Three Studies on SEC Tax-Related Comment Letters

Abstract

The US Securities and Exchange Commission (SEC) has consistently listed tax disclosures as one of the top ten focus areas in its comment letters issued on firms' public financial disclosures. Prior studies show that SEC tax-related comment letters affect firms' tax avoidance (Kubick et al. 2016), equity value (Edwards et al. 2019) and analyst forecast accuracy (Ehinger 2020). In three studies, this thesis makes a novel contribution to the literature in this important area by investigating the effects of tax-related comment letters on the bond market response, firms' tax disclosure informativeness and firms' tax planning strategies.

Study 1 examines the effect of SEC tax-related comment letters on the informativeness of unrecognised tax benefits (UTBs) for future tax cash flows. UTBs reflect future tax payments that could be required if firms' uncertain tax positions are overturned by the tax authorities. Prior research suggests that UTBs are informative for predicting firms' future cash outflows (Ciconte et al. 2024). I find that firms' UTB disclosures become less informative after receiving tax-related comment letters. This suggests that greater tax-related regulatory scrutiny can lead to more bias in the recognition and measurement of UTBs. Further analysis shows a negative influence of SEC tax-related comment letters on the investor valuation of UTBs. This loss of UTB informativeness is associated with managers underestimating UTBs, thereby reducing the visibility of their tax positions from the tax authorities. My findings contribute to the disclosure regulation literature by showing a situation where heightened regulatory scrutiny does not enhance firms' tax disclosure informativeness.

Study 2 explores whether SEC tax-related comment letters affect conforming tax avoidance. Conforming tax avoidance involves tax planning strategies that reduce firms' book and taxable incomes simultaneously. I find that after resolving tax-related comment letters, firms increase their use of conforming tax planning strategies. In contrast, firms decrease nonconforming tax avoidance activities (Kubick et al. 2016), where taxable income is reduced without reducing book income. Overall, there is no significant change in firms' total levels of tax avoidance following the resolution of tax-related comment letters. This suggests that firms substitute the riskier nonconforming tax planning with conforming tax planning in response to increased regulatory scrutiny of tax disclosures. Additionally, managerial decisions to pursue conforming tax avoidance are found to be constrained by capital market pressure and debt contract covenants, while they are encouraged by executive equity incentives and good corporate governance. These findings collectively provide insights into how regulatory scrutiny on tax disclosures influences firms' trade-offs between different tax planning strategies.

Study 3 investigates the bond market response to the common issues raised in SEC tax-related comment letters. I find a negative bond market reaction following the public release of tax-related comment letter conversations. This is consistent with bondholders reassessing firms' tax risk following revelation of deficiencies or ambiguities in financial statement tax disclosures. This negative reaction concentrates on conversations involving deferred tax issues that contain information about estimated future cash flows, but does not apply to disclosures related to current tax positions. Bondholders also respond negatively to SEC enquiries into complex tax disclosures. Taken together, the disclosure of tax-related future cash flows and tax disclosure complexity constitute critical components of tax disclosure risk for bondholders. My findings shed light on the role of tax-related regulatory scrutiny in the bond market. Show more