manual inspection discloses tax-related matters as an issue during the current fiscal year, zero otherwise.
TAXCLFIRM Equal to 1 if the firm has resolved an SEC comment letter which upon manual inspection does not disclose tax-related matters as an issue during the current fiscal year, zero otherwise.
Determinants of Tax-Related Comment Letters
SIZE Firm size: Natural log of the lagged market value of equity (Compustat PRCC_F*CSHO).
ROA Return on assets: computed as pretax book income (Compustat PIi,t) divided by
lagged total assets (Compustat ATi,t-1).
ACC Performance-matched pretax discretionary accruals: computed following Frank et al. (2009).
LEV Leverage: computed as total long term debt (Compustat DLTT) divided by lagged total assets (Compustat AT). We set missing observations of DLTT equal to zero.
FOREIGN Foreign operations indicator: equals one if the firm reports a foreign currency translation adjustment (Compustat FCA), zero otherwise.
RESTRUCTURE Restructuring charges indicator: equals one if the firm reports non-zero restructuring costs (Compustat RCP), zero otherwise.
MERGER Merger activity indicator: equals one if the firm engages in any merger or acquisition activity during the fiscal year (AQC), zero otherwise.
PRIORLIT Prior litigation indicator: equals one if the firm’s 10-K is involved in any litigation within the last five years (Source: Stanford University lawsuit database), zero otherwise.
BIG4 Big 4 auditor indicator: equals one if a firm retains a Big 4 auditor, zero otherwise
RESTATE Restatement indicator: equal to one if the firm experienced a restatement in prior years, zero otherwise
TAXICW Tax-related internal control weakness: equal to one if the firm discloses a tax-related 404(b) material weakness in internal control in the current year, zero otherwise.
NONTAXICW Non-tax internal control weakness: equal to one if the firm discloses a non-tax related 404(b) material weakness in internal control in the current year, zero otherwise.
TAXHAVEN Tax haven indicator: equal to one if the firm discloses a subsidiary in a listed tax haven (Source: Dyreng and Lindsey 2009), zero otherwise.
NUM_CL_IND Number of comment letters in industry-year: Number of tax-related comment letters issued in a firm’s industry year.
Additional Tax Avoidance Control Variables
EQINC Equity method earnings: computed as equity in earnings (Compustat ESUB) divided by lagged total assets (Compustat AT). We set missing observations of ESUB equal to zero.
INTAN Intangibles: computed as reported intangibles (Compustat INTAN) divided by lagged total assets (Compustat AT). We set missing observations of INTANi,t
equal to zero.
PPE Property, plant & equipment: computed as net property, plant and equipment (Compustat PPENT) divided by lagged total assets (Compustat AT). We set missing observations of PPENT equal to zero.
NOL Presence of NOL: Indicator variable equal to one if the firm reports a positive tax loss carryforward during the year (Compustat TLCF).
ΔNOL Change in NOL: computed as the change in firm i's NOL during the year scaled by lagged total assets (Compustat AT).
MTB Market-to-book ratio: computed as the ratio of lagged market value of equity (Compustat PRCC_F*CSHO) to lagged book value of equity (Compustat CEQ).
R&D Research & development: Computed as R&D expense (Compustat XRD) scaled by lagged total assets (Compustat AT). We set missing observations of XRD equal to zero.
FCF Free cash flow: computed as operating cash flows less capital expenditures (Compustat OANCF- CAPX) scaled by lagged total assets (Compustat AT). We set missing observations of OANCF or CAPX equal to zero.
APPENDIX B
Examples of SEC Comment Letters and Resolutions 1. General Motors 12/31/2010 10-K Filing SEC Comment Letter and Response SEC Comment (4/7/2011):
We note from your disclosure in Note 23 that you have material assets that you consider permanently reinvested overseas. In this regard, it appears there may be amounts recorded in your financial statements, and included in your discussion of liquidity, for which there are material tax-driven restrictions on the free flow of funds from foreign subsidiaries. If so, please add a discussion of such assets. This discussion should include the potential charges that may be incurred if such amounts were repatriated.
Management Response (4/19/2011):
The Company respectfully advises the Staff that $4.7 billion of the $6.9 billion of permanently reinvested amounts is not recorded as liquid assets on the balance sheet as of December 31, 2010, as it is derived from the Company’s investments in non-consolidated joint ventures which were adjusted to their fair value as a result of fresh-start reporting. As such, the cash, marketable securities and lines of credit of these joint ventures are not included in the Company’s total reported liquidity.
The remaining $2.2 billion is primarily composed of earnings subject to excessive additional taxes on distributions, such as earnings generated in Mexico. Although this liquidity is permanently reinvested, the Company has taken and will continue to take steps to utilize this liquidity globally, as needed, on a less than permanent basis via inter-company loans and other cash pooling initiatives. The Company continues to believe that these amounts are appropriately included in total available liquidity. Because these
earnings are effectively available for use by the Company, we do not believe disclosure of the potential charges that would be incurred if such amounts were repatriated is meaningful to our liquidity discussion. In response to the Staff’s comment, the Company proposes to revise disclosures in future filings which contain a discussion of Liquidity and Capital Resources by adding the following:
“A portion of our total liquidity includes amounts deemed permanently reinvested in our foreign subsidiaries. Such amounts are available for global operations through methods such as inter-company loans.”
2. Apple, Inc. 09/29/2012 10-K Filing SEC Comment Letters and Responses (6/24/13 & 7/22/2013
1st SEC Comment Letter (6/13/2013):
1) You state that because you are subject to taxes in the United States and numerous foreign jurisdictions, you could be subject to changes in tax rates, the adoption of new United States or international tax legislation, or exposure to additional tax liabilities. These appear to be risks that could apply to any registrant with international operations. Please tell us what consideration you have given to including a more tailored discussion of any specific risks associated with your current tax structure, including any agreements or arrangements that provide material tax benefits. See Item 503(c) of Regulation S-K. 2) We note the caption in your effective income tax rate reconciliation table “Indefinitely invested earnings of foreign subsidiaries.” Please explain how such amounts were determined in each period and identify the significant components of this line item for each period presented.
Management Response (6/24/2013):
1) The Company acknowledges the Staff’s comment and notes that Item 503(c) of Regulation S-K states, among other things, that the Company is to “Explain how the risk affects the issuer . . . .” Accordingly, the Company’s existing risk factor disclosure specifically explains that its future effective tax rates are subject to “changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation.”
2) In response to the Staff’s comment, the Company notes that the tax benefits disclosed in the effective tax rate reconciliation table under the heading “Indefinitely Invested Earnings of Foreign Subsidiaries,” solely represent the difference between the U.S. statutory rate of 35% and the local tax rate on those indefinitely reinvested undistributed earnings, substantially all of which were generated by subsidiaries organized in Ireland. As disclosed in the effective tax rate reconciliation table, the Company had tax benefits from indefinitely reinvested earnings of foreign subsidiaries totaling $5,895 million, $3,898 million, and $2,125 million for 2012, 2011, and 2010, respectively.
2nd SEC Comment Letter (7/9/2013):
We note your response to prior comment 1. The revised language still refers to “foreign” jurisdictions and appears to discuss risks that could apply to any registrant with international operations. Your responses state that your Irish subsidiaries generated substantially all of your $40.4 billion in
undistributed international earnings, creating a tax benefit of approximately $5.9 billion in 2012. Thus, it appears that you should specifically reference the potential risks associated with any changes in Irish tax laws.
Management Response (7/22/2013):
In response to the Staff’s comment, the Company intends to include additional disclosure in the risk factor in future filings substantially similar to the underlined language set forth below (which also reflects modified additional language proposed by the Company in its previous response letter to the Staff, dated June 24, 2013):
“The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities.”
The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts
previously accrued, the Company’s operating results, cash flows, and financial condition could be adversely affected.”