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Governments across the planet lose billions each year to tax avoidance. Not all of it is necessarily tax evasion – that’s illegal. We’re talking tax avoidance, where firms engage in tax planning to reduce their overall tax burden ranging from benign to fraudulent tax reduction.
Tax returns are proprietary, leaving interested stakeholders with limited information, including the information in the financial statement. Financial statements are often vague, investors aren’t necessarily up to speed on what’s buried within corporate footnotes -- and there are reasons that’s the way they like it.
So transparency isn’t always best? Believe it, or not, investors don’t necessarily run from public companies that release vague disclosures in the footnotes of their financial statements, provided to investors and the Securities and Exchange Commission, regarding tax information.
Sure, investors often rely on financial statements for information about a firm’s tax position because tax returns are proprietary, but why make tax footnotes perfectly clear for the IRS to decipher?
“That tax footnote can be viewed as a roadmap for the IRS,” said Kerry Inger (left), assistant professor in the Harbert College School of Accountancy. “If corporate accountants can keep it vague, then that provides less information to the IRS because prior research finds the IRS is likely to look at it. At a small cost to the investor, it’s going to have very little information, too. But investors are willing to give up that transparency because they don’t want the IRS to be given more opportunities to constrain the tax planning activity.”
Inger’s co-authored paper, “An Examination of the Impact of Tax Avoidance on the Readability of Tax Footnotes,” revealed firms that avoid the most taxes are also less transparent. The paper examined tax footnotes from financial annual reports of all companies included in the S&P 1500 from 2000 to 2014.
Tax avoidance is popular among investors because … higher after-tax profit!
“The investors view tax avoidance just like any other positive-value project, in that, ‘if we’re paying less tax, we keep more of our cash and we can invest the tax savings in order to make a positive return,’” Inger answered. “It could be doled out to the shareholders, it could be invested into fixed assets or other investments.”
On the other hand, when firms are under-avoiding, they also provide less transparent disclosures. This suggests that firms will provide information that is less transparent when firms are performing poorly, in this case when they are not engaging in effective tax planning, according to research.
But tread carefully: cloudy tax footnotes do not mean unreadable footnotes, only more difficult to read.
“The more aggressive tax avoidance a company does, it is could increase the likelihood that they will be audited,” Inger added. “But a lot of what they do (tax avoidance) is legal. They are taking advantage of different rates and different jurisdictions, all sorts of things that you might call loopholes, or you might call bending the law.”