Academic research sheds light on important tax matters

Editor: Annette Nellen, Esq., CPA, CGMA

In the spirit of increasing collaboration and understanding between academic tax researchers and tax practitioners, the American Taxation Association (ATA), a subsection of the American Accounting Association (AAA), through its External Relations Committee, provides an annual column covering a few academic tax research articles.  This annual column includes summaries of recent tax research that may be of interest to practitioners and continues a practice that began in 2020 (see Greenstein, Hogan, Nellen, Oler, and Persson, “Insights From Academic Tax Research to Inform Tax Reform and Practice,” 54-8 The Tax Adviser (August 2023); and Hulse, Inger, Nellen, and Oler, “Practice and Policy Insights From Academic Tax Research,” 53-11 The Tax Adviser 52 (November 2022)).

As a large number of tax articles are published yearly in numerous academic journals, the External Relations Committee narrows its selection to five articles that would not only interest practitioners but also span a wide range of current topics in taxation. This year, articles chosen include updates on measuring firm tax avoidance, the benefits of knowledge sharing between audit and tax personnel, the effects of a recent tax law change (the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97) on firm capital structure as well as tax burdens of corporate profits for public U.S. corporations, and an investigation into How cryptoasset investors respond to increased tax scrutiny.  A goal of each of these articles is to provide additional clarity to issues facing tax practitioners and policymakers.

‘How Costly Is Tax Avoidance?  Evidence From Structural Estimation’

The degree to which firms engage in tax-avoidance strategies is not well understood.  As tax avoidance represents an important factor in maximizing shareholder returns, by reducing payments to tax authorities and increasing reported earnings, identifying the components of firm decision-making for avoidance has long garnered the interest of tax researchers.  Prior research has shown that these decisions are at least partly made by examining how firms trade off tax savings with the costs that arise from tax avoidance, such as tax authority scrutiny or reputation damage with customers.  Unfortunately, some of these costs are difficult to observe and quantify.

In his article published in the October 2023 issue of The Accounting Review (Vol.  98, No.  6), Charles McClure uses structural estimation to quantify a firm’s tax avoidance.  The model incorporates three determinants of tax avoidance: tax authority scrutiny, financial reporting benefits, and operational frictions from tax avoidance, which are labeled as nontax costs.  The author notes that tax authority scrutiny is a function of firm tax risk: Firms with greater risk invite greater scrutiny, leading to larger repayments and penalties when positions are disallowed.

Financial reporting benefits are affected through the impact of risky tax strategies on the FIN 48 reserve (FASB Interpretation No.  (FIN) 48, Accounting for Uncertainty in Income Taxes, mostly codified under Subtopic 740-10 of FASB Accounting Standards Codification Topic 740, Income Taxes). As tax positions get riskier, firms recognize lower financial reporting benefits through tax avoidance as, the author notes, the FIN 48 reserve leads firms to delay recognizing any tax savings until the resolution of any tax audit uncertainty.

Finally, nontax costs are variable or fixed in nature, serve to reduce pretax income, and represent the trade-off between profit maximization and tax minimization.  While nontax costs are more difficult to observe, the author cites examples, including reputation concerns from being too tax-aggressive and the cost of coordinating tax strategies across corporate divisions.

Results indicate that tax avoidance increases if firms have greater access to lower tax risk positions or incur fewer nontax costs, or if tax authorities inspect fewer positions.  More specifically, the author’s model, which identifies a representative firm’s optimal level of tax avoidance, leads the author to estimate that on average, a firm engaging in tax avoidance reduces its tax liability by 7. 8% of its pretax book income.

More importantly, through structural estimation, the author identifies the component costs of tax avoidance. Average nontax costs are estimated to reduce pretax income by 6.4%. Further, in an alternative scenario in which firms were not required to set up a reserve and therefore could immediately recognize the full tax savings from tax avoidance, the financial reporting benefits of FIN 48 tax avoidance accounted on average for 10.9% of pretax income.  In another alternative scenario in which tax authority scrutiny was altered to remove additional penalties beyond paying the original tax savings, tax avoidance increased on average to 11. 1% of pretax income.

While the determinants of tax avoidance have often been seen as an important and necessary contribution to tax literature, this paper should be of interest to practitioners as well. By examining the components of tax avoidance, the author extends our understanding of this characteristic of corporate decision-making.  Practitioners, with more direct access to firms, can utilize this knowledge to better recommend optimal levels of tax avoidance, given the other trade-offs that exist.  Therefore, tax-avoidance strategies will not be underutilized, and firm resources can be further maximized by reducing tax payments.

‘Knowledge Sharing in Auditor-Provided Tax Services: Experiences of Audit and Tax Personnel’

While the Sarbanes-Oxley Act of 2002 (SOX), P.L. 107-204, prohibited audit firms from providing most nonaudit services to their public clients, certain tax services, such as compliance and advisory services, are still allowed.  A long line of academic literature has examined whether auditor-provided tax services are associated with either better audit or better tax outcomes.  Studies conducted after the passage of SOX have generally found higher audit quality and lower taxes when the audit firm is also providing tax services.  These studies have proposed that knowledge sharing between the audit and tax teams is an important factor in improving the client’s audit and tax outcomes.  The majority of these studies use published firm data and therefore cannot directly observe how or when knowledge-sharing activities occur.

Candice Hux, Jean Bedard, and Tracy Noga contribute to our understanding of knowledge sharing between audit and tax teams in their 2023 article published in The Journal of the American Taxation Association (Vol.  45, No.  1, p. 63 (Spring 2023)) by examining when it occurs and the factors that encourage or impede knowledge sharing.  They gather professional observations of knowledge sharing by conducting semi-structured interviews with 33 highly ranked audit and tax professionals from three Global 6 accounting firms.  Participants included 15 audit professionals with an average of 18 years of experience and 18 tax professionals with an average of 14 years of experience.  The authors developed interview questions based on the findings of previous literature. Questions were pretested and refined through interviews with current and retired audit and tax professionals.

The authors found that knowledge sharing occurs in two phases.  Phase 1 occurs during the audit process and prior to the provision of tax services. Phase 1 is where the majority of the knowledge sharing occurs and is an important phase for building relationships and trust among the audit team, tax team, and client.  During this phase, the auditors, tax team, and client share information about client concerns, any new issues or transactions that the client is experiencing, and other items that the audit and tax teams need to be aware of or concerned with.  This phase may result in identification of additional tax service proposals that can be referred to the audit partner for vetting and presented to the client for approval.

Phase 2 occurs as the tax services are being provided to the client.  This phase may overlap the end of the audit or occur after the completion of the audit. During this phase, tax professionals are able to leverage the knowledge that they gained during Phase 1 when completing the client’s tax services.  In addition, through the completion of the tax services, tax professionals gain further client knowledge that, if shared with the audit team, may help identify additional risks and/or potential misstatements. This feedback into the audit process may benefit both the current and future audits.

The authors identify factors that may affect knowledge sharing during both phases of the process.  These factors include expertise or lack thereof, communication processes, relationships and trust, organizational culture and incentives, independence concerns, and time and budgetary pressures. Audit and tax teams need not only domain-specific expertise but also an understanding of what information is important or relevant to the other team. While frequent and proactive communication between teams facilitates knowledge sharing, communication through electronic means, such as email, is viewed as less effective, especially during busy times of the year.

Knowledge sharing depends on both the relationship among the audit, tax, and client teams and the relationship between the audit and tax partners.  A good relationship with a high degree of trust between the two partners encourages knowledge sharing, while no relationship or a difficult working relationship can impede knowledge sharing.  Organizational cultures that incentivize a holistic approach to client service also encourage knowledge sharing.  Independence concerns may increase knowledge sharing so that all teams involved have the information necessary to recognize any potential independence concerns from tax services provided.

On the other hand, independence concerns may result in a different tax team providing certain tax services than the team involved in the audit, reducing the benefits of knowledge sharing.  Finally, time and budgetary pressures can reduce the amount of knowledge sharing that occurs, especially during Phase 2, when the audit team has moved on to other projects and clients.

This study’s findings are of interest to both accounting firms and regulators.  As noted in the study, firms wanting to promote knowledge sharing between audit and tax teams may want to consider holding joint audit and tax team trainings; offering informal social events involving both audit and tax professionals; encouraging frequent in-person communication both during and after the audit work is completed; fostering a firm team culture, as opposed to separate audit and tax team cultures; and aligning incentives between audit work and tax projects.  Regulators considering the future allowance of auditor-provided tax service may want to consider the benefits knowledge sharing provides and the curtailment of those benefits that might occur with future restrictions to the tax services a client’s audit firm can provide.

‘Debt and Taxes?  The Effect of Tax Cuts & Jobs Act of 2017 Interest Limitations on Capital Structure’

Prior to the TCJA, corporations were generally allowed a deduction for any interest payments, providing a tax advantage to debt financing relative to equity. Since the TCJA took effect in 2018, Sec.  163(j) imposes strict limitations on the deductibility of business interest by taxpayers, thereby reducing the tax incentive for corporations to be highly leveraged.  Deductions for business interest are now limited to 30% of taxable income before interest, taxes, depreciation, and amortization, and with the TCJA’s passing, politicians, practitioners, and researchers anticipated a reduction in financial leverage in the years to come. Even the Congressional Budget Office, when scoring the TCJA for its impact on anticipated tax revenues, incorporated this expected behavior in its analyses.

In their article published in The Journal of the American Taxation Association (Vol.  45, Issue 2, pp.  35–55 (Fall 2023) ) researchers Richard Carrizosa, Fabio Gaertner, and Daniel Lynch investigate whether affected companies have indeed reduced the role of debt in their capital structure.  As it is impossible to know the counterfactual events that would have occurred had the limitation not been enacted, the authors use a difference-in-differences approach to estimate the impact of the TCJA on affected U. S. firms’ capital structures.  Relying on the annual financial statements for a sample of U.S. publicly traded firms from 2014–2019, the authors first estimate the capital structure changes of U.S. publicly traded companies before and after the TCJA’s enactment. The researchers then estimate for each company whether the Sec.  163(j) limitation applied, allowing for comparison of the pre- to post-TCJA capital structures between companies where the limitation applied and the companies where it did not.

The reported results of these comparisons show that, compared to U. S. companies unaffected by the Sec. 163(j) limitation, companies facing limited interest deductions reduced their leverage by an average $330 million, representing, on average, 7.6% of assets.  These results are shown to be consistent with the expectations of legislators and regulators who predicted less reliance on debt in the capital structure of affected companies. The authors’ further analyses show these declines are driven by decreases in long-term domestic debt, including a decline in new debt issuances, as opposed to affected companies paying down existing debt.

‘The Effect of US Tax Reform on the Taxation of US Firms’ Domestic and Foreign Earnings’

Much has been written about the disparity between the top statutory corporate tax rate for many foreign countries and that of the United States. The TCJA ameliorated that situation by reducing the domestic maximum statutory tax rate from 35% to 21%, as well as moving the United States from a “worldwide” to a “territorial” tax system.

In their article published in Contemporary Accounting Research (Vol.  40, Issue 3, pp.  1881–1908 (Fall 2023)), Scott Dyreng, Fabio Gaertner, Jeffrey Hoopes, and Mary Vernon quantify the immediate net effect of the TCJA on the tax burden of corporate profits for public U.S. corporations.  They posited three questions: (1) How did U. S. multinational firms fare relative to U. S. domestic firms?  (2) Among U.S. multinational firms, how did the TCJA affect the effective tax rates on domestic income and foreign income?  And (3) How did the TCJA affect the rate of federal tax on the foreign income of U. S. multinational firms?

The authors selected all public companies with firm-year observations available in the Compustat database with total assets greater than $10 million for the years between 2014 and 2020. Both utility and financial companies were removed from their sample. This yielded 3,379 observations from 606 firms (213 domestic and 393 multinational).  Using a previously validated technique for measuring changes in worldwide effective tax rates, they compared the effects of the TCJA on both domestic and multinational firms.

The authors’ analysis found similar reductions in the effective tax rates for domestic and multinational firms. However, all the multinational tax savings were derived from tax savings on their domestic rather than foreign earnings.

They found no significant change in the federal tax burden on foreign earnings, neither on average nor specifically for firms most likely to be subject to new anti-abuse provisions (for example, those subject to the global intangible low-taxed income tax).  Finally, the authors found a “significant narrowing of the gap in the worldwide effective tax rate on domestic earnings as compared to foreign earnings after the TCJA, suggesting capital export neutrality and likely reducing the incentive to shift earnings to foreign jurisdictions relative to the pre-TCJA regime.”

The authors conclude as a key takeaway of their study that companies found investment in the United States under the TCJA much more attractive and that incentives for U.S. multinational companies to move investment and jobs offshore or to artificially avoid paying U.S. taxes in other ways decreased significantly.

‘Tax-Loss Harvesting With Cryptocurrencies’

Cryptocurrencies have been a growing part of the world economy since the advent of bitcoin in 2009, with the global cryptocurrency market valued at over $2.3 trillion as of April 30, 2024. According to a 2023 Pew Research Center survey, 17% of Americans have invested in, traded, or used cryptocurrencies, with 74% of those indicating that they did so for the first time within the last five years (Faverio and Sidoti, “Majority of Americans Aren’t Confident in the Safety and Reliability of Cryptocurrency,”  Pew Research Center (April 10, 2023)).  The growth in demand for cryptocurrencies has led to increased regulatory interest in these markets and their underlying transactions. Tax scrutiny of digital asset transactions has gained momentum since the first IRS campaign targeting cryptocurrencies was launched in 2018; however, it continues to be hindered by limited reporting by investors and exchanges and the lack of consensus on what a unit of cryptocurrency represents (property, security, or currency).  It remains an empirical question as to how investors will respond to tax scrutiny of their cryptocurrency transactions.

In their article published in the Journal of Accounting and Economics (Vol.  76, November-December 2023), authors Lin Cong, Wayne Landsman, Edward Maydew, and Daniel Rabetti shed light on this question by examining how crypto investors respond to increased tax scrutiny.  Specifically, the authors identify tax planning behaviors exhibited by crypto traders in the wake of increased tax scrutiny by U.S. tax regulators, as tax planning can be an indication of tax compliance.

The authors examine cryptocurrency trading behavior during a period when clear “wash sale” rules did not exist in the cryptocurrency market. During this period, the authors explain, cryptocurrency traders could “harvest” tax losses related to the decline in their cryptocurrency values and quickly repurchase their holdings without having their losses limited due to conventional wash-sale rules.  The authors further explain that such loss harvesting would be evidence of tax planning and demonstrate that investors are aware of their tax-compliance obligation to report gains and losses on cryptocurrency investments.

Using trading data from a proprietary dataset of 500 large retail traders, the authors compare the tax-loss harvesting of domestic traders to that of their international counterparts before and after the IRS increased its scrutiny on cryptocurrency transactions. They find that loss harvesting by the domestic traders was 8% higher than that of international traders during their sample period and that domestic traders engaged in significantly more wash trades.

The authors bolster these findings by running additional tests using an alternative dataset that aggregates trading data from major crypto exchanges and find substantially similar results.  In additional analysis, the authors find that the crypto wash-sale activity is concentrated at year ends and during market downturns, further demonstrating that these activities are the result of tax planning.  They also find that increased regulatory scrutiny and tax regulation incentivize some investors to move to unregulated corners of the digital asset marketplace (nonfungible tokens and decentralized finance).  Finally, the authors estimate the 2018 tax revenue losses to the U.S. government as a result of cryptocurrency wash-sale activity to be between $10.02 billion and $16.2 billion.

Practice relevance

The five articles summarized here represent a small portion of the annual tax research produced by tax faculty.  When practitioners visit campuses or otherwise interact with faculty, we encourage them to ask faculty about their research. By increasing dialogue, academics will benefit from additional insights into how that research relates to practice, and we believe practitioners will gain insights that can help in planning and advocacy work.

Contributors

Mollie Adams, CPA, Ph.D., is an assistant professor in the School of Accountancy at Missouri State University in Springfield, Mo.; Brian Greenstein, Ph.D., is an associate professor of accounting at the Lerner College of Business and Economics at the University of Delaware in Newark, Del.; Brian Hogan, CPA, Ph.D., is a clinical associate professor of accounting at the Joseph M. Katz Graduate School of Business at the University of Pittsburgh in Pittsburgh; Joanna Shaw, CPA, Ph.D., is an assistant professor of accounting at The Philip L. Kintzele School of Accounting at Central Michigan University in Mount Pleasant, Mich.; and Jason Stanfield, CPA, Ph.D., is an assistant professor of accounting at the Miller College of Business at Ball State University in Muncie, Ind.  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.  For more information about this column, contact thetaxadviser@aicpa.org.