Tax Risk as the Likelihood of an Unfavorable Settlement with Tax Authorities

• In Event: New Faculty/Doctoral Session II

Abstract

In this paper, we examine tax risk as the likelihood that a firm will face an unexpected and negative tax outcome. More specifically, we predict the probability that a firm will have an unfavorable settlement with tax authorities, what we define as a tax loss event. We further consider whether market participants anticipate this risk and consequently how they react to the tax loss event. We combine an industry-adjusted measure of high cash effective tax rate (Cash ETR) values with financial statement verification of a tax settlement to identify a sample of tax loss event firms. To predict the likelihood of these events, we develop a logistic model from a parsimonious set of factors that are associated with tax risk. Empirical tests show that our model provides strong predictions of a tax loss event. Additional tests show that our model performs well against a matched set of holdout control observations – that is, observations with unusually high Cash ETR values yet no tax settlement. In related valuation tests, the abnormal returns are negative in the event year for firms with a tax loss event and high ETR volatility, suggesting that investors may not recognize the risk beforehand. These results imply that the market punishes firms that appear to poorly manage the financial reporting of tax risk, yet only when they subsequently reveal a significant tax settlement. Our research adds to the emerging literature that examines the tax risk within firms. Specifically, we develop a prediction model useful for various firm stakeholders, as well as provide additional insight into the factors that create risk for the firm and how the market reacts to the revelation of such risks.

Authors

• Andrew M Bauer, University of Illinois-Urbana-Champaign

• Kenneth J Klassen, University of Waterloo