Corporate Tax Compliance: The Role of Internal and External Preparers Kenneth Klassen, Univ. of Waterloo Petro Lisowsky, Univ. of Illinois Devan Mescall, Univ. of Saskatchewan 2012 IRS Research ConferenceJune 21, 2012

Disclaimer Confidential tax return data are obtained from the IRS via the Large Business & International Division. These data are not publicly available. Because tax return data are confidential and protected by data non-disclosure agreements under the Internal Revenue Code, all statistics are presented in the aggregate; no statistics with three or fewer observations are disclosed. Any opinions are those of the authors and do not necessarily reflect the views of the Internal Revenue Service.

Overview How do companies incorporate tax incentives into their decisions? What is the process that leads some companies to use aggressive tax strategies? Does the tax advisor matter? – If the company internally prepares, will it report differently for tax purposes? – Is there a difference between external advisors depending on if they are also the auditors?

Research questions Specific questions addressed ① Do internally-prepared tax returns differ from those with an external advisor? ② Do auditor firm preparers differ from other preparers in the aggressiveness of the resulting tax positions? ③ Can we infer tax compliance work from public tax fee data?

Why are these questions important? The role of tax advisors is important to the working of the tax system – Renewed focus by IRS on role of preparers Tax advisory role is significant – $816 M in Tax Fees paid to Auditors in our sample – Role of preparers in individual and non-profit settings; little known in corporate setting Tax fees are used extensively in research – What do they suggest about tax compliance work, if anything? Can we use them? If so, how?

Survey Tax Executives Institute Survey – October - December 2010 – 8.1% response rate – Our respondents: slightly larger than TEI population – Tool to “look inside” the corporate tax department

Theory Why choose one preparer over another and how does this affect tax reporting outcomes? Phillips and Sansing (1998) Taxpayers have an aversion to audit adjustments – Affects whether taxpayers file favorable position if uncertain; more averse taxpayers will not file favorably.

Theory Low Aversion  Internally Prepare – Fees paid to hire advisor are greater than the benefit of certainty from advisor’s research – Internally prepared returns signal favorable positions Medium/High Aversion  Hire External Advisor – Research causes favorable or unfavorable filing H1: Tax returns filed w/o external preparer will be more aggressive than those filed w/external preparer

Theory Cripe and McAllister (2009) survey: – “Low Cost” was #1 reason to use auditor as preparer – 31% pay higher fees by foregoing auditor as preparer – To be rational, benefits from external non-preparer must exceed incremental cost: “preparer quality” was #2 reason to not purchase tax services from auditor. If external non-auditors are higher quality, marginal taxpayers can report more favorably when uncertain. H2: Tax returns filed with a non-auditor external preparer will be more aggressive than those filed with an auditor preparer.

Research Design Log(UTB EB) = f(INTERNAL PREP, OTHER PREP, Controls) OLS, Tobit, Multinomial Treatment Effects Tax Return, Compustat, FIN 48 disclosures, Audit Analytics

Who Signs the Tax Return? External Tax Preparer: is the Auditor 312 (20%) is not the Auditor 378 (25%) Total External 690 Internal Tax Dept. 843 (55%) 81% disclose tax fees paid to the auditor

Main Results OLSTobitSelection Internal Prep 0.29**0.35*** 0.67*** Other Prep 0.22*0.27*0.55** Log Assets 0.92***0.96***0.90*** Pretax ROA Foreign Income 3.48***3.48**3.27** NOL 0.28***0.30***0.28*** R&D 2.50**2.54*2.60** Leverage n 1,533 R2R2 60%***21%*** Tax reserve is 29-67% higher for Internal Prep Tax reserve is 22-55% higher for Other Prep

Selection Model Internal PrepOther Prep Log Assets 0.66***-0.13 Pretax ROA Foreign Income 5.15*-0.18 NOL R&D -5.06*2.51 Leverage Non-tax fee ratio -1.64*-2.07* n

Analysis with Tax Fee Data Because only tax fees paid to auditors are publicly disclosed, many have used them – As a proxy for tax planning level, use of the auditor for compliance, or other features We attempt to replicate our results using tax fees – Are tax fees a reasonable proxy to infer compliance? We cannot replicate the positive coefficient using tax fee data to infer tax preparer

Benchmark: Using Tax Returns OLSTobit Non Auditor Prep 0.26**0.32** All Controls YES Adj./Pseudo R 2 60%***20%*** n 1,533 Non Auditor Prep = 1 if Internal Prep =1 or Other Prep = 1

Iterations: Using Tax Fees Non Auditor Prep=1 if OLSTobit Tax Fees= Tax Fees/Total Fees < 1% Tax Fees/Total Fees < 5% -0.14* Tax Fees/Total Fees < 10% Tax Fees/Total Fees < 25% -0.30**-0.35*** Tax Fees/Total Fees < 50%

Classification Accuracy 10-K suggests non -auditor prepares, but auditor prepares 10-K suggests auditor prepares, but a non -auditor prepares

Conclusion Companies choose a variety of preparers, but most do compliance and planning work internally Relative to companies with external auditor preparers – Companies with internally prepared returns are more tax aggressive – Companies with external non-auditor prepared tax returns are also more tax aggressive Tax-fees are not sufficient to infer tax compliance work – 20-62% inaccuracy rate

Thank You!