Relative Valuation Of Alternative Methods Of Tax Avoidance

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RELATIVE VALUATION OF ALTERNATIVE METHODS OFTAX AVOIDANCEKerry Katharine IngerDissertation submitted to the faculty of the Virginia Polytechnic Institute and State University inpartial fulfillment of the requirements for the degree ofDoctor of PhilosophyInAccounting and Information SciencesC. Bryan Cloyd (Committee Chair)Thomas B. HansenSattar A. MansiDebra A. SalbadorW. Eugene SeagoApril 30, 2012Blacksburg, VirginiaKeywords: Tax Avoidance, firm value, corporate governanceCopyright 2012, Kerry K. Inger

RELATIVE VALUATION OF ALTERNATIVE METHODS OF TAX AVOIDANCEKerry Katharine IngerAbstractThis paper examines the relative valuation of alternative methods of tax avoidance. Prior studies findthat firm value is positively associated with overall measures of tax avoidance; I extend this research byproviding evidence that investors distinguish between methods of tax reduction in their valuation of taxavoidance. The impact of tax avoidance on firm value is a function of tax risk, permanence of taxsavings, tax planning costs, implicit taxes and contrasts in disclosures of tax reduction in the financialstatements. My empirical results suggest that tax avoidance resulting from stock option tax benefits ispositively associated with firm value, accelerated depreciation is not associated with firm value anddeferral of residual tax on foreign earnings is negatively associated with firm value. Prior studies thatfind the positive association between firm value and tax avoidance is attenuated in poorly governed firmssuggest the discount results from investor concern of managerial opportunism. Self-serving managersconceal diversion of tax savings from investors under the pretext that aggressive tax positions must behidden from tax authorities in the financial statements. Under this theory transparent tax reductionmethods that are clearly supported by the law should not be discounted by investors of poorly governedfirms. However, I find that tax avoidance resulting from transparent stock option tax deductions isdiscounted in poorly governed firms, while tax avoidance derived from opaque deferral of the residual taxon foreign earnings is not, inconsistent with investors believing that managers are exploiting thecompromised information environment associated with complex tax transactions.

DedicationI dedicate this dissertation to my family. Matt, thanks for the support, sacrifice and understandingalong the way. Marlowe, thanks for the perspective and smiles when I needed it most. Mom, Dad, Chrisand Steve, thanks for the encouragement and support, both emotionally and financially.iii

AcknowledgementsFirst, I thank Dr. Bryan Cloyd, my dissertation chair, for his direction throughout the doctoralprogram. Thank you for your time and energy over the past four years to get me to this point. Iappreciate that you always are able to help me see things in new ways, both from an academic and lifestandpoint. It was an honor to work with you. I would also like to express my gratitude to Dr. BoweHansen, Dr. Sattar Mansi, Dr. Debra Salbador and Dr. Gene Seago for serving on my committee andproviding with my helpful feedback as I completed this process. I am grateful to Patrick and Jing Fan forcollecting the tax-haven data used in my dissertation. I would also like to thank Dr. Jack Maher for hisguidance during my doctoral program.Thank you to the Accounting and Information Systems department for the financial andadministrative support that was provided for my academic program and research. Specifically, theRonald J. Patten Scholarship, the Johnny R. Johnson Memorial Scholarship and the Floyd A. BeamisScholarship greatly reduced the financial burden of my doctoral program. In addition, the VirginiaSociety of CPA’s provided me with the Austin M. Cloyd, Matthew G. Gwaltney and Maxine S. TurnerDoctoral Scholarship for which I am endlessly grateful and honored to represent three outstanding Hokieslost on April 16, 2007. I would also like to thank Katherine Caldwell, Phyllis Neece and Arnita Perfaterfor their assistance and support during my time at Virginia Tech.I would like to acknowledge each of the exceptional doctoral students that I had the pleasure ofsharing this experience with. First, I would like to thank my cohort Ryan Leece and Todd White. I couldnot imagine this journey without each of you and look forward to continuing the journey as colleagues.James Long welcomed me to Blacksburg and I look forward to a similar warm welcome to Auburn,thanks for your friendship. Additionally, several other students added to my experience in the doctoralprogram and enjoyment of life while in Blacksburg: Lasse Mertins, Rob Crossler, Mollie Adams, MeganMcInerney, Chris Edmonds, Lucian Zelazny, Jennifer Edmonds, Becky Fay, Michele Meckfessel, Jimiv

Penner, Owen Brown, Eric Negangard, Mike Ozlanski, Jon Pyzoha, Kathy Enget, Joanna Garcia, GabeSaucedo, Alan Stancill, Nichole Wright, Brandon Ater, Christine Gimbar, John Lauck and Joe Rakestraw.It has been a pleasure getting to know each of you.I would also like to thank my family. Matt, your love, patience and support for the last 14 years havebeen amazing. You are an awesome husband and dad and I look forward to sharing this life with youeach day. Marlowe, thanks for being the shining light at the end of many hard days and for giving meperspective on what is important in life. Mom and Dad, thanks for your love and support, and for raisingme to love education and to have the confidence required of this career. Tommy, thanks for being a greatbrother, true friend and someone I can always talk to. Chris and Steve, thanks for loving me like adaughter and your encouragement in the quest to be the next “Dr. Inger.” Finally, I thank God for thiswonderful life.v

Table of ContentsChapter 1. Introduction. 1Chapter 2. Adjusted Cash Effective Tax Rate . 52.1 Stock option tax benefits and tax avoidance . 62.2 Accelerated tax depreciation deductions and tax avoidance . 92.3 Deferral of residual tax on foreign earnings and tax avoidance . 102.4 Summary of adjustments . 14Chapter 3. Hypotheses . 143.1 Cross-sectional variation of tax avoidance . 143.2 Valuation of tax avoidance . 173.3 Valuation of tax avoidance in an agency context . 22Chapter 4. Research Design . 244.1 Sample Selection . 244.2 Descriptive Statistics for Hand Collected Data . 244.3 Descriptive Statistics for Tax Avoidance Measures . 274.4 Cross-sectional variation of tax avoidance analysis . 294.5 Relative valuation of tax avoidance. 324.6 Relative valuation of tax avoidance in an agency context. 38Chapter 5. Multivariate Results . 405.1 Differential valuation of tax avoidance . 405.2 Differential valuation of tax avoidance in an agency context . 44Chapter 6. Conclusion . 49References . 52Appendix A: Variable Definitions. 56Appendix B: Sample Selection. 59Appendix C: Tax Haven Country Listing . 60Appendix D: Illustration of Tax Avoidance Adjustments . 61vi

List of TablesTABLE 1: Descriptive Statistics . 62TABLE 2A: Test of Adjusted Tax Avoidance Measures Relation to Traditional Control Variablesusing CETR3 . 65TABLE 2B: Test of Adjusted Tax Avoidance Measures Relation to Traditional Control Variablesusing CETR . 66TABLE 3: Descriptive Statistics . 67TABLE 4: Descriptive Statistics for Dependent, Tax Avoidance and Control Variables in Tax HavenFirm Value Analysis . 69TABLE 5A: Descriptive Statistics . 70TABLE 5B: Descriptive Statistics. 73TABLE 6: Firm Value Baseline Model. 75TABLE 7A: Firm Value and Alternative Methods of Tax Avoidance Model . 76TABLE 7B: Firm Value and Alternative Methods of Tax Avoidance Model – KRULL PRE TAXEstimation. 77TABLE 8: Firm Value and Alternative Methods of Tax Avoidance Model including Tax HavenInteraction. 78TABLE 9A: Firm Value and Alternative Methods of Tax Avoidance Model Expansion of ResidualTax Deferral . 79TABLE 9B: Firm Value and Alternative Methods of Tax Avoidance Model – KRULL PRE TAXEstimation Expansion of Residual Tax Deferral . 80TABLE 10A: Firm Value and Governance Baseline Model – G-Index . 81TABLE 10B: Firm Value and Governance Baseline Model – E-Index . 83TABLE 11A: Firm Value and Expanded Avoidance Measure Governance Models – G-Index . 85TABLE 11B: Firm Value and Expanded Avoidance Measure Governance Models – E-Index . 87TABLE 12: Firm Value and Expanded Avoidance Measure Governance Models – G-Index and TaxHavens . 89TABLE 13A: Firm Value and Alternative Avoidance Measure Governance Models – G-IndexExpansion of Residual Tax Deferral . 91TABLE 13B: Firm Value and Alternative Avoidance Measure Governance Models – E-IndexExpansion of Residual Tax Deferral . 93vii

1. IntroductionThis paper examines the relative valuation of alternative methods of tax avoidance. Specifically,I examine two related research questions. First, do investors distinguish among methods of tax reductionin the valuation of tax avoidance? Second, is the relative valuation of tax avoidance a function ofcorporate governance mechanisms?Corporate tax avoidance increases shareholder wealth to the extent that it increases the presentvalue of expected future dividends. Recent studies find that tax avoidance is, on average, positivelyassociated with firm value (Desai and Dharmapala 2009; Wilson 2009; among others). My study extendsthis literature by examining the relative valuation of alternative methods of tax reduction. The fact thatdifferent methods of tax avoidance involve varying risk profiles, permanent verses temporary taxreduction, tax planning costs, implicit taxes, and variation in disclosures in the financial statements of taxavoidance activities suggests differential valuation of specific methods of avoiding tax. Aggressive taxreduction schemes are associated with the risk of future costs (e.g. penalties and interest, cost of litigation,adverse publicity) that mitigate the value of tax avoidance to shareholders. Therefore, the value of taxavoidance to shareholders per dollar avoided is decreasing in risk. While some methods of tax reductioncreate permanent tax savings (i.e. stock option tax benefits), other methods reduce taxes in the currentperiod at the expense of higher future taxes (i.e. accelerated tax depreciation deductions). The value toinvestors of permanent tax reduction is greater than temporary tax reduction. The benefits of tax planningare a function of the implementation costs and these costs vary with the complexity of the tax planningstrategy. The value of tax avoidance is tied to the transaction or activity generating it. For example,bonus depreciation creates an implicit tax in the form of increased prices on certain types of assets (Key2008), reducing the benefit of tax reduction. Due to the proprietary nature of tax returns, investors rely ontax disclosures in the financial statements to gather information about firms’ tax avoidance anddisclosures vary from vague (i.e. increase in reserve for uncertain tax positions) to straightforward (i.e.1

effective tax rate reduction from domestic manufacturing deduction). A premium may exist for taxavoidance when the source is clearly identifiable. These points suggest differential valuation acrossmethods of tax avoidance.Recent research suggests that poor corporate governance attenuates the positive relationshipbetween tax avoidance and firm value (Desai and Dharmapala 2009; Wilson 2009), presumably becauseinvestors believe the benefits of tax avoidance are diverted to managers. Opacity in the financialstatements is required for firms to conceal aggressive tax strategies from tax authorities. This opacitycreates a compromised information environment enabling managers to divert the value of tax avoidancefrom shareholders. However, benign tax avoidance (e.g. stock option tax benefits and accelerateddepreciation) does not require concealment from tax authorities to prevent detection because the taxpositions are fully supported by the law and should not be associated with an opaque informationenvironment conducive to diversion. Therefore, benign tax reduction should not be associated with avaluation discount. Isolating the type of tax reduction activities responsible for the differential valuationprovides insight into why investors discount tax avoidance in poorly governed firms.Traditional measures of tax avoidance, such as a corporation’s cash effective tax rate (CETR) andtotal book tax differences, do not distinguish the activities creating the tax reduction. Studies that usethese measures inherently treat all methods of tax avoidance the same. To study the relative valuation oftax avoidance, I focus on three specific methods of tax reduction: the tax benefits of stock optioncompensation, accelerated tax depreciation, and the deferral of the residual U.S. tax on foreign earnings.I select these items because they comprise a large portion of the book-tax gap (Desai 2003) and areimportant factors in assessing tax burdens. These methods of tax avoidance have different risk profiles,vary from temporary to permanent, and are associated with different levels of tax planning costs andimplicit taxes; suggesting differential valuation. Additionally, these methods range from transparent (i.e.stock option tax benefits) to opaque (i.e. deferral of residual U.S. tax on foreign earnings), allowing for atest of whether investors in poorly governed firms only discount opaque tax reduction under the diversion2

theory of tax avoidance. My study utilizes hand collected data, requiring selection of tax avoidancemethods that are commonly reported in firms’ financial statements. These items are generally largeenough to exceed the materiality threshold for financial statement disclosure.Prior corporate tax avoidance studies include stock compensation, fixed assets, and/or foreignearnings as control variables (Ayers, Jiang, and Laplante 2011; Dyreng, Hanlon, and Maydew 2010;Desai and Dharmapala 2009) because these activities enable firms to reduce their tax burdens relative toother firms; however, inclusion of these control variables does not result in isolation of these activitiesfrom the tax avoidance measure. The value of option grants or exercises does not capture tax reductionfrom option exercises because deductible and non-deductible stock options are not distinguished, only thetop five executives are included, and the stock price appreciation from grant to exercise determining thetax deduction is not accounted for. A firm’s level of fixed assets is not indicative of the tax benefits ofaccelerated depreciation because the magnitude and sign of the book-tax difference is a function of thelife cycle of the firm’s assets. The impact of foreign earnings on observed tax avoidance depends onforeign tax rates, repatriation decisions, and the method of reporting the deferral of residual U.S. tax inthe financial statements.The CETR encompasses the entire range of the tax avoidance continuum, reflecting most taxplanning strategies. My study uses hand collected data to isolate avoidance related to specific activitiesby adjusting the CETR, allowing for study of alternative methods of tax avoidance. The CETR is selectedbecause it is impacted by the three major categories of tax reduction examined in my study, its prevalentuse to measure a firm’s level of tax avoidance in recent studies, and its inclusion of both temporary andpermanent tax planning strategies. Additionally, the CETR is not impacted by items such as the valuationallowance and tax rate changes that are not associated with changes to cash flow. Myers and Rajan(1998) argue that it is easier for managers to divert liquid assets than illiquid assets, suggesting thatmanagers diverting tax savings are diverting cash or other fungible assets. My adjustments to the CETRresult in an adjusted CETR unrelated to stock option tax benefits, accelerated tax depreciation, and3

deferral of the residual tax on foreign income and isolation of the level of tax avoidance associated witheach of these methods of tax reduction.I assess the importance of adjusting the CETR by examining the cross-sectional variation of taxavoidance implied by the adjusted and unadjusted measures. I observe a reordering of firms on the taxavoidance continuum, suggesting a different cross-sectional variation of tax behavior than implied by thetraditional measure. This is an important finding because several recent studies (Ayers, Jiang, andLaplante 2011; Blaylock, Shevlin, and Wilson 2011) use the CETR to identify high tax avoidance firms.My study highlights the importance of selecting a measure of tax avoidance that is appropriate for theresearch question under examination, in the spirit of Hanlon and Heitzman (2010). For example, ameasure of tax avoidance that is impacted by the tax benefits of stock options is not necessarily indicativeof a firm’s level of tax planning.I examine whether prior studies’ inferences about shareholder valuation of tax avoidance areprimarily associated with total tax avoidance or if specific methods of tax avoidance have differentvaluation implications. Understanding the way investor’s value different methods of tax reduction is animportant extension of the research on the valuation of tax avoidance because some firms spendstaggering amounts of money to engage in high-risk aggressive tax reduction strategies1 that investorsmay not view as value enhancing. Specifically, I find that tax avoidance resulting from stock option taxdeductions is positively associated with firm value, accelerated tax depreciation deductions is notassociated with firm value and deferral of the U.S. residual tax on foreign earnings is negativelyassociated with firm value. The discount on tax avoidance derived from deferral of the U.S. residual taxon foreign earnings is limited to firms with a presence in a tax-haven.1A report about the role of professional firms in the U.S. tax shelter industry by the United States Senatecommittee of Homeland Security and Government Affairs (permanent subcommittee on investigations) reports thatthe SC2 (S-corporation charitable contribution strategy) tax shelter developed and promoted by KPMG had aminimum fee of 500,000 and fees ranged as high as 2 million dollars. The report also documents that the typicalBOSS (Bond Option and Sales strategy) tax shelter promoted by PwC resulted in average fees of 400,000 for a 10million dollar capital loss transaction.4

Of the types of tax avoidance examined in my study, stock option tax benefits provide permanenttax reduction, have the lowest risk, and the most transparent disclosure; suggesting the tax benefits shouldnot be discounted in poorly governed firms under the diversion theory. Tax avoidance resulting fromdeferral of the residual tax is the least transparent, suggesting a discount in poorly governed firms underthe diversion theory. However, I find that tax avoidance resulting from stock option deductions isdiscounted in poorly governed firms while tax avoidance from deferral of residual tax is not. Theseresults are inconsistent with managers exploiting the compromised information environment associatedwith complex and opaque tax transactions to divert tax savings.My study provides unique insight into how alternative methods of tax avoidance are associatedwith firm value. Demonstration of differential valuation of alternative methods of tax avoidance is animportant extension to previous literature that focuses on overall tax avoidance (Desai and Dharmapala2009) or narrow types of tax avoidance in isolation (Wilson 2009). A new method of measuring taxavoidance will allow researchers to focus on the type of tax avoidance that is appropriate for the researchquestion under examination. In addition, my results add to the debate about tax avoidance in an agencycontext by providing evidence inconsistent with a discount on tax avoidance in poorly governed firms dueto investor concern of self-serving managers diverting tax savings from complex and opaque taxtransactions. Finally, my findings provide useful evidence to managers and boards of directors interestedin equity investor perception of methods of reducing corporate income tax.2. Adjusted Cash Effective Tax RateThis section outlines the institutional details underlying my adjustments to the CETR2 andreviews the tax rules and accounting methods for the tax benefit of stock options, accelerated tax2Following Dyreng, Hanlon, and Maydew (2008), the cash effective tax rate (CETR) is defined as: (CashIncome Taxes Paid/Earnings before tax and special items). Special items represent unusual and non-recurring itemsreported by the company above taxes on the income statement. All variable names are presented in italics. Taxavoidance measures are also presented in CAPS.5

depreciation deductions, and deferral of the residual U.S. tax on foreign income. Determining the impacteach method of tax avoidance has on the CETR allows for the study of the relative valuation of alternativemethods of tax reduction. Measuring tax avoidance in this way enables comparison of a one percentreduction in the CETR across methods.2.1 Stock option tax benefits and tax avoidanceNon-qualified stock options (NQOs) generate a tax deduction for firms equal to the amount ofordinary income recognized by the employee upon exercise (the bargain element). Under FAS 123,effective for years beginning before June 15, 2005 for large publicly traded corporations, firms wererequired to recognize compensation expense for stock options in the financial statements only if theoptions had positive intrinsic value, thus there was generally no impact to net income from stock optioncompensation.3 The tax benefit was a direct to equity adjustment at the time of employee exercise; as aresult the tax deduction reduced cash taxes paid with no corresponding reduction to book income,overstating tax avoidance implied by the CETR. In order to isolate tax avoidance related to stock optiontax benefits from the measure, the cash tax benefit of stock options (Option Tax Benefit) is added to cashincome taxes paid. Under FAS 123, the cash tax benefit of stock options (Option Tax Benefit: Reported),if material, should be reported as an adjustment in the operating section of the statement of cash flows(EITF 00-15 effective 2000) because the tax benefit of the stock options decreased cash taxes paidwithout a corresponding decrease to current tax expense.FAS123R (ASC 718), effective for years beginning after June 15, 2005 for large publicly tradedcorporations, requires firms to recognize compensation expense for the estimated value of the options at3A Bear Sterns report cited in Hanlon and Shevlin (2002) indicates that recognition of stock compensationexpense under FAS 123 was rare. See Hanlon and Shevlin (2002) for a detailed discussion of accounting for the taxbenefits of stock options under the FAS 123 regime. Few firms in my sample report stock option compensationexpense prior to 2006.6

grant over the vesting period, creating a deferred tax asset.4 The future tax deduction reduces the deferredtax asset, with any difference (“windfall”) recognized in additional paid-in-capital. FAS 123R supersededEITF 00-15 and requires disclosure of the actual tax benefit realized from option exercises in the sharebased compensation footnote. In order to derive a post-123R adjusted CETR that is comparable to thepre-123R adjusted CETR, post 123R observations also require the addition of stock option compensationexpense (123R Option Expense) to book income.Following Kahle and Shastri (2005), I examine the statement of cash flows, statement of equity,share based compensation footnote and tax footnote for each firm for the disclosure of the stock optioncash tax benefit. For firms that do not disclose the benefit or lump it with another number, such as“option exercises-net” on the statement of cash flows, I estimate the cash tax benefit from stock optionsusing an approach provided in Hanlon and Shevlin (2002). They estimate the deduction as the number ofoptions exercised multiplied by the difference between the weighted average exercise price of new grantsduring the year and the weighted average exercise price of options exercised during the year. Theweighted average exercise price of new shares granted during the year is a proxy for the fair market valueof the shares that were exercised during the year because grants are generally issued at the fair marketvalue on the grant date. Multiplying the estimated deduction by the statutory rate (i.e. 35%) provides anestimate of the cash tax benefit from stock option exercises (Option Tax Benefit: Estimated).5 Thenumber of shares exercised, the weighted average exercise price of new grants, and options exercisedduring the year is available on Compustat beginning in 2004 and hand collected from the share basedcompensation footnote for years prior to 2004. Stock option compensation expense (123R OptionExpense: Reported) is hand collected from the share based compensation footnote.6 For firms that do not4FAS123R changed the financial accounting treatment for stock options; there was no change in tax lawsgoverning stock option tax deductions.5Graham, Lang, and Shackelford (2004) use a similar approach.6Compustat provides the annual stock compensation expense (DATA #398, STKCO); however this amountincludes compensation for other forms of stock based compensation, such as restricted stock. The growingpopularity of restricted stock limits the use of annual stock compensation expense as a proxy for stock optioncompensation expense.7

report stock option compensation expense for years after 123R, I estimate the expense (123R OptionExpense: Estimated) by dividing the prior year’s disclosed unrecognized stock option compens

This paper examines the relative valuation of alternative methods of tax avoidance. Prior studies find that firm value is positively associated with overall measures of tax avoidance; I extend this research by providing evidence that investors distinguish between methods of tax reduction in their valuation of tax avoidance.

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