Want to Pay Less Tax? Improve Your Firm’s Internal Reporting

When companies engage in the great American pastime known as tax avoidance, many parse the Internal Revenue Code for loopholes to reduce their effective tax rate. But research suggests they should also scrutinize the quality of their internal reporting.

Internal information quality (IIQ), a term coined by Chicago Booth’s John Gallemore and University of North Carolina’s Eva Labro, encompasses computer reporting systems and any other resources that a company devotes to ensuring the quality and ease of access of information within a firm. The elements that constitute IIQ have been largely overlooked in tax-avoidance literature—perhaps because they are usually not observable, and are difficult for academics to measure.

Gallemore and Labro argue companies should pay more attention to these issues, which they define in terms of the accessibility, usefulness, reliability, accuracy, quantity, and signal-to-noise ratio of the data and knowledge within an organization. Their findings suggest that firms with high IIQ tend to enjoy lower effective tax rates and, all else being equal, a smaller tax bite.

Gallemore and Labro employed four publicly available variables, using data from 1994 to 2010, to rate firms’ IIQ: the speed at which management released an earnings announcement after its fiscal year closed, the accuracy of management’s earnings forecasts, the absence of material weaknesses in internal controls, and the lack of restatements due to errors.

The researchers used these measures to identify companies that released earnings more rapidly and forecasted them more accurately, and had fewer Section 404 citations and restatements due to errors. They assigned these firms higher IIQ ratings.

High-IIQ firms, they find, tend to exhibit some positive traits, including centralized and standardized business transaction processing, more-efficient reporting practices, and the ability to share data across business units and geographical locations. Because these firms have timely access to accurate information as well as enhanced internal transparency, it’s easier for employees to find and assess information. That makes the firm better positioned to use accounting techniques to shift corporate income from high-tax locations to lower-tax ones, and to coordinate tax planning across the different parts of the firm, says Gallemore.

When IIQ is low, by contrast, a company may miss out on tax-reducing opportunities, its tax risk might be higher, and any tax-avoidance measures that it takes may be jeopardized during an audit if the firm’s documentation is deemed unacceptable to tax authorities.

Gallemore and Labro tested the relationship between IIQ measures and a firm’s ability to avoid taxes by performing a regression analysis—a statistical process for estimating the relationships among variables—between the company’s IIQ measures and the firm’s cash-effective tax rate.

The results point to a significant economic and statistical link between IIQ and tax-avoidance efficiency. Also, high-IIQ firms—particularly those doing business in dispersed geographies and more-uncertain operating environments—tend to achieve both increased tax avoidance (leading to lower effective tax rates) and decreased tax risk, or reduced uncertainty regarding the firm’s eventual tax bill.

Companies that have internal information deficiencies and fail to address them can suffer significant negative consequences. For example, when the IRS denied more than $175 million in research-and-development tax credits claimed by Bayer Corp. from 1998 to 2004, the German multinational maintained it was owed those credits, but predicted that it would take several years to sort through the documentation because the company’s accounting system could not readily provide the required information. As of mid-February, the case was still being argued.

Additionally, although globally coordinated transfer-pricing schemes—where companies use internal pricing to charge off more costs to high-tax domiciles, reducing taxable income—can allow multinational firms to avoid substantial amounts of taxes, a 2010 Ernst & Young survey indicated that only 41 percent of multinationals prepared transfer-pricing documentation concurrently on a globally coordinated basis, report Gallemore and Labro.

A low IIQ may also result in opportunity costs. For example, a high-IIQ firm that is providing management with real-time information about a company’s financial condition can enjoy improved decision-making, which can lead to improved profits. A high-IIQ environment can also enable companies to issue their monthly or other periodic financial reports in a more timely manner.

With all of the positives associated with a high level of IIQ, and the realized and opportunity costs that come with a low IIQ, why don’t more firms address the issue?

One reason is the costs involved in upgrading a company’s reporting system, according to Gallemore. Multinational firms, in particular, may incur significant initial costs, thanks to the many tax regimes and currencies that have to be considered.Internal turf battles may also inhibit the adoption of an IIQ-centric reporting system. That’s because the effort adds personnel and other hard costs across the organization, while providing visible benefits to a limited number of departments—even though over time the entire enterprise will benefit from the improved IIQ. The advantages, Gallemore says, may go beyond tax-planning efficiency to encompass improved capital-investment decision-making and other benefits.