Tax Incentives to Hedge

For corporations facing tax-function convexity, hedging lowers expected tax liabilities, thereby providing an incentive to hedge. We use simulation methods to investigate convexity induced by tax-code provisions. On average, the tax function is convex (although in approximately 25 percent of cases it is concave). Carrybacks and carryforwards increase the range of income with incentives to hedge; other tax-code provisions have minor impacts. Among firms facing convex tax functions, average tax savings from a five percent reduction in the volatility of taxable income are about 5.4 percent of expected tax liabilities; in extreme cases, these savings exceed 40 percent.     

Reinsurance and corporate taxation in the United Kingdom life insurance industry

There are two main tax-related arguments regarding the use of reinsurance – the income volatility reduction and the income level enhancement arguments. The income volatility reduction argument contends that firms facing convex tax schedules have incentives to hedge in order to reduce the volatility of their annual taxable income and thereby lower expected tax liabilities [Smith, C.W., Stulz, R.M., 1985. Optimal hedging policies. Journal of Financial and Quantitative Analysis 19, 127–140]. The income level enhancement argument, advanced by Adiel [Adiel, R., 1996. Reinsurance and the management of regulatory ratios and taxes in the property–casualty insurance industry. Journal of Accounting and Economics 22, 207–240], is more specific to hedging via reinsurance. This perspective holds that reinsurance enhances current reported earnings via the receipt of reinsurance commissions and so increases tax liabilities. Consequently, insurance firms with high marginal tax rates should use less reinsurance than those with low marginal tax rates if tax matters. Prior studies using data on financial derivatives have produced mixed results on the validity of the first argument, while Adiel (1996) finds the second argument insignificant in his study of the use of reinsurance by a sample of United States (US) property–liability insurance firms. This study tests the two tax-related arguments using 1992–2001 data for a sample of United Kingdom (UK) life insurance firms. We find that UK life insurers with low before-planning marginal tax rates tend to use more reinsurance; in contrast, tax convexity is found to have no significant impact on the purchase of reinsurance and so the volatility-reduction argument is not supported.     

An innovative analysis of taxes and corporate hedging

Theoretical research predicted that firms with convex tax schedules would hedge to minimize expected taxes. However, previous empirical research did not detect a relationship between derivative use and tax losses carry forward, which contribute to tax schedule convexity. This study aims to show that the tax incentive to hedge depends on tax losses carry forward and the ability of the firm to carry losses forward and back, which depends on the distribution of taxable income. A new measure of the tax incentive to hedge, which incorporates this, will be proposed. Hedging could be accomplished by methods other than by using derivatives. Measures of hedging activity which incorporates the effect of all methods of hedging, and which are consistent with previous theoretical research, will also be proposed. Using the new measures of the tax incentive to hedge and hedging activity, the firm’s tax incentive to hedge will be empirically established to significantly influence its hedging activity¹.     

Earnings management induced by tax planning: The case of Portuguese private firms

In Portugal, a concept of taxable income associated closely with reported accounting income is used to determine the tax liability of firms. Recently, the Portuguese government legislated to introduce a system of “special payment on account” (SPA). Firms were required to pay an amount of income tax in advance that varied between a promulgated minimum and maximum. Although such a tax is unique to Portugal, other countries have tax arrangements that are similar in intent. Thus, Portugal's experience with the introduction of a SPA regime is likely to be instructive in fiscal policy deliberations in other settings.We assess the extent to which the SPA tax policy measure encouraged private Portuguese companies to manipulate earnings. We find that earnings manipulation appears to have been motivated by desire to minimize SPA. Firms whose estimate of SPA liability fell within the range of minimum and maximum limits of the SPA had higher levels of discretionary accruals than firms whose estimate was (equal to or) above the ceiling imposed by the new legislation. Firms with higher rates of income tax were found to reduce earnings to near zero. Firms with higher average income tax rates were more likely to manipulate their earnings than other firms.Our results reinforce the importance for auditors, stakeholders, and tax policy advisors to be alert to the close association between tax planning considerations and reported earnings in their monitoring, analysis, and policy advising activities.     

Leverage and Taxes: Evidence from the Real Estate Industry

Finance theory has long viewed corporate income taxes as a potentially important determinant of corporate financing decisions and capital structures. But finance academics have been unable to provide convincing empirical evidence of a material effect of taxes on corporate leverage, in part because of difficulties in constructing an effective proxy for marginal corporate tax rates, and hence for the tax benefits of debt, for large samples of individual companies. The authors address this by analyzing leverage decisions in an industry whose publicly traded entities are organized either as taxable corporations, or as real estate investment trusts (REITs) that effectively avoid entity level taxation. This enables them to measure the relative tax benefits of debt with greater precision while controlling for important nontax characteristics that affect debt usage. The tax hypothesis predicts that for real estate firms with similar asset portfolios, taxable firms should have more debt than their nontaxable counterparts. Both the nontaxable and the taxable real estate firms in our sample routinely have more than twice the leverage of industrial firms, which suggests that factors other than taxes are contributing to their use of debt. But among real estate firms, tax status appears to play a much weaker role. Taxable firms have significantly more leverage only after 2000, when restrictions on REITs were removed through new regulations that made their operations much more like those of taxable real estate firms. Our findings also depend on real estate characteristics—most notably, only residential real estate firms demonstrated differences that are consistent with the tax hypothesis. Taken together, the authors’ findings suggest that although taxes do seem to matter, their role is clearly secondary relative to factors such as the nature of the firm’s assets. A generous interpretation of our evidence puts the effect of taxes between one‐third and one‐half of that implied by prior research.     

Managerial Ownership and Corporate Hedging

Abstract:  Using information on 443 UK non-financial companies, this work provides evidence supporting the hypothesis that managerial risk aversion is an incentive to deviate from the optimal hedging position. Conflicts of interest between shareholders and managers are at the centre of the decision about the firm's risk profile but are not relevant as determinants of the decision to hedge. This is rather associated with factors enhancing the firm's expected value (underinvestment, scale economies, tax savings).     

ESTIMATING THE TAX BENEFITS OF DEBT

The standard approach to valuing interest tax shields assumes that full tax benefits are realized on every dollar of interest deduction in every scenario. The approach presented in this paper takes account of the possibility that interest tax shields cannot be used in some scenarios, in part because of variations in the firm's profitability. Because of the dynamic nature of the tax code (e.g., tax-loss carrybacks and carryforwards), it is necessary to consider past and future taxable income when estimating today's effective marginal tax rate. The paper uses a series of numerical examples to show that (1) the incremental value of an extra dollar of interest deduction is equal to the marginal tax rate appropriate for that dollar ; and (2) a firm's effective marginal tax rate (and therefore the marginal benefit of incremental interest deductions) can actually decline as the firm takes on additional debt.
Based on marginal benefit functions for thousands of firms from 1980–1999, the author concludes that the tax benefits of debt averaged approximately 10% of firm value during the 1980s, while declining to around 8% in the 1990s. By taking maximum advantage of the interest tax shield, the average firm could have increased its value by approximately 15% over the 1980s and 1990s, suggesting that the consequences of being underlevered are significant. Surprisingly, many of the companies that appear best able to service debt (i.e., those with the lowest apparent costs of debt) use the least amount of debt, on average. Treasurers and CFOs should critically reevaluate their companies' debt policies and consider the benefits of additional leverage, even if taking on more debt causes their credit ratings to slip a notch.     

The role of the corporate income tax as an automatic stabilizer

This paper analyses the effectiveness of the corporate income tax as an automatic stabilizer. It employs a unique firm-level data set of German manufacturers combining financial statements with firm-specific information about credit market restrictions. The results show that approximately 20 per cent of all firms report both positive taxable income and capital market restrictions. Taking account of the income tax rates and the size differences of the firms, we find that demand stabilization through the corporate income tax amounts to about 8 per cent of an initial shock to gross revenues. This stabilization effect varies over the business cycle and tends to increase during cyclical downturns.     

Analyzing the Tax Benefits from Employee Stock Options

Employees tend to exercise stock options when corporate taxable income is high, shifting corporate tax deductions to years with higher tax rates. If firms paid employees the same dollar value in wages instead of stock options, the average annual tax bill for large U.S. companies would increase by $12.6 million, or 9.8%. These direct tax benefits of options increase in the convexity of the tax function. In addition, profitable firms can realize indirect tax benefits because stock options increase debt capacity. Although tax minimization is probably not the main motive for option grants, firms with larger potential tax benefits grant more options.     

Do Firms Hedge in Response to Tax Incentives?

There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.     

Distilling the reserve for uncertain tax positions: the revealing case of black liquor

We examine the extent to which management discretion affects the reserve for unrecognized tax benefits. We analyze the financial statement disclosures of 19 paper companies that received a total of $6.4 billion in refundable excise taxes during 2009. All of these companies included the refunds in financial income, but 14 excluded all or part of the refunds from taxable income. Despite the magnitude and unprecedented nature of the exclusion, we find that only five of the excluding firms accrued a full reserve for an uncertain tax position, three firms accrued a partial reserve, and six firms did not accrue any reserve. This variation suggests managers enjoy wide latitude in applying the more likely than not standard for determining additions to the reserve. Our findings suggest that financial statement users should exercise caution when comparing tax reserves across companies. In addition, we find some evidence that income-increasing tax accrual decisions are related to characteristics generally associated with weak corporate governance.     

Changes to Income Trust Taxation in Canada: Investor Reaction and Dividend Clientele Theory

Abstract:  This paper explores the relationship between tax-induced dividend clientele theory and the recent changes to the taxation of income trusts in Canada. On October 31, 2006, the Canadian government announced the Tax Fairness Plan ( TFP ) calling for the elimination of the considerable tax advantage enjoyed by income trusts. Generally, distributions from income trusts are now taxed at rates comparable to those imposed on corporate dividends. We examine market reaction to the  TFP  to address three issues: first, whether the valuation effect of a dividend tax increase is consistent with the traditional or the new view of dividend taxation; secondly, whether the market reaction to tax increases has a differential impact on firm value that is related to the tax preferences of taxable, tax-exempt, and foreign investor tax clienteles; and thirdly, whether firms change their dividend policies in response to the preference of institutional investors (tax-based dividend policy effect) or whether institutional investors are sorting themselves across firms based on their dividend policies (investor sorting effect). Our results provide strong evidence as follows. First, the valuation effect in reaction to the  TFP  announcement is consistent with the traditional view of dividend taxation – i.e. that taxes on dividends reduce the net return to investors, increase the firm's cost of capital and lower the firm's ability to access capital markets, thereby discouraging investment and savings. Secondly, we saw that trusts with a larger percentage of their units held by tax-exempt, low-tax, and foreign investors had a higher decline in value when compared with trusts held mostly by ordinary taxable investors. These results support dividend tax clientele theory. Finally, we observed changes in institutional investor clienteles consistent with the investor sorting effect.     

TAX UNCERTAINTIES AND THE INVESTMENT DECISION

This paper investigates how the firm's investment decision is affected by uncertainties in the tax laws under an asymmetric structure of income taxation. Tax liability is modelled as a call option, and tax uncertainties are modelled as randomness in the exercise price of the call option. The effects on the investment decision are derived by evaluating the comparative statics of the optimal investment level with respect to the volatility of the exercise price. The central result is that the disincentive effects of the tax uncertainties are generally exacerbated under the tax asymmetry.     

Corporate tax avoidance: data truncation and loss firms

Loss firms are an economically significant and growing segment of the population of publicly traded corporations. Relatively little is known about the tax positions of loss firms because the firms are typically dropped from tax avoidance studies. We develop a new measure of corporate cash tax avoidance that is meaningful for all observations and reflects the extent to which a firm is tax-favored. We examine the extent to which inferences about corporate tax avoidance over the past twenty-seven years change when we examine the full population of firms, as opposed to a profitable and/or taxable subsample. In contrast to prior research findings, our results suggest that on average firms are tax-disfavored, by which we mean cash taxes paid exceed the product of the firm’s pre-tax book income and the statutory tax rate. In addition, many industries that appear to be tax-favored in profitable subsamples are tax-disfavored when the entire population is examined. We also find that the extent to which firms are tax-disfavored is increasing over time, and that domestic firms are more tax-disfavored than multinationals.     

Have the tax benefits of debt been overestimated?

We re-examine the claim that many corporations are underleveraged in that they fail to take full advantage of debt tax shields. We show prior results suggesting underleverage stems from biased estimates of tax benefits from interest deductions. We develop improved estimates of marginal tax rates using a non-parametric procedure that produces more accurate estimates of the distribution of future taxable income. We show that additional debt would provide firms with much smaller tax benefits than previously thought, and when expected distress costs and difficult-to-measure non-debt tax shields are also considered, it appears plausible that most firms have tax-efficient capital structures.     

Effects of Progressive Taxes under Decentralized Bargaining and Heterogeneous Labor

We consider changes in income tax progressivity in an economy where workers' productivities differ and workers and firms bargain individually over wages. With given employment a pure increase in tax progressivity reduces wages by reducing workers' relative bargaining power. When average taxes also increase, after-tax wages are unambiguously reduced, while the effects on gross wages and firm profitability are ambiguous. We next endogenize employment and firm entry under a uniform worker productivity distribution and the government's only policy instrument is a linear income tax. While a first-best solution then is ruled out, a second-best solution can be implemented using a family of linear tax functions, where a more progressive tax implies a higher tax revenue to the government. We show that the government can increase its tax revenue, and reduce after-tax income differences, without any additional disturbance to allocation.     

The effects of standardized tax rates,average tax rates,and the distribution of income on tax progressivity

This study examines the changes in US individual income tax progressivity over the 1986–2003 period using the indexes developed by [Kakwani, N.C., 1976. Measurement of tax progressivity: An international comparison. Economic Journal 87(March), 71–80]. Although progressivity over this time frame has generally been studied in the literature, we provide additional insights by decomposing the changes in index values to account for the effects of concurrent changes in the standardized tax rates, average tax rates, and the income distribution. The decomposition should prove to be particularly useful when different summary indexes lead to conflicting conclusions about progressivity changes, as is often the case. From a policy standpoint, we show that it is the standardized tax rates, a derivative of the legislated tax rates, which need to be monitored and managed to offset the negative progressivity effects of increasing before-tax income inequality.     

Foreign Exchange Risk,Hedging, and Tax-Motivated Outbound Income Shifting

Although outbound income shifting to low-tax jurisdictions provides tax savings, it is often accompanied by nontax costs. In this study, I examine whether foreign exchange (FX) risk constrains tax-motivated outbound income shifting by U.S. multinational corporations. My findings indicate that exposure to greater currency volatility is associated with less outbound income shifting, and this effect is stronger for firms with foreign affiliates using foreign functional currencies. I also investigate whether hedging facilitates outbound income shifting. Consistent with hedging lowering costs associated with exchange rate volatility, I find that U.S. firms that use more currency derivatives tend to shift more income to low-tax foreign jurisdictions. Overall, these findings suggest that FX risk is an important cost of outbound income shifting.     

Should Firms Going Public Enjoy Tax Benefits? An Analysis of the Italian Experience in the 1990s

In Italy tax benefits are granted to firms going public. However, does such tax relief really reduce the corporate tax burden? In this study we tackle the issue by considering 21 industrial firms that were listed on the Italian Exchange from 1995 to 1997 and enjoyed a temporary tax rate cut‐off. We find that the increase in the taxable income reported by these firms largely counterbalances the effect of the tax relief. We conclude that a tax rate cut‐off may not necessarily provoke a reduction in the tax burden for newly listed firms, since in the short term they report larger earnings compared with privately‐owned companies. We claim that this ‘induced’ effect is mainly due to: the significant improvement of operating performance in the year of the listing; the reduction of the debt tax shield; an increase in investment and more accounting transparency. Our findings suggest that tax relief for IPO firms does not necessarily mean a loss of revenue for the government.     

有效预警上市公司违规的递延所得税异动指标和人工智能模型

2000-2017年,3434家A股上市公司样本中的47.79%至少有一次违规记录,每年平均有17%的公司违规,而监管机构平均需要2.7年查证并通告违规行为。我们用当年数据构建递延所得税异动指标,可有效预判违规,并发现监管机构未能识别这一指标的警示作用,实际激励了违规公司通过操纵递延所得税提高财务指标以规避稽查。进一步构建决策树模型,对违规事件实现样本外精准判别。本文揭示了A股公司大面积违规而稽查过程冗长迟缓这一重要现象,并分析了违规机制,指出了所得税数据在稽查违规中可以发挥的预警作用,为监管者和投资者提供有效预警上市公司违规行为的新指标和方法。