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The aim of SEC comment letters on taxes is to improve info for investors, but they hike firms’ tax-paying too, study finds

Should the SEC and IRS coordinate efforts and share data?

Does the resignation of the SEC's chairman a matter of days after the election of Donald Trump foreshadow decreased vigor in future enforcement? Some new research suggests the issue has wider ramifications than generally appreciated.

A paper in the current issue of the American Accounting Association journal The Accounting Review finds that, in serving as the investment community's watchdog, the commission has had an unheralded side effect – spurring corporate tax compliance.

Analyzing the impact of comment letters that the SEC periodically issues in response to companies' financial statements, the study finds that, following the receipt of letters dealing specifically with taxes, a sample of close to 500 companies increased their provision for income taxes by about 1.4 percentage points and their actual cash payments by 1.5 percentage points. Given that the sample of firms receiving the letters had mean effective tax rates of close to 30%, those amounted to about 5% increases.

According to Thomas C. Omer of the University of Nebraska-Lincoln, a co-author of the study, those nearly 500 companies averaged about $5.6 billion in assets. And the one-year increase in taxes that they paid to federal, state, and foreign governments totaled $3 billion, not a bad haul in a year’s time for a limited sample of firms.

In addition, the letters have an impact on other companies in the recipients' industries. In the words of the study, "peer firms react to the disclosure of the tax-related comment letter resolution within their industry by increasing their [provision for taxes], consistent with an indirect effect of SEC scrutiny on certain forms of tax avoidance."

Explains Prof. Omer, who collaborated on the study with Thomas R. Kubick of the University of Kansas, Daniel P. Lynch of the University of Wisconsin-Madison, and Michael A. Mayberry of the University of Florida, "While it is not the SEC’s mission to enforce tax laws, its charge includes overseeing the financial information that companies provide to investors, which of course includes tax data. In our survey of almost 3,000 comment letters over nine years, about 30 percent had to do specifically with taxes. And, even though their purpose was not to increase tax payments, they had that effect.

"Earlier research," the professor continues, "had found that IRS personnel are frequent visitors to corporate financial documents available on the SEC's web site. While our study doesn't show straight out that IRS folk are also attending to comment letters, companies seem to be operating on that assumption."

He adds: "While the agencies are not prohibited from coordinating their efforts and sharing data, in point of fact they don't. Given the results of our study, maybe they ought to consider doing so more than the minimal amount they now do."

Section 408 of the Sarbanes-Oxley Act of 2002 (SOX) directs the SEC to review public companies' annual financial reports at least once every three years. The commission issues comment letters if filings are materially deficient or require clarification, giving companies 10 business days to respond. Although firms may be required to restate filings, more typically they commit to providing requested information in future reports.

The professors collected 2,820 SEC comment letters issued between 2004 (when they became readily available to researchers) through 2012, of which 845 were tax-related. The largest number of the 845, about one third, had to do with taxes owed on foreign earnings, while the remainder pertained to such issues as non-foreign taxes, company reserves for unrecognized tax benefits, deferred tax assets or liabilities, and estimates of whether deferred tax assets would be realized.

To measure the effect on companies' tax behavior of receiving tax-related letters, the professors compared changes in tax behavior at 479 firms that received those missives and 479 that received comment letters about other matters, with each company in the first group matched by industry, year, and many other factors with a firm in the second. Since the controls received comment letters, the researchers could be sure that any change they detected in the focal group was not attributable to simply being subject to government scrutiny but to tax-related scrutiny specifically.

The professors found no significant effect on tax behavior among the group that received non-tax-related comment letters, but, as indicated above, quite significant changes among recipients of letters concerning taxes.

In another analysis, though, the researchers probed changes in firms that received no tax-related comment letters themselves but were in industries where two or more peers did receive them. Those non-recipients increased their provision for taxes in the following year, which suggests, in the words of the study, that “peer firms respond to tax-related scrutiny by decreasing the level of their tax avoidance…after observing resolution of tax-related letters in their industry.”

The study also reveals that tax-related comment letters are significantly more likely to go to companies that showed evidence of avoiding taxes than to those that did not. More specifically, "a 10 percentage point decrease in effective tax rate...is associated with a 4.8% increase in the likelihood of receiving a tax-related comment letter."

In addition, despite the increase in company taxes in the year following a tax-related comment letter, the second and third years witnessed declines. What accounts for this? The authors surmise that the tax-policy disclosure the letters elicit leads firms to seek out other means of tax avoidance, which returns them to about to their prior level.

Given the totality of the study's findings, should the IRS and SEC be seeking closer ties? Prof. Omer concedes that the issue is anything but cut-and-dried. "Investors are hardly likely to view a closer relationship as in their interest if it results in their companies paying more taxes, and, after all, the SEC is supposed to protect investors. Yet, a more honest tax climate may very well work to the advantage of shareholders if it diminishes the risks that attach to some of the extreme corporate aggressiveness on taxes we've seen in recent years.

"It well may be," the professor adds, "that we are approaching a crisis in public outrage against the corporate sector for not paying its fair share on taxes. After a quite different crisis, 9/11, we saw a coming together of intelligence and enforcement agencies that previously had kept their distance from each other. Admittedly that was a crisis of a different order, but maybe the agencies responsible for financial enforcement and security ought to be thinking about closer relationships too."

The new study, entitled "The Effects of Regulatory Scrutiny on Tax Avoidance: An Examination of SEC Content Letters,” is in the November/December issue of The Accounting Review, published six times yearly by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Accounting Horizons, Auditing: A Journal of Practice and Theory, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, and The Journal of the American Taxation Association. In addition, the AAA is inaugurating two additional publications, the Journal of Financial Reporting and Journal of Forensic Accounting Research.