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Review of Quantitative Finance and Accounting

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13-09-2023 | Original Research

Corporate debt policy and tax uncertainty

Authors: Kathleen Petrie Fuller, Qun Wu, Serhat Yildiz

Published in: Review of Quantitative Finance and Accounting

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Abstract

The relation between taxes and capital structure has long been studied in academic literature but the relation between tax uncertainty and capital structure remains underexplored. Using a measure of tax uncertainty based on an accounting reserve for contingent tax liability, we find that tax uncertainty is negatively associated with firms’ leverage. In terms of economic significance, the effect of tax uncertainty on capital structure is comparable to that of nondebt tax shields. Our results also show that tax uncertainty is negatively related to debt issuance. The impact of tax uncertainty is more pronounced for firms with more financial constraints and default risks. Overall, our findings highlight a new channel through which tax planning policies affect corporate policies and document that the firm’s tax uncertainty is an important determinant of its capital structure and financing policies. Our results are robust to different empirical specifications and tests.

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Appendix
Available only for authorised users
Footnotes
1
Jacob and Schütt (2020) provide an excellent review of literature on tax policies and firm value.
 
2
See Graham (2003) and Hanlon and Heitzman (2010) for surveys of tax and tax avoidance research, and Saragih and Ali (2023) for a detailed survey of corporate tax risk studies.
 
3
Tax uncertainty arises when taxpayers are unsure whether the tax authority will assess an additional tax payment upon audit of their income tax returns (Blouin and Robinson 2014).
 
4
Uncertainty associated with other aspects of the firm can also impact its capital structure. For example, the uncertainty associated with stock returns is related to lower leverage ratios (Dinçergök and Eruygur 2023).
 
5
On September 24, 2010, the Internal Revenue Service (IRS) released the final version of Schedule UTP (Uncertain Tax Positions) and announced that certain corporate taxpayers must attach the Schedule to their annual income tax return. We explain Schedule UTP in Sect. 4.2.2.
 
6
Table 8 report the results for the regressions with the interaction terms of high cash holding (high capital expenditure) and tax uncertainty. The results show that the overall impact of tax uncertainty on leverage is negative even for sub-samples of high cash holding (high capital expenditure). For example, the net effect of tax uncertainty for the high cash holding sub-sample is −0.3863 (= −1.0031 + 0.6168) as shown in Column 1. The net effect of tax uncertainty for the high capital expenditure sub-sample is −0.4173(= −0.8091 + 0.3918) as reported in Column 3.
 
7
Following Chen, Goldstein, and Jiang (2007) and Kaplan and Zingales (1997), we measure financial constraints with Four-variable KZ score (KZ4). Following (Brogaard et al. 2017; Bharath and Shumway 2008), we measure firm-level default risk with expected default frequency (EDF).
 
8
Similar to Graham and Tucker (2006), Lee, Shevlin, and Venkat (2023) also document the impact of level of tax avoidance on firms’ financing policies in a more comprehensive sample.
 
9
Our final sample has 4221 unique firms and 24,613 firm-year observations from 2007 to 2018.
 
10
Using a structural model, McClure (2023) documents significance of the financial reporting considerations such as FIN 48 in firms’ planning policies.
 
11
We give detailed variable definitions in Appendix A.
 
12
In our empirical model specifications, we closely follow Graham and Tucker (2006).
 
13
For example, the means of Log(sales) and Log(M/B) in our sample are consistent with Saretto and Tookes (2013) and our average collateral to asset ratio is comparable to Graham and Tucker (2006).
 
14
Jacob, Wentland, and Wentland (2022) examine the impact of tax uncertainty on investment and uses staggered implementation of Schedule UTP as a setting for difference-in-differences analysis.
 
15
In additional tests, we follow Jacob, Wentland, and Wentland (2022) and conduct placebo analyses to provide additional evidence for the validity of our difference-in-differences analysis. Our placebo tests show that our results are not driven by size differences. We report these tests in Appendix B.
 
16
Tax uncertainty is positively associated with firms’ cash holdings (Hanlon et al. 2017), but negatively related to firms’ capital expenditures (Jacob, Wentland, and Wentland, 2022).In additional robustness tests, we show that our findings are not driven by firms’ cash holdings or capital investments. We report these tests in Appendix C.
 
17
Our empirical model specification for tax uncertainty and debt issuance policy tests are like Graham and Tucker (2006).
 
18
Following Bakke and Whited (2010) and Kaplan and Zingales (1997), we measure financial constraints with Four-variable KZ score (KZ4). Following (Brogaard et al. 2017; Bharath and Shumway 2008), we measure firm-level default risk with expected default frequency (EDF). See Appendix D for calculation details.
 
19
We experiment with different placebo settings. For example, as in Jacob, Wentland, and Wentland (2022) we consider firms with assets above $100 M and increase placebo limits upwards by $100 M in 2010, 2012, and 2014. Our main findings are quantitatively similar.
 
20
Our four-variable version of Kaplan and Zingales’ (1997) measure is like that used in other studies. For example, Baker et al. (2003), Chen, Goldstein, and Jiang (2007), and Bakke and Whited (2010).
 
21
Detailed variable definitions are given in the Appendix A.
 
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Metadata
Title
Corporate debt policy and tax uncertainty
Authors
Kathleen Petrie Fuller
Qun Wu
Serhat Yildiz
Publication date
13-09-2023
Publisher
Springer US
Published in
Review of Quantitative Finance and Accounting
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI
https://doi.org/10.1007/s11156-023-01202-y