Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk. David A. Guenther, Steven R. Matsunaga*, Brian M. Williams

Transcription

1 Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk David A. Guenther, Steven R. Matsunaga*, Brian M. Williams Lundquist College of Business, University of Oregon, Eugene, OR USA August 2013 Abstract: In this study we distinguish between the concepts of tax avoidance, tax aggressiveness, and tax risk and examine which, if any, of those concepts is related to overall firm risk. Prior research has argued that aggressive corporate tax avoidance, as measured by low cash effective tax rates or high reserves for unrecognized tax benefits, increases firm risk, thereby requiring firms to provide risk-taking incentives to managers. In this paper we define the concept of tax risk as the ability of a firm to sustain its tax positions over time and test whether tax avoidance, tax aggressiveness, or tax risk are related to future stock return volatility. We find a significantly positive relation between tax risk and firm risk, but do not find evidence of a significant association between either tax avoidance or tax aggressiveness and firm risk. JEL classification: M41 Key Words: effective tax rates; unrecorded tax benefit; tax aggressiveness; tax risk *Corresponding author: Professor Steve Matsunaga Lundquist College of Business 1208 University of Oregon Eugene, OR Phone: (541) Fax: (541) stevem@uoregon.edu We thank Kathleen Powers and the rest of the Texas Tax Reading Group, the Iowa Tax Reading Group, Jenny Brown and the rest of the Arizona State Tax Reading Group, Michelle Hutchins, Sonja Rego, Carlos Jiménez-Angueira and workshop participants at the University of Oregon, the 2013 AAA Western Regional Meeting and the 2013 AAA Annual Meeting for helpful comments. Support from the Finance and Securities Analysis Center at the Lundquist College of Business is gratefully acknowledged.

2 Tax Avoidance, Tax Aggressiveness, Tax Risk and Firm Risk 1. Introduction Surveys and other publications by tax practitioners have focused attention on the notion of "tax risk" as a type of business risk that must be managed by public corporations. 1 Tax risk and its effect on public companies has also been the subject of academic research in accounting. Since tax risk is by definition "risky," it has been argued that firms must provide risk-taking incentives for managers to encourage them to undertake risky value-maximizing strategies that reduce the firm s tax payments (Brown, Drake, and Martin 2013; Rego and Wilson 2012; Boivie et al 2012; Higgins, Omer and Phillips 2012; and Robinson, Xue, and Zhang 2012). Despite the view that reducing corporate taxes is risky, there is a lack of empirical evidence linking taxreduction activities to an increase in firm risk. 2 Managers adopt a wide range of tax policies designed to reduce firms corporate tax payments, and researchers are not always consistent in either the terms used to describe these policies, or the empirical measures used to identify them. Our goal in this study is to differentiate between three different concepts that characterize tax policy which we refer to as tax avoidance, tax aggressiveness, and tax risk and to propose appropriate empirical measures for each concept. 3 We then investigate whether any, or all, of the empirical measures are associated with a well-accepted measure of firm risk: future stock return volatility. 4 Our purpose is to provide insight into how firms tax policies affect the overall risk of the firm. 1 See for example Ernst & Young (2011), KPMG (2011), and PricewaterhouseCoopers (2004). 2 In work that is somewhat related to our question, McGuire, Neuman and Omer (2013) examine how the persistence of tax avoidance strategies affects earnings persistence, and Campbell, Chen, Dhaliwal, Lu, and Steele (2013) examine how corporate effective tax rates are related to managers' discussion of tax risk in 10-Ks. 3 Our classification of three different concepts of tax policy is similar to the classification used in Lisowsky, Robinson and Schmidt (2013). 4 We focus on the traditional view of firm risk as being reflected in the volatility of stock returns, since this is the type of risk for which managers are compensated by the use of employee stock options. 1

3 In finance the term "risk" is generally used to describe the spread or dispersion of possible outcomes or payoffs from an investment, reflecting the degree of uncertainty about the future (Brealey and Myers 1991 p 114). Neuman, Omer and Schmidt (2013, 6) relate this concept to corporate tax risk, stating: "Tax risk refers to the potential that a chosen action or activity [...] will lead to a tax outcome that is different than initially expected." The simplest and most commonly used measures of spread or dispersion are the standard deviation and variance of the payoffs (Powers 2009). These have been the traditional measures of risk in academic finance research for some time (e.g., Markowitz 1952) and continue to be used in current research (e.g., Cassel, Huang, Sancez, and Stuart 2012). Measuring risk as the variance or standard deviation of expected outcomes or payoffs is also a standard approach in finance textbooks (e.g., Fama 1976; Cochrane 2001; Pennacchi 2007). To investigate the relation between a firm s tax policies and firm risk, we consider three underlying concepts that have been used to characterize firms tax policies. The first concept is tax avoidance, which we define as adopting tax policies that reduce the firm s income tax payments. Following Dyreng, Hanlon, and Maydew (2008) we use the Cash ETR as the appropriate measure of tax avoidance. Dyreng et al. (2008) describe a low Cash ETR as the ability to pay a low amount of cash taxes per dollar of pre-tax earnings over long time periods." Tax policies that avoid more taxes, and lead to lower Cash ETRs, could increase the firm s risk if the underlying activities that allow the firm to lower tax rates are inherently risky, or if lower tax rates are less sustainable than higher tax rates. On the other hand, the ability to avoid taxes has been shown to be stable over long time periods (Dyreng et al. 2008). In this case, the firm s tax rate would be fairly stable over time, and the riskiness of the underlying activities may not be 2

4 different from similar more highly taxed investments, in which case tax avoidance activities would not be associated with firm risk. The second tax policy concept we examine is tax aggressiveness, which we define as the extent to which the firm takes tax positions that are unlikely to survive a challenge by the I.R.S. Tax avoidance differs from tax aggressiveness in that firms can lower their tax rates while still taking tax positions that are unlikely to be overturned by the I.R.S. For example, opening a subsidiary in a low tax country, taking advantage of accelerated depreciation deductions, or qualifying for research and development tax credits would allow a firm to avoid paying income tax in ways that would generally not be challenged by the I.R.S. and therefore would not represent tax positions that are aggressive. On the other hand, if firms reduce their tax payments by engaging in activities or interpreting the tax code in ways that would be unlikely to be upheld if the firm were audited, they are exhibiting tax aggressiveness. The empirical measure that appears to best capture the concept of tax aggressiveness is the reserve for Unrecognized Tax Benefits (UTBs) as defined by FASB Interpretation No. 48 (FIN 48). FIN 48 was specifically created to limit the ability of firms to reduce their reported tax expense by taking positions that are unlikely to be upheld in the future. Tax aggressive policies, reflected in a high UTB reserve, could increase firm risk if there is a high degree of uncertainty with regard to future tax payments. However, despite the name, it isn t clear whether UTB reserves actually reflect uncertainty about a firm s future tax payments. Consistent policies whereby new aggressive positions offset settlements could lead to fairly predictable tax payments. In addition, the resolution of uncertain positions could take years to work through the judicial system. Finally, the determination of the UTB reserve is subjective and is therefore 3

5 subject to the biases inherent in the accrual process. We therefore view the effect of UTBs on firm risk as an empirical question. The third tax policy concept we examine is tax risk, which we define as uncertainty regarding the firm s future tax payments. Tax risk differs from tax avoidance and tax aggressiveness in that it reflects the extent to which a firm is able to sustain its tax positions over time. A firm s tax payments are likely to change over time for a variety of reasons, including changes in domestic and international tax law, the extent to which aggressive tax positions are settled for or against the firm, or the firm s ability to maintain tax-favored investments. Regardless of the source, variability in the firm s tax rate should be reflected in uncertainty about the tax rate investors should apply to pretax income or cash flows in assessing the firm s future after-tax cash flows. We use the standard deviation of the firm s annual cash ETR to measure tax risk. As noted above, recent and concurrent research assumes or asserts that policies that reduce the firm s tax payments are "risky." In other words, one of the economic consequences managers need to consider in determining the firm's tax policies is the impact on firm risk. This view leads to the conclusion that managers consider a trade-off of the benefit from increased cash flows from reduced tax payments against the cost of increased firm risk. To provide empirical evidence on this issue we estimate the relations between firm risk (the one year ahead volatility of the firm s stock return) and three measures of tax policy: (1) the level of tax avoidance (the cash effective tax rate), (2) tax aggressiveness (the reserve for UTBs), and (3) tax risk (the standard deviation of the annual Cash ETR). 4

6 Before conducting our main tests, we first examine how each of the three tax policy characteristics is related to the others. 5 As expected, we find that the Cash ETR is negatively correlated with the UTB reserve, which suggests that firms that take aggressive tax positions pay lower amounts of their pretax income in taxes. However, perhaps surprisingly, we find a positive correlation between the Cash ETR and tax risk, and a negative correlation between the UTB balance and tax risk. These results suggest that firms that take aggressive tax positions and are able to reduce their tax payments experience relatively stable tax rates. We also examine the characteristics of firms that have high levels of tax avoidance, tax aggressiveness, or tax risk. We find substantial differences in firm characteristics between firms that demonstrate high tax avoidance or tax aggressiveness and firms that have high levels of tax risk. Together, these results suggest that although the three concepts, or measures, are related, they seem to capture different aspects of a firm s tax policies. In our main tests we regress future stock return volatility against each of our tax policy measures. As discussed by Neuman et al. (2013), tax risk is an ex ante concept, and reflects expected uncertainty about future events, so our measure of firm risk captures future volatility. Our tests control for factors that prior research has linked to future stock return volatility, including the historical variance of pretax earnings. We find that our measure of tax risk the standard deviation of the annual Cash ETR, measured over a five-year period is positively related to future stock return volatility. This result holds for both the full sample and the more limited UTB sample, and is consistent with tax risk increasing the uncertainty of after-tax cash flows. On the other hand, we do not find significant associations between future stock return volatility and either the level of Cash ETR or the level of the UTB reserve. These results suggest 5 Because the UTB reserve is not available until 2007 or 2008, we conduct our tests on two samples. For tests that do not require UTB data we use the full sample from Tests that include the UTB reserve are conducted on a more limited sample for which UTB data are available. 5

7 that tax avoidance and tax aggressiveness do not increase overall firm risk, and suggest that such activities may not be risky in the traditional sense of that term. 6, 7 We also investigate possible reasons why firm risk appears to be unrelated to either tax avoidance or tax aggressiveness. One reason may be that these tax policies are only related to firm risk when firms use the policies to unusually high degrees. To test this explanation, we define indicator variables for each of our tax policy measures that identify observations in the lowest quintile of Cash ETR or highest quintile of the UTB reserve or standard deviation of the Cash ETR. Results using these extreme values are similar to our initial results in that firms with high tax risk (i.e., high standard deviation of Cash ETR) have significantly higher firm risk, but firms with high tax avoidance or tax aggressiveness do not have higher firm risk. Our study makes several contributions to the literature on accounting for income taxes. First, we clarify the underlying concepts reflected in different tax policies by differentiating the concepts of tax avoidance, tax aggressiveness, and tax risk and suggesting appropriate empirical measures to capture each type of tax policy. We also document systematic differences between the characteristics of firms that display differences in tax avoidance, tax aggressiveness and tax risk, which helps provide insight into which types of tax policies are captured by each measure. Our results also highlight the importance of carefully considering which empirical measure best reflects the underlying construct being studied. We also provide evidence regarding the impact of different tax policies on firm risk. A number of recent studies examining the determinants and economic implications of tax policies 6 If low Cash ETRs proxy for risky tax positions, we expect this risk to be reflected in stock returns in a future year when additional tax and penalties are paid. For consistency, we use the same twelve-month period to measure stock return volatility for all three of our tax aggressiveness measures. 7 In a concurrent paper, Hutchins and Rego (2012) document a significantly positive relation between the UTB reserve and concurrent stock volatility. However, their empirical model does not include many of the control variables from our study that prior research in finance has documented to be related to stock volatility. 6

8 have implicitly or explicitly assumed that tax avoidance and/or tax aggressiveness are risky activities. We do not find evidence that investments in tax avoidance, as measured by the Cash ETR, or tax aggressive policies, as measured by the UTB reserve, increase the firm s overall risk. In contrast, we document evidence that uncertainty with regard to the firm s Cash ETR, as measured by the standard deviation of the Cash ETR, is positively associated with firm risk. Our results are consistent with the notion that when the volatility of cash ETR is high, investors have more uncertainty regarding the tax rate applicable to the firm s pretax cash flows. As information is released that resolves that uncertainty, the stock price adjusts, thereby increasing stock return volatility. Overall, our results suggest that tax policies that reduce the firm s tax payments, or increase the firm s UTB reserve, only increase the risk of the firm if they increase uncertainty regarding the firm s tax future tax payments, suggesting that the firm is unable to sustain those positions over time. 2. Tax Policies and Firm Risk A key concept regarding a firm s tax policies is tax avoidance, which represents the ability of the firm to reduce its current tax payments. Tax avoidance is generally measured as the ratio of taxes paid during the year to pretax financial reporting income: the Cash ETR. The measure can be calculated on an annual basis, although Dyreng et al. (2008) recommend using the sum of taxes paid over a five-year period and the sum of pretax income over the same period to provide a better picture of the firm s tax policies. Studies such as Brown, Drake, and Martin (2013), Rego and Wilson (2012), Boivie et al (2012), and Higgins, Omer and Phillips (2012) suggest that aggressive tax planning is a risky activity. They argue that firms lower their tax payments by taking tax positions that have a relatively high probability of being disallowed. 7

9 Thus, although investments and policies that reduce the firm s tax payments have a positive expected value, the possibility that the firm s tax positions will be challenged by the I.R.S. and overturned by the courts makes these tax policies risky. Therefore, to encourage managers to take risky tax positions with a positive expected value, the compensation committee increases the reliance on stock options in executive compensation packages. This is consistent with the results in Rego and Wilson (2012), who document a negative relation between the CEO s risk-taking incentives (the vega of their equity portfolio) and the level of a firm s cash ETR. 8 However, it is not clear that investments that generate lower tax payments will lead to more volatile future cash flows and stock returns. Multinational companies generate a substantial amount of their income in countries with low tax rates. As long as these companies reinvest their operating earnings outside of the U.S., the corporation will continue to avoid the higher U.S. tax. If a firm maintains a low, stable tax rate it is unlikely that the firm s tax policies induce volatility in the firm s cash flows or stock returns. As an example, Panel A of Appendix A presents the Cash ETR and volatility of Cash ETR for IBM from 2003 to IBM was consistently able to pay a relatively low amount of taxes with a Cash ETR of 16.10%. The standard deviation of the annual Cash ETR over this period was a relatively low Thus, while the tax policies of IBM appear to have lowered the taxes paid, the company was able to maintain that low rate fairly consistently over the five-year period. A second characteristic of tax policies is tax aggressiveness, or the extent to which firms use ambiguity in the tax law to reduce their tax payments. For example, a firm may decide that there is no clear authority on the tax treatment applicable to a specific transaction and assesses the probability that a favorable interpretation has a 10% chance of being supported based on its 8 Armstrong, Blouin, and Larcker (2012) do not find a significant relation between the reliance on incentive-based compensation (compensation mix) for the CEO and the firm s Cash ETR. Thus, their evidence suggests that the provision of stronger incentives to the CEO does not affect the firm s tax policies. 8

10 technical merits. A tax aggressive firm would choose the favorable interpretation in preparing its tax return, thereby reducing its current tax payments. We argue that the appropriate measure for tax aggressiveness is the firm s UTB reserve. FIN 48 requires firms to establish a reserve for a tax position if it is more likely than not that the position will not be upheld based on its technical merits. Thus, by definition, the UTB reserve should reflect the extent to which firms take tax positions that are aggressive in the sense that they may not be in accordance with the tax law. As an example, in its K Microsoft reported a UTB reserve of $7.2 billion and noted that the primary unresolved issue relates to transfer pricing, which could have a significant impact on our financial statements if not resolved favorably. Taking aggressive tax positions can be considered a risky activity since it is likely that their positions will be overturned in the future and the firm could have to repay the tax plus interest and penalties. However, the impact of aggressive tax policies on overall firm risk is not clear. First, the determination of whether a given tax position should be included in the reserve requires subjective judgment. As a result, different firms taking the same tax positions are likely to have different UTB reserves. Second, the time period in which the tax positions will be resolved is not clear. Microsoft states that we do not believe the remaining open issues will be resolved within the next 12 months. Thus, the impact of aggressive tax positions on the firm s tax payments could be delayed for an indefinite period of time. In fact, because Fin 48 specifies that firms ignore the probability of audit, it is possible that the amounts in the UTB reserve will never be paid. Finally, if firms consistently take aggressive tax positions, unfavorable resolutions of prior aggressive tax positions could be offset by new aggressive tax positions, leaving the firm s total tax payments relatively constant over time. 9

11 The third characteristic of tax policies we consider is tax risk, which we define as uncertainty about the firm s tax rate. We measure tax risk as the standard deviation of a firm s Cash ETR, which captures the volatility of the Cash ETR. 9 Our measure of tax risk essentially measures the extent to which a firm is able to sustain its tax positions over time. As an example, consider the case of DPL Incorporated, detailed in Panel B of Appendix A. Over the period the standard deviation of the company s cash ETR is 0.23, which places it in the top quintile of the distribution.. DPL s annual cash ETR dropped from 75.58% in 2002 to 6.03% in 2003, and rose to 31.47% in The volatility in the Cash ETR for DPL suggests the company was unable to sustain the tax positions that lowered the Cash ETR in As a result, at the end of 2006, there is uncertainty whether the firm will pay a tax rate close to the 42.64% paid in 2006, drop to the 26.79% paid in 2005, or rise back to the 75.58% paid in Therefore, after forecasting pretax income, investors face additional uncertainty in determining the appropriate tax rate to use to forecast after-tax cash flows. While in the case of IBM, information released in the subsequent year regarding IBM s actual tax rate is likely to have a relatively small effect on IBM s after-tax cash flows and share price, information regarding whether DPL will be paying percent of its pretax income or 6 percent of its pretax income in taxes will have a relatively large effect on after-tax cash flows and thereby lead to a higher volatility in stock returns. While it may seem obvious that uncertainty about a firm's tax rate will affect overall firm risk, we believe there are two reasons why the relation between tax risk and firm risk is an empirical question. First, to the best of our knowledge there is no prior empirical evidence that uncertainty regarding a firm s tax rate leads to uncertainty with regard to the firm s after-tax cash 9 As we discuss below, we also conduct a sensitivity test using the coefficient of variation of the Cash ETR, which scales the standard deviation by the mean. Our results are similar with either measure of volatility. 10

12 flows. Second, despite publications by practitioners stating that tax risk is a component of firm risk, it may be the case that investors do not consider corporate taxes when making investment decisions, and in that case stock return volatility would be unrelated to tax rate volatility. In a concurrent paper, Hutchins and Rego (2012) examine how different measures of tax risk relate to the firm s cost of capital. The cost of capital can be interpreted as a measure of the risk perceived by shareholders. However, the theoretical link between tax risk and the firm s cost of capital is not clear, since tax risk is a type of idiosyncratic risk which investors can avoid by diversification. In addition, empirical measures of cost of capital relate current stock price to analysts' earnings forecasts. This is problematic because the UTB reserve, a measure of tax risk, reflects tax benefits that have, by definition, not been recorded in the firm's earnings. In other words, if the risky uncertain tax benefits are not reflected in the analysts' forecast of earnings, it isn't clear why a higher discount rate should be applied to those forecasted earnings to arrive at a stock price. In contrast, the measure of firm risk we use in this paper, stock return volatility, is a more direct, albeit ex post, measure of the underlying uncertainty regarding the firm s after-tax cash flows. 10 Stock return volatility also has a direct influence on the value of risk incentives in that option-pricing models show that the value of a stock option increases with stock return volatility. 3. Empirical Tests 3.1 Sample Selection and Key Variable Definitions Our sample begins with all observations on the CRSP/Compustat merged database from 1987 to 2011 with data necessary to compute our regression variables. We start with In other words, a firm with volatile after-tax cash flows will have volatile stock returns, regardless of the effect of tax risk on cost of capital. 11

13 because this is the first year that many of the data items necessary to compute our variables of interest, such as cash taxes paid, are available on Compustat. To reduce the impact of different legal systems, including tax laws and enforcement, we drop firms that are not incorporated in the U. S. To allow a meaningful interpretation of the Cash ETR we require firms to have positive pre-tax income (Dyreng, et al. 2008). In addition, each firm must have sufficient data for five consecutive years to calculate the Cash ETR, and data for a sixth consecutive year to calculate stock return volatility. Finally, we require firms to have stock return data for all 12 months of the year on the CRSP database. This procedure yields a total of 16,547 firm-year observations. Table 1 shows the number of times each unique firm appears in our sample. Because we use firm fixed effects in our analyses utilizing our full sample, we require each firm to appear at least twice in our sample. Our sample includes of 2,376 unique firms, with 388 firms appearing twice and a total of 69 firms appearing the maximum of 19 or 20 years. 11 The vast majority of firms in our sample are not present throughout the entire sample period, due to both sample changes (firms that exit before the end of the sample period or enter after the beginning of the sample period), and the requirement that the firm have positive pre-tax income for five consecutive years. To control for the fact that we have multiple and unequal numbers of observations per firm and per year in our sample, we include both firm and year fixed effects in the regressions. Following Dyreng et al. (2008), we calculate our measure of tax avoidance (Cash ETR) as the ratio of the sum of the cash tax payments over a five-year period to the sum of income before taxes and special items over the same five-year period. To calculate tax risk (Tax Risk), we compute the annual Cash ETR (cash taxes paid for the year scaled by income before taxes 11 Because fiscal years do not match up exactly with calendar years, some of our firms have a maximum of 20 years of reported data, while others only have 19 years. 12

14 and special items for the year) over each of the five years in the sample period and calculate the standard deviation of the five annual Cash ETRs. We use a rolling five-year window to calculate each measure and include a firm if it has sufficient data for the five-year period to construct the tax aggressiveness measures and sufficient data to calculate the subsequent year s stock return volatility. Examples of the calculation of the Cash ETR and standard deviation of the Cash ETR can be found in Appendix A. Our measure of tax aggressiveness is the FIN 48 UTB reserve scaled by lagged total assets. Because the UTB reserve is only available for a limited set of firms for a few years ( ), the sample for tests that require the UTB reserve is limited to the 1,960 firm-years for which the UTB data are available. In addition, because firms can only be included in the sample for a maximum of 4 years, we replace the firm fixed effects with industry fixed effects in tests on the UTB sample. The dependent variable in our analysis is the volatility of stock returns (StdDev_Return). To compute the volatility we use the standard deviation of the twelve monthly returns in the fiscal year immediately following the last of the five years used in our tax measures. 3.2 Research Design To examine the association between tax policies and firm risk, we separately regress the subsequent year stock return volatility on each tax policy measure and a common set of control variables derived from prior research. SD_Ret it+1 = TAX it + 2 PTBI t + 3 Vol_of_PTBI it + 4 BTM it + 5 Leverage it + 6 Size it + 7 Abn_Accruals it + 8 Return it Shares_Out it + 10 Inst_Own it1 + it (1) 13

15 To calculate our variables we use the following formulas (Compustat Variable Name): SD_Ret TAX = standard deviation of monthly stock returns; = either Cash ETR, Tax Risk, or UTB, where Cash ETR is the five year sum (measured from year t-4 to year t) of cash taxes paid (TXPD) divided by the five-year sum of pre-tax income (PI) less special items (SPI). Tax Risk is the standard deviation of annual Cash ETRs over the previous 5 years, or UTB, calculated as the balance of the unrecognized tax benefits (TXTUBEND) scaled by lagged total assets (AT); 12 PTBI Vol_of_PTBI = pretax book income (PTBI) scaled by lagged total assets; = standard deviation of the ratio of annual pretax income (PI) to lagged total assets (AT) measured over a five-year period; BTM = year-end book value of equity (CEQ) over the price per share (PRCC_F) times the total number of shares outstanding (CSHO); Leverage Size Abn_Accrual = year-end long-term debt (DLTT) scaled by lagged total assets; = natural log of total assets (AT); = square of year-end discretionary accruals, estimated using the modified Jones model from Dechow et al. (1995); Return Shares Out Inst Own = firm s annual buy and hold stock return measured over the fiscal year; = log of the firms common shares outstanding (CSHO); and = firm s average institutional ownership measured over the fiscal year. As noted above, we use the standard deviation of returns rather than systematic risk (i.e., beta) because we are interested in the impact of tax policies on the overall risk of the firm, as 12 To have a meaningful interpretation of the Cash ETR we require positive pretax income and we winsorize the Cash ETR at 0 and 1 (following Dyreng et al 2008). 14

16 reflected in the riskiness of the firm s cash flows. We use pretax income from operations to control for the firm s operating performance, which has been shown to be negatively associated with stock return volatility (Hanlon et al. 2004). The volatility of pretax income measured over the same period as the tax rate variables controls for the riskiness of the firm s operations. 13 The book-to-market variable controls for the extent of the firm s growth opportunities, which we expect to be positively associated with stock return volatility. We include financial leverage to control for the additional risk imposed by financial distress and capital constraints (Rajgopal and Venkatachalam 2011). We control for size since smaller firms experience greater return volatility (Pastor and Veronesi 2003). The extent of discretionary accruals controls for the risk associated with lower earnings quality (Rajgopal and Venkatachalam 2011). We also control for the firm s stock return over the current year, as stock return is negatively related to return volatility (Duffie 1995). To control for stock trading differences due to investor composition, we include the firm s average institutional ownership over the year (Bushee and Noe 2000). Finally, we include the number of shares outstanding in the current year, as the supply of a firm s shares has been shown to be a significant determinant of stock return volatility (Cohen, Ness, Okuda, Schwartz and Whitcomb 1975). Our regression specification also includes firm and year fixed effects for the full sample and industry and year fixed effects for the UTB sample. A Hausman test between fixed and random effects indicates that OLS is not consistent and that fixed effects are appropriate. As noted above, we have a substantial number of firms included in the sample multiple times. By including firm fixed effects the regression explains deviations from the average return volatility for each firm and therefore reduces potential problems associated with firm-specific omitted 13 In unreported sensitivity tests we use the standard deviation of cash flows from operations and sales instead of pretax income to control for the riskiness of the firm s operations. Inferences are unchanged. 15

17 variables that are correlated with the firm s average stock return volatility. 14 The year fixed effect controls for differences in tax laws and other macroeconomic effects across time. 3.3 Descriptive Statistics Table 2 presents descriptive statistics for the dependent and independent variables used in the regressions. The mean (median) Cash ETR of 28.9% (30%) is similar to the levels reported in prior research. The distribution of the standard deviation of Cash ETR appears to be positively skewed with a mean of 11.6% and median of 7.7%. Table 3 provides data regarding the correlations between our tax policy measures. The data reported in Panels A and C include observations for the restricted sample for which UTB data are available. The data in Panel B are based on the full sample. The pairwise correlation coefficients presented in Panel A indicate a strong positive correlation between the level of Cash ETR and tax risk. Because a low Cash ETR is indicative of a high degree of tax avoidance, this suggests that firms that avoid taxes pay a fairly stable proportion of pretax income in taxes. Similarly, we find significantly negative correlations between the Cash ETR and UTB reserve, which is consistent with firms that avoid tax taking more aggressive tax positions. However, the relation between tax risk and tax aggressiveness is less clear. Although the Pearson correlation coefficient is significantly negative, it is small (-0.090) and the Spearman Rank correlation coefficient is not significant (-0.002). To further illustrate the relationships among tax avoidance, tax aggressiveness and tax risk we compare the number of observations in common quintiles. Panel B of Table 1 compares tax avoidance and tax risk. As there are 25 possible combinations, the expected number of 14 In our tests using the UTB sample, we re-estimate these regressions using industry (two-digit SIC code) effects instead of firm effects and find similar results. 16

18 observations in each cell is approximately 667, or 1/25 of the total of 16,686. Consistent with the positive correlation, we find that firms with extremely low tax rates tend to have low risk. A total of 871 observations fall in the lowest quintile of both Cash ETR and standard deviation of Cash ETR. Similarly, firms that have high levels of tax risk tend to have high Cash ETRs. A total of 1,183 observations are in the high tax rate, high tax risk quintile combination. These results suggest that tax policies that reduce the amount of taxes paid do not increase the volatility of the firm s tax payments. To a certain extent, this is mechanical given that the Cash ETRs are computed over a five-year period, i.e., firms in the lowest Cash ETR quintile probably didn t pay a high amount of taxes in any of the five years. However, we also note that although the highest concentration of observations from the low Cash ETR quintile row is in the lowest Cash ETR column, there are at least 500 observations in each cell in the row. The relation between tax aggressiveness and tax risk (Panel C of Table 3) is less clear. Because UTB data are only available after 2007, the number of observations declines to 1,960 leading to expected value of 78 observations in each cell (assuming random distribution). The 82 observations in the high UTB, high tax risk cell is only slightly higher than the 78 observations based on random assignment. The cell with the highest number of observations (107) includes firms that are in the lowest UTB quintile and highest volatility quintile. Thus, the evidence does not appear to suggest that firms that take aggressive tax positions (as measured by the UTB reserve) experience volatile tax payments. To provide more evidence on the stability of low tax rates, we estimate separate logit regressions with the dependent variable equal to one if the firm is in the lowest (highest) quintile of Cash ETR, and zero otherwise. In each regression the variable of interest is equal to one if the firm was in the lowest (highest) Cash ETR quintile in the latest non-overlapping five-year 17

19 period, and zero otherwise. The regressions also include year dummy variables. The coefficient on the lagged indicator variable can be used to assess the persistence of the firm s tax rate. We present the results in Panel D of Table 3. In Column (1) the coefficient on the lagged Cash ETR quintile variable of indicates that a firm that is in the lowest Cash ETR is 10 times (e ) more likely to be in the lowest Cash ETR quintile computed over the next five-year (nonoverlapping) period than firms that are not in the lowest quintile. In contrast, the coefficient on the lagged indicator variable for the highest Cash ETR quintile of shown in Column (2) indicates that a firm in the highest Cash ETR quintile is only 3 times (e ) more likely to remain in the highest Cash ETR quintile. These results suggest that low tax rates are more persistent than high tax rates, and that firms who are able to lower their tax payments are often able to sustain those positions over a long period of time. Panel D of Table 3 presents the Pearson and Spearman pairwise correlations for the full sample. There appear to be significant correlations between the volatility of stock returns and each of our control variables, with the strongest correlations with the volatility of pretax income and size. Tax avoidance seems to be most highly correlated with size, institutional ownership and the number of outstanding shares, where tax risk appears to be most highly correlated with pretax income, the book to market ratio, and shares outstanding. 3.4 The Determinants of Tax Avoidance, Tax Aggressiveness and Tax Risk To provide insight into the factors that generate high tax avoidance, tax aggressiveness or tax risk, we regress the incidence of being in the lowest Cash ETR quintile, highest UTB reserve quintile, or highest standard deviation of Cash ETR quintile, on firm characteristics that are likely to affect the firm s tax payments. For consistent comparisons across regressions we 18

20 conduct this test using only our sample of firm-year observations that also have data available for UTBs. Specifically, we estimate the following logit regression: 15 Tax_Quintile it = Size it + 2 PPE it + 3 Foreign_Sales it + 4 R&D it + 5 Intang_Assets it Where: + 6 ESO_Benefit it + 7 Leverage it + it (2) Tax_Quintile = alternately, High Tax Avoidance, which is equal to one if the observation is in the lowest Cash ETR quintile and zero otherwise, High Tax Aggressiveness, which is equal to one if the observation is in the highest quintile of Unrecognized Tax Benefits and zero otherwise, or High Tax Risk, which is equal to one if the observation is in the highest standard deviation of Cash ETR quintile, and zero otherwise; PPE = net property plant and equipment (PPENT) scaled by lagged total assets; Foreign_Sales = foreign sales (foreign sales from geographic segments) divided by total sales (sale), where foreign sales is set to 0 if missing; R&D Intang Assets ESO_Benefit = research and development expense (XRD) scaled by lagged total assets; = intangible Assets (INTAN) scaled by lagged total assets; = the excess tax benefit of stock options (TXBCOF) scaled by lagged total assets, and other variables are as previously defined; and Leverage = year-end long-term debt (DLTT) scaled by lagged total assets. We include size to capture the firm s investment in tax savings. To the extent there are economies of scale in tax investments, larger firms are able to invest more in tax departments to find tax savings. The relative investment in net property, plant, and equipment is included to 15 Detailed variable definitions for the Logit Prediction Model can also be found in Appendix B. 19

21 capture the value of the depreciation tax shield. Because tax rates in foreign jurisdictions are often lower than domestic rates, we include foreign sales. We include research and development expenditures to capture the various tax credits that are available for research activities. We include intangible assets because these assets are easier to transfer between operating units and have therefore been associated with income shifting (either between countries or between states) to lower tax payments. The excess tax benefit from stock option exercises affects tax rates because the amount of the tax deduction is based the ex post gain on exercise, while the amount of the option expense is based on the ex-ante value of the stock option. Finally, we include leverage to capture the debt tax shield. We conduct our tests on the limited sample for which UTB data are available, include year fixed effects and cluster standard errors by firm. The results of estimating equation (2) are presented in Table 4. Column (1) indicates that firms that display high tax avoidance (low Cash ETRs) have significantly higher investments in property, plant, and equipment, have higher levels of research and development, greater tax benefit from the exercise of options by employees and higher financial leverage. These results are consistent with firms using tax shields to reduce their tax payments. The greater tax benefit from the exercise of stock options is consistent with the Rego and Wilson (2012) finding that firms that avoid taxes tend to utilize more stock options. However, attributing the relation to the need to provide risk-taking incentives to encourage tax avoidance assumes that tax avoidance activities increase firm risk. The results in column (2) of Table 4 show that tax aggressive firms (high UTB reserves) are significantly larger, have lower investments in PPE, a greater proportion of foreign sales and higher R&D expenditures. The positive relation with size is consistent with larger firms investing greater resources into taking aggressive tax positions. The negative coefficient on property, plant 20

22 and equipment, combined with the positive coefficients on foreign income and R&D expenditures are consistent with tax aggressive firms utilizing foreign subsidiaries to reduce their tax payments. 16 Unlike high tax avoidance firms, firms that display high tax aggressiveness do not have significantly higher tax benefits from employee stock option exercises or greater degrees of leverage than non-tax aggressive firms. The results reported in column (3) of Table 4 indicate that firms that display high tax risk tend to be smaller than the average firm. This is consistent with smaller firms not having the resources to invest in devising sustainable tax policies. High tax risk firms also have lower investments in intangible assets, lower tax benefit from stock options, and higher leverage than average firms. Overall, Table 4 documents that there are a large number of differences in the characteristics of firms that have high tax avoidance, aggressiveness and risk. Specifically, while firms with high tax avoidance are able to take advantage of the tax shields associated with accelerated depreciation, research and development expenditures, employee stock option exercises and interest payments, high tax aggressive firms are larger firms that generate a higher degree of foreign sales, have lower investments in property, plant and equipment, and higher investments in research and development. In contrast, firms that have volatile Cash ETRs tend to be smaller firms with fewer intangible assets, fewer employee stock option exercises and a higher degree of leverage than the average firm. 16 Because it is easier to transfer intangible assets than physical assets, firms often use intangible assets to transfer income to low tax jurisdictions. The positive coefficient on R&D and the insignificant coefficient on intangible assets suggest that tax aggressive firms are more likely to use internally generated intangible assets to shift income. 21

23 3.5 Regression Analysis To test whether tax avoidance, tax aggressiveness or tax risk is associated with firm risk, we estimate regression equation (1) for each tax policy measure and report the results in Table 5. Panel A of Table 5 presents the results for the full sample. In each regression, the dependent variable is the one-year ahead stock return volatility measured as the standard deviation of twelve monthly stock returns. In columns 1 and 2 we report the results for tax avoidance and tax risk without the control variables. These results differ from the pairwise correlations because they include both year and firm fixed effects. We find an insignificant coefficient for the Cash ETR (column 1) and a significantly positive coefficient on tax risk (column 2). We find similar results in Columns 3 and 4 when we include the control variables. The insignificant relations for the Cash ETR raise questions as to whether tax avoidance, per se, is a risky activity. The significantly positive coefficient for the standard deviation of the annual cash ETR suggests that tax avoidance is only a risky activity if the firm is unable to sustain its tax positions over time. Our results also suggest that the degree of uncertainty regarding the firm s tax rate is associated with the riskiness of the firm s after-tax cash flows. The results for the control variables are generally significant in the expected directions. The exceptions are insignificant relations for our measures for expected growth (book to market), and accounting quality (abnormal accruals), and significantly positive relations for firm performance (stock return and pretax book income). The insignificant results could be attributed to their effect being reflected in the other independent variables. The positive relation between performance and future volatility could be due to the composition of our sample. We require firms to have six consecutive years of data and five consecutive years of positive pretax book income. As a result, firms in financial distress, which are generally responsible for the negative 22

24 relation between performance and volatility, are excluded from our sample. Panel B of Table 5 reports the results from the estimation of equation (1) on the limited sample with UTB data. In Columns 1-3 we present the results without control variables and in Columns 4 6 we present the results after including the control variables. Because the limited time period reduces the number of observations per firm, we replace the firm fixed effects used in the full sample regressions with industry fixed effects. We retain year fixed effects. We find insignificant coefficients for the level of the Cash ETR (columns 1 and 4) and the UTB reserve (columns 2 and 5). Thus, we do not find evidence that tax avoidance or tax aggressiveness increases the riskiness of the firm s cash flows. On the other hand, we continue to find a positive relation between tax risk and stock return volatility. Overall, our results suggest that uncertainty regarding the firm s tax rate, as reflected in the standard deviation of the firm s annual Cash ETR, increases uncertainty regarding the firm s cash flows, as reflected in the volatility of the firm s stock return. Tax policies that reduce the firm s tax payments or increase the firm s UTB reserve only increase firm risk if they also increase the volatility of the firm s tax payments. Tax policies, whether aggressive or not, that lead to relatively stable tax payments over time do not appear to increase firm risk. The regression results reported in Table 5 assume a linear relation between the tax measures and stock return volatility. However, it is possible that the impact on firm risk is concentrated in extreme tax policies. In other words, while there may be relatively weak overall relations between tax avoidance, or tax aggressiveness, and firm risk, unusually large degrees of tax avoidance or aggressiveness could be still lead to a high degree of volatility. This effect could be obscured by the inclusion of firms for which the relation is small, or nonexistent. To provide evidence on this question we define indicator variables that are set equal to one if the 23

25 firm is in either the lowest quintile of Cash ETR, the highest quintile of the UTB reserve, or the highest standard deviation of Cash ETR quintile. We then replace the continuous tax variables with the indicator variables in estimating equation (1). Table 6 reports the results using the indicator variables for extreme quintiles. Panel A of Table 6 presents the results for the full sample and Panel B of Table 6 presents the results for the limited UTB sample. In both samples, the coefficients for the high tax avoidance and high tax aggressiveness indicator variables are not significant. Thus we do not find evidence that displaying an unusually high degree of tax avoidance or tax aggressiveness increases firm risk. The coefficients for the high tax risk indicator variable remain significantly positive. This is consistent with unusually high tax risk leading to higher firm risk. Finally, we consider the coefficient of variation of the Cash ETR as an alternative measure of tax risk. The coefficient of variation scales the standard deviation by the mean of the Cash ETR. Thus, the coefficient of variation considers volatility relative to the mean, or converts raw differences to percentage differences. For example, consider a firm that has a mean Cash ETR of 15% and a firm that has a mean Cash ETR of 35% and assume that both firms receive a shock that increases the mean by 5% of pretax book income, i.e., to 20% and 40%. The standard deviation of the Cash ETR would treat the shock equally for both firms, i.e., going from 15% to 20% is equivalent to going from 35% to 40%. However the coefficient of variation would consider the shock to be greater for the low Cash ETR firm because the 5% increase is a greater percentage increase for the low Cash ETR firm. Panels A, B, and C of Table 7 present the correlations between the coefficient of variation of Cash ETR, the level of the Cash ETR and UTB reserves. Not surprisingly, dividing the standard deviation by the mean generates a negative correlation between the coefficient of 24