Tax Avoidance and Geographic Earnings Disclosure

This study tests the relation between corporate tax avoidance and disclosure of geographic earnings for U.S. multinational companies. We find that after the adoption of Statement of Financial Accounting Standards No. 131 in 1998, firms opting to discontinue disclosure of geographic earnings in their financial reports experience a decrease in their worldwide effective tax rates through reduced foreign tax rates. These results are consistent with non-disclosure of geographic earnings making it easier (i.e., less transparent) for firms to shift income to lower-tax foreign operations without detection by financial statement users and tax authorities. However, the relation between tax avoidance and non-disclosure exists only until implementation of Schedule M-3 in the annual corporate tax filing beginning in 2004. Schedule M-3 requires a detailed reconciliation of book income to tax income. Part of that reconciliation includes reporting the profitability of each foreign entity that is part of the consolidated financial group but whose net income is excluded from consolidated taxable income. Thus, Schedule M-3 aims to make firms’ tax avoidance activities associated with shifting profits to lower-tax foreign jurisdictions more apparent to the IRS, and our results confirm that it has this effect. This study contributes to our understanding of the interaction between financial reporting behavior and tax reporting behavior.