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Published in:

09-05-2017

# The taxman cometh: Does tax uncertainty affect corporate cash holdings?

Authors: Michelle Hanlon, Edward L. Maydew, Daniel Saavedra

Published in: Review of Accounting Studies | Issue 3/2017

## Abstract

We examine whether firms hold more cash in the face of tax uncertainty. Because of gray areas in the tax law and aggressive tax avoidance, the total amount of tax that a firm will pay is uncertain at the time it files its returns. The tax authorities can challenge and disallow the firm’s tax positions, demanding additional cash tax payments. We hypothesize that firms facing greater tax uncertainty hold cash to satisfy these potential future demands. We find that both domestic firms and multinational firms hold larger cash balances when subject to greater tax uncertainty. In terms of economic significance, we find that the effect of tax uncertainty on cash holdings is comparable to that of repatriation taxes. Our evidence adds to knowledge about the real effects of tax avoidance and provides a tax-based precautionary explanation for why there is such wide variation in cash holdings across firms.
Footnotes
1
We follow prior literature and assume that tax aggressiveness is a subset of tax avoidance in that the latter includes benign, perfectly legal tax planning or tax advantaged investments (e.g., investing in municipal bonds, the income on which is tax exempt).

2
FIN (FASB Interpretation Number) 48 was enacted by the Financial Accounting Standards Board and has since been codified as part of ASC 740. We discuss this in more detail below.

3
We also considered using a measure of effective tax rate volatility (Guenther et al. 2016). However, given that tax volatility is only partially explained by tax settlements (Saavedra 2017), we prefer to use UTBs, which conceptually are more directly linked to future audits and tax settlements.

4
To enable a better comparison of the economic magnitudes of a stock measure (UTB) with those of a flow measure (repatriation tax costs as measured by Foley et al. (2007)), we develop a measure of long-run (five-year) repatriation tax costs. Our results are robust to using the one-year repatriation tax cost measure used by Foley et al. (2007).

5
We acknowledge that there are other precautionary reasons why firms might hold more cash. An advantage of our research setting is that, with the adoption of FIN 48, firms are required to provide detailed tax disclosures and thus this is a measurable precautionary reason.

6
There are also other papers somewhat related to our study. Dhaliwal et al. (2011) posit that the greater the tax avoidance, the greater likelihood that managers are diverting rents from shareholders and thus greater tax avoidance leads to lower cash balances because cash is easily diverted. Campbell et al. (2014) find the market values foreign cash holdings less, consistent with its eventual effect on tax expense when repatriated. Thomas and Zhang (2014), however, find, in a more general setting, that valuation effects of tax expense are complicated and depend upon controlling for future profitability.

7
When discussing different firm disclosures, we acknowledge that firms might intentionally provide vague statements because they do not want to indicate to tax authorities how much tax they expect (or are willing) to pay to settle disputes with tax authorities.

8
Some additional anecdotal evidence is provided by the following company disclosures. (1) Epiq Systems disclosed in the liquidity section of its 2010 annual report the following: “…we have approximately $2.8 million of unrecognized tax benefits that have been recorded as liabilities, and we are uncertain as to whether, or when, such amounts may be settled. Settlement of such amounts could require the use of working capital.” (2) Oshkosh disclosed in its liquidity section (2010 10- K): “Due to the uncertainty of the timing of settlement with taxing authorities, the Company is unable to make reasonably reliable estimates of the period of cash settlement of unrecognized tax benefits for the remaining uncertain tax liabilities. Therefore,$52.1 million of unrecognized tax benefits as of September 30, 2010 have been excluded from the Contractual Obligations table. …” (3) Wausau Paper indicated in the liquidity section of its 2007 annual report: “At December 31, 2007, we had a liability for unrecognized tax benefits, including related interest and penalties, totaling $6.7 million, of which approximately$3.8 million is expected to be paid within one year. For the remaining liability, due to the uncertainties related to these tax matters, we are unable to make a reasonably reliable estimate when cash settlement with a taxing authority will occur.” (4) Whole Foods Market disclosed in its 2010 annual report: “At September 26, 2010, the Company had gross unrecognized tax benefits totaling approximately $14.9 million including interest and penalties. Although timing of the resolution… is highly uncertain … [it is] reasonably possible to result in payment of cash within 12 months, including interest and penalties, of approximately$5.4 million.”

9
Specifically, firms can generally choose to litigate federal tax disputes in U.S. District Court, the U.S. Court of Federal Claims, or U.S. Tax Court. The first two courts require firms to pay the disputed tax upfront, while the Tax Court does not.

10
Before FIN 48, companies were required to record a tax reserve under the general standard for contingent liabilities, SFAS 5 “Accounting for Contingencies.” Thus the concept of a tax reserve is not new. However, before FIN 48, the amount of tax reserve was almost never separately disclosed (Gleason and Mills 2002), making it difficult to study empirically. In addition to requiring disclosure, FIN 48 provided additional guidance designed to standardize the computation of the tax reserve.

11
Including these observations leads to qualitatively similar results.

12
As discussed by Foley et al. (2007) and Hanlon et al. (2015), the tax repatriation tax cost measure as computed in Foley et al. involves assumptions. First, the calculation assumes that foreign reported earnings are an approximation of foreign taxable income. Second, the calculation of the repatriation tax cost uses annual foreign income to calculate the incremental U.S. taxes due upon repatriation, even though the measure is intended to capture the taxes on repatriating the unremitted foreign earnings of the company. Thus the measure assumes that the annual income is proportional to the total stock of foreign earnings that has not yet been repatriated. Finally, Foley et al. (2007) assume that the foreign tax rates applicable at the time that foreign taxes are paid resemble rates at the time of repatriation. This assumption reflects that the measure includes an estimate of the available foreign tax credit upon an eventual repatriation. Foley et al. (2007) validate these assumptions by showing that their measure of repatriation tax cost is associated with the stock of foreign cash holdings using confidential data from the BEA.

13
To enable a better comparison of the economic magnitudes of a stock measure (UTB) with those of a flow measure (repatriation tax costs), we develop this measure of long-run repatriation tax costs. Our results are robust to using the one-year repatriation tax cost measure suggested by Foley et al. (2007).

14
We retain firms with a negative denominator to maximize the sample size—the number of years with UTB data is small and the UTB (our test variable) is available and useful for loss firms. The Cash ETR is a control variable and re-coded to be constrained between 0 and 1. To make sure the inclusion of these firms does not drive our results, we also estimate our tests over the subsample of firms with a positive denominator. The results are very similar, and we discuss them in more detail below.

15
Alternatively, instead of EBITDA, we employ cash flow from operations, which is an after-tax measure of cash flows. Our overall inferences are unchanged when using this alternative measure of cash flows.

16
We also employ an alternative measure of cash flows using the cash flow statement (cash flows from operations minus dividends) and obtain similar results.

17
The increasing time trend of UTB observations is consistent with Lisowsky et al. (2013). Their analysis reveals that the incidence of missing data is declining over time, for example, 35% and 22% missing in 2007 and 2009, respectively.

18
While we remove missing UTB observations from our sample, based on prior literature (discussed above), we retain zero-UTB firms under the assumption they are correct. However, the zero-UTB firms do seem different and if they are not true zero UTB firms, including them may be biasing our results downward.

19
In untabulated results, we find that the difference in the magnitudes of the coefficients on Tax uncertainty between the multinational and domestic samples is partially due to the inclusion of Five-year repatriation tax costs. When we exclude Five-year repatriation tax costs from the specification, we find that the coefficient on Tax uncertainty in the multinational sample increases to 0.67.

20
In untabulated tests, we estimate the regression over the subsample of observations with a positive denominator in the control variable Five-year cash ETR. The results are qualitatively unchanged (i.e., the coefficient on Tax uncertainty is statistically significant at the 1% level). We also estimate the regression including deferred tax liabilities as an additional control and find that our results and inferences are qualitatively unchanged.

21
=0.741*0.016

22
=0.563*0.019

23
We conduct an untabulated test where we first partition UTB into the portion explained by temporary differences (regressing UTB on deferred tax liabilities and deferred tax assets) and the remainder. We then examine the effect of each UTB partition on cash holdings. The results indicate that both temporary differences and permanent differences are significant in explaining cash holdings.

24
Note that the average UTB scaled by total assets of firms in the top decile is 0.053 and in the lowest decile the average is zero.

25
The timing issue is not as important in the levels regression because the levels regression includes accumulated balances of the UTB and cash holdings.

26
We include lagged cash-to-assets and change in cash-to-assets following Bates et al. (2009) although we did not include lagged cash-to-assets in the levels regressions (nor did Bates et al. (2009)). In robustness tests, we estimate our levels regression including the lagged cash-to-assets ratio and find similar results. We note that lagged cash-to-assets ratio is highly collinear with the cash-to-assets ratio. This explains why this additional variable is only included in changes specifications. Furthermore, we also estimate the changes specification excluding lagged cash-to-assets and change in cash-to-assets and find qualitatively similar results.

27
In untabulated tests, we estimate the regression over the subsample of observations with a positive denominator in the control variable five-year cash ETR. The results are qualitatively unchanged (i.e., the coefficient on Lagged change tax uncertainty is statistically significant at the 1% level).

28
In untabulated tests, we examine whether the effect holds for increases and decreases in the UTB. We find that both explain changes in cash holdings.

29
Hirshleifer and Teoh (2009) discuss possible connections between tax incentives, favoring debt financing and systemic risk as firms become over-levered and financially constrained in a crisis.

30
In untabulated tests, we also use alternative proxies of financial constraints based on firm size, age, long-term S&P credit rating, and dividend payout and find results similar to those in Table 7.

31
Gupta et al. (2015) and Cazier et al. (2015) examine how financial reporting incentives directly influence the amount of unrecognized tax benefits.

32
Depending on data availability, some firms might have five years of future tax payments while others just one.

33
The sample size for this test differs from the one used in our main analysis because we require data about future tax payments and because of the more limited number of observations with available changes variables.

34
Givoly and Hayn (2000) define non-operating accruals as accruals consisting primarily of such items as loss and bad debt provisions (or their reversal), restructuring charges, the effect of changes in estimates, gains or losses on the sale of assets, asset write-downs, the accrual and capitalization of expenses, and the deferral of revenues and their subsequent recognition.

35
Results are similar if we use the continuous measure of conservatism.

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Title
The taxman cometh: Does tax uncertainty affect corporate cash holdings?
Authors
Michelle Hanlon
Edward L. Maydew
Daniel Saavedra
Publication date
09-05-2017
Publisher
Springer US
Published in
Review of Accounting Studies / Issue 3/2017
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-017-9398-y

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