What do We Learn from Tax-Related Financial Disclosures?

1. What do We Learn from Tax-Related Financial Disclosures? 2012 ATA Doctoral Consortium Linda Krull University of Oregon

2. It Depends… • What we learn depends on how we combine tax-related disclosures with other information in the financial statements. • I’ll concentrate on what we learn from two disclosures • Income tax expense • Permanently Reinvested Earnings (PRE)

3. Income Tax expense DELL INC. CONSOLIDATED STATEMENTS OF INCOME (in millions, except per share amounts) 715

4. Income tax expense • Within income tax expense we have • Current and deferred tax expense • Federal and foreign tax expense • Back to Dell • Current • Federal = 597 • State/Local = 66 • Foreign = 97 • Total current = 760 • Deferred • Federal = (95) • State/Local = 9 • Foreign = 41 • Total deferred = (45) • Current + Deferred = 715

5. Effective Tax Rate • If we divide total income tax expense by pre-tax book income we get an effective tax rate • Dell’s 2011 ETR = 715/3350 = 21.3% • This measure tells us something about tax avoidance • Early research investigates the relation between tax avoidance (aka ETR) and firm size with mixed results (Zimmerman (1983), Gupta and Newberry 1997, among others). • Other studies find that ETRs are related to manager compensation (Phillips (2003), family ownership (Chen et al. 2010) and individual managers (Dyreng et al. 2010)

6. Let’s get A little mORE Accurate • Desai and Dharmapala (2007) • BTDiff = BI – TI • TI = CFTE/t • BTDiffi,t = b1TAi,t + mi + ei,t • They combine this measure with measures of managerial compensation incentives to show that increases in incentive compensation reduce tax sheltering

7. What can we learn about foreign operations? • Firms with foreign operations avoid more taxes • Wilson (2009): firms with foreign income are more likely to engage in tax sheltering • Lisowsky (2010) firms with subsidiaries in tax havens are more likely to participate in tax shelters • Rego (2003) Multinational corporations have lower ETRs than domestic corporations

8. Dell’s ETR

9. A Little More Innovative • So maybe we need to look at domestic and foreign operations separately. • And combine with some new data • Dyreng and Lyndsey (2009)use two innovations to study how the use of foreign subsidiaries and tax havens affect firms’ effective tax rates • Use footnote 21 disclosures of material subsidiaries • Use a ‘reverse regression’ technique to estimate the incremental effect on effective tax rates

10. The Methodology • ETR = TXWW/PI • TXWW = tww*PI • tww = g1 + g2Havenyear + (controls) • Substitute 3 into 2 to get: • TXWW = g1 PI + g2PI*Havenyear + (PI*controls) TXWW = worldwide taxes PI = pretax income tww = the worldwide effective tax rate Havenyear=1 if the firm has material operations in a tax haven in year t

11. The methodology continued • TXWW = g0 +g1PI + g2PI*Havenyear + (PI*controls) • Now expand for domestic and foreign operations • TXWW = f0 + f1 PIDOM + f2PIDOM*Havenyear + f3 PIFO + f4PIFO*Havenyear + (PIDOM*controls +PIFO*Controls) • f3 represents tFO, the rate of worldwide taxation on foreign pretax income for firms with no material operations in tax havens • f4represents the incremental tFO for firms with material operations in tax havens

12. The Results • The average rate of worldwide taxation on domestic income for firms without material operations in tax havens is 35.8% • This rate is not significantly different for firms with material operations in a tax haven • The average rate of worldwide taxation on foreign income for firms without material operations in tax havens is 31.3% • This rate is 3.2% lower for firms with material operations in tax havens

13. Enter: Permanently Reinvested Earnings (PRE) • Broadly, PRE is the unremitted foreign earnings on which the firm has not recognized the potential U.S. tax expense due upon repatriation • The U.S. taxes foreign earnings when repatriated • Rate equals approximately 35%-FTR • Recognize tax expense for the potential U.S. tax liability when earned • Unless designated as PRE • Report PRE and expected tax liability (if practicable) in tax footnote • Permanently reinvested earnings can tell us something about foreign operations • Unremitted foreign earnings • Basis differences

14. Dell’s pre • Deferred taxes have not been recorded on the excess book basis in the shares of certain foreign subsidiaries because these basis differences are not expected to reverse in the foreseeable future and are expected to be permanent in duration. These basis differences in the amount of approximately $12.3 billion arose primarily from the undistributed book earnings of substantially all of the subsidiaries in which Dell intends to reinvest indefinitely. The basis differences could reverse through a sale of the subsidiaries or the receipt of dividends from the subsidiaries, as well as various other events. Net of available foreign tax credits, residual income tax of approximately $3.9 billion would be due upon reversal of this excess book basis as of January 28, 2011.

15. What can we learn from pre: Valuation of PRE • Combine with firm value to learn about whether investors value PRE (Collins, Hand, and Shackelford 2001) • PRICE = b0 + b1DNI + b2FNI + b3CS + b4RE + b5PRE + b6PRETAX • Find that both PRE and TAX on PRE are valued • The value of PRE is lower for firms that report tax on PRE

16. What Can we learn from PRE: Earnings management • Combine with forecast errors and this tells us whether firms use PRE to manage earnings (Krull 2004) • DPRE = a0 + a1Nonbind + a2FEmiss + a3FEmiss*Nonbind + Controls • Nonbind equals 1 for firms in a nonbinding FTC position (i.e. firms with average foreign tax rate less than .35) • FEmiss = I/B/E/S earnings forecast minus pre-managed earnings if the I/B/E/S forecast is greater than pre-managed earnings • a3 is positive suggesting that firms use PRE to manage earnings

17. What can we learn from pre: earnings effects of repatriations • Combine with repatriations and this tells us how important the financial statement effects of repatriations are for repatriations (Blouin, Krull, and Robinson 2012a) • Firms with high financial statement effects (firms with high reporting incentives) are those with PRE greater than assets in low tax foreign affiliates.

18. Now think about PRE in the context of Dyreng and Lyndsey (2009) • What we don’t know is where the PRE is. • We also don’t know a lot about motivations for designating earnings as PRE. • Blouin, Krull, and Robinson (2012b) combines PRE with data on assets in foreign affiliates to answer these questions.

19. Where is the pre? • To answer this question we estimate the following regression: • PREi,t= a0 + a1Total Foreign Assetsi,t + a2Characteristic Foreign Assetsi,t + SakYeark+ ei,t(1) • Where total foreign assets are the firms total foreign assets and Characteristic Foreign assets is total assets in affiliates with the characteristic of interest • Tax Due • Tax havens • Volatile foreign currency • Growth • We interpret a1 as the ratio of PRE/assets in affiliates without the characteristic of interest • We interpret a2as the incremental ratio of PRE/assets in affiliates with the characteristic of interest.

20. Affiliate characteristics • Tax Due affiliates: affiliates that will owe either U.S. taxes upon repatriation or withholding taxes • If the affiliates average tax rate is less than the U.S. tax rate of 0.35 • Or if the affiliates average tax rate is greater than 0.35 and it will owe withholding taxes upon repatriation • Tax havens • Used to avoid or defer U.S. taxes • Big 7 havens from Hines and Rice (1994) based on population and GDP • Hong Kong, Ireland, Lebanon, Liberia, Panama, Singapore, and Switzerland

21. Affiliate Characteristics • Currency Volatility • Changes in the potential U.S. tax liability due to foreign currency movements must be reported in earnings (if functional currency is U.S. dollar) • If the earnings are PRE, these fluctuations do not affect earnings • Higher currency volatility, more PRE? • Growth • U.S. investment abroad is increasing in growth, and reinvested when foreign atr > U.S. atr • The standard for PRE says “the subsidiary has invested or will invest the undistributed earnings indefinitely…”

22. Results Tax due: (0.1815+0.1059)*0.3014 = 0.0866 No tax due: (0.3344-.3014)*0.1815 = 0.006 0.0866/(0.006 + 0.0866) = 94%

24. So where is it? • PREi,t = SdnCountrynAssetsi,t + ei,t (5) • Where SdnCountrynAssets equals total assets in country n. • Sd tells us the change in PRE for each dollar of assets in country n, which we interpret as the ratio of PRE to assets in country n

25. Country Results

26. Country results with compustat data • But what can researchers do with this? • Go back to Dyreng and Lyndsey (2009) • PREFA = PRE/FA • PRE = r*FA • r = g1GBR + g2CAN + … • Substitute 3 into 2 to get: • PRE = g1 FA*GBR + g2 FA*CAN… • FA =foreign assets • r = the ratio of PRE to foreign assets • GBR = 1 for firm years with a material subsidiary in the UK • CAN = 1 for firm-years with a material subsidiary in Canada • And so on…

27. PRE and DL • PRE = g1FA*GBR + g2FA*CAN… • g1tells of the ratio of PRE to foreign assets for firms with material subsidiaries in the UK • g2 tells us the ratio of PRE to foreign assets for firms with material subsidiaries in Canada • And so on

28. Country Results with Compustat Data

29. What Can we learn from tax-related financial disclosures • That’s up to you and depends on • Which disclosures you use • I talked about income taxes (current and deferred, foreign and federal), PRE • FIN 48 • Deferred tax assets and liabilities and their components • Rate reconciliation • Deferred tax valuation allowance • Cash taxes • What financial data you combine them with • I talked about earnings (foreign and domestic), Footnote 21 data • What other data sources you use • BEA, IRS, Amadeaus, Orbis • Write your own survey • The possibilities are infinite