The Impact of Large Tax Settlement Favorability on Firms' Subsequent Tax Avoidance

Abstract

I consider how large tax settlements compare to management expectations and then test how the favorability of a resolution (from the firm’s perspective) affects subsequent tax avoidance. Using unrecognized tax benefit information disclosed in firms’ tax footnote, pursuant to FIN 48, I develop and validate a measure of large tax settlement favorability. I find that firms with relatively favorable settlements subsequently increase their tax avoidance but that firms with relatively unfavorable settlements do not change their behavior. The implication is that favorable settlements inform management of weak tax monitoring or opportunities to avoid taxes. In additional analysis, I find that increasingly unfavorable settlements are positively associated with the likelihood of a tax-related restatement announcement. Overall, these findings illustrate how tax settlement favorability has reporting consequences for both subsequent tax returns and the financial statements.

Keywords: tax enforcement, tax avoidance, FIN 48

JEL Classification: H26, K42, M41