Many corporations work with tax planning firms to reduce their liability and improve their bottom line. But when an accounting agency is too aggressive, a lack of transparency can develop, which often increases the financial complexity of the organization. This can become problematic for outside parties such as stockholders or investors who need all of the appropriate information to make good decisions about their investments. New research from Wharton accounting professors Jennifer Blouin and Wayne Guay, and Karthik Balakrishnan, a former Wharton accounting professor now at the London School of Business, shows the significance of the problem. Blouin and Guay spoke on the Knowledge at Wharton radio show about their paper, “Does Tax Aggressiveness Reduce Financial Reporting Transparency?” The research was published in The Accounting Review. (Listen to the podcast at the top of this page.)
An edited transcript of the conversation follows.
Knowledge at Wharton: Why did you want to research this particular topic?
Jennifer Blouin: I think one of the primary reasons we started down this path is that there has been a lot of work that shows there is a benefit to tax planning. Companies will save cash. They’ll have higher earnings because of lower tax expense. But not all firms seem to tax plan at the same level. We hear in the press often about Apple and the intangible, intensive type firms, then maybe not so much about the big durable manufacturers. But the reality is, not every firm can tax plan the same way. We questioned why some firms seem to tax plan more than others, even within like-types of firms. We conjectured that there must be other costs that maybe we haven’t thought about. One of these other costs that we think we’ve identified is reducing the firm’s transparency in the capital markets, for example.
Wayne Guay: I started to think about this 15 years ago, when I was teaching tax planning in the classroom. I started to think about firms that are engaged in some pretty complicated tax transactions and was trying to explain how it all works to the students. I was doing some of my own investigations, looking at companies and realizing that the more complex they got with respect to the tax planning, the harder it was to explain to the students what it was the companies were up to. That got me thinking about this issue.
Knowledge at Wharton: Where does this concern about transparency come from?
Guay: It comes from investors wanting to understand what the firm does to generate profits. If you think about a company like Apple or Google, investors want to know how the iPhone business is going around the world, what new products Apple is putting out and where they’re expanding to. At the same time, [Apple is] layering on that a bunch of transactions and organizational structures that help them minimize taxes. When you put those two things together, investors might look at Apple and say, “Hey, it’s great that you’re lowering your tax bill. But at the same time, at the end of the day, we want to know how the iPhone business is doing.” When the financial statements get more and more complicated because of how you’ve structured the organization to reduce taxes, investors might have more and more difficultly figuring out the company’s business model.
Knowledge at Wharton: Without transparency, can analysts accurately forecast the earnings for some companies? An expectation of a company earning $1.15 per share in a particular quarter may end up being something totally different.
Blouin: That’s absolutely right. One of the points of the paper was specifically to look at analysts’ forecasts and try to anticipate whether they do better or worse, depending on the level of tax planning or tax aggressiveness of the firm.
The anecdote that got me interested in this paper was actually Google back in 2005. Google has just gone public, and people were still trying to get a handle on what it was that Google did. Google’s management had provided forecasts of a 30% average effective tax rate. At the time, the U.S. rate was 35%, so they were clearly bringing it down from where they had been, which was at 36% or 37%. They said, “We’re going to go down to 30%.”
“When the financial statements get more and more complicated because of how you’ve structured the organization to reduce taxes, investors might have more and more difficultly figuring out the company’s business model.”— Wayne Guay
Then, in the fourth quarter, they reported a 42% effective tax rate instead of 30%, and the analysts just went a little bit crazy trying to understand what was going on. At that point in time, what Google was trying to do was set in place their international tax structure. They were trying to move their non-U.S. business to Ireland. They were trying to put intellectual property offshore so that profits related to the international business would go into Ireland, which at that time had a tax rate between 10% and 12.5%.
Well, they required approval from the U.S. Treasury before they could start allocating the income offshore. It turned out that there was some delay in the Treasury’s approval and so Google had less income that would be reportable in a 12% jurisdiction than in a 35% jurisdiction. Google’s effective tax rate was much higher, and a whole bunch [of analysts] blew their forecast…. A lot of analysts anticipated that Google wasn’t growing as much overseas as they had projected; therefore, the business wasn’t going to be as lucrative offshore. So, a number of analysts revised their recommendations with regard to Google.
Knowledge at Wharton: I guess international tax standards play a big role in this transparency?
Blouin: Absolutely, but it’s not just international. You can have the issues at the state level. There are opportunities within certain industries, real estate investment trusts and other types of organizational forms. While it’s very salient in the international context, I think it can be found in any domestic company as well.
Guay: Another thing to think about is when analysts or investors are trying to forecast earnings, they are, in part, looking backwards at what happened to a company over the last year or two, and trying to extrapolate into the future. If you’ve got a firm with various operating strategies and various tax strategies, the persistence or the transitory nature of those different strategies can be different. I might have a tax strategy in place that’s going to give me a one- or two-year reduction in my taxes because I get certain types of credits. But it might not be expected to persist beyond that. Whereas some changes I’m making in my operating efficiency or with respect to new products — those might persist well into the future. The analysts are trying to weigh the different components of earnings based on whether they’re expected to persist into the future.
Knowledge at Wharton: Why do some firms have this aggressiveness? Is it strictly the complexity of a particular company?
Blouin: There are several structures. You can use the sort of sexily titled “Double Irish” or the “Dutch Sandwich” — the provocative titles of these structures are great. What they require firms to do is actually move the intellectual property to another entity. [They say,] “I have a domestic entity,” and then they would report, “I have one foreign affiliate or foreign subsidiary,” and all of the sudden they have six foreign affiliates. Analysts are trying to infer where revenue growth is, or whether these are new markets, basically what’s happening. Part of the issue is that the company doesn’t want to say, “Oh, that’s just for tax planning,” because revealing it’s just for tax planning somewhat increases the likelihood that it could be contested by the tax authorities. So, they have this tension between wanting to explain to the market what exactly they’re doing for tax planning purposes, and revealing too much to the tax authorities.
You see these Double Irish or Dutch Sandwich structures, but also you have this integrated supply chain management. [Companies] have to physically move goods across multiple jurisdictions. They have to be in that jurisdiction. But they don’t want to just say, “Well, the only reason we’re parking inventory in this low tax jurisdiction is because it gives us a good tax answer.” Those are the types of transactions that increase the number of entities that are, perhaps, in somebody’s organizational structure. It increases the amount of record keeping or bookkeeping or physical flow of goods within an organization that just makes the company look and appear more complicated.
One of my best anecdotes [came while I was] presenting this paper in an academic setting. There had been a managerial accountant in the room. She had done some cost accounting and said, “We had one manufacturing facility that had 42 different cost centers in it only for tax planning purposes. The cost centers could facilitate the transfer pricing and where goods and what costs went.” That was not only international, but also for state-level purposes and generating certain tax credits. What this paper is trying to capture is all that complexity that goes on merely for getting a good tax [rate].
“[Companies] have this tension between wanting to explain to the market what exactly they’re doing for tax planning purposes, and revealing too much to the tax authorities.” –Jennifer Blouin
Knowledge at Wharton: How much does this affect the governance of a company?
Guay: If outside investors don’t know what’s going on, it becomes harder to monitor what management is doing. Within the organization, when the board of directors or management is trying to think about, “Are we doing enough tax planning? Are we doing too much tax planning?” — you could imagine investors saying, “Hey, it’s great that you guys are reducing your taxes. But don’t do this to such an extent that we can’t figure out what’s going on in the organization.”
The board of directors has to step in the middle here and make sure that they’ve got a sense of how much is too much tax planning. We’re not here to say that reducing your taxes is a bad thing. That’s certainly not what we’re doing. But there are costs associated with doing that. And there is some evidence out there that management can sometimes, in certain circumstances, hide behind some of these tax strategies when they’re playing games or trying to funnel resources to pet projects and things like that.
Knowledge at Wharton: And that’s when you can run into legal trouble, right?
Blouin: Right. This is something that is broadly discussed. I don’t think this is any hidden thing — where only a segment worries about governance. It’s a big deal when it comes down to tax planning and what’s actually going on in the firm. But what we see is that our sample firms — or at least a group of our sample — seem to be cognizant that there’s this issue where either the organization has gotten a little bit too opaque, or they are trying to reveal that they’re a good type, that their management is not stealing from the firm, by disclosing more. That’s what we see in the presence of more aggressiveness. These firms seem to chat a little bit more about tax in an effort to mitigate some of this cost that we’ve identified.
Guay: When we talk about firms becoming less transparent, we’re not just talking about that qualitatively. We’re going out and looking at the capital market effects. We find that liquidity in the capital markets goes down when these firms [are less transparent]. Analysts have a more difficult time forecasting earnings. The quality of financial reporting goes down. Managers then step in and try to balance this reporting complexity with additional disclosures.
We look at thousands of companies across a bunch of industries. In part of our analysis, what we’re also recognizing is that in different industries there are different types of strategies that firms can engage in. For example, our analysis controls for the fact that in the tech industry they might have certain tax strategies available to them, in the oil industry maybe something else, in the pharmaceutical industry something else. Our analysis is trying to get at whether within an industry, given the menu of tax strategies you have available, are the firms that are taking greater advantage of those tax strategies more likely to have these liquidity and transparency problems?
Blouin: I think an important aspect is that these transparence problems are not just affecting the external market. It gets a little bit harder to manage the accounting. It’s not necessarily intentionally bad behavior, but it makes it harder to forecast externally. And it’s not just a tax expense. It actually comes down to [the question], where is the growth taking place? How am I monitoring and presumably managing my margins across the organization? I think that’s what we’re trying to capture — it is a bigger-picture idea than just, “I’m managing taxes.”
“If outside investors don’t know what’s going on, it becomes harder to monitor what management is doing.” –Wayne Guay
Knowledge at Wharton: Were you able to tell from your research what the impact was on investors when you saw this going on?
Blouin: In this paper, we don’t go into whether it is overall aggregate market bad news or good news. That’s a really tough question to answer because we’ve identified this cost, but [companies are] incurring that cost, presumably because the benefits they’re getting for it exceed that cost. A firm’s going to continue to tax plan, but it’s not dollar for dollar — it’s maybe 99 cents, once you account for this transparency issue.
Guay: And it’s really hard to figure out what’s the sweet spot because it’s going to be very company-specific, depending upon the tax jurisdictions where the companies are operating. We can say the firms that are more aggressive with the taxes suffer these capital market effects in terms of things like their bid-ask spreads going up — so investors try to protect themselves against the fact that they don’t know what’s going on. There are these liquidity issues. There are these tax advantages. And the sweet spot for a given company — you can’t tease that out if you’re looking at 1,000 firms. One of the advantages of looking at thousands of firms is that you get a lot of power to see what the pervasive effects are. But the disadvantage is that you can’t say for any given firm what the sweet spot is.
Knowledge at Wharton: You brought up something interesting from the state perspective. Because of the variance of tax rates from state to state, you can have this type of activity going on between Florida and Mississippi or Ohio and Pennsylvania. Can you talk more about that?
Blouin: If you ever look at a U.S. perspective of the list of tax-shelter countries or havens, you start with things like Bermuda and the Caymans. But if you look at any foreign jurisdiction’s list of the world’s biggest tax havens, Delaware is always at the top of the list. There are many, many structures with regard to intangible assets within the United States, and all of them are driven by Delaware. For example, restaurants are a uniquely domestic-only business. When we can look across state lines, they have the incentive to try and say, “Well, the branding or the marketing assets, that goes to Delaware.”
Knowledge at Wharton: What about a steel company that isn’t strictly domestic?
Blouin: The Double Irish and the Dutch Sandwich doesn’t work for steel because although there is some intellectual property, it’s not to the extent that you will see in pharma or computers or things along that line. But they have different structures and incentives and credits that jurisdictions want to give them to bring them to do business in one state or another, or country or another.
Guay: Essentially, this issue will crop up any time you have different places where firms can move profits that have different tax rates, and that can be across countries. It can be even across cities. Cities compete aggressively for getting tax credits. Look at the most recent Amazon case in terms of what they got from all the different cities that were bidding for that business.
I also want to say it’s not just a U.S. specific phenomenon. We would expect these findings to hold for international companies, like Jennifer said. Some of those companies come to the U.S. for tax-planning purposes. And when they do so, you would expect their investors back home to try to figure out, “Why are we doing business in Delaware again?”
“If there’s a tax strategy that’s known to work that effectively … then why shouldn’t a firm take advantage of it?” –Jennifer Blouin
Knowledge at Wharton: The “bankruptcy state” has got a great tax haven.
Blouin: It’s got everything. Right? One-stop shopping. Geoffrey the Giraffe and Toys R Us started all of that. Toys R Us had a store in every jurisdiction, every state in the country, pretty much. What they astutely figured out is Geoffrey the Giraffe, the intellectual property, was placed in Delaware. Then every Toys R Us store in every state paid a royalty payment to Delaware for the use of Geoffrey the Giraffe. A firm then got to take a deduction of that royalty payment in their home state, reducing the amount of taxable income that was reportable in each state. Delaware has a 0% tax rate on royalty income. This transaction has no effect on the federal level. It was all a state-by-state play.
Guay: And when Jennifer was talking about the Double Irish, Dutch Sandwich, that’s precisely what she was talking about in Ireland as well. Companies like Apple and Google will put their intellectual property in Ireland, then anybody that uses Apple’s technology around the world has to pay royalties to Ireland, which gets taxed at a lower rate. Then those profits will be funneled somewhere else where it’s an even lower rate. It’s this intellectual property, putting that in a low tax area, that’s a big part of this game.
Knowledge at Wharton: Where does the responsibility lie with this aggressiveness in tax planning? As you mentioned, the board of directors has to be aware of this. Are investors probably not as much aware of it?
Blouin: The [problem] is, if there’s a tax strategy that’s known to work that effectively — I use the term “blessed by the tax authorities” — then why shouldn’t a firm take advantage of it? We’ve talked about the Double Irish; I will say Ireland is complicit in that strategy. In Ireland, [you can] have a quasi-Irish organization. It has an Irish name. It’s Irish registered. But as long as your assets, your income, and your management happen outside of Ireland, it’s not taxed in Ireland.
Legally, the structures are in place. Other countries might not like it, but Ireland has said, “We want to bring in the skilled labor.” Because in order to have the structure, you have to have the call center or the people. You come in for the low tax rate, but we get your skilled labor.
Guay: And we’ve got a new tax law of the land here, so a lot of this could get flipped around on its head. Now you’ve got a much lower U.S. tax rate, so the strategy that was the right strategy for tax purposes two years ago is no longer the right strategy. If you’re an analyst and you’re trying to figure out how Apple is going to play the game now, how Google is going to play the game now, you might know how they’re going to be selling iPhones or generating value through the search engine business, but you may not have any idea what the new tax game is going to be.