Description
This study investigates how a tax agency would
assess the liability of a taxpayer who has first
adopted a new, controversial tax-saving scheme,
which might be employed by other taxpayers.
The tax agency’s post-audit assessment to the
first taxpayer influences whether and how the
innovation will diffuse among taxpayers
Accounting Research Journal
Diffusion of Tax Innovation and Post-Audit Settlement
Sungsoo Yoon Seung Won Yoo
Article information:
To cite this document:
Sungsoo Yoon Seung Won Yoo, (2007),"Diffusion of Tax Innovation and Post-Audit Settlement", Accounting Research
J ournal, Vol. 20 Iss 2 pp. 89 - 95
Permanent link to this document:http://dx.doi.org/10.1108/10309610780000694
Downloaded on: 24 January 2016, At: 21:02 (PT)
References: this document contains references to 0 other documents.
To copy this document: [email protected]
The fulltext of this document has been downloaded 475 times since 2007*
Users who downloaded this article also downloaded:
Seok Woo J eong, J inbae Kim, Sungsoo Yoon, (2007),"Assigned Auditors and Market Valuation: Korean Evidence",
Accounting Research J ournal, Vol. 20 Iss 1 pp. 37-46http://dx.doi.org/10.1108/10309610780000688
Paul Mather, Alan Ramsay, (2006),"The Effects of Board Characteristics on Earnings Management around Australian CEO
Changes", Accounting Research J ournal, Vol. 19 Iss 2 pp. 78-93http://dx.doi.org/10.1108/10309610680000680
Le Luo, Qingliang Tang, Yi-Chen Lan, (2013),"Comparison of propensity for carbon disclosure between developing and
developed countries: A resource constraint perspective", Accounting Research J ournal, Vol. 26 Iss 1 pp. 6-34 http://
dx.doi.org/10.1108/ARJ -04-2012-0024
Access to this document was granted through an Emerald subscription provided by emerald-srm:115632 []
For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service
information about how to choose which publication to write for and submission guidelines are available for all. Please visit
www.emeraldinsight.com/authors for more information.
About Emerald www.emeraldinsight.com
Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of
more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online
products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication
Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation.
*Related content and download information correct at time of download.
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Diffusion of Tax Innovation and Post-Audit Settlement
89
Diffusion of Tax Innovation and
Post-Audit Settlement
Sungsoo Yoon and Seung Won Yoo
Korea University Business School
Abstract
This study investigates how a tax agency would
assess the liability of a taxpayer who has first
adopted a new, controversial tax-saving scheme,
which might be employed by other taxpayers.
The tax agency’s post-audit assessment to the
first taxpayer influences whether and how the
innovation will diffuse among taxpayers.
We find that it is optimal for the tax agency
to settle the issue regardless of whether and how
fast the innovation diffuses. A trial is too costly
an option for the agency: losing in court would
make the innovation public knowledge, and
other taxpayers would immediately adopt the
new scheme. Neither the number of other
taxpayers nor the speed of diffusion affects the
amount of the optimal post-audit assessment.
These results suggest that a tax practitioner who
markets a new tax-saving scheme need not limit
the speed of diffusion for fear of an aggressive
response from the agency.
1. Introduction
An important characteristic of interplay between
taxpayers and a tax agency such as the Australian
Taxation Office (ATO) and the U.S. Internal
Revenue Service (IRS) is that the tax agency
faces multiple taxpayers. Moreover, interactions
between these two parties can occur in multiple
periods. In a model with multiple taxpayers and
multiple periods, we investigate how a tax
agency would respond to a tax innovation that
can diffuse among taxpayers over time.
Structuring transactions to minimize taxes is
considered one of the fundamental rights of
taxpayers. In the United States, the market for
Acknowledgements: This study is supported by Suam
Foundation. We are grateful to Woon O. Jung, Paul J. Beck,
Young K. Kwon, Lee-Seok Hwang, an anonymous referee,
and seminar participants at Seoul National University for
their helpful comments on earlier drafts of the paper. All
remaining errors are our own.
professional tax services has grown significantly.
Between 1995 and 2001, the U.S. tax practices of
the Big Four accounting firms more than doubled
their revenue from$2.4 billion to $5.6 billion.
Rostain (2006) notes that large accounting firms
created specialized groups to identify obscure
provisions of the Internal Revenue Code, new
financing devices, and esoteric legal forms that
could be combined to develop innovative
products. For example, in the late 1990s, KPMG
established a “Tax Innovations Center” to
spearhead the development of new tax products.
1
Taxpayers and tax administrators, however,
have struggled to determine the line between
legitimate tax planning and unacceptable tax
shelters.
2
When taxpayers and a tax agency fail
to agree upon taxes due, disputes between the
two parties need to be resolved by a court. The
number of cases heard by a court is, however,
very small relative to the total number of
returns. For example, in Australia, fewer than
0.3 percent of the ATO compliance adjustments
have led to appeals and disputes
(Vos 2006)
.
Although tax litigation is rare ex post, it is an
option available to all taxpayers ex ante. Bersten
et al. (2006) point out that tax litigation is in the
background at all times and that it plays a
significant role in influencing the ATO and
taxpayer behavior.
Tax litigation is costly not only to taxpayers
but also to a tax agency. This study identifies
and examines the role of a litigation cost unique
to a multi-taxpayer, multi-period setting: loss of
tax revenue due to the diffusion of tax
innovation. When a case is tried in court, the
result becomes public knowledge. If the tax
1 To help market these tax products, KPMG provided
opinion letters to clients on the possibility that the
transaction would be upheld in court. [Rostain 2005]
2 U.S. Joint Committee on Taxation, Background and
Present Law Relating to Tax Shelters, JCX-19-02
(Washington, D.C.: Mar. 19, 2002)
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 2 (2007)
90
agency prevails, then the victory will discourage
other taxpayers fromfollowing the example of
the taxpayer who lost. In the opposite case,
however, a court decision in favor of a taxpayer
may prompt others to engage in similar
transactions. The current study investigates how
a rational tax agency would consider the
benefits and costs of litigation of this nature
when it determines post-audit tax assessments.
We develop a model with a tax agency and
multiple taxpayers. After audit, a tax agency
finds that a taxpayer (“first taxpayer”) has
adopted a new, controversial tax-saving
scheme. There exist other taxpayers who might
follow the example of the first taxpayer in the
future if they learn that the new scheme is
approved by the agency or the court. The tax
agency’s post-audit assessment to the first
taxpayer influences whether and how the
innovation will diffuse among taxpayers. If the
first taxpayer rejects the assessment and takes
the case to court, then the innovation becomes
public knowledge. If instead the tax agency
settles with the first taxpayer, then the new
scheme may remain confidential or diffuse to
others. This study examines both cases.
We find that it is optimal for the tax agency to
settle the issue with the first taxpayer and all
those who subsequently adopt the scheme,
regardless of the speed of diffusion. A trial is too
costly an option for the agency in the current
setting. Losing the case in court would make the
innovation public knowledge, and other
taxpayers would immediately take advantage of
the new tax-saving opportunity. These costs
would outweigh potential benefits of a trial.
Neither the number of other taxpayers nor the
speed of diffusion would affect the amount of
the optimal post-audit assessment. An
implication of this result is that a tax practitioner
who creates a new tax-saving scheme need not
limit the speed of diffusion for fear of an
aggressive response from the agency. The
number of periods for which the tax innovation
is valid, however, influences the settlement
amount: the more periods subject to the
innovation, the lower the assessment per period.
The remainder of the paper is organized as
follows: Section 2 reviews prior literature.
Section 3 develops the model, and Section 4
presents the equilibrium of the model. Finally,
Section 5 concludes the paper.
2. Literature
Post-audit disputes between a tax agency and
taxpayers have drawn the attention of
researchers. Jung (1995) develops a model
where a taxpayer can challenge the IRS’s post-
audit assessments in court. He investigates how
the possibility of tax litigation affects reporting
and audit behaviors. In his study, the IRS’s
audit is assumed to reveal without errors the
probability with which the agency would
prevail in court. Taxpayers do not know their
own probability of winning at trial. Instead, they
need to infer it from the agency’s post-audit
assessment.
Yoon (1995) examines an opposite case of
information asymmetry. His model assumes
that a sophisticated taxpayer knows his own
probability of winning the case. In contrast, a
tax audit is assumed to be imperfect: it does not
always reveal the taxpayer’s private information
on the prospects of litigation. As a result, a tax
agency and a taxpayer may have different
expectations about the result of a trial, and this
results in tax litigation.
Litigation is not the only way to resolve
conflicts between taxpayers and the agency. For
example, Rhoades (1997) assumes that a tax
agency can correct its own errors made in initial
audits. Sansing (1997) examines two voluntary
arbitration methods as an alternative to costly
litigation.
The above studies focus on a single-taxpayer,
single-period setting. Our study contributes to
the literature by examining how the possibility
of diffusion affects a tax agency’s post-audit
settlement decision in a multiple-taxpayer,
multiple-period setting.
3. The Model
A tax agency, an expected net revenue
maximizer, finds after audit that one taxpayer
(“the first taxpayer”) has employed a new tax-
saving scheme in his tax return. The agency also
finds that there are n other taxpayers who may
adopt the new scheme later if they become
aware of it. The current tax laws are ambiguous
about whether the deduction is acceptable. The
tax innovation, if allowed, reduces the
taxpayer’s taxes by T every year for a total of m
years, where T>0 and m?1. If the deduction is
denied, the taxpayer must pay Tq, where q>1.
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Diffusion of Tax Innovation and Post-Audit Settlement
91
The tax agency needs to determine how
much tax to impose on the new transaction. If
the first taxpayer accepts the agency’s post-
audit adjustment and settles the case, the
settlement serves as a precedent in his
negotiations with the tax agency in the
remaining (m-1) years. We first examine a case
in which details of the tax settlement are not
revealed to other taxpayers. Next, we consider a
case in which the tax innovation diffuses to d
other taxpayers every period after settlements,
where d ?1.
If the taxpayer rejects the assessment and
litigates, the court is expected to deny the
deduction with a probability of p, where 0
This study investigates how a tax agency would
assess the liability of a taxpayer who has first
adopted a new, controversial tax-saving scheme,
which might be employed by other taxpayers.
The tax agency’s post-audit assessment to the
first taxpayer influences whether and how the
innovation will diffuse among taxpayers
Accounting Research Journal
Diffusion of Tax Innovation and Post-Audit Settlement
Sungsoo Yoon Seung Won Yoo
Article information:
To cite this document:
Sungsoo Yoon Seung Won Yoo, (2007),"Diffusion of Tax Innovation and Post-Audit Settlement", Accounting Research
J ournal, Vol. 20 Iss 2 pp. 89 - 95
Permanent link to this document:http://dx.doi.org/10.1108/10309610780000694
Downloaded on: 24 January 2016, At: 21:02 (PT)
References: this document contains references to 0 other documents.
To copy this document: [email protected]
The fulltext of this document has been downloaded 475 times since 2007*
Users who downloaded this article also downloaded:
Seok Woo J eong, J inbae Kim, Sungsoo Yoon, (2007),"Assigned Auditors and Market Valuation: Korean Evidence",
Accounting Research J ournal, Vol. 20 Iss 1 pp. 37-46http://dx.doi.org/10.1108/10309610780000688
Paul Mather, Alan Ramsay, (2006),"The Effects of Board Characteristics on Earnings Management around Australian CEO
Changes", Accounting Research J ournal, Vol. 19 Iss 2 pp. 78-93http://dx.doi.org/10.1108/10309610680000680
Le Luo, Qingliang Tang, Yi-Chen Lan, (2013),"Comparison of propensity for carbon disclosure between developing and
developed countries: A resource constraint perspective", Accounting Research J ournal, Vol. 26 Iss 1 pp. 6-34 http://
dx.doi.org/10.1108/ARJ -04-2012-0024
Access to this document was granted through an Emerald subscription provided by emerald-srm:115632 []
For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service
information about how to choose which publication to write for and submission guidelines are available for all. Please visit
www.emeraldinsight.com/authors for more information.
About Emerald www.emeraldinsight.com
Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of
more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online
products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication
Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation.
*Related content and download information correct at time of download.
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Diffusion of Tax Innovation and Post-Audit Settlement
89
Diffusion of Tax Innovation and
Post-Audit Settlement
Sungsoo Yoon and Seung Won Yoo
Korea University Business School
Abstract
This study investigates how a tax agency would
assess the liability of a taxpayer who has first
adopted a new, controversial tax-saving scheme,
which might be employed by other taxpayers.
The tax agency’s post-audit assessment to the
first taxpayer influences whether and how the
innovation will diffuse among taxpayers.
We find that it is optimal for the tax agency
to settle the issue regardless of whether and how
fast the innovation diffuses. A trial is too costly
an option for the agency: losing in court would
make the innovation public knowledge, and
other taxpayers would immediately adopt the
new scheme. Neither the number of other
taxpayers nor the speed of diffusion affects the
amount of the optimal post-audit assessment.
These results suggest that a tax practitioner who
markets a new tax-saving scheme need not limit
the speed of diffusion for fear of an aggressive
response from the agency.
1. Introduction
An important characteristic of interplay between
taxpayers and a tax agency such as the Australian
Taxation Office (ATO) and the U.S. Internal
Revenue Service (IRS) is that the tax agency
faces multiple taxpayers. Moreover, interactions
between these two parties can occur in multiple
periods. In a model with multiple taxpayers and
multiple periods, we investigate how a tax
agency would respond to a tax innovation that
can diffuse among taxpayers over time.
Structuring transactions to minimize taxes is
considered one of the fundamental rights of
taxpayers. In the United States, the market for
Acknowledgements: This study is supported by Suam
Foundation. We are grateful to Woon O. Jung, Paul J. Beck,
Young K. Kwon, Lee-Seok Hwang, an anonymous referee,
and seminar participants at Seoul National University for
their helpful comments on earlier drafts of the paper. All
remaining errors are our own.
professional tax services has grown significantly.
Between 1995 and 2001, the U.S. tax practices of
the Big Four accounting firms more than doubled
their revenue from$2.4 billion to $5.6 billion.
Rostain (2006) notes that large accounting firms
created specialized groups to identify obscure
provisions of the Internal Revenue Code, new
financing devices, and esoteric legal forms that
could be combined to develop innovative
products. For example, in the late 1990s, KPMG
established a “Tax Innovations Center” to
spearhead the development of new tax products.
1
Taxpayers and tax administrators, however,
have struggled to determine the line between
legitimate tax planning and unacceptable tax
shelters.
2
When taxpayers and a tax agency fail
to agree upon taxes due, disputes between the
two parties need to be resolved by a court. The
number of cases heard by a court is, however,
very small relative to the total number of
returns. For example, in Australia, fewer than
0.3 percent of the ATO compliance adjustments
have led to appeals and disputes
(Vos 2006)
.
Although tax litigation is rare ex post, it is an
option available to all taxpayers ex ante. Bersten
et al. (2006) point out that tax litigation is in the
background at all times and that it plays a
significant role in influencing the ATO and
taxpayer behavior.
Tax litigation is costly not only to taxpayers
but also to a tax agency. This study identifies
and examines the role of a litigation cost unique
to a multi-taxpayer, multi-period setting: loss of
tax revenue due to the diffusion of tax
innovation. When a case is tried in court, the
result becomes public knowledge. If the tax
1 To help market these tax products, KPMG provided
opinion letters to clients on the possibility that the
transaction would be upheld in court. [Rostain 2005]
2 U.S. Joint Committee on Taxation, Background and
Present Law Relating to Tax Shelters, JCX-19-02
(Washington, D.C.: Mar. 19, 2002)
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 2 (2007)
90
agency prevails, then the victory will discourage
other taxpayers fromfollowing the example of
the taxpayer who lost. In the opposite case,
however, a court decision in favor of a taxpayer
may prompt others to engage in similar
transactions. The current study investigates how
a rational tax agency would consider the
benefits and costs of litigation of this nature
when it determines post-audit tax assessments.
We develop a model with a tax agency and
multiple taxpayers. After audit, a tax agency
finds that a taxpayer (“first taxpayer”) has
adopted a new, controversial tax-saving
scheme. There exist other taxpayers who might
follow the example of the first taxpayer in the
future if they learn that the new scheme is
approved by the agency or the court. The tax
agency’s post-audit assessment to the first
taxpayer influences whether and how the
innovation will diffuse among taxpayers. If the
first taxpayer rejects the assessment and takes
the case to court, then the innovation becomes
public knowledge. If instead the tax agency
settles with the first taxpayer, then the new
scheme may remain confidential or diffuse to
others. This study examines both cases.
We find that it is optimal for the tax agency to
settle the issue with the first taxpayer and all
those who subsequently adopt the scheme,
regardless of the speed of diffusion. A trial is too
costly an option for the agency in the current
setting. Losing the case in court would make the
innovation public knowledge, and other
taxpayers would immediately take advantage of
the new tax-saving opportunity. These costs
would outweigh potential benefits of a trial.
Neither the number of other taxpayers nor the
speed of diffusion would affect the amount of
the optimal post-audit assessment. An
implication of this result is that a tax practitioner
who creates a new tax-saving scheme need not
limit the speed of diffusion for fear of an
aggressive response from the agency. The
number of periods for which the tax innovation
is valid, however, influences the settlement
amount: the more periods subject to the
innovation, the lower the assessment per period.
The remainder of the paper is organized as
follows: Section 2 reviews prior literature.
Section 3 develops the model, and Section 4
presents the equilibrium of the model. Finally,
Section 5 concludes the paper.
2. Literature
Post-audit disputes between a tax agency and
taxpayers have drawn the attention of
researchers. Jung (1995) develops a model
where a taxpayer can challenge the IRS’s post-
audit assessments in court. He investigates how
the possibility of tax litigation affects reporting
and audit behaviors. In his study, the IRS’s
audit is assumed to reveal without errors the
probability with which the agency would
prevail in court. Taxpayers do not know their
own probability of winning at trial. Instead, they
need to infer it from the agency’s post-audit
assessment.
Yoon (1995) examines an opposite case of
information asymmetry. His model assumes
that a sophisticated taxpayer knows his own
probability of winning the case. In contrast, a
tax audit is assumed to be imperfect: it does not
always reveal the taxpayer’s private information
on the prospects of litigation. As a result, a tax
agency and a taxpayer may have different
expectations about the result of a trial, and this
results in tax litigation.
Litigation is not the only way to resolve
conflicts between taxpayers and the agency. For
example, Rhoades (1997) assumes that a tax
agency can correct its own errors made in initial
audits. Sansing (1997) examines two voluntary
arbitration methods as an alternative to costly
litigation.
The above studies focus on a single-taxpayer,
single-period setting. Our study contributes to
the literature by examining how the possibility
of diffusion affects a tax agency’s post-audit
settlement decision in a multiple-taxpayer,
multiple-period setting.
3. The Model
A tax agency, an expected net revenue
maximizer, finds after audit that one taxpayer
(“the first taxpayer”) has employed a new tax-
saving scheme in his tax return. The agency also
finds that there are n other taxpayers who may
adopt the new scheme later if they become
aware of it. The current tax laws are ambiguous
about whether the deduction is acceptable. The
tax innovation, if allowed, reduces the
taxpayer’s taxes by T every year for a total of m
years, where T>0 and m?1. If the deduction is
denied, the taxpayer must pay Tq, where q>1.
D
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)
Diffusion of Tax Innovation and Post-Audit Settlement
91
The tax agency needs to determine how
much tax to impose on the new transaction. If
the first taxpayer accepts the agency’s post-
audit adjustment and settles the case, the
settlement serves as a precedent in his
negotiations with the tax agency in the
remaining (m-1) years. We first examine a case
in which details of the tax settlement are not
revealed to other taxpayers. Next, we consider a
case in which the tax innovation diffuses to d
other taxpayers every period after settlements,
where d ?1.
If the taxpayer rejects the assessment and
litigates, the court is expected to deny the
deduction with a probability of p, where 0