Analysts are sophisticated market participants who provide an expert evaluation of firms’ likely economic prospects to shareholders, lenders and other stakeholders. However, the ability of analysts to provide reliable forecasts of firm performance is challenged in the context of aggressive tax practices.
Our study examines whether corporate tax avoidance affects analyst forecast accuracy in the Australian capital market.
Corporate tax avoidance and analyst forecast accuracy
As commonly understood in the tax empirical literature, “tax avoidance” here means any action that is designed to reduce tax. It may, but does not necessarily, entail a breach of anti-avoidance provisions in tax legislation.
Analysts’ forecasts inform capital market participants about a firm’s prospects. Both institutional and retail investors rely on analysts’ forecasts in making decisions about whether to buy, accumulate, sell or reduce corporate shareholdings. Therefore, it is important that analysts’ forecasts are as accurate as possible so that the information in the capital market can be relied upon.
The accuracy of analysts’ forecasts is likely to benefit from firm-provided information, such as, financial statements, other managerial voluntary disclosures, and private communications with the top management team. In Australia, it is common for firms to make presentations about their performance and prospects specially for analysts.
Tax avoidance strategies add complexity and uncertainty to firms’ disclosures and operations. Firms are often required to split their tax planning strategies into separate business activities, and possibly, different tax jurisdictions, which makes their earnings more difficult to interpret and predict by market participants.
For example, a multinational firm’s pursuit of transfer pricing strategies to shift profits to lower tax countries makes it harder for outsiders to understand the true nature of a firm’s foreign operations. This is relevant to analysts because the quality of a firm’s information is an important determinant of analyst forecast accuracy.
Firms with higher levels of tax avoidance are expected to be less willing to disclose all the details of their earnings and performance. This is because such disclosures could provide a clear path for examinations by tax authorities, which may lead to their tax positions being disallowed and their tax savings being rolled back in the future. More accurate analyst forecasts are also more likely to be achieved when firms have more persistent earnings.
If a firm’s high earnings in a particular year reflects the extent to which firms pursue risky tax avoidance strategies, then the high earnings are likely to be followed by low earnings in the following years when the risky tax positions are detected by the tax authority. Therefore, if the level of tax avoidance increases information asymmetry and information uncertainty, it would influence analysts’ ability to understand and forecast earnings.
Research methods and empirical findings
We investigate the impact of corporate tax avoidance strategies by considering how tax volatility and tax aggressiveness affect analyst forecast accuracy.
First, measures of tax volatility are associated with uncertainty regarding the future earnings of a firm. The more uncertain the firm’s tax strategies, the greater the probability that the firm will have to reverse their tax positions and pay back their tax savings in the future. All other things being equal, firms that have greater volatility in their reported tax outcomes will have less persistent earnings, which will make earnings less predictable by analysts.
Second, given that firms of similar size in the same industry have similar levels of corporate complexity and tax avoidance opportunities, we capture tax aggressiveness by comparing firms’ tax behaviour against that of their industry-size peers. The fact that a firm is able to pay less tax compared to others of the same size and in the same industry group suggests the pursuit of active tax planning or tax aggressive strategies.
Tax volatility and tax aggressiveness are associated with earnings volatility and reduced transparency in financial reporting. They are therefore expected to increase the difficulty of forecasting corporate earnings, and to reduce analyst forecast accuracy.
To identify the mechanisms through which tax avoidance affects the accuracy of analyst forecasts, we analyse different aspects of forecasts made at different times of the financial year, including analysts’ after-tax earnings per share forecasts at the beginning and end of the year, and their forecasts of pre-tax income as well as after-tax income.
Controlling for other factors that could also affect analyst forecast accuracy, we find that analyst forecast accuracy declines as tax volatility and tax aggressiveness increase. These findings indicate difficulty in understanding the implications of tax avoidance for both the tax and non-tax components of earnings.
Our empirical results highlight that the consequences of aggressive corporate tax practices extend beyond potential losses of tax revenue. By reducing the accuracy of analysts’ forecasts, corporate tax avoidance impedes participants in the Australian capital market from making informed decisions.
Implications and a comment on the public CbC regime
In the last decade, the Australian government introduced several measures that aim to curtail corporate tax avoidance, particularly by multinational enterprises (MNEs), and these include enhanced disclosure requirements.
Our research findings support the imposition of enhanced disclosure requirements for Australian firms. Specifically, we expect that more extensive public disclosure requirements would not only curb corporate tax avoidance but would also reduce information asymmetry and improve the accuracy of analysts’ forecasts of corporate earnings.
Australian government policy recognises that “[t]ransparency is a key factor underpinning the integrity of the tax system” and notes that improved transparency is one of the three key pillars of the OECD Base Erosion and Profiting Shifting (BEPS) project. The major BEPS disclosure measure is mandatory Country by Country (CbC) reporting for large companies (CbC reporting entities), which was legislatively implemented in Australia from 1 January 2016.
The CbC legislation requires regulated companies to disclose various categories of information to the Australian Tax Office (ATO), with the purpose of providing the ATO an informed basis to evaluate transfer pricing risks and commence tax audits. The information covers the company’s global operations and activities, pricing policies relevant to transfer pricing, and their global allocation of income, and tax paid among countries in which members of the MNE operate.
An essential feature of the CbC reporting regime enacted in 2016 was confidentiality between the taxpayer and the regulator. This was seen as “the foundation of a collaborative relationship” between companies and the tax authority.
Since the publication of our article, we note that the government has legislated a public CbC reporting regime (effective from the 2024-2025 fiscal year), which applies to parent companies under the existing CbC regime, provided $10 million of their aggregated annual turnover is Australian-sourced. The public CbC regime will apply in addition to the confidential disclosures that MNEs make to the ATO.
The major items to be reported are the names of each entity in the CbC group, a description of the group’s approach to tax, information about Australia and “specified jurisdictions” on a CbC basis, and information about other jurisdictions, either on a CbC basis or an aggregate basis. The ‘specified jurisdictions’ list includes numerous tax havens (including British Virgin Islands, Cayman Islands, Vanuatu) and low-tax jurisdictions (including Singapore, Switzerland).
In our view, the public CbC reporting regime is a good policy development as stronger measures to increase tax transparency were clearly needed due to serious deficiencies with the two existing measures: the Voluntary Tax Transparency Code (VTTC) and the Corporate Tax Transparency Report (CTTR).
In 2022, the government had launched consultation to specifically increase public “multinational tax transparency”, on the basis that “public tax transparency has an important role in ensuring MNEs pay their fair share of tax”, emphasising the “benefits of extra public scrutiny”.
The government had acknowledged “claims that the current transparency reporting framework is deficient”, noting the “low uptake” of companies under the VTTC and the limited items disclosed pursuant to the CTTR. The VTTC does not provide a suitable template for a mandatory regime because it does not require standard formats and impedes comparability. Whether the public CbC requirements provide disclosures useful to stakeholders, including analysts, cannot yet be reliably evaluated.
As Kerrie Sadiq, Richard Krever and Rodney Brown note, for any public tax transparency regime to be useful, readability and comprehensibility must be a key priority. In Europe, Brown’s findings indicate that public CbC reporting for EU banks has not curtailed tax avoidance, and the difficulty of comprehending the data and reports required under CbC data may be a contributing factor.
As suggested by Andrew Johnston and Kerrie Sadiq, the inclusion of qualitative data that provides information as to the structure of the corporate group, related party transactions, and the worldwide location of the company’s operations may assist in allowing stakeholders to understand the extent of a firm’s tax aggressive practices. We suggest an important topic of future research would be to assess whether public CbC disclosures improve tax transparency and the information environment for capital market participants.
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