How companies will game tax cuts By Francine McKenna September 03, 2013 From: Magazine View this article's issue » Share After President Barack Obama pledged this summer to lower corporate taxes by up to 10 percentage points, Washington-watchers say the US Congress seems more likely than ever to pass a reform bill that would simplify the corporate tax code and lower rates. Lowering rates from 35% to 25% would put the United States at a comparable rate to most of its trading partners, according to the Organisation for Economic Co-operation and Development. Corporations, their lobbyists, and many economists have argued that corporate tax cuts will stimulate economic growth. They’ll also stimulate tax-motivated loss-shifting activity, suggests research by Chicago Booth Professor Merle Erickson, coauthored by the University of Rochester’s Shane M. Heitzman and Yale’s X. Frank Zhang. Tax-motivated loss shifting is what a company does to maximize losses in the current year in order to minimize its tax bill, by using those losses to request a refund of taxes paid in prior years. Tax-motivated loss shifting can be accomplished by manipulating recurring transactions, such as writing off obsolete inventory, or coming up with a tax-beneficial nonrecurring transaction, such as writing down a dud acquisition. It happens more often when companies are under financial pressure. Companies will make a bad situation look even worse if they can reclaim taxes paid in prior years. The researchers’ paper says that between 1981 and 2010, companies deliberately increased losses—by frontloading expenses, writing down inventory, or selling assets at a loss, for example—specifically to claim cash refunds of recent tax payments in the time that tax law allowed. The researchers estimate companies with tax-refund–based incentives accelerated about $64.7 billion in losses during the 30-year period. “The loss equates to 11.25% lower reported earnings for the average loss firm with carryback incentives versus comparable firms and implies that incentives for tax-motivated loss shifting play an important role in reported earnings,” according to the study. The researchers also find that if a company expects to report a loss, and has an opportunity to minimize taxes, it’s likely going to find a way to report an even larger loss to take full advantage of the tax benefit. Analysts often missed these moves. When analysts issue forecasts about companies that report a loss to claim a tax refund, their errors are about 2.7 percentage points larger than they are when forecasting about companies without that option. The researchers say that suggests most analysts don’t understand tax-motivated loss shifting. By contrast, investors appear to take the unexpected losses in stride, suggesting they may understand that companies are using losses to take advantage of tax incentives. Companies have incentives to accelerate losses even when statutory tax rates are constant, in part because a tax refund provides cash. Companies with liquidity challenges accelerate losses more aggressively to obtain bigger cash refunds, according to the researchers. Extensions of the carryback period—the period of time during which companies can apply losses to claim a tax refund—have been used to inject liquidity into the system during economic downturns, too. The Worker, Homeownership, and Business Assistance Act of 2009 expanded a net operating loss carryback period extension previously enacted in 2008 to five years from two. Senator Patty Murray argued at the time that the temporary law change “would also provide a critical boost to businesses…This tax provision will provide badly needed capital to help companies avoid layoffs, expand their operations, and create jobs.” Counterintuitively, the incentive to accelerate and increase losses strengthens when corporate tax rates are about to be cut, as happened in 1986, when Congress cut corporate tax rates from 40% to 34%. Since lower tax rates reduce the benefit of taking losses, companies have an incentive to maximize losses before tax rates fall. As the researchers explain, “the benefit of accelerating those losses to generate cash flow is therefore stronger when the firm expects losses in future periods as well.” Why? Cash in hand has a higher value than uncertain tax benefits, perhaps discounted because of lower rates, in the future. It’s no surprise that corporate tax strategy plays, according to the researchers, a “material and persistent role in corporate reporting decisions and capital markets activities.” Works cited Merle Erickson, Shane M. Heitzman, and X. Frank Zhang, “Tax-Motivated Loss Shifting,” Accounting Review, In-press, 2013.