This week, Mirit Eyal-Cohen (Alabama) reviews Israel Klein (Ariel University), Contemptuous Tax Reporting, 2019 Wis. L. Rev. ___ :
This interesting article is right down my alley, namely R&D tax incentives. Recently, legal scholars (including yours truly here and here) have questioned the justifications for the current R&D tax incentives regime and their effectiveness in inducing additional research expenditures. Every year, about 25 billion dollars of research incentives are claimed by companies. Likewise, the current R&D credit allows companies to reduce tax bills by an amount equal to 14 or 20 percent of their current year Qualified Research Expenditures. The article points out that this tax benefit combined with the U.S. self-assessment principle that encompasses only occasional ex-post audits create an incentive for managers to participate in contemptuous self-reporting, that is reporting their companies’ tax while intentionally miscategorized R&D expenditures. Moreover, the recent repeal of the corporate Alternative Minimum Tax (AMT) in the Tax Cuts and Job Act removed the limits on the extent to which taxpayers can utilize credits and deductions to lower their overall tax liability, thus created a bigger tax break for R&D while perpetuating the incentive to overstate R&D spending.
The article distinguishes contemptuous tax reporting from false reporting by claiming the former involves intentional tax interpretation of the code that is inconsistent with prevailing tax doctrines. Accordingly, contemptuous tax reporting presents de jure reporting of a possibly-valid legal position that might prevail (albeit with extremely low chances) if accepted by the court. The article proposes a “litmus paper” that can identify a contemptuous tax position taken by a company by looking at court ruling as an indicator. It defines contemptuous reporting as “the reporting of positions which, if were challenged by the IRS and litigated by the parties in the tax court (and even up to the Supreme court), would have been denied by the court, i.e., ruled against, resulting with additional tax being paid by the taxpayer.”
The underlying assumption of the article is that legal scholarship has been treating tax evasion and tax avoidance as the only spectrum of tax payers’ behaviors. Meanwhile, the finance literature treated all behaviors—evasion, avoidance and all the points in-between— as “tax avoidance” for empirical pragmatic reasons. Both approaches create challenges in distinguishing between corporate tax reductions that result from non-legitimate tax behaviors (e.g. hiding money in offshore accounts) and legitimate tax sections (e.g. choice of entity). The article points out to this new third type of behavior—contemptuous tax reporting—as another offshoot of non-legitimate behavior distinguishable from tax avoidance or evasion. It argues that managers engage in contemptuous tax reporting by reporting tax positions while knowing their circumstances contradict prevailing tax doctrines. They do so to gain the immediate tax savings hoping their position will not get audited. Although theoretically audit rate and punishment level (interest and fines) are supposed to deter managers from playing the “tax lottery”, the article states that even if such equilibrium point were to theoretically exist, the system is not efficient due to low audit rates or low sanction rate, or both.
The article repeatedly mentions Shami v. Commissioner, a 2012 T.C. Memo (about a CEO of a cosmetic company who unsuccessfully claimed his salary as qualified R&D expenses) as the pillar example to over-claiming of non-R&D business expenditures contemptuously and argues that this represent a much broader phenomenon. Thereafter it provides empirical findings and demonstrate that managers are highly engaged in contemptuous reporting by pointing to S&P 500 companies financial reports indicating more than $20 billion worth of contemptuous tax positions annually resulting with more than $190 billion of unpaid tax funds. Using a pretty straightforward model the article controls for financial parameters and finds that reporting R&D expenses has a positive and significant effect on contemptuous reporting. Statistically speaking, every increase of $1 in reported R&D expenses is correlated with an increase of ~3 cents in contemptuous reporting.
In order to minimize contemptuous tax reporting, the article suggests doing more than just aligning investor-reporting with tax-reporting in hope of reducing the gap between book-tax (BTD) and the effective tax rate (ETR). Currently, companies that engage in contemptuous reporting enjoy higher ETR and lower BTD. The article’s proposal relies on the GAAP disclosure rules and accounting principles that govern contemptuous reporting on a company’s financial report. When preparing its financial statements, the company is required by GAAP rules to assume that all the positions reported in tax returns will be audited by the IRS and report to investor under the category of “additional tax expenses” positions that “it is more likely than not, based on the technical merits, that the position will be sustained upon examination [by the IRS] … [T]he term ‘more likely than not’ means a likelihood of more than 50 percent.” GAAP also requires companies to include in the notes for the company’s financial statements a tabular disclosure that aggregates information regarding all current and past deemed tax expenses resulting from such contemptuous reporting. The aggregated deemed expenses are disclosed as “unrecognized tax benefits” (“UTBs”) in a separate schedule UTP (Uncertain Tax Positions Statement) and represents the difference between all tax benefits gained and the benefits that meet the GAAT recognition rules.
The article proposes to curb contemptuous reporting of R&D expenditures by preventing companies from reporting R&D expenditures on their tax return unless expenditures were also treated as such in the company’s financial statement reported to investors. It suggests that in some observed tax measures (such as R&D expenditures) a better linkage between managers’ interpretations used in tax reporting to reports for investors will enhance scrutiny over managers’ contemptuous interpretations. For example, managers’ interpretations concerning R&D expenditures, as they appear in positions taken in tax reports, would be permitted only if the same interpretations were followed in reports to investors, thus making it harder for managers to report contemptuously. Such interpretations will be subject to the same external auditing process of the company’s financial statements such as the review of the general public, stock analysts, SEC authorities, and the media as part of the company’s publicly disclosed reports. So while managers can still report different positions in their tax and financial statements the proposal, their interpretation of what will likely be scrutinized by the IRS will have additional layer of scrutiny by investors and other stakeholders.
A few observations that come in mind. The article focuses on one example only for contemptuous tax reporting in the R&D context of managers self-reporting their salaries as related to R&D activity. This is a straightforward and too simplistic illustration. Real world discrepancies between R&D expenditures in pre-audits and post-audits are much more complicated. The article admittedly states that tax is complex and that “applying a generalized legal tax code, and especially a long and complicated one such as the US tax code, to a taxpayer’s unique circumstances is not always straightforward. Occasionally, application results in more than one possible interpretation of the code’s relevance to the specific taxpayer’s circumstances.” Some more common areas of contention with the IRS around the R&D credit worth noting in the article include whether the development process is a second-generation phase, whether the process involves optimizing manufacturing process in a more cost-effective way, if the facts involve designing and evaluating process alternatives, increasing manufacturing capacities, or evaluating process alternatives, etc.. There are no bright-line guidelines regarding these factors and the realities of each company may dictate different tax outcomes. R&D tax credit eligibility depends on whether the activity also meets a four-part convoluted test that includes elimination of uncertainty about development of new or improvement of existing product, process of experimentation through modeling, simulation, etc., the process has to be technological in nature and involve hard science, and its purpose has to create a new or improved product, function, performance or quality. These are issues that can fall on either side of the gray line depending on the specific facts and circumstances of each company’s activity.
Moreover, the article is citing to IRS audit rates of only 1% of corporate income tax returns to emphasize managers’ incentive to engage in contemptuous tax reporting. But in that context, it would have been more beneficial to cite to the IRS audit rates in the specific area of R&D tax expenditures. According to a recent GAO report these rates are much higher and, in many cases, taxpayers settle for 50 cents on the dollar when the IRS challenges a claim. Besides, instead of intentional misreporting can we view “contemptuous tax reporting” simply as the company taking-on a litigation risk? Legal scholars indicated here that citizens often take on the role of regulatory entrepreneurs in spurring change. They knowingly take on legal position not only to avoid the rule of law but also in hope of spurring legislative change or encourage the regulator to alter its interpretation of a certain rule. This is especially so in adjudication of tax matters that lack uniformity as it involves several courts (District Court, Court of Claims, Tax Court) and various Circuits. A court decision in a certain tax dispute is not necessarily going to be decided alike in other courts or even different Circuits. We have to be mindful that contemptuous tax reporting might simply indicate the company’s calculated litigation risks taken for positions that it truly believes it can defend due to special circumstances or ought to take to be able to change the way tax law is currently administered.
Lastly, the article early on makes the determination that managers have the discretion on how to report a certain transaction. Thus, it concludes that managers abuse their responsibility given to corporate taxpayers to self-report their taxes when they report a position on their tax return that does not correspond to prevailing tax doctrines. The article goes as far as promising a measurement of the mens rea involved in managers’ tax avoidance actions by which managers knowing the positions taken are inconsistent with IRS rulings. In that context, it is worth asking, who’s mens rea is it? The company is a collection of stakeholders and it seems that the article is putting utmost responsibility for contemptuous tax reporting on the company’s C Suite, which may not be realistically so. The article admits that in case of large corporations, managers employ full-time professionals to handle corporation’s taxes with some supervision. Indeed, in a recent field study I conducted interviewing CFO’s in big tech companies in Silicon Valley I found that managers are not necessarily aware of their company’s R&D tax positions, which are handled entirely by their accounting firms. The choice about what and how to report R&D tax positions is, de facto, at the tax professionals’ level. If we decide we need to abolish contemptuous tax reporting it might be more efficient to tackle it directly via professional liability and ethics rules.
Update: Response from Israel Klein (Ariel University):
I would like to thank Prof’ Mirit Eyal-Cohen for reviewing my recently published article, Contemptuous Tax Reporting.
Reading through the review, I thought a response might be needed, if only to shed a proper light on the unique properties of Contemptuous tax reporting as a general tax behavior that worth special attention.
By reading only the review, one might confuse Contemptuous reporting with other types of ‘opportunistic’ reporting by managers; more so, one might wrongly limit its appearances to the reporting of R&D (however the article only discusses R&D instrumentally, as a prominent example, identified empirically, for Contemptuous reporting).
Prof’ Eyal-Cohen mentioned “[w]e have to be mindful that contemptuous tax reporting might simply indicate the company’s calculated litigation risks taken for positions that it truly believes it can defend due to special circumstances or ought to take to be able to change the way tax law is currently administered.“
However—and this is crucial for the discussion and understanding of Contemptuous reporting—if a company believes it will eventually prevail on the specific case (e.g., be able to change the law or the way the Code is regulated etc.), than her report of the transaction is not termed Contemptuous—remember the “litmus paper” used for identifying, more so—defining, “Contemptuous tax reporting”: The subjective believe of a filling manager of the final outcomes of the position. Contemptuous tax positions are positions which managers take while knowing/believing they will not upheld audit and litigation, hence will result with additional tax being paid.
More so, cases in which managers believe they will eventually win (e.g., defend due to special circumstances), are not included in FIN48’s UTBs provisions (used in the empirical part of the study): that is, because FIN48 also uses a subjective test which requires managers to create provisions for, and only for, tax positions they believe will eventually result with additional tax payments.
All-in-all Contemptuous tax reporting does not indicate calculated litigation risk, but rather positions managers/taxpayers take while knowing they are position, they will not win. Hence, one might further argue Contemptuous positions represent an ‘abuse’ of the current self-reporting system.
Here's the rest of this week's SSRN Tax Roundup:
- Ellen P. Aprill (Loyola LA), The Private Foundation Excise Tax on Self-Dealing: Contours, Comparisons, and Character, Pitt Tax Rev. (Forthcoming 2020).
- Kimberly A. Clausing (Reed College), How Big is Profit Shifting?(Jan. 2020).
- Arthur J. Cockfield (Queen's U.), Tax Wars: How to End the Conflict over Taxing Global Digital Commerce, Berkeley Bus. L. J. (Forthcoming 2020).
- Jiapin Deng (Sun Yat-sen U.), Qiao Liu (Peking), Se Yan (Peking), Keeping Them Honest: The Long-term Effects of Protestant Missionaries on Honesty and Corporate Tax Avoidance in Modern China(Jan. 2020).
- Stephen G. Dimmock (NTU), Fan Feng (Shanghai Lixin U.) & Huai Zhang (NTU), The Capital Gains Lock-In Effect and Earnings Quality (Jan. 2020).
- Assaf Harpaz (Duke) The OECD Unified Approach: Nexus, Scope, and Coexisting With DSTs, Tax Notes, Int’l 909 (2019).
- Vanessa Gawehn (Paderborn U.), Banks and Corporate Income Taxation: A Review (Jan. 2020).
- Monica Gianni (CSU Northridge), Inventory Sourcing Rules After the U.S. Tax Cuts and Jobs Act: Do the Changes Work?, 90 Tax Notes Int’l 1513 (2018).
- Yehonatan Givati (Hebrew U.), Theories of Tax Deductions: Income Measurement versus Efficiency, J. of L., Fin., & Account. (Forthcoming 2020).
- Adi Libson(Bar Ilan U.) & Gideon Parchomovsky (UPenn), Reversing the Fortunes of Active Funds (Jan. 2020).
- Phil Lord (Mcgill), Ending Poverty (Jan. 2020).
- Chris Mitchell (Osaka U.), The Lock-In Effect and the Corporate Payout Puzzle (Jan. 2020).
- Shu-Yi Oei(Boston College) and Diane M. Ring (Boston College), The Importance of Qualitative Research Approaches to Gig Economy Taxation, in Deepa Das Acevedo, ed., Beyond the Algorithm: Qualitative Insights for Gig Work Regulation (Cambridge University Press, (Forthcoming).
- Oliver N. Okafor (UTRGV), Akinloye Akindayomi(UTRGV) and Hussein A. Warsame (UTRGV), Did the Adoption of IFRS Affect Corporate Tax Avoidance?, 67 Tax J. 947 (2019).
- Francis Okoye (Pan-Atlantic U.), The Influence of Tax Amnesty Programme on Tax Compliance in Nigeria: The Moderating Role of Political Trust, 11 J. of Account. & Tax (2019).
- Suresh Kumar Oad Rajput (Sukkur IBA U.) & Jahanzeb Marwat (Sukkur IBA U.), Tax Avoidance and Earning Management in Pakistan (Jan. 2020).
- Enelia Jansen van Rensburg (Stellenbosch U.), The Application and Interpretation by South African Courts of General Renvoi Clauses in South African Double Taxation Agreements, 22 Potchefstroom Elect. L. J. __ (2019).
- Divya Singh (Columbia), Merging to Dodge Taxes? Unexpected Consequences of VAT Adoption in India (Jan. 2020).
- Samya Beidas-Strom(IMF) and Marco Lorusso (Heriot-Watt U.), Macroeconomic Effects of Reforms on Three Diverse Oil Exporters: Russia, Saudi Arabia, and the UK (2019).
- Sylvia Villios (Adelaide), Digitalization and Future Tax Policy Design, Tax L. Bul. 83 (2019).
- Libin Zhang (Fried Frank), Springtime for Opportunity Zones and Exclusion of All Gain, 165 Tax Notes 1587 (2019).