IFRS convergence and tax avoidance

Earnings management (a judgement call about application of accounting policies to achieve a desired outcome) is a tool to achieve profitability at least on paper. There are accrual and real earnings management techniques involving changes of accounting methods, transaction restructuring or adjusting the timing of transactions. Tax avoidance is another instrument which incorporates elements of both accrual and real earnings management aimed at minimizing the company’s tax liabilities by manipulating accounting policies and transaction structuring (Febriyanto and Firmansyah, 2018: p.41).  Hence, tax avoidance is in direct contradiction to IFRS convergence goals of transparent and comparable reporting but it is still a significant element of the capital markets mechanism. 

IFRS convergence as a road to better capital markets
Not disregarding the benefits of multinational corporations to economies and consumers, their reach and size makes it hard for regulators to collate information across jurisdictions and assemble a wholesome picture. Transparency and accountability dwindle across borders and public trust is eroded undermining the capital markets.

IAASB has been attempting to address these concerns for several decades through IFRS convergence initiatives. There are two aspects to consider in this regard: first, the standards themselves, their content, basis, implementation, enforcement and punishment for non-compliance in a given jurisdiction, and second, is convergence across jurisdictions.

Supporters of IFRS convergence argue that it will lead to more useful information being reported leading to increased liquidity and decreased cost of capital for adopters thus improving the efficiency of capital markets. The information will allow financial analysts and other users make better decisions and higher quality reporting will lead to growth of capital markets by creating a more stable and sophisticated financial infrastructure and a sound regulatory ecosystem. Comparability creates a common language for all stakeholders and erases borders for information sharing thus reducing the risk of misinterpretation. Additionally, a single set of reporting standards will significantly reduce the costs of reporting and auditing (Tweedie and Seidenstein, 2005: p.591).

The 1998 Asian financial crisis was a strong argument for convergence. The argument goes that the crisis was caused by the lack of transparency in reporting and poor governance and IFRS adoption can be a tool for improving both at company and country levels, benefiting the capital markets and also integrating the adopting nations into the global economy.  

On the other hand, if there is a failure in the system such as non-compliance or abuse of reporting requirements then one large enough incident or a group of incidents could impact the entire global financial system. Global integration is a risk that can lead to a global crisis. It is also noted by some researchers that IFRS convergence is a political tool ensuring compliance to a single ideology (Arnold, 2012: p.370-372). 

Besides, there are other criticisms of IFRS convergence such as different regulatory practices and degrees of enforcement; differences in business, accounting, auditing and regulatory cultures; issues relating to convergence as a balance between uniformity and ability to address firm-specific operations and technical aspects such as fair value accounting in the absence of markets for some assets in some jurisdictions. 

Tax avoidance and corporate social responsibility
IFRS has been a long-standing instrument to ensure quality, transparency and comparability of financial reporting. Emergence of environmental, social and governance (ESG) issues have put further pressure on corporation for more transparent and responsible reporting. But scouring the regulatory plain there is noticeably one aspect that is always missing - taxation. As Dowling (2014: p.173-174) notes taxation often escapes both the dialogues about it being something that needs to be managed in order to avoid future crises and its relevance to corporate social responsibility.

If IFRS as a concept, its global adoption and the underlying ideas behind it are seen as clearly linked to responsible corporate behavior, taxation is not so much. However, the 2007-2008 crisis has clearly shown the extent of questionable tax practices such as use of offshore tax jurisdictions which were clearly one of the precursors to the crisis amongst other things. Alongside IFRS reporting, taxation should be as straight-forward and transparent a tool facilitating efficient capital markets and addressing stakeholder needs.  Companies engage in tax planning as they would in managing any other costs but the characteristic that sets tax costs apart is the social nature of taxation which, unfortunately is a view not always shared by the corporations themselves. 

The social nature of tax avoidance
Stiglitz (1968: p.3-4) has outlined three basic principles of tax avoidance: postponement of tax where time value of money takes effect and reduces future liabilities; exploitation of different tax rates; and tax arbitrage across different income streams.

These three categories of tax avoidance come in various shapes and sizes. For example, for an individual a pension plan can be a variation on the theme of tax avoidance as tax liabilities are postponed until retirement. For a company the use of tax havens, profit shifting to offshore jurisdictions, transfer pricing, structuring transactions to reclassify income that is taxed at lower rates (such as royalties or dividends) are all ways to manipulate tax through either accounting application or transaction classification.

Tax avoidance rather than breaking laws exploits gaps and finds loopholes in either accounting standards or tax legislation in different jurisdictions to avoid or reduce tax payments creating the so called “stateless income”. The OECD/G20 Inclusive Framework forms the basis for a global campaign against tax avoidance focused on eradicating Base Erosion and Profit Shifting (BEPS) practices through international cooperation much like the IAASB is looking to eradicate capital market imperfections through IFRS convergence.

According to the Framework tax avoidance has many negative effects. The primary impact is on government revenue which is estimated as a loss of up to US$240 billion annually across the globe. The secondary impact is every aspect of social and economic life that is financed from the state budget such as public goods and fixed income populations. The “social” impact of tax avoidance is the increased burden on the individual when corporate tax budget is not met. Tax avoidance has direct impact on society by taxing the individual for the resources he/she has not used but which were used by the corporation (possibly even in another jurisdiction) which should be paying taxes but is not. Hence the impact of taxation on the social and financial systems through fiscal policy implications makes it a matter for discussion in the corporate social responsibility context rather than it being just another cost of running a business.

This raises a question of corporate responsibility and equity, especially on the part of multinational companies. BEPS creates a situation where profits are artificially shifted to jurisdictions where no business activities take place but taxes are low from those jurisdictions where corporations are using the resources but are not paying any taxes. According to OECD by implementing tax avoidance practices companies gain unfair competitive advantage, make poor role models for other taxpayers and undermine the entire tax system which disproportionately affects low and middle-income countries which have a greater reliance on corporate tax incomes. Is responsibility before shareholders and capital markets of greater value than responsibility before tax payers?