How CFOs Maximize Corporate Tax Cuts

In a speech last Tuesday to workers at an Amazon facility in Tennessee, President Obama gave Congress some new ideas about proposed tax reform while repeating his earlier support for cutting the corporate tax rate to 28 percent from 35 percent. The President is now suggesting manufacturers should get a 25 percent special rate to spur jobs and economic growth. Some timely research by Chicago Booth’s Merle Erickson, along with the University of Rochester’s Shane M. Heitzman and the Yale School of Management’s X. Frank Zhang may shed light on what corporations will do when they know these tax cuts are coming for certain.

CFOs may already have their favorite tax “surgeons” on speed dial because the research says corporations will likely take advantage of any significant drop in corporate tax rates to substantially increase their tax-motivated loss shifting activity. Under current tax law, companies can maximize the tax benefit of potential losses, especially if corporate tax rates are going lower, by moving as much loss into the current period as possible.

There’s more incentive, according to the researchers, to accelerate and increase losses when corporate tax rates are about to fall because the tax deduction is worth more to the company at higher rates. For example, when Congress cut corporate tax rates in 1986, from 40 percent to 34 percent, this rate reduction provided firms with “stronger incentives to accelerate losses between 1987 and 1990 in order to generate a refund of taxes paid at the higher rate," the researchers noted.

Loss shifting around the 1986 Tax Act focused on decreasing gross margins and increasing selling, general, and administrative expenses such as salesmen’s commissions, bonuses and other marketing-related costs. Gross margins will go down if cost of goods is temporarily increased via higher inventory write-offs for scrap, shrinkage, and obsolescence, for example. As the researchers explain, “the benefit of accelerating those losses to generate cash flow is therefore stronger when the firm expects losses in future periods as well.” Why? Cash in hand is worth more than uncertain future tax benefits, perhaps discounted for lower rates in the future.

The severe economic downturn after the financial crisis drove losses in more companies and more sectors for prolonged periods. Tax losses are a now critical component of many corporate valuations. Companies with weak share prices are also more vulnerable to hostile takeovers. Takeover defenses are now strategically designed to preserve tax losses, since Internal Revenue Code Section 382 limits the use of net operating losses if one or more of the company’s 5% shareholders increase ownership by more than fifty percentage points within a three-year period.

Legislators have liberalized tax laws in the past to allow longer tax loss carry back periods, in the hope that the larger corporate tax refunds would flow into the economy. Tax-based incentives have always significantly influenced corporate financial reporting decisions even when tax rates were stable. When tax rates are expected to change significantly, the impact on the capital markets should not be underestimated or ignored.

The paper, “Tax-Motivated Loss Shifting,” is pending publication in The Accounting Review.