Compensation in the Post‐FIN 48 Period: The Case of Contracting on Tax Performance and Uncertainty

Abstract

Academic and anecdotal evidence indicates that incentive systems often provide short-term payouts without regard for long-term consequences. New detailed disclosures mandated by FIN No. 48, Accounting for Uncertainty in Income Taxes, enable us to use a tax setting to investigate whether boards adjust performance-based pay for uncertainty. We find managers' bonus payouts are positively associated with tax performance; however, bonus payouts are lower when measures of ex ante tax uncertainty are higher. Our results are robust to tests of alternative explanations including financial reporting aggressiveness, overall firm risk, and other forms of compensation. Further, we document that the relation between bonus compensation and tax performance has changed in the post-FIN No. 48 period. Specifically, we identify a significant association between bonus payout and GAAP ETR only in the pre-FIN No. 48 period and a significant association between bonus payout and cash ETR only in the post-FIN No. 48 period, suggesting that the relation between compensation and tax avoidance should be examined carefully with particular attention to the post-FIN No. 48 period.Ceteris paribus, we expect managers who achieve current tax performance (avoidance) associated with less uncertainty (lower UTB) will receive higher performance-based pay. 2 To test our research question, we analyze an unbalanced panel of 1,468 CEO-years consisting of 458 unique firms from ExecuComp over a sample period from 2007 to 2012. However, because not all boards place the same emphasis on tax avoidance, we also use disclosures made in the Compensation Discussion and Analysis (CD&A) section of firm proxy statements to classify firm-years into two groups: "tax-focused," in which the firm uses at least one after-tax measure in the bonus contract, and "non-tax-focused," in which the firm does not use after-tax measures in the bonus contract.Using a two-stage Heckman (1979) approach to control for the board's choice to compensate on an after-tax basis, we estimate the sensitivity of CEOs' bonus payouts to tax performance, measured by 1 À CashETR (the cash effective tax rate). We find that, on average, boards reward managers who achieve higher tax performance (avoid more taxes) with higher bonuses, but only within our subsample of "tax-focused" firms. In other words, payouts vary with performance, but as expected, only among the subset of firms with bonus contracts that include tax incentives. Next, we interact tax performance with tax uncertainty, as measured by additions to the UTB related to current-year tax positions. Consistent with our expectations, we find that boards adjust managers' bonus payouts downward for uncertainty in the firm's underlying tax positions. We interpret our results as evidence that boards reward tax performance but penalize (reward at a lower rate) managers for performance achieved with uncertainty, consistent with the model proposed in De Waegenaere, Sansing, and Wielhouwer (2015).We explore alternative explanations for our findings in...

Corporate tax risk: a literature review and future research directions

“…Kubick and Masli (2016) document that tournament incentives are associated with higher corporate tax aggressiveness. Furthermore, Brown et al (2016) reveal that executives receive higher bonuses for achieving greater tax avoidance with lower levels of tax uncertainty. However, further studies are needed to investigate whether the tax risk also has an impact on the overall compensation offered to managers, which includes both fixed and variable components in the short, mid, and long term.…”

“…48 (FIN 48, effective for fiscal years beginning after December 15, 2006) (see Watrin et al 2019). US GAAP requires that if a firm has a position in its tax return that may not be approved by the tax regulators, and may bear incremental tax payments after a tax investigation, it has to disclose any unrecognized tax benefit (Brown et al 2016;Watrin et al 2019). In the context of IFRS, the International Financial Reporting Interpretations Committee (IFRIC) announced IFRIC 23 (guidance for uncertainty over income tax treatments, effective for the fiscal year beginning January 1, 2019).…”

The predictive ability of tax contingencies for future income tax cash outflows

“…Similarly, J. Brown et al (2016) find that corporate boards consider UTBs when compensating management and reduce remuneration when managers avoid taxes by inducing relatively more tax uncertainty.…”

“…From a tax perspective, the UTB is a contingent liability that should be useful, on average, for predicting future income tax cash payments (J. Brown et al, 2016). Despite FIN 48 provoking the greatest interest in accounting for income taxes since the enactment of Statement of Financial Accounting Standards (SFAS) No.…”

“…Some studies find that managers circumvent its prescriptions (De Simone et al, 2014; Robinson & Schmidt, 2013), while others find that the disclosures are useful to stakeholders (J. Brown et al, 2016; Hasan et al, 2014). Another line of research examines the impact of FIN 48 on the extent to which income tax expense explains future cash taxes paid.…”