Uncertain tax benefits, international tax risk, and audit specialization: Evidence from US multinational firms

• Author: Grant Richardson,Ahmed Al‐Hadi,Grantley Taylor
• DOI: http://doi.org/10.1111/ijau.12117
• Published date: 01 July 2018
• Date: 01 July 2018

ORIGINAL ARTICLE

Uncertain tax benefits, international tax risk, and audit

specialization: Evidence from US multinational firms

Grantley Taylor

1

|Grant Richardson

2

|Ahmed Al‐Hadi

1

1

School of Accounting, Curtin Business

School, Curtin University, Perth, Western

Australia, Australia

2

School of Accounting and Finance, The

Business School, The University of Adelaide,

Adelaide, South Australia, Australia

Correspondence

Grant Richardson, School of Accounting and

Finance, The Business School, The University

of Adelaide, 10 Pulteney Street, Adelaide,

South Australia, Australia 5005.

Email: grant.richardson@adelaide.edu.au

The purpose of this study is twofold. First, it examines the association between

income‐shifting arrangements consisting of transfer pricing aggressiveness, tax

haven use and foreign tax rate differentials, and Financial Interpretation No. 48

(FIN48, now ASC740–10‐25) unrecognized tax benefits (UTBs). Second, it analyzes

the impact of audit specialization on the association between income‐shifting

arrangements and UTBs. Using a dataset of 286 US multinational firms over the

2007–2016 period (2,097 firm‐years), our regression results show that income‐

shifting arrangements represented by transfer pricing aggressiveness, tax haven

use and foreign tax rate differentials are significantly positively associated with

UTBs. We also observe that audit specialization magnifies the positive association

between transfer pricing aggressiveness and UTBs, and foreign tax rate differentials

and UTBs. Finally, in additional analysis we provide some evidence that the positive

association between income‐shifting arrangements and UTBs is magnified in the

post‐2010 uncertain tax position reporting requirement period. Overall, our study

extends prior research on the topic of audit characteristics (i.e., audit specialization)

and tax aggressiveness.

KEYWORDS

audit specialization, Income shifting, uncertain tax benefits, uncertain tax positions

1|INTRODUCTION

The purpose of this study is twofold. First, it examines the association

between income‐shifting arrangements relating to transfer pricing

aggressiveness, tax haven use and foreign tax rate differentials, and

Financial Interpretation No. 48 (FIN48, now ASC740–10‐25) unrecog-

nized tax benefits (UTBs).

1

Second, it analyzes the impact of audit spe-

cialization on the association between income‐shifting arrangements

and UTBs.

Income shifting can be described as a plan or structure that leads

to more income being earned in low‐tax jurisdictions than would

otherwise be expected based on a firm's worldwide asset allocation

(Klassen & Laplante, 2012a). Income‐shifting arrangements impose a

significant amount of uncertainty as reflected in the calculation of a

firm's UTBs (Lisowsky, Robinson, & Schmidt, 2013; Mills, Robinson,

& Sansing, 2010; Rego & Wilson, 2012). In particular, management is

faced with much uncertainty in determining whether tax benefits

recorded in a firm's tax returns are likely to be sustained following

audit by the Internal Revenue Service (IRS) and also the specific

amount of UTBs reported in a firm's financial statements (Lisowsky

et al., 2013; Mills et al., 2010; Rego & Wilson, 2012). In fact, the com-

putation of UTB estimates requires a great deal of judgment by man-

agement due to the significant uncertainties, complexities, and

subjectivity dealing with the application of tax legislation and case

law, and the nature, timing, and settlement of anticipated audits by

the IRS (Blouin & Robinson, 2012; Ciconte, Donohoe, Lisowsky, &

Mayberry, 2016; Tax Executives Institute [TEI], 2011). Given that

audit client risk and complexity are major drivers of audit fees

(Donohoe & Knechel, 2014), it is therefore not unreasonable to expect

that audit specialization plays an important role in the association

between income‐shifting arrangements and UTB estimates.

[Correction added on 25 May 2018, after first online publication: The title of the

article has been modified in this current version.]

Received: 10 October 2016 Revised: 9 January 2018 Accepted: 28 February 2018

DOI: 10.1111/ijau.12117

230 © 2018 John Wiley & Sons Ltd Int J Audit. 2018;22:230–248.wileyonlinelibrary.com/journal/ijau

We are motivated in this study to examine the association

between UTB estimates and major areas of income‐shifting arrange-

ments for two important reasons. First, prior research shows that US

multinational firms encounter significant uncertainty concerning the

recording of tax benefits (e.g., transfer pricing benefits) and their ulti-

mate tax positions (e.g., Blouin, Devereux, & Shackelford, 2012;

Hutchens & Rego, 2013; Lisowsky et al., 2013; Neuman, Omer, &

Schmidt, 2013; Rego & Wilson, 2012). Hanlon and Heitzman (2010)

argue that larger UTB estimates denote a greater amount of uncer-

tainty of a firm's tax position and its level of corporate tax aggressive-

ness.

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Other researchers also claim that the magnitude of UTBs is a

function of the uncertainty of a firm's underlying tax position (e.g.,

Cazier, Rego, Tian, & Wilson, 2015). Robinson, Stomberg, & Towery

(2016) find that over a 3‐year period, some 24 cents in every dollar

of UTB reverses as a result of IRS audit settlements. In fact, IRS settle-

ments are highly variable and can range from a zero adjustment to a sub-

stantialreversal of a recorded UTB amountin a particular year.While the

tax benefit is generally more likely than not to result from a series of

transactions or arrangements, the total amount of the benefit is uncer-

tain because of the subjectivity or complexity involved in those transac-

tions. This uncertainty is manifested by the quantum of UTBs recorded,

any magnitude of difference between actual and predicted UTBs, and

audit adjustments to the UTB amount. Overall, firms have come under

increased scrutiny by the IRS in terms of an array of income‐shifting

activities that can lead to considerable uncertainty in determination of

their tax positions (, 2012; , 2013a; , 2013b; IRS, 2010).

Second, external audit firms have added responsibilities following

the implementation of FIN48, such as assisting a firm with the recog-

nition and measurement of recognized tax benefits and the computa-

tion and disclosure of UTBs (Donohoe & Knechel, 2014). Hence, many

new auditing challenges arise due to the implementation of FIN48,

and a firm's aggressive tax positions are also likely to generate further

audit risk and effort on the part of external audit firms. In addition to

the uncertainties in applying tax laws to various transactions and

arrangements, a firm also faces uncertainty about the outcome of

audits by the IRS which may reduce some or all of its UTB estimates

(FASB, 2006). Thus, we also conjecture that audit specialization is

likely to significantly impact the association between income shifting

arrangements and UTBs.

Employing a dataset of 286 US multinational firms over the

2007–2016 period (2,097 firm‐years), our regression results show that

income‐shifting arrangements denoted by transfer pricing aggressive-

ness, tax haven use, and foreign tax rate differentials are significantly

positively associated with UTBs. We also observe that audit speciali-

zation magnifies the positive association between transfer pricing

aggressiveness and UTBs, and foreign tax rate differentials and UTBs.

Finally, in additional analysis we provide some evidence that the pos-

itive association between income‐shifting arrangements and UTBs is

magnified in the post‐2010 uncertain tax position (UTP) reporting

requirement period.

This study makes the following important contributions. First, it

shows that audit specialization magnifies the positive association

between transfer pricing aggressiveness and UTBs, and foreign tax

rate differentials and UTBs. To the best of our knowledge, no prior

study has analyzed the linkages between audit characteristics in terms

of audit specialization, income‐shifting arrangements and UTB esti-

mates. Second, in additional analysis, we furnish some new evidence

showing that the positive association between income‐shifting

arrangements and UTBs is magnified in the post‐2010 UTP reporting

requirement period. Third, this study is also timely because there are

several audit implications stemming from large or abnormal UTB esti-

mates. For instance, the link between the financial and tax reporting of

UTBs post implementation of the UTP reporting requirement from

2010 has placed greater pressure on auditors with regard to identify-

ing and evaluating possible tax uncertainties (Robinson & Schmidt,

2013). Finally, the results of this study should be of interest to audi-

tors, policymakers, regulators and tax authorities (e.g. the IRS).

The rest of this paper proceeds as follows. Section 2 provides the

background to FIN48 and the calculation of a firm's UTB estimates.

Section 3 considers theory about tax aggressiveness, external audit,

and UTBs, while Section 4 develops our hypotheses. Section 5

describes the research design, and Section 6 reports the empirical

results. Finally, Section 7 concludes.

2|BACKGROUND TO FIN48 AND THE

CALCULATIONOFUNRECOGNIZEDTAX

BENEFITS

In July 2006, the FASB (2006) issued FIN48, which became effective

for fiscal years after December 15, 2006. According to FIN48, a firm

recognizes a tax benefit in its financial statements for a UTB only if

management's assessment is that its position is more likely than not

(i.e., a greater than 50% likelihood) to be upheld on audit based only

on the technical merits (i.e., legislation, legislative intent, and prece-

dent cases) of the tax position. UTBs denote the difference between

a tax position taken or expected to be taken in a firm's tax return

and the benefit recognized and measured based on FIN48 require-

ments. A liability is created as it represents a potential future obliga-

tion to the IRS if a firm is unable to recognize the tax benefits on a

tax filing pursuant to FIN48 requirements (FASB, 2006). The presump-

tion is that the IRS possesses full knowledge of a firm's tax reporting

position, together with all of the pertinent facts and details of arrange-

ments that affect its tax position. Resolution of a firm's related tax

positions through negotiation with the IRS or by litigation can take

many years to finalize.

The computation of a firm's UTB estimates requires a great deal

of judgment by management because of the significant uncertainties

associated with estimating its tax liabilities (e.g., provision for taxes

based on the global variability in taxes to be paid) or tax assets (e.

g., estimates of deferred tax assets based on the criteria that tax

losses will probably be recouped at a future point in time). These

risks arise due to the high likelihood of a mismatch between the

reported tax expense (and liability) of a firm's tax return and financial

statements, and what taxes it should be paying the IRS. Uncertainty

also exists for a firm regarding the applicability of relevant tax legis-

lation or case law, the anticipated actions of the IRS in terms of rec-

ognized tax benefits, and to publicly disclosed UTBs, including

settlement amounts and the timing of those settlements.

3

Manage-

ment also faces considerable uncertainty concerning the assignment

TAYLOR ET AL.231