Unintended consequence of SEC tax letters: Companies pay more taxes

Ever slow down when approaching a spot where you got stopped for speeding? Major companies react in a similar fashion when filing taxes the year after being flagged by the Securities and Exchange Commission.

While motorists hit the brakes, public companies increase their tax payments the year after receiving a comment letter from the SEC, according to new research from UF accounting professor Michael Mayberry.

Mayberry, along with Thomas Kubick of the University of Kansas, Daniel Lynch of the University of Wisconsin, and Thomas Omer of the University of Nebraska, collected 2,820 SEC comment letters between 2004 and 2012, of which 845 were tax-related. He compared the tax behavior of 479 companies that received SEC tax-related letters to 479 that received SEC letters not related to taxes with controls put into place matching industries, years, profitability, and other factors.

The study revealed that companies increased their provision for income taxes by approximately 1.4 percentage points, and their actual cash payments by 1.5 percentage points after receiving a tax-related comment letter.

The one-year increase in tax provisions from these companies totaled $3 billion.

“The SEC, in theory, only cares about the reporting of taxes, and they’re asking firms to get the disclosure right,” Mayberry said. “But we see an actual change in cash payments. So how they are reporting is affecting how they’re behaving. That’s an unintended consequence.”

The Sarbanes-Oxley Act of 2002, which was passed in response to major corporate scandals like Enron, requires the SEC to review annual financial reports of public companies every three years. If the SEC has questions on these reports, the organization sends the company a comment letter.

Comment letters aren’t always intrusive. It may ask for a simple clarification about the report. But the mere receipt of the letter—when it is tax-related— spurs companies to increase tax payments the following year.

Furthermore, Mayberry found an industry-wide effect regarding these comment letters. Companies that did not receive a tax-related comment letter—but share an industry with multiple peer companies that did receive tax-related letters—increased their tax provisions as well.

“A comment letter affects the company that received the letter, and the companies surrounding it,” Mayberry said. “Company A observes that Company B is suffering costs because it had poor disclosure.  So because Company A doesn’t want to incur those costs, it will increase disclosure, and hope it doesn’t get a comment letter in the future.”

The SEC does not explicitly state tax compliance in its mission to protect investors, but the comment letters the organization sends to companies is certainly having that effect. This effect raises the question if the SEC and the Internal Revenue Service should work closer together.

“There’s no rule against it, but there’s very little evidence that they do,” Mayberry said. “One implication of our research could probably be that they should be open to working together more in the future.”

The paper, “The Effects of Regulatory Scrutiny on Tax Avoidance: An Examination of SEC Comment Letters,” appears in the November issue of The Accounting Review.