Insights from academic tax research to inform tax reform and practice

Editor: Annette Nellen, Esq., CPA, CGMA

The American Taxation Association (ATA) is a subsection of the American Accounting Association and the leading academic organization in the field of tax accounting. Through its External Relations Committee and various other initiatives, the ATA has a long-standing history of cooperation with the AICPA on all matters involving tax practice. Many ATA members are active in the AICPA as authors and volunteers, and most are regular readers of The Tax Adviser and other professional publications.

As academic journals and articles are somewhat less accessible to tax practitioners, the External Relations Committee of the ATA publishes an annual column in The Tax Adviser summarizing some of the past year’s highlights in academic tax research as reflected in leading academic accounting and taxation journals (see, e.g., Hulse, Inger, Nellen, and Oler, “Campus to Clients: Practice and Policy Insights From Academic Research,” 53-11 The Tax Adviser 52 (November 2022); and Meade, “Campus to Clients: Academic Research for Your Practice Consideration,” 52 The Tax Adviser 526 (August 2021)).

This year, five papers were selected to share with readers of The Tax Adviser. These articles range from how corporations minimize their effective tax rates (ETRs) through international planning and the use of tax holidays to how companies identify and manage tax risk, as well as the effects of big data analytics on tax compliance. Academic tax research analyzes data using sometimes complex statistical techniques, yet it seeks to answer fundamental questions relevant to tax practitioners and policymakers.

‘Big Data Analytics in IRS Audit Procedures and Its Effects on Tax Compliance: A Moderated Mediation Analysis’

The amount of funding to be allocated to the IRS has long been a point of contention in Washington, D.C. Partially due to budget decreases over time, the IRS has continued to adopt new audit procedures to adapt to less money and manpower. One such change has been the incorporation of big data analytics (artificial intelligence and machine learning) to supplement traditional data collected for selection of IRS audits. However, while generally viewed as a solution to help the IRS collect revenue more efficiently and increase taxpayer compliance, a lack of transparency and privacy issues have been cited as concerns.

In their article published in the Fall 2022 issue of The Journal of the American Taxation Association (Vol. 44, No. 2, p. 97), Erica Neuman and Robert Sheu examined the effects of increased monitoring using IRS big data analytics on taxpayer compliance. Prior studies have found that procedural tax fairness, or the belief that taxing authorities engage in sympathetic and respectful procedures, indirectly affects tax compliance through its effect on tax morale. Therefore, any decrease in procedural tax fairness using big data analytics could reduce compliance and tax collections, even with an increase in perceived IRS monitoring.

Examining a scenario in which taxpayers earn contract income through two levels of participatory self-monitoring, the authors hypothesized that individuals who engage in more participatory self-monitoring through earning contract income via social media advertising will assess big data analytics as less of a violation of procedural tax fairness and will engage in increased tax compliance over taxpayers obtaining income offline through word of mouth (nonparticipatory self-reporting). In other words, any benefits from increased tax compliance due to improved IRS monitoring through big data analytics will be negated in the nonparticipatory income group through decreased perceptions of procedural tax fairness.

Results of the study confirm that taxpayers do report an increase in perceived detection probability through the IRS’s use of big data analytics in both the participatory and nonparticipatory income groups. Therefore, the IRS and other interested parties can correctly point to this finding as confirmation for the continued use of big data analytics to potentially deter tax evasion.

However, the authors also found that, even though an increase in detection risk is reported across both groups, actual tax compliance is marginally improved in the participatory income group only. In the nonparticipatory income group, the IRS’s use of big data analytics had no influence on tax compliance, as decreases in procedural tax fairness served to suppress greater compliance due to the increased detection risk. For these taxpayers, the IRS’s use of more advanced audit techniques was potentially viewed as unfairly invasive. Therefore, if the goal is to reduce the tax gap, regulatory bodies should be cautious of viewing the use of big data analytics as a perfect solution. For those taxpayers with less traceable income (nonparticipatory), views on transparency and privacy concerns may serve to hinder its effectiveness.

‘Defining and Managing Corporate Tax Risk: Perceptions of Tax Risk Experts’

Researchers observe that some companies underutilize tax planning opportunities (i.e., the “under-sheltering puzzle” initially presented in Weisbach, “Ten Truths About Tax Shelters,” 55 Tax Law Review 215 (2002)) and propose that tax risk may be an explanation for this phenomenon. In other words, a reason why some companies do not engage in more aggressive tax planning is because of the potential risk involved in such activities. Recent developments such as the adoption of various tax transparency disclosure regulations, increased enforcement by tax authorities, and higher public scrutiny have also resulted in corporate managers’ spending more time managing their companies’ tax risks. Yet little is known about what constitutes tax risk and the nature of tax risk management practices.

In their 2022 article published in Contemporary Accounting Research, Vol. 39, No. 4, p. 2861 (Winter 2002), Alissa Brühne and Deborah Schanz investigate corporate tax risk management by providing insights into practitioners’ perceptions of tax risk, their risk management practices, and factors that result in different practices among companies. Their analysis is based on 33 semi-structured interviews with tax risk experts, including company insiders (i.e., CFOs and tax directors) and outsiders (i.e., regulators and tax authority representatives).

Through these interviews, Brühne and Schanz documented that tax risk is a multifaceted and context-dependent construct that involves six related but distinct components: financial, reputational, compliance, political, tax process, and personal liability risk. This definition is much broader than the one employed in the extant empirical literature, which mostly focuses on the financial or compliance angle of tax planning. Interestingly, the perception of tax risk varies substantially between company insiders and outsiders. Company insiders see tax risk primarily in terms of its downsides, while outsiders (i.e., tax consultants, regulators, and tax authority representatives) perceive it as a two-sided construct.

The management of tax risk is company-specific but can be grouped into five steps that involve identifying, evaluating, mitigating, monitoring, and controlling tax risk and establishing a beneficial internal information environment. One notable insight that arises from these interviews is that management employs various forms of tax communications, both internally within the different functions of the company, and externally with outside stakeholders, at almost every stage of the tax risk management process. Communication appears to be an important tax risk management tool for companies.

Tax risk exerts various pressures on companies. These come in three types: public, peer, and regulatory pressure. These pressures are associated with several business characteristics. For example, larger companies and companies with consumer-oriented businesses are exposed to higher public pressure. In contrast, a company’s network ties to other companies (i.e., board interlocks) and industry affiliation/product portfolio contribute to more peer pressure. Companies with a highly diversified product portfolio or numerous foreign activities face more regulatory pressure. Depending on the type of pressure, managers tailor their communication to manage tax risks. Finally, insights from these interviews indicate that there are six primary objectives of a company’s tax risk management, with CFO protection and legal certainty and compliance being the top two.

The study provides important insights into the “black box” of corporate tax risk management practices and highlights the use of communication as an important tool to mitigate tax risk. In addition, the study has important implications for future archival studies that attempt to measure and define tax risk.

‘Profit Shifting During Foreign Tax Holidays’

Tax holidays — temporary tax reductions — have been increasingly popular. In 1995, approximately 1% of U.S.-based companies with multinational locations invested in countries that used tax holidays. By 2013, that number had risen to just over 12% before settling down to 8.6% by 2019. Generally, foreign governments use tax holidays to encourage companies to invest in operations in their countries. For example, in the early 1980s, Ireland offered Apple a tax rate close to 0%, which spurred economic growth in Ireland as Apple moved operations (and intangible assets) to the country (Gupta and Halpin, “Apple Enjoyed Irish Tax Holiday From the Start,” Reuters Business News (May 23, 2013)).

Travis Chow, Jeffrey Hoopes, and Edward Maydew’s article (The Accounting Review, Vol. 98, No. 4, p. 1 (July 2023)) investigated the use of tax holidays, whether there is a correlation between tax holidays and additional profit shifting, and whether that profit shifting also affects tax uncertainty. Using a textual search through the SEC’s EDGAR database, they identified 1,466 unique companies (12,888 company-years) from 1995 through 2019 that participated in tax holidays offered by a foreign country. Their sample did not include tax holidays within the United States, such as Virginia’s $2.5 billion in tax incentives to attract Amazon (Bauerlein, Vielkind, and McKinnon, “Amazon Announces HQ2 Winners,” The Wall Street Journal (Nov. 13, 2018)).

The authors found evidence consistent with companies using tax holidays to shift income from high-tax to low-tax jurisdictions. In terms of dollar amounts, the study suggests that, on average, a company will shift an additional $74.6 million in profits per year out of the United States while participating in a tax holiday. This amount is not conditional and does not include the level of foreign investment. In aggregate, from 1995 to 2019, 175 companies shifted approximately $77.4 billion in income out of the United States while participating in a tax holiday. In terms of tax rates, this is the equivalent of a 16-percentage-point reduction in the average foreign tax rate.

As part of the authors’ research into whether profit shifting affects tax uncertainty, they considered whether the increase in profit shifting increased the difficulty in applying ambiguous tax laws and anticipating the future outcomes of tax audits. Using an increase in unrecognized tax benefits (UTBs) as a measure for uncertainty, the authors found that, on average, a company participating in a tax holiday accrued an additional $5.71 million in UTBs per year.

This paper provides some interesting insights into companies’ behavior and reactions to tax holidays. The authors showed that companies take advantage of tax holidays in two ways: (1) by direct investment in countries offering those tax holidays and (2) by shifting additional profits out of the United States to those foreign countries. They further showed that this profit shifting causes an increase in tax uncertainty. These findings should be of interest to practitioners as they consider alternatives to tax havens, as well as to regulators and tax authorities as they consider the economic impact of tax holidays.

‘How Do Most Low ETR Firms Avoid Paying Taxes?’

A widely measured financial disclosure for public corporations is the entity’s ETR paid on reported income. Much has been made of the fact that many profitable corporations have an ETR far below the statutory corporate rate of 21%. Public opinion (supported in part by prior literature) suggests that these companies must be engaging in aggressive or higher-risk tax planning to achieve these low ETRs.

In their 2022 article in Review of Accounting Studies (Vol. 27, Issue 2, p. 570), authors Dane Christensen, David Kenchington, and Rick Laux found that the majority of profitable low-ETR corporations achieved this status through the use of net operating loss (NOL) carryovers rather than aggressive tax planning. The authors defined low-ETR companies as those companies with an effective tax rate of 0% to 10%, well below the U.S. statutory corporate rate of 21%.

A large sample of profitable companies was drawn from Compustat, a database published by Standard and Poor’s, containing comprehensive financial information on thousands of global companies. Of the companies sampled, approximately 25% had large NOLs yet made up almost 80% of the companies sampled that were considered to have low ETRs. While it is intuitively appealing to assume that low-ETR companies are taking aggressive tax positions, most companies reporting low ETRs accomplished this using benign tax provisions such as NOL carryforwards. The paper does not definitively argue that some low- ETR companies do not take aggressive tax positions, but it does refute the common public assumption that aggressive tax planning is the root cause of the majority of low ETRs reported by profitable corporations.

‘How Do Firms Use Cash Tax Savings? A Cross-Country Analysis’

In their 2022 article published in The Journal of the American Taxation Association, Vol. 44, No. 1, p. 93 (Spring 2002), authors Danielle Green and Jon Kerr explored how corporations use cash savings from tax avoidance. The goal of this study was to determine whether tax-avoidance savings are reinvested in operations — likely viewed positively by lawmakers, the press, and the public — or used primarily for stock buybacks and dividends to benefit shareholders, which is viewed less favorably.

While others have explored how cash savings from tax avoidance are used, Green and Kerr distinguished their study by including both U.S.-based and non-U.S.-based companies. The authors posited that this broader focus allowed them to find any difference between U.S.-based and other companies, since results only from U.S.-based companies may not translate to all companies due to the U.S. worldwide tax system.

The authors found that companies prefer to use tax-avoidance cash savings for stock repurchases rather than dividends. They posited that this is because, unlike dividends, stock buybacks do not set an expectation that they will continue. The authors also found that companies in weak governance countries were more likely to use cash savings from tax avoidance for current investment, likely because other funding sources may be limited in these countries. Companies in these countries are also likely to use some of the savings to pay dividends to gain favor and possible future investment from shareholders.

Practice relevance

This small sample of academic tax research from the past year illustrates the range of topics explored. The questions explored and findings obtained can help other researchers and practitioners understand various practices and their tax effects. This glimpse into academic tax literature may lead you to better appreciate the research and scholarship that accounting and tax faculty are engaged in. We encourage tax professionals to ask faculty about their research and findings when they meet them at job fairs or when serving as a guest presenter.

Contributors

Brian Greenstein, Ph.D., is an associate professor of accounting and management information systems at the Lerner College of Business and Economics at the University of Delaware in Newark, Del.; Brian Hogan, CPA, Ph.D., is clinical associate professor of accounting at the University of Pittsburgh in Pittsburgh; Annette Nellen, Esq., CPA, CGMA, is a professor in the Department of Accounting and Finance at San José State University in San José, Calif., and is a past chair of the AICPA Tax Executive Committee; Mitchell Oler, CPA, Ph.D., is a department chair and associate professor at the University of Wyoming in Laramie, Wyo.; and Anh Persson, Ph.D., is an assistant professor in the Gies College of Business at the University of Illinois-Champaign in Urbana-Champaign, Ill. All are members of the External Relations Committee of the American Taxation Association. For more information about this column, contact thetaxadviser@aicpa.org.