Financial Derivatives in Corporate Tax Avoidance: Outcomes and Determinants

Abstract:     
Although derivatives are increasingly used to avoid corporate taxes, existing evidence is largely anecdotal. This study empirically investigates the extent to which tax avoidance is an outcome of derivatives use, whether tax avoidance is a determinant, and if derivatives-based tax avoidance is evident from derivatives disclosures. I find that (1) firms’ current and cash taxes paid decrease by 1.7 and 4.0 percentage points, respectively, following derivatives implementation; (2) these benefits increase with derivatives magnitude, result from timing strategies, and are not explained by risk management; (3) a derivatives-based tax avoider is illiquid and has few existing tax benefits and no risk management motive for using derivatives; (4) firms’ proclivity for aggressive tax avoidance influences derivatives initiation; and (5) tax aggressive firms implement derivatives to maintain low taxes. While tax avoidance is both an outcome and determinant, recently enhanced derivatives disclosures are of little value for detecting such behavior.

Number of Pages in PDF File: 45

Keywords: financial instruments, derivatives, tax burden, tax avoidance, tax aggressiveness, hedge, speculate

JEL Classification: G32, H25, M41, M48

working papers series