Deferred Taxation Under Default Risk

Abstract

In this article, we have used a continuous EBIT-based model to study deferred taxation under default risk. Quite surprisingly, default risk has been disregarded in research on deferred taxation. In order to underline its importance, we first calculated the probability of default, over a given time period, together with the contingent value of tax deferral. We then applied our theoretical model to a sample of 27,749 OECD companies. We showed that, when accounting for both firms with a negative EBIT and firms with a probability of default higher than 50% (over a 10-year period), a relevant percentage of firms were close enough to default. Hence, these taxpayers should not consider deferred taxation in their financial statements, for the sake of prudence. Moreover, under default, the expected present value of deferred taxes was much lower than that obtained in a deterministic context. Hence, if we look at deferred taxes from the Government’s point of view, we must consider them as being risk-free loans. However, only a portion are subsequently repaid, due to default. This implies that, when a Government allows accelerated tax depreciation it should be aware of future losses due to default. So far, these estimates have been missing, although techniques do exist and are quite practical.