Valuation of Corporate Tax Assets Under Tax Asymmetry: A Market-Based Approach

Abstract

The paper proposes an analytical framework to value corporate tax assets (carryforwards and carrybacks) subject to refundability risk under tax asymmetry. Building on the existing literature, tax assets are modelled as derivatives contracts. The framework captures earnings’ volatility, the dynamic features of the tax code and the complex intertemporal and substitution effects between tax assets. The paper makes five contributions to the existing literature. First, it derives the relationship between the book value and the market value of tax assets. The difference between the two values captures refundability risk, defined as the risk that earnings will not materialize in the future. Second, the paper provides a formal derivation of the cost of tax asymmetry and shows that tax assets decrease the cost of tax asymmetry but leave the convexity of the tax liability function unchanged. Third, the paper highlights the role of earnings’ volatility and sheds light on incentives issues that arise from the difference between the market and the book value of tax assets for firms endowed with large stocks of carryforward or carrybacks. Fourth, the paper provides estimates of conditional transition probabilities and tax persistence. They differ from their unconditional counterparts by being firm-specific and by exploiting the information contained in the distance between earnings and the stock of carrybacks or carryforwards scaled by earnings’ volatility (akin distance-to-default in credit risk models). The last contribution is to show how to formulate marginal tax rates in terms of conditional transition probabilities. The paper has important implications for empirical work that involves tax assets.