What Effect Do SEC Comment Letters Have on Tax Compliance?

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Terry Sheridan
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US Securities and Exchange Commission (SEC) comment letters about corporate tax disclosures could go far in helping the IRS target companies’ tax avoidance, according to a new study published by the American Accounting Association.

Companies that get a slap (i.e., comment letter) from the SEC after the agency’s look-see at their tax disclosures tend to increase their tax compliance, as do their corporate peers that observe these reprimands, according to the study, The Effects of Regulatory Scrutiny on Tax Avoidance: An Examination of SEC Comment Letters, which was featured in the November/December issue of The Accounting Review.

“Our findings are important to legislators because we document evidence of spillover benefits from a securities regulator to tax regulators,” the study’s four authors wrote. “Our conclusions also inform tax regulators, suggesting that targeting firms receiving SEC tax-related comment letters could aid in identifying firms engaged in aggressive tax avoidance.”

Further, the study reveals a correlation between the SEC-scrutinized companies’ GAAP and cash effective tax rates and their corporate peers’ GAAP and effective tax rates.

“We provide evidence that scrutiny by one governmental agency that focuses on the financial reporting of tax information (the SEC) positively affects other agencies that focus on tax avoidance,” such as the IRS, they wrote.

The study was authored by professors Thomas Kubick of the University of Kansas, Daniel Lynch of the University of Wisconsin–Madison, Michael Mayberry of the University of Florida, and Thomas Omer of the University of Nebraska–Lincoln.

The four researchers reviewed 2,820 public SEC comment letters issued between 2004 and 2013, of which 845 were tax-related. Section 408 of the Sarbanes-Oxley Act requires the SEC to examine each registrants’ Form 10-K at least once every three years. Comment letters are issued when the SEC needs clarifications.

Corporate responses to the letters include additional information, disclosures, and a commitment to either adjust future filings or restate previously issued filings. Most tax-related SEC comment letters relate to a lack of disclosures about accounting assumptions and reconciliation of the GAAP effective tax rates, undistributed foreign earnings, uncertain tax positions, and valuation allowances, the study states.

A sample of almost 500 companies that received tax-related comment letters indicated that they increased their provision for income taxes by about 1.4 percentage points in the following year and their actual cash payments by 1.5 percentage points. With mean effective tax rates of almost 30 percent, those amounted to about 5 percent increases, according to the study.

According to Omer, the companies averaged about $5.6 billion in assets. The post-comment letter one-year increase in taxes they paid to federal, state, and foreign governments amounted to $3 billion.

What’s more, corporate peers also increased their tax compliance.

Still, the second and third years after a tax-related comment letter saw declines in tax compliance, the study found. The authors contend that the letters perhaps prompted the C-suites to find other ways to avoid taxes.

That circles back to how the SEC and the IRS could work together.

“Earlier research had found that IRS personnel are frequent visitors to corporate financial documents available on the SEC’s website,” Omer said. “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.”

While nothing stops the SEC and the IRS from coordinating with each other, they don’t, Omer stated.

“Given the results of our study, maybe they ought to consider doing so more than the minimal amount they now do,” he added.

How the SEC could reconcile that with its mission to protect investors – who surely wouldn’t want their companies to pay higher taxes – isn’t clear.

“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,” Omer said. 

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Dec 20th 2016 17:40

Well done, great piece, thanks.

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