INTRODUCTION
The financial accounting disclosures of unrecognized tax benefits (UTB) made by publicly traded corporations have garnered significant interest in the academic literature (e.g., Blouin, Gleason, Mills, & Sikes, 2007; Donohoe, McGill, & Outslay, 2012; Robinson & Schmidt, 2013). The IRS also demonstrated a keen interest in these disclosures when they introduced Schedule UTP, Uncertain Tax Position, on January 26, 2010, in a speech by IRS Commissioner Douglas Shulman. During this speech, Commissioner Shulman expressed a need to increase IRS audit efficiency and transparency while reducing the amount of time spent searching for taxpayer issues (Shulman, 2010). Schedule UTP requires corporate taxpayers with more than US$10 million in total assets to disclose details of the uncertain tax positions that comprise the US portion of their worldwide UTB balance.1
Our research objective is to examine whether the Schedule UTP disclosure has led to more timely identification of uncertain tax positions. A more timely identification of uncertain tax positions after Schedule UTP was implemented would suggest Schedule UTP has been an effective audit tool to the IRS. Whether Schedule UTP has been an effective audit tool to the IRS is an important research question for a number of reasons: (1) it represents a significant change in tax administration, (2) it appears the IRS may rely more on Schedule UTP than on Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, as an audit tool in the future, and (3) it has emerged amidst substantial IRS budget cuts.
Former IRS Commissioner Lawrence Gibbs described Schedule UTP as âthe biggest change in tax administration in the last 50 yearsâ (Fahey, 2011), while academics suggested that it represented âthe broadest form of corporate tax disclosure yetâ (Lipin, 2012). Shortly after Schedule UTP was introduced, the IRS stated that it would likely âreduce the need for some of the information currently reported on the Schedule M-3â (IRS, 2010). In the years after Schedule UTP was introduced the budget of the IRS was reduced by 10 percent, including a budget and employee reduction in 2015 of US$346 million and 17,000, respectively (Hicks, 2015). This reduction in IRS resources further heightens the importance of automated, standardized audit tools, such as Schedule UTP in the audit process of the IRS.
To assess whether Schedule UTP has been an effective audit tool to the IRS we examine the probability of a reduction in unrecognized tax benefits due to a lapse in the statute of limitations.2 For ease of exposition, we use Lapse (not italicized) as an abbreviation for âreductions in unrecognized tax benefits due to a lapse in the statute of limitations.â The statute of limitations limits the amount of time the IRS has to assess a deficiency to three years.3 When a corporation is able to recognize the benefit of an uncertain tax position because the statute of limitations expires, it signifies lost revenue that may have been collected but for an inefficiency in the taxing authorities audit process â the position was not identified and examined timely. A reduction in Lapse after Schedule UTP would suggest that the IRS has been able to identify and examine uncertain tax positions in a timelier manner, i.e., before the three-year statute of limitations expires. As such, if Schedule UTP has been effective in helping the IRS identify and prioritize tax issues, then we expect to document fewer incidences of a Lapse after a firmâs third Schedule UTP filing.
We also consider whether Schedule UTP has been more effective in the audit of US domestic-only firms (hereinafter, domestic firms) or US multinational firms (hereinafter, multinational firms). Because Schedule UTP relates to only the US portion of a firmâs worldwide unrecognized tax benefits, this IRS disclosure may prove to be more effective in the audit of domestic firms relative to multinational firms. For domestic firms, most, if not all, of their uncertain tax positions are required to be reported on Schedule UTP.4 In contrast, a number of the uncertain tax positions that comprise the UTB of a multinational firm may relate to foreign jurisdictions, which are not subject to Schedule UTP. However, the increased IRS focus on cross-jurisdictional income shifting and other tax avoidance activities of multinationals in recent years (Spencer, Thomas, & Welty, 2015) suggests that the IRS may use Schedule UTP to better understand the tax strategies of multinational firms.
Using a sample of 7,173 domestic and multinational firm-year observations spanning the years 2007â2015, our multivariate analysis supports the conclusion that Schedule UTP has been an effective audit tool to the IRS. Specifically, we find that after Schedule UTP the probability of a Lapse is 2.1 percentage points lower (3.4 percent lower than the sample mean). However, the decline in the likelihood of a Lapse is driven by domestic firms, supporting the conclusion that Schedule UTP has been an effective audit tool to the IRS for domestic firms but not multinational firms. Our results indicate that the likelihood of a Lapse after Schedule UTP is significantly less for domestic firms but not multinational firms. We find that the probability of a Lapse after Schedule UTP is 9.4 percentage points lower for domestic firms than for multinational firms. Taken together, the multivariate results suggest that Schedule UTP has been an effective audit tool and is more effective in the audit of domestic firms.
Additionally, we investigate whether investors anticipated that Schedule UTP would be a more effective audit tool to the IRS for domestic firms or multinational firms. We test this hypothesis following the event study approach in Abernathy, Davenport, and Rapley (2013) and find that shareholders of both domestic and multinational firms reacted negatively to the initial announcement of Schedule UTP on January 26, 2010. However, our results suggest that the positive reaction to the finalization of Schedule UTP on September 24, 2010, documented by Abernathy et al. (2013) was isolated to multinationals.5 Thus, while Abernathy et al. (2013) find that investor reaction to Schedule UTP was initially negative and later positive, we find that investors in domestic firms reacted only negatively to Schedule UTP. Taking into consideration our ex-post finding that the likelihood of a Lapse is significantly lower for domestic firms after Schedule UTP, the ex-ante concerns of investors in domestic firms with respect to Schedule UTP appear to have been warranted.
Our results shed light on whether the IRS has been able to use Schedule UTP to identify audit issues. Relatedly, our study should be informative for the debate on whether the IRS should rely more on Schedule UTP and less on Schedule M-3 to identify audit issues in the future.6 Practitioners have argued that the combination of Schedule UTP and Schedule M-3 was duplicative, awkward, and a compliance burden, concluding that the IRS should reduce the overlap (Lipin, 2012). In October 2010, the IRS announced the creation of a working group aimed at reducing the duplicative nature of Schedule M-3 and Schedule UTP and has since moved in the direction of placing more emphasis on Schedule UTP and less on Schedule M-3.7
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