Seeking Shelter: Empirically Modeling Tax Shelters Using Financial Statement Information

Abstract

Using confidential tax shelter and tax return data obtained from the Internal Revenue Service, this study develops and validates an expanded model for inferring the likelihood that a firm engages in a tax shelter. Results show that tax shelter likelihood is positively related to subsidiaries located in tax havens, foreign-source income, inconsistent book-tax treatment, litigation losses, use of promoters, profitability, and size, and negatively related to leverage. Supplemental tests show that total book-tax differences (BTDs) and the contingent tax liability reserve are significantly related to tax shelter usage, while discretionary permanent BTDs and long-run cash effective tax rates are not. Finally, the model is weaker, yet still significant, in the FIN 48 disclosure environment. This research provides investors and policymakers with an extended, validated measure to calculate the presence of extreme cases of corporate tax aggressiveness. Such information could also aid analysts and other tax and non-tax researchers in assessing the benefits and risks of firm behavior.

Book-Tax Income Differences and Major Determining Factors

“…But the combination of these three factors only explains about 55% of the variation in BTDs, leaving 45% presumed to be associated with variations in the tax law during the study period. Thus, Seidman's findings support tax aggressiveness as one of the major causes for BTDs, consistent with other studies, such as Heltzer (2009), Desai (2003), and Lisowsky (2010). However, another stream of accounting studies report earnings management as an additional key explaining factor for BTDs (Phillips et al 2003;Desai 2003;Lev and Nissim 2004;Hanlon 2005;and Lisowsky 2010).…”

“…Accounting researchers developed an interest in investigating managers' use of tax sheltering and earnings management techniques to expand BTDs as they would be motivated to increase book income while reducing tax income (Mills 1998;Revsine et al 2011;Desai 2003;Phillips et al 2003;Hanlon 2005;Wilson 2009;Lisowsky 2010;Palepu et al 2012;Penman 2012). Revsine et al (2011) indicate a firm's accounting aggressiveness can be measured by the ratio of pre-tax book income to taxable income.…”

“…Lisowsky reports there is no significant association of tax sheltering behavior with either discretionary permanent BTDs or long-run effective tax rates. Wilson (2009) andLisowsky (2010) have a methodological advantage by identifying firms that were known to commit tax sheltering activities and thus could evaluate the relevance of proxies for tax sheltering, which are estimated from financial statements. However, these firms do not necessarily represent the population of tax sheltering firms as most of them might not be caught by the IRS.…”

“…Thus, Wilson concludes that firms with aggressive corporate strategies are inclined to choose aggressive reporting for both book and tax income. Lisowsky (2010) expands the sample size by identifying 267 tax shelter observations reported from 2000 to 2004 in order to evaluate the relevance of four alternative proxies for tax sheltering activities. Lisowsky examines the association of tax sheltering behavior with four alternative proxies for tax avoidance, such as discretionary permanent BTDs (Frank et al 2009), long-run cash effective tax rates (Dyreng et al 2008), total BTDs (Mills 1998), and the tax cushion (Gleason and Mills 2002).…”

“…Thus, Wilson (2009) and Lisowsky (2010) examine firms that were accused of tax sheltering to characterize their attributes. Wilson (2009) identified 193 firm-year observations, which were involved in tax sheltering.…”