Assessing Tax Risk: Practitioner Perspectives

Abstract

ABSTRACTThis study uses insights from tax practitioners and tax authorities to define and develop an estimate of ex ante tax risk that is independent of common tax outcomes studied in prior literature. Validation tests confirm that our tax risk measure (i) represents the predictable and unpredictable uncertainty inherent in the three sources of tax risk (i.e., economic risk, tax law uncertainty, and inaccurate information processing) and (ii) is a construct different from tax avoidance, tax uncertainty, and general business risk. Using our tax risk measure, we address two research questions of interest to academics and practitioners. First, we examine the association between tax risk and long‐run tax avoidance and find a negative association between tax risk and future long‐run cash effective tax rates (ETRs). Second, we consider the extent to which unrecognized tax benefits (UTBs) reflect tax risk, tax avoidance, or financial reporting incentives and demonstrate that our tax risk measure explains a substantial portion of UTBs, incremental and relative to measures of information risk, conditional conservatism, unconditional conservatism, and tax avoidance. Our study offers a measure of tax risk that, consistent with the Scholes‐Wolfson paradigm, reflects the tax risk inherent in all business activities, not just tax avoidance activities; has unique industry effects; and contributes to our understanding of the factors that affect tax planning decisions and result in variation in firms' ETRs. Our findings will help managers and tax practitioners focus on industry‐specific tax risk components, assess risk during tax planning initiatives, exercise caution when engaging in additional risk if ETRs are low, and adapt tax risk strategies to fit specific company needs. We enhance future tax research by improving the definition and measurement of tax risk.