Abstract
We examine the extent to which management discretion affects the reserve for unrecognized tax benefits. We analyze the financial statement disclosures of 19 paper companies that received a total of $6.4 billion in refundable excise taxes during 2009. All of these companies included the refunds in financial income, but 14 excluded all or part of the refunds from taxable income. Despite the magnitude and unprecedented nature of the exclusion, we find that only five of the excluding firms accrued a full reserve for an uncertain tax position, three firms accrued a partial reserve, and six firms did not accrue any reserve. This variation suggests managers enjoy wide latitude in applying the more likely than not standard for determining additions to the reserve. Our findings suggest that financial statement users should exercise caution when comparing tax reserves across companies. In addition, we find some evidence that income-increasing tax accrual decisions are related to characteristics generally associated with weak corporate governance.
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Notes
Taxpayers often face ambiguity in applying the tax law even when engaging in routine transactions. For example, Congress permits an income tax credit for qualified research and development expenditures. Yet the precise definition of which expenditures qualify has been a matter of extensive litigation (for example, see Union Carbide Corp. v. Comm. (2nd CIR, 2012) 110 AFTR 2d 2012-5837 affm TC Memo 2009-050). Additionally, prior to the July 2006 temporary regulations governing intercompany service transactions, there were no prescribed methods to determine arm’s length transfer prices for services. Thus multinational entities faced tax law ambiguity when pricing routine intercompany service transactions.
We do not take any position on the proper income tax treatment of the credit refunds. Rather, we argue that there is an absence of legal authority for excluding the refunds. Also, note that the amount of the excise tax refund is not uncertain because all firms in our sample received IRS approval to quality for the credits.
IRC Section 61 states that taxpayers must include “income from all sources derived” in taxable income. Treasury Regulation Section 1.61-1(a) emphasizes that this presumption applies to all forms of income “unless excluded by law.”
FIN 48 permits management to consider a wide range of possible factors when assessing the probability that a position will be sustained, including tax opinions from outside advisors and widely understood administrative practices (ASC topic 740-10-25-7b).
We identify 21 firms by searching the Edgar database for “alternative fuel mixture credit” and “black liquor,” and by examining public filings for firms in pulp paper SIC and NAICS industry codes. We exclude Appleton, an S corporation not subject to taxation, and Sappi, which reports using IFRS, thereby making it impossible to ascertain the tax status of the refunds. For Rock-Tenn and Buckeye Technology, two companies with fiscal years not ending on December 31, we estimate financial information over the 12 months ending on December 31, 2009, using quarterly and annual reports.
Excluding the credits from taxable income would result in a permanent book-tax difference reducing the effective tax rate. Under Regulation S-X Rule 4-08(h)(2), reconciling items must be itemized if the item is “significant in appraising the trend of earnings” or if it exceeds 5 % of the amount computed by multiplying the income before tax by the applicable statutory federal income tax rate. Only Newpage Holding disclosed that it currently intends to include credits in gross income (Newpage 2009 10K filing, p. 81).
For example, Packaging Corporation discloses in its effective tax rate reconciliation that $62 million of tax benefits were due to excluding credit refunds. However, the 2009 UTB addition was only $0.6 million, and this amount is comparable to the 2008 UTB addition of $1.4 million. Therefore we conclude that Packaging Corporation did not record any UTB addition for the credit refund in 2009.
We define free cash flows as cash flow from operations less capital expenditures.
We thank Ryan Wilson for helpful comments resulting from discussions with a tax department employee at one of the sample firms.
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Acknowledgments
We appreciate comments and helpful suggestions from an anonymous reviewer, Ben Ayers, Devan Mescall (discussant), Lillian Mills, D.J. Nanda, Ed Outslay, Sundaresh Ramnath, Jeri Seidman, Ryan Wilson (discussant), and Peter Wysocki as well as those made by participants in the AAA annual meeting, the ATA midyear meeting, and in accounting colloquiums at Michigan State University, the University of Texas at Austin, and the University of Miami. We also gratefully acknowledge research support provided by Red McCombs School of Business, the C. Aubrey Smith Professorship, and the Accounting Doctoral Scholars program. Robinson worked on this topic while serving as the academic fellow for the Division of Corporation Finance of the Securities and Exchange Commission, but all information presented here is available from public sources. The Securities and Exchange Commission as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. Therefore the views expressed in this paper are those of the authors and do not necessarily reflect the views of the commission or the other members of its staff of the commission.
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De Simone, L., Robinson, J.R. & Stomberg, B. Distilling the reserve for uncertain tax positions: the revealing case of black liquor. Rev Account Stud 19, 456–472 (2014). https://doi.org/10.1007/s11142-013-9257-4
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DOI: https://doi.org/10.1007/s11142-013-9257-4