Tax Avoidance vs.

Tax Aggressiveness:
A Unifying Conceptual Framework

Gerrit Lietz
University of Mnster
gerrit.lietz@wiwi.uni-muenster.de
Working Paper
Current draft: 12/2013

Abstract

I develop a unifying conceptual framework of corporate tax planning. The framework accommodates constructs frequently studied in empirical tax accounting research, i.e. tax avoidance, tax aggressiveness, tax
sheltering, and tax evasion, by relating them to the seminal notion of effective tax planning presented in
Scholes and Wolfson [1992]. Most importantly, literature knows no universal approach to the constructs of
tax avoidance and tax aggressiveness (Hanlon and Heitzman [2010]). In search of a useful reference point
to delimit non-aggressive from aggressive tax avoidance, I put a particular focus on the more-likely-thannot probability of a tax transaction being legally sustainable upon potential audit (Lisowsky, Robinson, and
Schmidt [2013]). I further provide an overview of commonly used and recently suggested empirical
measures of the underlying constructs and discuss their context-sensitive strengths and weaknesses. Finally,
I arrange the measures along the lines of the proposed conceptual framework in an attempt to provide guidance as to which proxy most adequately reflects which conceptual construct. Although a demanding task,
the promotion of a sound theoretical understanding and careful empirical handling of the relevant tax constructs should enrich the discussion and foster consistent inferences.
Keywords: Tax avoidance; tax aggressiveness; corporate tax planning; conceptual framework.
JEL Classification: H20; H25; H26; M41

I thank Bradford Hepfer, Adrian Kubata, Sven Nolte, John Robinson, Tim Wagener, Christoph Watrin, Ryan Wilson, and
brown bag seminar participants at the Mnster Institute of Accounting and Taxation for their comments and suggestions.

Electronic copy available at: http://ssrn.com/abstract=2363828

1.

Introduction

Empirical tax research in accounting knows no uniform definition of frequently investigated constructs, such as tax avoidance or tax aggressiveness (Hanlon and Heitzman [2010], Dunbar,
Higgins, Phillips, and Plesko [2010]). Some consider these terms to describe essentially the same construct and hence use them interchangeably.1 However, others interpret avoidance to have a different
meaning than aggressiveness, and consequently prefer one expression over the other, sometimes
further depending on the specific research context (e.g., Balakrishnan, Blouin, and Guay [2012]). Beyond that, tax avoidance and tax aggressiveness are both related to tax sheltering, which itself is subject to extensive research and ongoing public debates (e.g. Weisbach [2002a], Wilson [2009],
Lisowsky et al. [2013], U.S. Department of Treasury [1999]). Finally, some may be able to clearly
distinguish between the constructs of tax sheltering and tax evasion, while yet others may perceive
sheltering and evasion to be rather similar in that they share a criminal or fraudulent connotation.
In this study, I develop and illustrate a conceptual framework that strives to promote a shared understanding about commonly investigated constructs of corporate tax planning. This framework is unifying in putting constructs with a focus on explicit income tax reductions in perspective with the fundamental Scholes-Wolfson theme of global effective tax planning, which advocates the consideration of
all parties, all taxes, and all costs (Scholes and Wolfson [1992]).2 The goal is to comprehensively discuss and best possibly delimit the explicit tax planning constructs that continue to be investigated
in a large and growing body of empirical research (see Shackelford and Shevlin [2001], Hanlon and
Heitzman [2010], and Lietz [2013] for reviews). A thorough conceptual framework further provides a
basis for an orderly assessment of the various empirical proxies, which have been developed to operationalize the discussed constructs. In sum, an advanced conceptual understanding may provide opportunity for greater consistency in future research and improve inferences made from corporate data.
Given the plurality of possible perceptions of explicit tax planning constructs, a conceptual framework
must be capable of accommodating existing constructs, but also leave room to include perceptions that

E.g. Chen et al. [2010], Huseynov and Klamm [2012], or Katz et al. [2013]. Further, some may prefer to use
alternative terms such as tax management (e.g. Minnick and Noga [2010]) to describe essentially what is
more commonly referred to as general tax avoidance (as e.g. proposed in Dyreng et al. [2008] and Hanlon
and Heitzman [2010]).
The seminal textbook is currently available in its 4th edition, Scholes et al. [2009].

Electronic copy available at: http://ssrn.com/abstract=2363828

may yet emerge in the future. A comprehensible classification of explicit tax planning manifestations
should also be accompanied by a clear use of terminology. However, simply agreeing on one single
term (e.g. just tax avoidance or just tax aggressiveness) for in fact a wide and diverse range of
explicit tax actions may not always proof useful. A simplified, yet no longer differentiated use of terminology can complicate the study of related, but still different notions of explicit tax planning. Sometimes it appears rewarding to study constructs individually and/or in their own particular contexts in
order to reach flawless conclusions and consistent implications.
With a view to ongoing political debates circulating around noncompliant corporate tax behavior and a
growing public perception of corporate tax unfairness, it appears particularly advisable to raise concerns about the undifferentiated use of tax planning terminology. Accusations of corporate tax misbehavior have gained momentum in the light of the recent financial crisis, tight economic budgets, closeto-zero corporate effective tax rates, and the revelation of large-scale offshore tax haven use.3 Unfortunately, public and political concerns with regards to corporate tax savings are often ambiguously
stated in that they do not clearly enough differentiate between potentially unfavorable tax avoidance,
particularly aggressive types of tax avoidance (e.g. the use of tax shelters?), and most likely criminal
forms of tax evasion. In order to promote a more target-oriented debate, especially with a view to the
general desire to improve the fairness a construct which itself is already difficult to handle 4 of
the tax system, all involved parties may eventually benefit from a more careful handling of relevant
tax constructs. An imprecise use and recitation of different tax planning constructs can increase the
risk that opinion-forming institutions, and regulators themselves, mistakenly convey the impression
that any sort of tax planning directed at a relative reduction of explicit taxes (i.e. avoidance) is inevitably illegal or has to have at least a connotation of moral doubt. While this might be true for some
3

On June 15, 2013, the international consortium of investigative journalists (ICIJ) published online its latest
version of an offshore leaks database, containing ownership information about companies established in
ten offshore jurisdictions including the British Virgin Islands, the Cook Islands and Singapore, covering
nearly 30 years up to 2010, see http://offshoreleaks.icij.org/. For an example of the (rather herculean) task of
estimating the amount of global wealth shifted offshore and the tax loss associated with offshore structuring,
see Henry [2012].
Fairness, to most people, requires that equally situated taxpayers pay equal taxes (horizontal equity) and
that better-off taxpayers pay more tax (vertical equity). Although these objectives seem clear enough, fairness is very much in the eye of the beholder. There is little agreement over how to judge whether two taxpayers are equally situated. (Minarik [2008], p. 489). Apart from (given) degrees of horizontal and vertical equity within an established tax system, fairness also means that all taxes owed are rigorously collected: "[]
you have to collect the taxes that are owed. That is only fair to companies and people who play by the rules
and it's vital for developing economies too." (Mr. David Cameron, WSJ Europe, June 18, 2013).

constructs, in particular tax evasion, which is conducted with a clear and criminal intent to defraud,
this might not be the case for others. Different tax constructs may vary considerably in terms of the
assumed legal sustainability and tax system favorability of underlying tax transactions. One should
objectively take into account that many observable tax avoidance schemes are not only legal according
to the letter of the law, but their use might oftentimes actually turn out to be socially desirable, once all
implicit consequences and nontax costs are fully incorporated.5
Surely, if relevant actors and institutions in charge would arrive at a more consistent understanding of
underlying constructs and terminology, more target-oriented reforms and correctives of unwanted tax
behavior could be accomplished. The standpoint assumed here is that an adequate approach to this
topic is to acknowledge that each of the more widely-cited tax constructs on their own have valid reasons to be separately circumscribed and investigated. Thus, an important feature of the conceptual
framework proposed here is that the key constructs, namely corporate effective tax planning, tax
avoidance, tax aggressiveness, tax sheltering and tax evasion, all have individual features and thus
usually do not reflect the exact same set of tax-motivated activities. The conceptual constructs can to
some extent overlap but should not be understood as completely identical; not least to be justified in
their parallel existence. Terminology-wise it follows that related terms should not simply be used interchangeably, but rather carefully taking into account the individual research setting and question.
As this studys focus is on the conceptual constructs underlying empirical tax accounting research, a
consequential challenge is to discuss the choice of adequate empirical proxies that best possibly operationalize the investigated construct. Many empirical measures, mostly based on publicly available
financial statement data, have been developed in prior literature.6 In addition, research consistently
develops new or refined ways to approximate corporate tax behavior. Thus, building on the conceptual
discussion, the second part of this paper is devoted to the assessment of empirical measures of explicit
corporate tax planning. I finally arrange and discuss the major empirical measures along the dimensions of the conceptual framework to suggest guidance which construct they likely capture. I conclude
with suggestions for consistent future research.
5

Tax systems are frequently designed to achieve social goals (e.g. encourage economic growth, finance public
projects, redistribute wealth and property) by granting tax-favored treatment to a number of business activities (e.g. R&D activities, agricultural production, foreign export activities, charitable and educational activities etc.); see Scholes et al. [2009] (p. 4).
See Hanlon and Heitzman [2010] for an earlier overview.

2.

Unifying Conceptual Framework of Corporate Tax Planning

Figure 1 illustrates the unifying conceptual framework of corporate tax planning. The relevant tax
constructs discussed in the following are depicted in the top half, namely tax planning in the ScholesWolfson sense, tax avoidance, tax aggressiveness, tax sheltering, and tax evasion. Apart from the general notion of effective tax planning, all constructs of explicit tax planning are further arranged along
the dimensions of legality and compliance. These dimensions represent the presumable degree of lawfulness and perceived compliance of the tax actions likely captured by the individual tax constructs.
The legality dimension ranges from perfectly legal, over increasingly grey-scaled, to clearly illegal
with an intent to defraud. The dimension of compliance stretches from strict compliance, over potentially tax system unfavorable noncompliance, to apparent noncompliance.
The bottom of Figure 1 provides some tangible examples for tax actions, which may be subsumed
under the corresponding constructs, e.g. the investing in tax-favored assets, choosing a specific depreciation method, opting to defer taxable revenue to future assessment periods, classifying certain transactions as tax exempt, shifting income between different tax jurisdictions (e.g. tax havens), engaging
in tax-relevant transfer pricing, or setting up particular tax shelter structures.

Tax Planning
explicit and implicit (all parties, all taxes, all costs)

Tax Avoidance
explicit income tax reduction

Constructs of
interest:

Tax Aggressiveness

more likely than not

chance of a tax-related
transaction being upheld
under audit >50%

Tax Evasion

Legality:
perfectly legal

or other specified
Reference Point

clearly illegal;
with intent to defraud

grey-scaled activities

Compliance:
strict
compliance

E.g. investment
in tax-favored
bonds; choice of
depreciation
method

apparent
noncompliance

potentially tax system unfavorable noncompliance

E.g. characterization of income (i.e. deferred revenue);

classification of a transaction as tax exempt; shift in
income between jurisdictions (i.e. transfer pricing);
decision to file (multi-state) tax return; etc.

Figure 1: Unifying Conceptual Framework of Corporate Tax Planning

Tax Sheltering

The approach to arrange tax-reducing activities according to their perceived degree of legality is in
line with prior literature. Hanlon and Heitzman [2010] (p. 137) describe a continuum of tax avoidance, ranging from perfectly legal tax avoidance (e.g. investment in tax-exempt municipal bonds) to
such actions that can be described as pushing the envelope of tax law. Similarly, Lisowsky et al.
[2013] consider such tax transactions to range further toward the right end of the continuum, for which
there is weaker legal support, i.e. where the goal is more likely to create tax benefits that have no
economic corollary (Chirelstein and Zelenak [2005], p. 1939).7
Below the legality dimension, Figure 1 depicts the potential degree of tax system compliance.8 As a
closely related dimension, compliance can generally be understood in a legal sense, too.9 However,
compliance from the tax system perspective is here interpreted more broadly, stressing the occasional
mismatch between the letter of a rule and the actual spirit of the rule. While the literal application of
many tax-related actions may well be legal on paper, those actions might still be unfavorable to the tax
system and could be perceived as uncooperative towards the collective (Wenzel [2002a]).10 In the
context of the here proposed conceptual framework, this implies that not only more obvious acts of tax
evasion but also such tax avoidance that draws on (tentatively) legal means might still be considered
non-compliant in a social sense. Although not always easy to handle, the compliance dimension may
still help to motivate a more nuanced assessment of corporate tax behavior.11

10

11

Lisowsky et al. [2013] associate tax reserves with shelter activity and overlay the tax avoidance continuum
with the FIN 48 recognition and measurement process to illustrate that the UTB account balance should be
informative of tax sheltering. (p. 9).
As such, the compliance-degree of underlying tax behavior is not intended to serve as the primary dimension
to define or delimit the relevant tax avoidance constructs. It is rather intended to stimulate a more differentiated dealing with the subject of (and empirical findings on) corporate tax planning.
Lawrence H. Summers of the U.S. Treasury has characterized corporate tax avoidance as what may be the
most serious compliance issue threatening the American tax system today. (see U.S. Department of
Treasury [2000] press release from February 29, 2000).
Moreover, Wenzel [2002b] (p. 630) states that [], when taxpayers try to find loopholes with the intention
to pay less tax, their actions, even if technically legal, may be against the spirit of the law and in this sense
considered noncompliant. (with further reference to James et al. [2001]).
Admittedly, while it is clearly a noble goal to differentiate between more or less desirable tax avoidance, it
appears at the same time just as hard for research as for anyone else to reasonably gauge or objectively measure a consensus favorable degree of noncompliance. Nevertheless, when going far afield drawing political
implications from empirical findings, it should be kept in mind that not only tax evasion, but also tax avoidance and tax aggressiveness may well be worth debatable with regards to their overall favorability.

2.1.

Tax Planning

The underlying concept to which all other tax constructs within the unifying conceptual framework
relate is that of corporate tax planning (see top in Figure 1). Tax planning, as it is understood throughout the following, is based on the seminal global planning approach to taxes and business strategy
proposed in Scholes et al. [2009]. In accordance with the so-called Scholes-Wolfson framework12,
effective tax planning

considers the tax positions of all parties to a contract (multilateral approach),

considers all taxes, both explicit and implicit, and

acknowledges the relevance of all costs, both tax and nontax costs13

in the corporate decision making process aimed at the maximization of after-tax returns. From taking
into account the three general themes all parties, all taxes, and all costs it follows that mere tax
minimization strategies are not necessarily desirable. Besides changes in explicit taxes affecting aftertax returns, implicit taxes (e.g. reduced pre-tax rates of returns for tax-favored investments) and other
nontax costs (e.g. agency costs, transaction costs, financial reporting costs) may considerably decide
over the net effectiveness of corporate tax planning (or tax policy making, vice versa). The role and
assertiveness of tax authorities and other relevant stakeholders frequently co-determines the optimal
tax strategy and its potential outcome. Regardless of empirical difficulties to measure and quantify
nontax costs, it is important to emphasize that after-tax profitability of businesses frequently cannot be
maximized without affecting other stakeholders goals. Tax planning always requires an integral consideration and trade-off of all explicit and implicit taxes as well as nontax costs.
At this point, the subordinate constructs within the framework, i.e. tax avoidance, tax aggressiveness,
and tax evasion differ from the overarching construct of tax planning (see Figure 1). These constructs
specifically relate to the all taxes bucket of effective tax planning, more precisely that of explicit
taxes. They share the common purpose of reducing the explicit corporate tax burden.

12

13

Also referred to as the SWEMS framework. On the occasion of the recently held February 2013 ATA
Doctoral Consortium, Shevlin [2013] stressed the prevailing usefulness of the Scholes-Wolfson framework in
examining and understanding cross-sectional variation in firms propensity to engage in more or less tax
avoidance, pointing out that no paper really challenges the framework (pp. 4, 7).
See Scholes et al. [2009] (p. 3).

2.2.

Tax Avoidance

Tax avoidance within the here presented framework is broadly defined as the reduction of a firms
explicit taxes in any manner. This approach is in line with the definition assumed by Dyreng et al.
[2008] and Hanlon and Heitzman [2010], who point out that this definition does not differentiate between tax-favored real activities, tax planning that is explicitly undertaken to avoid tax payments,
and/or tax benefits expected from lobbying. Further, the construct of tax avoidance does not distinguish between clearly legal, legally doubtful or grey-scaled, illegal, and in fact fraudulent tax practices (Dyreng et al. [2008]).14 This broad definition appears adequate for research questions that address the overall extent to which firms manage an explicit reduction of tax liabilities or cash tax outflows. Research would principally prefer to gauge the global (i.e. combined explicit and implicit)
effects of corporate tax planning, but is often faced with substantial difficulties in empirically estimating all implicit taxes associated with tax avoidance. This circumstance frequently leads to the omission
of implicit taxes in the employed empirical measures (Scholes et al. [2009], p. 147),15 which is important to bear in mind when evaluating firms true effective tax burdens and when assessing the
distributions of tax burdens across taxpayers.
Hence, if one is interested in a firms general ability to reduce its explicit tax burden, without further
characterizing the specific nature of activities that are employed to realize the tax savings, the here
suggested construct of interest is tax avoidance (see Figure 1). Tax aggressiveness, tax sheltering, and
tax evasion can be subsumed under the construct of general tax avoidance, given that all of these constructs are likewise aimed at a reduction of a firms explicit tax payments or liabilities. While these
constructs do differ in the perceived degree of legal sustainability of the transactions they represent,
they all describe the explicit avoidance of taxes.
It follows that the construct of tax avoidance may include aggressive, potentially even evasive types of
explicit tax planning. At the same time, there agreeably exist numerous tax actions that are by no intuition aggressive, but still lead to a considerable reduction of explicit taxes. These non-aggressive tax
avoidance actions are represented by the overhanging left end of tax avoidance in Figure 1. For many
14

15

Put differently, tax avoidance captures all certain and uncertain (sustainable and unsustainable) tax positions
that may or may not be legally challenged (Lisowsky et al. [2013]).
E.g. the long-run cash effective tax rate, that is defined as the sum of cash taxes paid over ten years divided
by the sum of pretax book income over those same ten years (Dyreng et al. [2008]); see also Section 4.

straightforward types of tax avoidance there is no reason to doubt their lawfulness. Firms that restrict
their tax avoidance to a combination of perfectly legal activities, e.g. investing in tax-favored municipal bonds or opting for the tax-optimal depreciation method offered by the legislator, should fall under
the category of non-aggressive tax avoidance. With regards to similarly tax-motivated actions it appears unsuitable to speak of tax aggressiveness, given that the taxpayers main intention is to make
sure not to pay more taxes than is actually demanded of him; both in accordance with the letter of the
law and likely also with the spirit of the law. Presumably, government and regulators pursue specific
socially desired objectives by the formal exemption of certain asset types from taxation or by incorporating tax-favorable depreciation options into the law. Thus, from the global standpoint of efficient tax
planning (incorporating all parties, all costs, all taxes), a certain degree of explicit tax avoidance
is in fact desirable from a global standpoint. This should be true at least to the extent to which
courts,16 regulators and others see nothing unduly about straightforward legal tax avoidance. To label
and treat any possible avoidance behavior as aggressive would not only miss any additional merit.
More problematically, it would unnecessarily harbor the risk of signaling misleading connotations
about corporate tax behavior for which there actually exists wider public acceptance.

2.3.

Tax Aggressiveness

Tax aggressiveness (as depicted in Figure 1) is understood to be situated at the next lower aggregation
level of tax avoidance. It refers to a further delimited scope of tax avoidance actions that are particularly aggressive, a feature that calls for further specification. The outlined conceptual framework
generally suggests that the weaker the legal support of a firms tax position, the more reasonable it is
to consider this tax position aggressive.17 In a similar way, the degree of tax system favorable compli-

16

17

A quote that is regularly cited to underline that there is nothing generally immoral about paying as low
amounts of taxes as possible within the legal boundaries is that of Judge Learned Hand, dating back to 1935:
Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that
pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over
again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more
than the law demands. (Judge Learned Hand in the case of Gregory v. Helvering 69 F.2d 809, 810 [2d Cir.
1934], affd, 293 U.S. 465, 55 S. Ct. 266, 79 L.Ed. 596 [1935]).
See also Frischmann et al. [2008], who define tax aggressiveness as the act of engaging in significant tax
positions with relatively weak supporting facts. Lisowsky [2010] relatedly places tax aggressiveness close
to the right end of a range of avoidance activities stretching from legitimate tax planning to engagement in
abusive tax sheltering.

ance should generally decrease the more aggressive a firm plans its taxes. The great challenge lies in
the attempt to objectively define a cut-off point at which the underlying tax avoidance actions are to a
critical level legally challengeable in order for the construct of interest to be appropriately labeled tax
aggressiveness. Hence, it is expressly acknowledged that this cut-off point generally lies in the eye of
the beholder. Nonetheless, the framework developed here explicitly suggests a more-likely-than-not
(MLTN) threshold of a tax-related transaction being upheld under potential audit as a particularly
useful reference point to make a distinction between non-aggressive and aggressive types of tax avoidance (see Figure 1).18 Firms that structure their tax positions in ways that hypothetically bear the >50
% risk of not being sustained upon the potential examination by the IRS (or any other institution) are
here and in the following considered to be tax aggressive. Notwithstanding the given difficulties in
assessing the true probability of tax positions being more or less likely to be eventually sustainable,
the proposed MLTN reference point has the advantage that it is clearly linked to the well acknowledged assessment dimension of legality.19

2.4.

Tax Sheltering

A considerable share of the empirical tax avoidance literature deals with the important construct of
corporate tax sheltering (e.g. Wilson [2009], Lisowsky [2010]). Tax shelter engagement is sometimes
closely linked, or may even coincide with the actual evasion of taxes. According to Lisowsky et al.
[2013] (p. 8), tax sheltering can be considered as the most extreme subset of tax aggressiveness []
which tests the bounds of legality. Notice, however, that the here proposed framework does not view
tax sheltering as yet another sub-construct of explicit corporate tax planning (such as tax avoidance
and tax aggressiveness; see top of Figure 1). Rather, tax sheltering is generally considered a specific
category of explicit tax planning actions, e.g. involving the use of special legal vehicles, offshore tax
haven involvement, etc. (see bottom of Figure 1). As sheltering frequently lacks a considerable busi-

18

19

In a contemporary paper, Lisowsky et al. [2013] similarly use a MLTN threshold to differentiate between
general tax avoidance and tax aggressiveness, albeit their particular studys setting is focused on accounting
for UTBs under FIN 48 and its predictive ability to proxy for tax shelter participation.
As the target-oriented differentiation between tax avoidance and tax aggressiveness is one of the crucial elements, i.e. both a major benefit and a considerable challenge, of this study, Section 3 is further devoted to the
critical discussion of the MLTN reference point. In the pursuit of a well-rounded analysis, other examples of
potential reference points (implicitly) assumed in the literature will also be referred to, appropriately recognizing that perceptions and preferences in this regard justifiably vary among researchers.

10

ness purpose and often depends on the use of legal loopholes, it is here assumed to usually but not
necessarily reflect tax aggressiveness.
Other common definitions of tax sheltering likewise underscore the here depicted conceptual understanding and stress the particular aggressive character of sheltering. Definitions usually refer to the
tax-motivated misstatement of economic income with the goal to reduce explicit taxes (e.g. Bankman
[2004]). This is usually done in a fashion inconsistent with any purposive reading of the relevant regulation (McGill and Outslay [2004], p. 743, see also Bankman [1994]). The U.S. Congress [1999] describes tax shelters as arrangements aimed at the avoidance of taxes by generating economic benefits
without incurring economic loss or risk. The American Institute of Certified Public Accountants further defines abusive tax shelters as having no business purpose other than tax avoidance, unless they
are consistent with the intent of applicable tax laws.20 The U.S. Department of Treasury [1999] notes
that corporate tax shelters may take many different forms, making it difficult to find a universal definition of tax sheltering. Nonetheless, tax shelters share a number of common features, e.g. the lack of
economic substance, inconsistent financial and accounting treatment, presence of tax-indifferent parties, complexity, [], promotion or marketing, confidentiality, high transaction costs, and risk reduction arrangements (U.S. Department of Treasury [1999], p. 12). In relation to the suggested MLTN
reference point for the construct of tax aggressiveness, it is assumed that tax shelter activity would be
relatively challenging to sustain under audit, and/or may more often than other transactions turn out to
be prohibited and penalized after the fact.21
Moreover, with a view to the compliance dimension of the conceptual framework, tax shelter engagement is perceived to be largely unfavorable to the tax system as a whole, both in the eyes of policy
makers and the general public. Thus, the conceptual construct of tax sheltering is considered to be a
manifestation of more aggressive types of tax-motivated actions. Notice however that sheltering does
not necessarily have to be illegal,22 nor does it necessarily have to be conducted with the sole aim of

20
21

22

AICPA [2003] (p.1).

A feature that, at least by a selected few and to a limited extent, can in some cases be observed empirically,
e.g. drawing on mandatory private disclosures of tax shelter participation as made to the Internal Revenue
Services Office of Tax Shelter Analysis, see Lisowsky et al. [2013] or other confidential tax shelter and tax
return data (e.g. Wilson [2009], Lisowsky [2010]).
As illustrated by the dashed box around tax sheltering on the bottom of Figure 1.

11

evading taxes.23 In fact, many shelter structures are in probably designed on the premises that they
have some, although hard to maintain, legal justification.24 In other words, tax shelter firms that test
the bounds of legality (see reference to Lisowsky et al. [2013] above) do not always actually cross
them. Finally, even those types of tax shelters, which are in fact impermissible (e.g. because they do
not exhibit a formally required economic substance or a business purpose), do not necessarily fall
under the category of tax evasion (right end in Figure 1), which is further discussed in the following.

2.5.

Tax Evasion

A fundamental feature of tax evasion is its clear unlawfulness (see e.g. Holmes [1916], Slemrod and
Yitzhaki [2002]).25 However, in order to differ from (illegal) tax aggressiveness, tax evasion further
requires an affirmative action that constitutes the attempted evasion of a tax. It is committed willfully
with the deliberate intent to defraud.26 Acknowledging the difficulties in drawing the dividing line
between legal and illegal cases to begin with,27 this conceptual framework nonetheless requires these
additional criteria in the definition of tax evasion. This approach is beneficial in so far, as it follows
established jurisdiction:
According to a 2004 U.S. Supreme Court case, tax evasion connotes the integration of three elements:
(1) the end to be achieved, i.e., the payment of less than that known by the taxpayer to be legally due,
or the non-payment of tax when it is shown that a tax is due, (2) an accompanying state of mind which
is described as being "evil," in "bad faith," "willful," or "deliberate and not accidental", and (3) a

23

24

25
26

27

Further, tax sheltering - just as any other sub-construct of explicit tax avoidance - still needs to be evaluated
under the all parties-all costs-all taxes view of global tax planning.
Bankman [2004] (p. 9) describes a tax shelter as a transaction that is (1) marketed and tax-motivated, (2)
succeeds under at least one literal reading of the governing statute or regulation, (3) misstates economic income, and (4) in doing so reduces the tax on capital, (5) in a manner inconsistent with any purposive or intentionalist reading of the statute or regulation.
See right end of Figure 1.
Compare e.g. Sansone vs. United States [1965], 380 U.S. 343 par. 16: The elements of 7201 are willfullness; the existence of a tax deficiency; and an affirmative act constituting an evasion or attempted evasion
of the tax; referring to 7201 Attempt to evade or defeat taxes in 26 U.S.C (Subtitle F Chapter 75 Subchapter A).
Notice however that (formal) legality alone is not always understood consistently. For example, it lies in the
eye of the beholder if the legality of a tax shelter only depends on the letter of the law or if a substance over
form perspective should be assumed that also takes into account underlying legal doctrines and intentions of
the lawmaker, see e.g. Kersting [2008].

12

course of action or failure of action which is unlawful.28 As such, tax sheltering may constitute tax
evasion if it is illegal and conducted in an affirmative act with the willful attempt to defraud. In turn,
the mere absence of a business purpose in a transaction cannot be sufficient to qualify tax shelter activity as tax evasion.
Further in line with this understanding, the Joint Committee on Taxation of the U.S. Congress [1999]
describes a tax shelter as an aggressive arrangement that is designed principally to avoid or evade
federal income taxes. Thus, if it is possible to identify and investigate tax shelter activity that is clearly
illegal, it would be appropriate to consider the construct under investigation to be tax evasion, as long
as a clear intent to defraud on the side of the taxpayer is further assumed. Empirically, however, such
behavior is hard to detect. Some studies are able to identify tax transactions with a degree of legality
that may at least be considered questionable, by drawing on court dockets or confidential tax return
data (Wilson [2009], Lisowsky [2010]).29 Precisely, and in line with the here proposed conceptual
understanding, these studies refer to tax aggressiveness and at no point state to directly investigate the
construct of tax evasion.
With a view not only to the tax shelter literature but also to the corresponding public interest in tax
sheltering and tax evasion, the intention here is to underscore the need to clearly explain and delimit
the actual construct under investigation before drawing analogies with other evidence or in order to
reject or support common claims. To arrive at good results, institutions contributing to the tax policy
debate should not brush aside this challenge of carefully distinguishing between (oftentimes perfectly
legal) tax avoidance, more doubtful tax aggressiveness, frequently questionable tax sheltering, and
clearly abusive, in fact criminal shades of tax evasion.30 In their ongoing fight against tax evasion,31
28

29

30

31

Further, the court states that tax avoidance should be used by the taxpayer in good faith and at arms
length, whereas tax evasion is a scheme used outside of those lawful means and when availed of, it usually
subjects the taxpayer to further or additional civil or criminal liabilities., see court decision in the case of
Commisioner of Internal Revenue vs. The Estate of Benigno P. Toda [2004], G.R. No. 147188, September
14, 2004 with further reference to Vitug and Acosta [2000] and deLeon [1988].
With a view to court rulings, some of the observed firms likely decided not to settle but instead go to court,
where some eventually win their case (i.e. sustain their position in the aftermath).
Accordingly, the AICPA recently pointed out: Crucial to the debate is the difficulty of clearly distinguishing
between transactions that are abusive and transactions that are aggressive and legitimate. At the same time, it
must be recognized that taxpayers have a legitimate interest in arranging their affairs so that they pay no
more than the taxes they owe. (AICPA [2011], p. 12, par. 2).
E.g. G8 Leaders [2013]; G20 Leaders [2008]; U.S. Department of Treasury [2013]; Council of the European
Union [2013].

13

policy makers and regulators may first and foremost have an interest to focus on such aggressive tax
actions that without doubt could be identified as fraudulent and criminal. Such actions could be severely sanctioned, also in order to deter other firms from engaging in clearly tax system unfavorable
tax planning. Also in a social justice sense, measures to combat tax aggressiveness should especially
target such forms of illegal tax aggressiveness that are clearly designed to defraud the state of its tax
funds. In these veins it appears target-oriented to further differentiate (possibly illegal) tax aggressiveness and/or tax sheltering from the construct of fraudulent tax evasion. Nonetheless, when it comes to
safeguard or even increase corporate tax revenues on larger scales, it might be more purposeful to step
up efforts to curtail tax aggressiveness (or tax avoidance) more generally.

3.

Non-Aggressive Tax Avoidance vs. Tax Aggressiveness

3.1.

Requiring the Use of Reference Points

Next to tax avoidance, tax aggressiveness is the construct most frequently investigated in empirical tax
accounting research.32 Throughout the literature, tax avoidance and tax aggressiveness are often perceived to capture different scopes of explicit tax planning activities. Alternatively, some might simply
use terms and constructs synonymously. A possible reason for the interchangeable use of the two
terms or the identification of only one single relevant construct of explicit tax avoidance, respectively,
may be that some conceive it to be possible and/or beneficial to narrow down on one single consistent
concept of explicit tax planning. However, the problem is that in order for a single construct to be
universally accepted and generally applicable in terms of capturing every relevant type of taxmotivated action, it would be necessary to adopt a very broad definition of explicit tax planning. In
case of individual research settings and questions that do however not desire to address the general
spectrum of explicit tax-reducing actions, but rather want to focus on a particularly aggressive, e.g.
grey-scaled or morally doubtful, subset of tax avoidance, more precisely delimited constructs may in
fact prove useful.
32

By way of illustration, a straightforward online search using the Google Scholar engine as a starting point
provides 176,000 (22,600; 43,600; 91,900) results of research papers and related documentation that contain
the term tax avoidance (tax aggressiveness; tax sheltering; tax evasion). Narrowing down the search
to abstracts and working papers which are available and circulated on the social science research network
(SSRN) provides 517 (42; 32; 682) results for tax avoidance (tax aggressiveness, tax sheltering, tax
evasion), accordingly. [Search results as of July 10, 2013; see scholar.google.com and papers.ssrn.com].

14

It seems beneficial not to discard a separate construct of tax aggressiveness next to (non-aggressive)
tax avoidance in favor of one single, oftentimes too wide to consistently interpret construct of explicit
tax planning. In fact, the conceptual separation of tax avoidance from tax aggressiveness allows to
identify firms that exhibit high levels of tax aggressive (e.g. because they engage in legally risky
transactions), but at the same time realize low levels of overall tax avoidance (e.g. reflected by relatively high effective tax rates). It appears reasonable, that in some circumstances firms may get engaged in some risky tax transactions such as particular tax shelters, but apart from that are unable to
substantially lower the amounts of taxes paid. In other words, a conceptual differentiation may in fact
allow identifying firms that are aggressive, but in fact unsuccessful, tax avoiders.
However, the perception of what actually constitutes tax aggressiveness may vary depending on individual preferences or a particular research setting. Of course it is not mandatory to agree on one universally accepted reference point for aggressive tax planning, but it appears rewarding to at least reduce the impending ambiguousness and risk of misleading interpretations to a minimum. In order to
produce more consistent evidence, any individually adopted reference point of tax aggressiveness
should be comprehensibly explained. Consequently, and a bit more technical, the understanding in this
framework with regards to the necessary differentiation between tax avoidance and tax aggressiveness
can be illustrated as follows:

15

Figure 2: Delimiting Non-aggressive Tax Avoidance and Tax Aggressiveness

16

As depicted in Figure 2, the construct of tax avoidance as opposed to tax aggressiveness does not
refer to any reference point other than the hypothetical tax liability (or payment) that would result
from a state of zero explicit tax-planning. At exactly this juncture, the construct of tax aggressiveness differs from tax avoidance: With regards to the individual research question, tax aggressiveness
needs a well specified and explicitly articulated criterion (reference point, RP), at which general
avoidance turns into aggressive behavior in the eye of the beholder. This may be a benchmark-tax
strategy, a particular level of planning effort or success, etc. For at least as long as there is no single
universally accepted reference point, studies need to be very specific about what in particular characterizes the relevant subset of tax aggressive actions within their particular research setting. Put differently, it requires clarification why a study is in fact a tax aggressiveness study and not a general tax
avoidance study.
Drawing on a finance context, possible definitions of the term aggressive include an approach to investing that seeks above-average returns by taking above-average risks33 and concentrating on
growth and high yields, rather than long-term security.34 These definitions elucidate that an action in
order to be labeled aggressive requires a certain reference points. Speaking in terms of the above
examples, clarification would be required with regards to what is actually meant by above-average
risks, high yields, or particularly willing. Transferred to the field of taxation, aggressive firms
could be characterized as particularly willing to engage in tax transactions that might eventually be
overthrown by the IRS or earn disapproval by other regulators.35 Just as different people have different
ideas of risk, a universally accepted definition of tax aggressiveness based on clearly specified
characteristics is hard to obtain. In fact, some might consider it more serviceable to define tax aggressiveness using reference points that vary depending on a given research context. Thus, while the conceptual framework developed in this study stresses the likely usefulness of the MLTN probability of a
tax position being sustainable upon potential audit, i.e. the weak or strong legal support of a taxmotivated activitiy, there clearly are valid alternative reference points.

33
34
35

See The Free Dictionary by Farlex (2013), www.thefreedictionary.com/aggressiveness.

See The Oxford English Dictionary (2013), http://www.oed.com/view/Entry/3952#eid8581615.
[] intuitively, aggressiveness is thought of as pushing the envelope of tax law (Hanlon and Heitzman
[2010], p. 137).

17

3.2.

MLTN Probability of a Tax Position being Legally Sustainable

The here developed conceptual framework suggests a > 50 % probability of a tax position being sustainable under (hypothetical) audit as the preferred reference point of non-aggressive tax avoidance. In
turn, a tax position which is equally or less likely to be legally sustainable is considered aggressive
(See Fig. 1).36
Arguably, there are several advantages of using a MLTN threshold as the adequate reference point to
delimit non-aggressive from aggressive explicit tax planning. First, the central benefit of a MLTN
reference point is its close connection to the legal dimension of the conceptual framework. A particular focus on the assessment of the legal sustainability (and thus, uncertainty) surrounding a tax position
corresponds well with the frequently advocated notion to classify relevant tax constructs according to
the alleged degree of legality of underlying tax actions (Hanlon and Heitzman [2010], Rego and
Wilson [2012], Lisowsky et al. [2013]). Second, drawing on a MLTN criterion can be well-motivated
as it has clearly garnered broad acceptance in different tax-related regulatory contexts. Notwithstanding the fact that the MLTN-concept is not identical across all contexts in which it is already applied,
involved researchers, practitioners, and the U.S. standard setter should to a notable degree be familiar
with the general notion of MLTN. Since 2006, FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes (FIN 48)37, which has been extensively discussed throughout research and
the business community, mandates specific rules for the recognition, measurement, and disclosure of
uncertain tax positions. In a two-step approach, firms have to (1) accrue those tax positions that are
more likely than not to yield tax benefits, i.e. will likely be sustained upon examination (recognition
step), and (2) have to estimate the likely outcomes of recognized positions using scenario analyses and
assigned probabilities (measurement step). If a tax position does not meet the MLTN recognition
threshold, no tax benefit is recognized in the financial statements. Otherwise, a tax reserve (UTB)

36

37

Alternatively (e.g. from a tax return preparers point of view), one could think of aggressive tax avoidance,
which is more or equally likely not to be legally sustainable (right side of the MLTN reference point), as particularly risky positions with regards to their potential outcome under audit. Accordingly, risky tax avoidance could be a synonym for tax aggressiveness (e.g. Rego and Wilson [2012], p. 776).
FIN 48 is the interpretation of ASC 740, formerly known as FAS 109 Accounting for Income Taxes. In
2009, FASB has reorganized its accounting standards codification system FASB [2009]. Since then, FIN 48
(FAS 109) is officially codified as ASC 740-10 (ASC 740). However, consistent with still common practice
in the literature, this study continues to refer to the interpretation as FIN 48.

18

representing the difference between the recognizable tax benefit and the position reported on the tax
return is accrued.38
In a recent study, Lisowsky et al. [2013] explicitly draw on the FIN 48s MLTN standard in order to
conceptually frame their particular research setting that investigates tax disclosures and unrecognized
tax benefits (UTBs). Hence, Lisowsky et al. [2013] provide a related example for how a MLTN standard can be employed as a useful reference point for tax aggressiveness. The authors consider UTB tax
positions to be tax aggressive depending on whether the taxpayer believes that it is more likely than
not that the tax position would be sustained in court based on its technical merits.39 Slightly differing
from the here suggested conceptual understanding, the authors understand the break-point between tax
avoidance and tax aggressiveness to be located somewhere to the left of the actual MLTN threshold.
In other words, tax positions might also be subsumable under the concept of tax aggressiveness if
chances of legal sustainability are in fact somewhat greater than 50 %. While the idea behind this approach is reasonable in so far, as tax positions evaluated to be only slightly more likely than not to be
sustainable (e.g. 51 % instead of 50%) are conceptually probably not much less aggressive than tax
positions that are just below the MLTN threshold (e.g. 49 %) of being sustainable. However, given
that any explicitly and percentage-wise quantified MLTN recognition threshold (both in practice and
in theory) is to a large extent discretionary anyhow, it is here assumed at least for the benefit of a
clearly stated reference point that the critical threshold is in fact a >50 % chance. Notice that the
MLTN-concept in the context of this study and conceptual framework is understood in general terms,
i.e. with no necessary or required reference to FIN 48 or UTBs.40
Another usage of the MLTN standard is incorporated in the U.S. Department of Treasury Circular 230
rules, which govern the practice of lawyers, CPAs and other practitioners before the IRS.41 Depending

38

39
40

41

Hence, the tax reserve should reflect the degree of uncertainty inherent in a self-assessed tax position, suggesting UTBs (or changes thereof) may be an appropriate proxy for tax avoidance. This possibility is discussed in Section 4.2.d.
According to FIN 48, par. 6; see Lisowsky et al. [2013] (p. 9).
The MLTN test is understood to be (fictitiously) applicable to any type of tax avoidance behavior. Underlying tax actions at no point need to be subject to any actual audit under any specific standard or regulation by
any particular institution (e.g. IRS).
U.S. Department of Treasury [2011], Circular No. 230, Rev. 8-2011, (p. 26), 10.35 (b) (4) (i): Written
advice is a reliance opinion if the advice concludes at a confidence level of at least more likely than not a
greater than 50 % likelihood that one or more significant Federal tax issues would be resolved in the taxpayers favor.

19

on further specified circumstances, Circular 230 demands that written tax advice that may be relied
upon by a taxpayer for penalty protection lives up to a MLTN standard. Further, and very closely related to the here discussed constructs of tax avoidance and tax aggressiveness, the Public Company
Accounting Oversight Board (PCAOB) in 2006 adopted the MLTN standard in its Rule 3522 Tax
Transactions. Pursuant to this rule, public accounting firms are prohibited from providing non-audit
service to an audit client that involves marketing, planning, or opining in the favor of an aggressive
tax position transaction [...] that was initially recommended, directly or indirectly, by the registered
public accounting firm and a significant purpose of which is tax avoidance, unless the proposed tax
treatment is at least more likely than not to be allowable under applicable tax laws.42
In a related vein, another MLTN usage was introduced in revisions to Internal Revenue Code Section
6694 under the Small Business and Work Opportunity Tax Act of 2007. The goal of this revision was
to increase the preparer standard for tax return positions, requiring that a position that is not adequately disclosed must meet a MLTN criterion for the preparer to avoid penalty.43 Further, this MLTN penalty standard applies in assessing whether a taxpayer is subject to penalty for tax positions that fall
under tax shelter rules. Such shelter positions, that in turn are generally defined to involve significant
tax planning, must also satisfy the MLTN criteria as for the taxpayer to avoid penalty assessment.
Third, while especially FIN 48 and its interpretation-specific MLTN standard have received excessive
attention, it should be highlighted that MLTN standards have garnered global acceptance and are incorporated into numerous regulations across jurisdictions. In addition to the FASB, the International
Accounting Standards Board (IASB) has readily incorporated the MLTN concept into pivotal accounting standards. Similarly to FIN 48, International Accounting Standard 12 Income Taxes (IAS 12)
requires the realization of tax benefits to be probable in order for tax assets to be recognized. While
there may have been differing interpretations of probable and more-likely-than-not when IAS 12
was first established, standard setters and practitioners today largely agree that the MLTN threshold is
relevant in assessing uncertain tax positions and with respect to other accounting contexts.44

42

43
44

Public Company Accounting Oversight Board (PCAOB) [2006] ( p. 59), Rule 3522 (b) [Effective pursuant to
SEC Release No. 34-53677, File No. PCAOB-2006-01 (April 19,2006)].
For further details see e.g. PwC [2008] (p. 2).
See e.g. the appendices of IAS 37, IFRS 3, and IFRS 5 explicitly define probable as more likely than not.
According to IAS 37 par. 14, an entity must recognize a provision if, and only if, a present obligation has

20

In sum, for over almost a decade, MLTN standards have been actively promoted, many times explained to a broad audience, and frequently applied in many contexts. Taken together, the generally
observable efforts to improve objectivity and transparency in tax accounting by increasingly relying
on MLTN criteria speak in favor of employing a MLTN-based assessment as a useful reference point
of tax aggressiveness, which might actually be capable of broader consensus. Acknowledging that
MLTN standards are gaining momentum in accounting regimes even outside the U.S., the (increasingly international) research community, regulators, and involved institutions should benefit from a consistent use of a MLTN reference point to distinguish between tax avoidance and tax aggressiveness.
While the MLTN assessment of tax actions from a legal sustainability standpoint is here proposed as a
possible reference point that has the potential to foster more consistent future research, it is expressly
stated that this is not the only reasonable reference point for corporate tax aggressiveness. The next
section will thus attempt to further evaluate the differences between the MLTN reference point and
existing approaches to delimit tax aggressiveness and demonstrate to what extent the MLTN approach
is capable of capturing activities that are considered aggressive in contemporaneous research.

3.3.

MLTN in Relation to other Possible Reference Points

As indicated earlier, the reference point for tax aggressiveness could rest in a number of other possible
tax transaction characteristics. Alternatively, one could also establish a certain minimum level of tax
avoidance, which is likely to be only accomplishable by those firms that draw on aggressive tax
avoidance, without further specifying those actions. Examples for the former could be specifically
identified tax schemes, e.g. certain tax shelter structures, which may reasonably differ in their aggressiveness from rather benign types of tax avoidance, a closer defined tax risk associated with an underlying set of tax positions, or some impending negative consequences that may only be entailed in particularly aggressive transactions (e.g. specific IRS penalties). Examples for the latter could be the requirement of an above mean level of tax avoidance (e.g. using industry/size-benchmarked effective tax

arisen as a result of a past event, the payment is probable (more likely than not), and the amount can be estimated reliably. Even though footnote 1 to par. 23 of IAS 37 states that the interpretation of probable in
that specific standard as more likely than not does not necessarily apply in other standards, there appears
to be broad agreement among practitioners (see e.g. Ernst&Young [2012], PwC [2011], PwC [2009]) and in
the literature (see e.g. Kting and Zwirner [2005], p. 1554, Pellens et al. [2006], p. 197) that the more-likelythan-not approach should also apply in the context of accounting for deferred tax assets under IAS 12.

21

rates),45 the orientation towards a best-competitors tax expense or unrecognized tax benefit position,
or the use of propensity-matched book-tax differences as a proxy for tax aggressiveness.
Another way to distinguish aggressive from generally avoidant behavior would be to define tax aggressiveness as a generally socially irresponsible behavior (e.g. Erle [2008]). However, when compared to the above described reference points, it likely turns out to be even more subjective and prone
to conflicting interpretations to determine what is socially responsible or in fact desirable.46 Accordingly, the potential social irresponsibility associated with a tax position appears hardly capable of serving as a useful reference point for tax aggressiveness in most settings. Besides, it would likely turn out
to be difficult to measure and quantify social responsibility in empirical tests.47
To further illustrate the MLTN probability of a tax position being sustainable upon potential audit in
relation to other possible reference points, three alternative concepts of tax aggressiveness found in
contemporary empirical tax avoidance research will be discussed in the following (Lisowsky [2010],
Armstrong, Blouin, and Larcker [2012b], and Balakrishnan et al. [2012]). The goal is to (a) demonstrate at which point other (more context-specifically developed) definitions of tax aggressiveness may
not capture the scope of activities that are considered aggressive within the here proposed framework, and (b) further illustrate how the suggested MLTN reference for tax aggressiveness would be
transferable to the aggressive scopes of tax avoidance identified in the selected studies.

a.

First-Order Importance of Reducing a Firms Tax Burden

In his study on the empirical modeling of corporate tax shelter use, Lisowsky [2010] briefly discusses
the demand for a broadly accepted definition of corporate tax aggressiveness. He similarly identifies
the challenge that in fact tax aggressiveness is a matter of judgment, degree, and scope, and proposes to define tax aggressiveness as behavior in which the reduction of the corporate tax burden is of
first-order importance (= reference point). Subordinately, any non-tax effects are considered sec-

45
46

47

As e.g. suggested in Balakrishnan et al. [2012] and further discussed in the following.
Just as it is disproportionately harder to define non-favorable or non-cooperative tax behavior than more
or less legal activities.
To clarify, this does not mean that there is generally no particular research setting in which social irresponsibility may well serve as the crucial characteristic of the subset of tax avoidance activities under investigation.
As long as the perception of social irresponsibility is clearly defined and adequately depicted, it may still turn
out to be an appropriate reference point in the given context of a particular study or research objective.

22

ond-order, or marginal. By way of example, Lisowsky [2010] considers tax benefits from depreciation or stock options as being of second-order importance to the first-order capital allocation and/or
managerial incentive alignment effects. Consequently, he considers such tax benefits as benign
forms of tax avoidance and not as tax aggressiveness.
While it seems comprehensible to label many tax shelter activities aggressive, especially with a reference to the frequently predominant purpose of avoiding taxes, it is less clear why a tax position that
exists for second-order important reasons can categorically not be aggressive. For example, assume a
firm invests in a specific asset, solely basing this decision on its operational needs (i.e. first-order
importance is not tax). Assume further that there is uncertainty with regards to whether or not this
investment might actually qualify for a tax-favored treatment, e.g. in form of being granted a taxfavorable depreciation or even a tax-exempt status for the expected returns. Even though the tax treatment of this asset is clearly of second-order importance to management, it seems reasonable that the
tax department could either assume a more compliant position (e.g. opt for a standard depreciation
method and record all realized returns from the investment in its tax return), or a more aggressive
tax position (e.g. opt for a more tax-favorable treatment which applicability is not guaranteed and not
declare any returns provided by this investment). The use of the proposed MLTN reference point for
tax aggressiveness (which is also suggested in Lisowsky et al. [2013]) would be capable of subsuming
both tax sheltering (as intended by Lisowsky [2010]) and second-order important but still aggressive tax positions under the construct of tax aggressiveness.

b.

Tax-Related vs. Tax-Driven Tasks of Tax Directors

Armstrong et al. [2012b] investigate the type of tax planning referred to in tax directors compensation
contracts and whether the contractual incentives are associated with levels of tax aggressiveness. In
this specific context, it is assumed that responsible tax directors play three different roles. First and
foremost, they ensure general tax compliance. Second, they also act as an advisor in cases of strategic
investment decisions. Third, directors may be explicitly charged with actively pursuing tax planning
opportunities, i.e. invest in projects where the net present value is exclusively driven by tax benefits.
Armstrong et al. [2012b] consider only activities falling under the third category (= their individual
reference point) to be tax aggressive.

23

Similar to the earlier approach followed in Lisowsky [2010], the definition of Armstrong et al. [2012b]
may not be easily transferable to other contexts, as it probably does not capture all tax activities many
people would actually consider tax aggressive. For instance, it appears conceivable that a manager
advises strategic investment decisions (first role, not the third role) that are aggressive in that they
involve considerable risk taking with regards to the specific tax position associated with this investment. Even though the net present value of the investment may under no circumstance be primarily
driven by the expected tax benefits,48 management can still seek an aggressive tax treatment (involving
tax highly uncertain tax positions) of this investment.

c.

Uncommonly Low Tax Burden: Industry- and Size Benchmark

In a contemporary working paper, Balakrishnan et al. [2012] ask whether tax aggressiveness reduces
the financial reporting transparency of a firm. Just as transparency is a broader construct that is likely to be affected by various shades of corporate activities, the authors opt for a broader definition of
tax aggressiveness, respectively. In their given research context, Balakrishnan et al. [2012] define aggressive firms as such that pay unusually low amounts of taxes given their particular industry and size.
Hence, the understanding of tax aggressiveness in Balakrishnan et al. [2012] does not rely on or capture any specific tax planning technique.
While this conceptual definition of tax aggressiveness avoids the limitation (in this specific research
context) of capturing only specific tax transactions, e.g. certain tax shelters, it does not involve any
assessment of either the legal sustainability of a transaction or any alternative feature of the underlying
tax activities.49 With a view to the large number of potential determinants of cross-sectional (and within-industry) variation in corporate tax avoidance, it is not instantly intuitive why two firms with similar average industry-/size- adjusted ETRs would necessarily act equally (non-)aggressive. The authors themselves recognize that firms of comparable size within the same industry may still have very

48

49

Implying that the Lisowsky [2010] definition would probably consider this investment as being of secondorder importance to tax planning and likewise not subsume it under tax aggressiveness.
Which is of course a technical advantage in the empirical research design/measurement, but rather circumvents the challenge of conceptually differentiating the nature of underlying transactions that characterize
them as either aggressive or non-aggressive.

24

different tax avoidance options available (Balakrishnan et al. [2012], p. 5).50 However, if one does not
focus on the more or less aggressive nature of tax avoidance actions, the framework proposed here
would rather refer to tax avoidance51 and still agree with the use of ETR-based measures to proxy for
aggregate levels of not closer characterized explicit tax planning.52 In sum, the intention here is by no
means to criticize the innovative approach taken in Balakrishnan et al. [2012]. Rather, the goal is to
demonstrate the functioning of the here developed conceptual understanding by transferring it to the
context of contemporary research examples.

d.

Tax Risk

In their definition of tax aggressiveness, a number of papers have further incorporated the notion of
tax risk, which firms are exposed to during or after their tax planning decisions. For example,
Gallemore and Labro [2013] argue that two firms with equally low ETRs may ceteris paribus be faced
with different tax risks, i.e. due to differences in the internal information quality. If a firms tax risk is
high, Gallemore and Labro [2013] (p. 12) consider this firm to be more tax aggressive than the firm
with an equally low, but otherwise less risky tax position. In a similar vein, Frischmann et al. [2008],
Mills, Robinson, and Sansing [2010], or Rego and Wilson [2012] consider tax planning (more precisely, tax reporting) to be aggressive if it involves certain risks, e.g. a higher uncertainty on their UTB tax
positions under FIN 48. This concept of risky tax avoidance (Rego and Wilson [2012], p. 776; see
also Hanlon, Maydew, and Saavedra [2013]) is very much in line with the here proposed MLTN reference point of tax aggressiveness if one assumes that the risk involved in a tax position is largely
attributed to the more or less probable legal sustainability upon (hypothetical) audit.
Overall, the above discussion about other potential reference points of tax aggressiveness indicates
that a MLTN criterion with a focus on the potential legal sustainability of a tax position could well be

50

51
52

Even if the tax opportunities of comparable firms were in fact similar, it would still be required to assume
that the same quintile of total assets as well as 48 industries defined by Fama and French [1997] are sufficient
to adequately classify generally very large and geographically as well as functionally diversified multinationals in adequate size- and industry-bins.
With its levels being industry-/size benchmark being well intuitive and also useful.
With specific respect to the here proposed MLTN reference point for tax aggressiveness, it appears unlikely
that those firms that are more successful in avoiding taxes than their peer firms necessarily need to rely on
legally less sustainable tax positions.

25

transferable to various actual research settings and would likely be capable to capture activities others
would also agree to treat as tax aggressive.

4.

Empirical Measures of Corporate Tax Avoidance

4.1.

Obtaining Corporate Tax Data

In empirical tax research, the reliable measurement of corporate tax avoidance and its related constructs naturally is a key issue (Dunbar et al. [2010]). Accordingly, the number of existing proxies for
tax avoidance, tax aggressiveness, and tax sheltering is large.53 In most settings, it would probably be
preferable to directly study a firms true tax liabilities or tax positions as reported to the authorities.
However, since the actual taxable income and due tax payments are stated in confidential tax returns,
they are mostly unobservable to researchers.54 For this reason, most empirical measures are inferred
from publically available financial statement data and employ estimates of taxable income or tax payments (Manzon and Plesko [2002]).55
Publically Disclosed Financial Statement Data
As research progresses, a growing variety of financial statement-based measures is being employed
and further developed. These measures can broadly be divided into the following categories: GAAPor cash-based (long-run) effective tax rates (ETRs), variants of total, permanent, or temporary book-

53

54

55

There really is no direct empirical measure of tax evasion, probably because evasion is characterized by its
fraudulent illegality, which is determined only after the fact (when it actually becomes observable). At best, it
can be proxied for such particularly aggressive tax actions which can be reasonably assumed to be frequently, but not necessarily, also used for evasive purposes. Put differently, the best way to proxy for evasion
would be to proxy for aggressiveness. Moreover, at least from the perspective of tax avoidance research, the
need for a specific tax evasion measure appears questionable, as tax evasion should not be a significant driver
of variation in overall tax avoidance among larger publically traded firms.
Exceptions include Altshuler and Auerbach [1990], Boynton et al. [1992], Collins and Shackelford [1995],
Collins and Shackelford [1998], Cordes and Sheffrin [1981], Cordes and Sheffrin [1983], Lyon [1997], Lyon
and Silverstein [1995], Mills [1998], Mills et al. [1998], Omer et al. [2000], Plesko [1994], Plesko [2000],
Lisowsky [2009, 2010].
A standard procedure of estimating taxable income from financial statements is to gross-up the income
statements current tax expense (FAS No. 109) by the statutory tax rate (Omer et al. [1991], Omer et al.
[1993], Gupta and Newberry [1997], Manzon and Plesko [2002]). Studies usually draw on large public company databases, e.g. Compustat North America, which conveniently provides data standardized according to
financial statement presentation and specific data item definitions assuring [] consistent, comparable data
with which to analyze companies and industries. (Standard & Poor's [2013], p. 2).

26

tax differences (BTDs), residuals from regression models that estimate the discretionary portion of the
above measures to single out tax-motivated behavior, and unrecognized tax benefits (UTBs) recorded
under FIN 48.
Understandably, the estimation of taxable income from financial statements is problematic. This is
mainly for three reasons.56 First, there are items that may lead to an over- or understatement of the
reported current tax expense relative to the actual tax liability of a firm, e.g. certain stock option deductions, valuation allowances, or tax contingency reserves (e.g. Plesko [2003]). Second, even assuming that the current tax expense from the income statement is an adequate proxy for the actual tax liability, the grossing-up of the tax expense may still yield biased estimates of the actual taxable income.
This might be the case where tax credits exist, such as R&D- or foreign tax credits. With regards to
loss firms, the tax expense may be truncated at zero or relevant information on possible tax refunds
may be missing.57 Third, the group of firms consolidated for book purposes might not coincide with
the group of firms consolidated for tax purposes (e.g. Mills, Newberry, and Trautman [2002], Plesko
[2003]).58 Consequently, [t]he tax expense on the income statement cannot be expected to reflect the
taxes of entities that are not included on that income statement. (Hanlon [2003], p. 845)
Ultimately, most of the problems that arise when computing tax estimates from GAAP financial
statements are rooted in the predominant objective of GAAP reporting, which is to provide decisionuseful information about the firms economic performance to investors and not the general disclosure of tax information.59 Taxes, from this point of view, are mainly relevant insofar as they affect

56
57

58

59

See e.g. Hanlon [2003] and Plesko [2003].

Moreover, the use of the U.S. statutory tax rate to gross-up the total tax expense of a multinational firm
sourcing its income across many different tax jurisdictions likely produces measurement error.
Under FAS No. 94, firms are required to file consolidated financial statements for all operations in which the
ultimate owner has at least a 50 % interest. For tax accounting purposes (IRC 1501, 1504), consolidation
is only (voluntarily) permitted if there is a minimum ownership of at least 80 %; see Manzon and Plesko
[2002].
FASB [1978] states in SFAC 1 that financial accounting serves the purpose to provide decision-useful information to investors and creditors. In SFAC 2, FASB [1980] names relevance and reliability as the main
qualitative characteristics that make accounting information useful. Correspondingly, the IASB [2001] states
in its framework that [] further harmonisation can best be pursued by focusing on financial statements
that are prepared for the purpose of providing information that is useful in making economic decisions
(preface) and that while all of the information needs of these users cannot be met by financial statements,
there are needs which are common to all users. As investors are providers of risk capital to the entity, the
provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy. (par. 10).

27

GAAP net earnings and the balance sheet, notwithstanding conceivable reasons why outside investors
would actually want to know taxable income. For instance, investors may care about taxable income
because it may serve as a useful benchmark for reported earnings or to learn about a firms success in
avoiding taxes (Lenter, Shackelford, and Slemrod [2003], Hanlon, LaPlante, and Shevlin [2005]).
Nevertheless, drawing on available financial statement data often turns out to be not just the only
available, but in fact quite a reasonable solution. For instance, Plesko [2000] compares public financial
statement numbers with confidential tax return numbers and finds a significant positive correlation
between the actual tax liability (before tax credits) and the reported current federal tax expense. In a
related approach, Lisowsky [2009] is able to investigate a multi-period matched tax return-financial
statement data set and develops a model to infer the tax return liabilities of U.S. firms from publicly
obtainable financial statement data. He finds that SFAS No. 109 related disclosures, i.e. current tax
expense, tax benefits from stock options, current-year tax cushion accruals, consolidation BTDs, and
R&D, are informative in inferring actual tax (while intra-period tax allocation is not).
The addressed problems regarding the use of financial statements to infer a firms tax status are further
put into perspective if one considers the potential limitations of alternative data sources, in particular
actual tax return data. First, different consolidation scopes for book and tax purposes would make it
difficult to merge any one tax return with any one set of financial statements (see Mills and Plesko
[2003]). This is especially unhelpful if research is interested in comparing the accounting earnings
with the taxable income of the same set of entities. Second, studies often focus on large multinational
groups that may exhibit substantial tax-relevant activities outside the U.S. that may not be included in
U.S. tax returns. Third, if the goal is to learn about the markets perception of corporate tax avoidance,
e.g. the information content of firms taxable income conveyed to investors, it is only consistent to use
information that is also actually available to the market, i.e. information other than tax return data
(Hanlon and Heitzman [2010]).
Not uncommonly, existing measures are adjusted or refined within the context of particular studies.
A prominent example can be found in Dyreng et al. [2008] who investigate firms overall ability to
sustainably avoid taxes. The study introduces the long-run Cash ETR, which proxies firms tax liability over ten consecutive years, drawing on the item cash taxes paid. Further, empirical measures
may be adjusted as the individual and/or common understanding of the underlying tax construct

28

changes, e.g. when literature defines tax aggressiveness is in novel ways. Recent examples include
proposals to adjust corporate ETRs for the industry median or to benchmark ETRs based on firm-size
and industry (Brown and Drake [2012], Balakrishnan et al. [2012]). Alternatively, the development of
novel proxies can be motivated by the use of previously overlooked and hitherto unavailable data. A
measure for tax avoidance, in particular (risky) tax aggressiveness, that has only recently been introduced is the level of (or changes in) firms unrecognized tax benefits (UTBs), accounted for under
FIN 48 since 2006 (e.g. Lisowsky et al. [2013]). Yet others have access to tax return data (Mills
[1998]) or use confidential survey information to proxy for tax avoidance (e.g. Mills et al. [1998]).60
Identification of Tax-Motivated Transactions
Another way to approximate a companys tax avoidance status it to directly detect specific transactions, e.g. shelter structures, which are employed with the primary purpose to reduce the corporate tax
burden. For instance, shelter firms can be identified from court records or the financial press (e.g.
Graham and Tucker [2006], Wilson [2009]), or based on shelter information directly reported to the
IRS (Lisowsky [2010], Lisowsky et al. [2013]).61 This approach is beneficial as it allows for the proper
identification of intentional transaction-based tax aggressiveness, which can create unique research
settings. On the downside, information on firms actual tax shelter information is frequently limited
and only available for a small number of firms. To alleviate this issue, although advising caution with
regards to the generalizability of findings, studies have developed helpful predictive models that estimate the likelihood of firms being involved in tax sheltering, based on their actually observable fundamental firm characteristics (see e.g. Wilson [2009] and Lisowsky [2010]). Similarly focusing on
observable, likely tax-driven transactions, Dyreng and Lindsey [2009] identify U.S. multinational
groups foreign operations located in tax havens and show a significant association with a groups
ETR, making tax haven presence another potential way to gauge corporate tax avoidance behavior.
All of the above approaches to proxy for tax avoidance and/or tax aggressiveness based either directly
on financial statement data or on observations of tax largely tax-motivated transactions, are discussed
in more detail throughout the following.
60

61

Mills et al. [1998] use survey data from Slemrod and Blumenthal [1993] on 365 U.S. firms tax-related expenditures.
Lisowsky et al. [2013], for a sample of U.S. firms, have access to reportable transactions as disclosed in
Form 8886 under IRC Code 6011 to the IRS office of tax shelters (OTSA).

29

4.2.

Choosing between Measures

Empirical measures reflecting corporate tax avoidance should be selected with care as strong empirical
research designs demand for target-oriented operational definitions of theoretical constructs (Libby,
Bloomfield, and Nelson [2002]).62 Valid results and solid conclusions depend on a thorough comprehension of empirical measures definitions, strengths and limitations (Hanlon and Heitzman [2010]).63
As theoretical constructs of tax avoidance differ, different proxies should also be evaluated with regards to their potential capability of capturing respective constructs of explicit tax planning. While
some measures may better capture the aggressive end of the spectrum, others might be useful to better
reflect variation in howsoever achieved explicit tax reductions (broad measures of tax avoidance).
Moreover, measures generally capable of carving out particular scopes of tax avoidance (e.g. aggressiveness), may still suffer bias. For instance, measures may to some extent pick up earnings management rather than tax planning incentives. Another evaluation criterion is that of conforming versus
non-conforming tax planning. To the extent firms save taxes by concomitantly managing their book
and taxable income downwards, most non-conforming measures, such as ETRs and BTDs, will not
reflect this type of behavior.64 This can create concerns if sample firms are faced with relatively weak
financial accounting constraints (e.g. private firms). In this case, firms may be more willing to engage
in conforming types of tax avoidance because they perceive their GAAP figures in general, and GAAP
ETR in particular, to be of relatively low relevance to both their internal and external stakeholders
(Cloyd, Pratt, and Stock [1996]).
Depending on a measures particular definition, e.g. regarding the numerator and/or denominator of an
ETR, or the permanent or temporary character of a BTD, derived results may differ and it is important
to understand why or why not this might be the case.65 Further, while some proxies may be readily
computable for large firm samples, others impose specific data requirements that may restrict the sam-

62

63

64

65

For further illustration see the predictive validity framework (and the so-called Libby-Boxes), developed
in Libby [1981], Runkel and McGrath [1972], Libby et al. [2002].
Dunbar et al. [2010] perform extensive correlation analyses on nine tax avoidance measures and come to
conclude that the fundamental properties of the most frequently used measures are not only different from
each other, but that each possesses a distinct, and varied, pattern of behavior:
Accordingly, non-conforming proxies do generally not capture tax avoidance resulting from changes in leverage, i.e. will not reflect the tax benefits of interest deductibility (Bernard [1984]).
Hanlon and Heitzman [2010]; Dechow et al. [2010] on the appropriate choice of earnings quality proxies.

30

ple size or the periods covered. Some accounting-based measures rely on figures that are reported
under specific U.S. GAAP rules (e.g. UTBs as recorded under FIN 48) which makes them not easily
transferable to other, e.g. European corporate settings.66 Similarly, the usability of some metrics may
be restricted to firms with certain legal or organizational structures. For example, reporting requirements, and hence data availability, may vary according to the legal form of a firm.
To further illustrate that the use of particular measures is context-sensitive, the remaining section aims
to further explain the advantages and caveats of commonly applied measures. First, the definitions of
the various measures (and variations thereof) are discussed. Table 1 provides detailed definitions of 21
currently available tax avoidance measures. The key differences, advantages, and limitations, as well
as data requirements are systematically evaluated. In a second step, based on this initial assessment
and discussions in prior literature, the attempt is made to best possibly arrange each individual proxy
along the lines of the proposed unifying conceptual framework of tax planning (Section 5).

66

Another example is the information on cash taxes paid necessary to compute basic cash effective tax rates.
While this item is generally on Compustat for U.S. listed firms, it is not available (at least not in machinereadable form) for most European-based firms.

31

Table 1: Summary of Corporate Tax Avoidance Measures

Table 1 defines and describes empirical proxies of corporate tax avoidance. It complements the overview in Hanlon and Heitzman [2010] (p. 140), who summarize 11 of the following 21 measure variants.
References to original sources or examples in literature applying the measures are also provided. (Continued on next page).
Measure

Definition

Description

Reference(s)

GAAP ETR

Worldwide total income tax expense

Worldwide total pre tax accounting income

Effective tax rate (ETR) derived from financial statement information, reflecting the
total tax expense (TXT) per dollar of pre-tax book income (PI) in year t.

Tax footnotes to U.S. GAAP

financial statements

Current GAAP ETR

Worldwide current income tax expense

Worldwide total pre tax accounting income

Current tax expense (TXC) per dollar of pre-tax book income (PI) in year t, (un)adjusted e.g. for minority interests; extraordinary items. Alternative specifications
scale with operating cash flows.

Porcano [1986],
Zimmerman [1983]

ETR Differential

Cash ETR

Longrun Cash ETR

Cash tax ratio

Cash ETR_3_INDi,p

Statutory ETR

GAAP ETR

The difference between the statutory ETR and the firm's GAAP ETR in year t.

Hanlon and Heitzman [2010]

Worldwide cash taxes paid

Adjusted worldwide total pre tax accounting income

Cash taxes paid (TXPD) per dollar of pre-tax book income (PI) in year t, (un)adjusted e.g. for minority interests; extraordinary items.

E.g. Dyreng et al. [2008],

Chen et al. [2010]

Worldwide cash taxes paid

Adjusted worldwide total pre tax accounting income

Sum of cash taxes paid (TXPD) over n years divided by the sum of pre-tax earnings
(PI) over n years (less special items (SPI)).

Dyreng et al. [2008]

Pre

Worldwide cash taxes paid

tax operating cash flow before interest and taxes

Long run CASH ETR ,

where:
LRCASHETR ,

industrymedian Long

run CASH ETR

Ratio of cash taxes paid to cash flows from operations in year t.

Dyreng, Hanlon, and Maydew [2008, 2010]

cashtaxpaid
specialitems
pretaxincome

Three-year average cash ETR adjusted for the industry median; p indicating one of
twelve rolling three-year periods within the sample time frame.

Brown and Drake [2012]

TA_Cash ETR;
TA_GAAP ETR

Firms mean industry size Cash (or GAAP) ETR less firms Cash (GAAP) ETR, where Cash
(GAAP) ETR is the sum of current tax expense (cash taxes paid) over years t, t-1 and t-2, divided by
the sum of pre-tax income over years t, t-1 and t-2.

Average three-year GAAP ETR (or Cash-ETR), adjusted based on industry and size.

Balakrishnan et al. [2012]

Current
GAAP ETR_5

Worldwide current income tax expense

Worldwide total pre tax accounting income

Current GAAP ETR equals current (i.e. total less deferred) tax expense over five
years (t-4 to year t) divided by the sum of pre-tax book income calculated over the
same period; high tax planners defined as firms ranked in the lowest 20% of Current
GAAP ETR for each two-digit SIC industry and year.

Ayers, Jiang, and LaPlante [2009],

Harrington and Smith [2012]

CTA

See description.

Composite measure: 5-year GAAP- and Cash ETRs are ranked into deciles per year.
An average rank across the two measures is calculated and standardized between
zero and one.

Shevlin, Urcan, and Vasvari [2013]

32

BTD

Pretax book income U.S. CTE Foreign CTE / U.S. STR NOLt NOLt1

Total BTD Temporary BTD Permanent BTD




Definition in Manzon and Plesko 2002 :

US domestic income U.S.CTE/U.S. STR state income taxes other income taxes equity in
earnings

Permanent BTD
PermBTD

Total BTD Temporary BTD

Temporary BTD

Deferred tax expense Statutory tax rate

Discretionary total BTD

DD_BTD

Residual from
BTDit 1TACCit i it

DTAX
PERMDIFFit

Modified DTAX

Excess GAAP ETR;
Excess Cash ETR

Error term from the following regression:

ETR differential x Pretax book income a b x Controls e

Residual obtained from:
0 1INTANGit 2UNCONit 3MIit 4CSTEit 5NOLit 6LAGPERMit it

Equation as above plus log of foreign assets as additional control.

Residuals from the following regression:

GAAP ETR , or Cash ETR ,
LogTA ,
INSTOWN ,

Levearge , DivDummy ,

ROA , CapExp , ,

PB ,

The total difference between book and taxable income. Computed as the difference
between book income (PI) less minority interest (MII) and an estimate of taxable
income. Taxable income is estimated by grossing up the sum of federal tax expense
(TXFED) and foreign tax expense (TXFO) by the statutory rate and then subtracting
the change in the net operating loss (TCLF) from year t-1 to year 1. BTD is scaled by
beginning of the year total assets (AT).

E.g. Mills et al. [1998]

Measure estimates amount of variation between book and taxable income explained
by different tax and accounting rules and economic factors.

Manzon and Plesko [2002]

Permanent book-tax differences computed as the difference between total book-tax

differences (BTD) and temporary book-tax differences. According to Shevlin [2002]
(p. 439) the ideal tax shelter would give rise to permanent differences.

Shevlin [2002]

Computed by grossing up deferred tax expense (DTE) by the statutory rate (STR).

Hanlon [2005],
Blaylock, Shevlin, and Wilson [2012]

A measure of unexplained, "abnormal" total book-tax differences. Desai and

Dharmapala [2006, 2009] use the residuals from regression of the Manzon and
Plesko [2002] version of BTD on total accruals.

Desai and Dharmapala [2006, 2009],

Chyz, Leung, Li, and Rui [2013]

The unexplained portion of the ETR differential (=GAAP ETR minus statutory tax
rate).
Frank, Lynch, and Rego [2009]
DTAX is the residual obtained from estimating the equation to the left by GICS code
and fiscal year, where all variables, including the intercept, are scaled by beginning
of the year total assets (AT).
DTAX measure modified by including the Oler, Shevlin, and Wilson [2007] measure
of foreign assets to control for multinational operations.

Armstrong, Blouin, Jagolinzer, and Larcker [2012a]

Abnormal ETRs not explained by financial and firm- specific characteristics;

residuals from an equation that regresses ETR measures on firm specific variables.

Huseynov and Klamm [2012]

Tax liability accrued for taxes not yet paid on uncertain positions.
UTB

Unrecognized tax benefit, i.e. amount of tax reserves disclosed under FIN 48.

Can be predicted (Pred_UTB) at the end of year t. Calculated based on the estimated
coefficients from the following prediction model:
UTB

PT_ROA
SIZE
SG&A
MTB
SALES_GR

FOR_SALE

R&D

LEV

DISC_ACCR

E.g. Rego and Wilson [2012],

Lisowsky et al. [2013]

Tax shelter activity

TSP, SHELTER, RT

Indicator variable set equal to one for firms engaged in tax shelters.

Firms identified via court records, news from the financial press, or confidential tax
data (e.g. reportable transactions to the OTSA).

Graham and Tucker [2006]

(Shelter Active Dummy; TSP),
Wilson [2009] (SHELTER),
Lisowsky [2010, 2013] (RT),
Lanis and Richardson [2011]

Prob_SHELTER

Probability that a firm engages in a tax shelter.

Estimated probability that a firm engages in a tax shelter, derived from a tax shelter
utilization model's main parameter estimates. Prob_SHELTER cannot identify the
dollar size of tax shelter benefits.

Wilson [2009],
Lisowsky [2010] (TSS)

HAVEN

The number of material operations in tax haven locations

disclosed in Exhibit 21 of the current year 10K.

Tax haven involvement identified based on Exhibit 21 data (10-K).

33

Dyreng and Lindsey [2009]

a.

Variants of Effective Tax Rates

Effective tax rates (ETRs) relate a companys tax burden to its ability to pay taxes and are used to
indicate the relative tax burden across firms (Rego [2003]). ETR-based measures are generally calculated by dividing some estimate of a firms tax liability (numerator) by a measure of pretax profits or
cash flows (denominator). In order to fully understand possible inferences across different ETR
measures it is vital to know what the different numerators and denominators capture and what type of
explicit tax avoidance they do not reflect (see Hanlon and Heitzman [2010]). Most apparently, different ETR variants vary in terms of what they include as the relevant tax liability in the numerator.
Some GAAP-based ETRs include the total, i.e. the current plus the deferred tax expense, whereas alternative definitions merely use the current tax expense. Alternatively, ETRs can be calculated using
cash taxes paid in the numerator instead (Cash ETRs).67 With respect to the relevant time horizon,
ETRs can either be computed on an annual basis or cumulated over multiple years (long-run ETRs).

GAAP- and Cash ETRs

The GAAP ETR is defined as total income tax expense divided by pre-tax accounting income (see
Table 1). As the total tax expense in the numerator represents the sum of current plus deferred tax
expense, the GAAP ETR is not affected by any tax strategies that defer the expense of taxes (e.g. different depreciation patterns for book and tax purposes). Alternatively, the GAAP ETR can be defined
to only include the current tax expense in the numerator (Current GAAP ETR), in which case deferral strategies would be reflected. Thus, the GAAP ETR is the rate that impacts accounting, whereas the
Current GAAP ETR may only impact accounting earnings if the item that affects the Current GAAP
ETR is not a temporary difference (Hanlon and Heitzman [2010]).
As indicated more generally in Section 4.1, drawing on financial statement data to derive expensed
taxes bears the risk of over- or understating the estimated tax expense relative to the taxes actually
paid.68 This may be the case with respect to accounting items such as large tax deductions for stock

67

68

Cash taxes paid of U.S. firms can be found in the financial statements as a supplemental disclosure within the
statement of cash flows or in the notes. Cash tax paid is data item 317 in Compustat.
See e.g. Hanlon [2003] and Plesko [2003].

34

options, 69 valuation allowances, or tax contingency reserves (tax cushions)70 accounted for under
FAS No. 109. Another way to gauge a firms tax avoidance status involving the GAAP ETRs is to
calculate its ETR Differential. This measure is defined as the difference between a jurisdictions statutory tax rate and the firms GAAP ETR. The lower a firms realized GAAP ETR is compared to the
generally applicable tax rate, the more tax avoidance it likely conducts. Obviously, if using the same
(e.g. U.S.) statutory tax rate across all firms within a given sample, comparing GAAP ETRs directly
would yield similar results (Hanlon and Heitzman [2010]).
The Cash ETR is defined as cash income taxes paid over a firms pretax book income. As opposed to
GAAP ETRs, Cash-based ETRs do not impact accounting earnings and are not affected by changes in
accounting accruals. They do however reflect deferral strategies. If estimated on an annual basis, the
Cash ETRs numerator and denominator might not match if the cash taxes paid include taxes paid on
different periods earnings (Hanlon and Heitzman [2010]).71 An advantage of using cash taxes in the
numerator is that tax benefits are taken into account notwithstanding their income sheet treatment, e.g.
the tax consequences of employee stock options. Moreover, Cash ETRs (unlike GAAP ETRs) remain
unaffected by changes in valuation allowances or tax reserves (Dyreng et al. [2008]).
The tax expense (cash taxes paid) in the nominator of a GAAP ETR (Cash ETR) in most studies represents the worldwide tax expense (worldwide cash taxes paid), i.e. the estimated tax liability is not limited to federal taxes but includes all local, state, and foreign taxes.72 This is important in order to avoid
a mismatch between the numerator and the denominator, in particular in cases of large multinational

69

70
71

72

See Hanlon and Shevlin [2002] for further details on the research implications of accounting for tax benefits
of employee stock options. Evidence further suggests that management manipulates earnings through these
accounts (Gleason and Mills [2002], Miller and Skinner [1998], Schrand and Wong [2003], Dhaliwal et al.
[2004]).
See Cazier et al. [2009] for further discussion of tax reserves.
Another (general) source of mismatch between the numerator and the denominator of an ETR could be extraordinary items71 (Gallemore and Labro [2013]). Such items are not reflected in the denominator of the
ETR, as they are reported below pretax income (i.e. presented separately in the income statement). This is
problematic if firms pay at least some taxes on these items, which would lead to an increase in the numerator
while leaving the denominator unaffected. To control for this effect, Gallemore and Labro [2013] include extraordinary items (scaled by average total assets) as an explanatory variable in their cross-sectional regression
of information environment quality on the Cash ETR. They predict and find a positive effect.
For further variations of GAAP ETR definitions that can be selected along three dimensions: tax, income,
and sample., see Omer et al. [1993], with further reference to Stickney and McGee [1982], Zimmerman
[1983], and Shevlin [1987].

35

firms that conduct business and potentially pay taxes across multiple jurisdictions.73 More generally, available financial statement information allows only for the computation of worldwide tax rates on
worldwide income, federal tax rates on domestic income, or foreign tax rates on foreign income. In
other words, this simple [effective tax rate] calculation can only capture information as fine as the
numerator or denominator (Dyreng and Lindsey [2009], p. 1285).74
With further respect to the denominator, GAAP- and Cash ETRs both use pretax GAAP earnings and
thus can only capture non-conforming tax avoidance. That is, ETR measures only reflect tax avoidance activities that create a deviation between book and taxable income.75 In turn, ETRs do not reflect
any conforming tax strategies that avoid explicit taxes by reporting both lower GAAP earnings and
lower taxable income. For example, ETRs will generally not reflect the tax benefits of changes in leverage or interest deductibility (Bernard [1984]).76 This can be especially relevant if investigated firms
are private (not public) firms. Private firms are commonly assumed to engage in more conforming tax
planning than public firms because private firms face lower financial reporting costs (see Cloyd et al.
[1996], Hanlon, Mills, and Slemrod [2007]). In sum, particularly with a view to studies focusing on
private firms, results need to be interpreted with care when using common tax avoidance proxies.

73

74

75

76

An alternative approach can be found in Desai and Dharmapala [2009], who prefer using firms reported
current federal tax expense only, since this procedure avoids problems of inferring the applicable foreign tax
rates. Alternatively, the authors include a control variable approximating foreign activity in their regression
analysis (see. Desai and Dharmapala [2009], pp. 39-40).
For the case of large multinationals, in order to better depict how foreign operations actually affect worldwide, federal, and foreign tax rates of U.S. groups, Dyreng and Lindsey [2009] hence develop a specific regression framework. This allows capturing the variation in estimated tax expense measures associated with
income sourced in various locations.
Examples for book-tax non-conforming tax avoidance include the straightforward use of R&D development
tax credits, the relocation of operations to low-tax countries, the shift of income from high- to low-tax locations, the engagement in synthetic lease transactions, or the use of off-balance sheet entities to create deductions or losses that reduce the consolidated taxable income (see Badertscher et al. [2011] , p. 14, Fn. 12).
Further examples for conforming tax avoidance are the acceleration of R&D- as well as advertising expenditures, the deferral of revenue recognition to future periods (real transaction management), or the selling of
assets to generate one-time gains or losses that similarly affect book and taxable income (one-time transaction management), see Badertscher et al. [2011] (p. 19), Klassen [1997].

36

Long-Run ETRs
Dyreng et al. [2008] suggest the Long-run Cash ETR defined as the sum of cash taxes paid over ten
years divided by the sum of pre-tax earnings (less special items77) over those same ten years. The authors point out the long-run nature of the measure as a main benefit as it alleviates the year-to-year
volatility in annual ETRs and more closely depicts firms actual explicit tax costs over time.78 Further,
any long-run ETR should have the ability to capture potential reversals of accounting accruals and
should thus be less affected by accrual management, e.g. compared to annual ETRs.79 However, as the
denominator of the long-run Cash ETR is also a measure of GAAP pretax income, concerns may persist that upward earnings management (with no corresponding effect on taxes paid) biases the ETR
downward (e.g. Badertscher et al. [2011]). This concern is somewhat mitigated in the case of long-run
measures, because firms that succeed in permanently managing their pretax book-income upward
without having to pay additional taxes, can still be considered tax avoiders (Hanlon and Heitzman
[2010]). In their investigation exploring the effects of top executives on tax avoidance, Dyreng,
Hanlon, and Maydew [2010] alternatively use cash flows from operations in the denominator of their
long-run ETR (Cash tax ratio).80 This allows to better control for executives earnings management
incentives possibly affecting the pre-tax earnings in common ETRs denominators.81 In addition, the
Cash tax ratio is interesting as it allows for the measurement of some conforming tax avoidance, at
least as long as the underlying tax strategy is accrual-based.82
In sum, as Dyreng et al.s [2008] original research objective is to gauge the extent to which some U.S.
companies are able to avoid cash taxes (a) sustainably over time, and (b) by any available means, the
use of long-run cash-based ETR measures or variants thereof appears intuitive. However, the long-run
cash ETR was developed in the particular context of one study and does not necessarily need to be

77

78
79

80
81
82

It has become common practice to subtract special items as they are sometimes large, thus introducing considerable volatility (especially in annual) ETRs, see Dyreng et al. [2008], with further reference to
Burgstahler et al. [2002]. Dechow and Ge [2006] provide evidence that investors might misunderstand the
transitory nature of special items.
One obvious downside of long-run measures is that there are usually fewer available firms.
Studies have argued that earnings management most likely occurs through exercising discretion in determining accruals, e.g. Healy [1985].
Dyreng et al. [2008] originally developed this measure as an alternative specification in their 2008 paper.
Although the interpretation of this ratio becomes somewhat less intuitive (Dyreng et al. [2010], p. 1177).
As it otherwise would again reduce both the denominator (operative cash flows) and the numerator (taxable
income; taxes paid), see Hanlon and Heitzman [2010] (p. 141, Fn. 49).

37

(nor was it ever intended to be) the superior tax avoidance measure in every other research setting.
Even though (variants of) long-run Cash ETRs are probably the most frequently applied measures
throughout literature,83 research designs still need to be sensitive to the circumstance that for specific
questions there may be other, maybe more suitable measures available.
Besides varying the relevant time frame, another way to adjust long-run ETR measures is to benchmark the ratio against the industry median or based on firms relative size. Brown and Drake [2012] (p.
13) calculate firms three-year average cash ETR adjusted for the industry84 median cash ETR (Cash
ETR_3_INDi,p), with p indicating one of twelve rolling three-year periods within the samples time
span. In line with Dyreng et al. [2008], the notion behind using a three-year horizon is to reduce statistical noise. The idea behind benchmarking the ratio against the respective industrys mean is to account for the possibility that tax avoidance opportunities may be correlated with industry membership,
although results in Dyreng et al. [2008] demonstrate that there is also considerable within-industry
variation of corporate tax planning. Balakrishnan et al. [2012] define tax aggressive firms as the ones
that pay unusually amounts of taxes relative to their industry and size (TA_Cash ETR). Hence, this
study additionally benchmarks the three-year Cash ETR (and GAAP ETR alternatively) against a
firms size in the attempt to thoroughly single out the above normal85 level of explicit tax planning.
Alternatively, although less common, long-run ETRs can also be calculated using Current GAAP
ETRs. For example, Ayers et al. [2009] cumulate current effective tax rates over five consecutive
years (Current GAAP ETR_5) and treat firms ranked in the lowest 20 percent of Current GAAP
ETR_5 for each two-digit SIC industry and year as high tax-avoiding firms. The five-year accumulation is intended to offset some of the potential over- and understatement of the (actual) tax liability.
Moreover, since the studys particular focus is on taxes due in the current period, deferred tax expenses representing future tax effects from current transactions are excluded from the definition. Being
aware of GAAP-based ETRs own limitations, the study draws on Cash ETRs in alternative specifications; a procedure common to many studies investigating the determinants and consequences of tax
avoidance in order to thoroughly address research design limitations.
83

84
85

Although often using alternative time horizons, e.g. three or five years instead of ten. Notice that cash taxes
paid over shorter time periods become less meaningful as they include payments to (and refunds from) the
IRS and other authorities pertaining to tax disputes that began many years ago (see e.g. Dyreng et al. [2010]).
Industries are classified according to Barth et al. [1998].
Balakrishnan et al. [2012] p. 10. Industries in this study are classified based on Fama and French [1997].

38

Another recent approach to the ETR-based measurement of tax avoidance can be found in Shevlin et
al. [2013], who combine firms five-year cumulative GAAP- and Cash ETR into a single measure, the
so-called composite tax avoidance measure (CTA).86 The idea is to reduce error and noise effects
entailed in the GAAP- and Cash ETR. To obtain the CTA measure, both the GAAP- and the Cash
ETRs are ranked into deciles in every observed year. Then an average rank across both measures is
calculated and standardized to range between zero (high tax avoidance) and one (low tax avoidance).87

b.

Variants of Book-Tax Differences

The total, i.e. the permanent plus the temporary, book-tax difference (BTD) is an estimate of the difference between a firms reported pretax book income and its estimated taxable income.88 Such a reporting gap may generally result from the fact that firms follow separate sets of rules for tax and financial accounting, each pursuing different objectives.89 Assuming a high degree of conformity between financial and tax accounting rules, firms likely face a fundamental trade-off when making financial and tax reporting decisions. This is because a generally desired increase of financial reporting
income may inevitably come at higher tax costs, whereas the attempt to report a lower income to the
tax authorities would have to coincide with a lower income reported to shareholders (i.e. financial
reporting costs).90 Nonetheless, studies have documented a significant increase in BTDs during the
1990s,91 indicating that firms may in fact not always have to trade off their financial and tax reporting
choices. Instead, firms appear to have opportunities to manage their book income upwards (to report a

86

87
88

89
90
91

An application example being the observation in Shevlin et al. [2013] that a drop in the CTA measure from
the 90th percentile to the 10th percentile of its sample distribution is paralleled by a decrease in cash flows
(scaled by total assets) by 0.7 % (the samples average cash flow ratio being 11 %), (p. 6).
See Shevlin et al. [2013] (p. 18) and Panel A of Table 2 (p. 47).
The total BTD can be decomposed into a temporary and a permanent part (see Table 1). As tax avoidance
activities that generate temporary differences lead to a lower current tax expense, they also lead to a corresponding increase in the deferred tax expense. Thus, the total BTD would largely remain unaffected by temporary tax strategies. By contrast, the temporary BTD (defined as the deferred tax expense grossed up by the
statutory tax rate) would capture such reverting tax strategies. Accordingly, the permanent BTD is defined as
the total BTD minus the temporary BTD.
See Manzon and Plesko [2002] (pp. 178-184) for a thorough discussion. See also Section 4 of this study.
See Shackelford and Shevlin [2001] for a survey of literature investigating this trade-off.
See e.g. Manzon and Plesko [2002] (p. 186) for a graphic illustration of the increase in BTDs.

39

strong economic performance), while at the same time managing their taxable income downwards (to
reduce their tax burden).92
Research generally adopts the view that firms tax and financial accounting choices are fairly independent.93 Following this view, it appears intuitive that BTDs should provide some information about
corporate tax avoidance behavior.94 Nevertheless, BTDs conceptually do not necessarily reflect tax
avoidance, especially if the over-reporting of book income (earnings management) is the primary
cause of a BTD.95 As valid tax outcomes are much harder to derive than e.g. earnings quality characteristics, the great challenge for tax research is to accurately document the tax-related part of a BTD
(Hanlon and Heitzman [2010]). Moreover, the existence of firm-specific characteristics independent of
aggressive tax or book reporting may further complicate the use of BTDs as a proxy for tax aggressiveness (Wilson [2009]).
While caution is thus advisable,96 there is nevertheless considerable evidence indicating that large
positive BTDs might serve as a useful signal of tax avoidance. Considering that both financial and tax
income are ultimately based on the same underlying economic transactions,97 tax authorities might
view large gaps between the book income and the taxable income as a sign of potential tax aggressiveness and step up their investigative efforts (Cloyd [1995], Cloyd et al. [1996], Badertscher,

92

93

94

95

96
97

This incentive to reduce taxable income is also present in loss firms, as losses provide firms with tax benefits
through the use of carrybacks and carryforwards (Maydew [1997]).
See e.g. Cloyd [1995], Cummins et al. [1995], Kasanen et al. [1996], Mills [1998], Phillips [2003], Frank et
al. [2009].
As Hanlon and Heitzman [2010] (p. 141, Fn. 50) point out, BTD-measures are closely related to ETR measures, as BTD measures subtract one measure of income from the other and ETR measures relate some estimate of a tax liability to a measure of income. Obviously, the fundamental caveats to the approach of inferring taxable income from financial statements (Hanlon [2003]) also carry over to the estimates of BTDs.
In this case, the book income may be significantly increased within the scope of managerial discretion, while
leaving the taxable income rather unaffected. Prior studies provide compelling evidence that (aggressive) financial reporting practices in parts contribute to the existence of BTDs and that firms with large temporary
BTDs exhibit less persistent (i.e. lower quality) GAAP earnings (Hanlon [2005], Lev and Nissim [2004]).
E.g. Manzon and Plesko [2002], Hanlon and Shevlin [2005], Mills et al. [2002].
Further considering that not only GAAP standards but also IRC Section 446 (a) demands that tax accounting
methods clearly reflect income.

40

Phillips, Pincus, and Olhoft [2009]).98 Thoroughly outlining this argumentation, Mills [1998] predicts
and finds that firms with larger BTDs face greater proposed IRS audit adjustments.99
Desai [2003] investigates the above mentioned increase in BTDs during the 1990s and posits that the
divergence of book and tax income is not assignable to common financial accounting drivers (e.g.
depreciation), but rather to increased tax shelter activity. Moreover, Desai and Dharmapala [2009]
perform a validation check of BTDs as a valid measure of tax sheltering. Following Graham and
Tucker [2006], the authors compile a set of firms allegedly involved in shelter activity in a particular
year. Using a logit model (indicator variable set to 1 for alleged tax shelter firm-years), they estimate
the relationship between tax sheltering and BTDs, controlling for various firm characteristics.100 All
else constant, the BTD tends to be larger in firm-years of alleged sheltering (Desai and Dharmapala
[2009], Table 2, p. 540-41). Heltzer [2009] transfers the Basu [1997] measure of accounting conservatism to the taxation context, suggesting that while firms with large positive total BTDs exhibit financial-reporting conservatism similar to that of other firms, they do appear to engage in more conservative tax reporting (which, in a tax context, seems interpretable as being more aggressive).
Tax sheltering, an aggressive means to avoid taxes, is often considered to create permanent (rather
than temporary) BTDs, which makes Permanent BTDs particularly attractive to the tax planning corporation and potentially useful as a measure to gauge tax aggressiveness. Based on court records and
press articles, Wilson [2009] identifies a sample of firms accused of tax sheltering and develops a predictive model of the type of firms that are likely involved in tax sheltering. Estimated coefficients
from logistic regressions and marginal changes in the probability of employing a tax shelter indicate
that a 1 % increase in BTDs leads to a 2.78 % increase in the probability a firm is involved in tax sheltering. These findings imply that large BTDs may well serve as a signal of aggressive tax reporting.

98

99

100

In a similar notion, but with a focus on the earnings quality dimension, large BTDs have been found to lead
to greater scrutiny from external auditors (Hanlon et al. [2012]) and are likely interpreted as negative information by credit rating agencies (Ayers et al. [2010]).
Next to total BTDs, Mills [1998] uses the difference between the federal tax expense for book less the tax as
declared to the IRS as an alternative BTD measure. Third, she uses the deferred tax expense (temporary
BTDs).
The idea to infer tax shelter behavior from financial statements originally stems from the U.S. Department of
Treasury [1999], who noted that one hallmark of corporate tax shelters is a reduction in taxable income with
no concomitant reduction in book income. (pp. ii and 3) and that a major feature of tax shelters was the inconsistent financial accounting and tax treatment [] (p. v), see also McGill and Outslay [2004] (p. 743).

41

In another recent paper, Blaylock et al. [2012] extend prior research on the ability of Temporary
BTDs to provide information on earning quality (Hanlon [2005]). Their work contributes to current
research by suggesting novel methods for partitioning firms according to the source of their large
BTDs. The results provided in Blaylock et al. [2012] suggest that in cases where large positive temporary BTDs are predominantly driven by tax avoidance (earnings management), earnings and accruals
persistence is higher (lower), compared to other firms with large positive BTDs.
In sum, acknowledging the competing explanations for BTDs, evidence suggests that BTDs may capture a notable portion of tax avoidance. In particular, studies repeatedly highlight a significant association between rather tax aggressive actions, i.e. tax sheltering, and large BTDs. However, as an important limitation, studies name their (often small) samples including those firms who engage in tax
actions that draw the particular attention of tax authorities, or firms that are actually caught with
inappropriate tax sheltering by the IRS.101 Thus, there is a potential selection bias and results may not
easily be generalizable. Also, findings might not simply be transferable to newer or further advanced
types of tax sheltering that have not yet been present at the time of a study (Wilson [2009], p. 993).
Lastly, just like ETR-based measures, BTDs obviously only reflect non-conforming tax avoidance,
which makes them impractical to use when comparing tax avoidance behavior across firms that attach
varying degrees of importance on their financial accounting earnings.

c.

Discretionary and Abnormal Measure Partitions

In the manner of the Jones [1991] model, which proxies a firms engagement in earnings management
by estimating the discretionary part of accounting accruals, the literature suggests ways to isolate the
discretionary part of a BTD that most likely reflects tax avoidance (DD_BTD). Using the residuals
from panel data regressions of firms total BTDs102 on total accruals,103 Desai and Dharmapala [2006,
2009] aim to carve out the portion of the BTD that is attributable to tax planning, i.e. which is not

101

102
103

If the IRS or other tax authorities look for large BTDs to identify corporate tax aggressiveness, then what
many studies at least to some extent capture is the tax authoritys perception or model of tax aggressiveness (Hanlon and Heitzman [2010], p. 141).
Defined according to Manzon and Plesko [2002], see Table 1 above for details.
In alternative specifications (following e.g. Healy [1985], Dechow et al. [1995]), BTDs are regressed on
abnormal accruals in order to quantify the extent to which earnings management is the driver of the book-tax
gap, see Desai and Dharmapala [2006], Section 5).

42

explained by earnings management.104 In the context of their study, the authors use this abnormal
part of discretionary BTDs as their measure for tax avoidance, or more precisely, tax sheltering.
Frank et al. [2009] investigate the relation between aggressive tax reporting and aggressive financial
reporting. The authors consider firms to be tax aggressive if they exhibit high discretionary permanent
BTDs (rather than total or temporary BTDs) that are likely related to tax planning. The studys measure of tax aggressiveness is obtained by regressing permanent differences (PERMDIFF)105 on nondiscretionary items unrelated to explicit tax planning.106 The residual from this regression, the unexplained discretionary portion of permanent BTDs, is their measure of tax aggressiveness (DTAX).
Frank et al. [2009] (p. 471) support their decision to base the measure on permanent differences with
two main reasons. First, temporary BTDs have been found to capture pre-tax accrual management
(e.g. Phillips, Pincus, and Rego [2003]), hence tax avoidance measures that include temporary or total
BTDs may be spuriously correlated with proxies for financial reporting aggressiveness.107 Second,
(largely anecdotal) evidence on the common nature of aggressive tax shelters suggests that tax sheltering rather generates permanent, as opposed to temporary, BTDs.108 Hanlon and Heitzman [2010] assume a skeptical view with regards to the latter argument, pointing out that shelters come in many
different forms, some of them just as well generating temporary BTDs, or even no BTD at all.109

104

105

106

107

108

109

As the authors point out themselves, the fact that this measure is estimated in form of a residual makes it
impractical to be quantified in dollar amounts or to measure aggregated tax sheltering across firms and/or
whole economies (as the residual sums to zero for firm i over all years, see Desai and Dharmapala [2006], p.
160).
Hanlon and Heitzman [2010] stress that the denotation PERMDIFF is rather unfortunate, given that this
measure as it is defined actually captures more than permanent BTDs. In fact, PERMDIFF captures anything
that affects GAAP ETRs (e.g. also tax credits, foreign operations being subjected to different tax rates, earnings designated as permanently reinvested), and can alternatively be thought [] the difference between the
effective and statutory tax rates multiplied by pre-tax accounting income (Hanlon and Heitzman [2010], p.
142). DTAX then would be the portion of this ETR differential under managements control (e.g. by engaging in shelters).
These items include goodwill, intangible assets, minority interest, current state tax expense, change in tax
loss carryforwards, and prior periods permanent BTD (by year and two-digit SIC industry).
Tax avoidance actions that generate permanent tax benefits increase net income, but do not affect pre-tax
discretionary accruals.
Frank et al. [2009] (p. 472) refer to Weisbach [2002b], Shevlin [2002], Wilson [2009], Graham and Tucker
[2006] and the U.S. Department of Treasury [1999].
Descriptions of different types of tax shelters can be found in Wilson [2009] (Appendix, p. 995), Hanlon and
Slemrod [2009] (Appendix A, p. 139), Desai [2009] (p. 172, on Enrons project steel), and U.S.
Department of Treasury [1999].

43

A slightly modified version of the DTAX measure (Modified DTAX) can be found in Armstrong et
al. [2012a]. The definition is generally equal to that in Frank et al. [2009] (see Table 1), however, the
variables regressed on PERDMIFF to obtain the error term representing the discretionary portion of
tax-motivated permanent differences further include foreign assets as a control (as measured in Oler et
al. [2007]). The goal is to control for the presence of ordinary multinational operations that may
result in ETR differentials but do not necessarily make a firm a particular tax aggressive firm
(Armstrong et al. [2012a], p. 14, Fn. 9). Huseynov and Klamm [2012] alternatively estimate the abnormal part of a firms GAAP ETRs (Excess GAAP ETR), and Cash ETR respectively. Similar to the
approach taken in Frank et al. [2009], GAAP or Cash ETRs are regressed on firm fundamentals, such
as total assets, leverage, institutional ownership, return on assets, and capital expenditures, in order to
obtain a residual ETR component reflecting discretionary tax avoidance actions.
Overall, in order to get some sense of the extent to which firms (intentionally) engage in tax avoidance, the approach to infer tax-related discretionary portions of BTDs or ETRs appears conceptually
helpful. However, as is the case with the Jones [1991] model and modified versions thereof (e.g.
Dechow and Dichev [2002]), a models power greatly depends on its ability to accurately separate the
relevant abnormal part from the total effect.110 In this regard, a model is only as good as the proxies
included to single out the known (or rather believed to be known) determinants of non-discretionary
behavior. Closely related to this issue, it requires implicit assumptions as to which BTD-affecting actions are primarily tax driven (i.e. intentional tax avoidance), and which actions may only be of second-order importance (i.e. a byproduct of earnings management) and should thus rather be captured
in the non-tax driven controls than in the regressions residuals (Hanlon and Heitzman [2010]).

d.

Unrecognized Tax Benefits

In 2006, FASB issued FIN 48 Accounting for Uncertainty in Income Taxes (ASC 740-10) with the
intention to reduce the diversity in practice related to the reporting of tax reserves.111 Under FIN 48,

110

111

For example, original Jones-type models sometimes explain as little as 10 % of the variation in accruals
Dechow et al. [2010] and are likely to be severely misspecified if they fail to adequately control for firm performance (Kothari et al. [2005]) or firm growth (McNichols [2000], Collins et al. [2012]), which to a great
extent determine over what should be considered the normal level of accruals.
Prior to FIN 48, under SFAS 109 and SFAS 105, tax contingency reporting did not follow a uniform approach (alternatives included the loss contingency-, best estimate-, and tax advantaged- approach, see

44

publicly traded firms are required to disclose their unrecognized tax benefits (UTB), which represent
an income tax reserve for future tax contingencies. Accordingly, UTBs are also referred to as tax
reserves or tax contingencies (e.g. Cazier, Rego, Tian, and Wilson [2011]).112
Under FIN 48, all uncertain tax positions must be evaluated in a two-step recognition and measurement approach. This approach requires a firm to determine whether its tax position meets the morelikely-than-not (MLTN) probability of being legally sustainable upon audit on its tax return, based
solely on its technical merits. In cases where the MLTN threshold is not satisfied, no tax benefit will
be recorded. For tax positions meeting or beating the MLTN threshold, the recordable tax benefit is
the largest amount of benefit that is cumulatively greater than 50% likely to be realized. The remaining difference between the tax benefits as reported on the tax return and the benefits that passed the
two-step recognition and measurement procedure is recorded as an increase in the tax reserve.113
This approach to accounting for uncertain tax positions immediately suggests that the FIN 48 tax reserve should at least reflect some scope of uncertainty inherent in a (self-assessed) tax position and
hence also some extent of tax-related managerial discretion.114 Following this notion, Frischmann et al.
[2008] consider tax reporting to be aggressive if it involves certain risks. Adopting this concept of

112

113

114

e.g. Dunbar et al. [2007]), and relevant information was usually not disclosed. Gleason and Mills [2002] investigate the diversity in tax reserve disclosure practice prior to FIN 48 and find it to be partly related to
firms inconsistent interpretation of the materiality threshold. For an early post-implementation review of academic research dealing with FIN 48 see Blouin and Robinson [2011]. FIN 48 applies to annual periods after
December 15, 2006 (December 15, 2008 for private firms).
UTB data can be obtained from tax footnote disclosures. Based on that information, UTBs can also be estimated (PRED_UTB) using a predictive model that draws on other firm characteristics (see e.g. Rego and
Wilson [2012]).
See Dunbar et al. [2007] (pp. 3-5) for an illustrative example, Robinson and Schmidt [2013] (appendix A) for
an overview of the specific disclosure items required under par. 20 and 21 of FIN 48. In addition, from 2010
onwards, firms are required to report their uncertain tax positions (UTP), ranked in terms of largest to smallest. For further discussion on this Schedule UTP see Coder [2010], Dellinger [2010], Sapirie [2010].
This notion also lead auditors and their clients to heavily criticize FIN 48, fearing the new regulation would
provide a roadmap for the tax authority that may undercut the firms bargaining power in the associated tax
disputes (Spatt [2007], see also survey responses in Graham et al. [2012]). However, while investors generally appear to incorporate portions of UTBs in their valuation considerations (e.g. Robinson and Schmidt
[2013], Koester [2011], Song and Tucker [2008]), there is only little evidence that investors may have anticipated any incremental costs supposedly associated with the introduction of FIN 48 (Frischmann et al.
[2008]). Lisowsky et al. [2013] provide descriptive statistics on reportable transaction participation, suggesting that reporting aggressiveness decreased some years prior to FIN 48, possibly in response to other regulatory events (e.g. the Sarbanes-Oxley Act; SOX). Blouin and Robinson [2011] (p. 33) further summarize:
[] it appears that the IRS views the FIN 48 disclosure as not particularly helpful in audit selection because
it often aggregates a variety of tax positions as well as across several jurisdictions.

45

risky tax avoidance constituting tax aggressiveness (Rego and Wilson [2012], p. 776), the amount of
UTBs accrued under FIN 48 may serve as a reasonable measure of tax avoidance, if not tax aggressiveness (see also DeWaegenaere, Sansing, and Wielhouwer [2010], who provide theoretical analyses
of UTBs being adequate proxies for tax aggressiveness).
However, the question to what extent observable tax reserves in fact approximate tax avoidance may
be difficult to answer. Problematic is the dual nature of the UTB account (Hanlon and Heitzman
[2010], p. 143). As illustrated above, the uncertainty taken on in a tax position underlying UTBs
should provide insights into firms tax avoidance behavior. However, because the accrual of a tax reserve eventually affects book net income, UTBs can also be useful instrument to engage in earnings
management.115 Hence, managers may have to trade off their aggressive tax and financial reporting
incentives when deciding on whether or not to record a tax reserve. If managers essentially pursue
their financial reporting goals, some risky uncertain tax positions may not be reflected by changes in
UTBs, while other observable changes in UTBs may in fact not always reflect tax avoidance, but earnings management instead.116
Empirical studies so far suggest that UTBs capture at least some scope of tax avoidance, albeit the
true bias caused by aggressive financial reporting remains largely unclear. There is however some
considerable evidence that implies UTBs may at least serve as useful proxies for tax sheltering.
Lisowsky [2010] finds a positive relation between the estimated tax reserve and reportable transactions disclosed to the IRS. Under the awareness that financial reporting incentives may considerably
affect FIN 48 reserves, Lisowsky et al. [2013] seek to further validate the use of tax reserve accruals to
signal aggressive tax positions. They estimate logistic regressions of reportable transaction use on the
FIN 48 tax reserve (UTB). The results suggest a significant positive association between tax shelter

115

116

Studies find that managers likely exercise discretion over tax reserves to achieve financial reporting goals
(Dhaliwal et al. [2004], DeSimone et al. [2011]). With regards to the post-FIN 48 regime, early evidence
suggests that UTBs are used to smooth earnings (e.g. Blouin and Tuna [2007], Gupta et al. [2012]). Auditorprovided tax services may also play an important role in the (discretionary) determination of UTBs (Gleason
and Mills [2011]).
Apart from the here discussed studies, research investigating the cross-sectional determinants of UTBs to
learn more about whether FIN 48 yields valuable information related to the nature and degree of corporate
tax avoidance is still scarce (see Alexander et al. [2009], Campbell [2010], Cazier et al. [2009] for some recent work in progress).

46

participation and the tax reserve, indicating that UTBs may be a reliable proxy for predicting tax shelters.117

e.

Tax Shelter Participation

An alternative approach to classify firms as tax avoiders is to directly check for their actual engagement in specific tax avoidance actions, namely tax sheltering.118 Empirical studies have detected Tax
shelter activity from the financial press, tax court records, or reportable transactions to the IRS or
other (tax) authorities.119
Based on court records and financial news stories, Graham and Tucker [2006] investigate a sample of
44 tax shelter participators between 1975 and 2000 and show that these firms have larger interest deductions (approximately 9 %) and lower debt ratios (8 %) than comparable non-sheltering firms. Adding further observations to the Graham and Tucker [2006] sample, Wilson [2009] investigates the financial reporting effects of tax shelter involvement and develops a predictive model based on his sample of tax shelter firms (Prob_SHELTER).120 The model identifies specific firm-characteristics that
likely result from tax shelter participation (e.g. large BTDs) and are associated with the type of firm
likely engaged in tax sheltering (e.g. firm size). Lisowsky [2010] also seeks to infer tax shelter usage
from financial statements, employing confidential information on reportable transactions to the office
of tax shelter analysis (OTSA). The IRS data allows for the examination of 64 tax shelter firms (267
tax shelter observations) reported between 2000 and 2004. Results suggest that reportable transactions
are a valid proxy for publicly disclosed, i.e. litigated, tax shelters (see Graham and Tucker [2006]).
Lisowskys [2010] extended predictive model of tax sheltering identifies a positive relation between
shelter utilization and the presence of subsidiaries located in tax havens, foreign-source income, book117

118

119

120

In addition, with regards to the Lisowsky [2010] shelter detection model, the predictive ability of the tax
shelter score (TSS, indicating the probability of a firm engaging in tax shelters) turns out significant using
both the logged UTB and the Lisowsky [2010] variables as well as using logged UTB alone (as a summary
proxy) for tax shelter use.
Keep in mind that tax sheltering is not an individual construct of explicit tax planning, but rather a category of explicit tax planning activities, commonly assumed to reflect rather aggressive types of tax avoidance.
A comparable approach to identify tax shelter engagement for an Australian firm sample is also employed in
Lanis and Richardson [2011].
Hanlon and Slemrod [2009] also identify tax shelter firms and relate sheltering news to stock price reactions.
In a recent working paper, Gallemore et al. [2012] combine the samples of Graham and Tucker [2006],
Wilson [2009], and Hanlon and Slemrod [2009] to obtain the largest sample of publicly identified tax shelter
firms to date (see Lietz [2013] for a detailed review).

47

tax differences, litigation losses, use of promoters, profitability, and size (Lisowsky [2010], p.
1695).121 In addition, the study provides a metric called TaxShelterScore, which represents the estimated probability that a corporation engages in sheltering activities (see Table 1 for calculation details).
The apparent advantage of investigating a sample of actual tax shelter firms is to identify intentional
tax aggressiveness at a transaction level (Hanlon and Heitzman [2010]). Hence, if the objective is to
learn something about the tax behavior implications or typical characteristics of firms that actually
engage in sheltering, this is a valid proxy as it straightforwardly covers a particularly relevant scope of
firms. Conversely, if the desire is to gauge the overall level of explicit tax avoidance, tax shelter
engagement is probably an inappropriate proxy, given that shelters describe a limited scope of transactions, next to a range of other possible tax avoidance activities. Thus, tax shelter firms are not necessarily the ones that avoid the most taxes, also because the choice to engage in a tax shelter is most
likely an endogenous one. On the one hand, firms that cannot reduce their explicit tax burden in other
ways might use tax sheltering as the ultima ratio to avoid taxes. Firms that do have other means
available, on the other hand, may not need to (additionally) engage in sheltering (Hanlon and
Heitzman [2010], p. 143).
Moreover, as previously indicated in the discussion on BTD-measures, there are important selection
considerations with regards to shelter samples. Tax shelter firms, in order to be identifiable, are firms
that were actually caught, that is formally charged, filed suit, or revealed themselves by reporting
their tax shelter involvement to the IRS (e.g. Graham and Tucker [2006], Lisowsky et al. [2013]). To
that extent, the characteristics of the observable sample firms may not be representative of shelter
firms in general.

f.

Tax Haven Presence

In the context of multinational firms, Dyreng and Lindsey [2009] show that the presence of operations
in tax haven jurisdictions (HAVEN) is significantly associated with a groups effective tax rate. More
precisely, the authors find that U.S. firms with affiliates in at least one tax haven country display a

121

Moreover, the model yields a negative relation between tax shelter usage and leverage, which is consistent
with the findings in Graham and Tucker [2006].

48

worldwide ETR on pretax income that is approximately 1.5 percentage points lower than that of firms
with no tax haven operations.122 The study defines tax havens as material operations (disclosed in exhibit 21 of form 10-K) in particular low-tax countries, e.g. Bahamas, Cayman Islands, Liechtenstein,
or Malta. Altogether, the study identifies 53 tax haven countries, considering a country a tax haven if it
can be identified as a haven according to at least three of four sources quoted at
http://www.globalpolicy.org (as of 03/04/2008).123 The authors themselves note that as this definition
of tax havens is static, measurement error is introduced to the extent that countries evolve into (devolve out) of tax haven status going forward (Dyreng and Lindsey [2009], p. 1297).
Since some affiliation of a large multinational firm to a tax haven jurisdiction is likely not very representative of its overall efforts to engage in tax avoidance, tax haven presence is rather employed as an
alternative proxy next to other common measures124 or as a useful control variable when tax avoidance
is investigated in a global setting. For instance, Atwood, Drake, Myers, and Myers [2012] in a recent
study investigate home country tax system characteristics. The study finds that required book-tax conformity, worldwide or territorial tax system, and the perceived enforcement quality are related to corporate tax avoidance across jurisdictions, after controlling for various firm-specific and cross-country
factors. One of these factors is the presence of tax haven operations. Interestingly, the inclusion of tax
haven presence allows the authors to infer that a change of home-country tax system features not only
affects managements tax avoidance through accruals management, but also through specific taxmotivated transactions, e.g. tax havens or tax shelters (see Atwood et al. [2012], p. 1853).

122

Dyreng and Lindsey [2009] (pp. 1286-1287).

The three sources are the OECD, the U.S. Stop Tax Havens Abuse Act, the IMF, and the Tax Research Organization, see Dyreng and Lindsey [2009] (pp. 1297-1298, and table 2).
124
E.g. Balakrishnan et al. [2012] or Higgins et al. [2013] use tax haven presence as alternative tax aggressiveness proxies in their investigations.
123

49

5.

Arranging the Measures within the Unifying Conceptual Framework

In the following, the most commonly used empirical measures of tax avoidance are arranged along the
lines of the proposed unifying conceptual framework of corporate tax planning. Admittedly, given that
the delineation of underlying theoretical constructs itself is ultimately a matter of judgment, and further bearing in mind the limitations and unresolved issues surrounding the common empirical proxies,
this clearly is a demanding task.125 Still, this procedure may yield useful illustrative guidance indicating which of the empirical measures most likely capture which particular scope of explicit tax planning, e.g. tax avoidance, tax aggressiveness, or tax sheltering. Figure 3 illustrates the relevant conceptual constructs, complemented by the most commonly employed measures of tax avoidance.
The proxies placed along the the framework are (variants of) the GAAP- and cash ETR (GAAP ETR,
Cash ETR), book-tax differences (BTD), the discretionary portion of BTDs (DD_BTD, see Desai and
Dharmapala [2006]), permanent BTDs (PermBTD), the discretionary portion of permanent BTDs
(DTAX, Frank et al. [2009]), (changes of) unrecognized tax benefits (UTB), probabilities for tax shelter engagement derived from predictive models (Prob_Shelter, Wilson [2009]; TSS, Lisowsky [2010]),
and actual tax shelter activity (TSP, Graham and Tucker [2006]; SHELTER, Wilson [2009]; RT,
Lisowsky [2010]).126

125

126

For this reason, and also for reasons of clarity, particular subforms of common measures (e.g. ETR differential or CTA as a variation of general ETR measures; see Table 1) are not further included in the discussion
(arrangement) of empirical measures along the lines of the conceptual framework (see Figure 3).
As discussed in Section 4.2.f., tax haven presence as opposed to active tax shelter participation, does not give
much indication of the overall tax avoidance status of a corporate group, but rather useful as an additional
control variable in studies of multinational groups tax behavior.

50

Tax Planning
explicit and implicit (all parties, all taxes, all costs)

Tax Avoidance
explicit income tax reduction
GAAP ETR
Cash ETR

Measures
arranged
according to
the scope of
tax avoidance
they largely
capture

Tax Aggressiveness
BTD
DD BTD
PermBTD
DTAX
UTB
Prob_SHELTER
TSP, SHELTER, RT

more likely than not

chance of a tax-related
transaction being upheld
under audit >50%,

Tax Evasion

Legality:
perfectly legal

or other specified
Reference Point

clearly illegal;
with intent to defraud

grey-scaled activities

Tax Sheltering

GAAP ETR

(Variants of) GAAP effective tax rate(s), e.g. total tax expense devided by pretax financial income (e.g. Stickney and McGee 1982).

Cash ETR

(Variants of) cash effective tax rate(s), e.g. cash taxes paid over n years divided by pretax financial income over same n years (Dyreng, Hanlon, and Maydew 2008).

BTD

Book-tax-differences: total difference between financial and estimated taxable income (e.g. Desai 2003).

DD_BTD

Discretionary book-tax difference: portion of BTD unexplained by earnings management (Desai and Dharmapala 2006).

PermBTD

Permanent BTDs: a subset of BTDs that reflect a reduction of the firms tax liability while increasing net financial income.

DTAX

Discretionary permanent differences: portion of Perm_BTDs unexplained by legitimate tax positions (Frank, Lynch, and Rego 2009).

UTB

Unrecognized tax benefits (e.g. Rego and Wilson 2012, Lisowsky 2013).

Prob_SHELTER

Prob_S (predicted probability of a firm engaging in a tax shelter (Wilson 2009), Tax Shelter Score (TSS) (Lisowsky 2010, 2013).

TSP, SHELTER, RT

Actual tax shelter activity, identified e.g. based on tax court records and news articles (e.g. tax shelter participation (TSP), Graham and Tucker 2006; SHELTER, Wilson
2009), or via reportable transactions disclosed to OTSA (RT, Lisowsky 2010, 2013).

Figure 3: Empirical Measures within the Unifying Conceptual Framework of Tax Planning

51

The purpose of placing the individual measures along the continuum of tax avoidance is to illustrate
their aptness to capture individual constructs of explicit tax planning and to provide illustrative guidance as to their usefulness depending on the specific research question. Proxies placed toward the left
end of the continuum, i.e. GAAP ETR and Cash ETR, can be reasonably assumed to reflect the
broader range of tax avoidance, i.e. tax avoidance including both the non-aggressive and the aggressive portion of activities.127 By contrast, measures that are located further toward the right are better
suitable to proxy for aggressive tax avoidance. In line with the conceptual understanding, each individual measure graphically extends to the right (as indicated by the grey bars in Figure 3), as any
measure captures (i.e. is likewise affected by) relatively more aggressive types of tax planning.128
In turn, measures located further right may to some extent also be affected by activities usually underlying constructs further to the left. For instance, BTDs likely also reflect perfectly legal tax positions
(e.g. differences in book and tax depreciations; Lisowsky et al. [2013]). Similarly, tax shelter activity
may also impact ETRs. However, the fact that tax shelter activity may have an impact on other
measures does not impair its ability to identify firms that intentionally engage in particular aggressive
tax planning.129 By contrast, one cannot clearly identify the extent to which non-aggressive actions
obscure the BTDs power to proxy for more aggressive tax avoidance (e.g. Phillips et al. [2003]),
which implies a placement further to the left (e.g. in relation to RT or SHELTER.) Nonetheless, and as
discussed earlier, shelters are frequently assumed to lead to permanent BTDs, and BTDs have also
been shown to be correlated with IRS audit adjustments. This suggests a placement further to the right,
e.g. when compared to ETRs. Since the purpose of the DD_BTD (DTAX) measure is to extract the
discretionary part of the BTD (Perm_BTD) associated with aggressive tax avoidance, it is placed to
the right of BTD (Perm_BTD); although only slightly, taking into account the limitations of regression-based partitions (see Hanlon and Heitzman [2010] and above).
Measures like DTAX or UTB are likely to primarily reflect aggressive types of tax planning as they
incorporate the notions of abnormal or discretionary tax avoidance and the risk associated with a
less sustainable tax position. The Frank et al. [2009] measure of adjusted permanent BTDs, DTAX,
127

That is, ETRs capture explicit tax planning activities that have both certain and uncertain outcomes with tax
authorities (see Katz et al. [2013], p. 14, with reference to a three-year Cash ETR employed in their study).
128
The bars stretching all the way to the right end of the spectrum thus also illustrates that any empirical measure
is potentially affected by explicit tax reductions that result from evasive (fraudulent) illegal tax actions.
129
This places tax shelter activity (and shelter probabilities) to the aggressive end of the spectrum.

52

tends more toward the aggressive end of the conceptual framework (e.g. Blaylock et al. [2012]). It has
further been shown to be significantly associated with SHELTER involvement (e.g. Wilson [2009],
Dunbar et al. [2010]). Similarly, Balakrishnan et al. [2012] (pp. 9-10) posit that shelter probabilities
and DTAX likely correlate with aggressive types of tax avoidance but also point out that neither reflects the full array of tax planning activities.
Alternatively, FIN 48 straightforwardly asks management to assess the legal sustainability of any uncertain tax position when accounting for tax reserves, implying that UTBs should be well reflective of
aggressive types of tax avoidance (Frischmann et al. [2008], DeWaegenaere et al. [2010]).130 However, given that UTBs are likely to not only reflect the uncertainty in a firms tax position, but also earnings management incentives (tax reserve accrual management), this measure is likely inappropriate to
proxy for broader scopes of tax avoidance.131 Additional analyses provided in Lisowsky et al. [2013]
support this placement of UTBs among the other measures of explicit tax planning. The authors run
supplementary analyses on the FIN 48 tax reserves ability to reflect tax shelter activity and further
include common tax avoidance measures (ETR, Cash ETR, BTD, permanent BTD, and DTAX) in
their regression of reportable transaction use (i.e. tax shelter activity) on UTBs.132 Results indicate that
none of the tax avoidance measures provide information about firms tax shelter engagement except
for the UTB.133 This test might imply that the tax reserve may be the strongest available proxy for tax
sheltering when compared to other existing metrics, while it is not a well suited proxy for broader
constructs, such as (non-aggressive) tax avoidance. Notice however, that the above approaches arrange
measures relative to tax sheltering, which may well be assumed to reflect individual aggressive tax
actions, but may not necessarily be representative of the overall level of tax avoidance (and thus also
aggressiveness).134

130

131

132
133

134

According to Frischmann et al. [2008] (p. 263), UTBs provide an excellent measure of a firms tax aggressiveness because they represent managements beliefs about the tax positions most likely to be challenged.
[] the tax contingency or UTB is not a clean measure of tax avoidance by any stretch, Hanlon and
Heitzman [2010] (p. 143).
See Lisowsky et al. [2013], eq. (1b) and Panel B of Table 4.
The authors conduct several robustness tests, e.g. including the other measures while excluding the UTB (test
of multicollinearity), including each measure one at a time (with/without UTB), or adjusting the BTD to
eliminate the change in UTB. Results remain unchanged, see Lisowsky et al. [2013], Fn. 38.
Hanlon and Heitzman [2010] (p. 143) to conclude that studies that correlate a measure of tax avoidance with
tax shelter use may or may not be establishing support for the validity of their tax avoidance measure.

53

In a contemporary working paper, Hutchens and Rego [2012] provide preliminary evidence indicating
that larger tax reserves are related to higher costs of capital. The authors start from the premise that tax
avoidance should increase after-tax cash flows and thus have a positive impact on shareholder wealth.
As UTBs likely reflect much uncertainty (i.e. risk) with respect to firms tax positions, shareholders
may demand higher returns from risky tax positions.135 However, when drawing on a variety of alternative measures of tax avoidance, Hutchens and Rego [2012] no longer find a positive association. For
lower Cash ETRs the relation with cost of capital is actually negative. As an explanation, the authors
point to the circumstance that general tax avoidance measures, e.g. Cash ETRs, likely do not capture
firms risk exposure. Hence, early stage findings in Hutchens and Rego [2012] would largely support
the here presented arrangement of measures along the lines of the proposed conceptual framework.
In sum, measures that predominantly capture the aggressive end of tax avoidance may be unsuitable
depending on the research question. Studies that are indifferent to the legality of the tax avoidance
(Blaylock et al. [2012], p. 103) should opt for rather broad measures (e.g. long-run Cash ETR), e.g. to
partition their sample in tax avoiders vs. non-tax avoiders.136 In this case, a traditional ETR may not
reflect temporary differences, and tax shelter activity could be too narrow to classify firms (e.g. according to the likely source of their BTDs). Thus, long-term Cash ETRs are appropriate for their objective (Frank et al. [2009], Fn. 3), but not appropriate for studies that examine tax aggressiveness.137
If a study strives to provide policy recommendations with respect to questions such as how to curb
aggressive forms of tax avoidance?, how to identify firms involved in unfavorable tax sheltering?,
or how to efficiently combat tax evasion?, proxies situated toward the right hand side appear more
appropriate. However, with regards to the latter question, it needs to be stressed that none of the existing measures directly identifies, or is explicitly designed to proxy for, clearly criminal types of tax
aggressiveness (i.e. tax evasion). Although most empirical measures should pick up at least some of

135
136

137

Largely consistent with the findings presented in Wilson [2009].

Frequently firms in the lowest decile of long-run cash ETRs are classified as tax avoiders (e.g. Ayers et al.
[2009], Hanlon et al. [2012], Blaylock et al. [2012]).
Another way to question the suitability of ETRs to delimit tax aggressive subsamples can be derived from
Gallemore and Labro [2013], who incorporate the notion of tax risk assumed by firms during their tax planning decisions in the definition of tax aggressiveness (which would here be considered a less likely sustainable tax position, i.e. a move towards or eventually across the MLTN reference point). The authors argue that
two firms with equally low ETRs may ceteris paribus face different tax risks (in this case due to differences
in the internal information quality). If a firms tax risk is high, Gallemore and Labro [2013] (p. 12) consider
this firm to be more tax aggressive than the firm with an equally low, but otherwise less risky, tax position.

54

the tax reductions achieved through illegal and fraudulent means, even identified tax shelters by no
means have to be illegal,138 nor are they necessarily evasive.

6.

Concluding Remarks

All parties, all taxes, all costs are the three dimensions of the Scholes et al. [2009] paradigm of
efficient tax planning. In order to maximize after-tax returns, firms need to consider all explicit, implicit, and nontax costs and consequences of their tax decisions. In the light of this approach, tax
avoidance and its related concepts can be characterized by their focus on the reduction of explicit taxes. Tax avoidance, tax aggressiveness, tax sheltering, and tax evasion all relate to the all taxes bucket of the Scholes-Wolfson theme, and a growing body of tax research continues to study the determinants and consequences of firms varying levels of explicit tax burden, be it in more or less aggressive
ways, e.g. drawing on tax shelters or any other thinkable tax-motivated transaction.139
The unifying framework of corporate tax planning developed in this study provides readers with an
advanced conceptual understanding of theoretical constructs and researchers who are new to this area
with a comprehensive starting point. The framework raises awareness for the challenges associated
with a careful handling of underlying theoretical concepts and their adequate empirical operationalization. Firms generally have a large array of instruments and options available to reduce their explicit
tax burden. As a lot of these tax actions are quite straightforward and largely legal, others are legally
doubtful, harder to sustain upon (hypothetical) audit or even evasive. Research has a reasonable interest to make inferences with respect to all of these subsets of explicit tax planning. While a consistent
classification of the relevant constructs (and their related proxies) would theoretically be desirable, this
goal is practically hard to realize. All the more it is important to put considerable efforts into understanding both the conceptual and the empirical challenges present in this field of research. This study

138

139

Lisowsky et al. [2013] (p. 8) point out that tax aggressiveness, or even tax sheltering, does not imply illegality. Such a determination occurs in a court of law and relatively few tax shelter cases are litigated. Hence,
findings based on research designs that employ tax aggressiveness proxies may not necessarily tell us much
about the level firms are engaged in fraudulent tax evasion.
Ever more studies investigate how various stakeholders (the all parties dimension) might incentivize or
discourage firms to engage in more or less tax avoidance, which nontax costs (the all cost dimension) are
potentially associated with tax avoidance, and within which settings implicit taxes (the all taxes dimension)
may play an important role.

55

strives to make a contribution in this matter while clearly acknowledging that there are legitimate alternative perceptions and approaches to this matter.
Under the unifying conceptual framework of corporate tax planning developed in the context of this
particular study, future research and public debate may benefit from considering the following points:

It should only be referred to the construct of tax aggressiveness only if one specifically deals
with a specific scope of general tax avoidance which is further characterized as to what makes it
aggressive when compared to non-aggressive tax avoidance. In turn, tax avoidance could be
deliberately defined as not further differentiating between tax actions, as long as they are aimed at
the reduction of explicit taxes. If the intention is to gauge and investigate the overall extent of taxreducing efforts, it would be target-oriented to refer to general tax avoidance. Consequentially, in
the interest of diverse but conceptually consistent research, tax avoidance and tax aggressiveness
should not simply be used interchangeably.

It follows that studies may benefit from an explicitly stated reference point that serves as a defining benchmark for tax aggressiveness, as opposed to non-aggressive avoidance. In particular with
a view to the mounting research, the standpoint assumed here is that all involved parties, be it researchers, firms, or policymakers, would clearly benefit if they agreed on one explicit, comprehensible, and consistent reference point to distinguish tax avoidance from tax aggressiveness.
This study prefers the more-likely-than-not probability of a tax position being legally sustainable,
but expressly acknowledges the existence of other potential reference points.

Once a study has identified its relevant underlying conceptual construct, suitable empirical
measures need to be carefully selected. Given the plurality of operationalizations that exist in the
literature, sometimes strenuous efforts need to be put into fully understanding and incorporating
the benefits and limitations attached to the various available proxies.

In sum, it may proof beneficial to agree on a broader conceptual consensus with regards to underlying
concepts and terminology where possible. In cases where uniform definitions and/or perceptions of
relevant constructs are impossible to reach or, more importantly, could eventually compromise advances in research, a thorough conceptual discussion should still sensitize all interested parties to better understand and interpret the diversity in empirical tax accounting research.

56

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