Financial Derivatives in Corporate Tax Aggressiveness

Abstract

The purpose of this study is to investigate the utilization of derivative financial instruments in tax aggressiveness activities. The study is conducted by analyzing the fair value of derivative financial assets and liabilities in total and categorized it into hedging and speculative (non-hedging) designations to identify which type of derivatives are used for tax avoidance. The results of the analysis reveal that cash effective tax rate (Cash ETR) is negatively associated with the fair value of hedging derivative assets. This indicates that firms are reducing tax payment by delaying the realization of derivative gains designated for hedging. Furthermore, Cash ETR is found to be negatively (positively) associated with the fair value of non-hedging derivative assets (liabilities). This indicates that firms are delaying the realization of gains while accelerating the realization of losses on non-hedging derivatives to reduce tax payment. Moreover, GAAP ETR is positively associated with the fair value of the non-hedging derivative liabilities, indicating that there is a reduction of income tax expense through accelerating the realization of non-hedging derivative losses thus it can be implied that firms are utilizing derivative financial instruments in earning management activity to minimize their tax burden. This study contributes to the existing literature and public policy by providing evidence on the use of financial derivatives in tax aggressiveness along with policy recommendations related to tax implications of financial derivative transactions since, up to the time of this publication, Indonesia has not had specific tax provision which regulate taxation on financial derivative transactions.

Effect of Hedging, Financial Lease, Sales Growth, and Earning Management on Tax Aggressiveness

“…The Organization for Economic Co-operation and Development (OECD) in Devi and Efendi (2018) states that tax aggressiveness is carried out with hedging schemes because aspects of annual financial reports and tax regulations are treated asymmetrically. In the financial statements, risks arising from hedging instrument gains/losses can be recognized as unrealized gains/losses, while these risks are not deductible items in the taxation aspect.…”

“…In the financial statements, risks arising from hedging instrument gains/losses can be recognized as unrealized gains/losses, while these risks are not deductible items in the taxation aspect. Companies use hedging to carry out tax planning by delaying the realization of profits or accelerating the realization of hedging losses to reduce the tax expense (Devi and Efendi, 2018).…”

derivative on the value relevance through tax avoidance and earnings control

“…Derivative assets and derivative liabilities arise due to derivative transaction contracts, this value is closely related to the notional amount of the derivative transaction. The determinants of the Jaggi model development are (1) Derivative transactions are used for hedging or non-hedging Emery & Finnerty (1997); Devi & Efendi (2018), an important requirement in paragraph PSAK 55-2014. 85 requires that each derivative transaction has a partner in the form of a protected transaction or item (2) Derivative transactions are used as an earnings management strategy Barton (2001); Pincus & Rajgopal (2003); Minton et al (2009); Choi et al (2015); Murwaningsari et al (2015); Ozek (2016), derivative transactions in the hedged and non-hedged categories will affect net income, particularly non-hedged derivative transactions.…”

“…In their study, Devi & Efendi (2018) attempt to prove the derivative transaction as the toll to manage profits. They explain that the company can fasten to recognize the loss of speculative derivative transactions to postpone the realization of the earnings.…”

“…Subsidiary monetary instruments are utilized by organizations to lessen income and pay instability brought about by market hazard factors, like variances in financing costs, vacillations in unfamiliar cash trade rates, changes in product costs and other danger factors (Barton, 2001;Pincus & Rajgopal, 2003). Devi & Efendi (2018), the cash effective tax ratio (CETR) as a proxy for tax avoidance has a negative correlation with the fair value of hedged derivative assets. Shows that the firm reduces tax payments by delaying the realization of profit from derivative transactions designed to hedge.…”