The taxman cometh: Does tax uncertainty affect corporate cash holdings?

Abstract

We examine whether firms hold more cash in the face of tax uncertainty. Because of gray areas in the tax law and aggressive tax avoidance, the total amount of tax that a firm will pay is uncertain at the time it files its returns. The tax authorities can challenge and disallow the firm's tax positions, demanding additional cash tax payments. We hypothesize that firms facing greater tax uncertainty hold cash to satisfy these potential future demands. We find that both domestic firms and multinational firms hold larger cash balances when subject to greater tax uncertainty. In terms of economic significance, we find that the effect of tax uncertainty on cash holdings is comparable to that of repatriation taxes. Our evidence adds to knowledge about the real effects of tax avoidance and provides a tax-based precautionary explanation for why there is such wide variation in cash holdings across firms.

How Do Firms Use Cash Tax Savings: A Cross-Country Analysis

“…In pooled OLS regressions 5 , we find that greater cash tax savings are associated with increases in current year cash balances, but not future cash balances, which contrasts with US-based studies that suggest that firms hold on to cash for precautionary reasons (Hanlon et al 2017). Moreover, we find that cash tax savings is associated with greater investment, lower investment efficiency (particularly, overinvestment), and lower dividend payout.…”

“…In addition, we use a broad, large-sample international setting, one which is under-investigated in a literature which is dominated by US-only studies. In addition, and in contrast to Hanlon et al (2017), who use a US-only setting, our results suggest that firms in other countries continue to invest and indeed, overinvest, cash tax savings (in lieu of holding onto cash tax savings to satisfy future tax-related claims).…”

“…Relatedly, income taxes, paid as a percentage of pre-tax profits, are often one of the larger outflows of cash, and thus, the reduction of income taxes paid could serve as an important source of cash. Recent studies find that firms are successful at avoiding cash taxes (Dyreng, et al 2008) and that tax avoidance (e.g., tax savings) is associated with greater cash flows and cash holdings (Dhaliwal et al 2011, Hanlon et al 2017. Therefore, to the extent that effective tax planning reduces the amount of cash taxes paid, cash tax savings may act as an important source of cash, which can have a significant effect on the firm's cash management policy.…”

“…This suggests that cash generated via tax savings may be distinct from cash generated via other means and, therefore, the use of that cash may also be different. For example, cash generated via tax savings may be subject to greater uncertainty (Hanlon et al 2017). To the extent that tax planning activities are related to greater uncertainty and to the extent that firms hold on to cash to deal with that uncertainty, firms may be less likely to distribute that cash and prefer instead to retain it, either as liquid cash, or less liquid investment.…”

Corporate Political Connections and Tax Aggressiveness

“…Finally, political connections can be associated with a higher degree of tax aggressiveness because of their impact on risk taking. Recent tax research argues that aggressive tax avoidance represents a kind of risky investment (e.g., Hanlon, Maydew, and Saavedra ; Hutchens and Rego ; Rego and Wilson ). For example, Kim, Li, and Zhang () show that aggressive tax planning is associated with higher stock price crash risk.…”