Deciphering Tax Avoidance: Evidence from Credit Rating

Disagreements
Samuel B. Bonsall IV1 , Kevin Koharki2 , and Luke Watson3
1
The Ohio State University
2
Washington University in St. Louis
3
University of Florida

August 2015

The authors would like to acknowledge the helpful comments of Dane Christensen, Wayne Guay, Dave Guenther,
Eric Holzman, Je Hoopes (for providing tax footnote data), Stacie Laplante, Rick Laux, Brian Miller (discussant),
Karl Muller, and workshop participants at the University of Florida, Washington University in St. Louis, and the
Nick Dopuch Conference at Washington University in St. Louis. Bonsall would like to thank the Fisher College of
Business for its financial support. Koharki would like to thank the Olin Business School for its financial support.
Watson would like to thank the Fisher School of Accounting and Warrington College of Business for financial support.

Corresponding author: luke.watson@warrington.ufl.edu

Electronic copy available at: http://ssrn.com/abstract=2511454

 Deciphering Tax Avoidance: Evidence from Credit Rating Disagreements

Abstract
This study investigates the role of tax avoidance in the credit rating process and whether dif-
ferences exist in how rating agencies account for the risk relevance of tax avoidance. Using a
sample of initial credit ratings assigned to public debt issuances during the 19942013 period,
our evidence is consistent with credit rating agencies assessing the costs and benefits associ-
ated with tax avoidance dierently, resulting in more frequent and pronounced rating agency
disagreement. Rating agency disagreement over tax avoidance is most prominent when it is ac-
companied by relatively high levels of uncertain tax positions, foreign activities, or research and
development activities, as well as lower quality tax footnote disclosures. We also find evidence
that changes in tax avoidance (tax footnote disclosures) are negatively (positively) associated
with the convergence of split ratings, suggesting that firms can exacerbate or mitigate rating
agency disagreement subsequent to bond issuance. Our study complements prior research by
examining why sophisticated information intermediaries disagree about the risk relevance of
tax avoidance and sheds light on how firms can impact rating agencies understanding of tax
avoidance.

Keywords: tax avoidance, credit rating agencies, disagreement, uncertainty

JEL Classifications: M40, G24, H20

Electronic copy available at: http://ssrn.com/abstract=2511454

1 Introduction

This study investigates the impact of uncertainty arising from information asymmetry on sophisti-

cated users of accounting information. Specifically, we examine how credit rating agencies respond

to the inherent risks and uncertainties that accompany corporate tax avoidance during the rating

process.1 Prior literature suggests that tax avoidance engenders significant risks (Hasan et al.,

2014), which can be dicult to interpret due to the complexity and opacity of tax transactions

and disclosures (Weisbach, 2002; Donohoe and Knechel, 2014). Dierences in financial statement

users information access, sophistication, and analytical procedures can greatly influence how they

evaluate firms tax positions.

Credit rating agencies are a unique subset of market participants due to their level of sophis-

tication and their access to material nonpublic information arising through the issuer-pay business

model. During the rating process, credit rating agencies obtain material nonpublic information from

potential bond issuers: key transactions, multiyear financial statement forecasts including both sales

and capital budgets, and proprietary information concerning new product lines or markets. As a

result of credit rating agencies sophistication and information access, regulations and contracts rely

significantly on credit ratings (Cantor and Packer, 1995). In addition, as opinion providers, credit

rating agencies add value beyond that of other intermediaries with access to nonpublic information

because rating agencies must account for firms overall creditworthiness in their analyses.2

During the credit rating process, rating agency analysts are strongly encouraged to question

and obtain additional information pertaining to any complex or opaque transactions; tax-related

transactions are notable examples because of their crucial role in determining firms creditworthiness

(Ganguin and Bilardello, 2005). However, even if rating agencies obtain more granular information

concerning firms tax avoidance activities, disagreement between agencies can still arise regarding the

risk relevance of tax positions because tax avoidance often encompasses a range of outcomes whose

likelihood requires significant judgment. Therefore, our first hypothesis posits that tax avoidance

is positively associated with credit rating agency disagreement.

1
We define tax avoidance broadly as any positions taken on the tax return that reduce taxable income relative to
book income.
2
For instance, private lenders engage in syndicate lending, which typically requires seniority over all other debts
(Bharath et al., 2008). Because of this, private lenders can outsource the monitoring of firms overall credit risk to
rating agencies, which partly explains the increase in ratings-based lending contracts over time.

Electronic copy available at: http://ssrn.com/abstract=2511454

 We test our first hypothesis using three dierent empirical proxies of tax avoidance. These mea-

sures capture tax avoidance broadly: five-year Generally Accepted Accounting Principles (GAAP)

eective tax rate (ETR), five-year cash ETR, and a five-year measure of cash tax avoidance in-

troduced by Henry and Sansing (2014). We define rating agency disagreement in two ways: the

existence of a dierence between Moodys Investors Service (Moodys) and Standard & Poors (S&P)

initial credit ratings or the absolute level of the dierence between Moodys and S&Ps initial credit

ratings. For each of these tax avoidance measures, we find results consistent with our expectations.

Because credit rating agencies are sophisticated users of information, certain tax positions should

not be dicult to comprehend (e.g., municipal bond interest), and thus for these positions we

would not predict a significant association with rating agency disagreement. However, because

our eective tax rate proxies also include uncertain tax positions when they exist, uncertain tax

positions could confound the rating process to the point that the firms tax avoidance as a whole

becomes more dicult to interpret. Given this, credit rating agencies are more likely to disagree

on the interpretation of tax avoidance when its potential outcomes are more uncertain, and agree

on the interpretation of tax avoidance when its outcomes are less uncertain. Thus, the first part of

our second hypothesis posits an incrementally positive (negative) association between tax avoidance

and rating agency disagreement when firms engage in more uncertain (certain) tax avoidance.

To test this conjecture we first interact binary variables which capture whether firms tax avoid-

ance is in the lower or upper two-digit SIC industry-year quartile, with a binary variable that

captures whether firms unrecognized tax benefits are in the upper quartile of their two-digit SIC

industry-year. We find that rating agencies are incrementally more likely to disagree about firms

overall credit risk when firms report both high tax avoidance and high uncertain tax positions rela-

tive to firms that lack this combination. We find little evidence of rating agency disagreement when

firms engage in high amounts of uncertain tax positions but lower levels of tax avoidance.

Tax uncertainty can also arise from firms income shifting across jurisdictions because income

shifting often involves arcane ownership structures combined with a system of intercompany pay-

ments that exhibit uncertainty about their legal defensibility. Firms have the greatest opportunity

to use income shifting to reduce their tax payments if they have significant foreign activities (indica-

tive of cross-border tax rate dierentials necessary for income shifting) or research and development

activities (indicative of intangible assets that enable greater income shifting through intercompany

2
payments) or both. Therefore, we also separately interact foreign income and research and develop-

ment expense indicators with our three tax avoidance proxies. As before, we create binary variables

for our income shifting proxies, as well as our tax avoidance measures, to capture whether firms

are in the highest or lowest two-digit SIC industry quartiles in a given year, and zero otherwise.

We find that rating agencies are incrementally more likely to disagree over the credit risk of firms

having high tax avoidance when they are also in the highest industry-year quartile for both foreign

income or research and development expense. In addition, our findings suggest that rating agencies

are incrementally less likely to disagree over tax avoidance for firms in the lowest industry-year

quartiles of tax complexity. Collectively, these findings suggest that rating agencies are adept at

assessing the risk relevance of simple tax avoidance strategies but have diculty interpreting more

complex and uncertain tax avoidance.

Rating agencies acquire significant information about bond issuers from public filings (Ganguin

and Bilardello, 2005). Information from public filings can be useful to rating agencies because, while

they have access to issuer management during the rating process, resource constraints render unlikely

the resolution of all uncertainty through direct contact with issuers. This suggests that firms tax

disclosures can influence rating agencies assessment of firms credit risk. Thus, the second part of

our second hypothesis posits an incrementally negative (positive) association between tax avoidance

and rating agency disagreement when firms provide more (less) transparent tax disclosures.

We examine how tax disclosures aect rating agencies interpretations of issuers tax avoidance

by interacting our measures of tax avoidance with the length, quantitative content, and readability

of issuers tax footnotes. As before, we create binary variables for our tax disclosure proxies, as

well as our tax avoidance measures, to capture whether firms are in the highest or lowest two-

digit SIC industry quartiles in a given year, and zero otherwise. We find that firms with high

tax avoidance that are also in the lowest (highest) quartile of tax footnote length, quantitative

content, and readability are incrementally associated with more (less) rating agency disagreement.

Conversely, we fail to find incrementally significant results when firms engage in low tax avoidance.

These findings are consistent with rating agencies using disclosures in tax footnotes to help improve

their understanding of issuers tax avoidance, with more informative and more readable disclosures

being more helpful during the rating process.

Nonrandom rating disagreement related to tax avoidance suggests that credit rating agencies

3
do not treat the evaluation of credit risk from tax avoidance uniformly. This likely stems from the

relatively more conservative behavior of one credit rating agency compared to the other, suggesting

that each rating agency estimates the expected costs of rating errors dierently (Morgan, 2002;

Livingston et al., 2007). However, changes in firms tax avoidance can influence rating agencies to

reconsider their initially assigned ratings, which could lead to convergence or divergence between the

agencies in periods subsequent to bond issuance. Therefore, our third hypothesis predicts a negative

(positive) association between changes in tax avoidance (tax disclosures) and ratings convergence.

To examine this hypothesis, we first estimate regressions of changes in tax avoidance and tax

disclosure on whether a firm receives a split bond rating. We find that firms reduce (increase) their

tax avoidance activities (disclosure) in the periods subsequent to receiving a split bond rating. We

then estimate regressions of the probability of ratings convergence in the one-year period subsequent

to a bond oering on the changes in our three tax avoidance proxies and the changes in our tax

disclosure proxies. We find that changes in tax avoidance are negatively associated with ratings

convergence, while changes in tax footnote disclosures are positively associated with ratings conver-

gence. These results suggest that rating agencies are sensitive to the potential impact that changes

in tax avoidance or disclosure can have on firm credit risk, and also provide initial evidence on how

firms can influence rating agency disagreement subsequent to bond issuance.

In supplemental analysis, we also examine the impact of tax avoidance on rating accuracy

by testing whether a dierence in overall rating accuracy exists for firms that engage in higher

versus lower levels of tax avoidance. Using Receiver Operating Characteristic (ROC) curves and

identifying firms as high or low tax avoidance firms based on sample medians of our three tax

avoidance measures, we find evidence that suggests high tax avoidance firms have less accurate

credit ratings compared to low tax avoidance firms.

Finally, we examine whether the conservative (favorable) rating agency is more likely to upgrade

(downgrade) its rating to match that of the favorable (conservative) rating agency when firms reduce

(increase) tax uncertainty for a sample of bonds that eventually achieve rating convergence. We

find results consistent with our expectations. This evidence provides additional support for the

hypothesis that rating agencies do not assess the risk relevance of tax avoidance uniformly.

Disentangling why information intermediaries disagree about the interpretation of tax avoidance

is important because bond issuers bear substantial economic costs when rating disagreement occurs.

4
For instance, issuers may incur the direct costs of hiring a third rating agency to act as a tiebreaker

(Bongaerts et al., 2012), and they face, on average, higher interest costs and reduced demand for

their debt securities (Cantor et al., 1997; Livingston et al., 2010). In addition, because credit

rating disagreement is inherently sticky over time, these costs only grow as the persistence of the

disagreement increases (Livingston et al., 2008). Finally, in addition to the costs borne by issuers,

bond investors incur greater information gathering and processing costs to reduce uncertainty when

rating agencies disagree (Due and Lando, 2001; Gagliardini et al., 2009; Livingston et al., 2008).

Hasan et al. (2014) studies the pricing decisions that private lenders make with respect to bor-

rowers tax avoidance behavior. Our study complements this work by developing insights into the

process by which sophisticated information intermediaries reach their conclusions concerning tax

avoidance. For instance, our results suggest that tax avoidance is identifiable and quantifiable by so-

phisticated information intermediaries, but that credit rating agencies assess the outcome likelihood

of various tax transactions dierently. Our study also highlights that sophisticated information in-

termediaries have more divergent opinions when tax avoidance is accompanied by tax uncertainty,

complexity, or opaque disclosures. Therefore, our findings provide new evidence as to how market

participants cope with the previously documented challenges of assessing tax avoidance and why

even relatively benign tax avoidance can be dicult for information intermediaries to interpret.

Our study also has implications for firms and market participants because our findings indicate

that firms can take actions to eliminate rating disagreement. Since prior research suggests that

split bond ratings carry higher interest costs than non-split ratings and that split-rated bonds are

more likely to experience negative rating events subsequent to issuance (Livingston et al., 2007,

2008), it is important to document that firms have some control over future rating dispersion across

agencies. Finally, our study helps to explain why Ayers et al. (2010) find that book-tax dierences

are informative to rating agencies primarily as a proxy for earnings quality, but not tax avoidance.3

The remainder of our study proceeds as follows. Section 2 develops our hypotheses. Section 3

presents our sample selection and descriptive statistics. Section 4 discusses our research design and

empirical results. Section 5 concludes.

3
It is important to distinguish studies of book-tax dierences, which speak more to the information about future
performance contained in estimated taxable income that is incremental to that contained in book income, from studies
of tax avoidance such as our study. The former typically do not focus on tax avoidance and as a result often do not
separate tax eects from non-tax eects such as book earnings quality and o-balance-sheet financing (Wilson, 2010).
Our inferences remain unchanged when we control for book-tax dierences.

5
2 Hypothesis development

In order for rating agency analysts to assess the costs and benefits associated with tax avoidance,

they must first be able to identify and quantify the impact that such costs and benefits could

have on firms creditworthiness. This entails a thorough understanding of the costs and benefits

of tax avoidance, as well as reasonable estimation of the likelihood that such costs and benefits

are realized. Costs typically manifest in the form of reduced firm transparency, increased rent

diversion, complexity, penalties and interest, litigation costs, and heightened financial distress costs

(Mills, 1998; McGill and Outslay, 2004; Desai and Dharmapala, 2006; Balakrishnan et al., 2012).

Benefits typically arise in the form of tax savings, which increase after-tax cash flows and reduce

reliance on debt financing (Mills et al., 1998; Graham and Tucker, 2006). These costs and benefits

can be challenging to identify, quantify, and probability weight. However, this is not to suggest that

rating agencies typically fail to reach agreement when firms take on significant risks. In fact, our

sample suggests that ratings disagreement occurs in less than half of all initial bond oerings ( 45

percent), consistent with prior research (Livingston et al., 2007; Morgan, 2002). In addition, rating

agencies willingness to assign credit ratings when information uncertainty exists suggests that credit

rating agencies obtain enough information to perform their analytical tasks. In situations where

rating agencies believe they lack access to adequate information, they do not assign new ratings

and withdraw their existing ratings.4

Complicating the analytical process used by credit rating agencies is the fact that tax avoidance

often relies on complex and opaque positions, which are often structured by outside tax experts

(Weisbach, 2002; McGill and Outslay, 2004; Donohoe and Knechel, 2014). These experts are unlikely

to assist credit rating agencies in understanding issuers tax avoidance techniques during the rating

process. Without full and complete information, rating agency analysts are required to use their

best judgement in the face of information uncertainty with regard to both the ultimate magnitude

of potential outcomes, as well as their likelihood of occurrence (Ganguin and Bilardello, 2005). This

can be dicult because rating agency analysts are typically not tax experts.

Assuming that rating agencies dier in their relative costs of misclassifying bonds (i.e., rating a
4
Examination of rating agencies rating methodologies, as described in Exhibit 2 of Form NRSRO with the
Securities and Exchange Commission, and private discussions with agency analysts, reveal that rating agencies
typically withdraw or fail to assign a credit rating when issuers fail to provide enough information to reasonably
estimate firms overall creditworthiness, or when a bond is nearing maturity.

6
future defaulting bond too favorably, or rating a future non-defaulting bond too harshly), one of the

rating agencies will be more conservative than the other in the sense that it is punished relatively

more severely for over-rating future defaulting bonds compared to its counterpart (Morgan, 2002;

Livingston et al., 2007). This behavior should lead to more frequent and larger magnitude disagree-

ment between rating agencies as uncertainty increases. Accordingly, we examine the impact of tax

avoidance on rating disagreement using the theoretical framework of Morgan (2002) and Livingston

et al. (2007) and state our first hypothesis as follows:

H1: Tax avoidance is positively associated with rating agency disagreement.

Our first hypothesis treats various forms of tax avoidance similarly, suggesting that both rel-

atively certain and uncertain tax avoidance can confound the rating process, resulting in greater

rating agency disagreement. However, because rating agencies are sophisticated users of finan-

cial information, tax avoidance transactions whose outcomes are relatively certain (e.g., municipal

bond interest, dierences in depreciation methods across firms, and interest deductions related to

leverage) should not be dicult to interpret.

When firms engage in relatively uncertain tax positions, it may be dicult for rating agencies

to disentangle the eect of uncertain tax positions from certain tax positions, even when both have

the same eect of reducing the firms taxable income relative to its book income. Most public firms

engage in a variety of tax positions whose outcomes have varying levels of certainty. Therefore, each

firm has a relative level of tax uncertainty that can be compared cross-sectionally to other firms

and to the same firm in other time periods. We expect the relative level of uncertain tax avoidance

to make the firms tax avoidance as a whole more dicult to interpret because its outcomes are

more dicult to forecast. Given this, we expect a dierential impact on rating agency disagreement

when firms have more uncertainty in their tax avoidance outcomes versus other firms whose tax

avoidance outcomes are more certain. Therefore, we state the first part of our second hypothesis as

follows:

H2a: Tax avoidance is incrementally positively (negatively) associated with rating

agency disagreement for firms whose tax avoidance is relatively more (less) uncertain.

7
 Rating agencies rely on both public and material nonpublic information during the rating process

to assess firms credit risk. However, because tax accounting can be very dicult to comprehend

and interpret (Weisbach, 2002), nonpublic information may not necessarily eliminate this uncer-

tainty. For instance, prior research suggests that auditors can have diculty understanding firms

tax strategies, even when these firms consult on these tax strategies (Donohoe and Knechel, 2014).

Therefore, unless access to management reveals the truth without any noise, the quality of public

information about tax avoidance can have an eect on intermediaries with access to nonpublic in-

formation.5 Therefore, we state the second part of our second hypothesis as follows:

H2b: Tax avoidance is incrementally negatively (positively) associated with rating

agency disagreement for firms that provide more (less) transparent tax disclosures.

Credit rating agencies have an asymmetric loss function (Cantor and Packer, 1995; Partnoy,

1999), which helps shape their analytical standards and procedures. However, while analysts are

expected to adhere to these standards during the rating process, they are given leniency in how

ratings are assigned to issuers: rating agency professionals view credit analysis as both an art and

a science (Ganguin and Bilardello, 2005). This stems from the fact that credit rating agencies vary

in their sensitivities to appearing either optimistic or pessimistic in their rating parameters. Thus,

rating agencies likely do not account for the credit risk associated with complex or opaque trans-

actions uniformly. However, disagreement between rating agencies can also change in subsequent

periods because firm characteristics and risk profiles can change over time.

Because of the risk and complexity that accompanies tax avoidance transactions, changes in tax

avoidance or tax disclosures likely lead rating agencies to re-evaluate their assigned credit ratings.

Therefore, if firms reduce (increase) their tax avoidance behavior or improve (worsen) their disclo-

sures about existing tax positions and these actions reduce (increase) uncertainty about future cash

flow realizations, existing credit ratings should converge (diverge) over time. Therefore, we state

our third hypothesis as follows:

5
Certainly, models of disclosure in market settings (e.g., Kim and Verrecchia, 1994) consider private information
as a signal about the noise in public information, suggesting that even with rating agencies access to management
under nondisclosure agreements, the quality of public information can matter to their decision making process.

8
 H3: Changes in tax avoidance (disclosures) are negatively (positively) associated

with ratings convergence.

If rating agencies omit the impact that tax avoidance can have on issuers, tax avoidance would

not lead rating agencies to disagree over firms credit risk, consistent with prior research that suggests

information intermediaries fail to incorporate complex information into their analyses (Bushee, 1997;

Frost, 2007; Plumlee, 2003). Similarly, if firms desire more accurate ratings from multiple agencies,

they can furnish analysts with more granular data during the rating process, which could reduce

disagreement and increase convergence. To the extent that these behaviors occur, it is less likely

that tax avoidance or changes in tax avoidance will have an impact on rating agency disagreement.

3 Sample selection and descriptive statistics

3.1 Sample selection

As highlighted in Table 1, we gather our sample of new bond issues from the Mergent Fixed Income

Securities Database for the period covering 1994 through 2013. To limit our study to straight

corporate debt, we restrict our sample to debentures and medium-term notes. Because bonds are

not always rated on the date they are issued, we retain bonds that possess initial ratings from both

Moodys and S&P within 30 days of bonds oering dates. We use initial credit ratings to avoid the

eects of staleness in rating agencies monitoring activities, as well as to avoid the eects of time

lags between ratings changes on previously issued bonds, consistent with Livingston et al. (2007)

and Morgan (2002). Also, to limit the influence of outliers, we winsorize all continuous variables at

the 1st and 99th percentile values.

Based on these initial sample selection criteria, we retain 45,191 bonds with appropriate rating

information. Because we require accounting data from Compustat for tax-related and accounting-

based control variables, we created a unique database that allows us to manually match each six-digit

issuer CUSIP from Mergent FISD to a Compustat GVKEY, if available. We create this database

by first examining the names of each bond issuer in Mergent FISD and then matching these bond

issuers with a specific Compustat GVKEY of the same name, if available. For bond oerings where

9
the issuing firm cannot be easily linked to a Compustat firm, we manually search various databases

to determine if the issuing firm is a consolidated subsidiary of a Compustat-listed parent company.

If it is, we assign the specific bond a GVKEY that matches the parent company listed in Compustat.

This database allows us to retain considerably more observations than would be possible through

simply relying on Mergent FISD alone, thus increasing the power of our tests. We then match each

GVKEY to the appropriate CRSP PERMNO using the CRSP-Compustat linking table. Finally,

we match each issuers historical CUSIP to an I/B/E/S TICKER. As a result of this process, we

lose 15,479 observations due to missing database identifiers. For the majority of our tests, we also

eliminate observations for firms that have negative pre-tax income, as well as firms with lagged total

assets less than $1 million.6 Finally, after removing observations for which we have missing values for

any of the variables employed in our subsequent analyses, as well as observations related to firms in

the financial or utility industries, we retain a primary sample of 4,780 corporate bond issues. This

sample is reduced to 1,411 and 1,635 in a subset of tests that require data on unrecognized tax

benefits, which is only available after 2006.

3.2 Descriptive statistics

We present descriptive statistics for the variables in our study in Table 2. In Panel A, we show

that approximately 45 percent of the bond issues exhibit disagreement between Moodys and S&P

(Split), consistent with the percentage of disagreement for non-banks ( 50%) found by Livingston

et al. (2007) and Morgan (2002). When considering the magnitude of disagreement in the sample,

the average dierence between Moodys and S&P is slightly greater than a half-notch, where one

notch reflects a dierence from one rating level to another (e.g., the dierence between A and A-).

In our sample, roughly 37% of our bond observations are split by one notch, while approximately

7% are split by two notches, and 2% are split by three notches and above (untabulated). Moodys is

the more conservative rating agency in our sample as they assign lower initial credit ratings roughly

64 percent of the time when a split rating occurs (untabulated), which is statistically dierent from

a random dierences null hypothesis of 50 percent (p < 0.000).

Our tax avoidance proxies compare similarly to other studies (Dyreng et al., 2008; Lisowsky
6
We include loss firms for analyses using the delta measure developed by Henry and Sansing (2014). However,
the measurement error concerns with respect to eective tax rate measures raised by Henry and Sansing (2014) should
be less pertinent to our study since loss firms are much less likely to issue public debt.

10
et al., 2013). The average firm has a long-term eective tax rate of 25.3 percent, while its long-term

cash eective tax rate is 23.4 percent. Both ETRs are well below the U.S. statutory tax rate of 35

percent, suggesting that the average firm benefits significantly from its tax minimization strategies.

The mean Delta5 of -0.004 indicates that the average firms tax savings (compared to the U.S.

statutory tax rate) yields a 40 basis point boost in its return on assets.

The average firm in our sample is also large with average total assets of roughly $27 billion, as

expected, since firms that issue public debt are typically quite large (Alissa et al., 2013; Livingston

et al., 2007). Firms in our sample exhibit substantial equity analyst following, with an average of

nearly 21 analysts issuing or revising annual earnings forecasts for the fiscal year ending after the

bonds oering date during the 90 days leading up to the bond oering date. Firms in our sample

also spend 1.9 percent of their sales on research and development expenses, and collect 26.4 percent

of their pre-tax income from foreign operations. In addition, firms in our base sample average

roughly ten new bond issuances over our sample period (untabulated), reflective of their need to

roll over expiring debt or raise additional debt capital over time. In terms of bond characteristics,

the average bond in our sample has average initial ratings from Moodys and S&P of 13.31, which

corresponds to an average rating between Baa2/BBB and Baa1/BBB+. Given these ratings, the

average bond in our sample appears to be considered relatively creditworthy by both Moodys and

S&P. Lastly, the average firm in our sample also issues public debt with an average maturity of

roughly 119 months, or ten years. The shorter average maturity is indicative of the extensive use

of medium-term notes rather than long-term debentures to finance operations.

We present mean dierences between split and non-split firms in Panel B of Table 2. These results

suggest that firms with split bond ratings engage in greater tax avoidance. Specifically, split firms in

our sample have lower eective tax rates by 1.9 percentage points, lower cash eective tax rates by

1.7 percentage points, and a lower Delta5, which yields a 10 basis point increase in firms return on

assets compared to non-split firms. These dierences are statistically significant below the 0.01 level

under a two-sided hypothesis test. Split firms in our sample also appear to have less informative and

less readable tax footnotes, as proxied by Log(T axF N _Sent) and InvT axF N _F og, respectively.

These dierences are statistically significant below the 0.10 level under a two-sided hypothesis test.

In addition, split firms in our sample tend to be smaller, have more intangible assets, issue debt

with longer maturities, have greater sell-side analyst forecast dispersion, lower initial credit ratings,

11
and obtain less pre-tax income from foreign sources.

4 Research design and empirical findings

4.1 Tax avoidance and rating agency disagreement

To test our first hypothesis, we follow (Livingston et al., 2007) by estimating the following logit or

ordered logit model, depending on our dependent variable:

X X X
Disagreement = 1 T axAvoid + i Controlsi + i Industryi + iY eari + " (1)

in which Disagreement is one of two dierent proxies to capture rating agency information asym-

metry (disagreement). We use Split, defined as an indicator variable set equal to one if Moodys

and S&P disagree on their initial bond ratings, and zero otherwise. This is commonly referred to

as a split bond rating. To determine if a split bond rating occurred, we transform the Moodys

and S&P rating scales into a numeric format with Aaa/AAA ratings (on the Moodys and S&P

rating scales, respectively) equal to 21 and C/C ratings equal to one. However, while examining the

association between tax avoidance and the likelihood of rating agency disagreement is meaningful,

it is important to consider the magnitude of rating agency disagreement that can arise from tax

avoidance. For this purpose, we use SplitM ag, defined as the absolute dierence between Moodys

and S&Ps ratings at issuance. SplitM ag ranges from zero to six with greater positive values in-

dicative of greater rating agency disagreement. We use a logit model when estimating equation (1)

using Split as our dependent variable and an ordered logit model when estimating equation (1)

using SplitM ag as our dependent variable. We include both industry and year fixed eects and

employ heteroskedasticity consistent standard errors in our regression estimations.7

We use three dierent proxies for tax avoidance for our variable of interest, T axAvoid. We

begin by using two measures of eective tax rates that are widely considered to capture the broad

spectrum of tax avoidance activities (Dyreng et al., 2008), allowing us to assess the relation between

tax avoidance and rating agency information asymmetry. First, we use the firms GAAP ETR
7
Our inferences remain unchanged when we instead use firm and year fixed eects, and when we cluster standard
errors by firm throughout our analyses.

12
(ET R5), defined as a firms total tax expense divided by pre-tax income before special items,

averaged over the last five years. GAAP eective tax rates are prominent in financial analysis and

designed to reflect the amount of tax expense relating to the periods book income (Ganguin and

Bilardello, 2005). However, GAAP ET R does not capture the eects of deferral strategies and

is confounded by changes in the valuation allowance and tax reserve. Second, we use the firms

cash eective tax rate (CET R5), equal to cash taxes paid divided by pretax income before special

items, averaged over the last five years. Cash eective tax rates address some of the shortcomings

of GAAP eective tax rates because they capture the tax savings of deferral strategies and are

impervious to changes in the valuation allowance and tax reserve. However, they capture cash

tax payments that do not necessarily relate to the current accounting period, though averaging

over five years mitigates this issue (Dyreng et al., 2008). In addition, we employ a third measure

entitled Delta5, defined as sum of taxes paid minus the product of the statutory tax rate and

pre-tax income before special items, scaled by the market value of total assets (Henry and Sansing,

2014). Delta5 is a relatively new measure that aims to mitigate problems that can arise from the

denominators of eective tax rates. By computing a measure of the departure of cash tax payments

from the statutory tax on book income and scaling by the market value of total assets, Delta5

avoids the negative sign problem that occurs in ET Rs when pretax income is negative. Delta5

allows meaningful measurement of tax avoidance in loss firms and avoids bias toward the statutory

rate in high-income firms (Henry and Sansing, 2014). Because loss firms issue public debt less

frequently than profitable firms, we anticipate that the inclusion or elimination of loss firms will

not significantly change our results. One drawback to Delta5 is that it is not as easily interpretable

as ET Rs. While these three proxies capture many dierent types of tax positions, they do not

distinguish benign tax avoidance whose outcomes are relatively certain, such as tax-exempt interest

income produced by investments in municipal bonds, from more aggressive, complex tax avoidance

whose outcomes are relatively uncertain, such as income shifting to tax havens with low or zero

statutory tax rates. This distinction could be important in our setting if rating agencies are able to

understand certain tax avoidance better than uncertain tax avoidance.8

Because we multiply our tax avoidance proxies by negative one, a finding of 1 > 0 with respect
8
See Hanlon and Heitzman (2010) and Henry and Sansing (2014) for extended discussions of the benefits and
drawbacks to various tax avoidance proxies.

13
to ET R5, CET R5 and Delta5 would indicate that tax avoidance is negatively associated with

rating agency agreement, consistent with our empirical prediction. Alternatively, if rating agencies

superior analytical abilities or access to material nonpublic information allow them to reconcile the

future implications of tax avoidance, we will be unable reject 1 = 0.

We include a variety of control variables that prior research suggests are correlated with split

ratings (Livingston et al., 2007). These variables include firm size (Size), market-to-book ratio

(M B), intangible assets (Intangible), bond maturity (M at), bid-ask spread (BASpread), analyst

following (F ollow), analyst forecast dispersion (Disp), and credit rating (Rating). We also include

accrual quality (AQ) to control for the eects accruals management can have on both rating agency

disagreement and some of our tax avoidance variables. For instance, prior research suggests that tax

avoidance firms with high information risk, measured with accrual quality, suer from higher debt

costs (Hasan et al., 2014). Therefore, we include this control variable to ensure that our findings

are indeed unique. Lastly, we include both research and development (R&D) and foreign income

(F oreignInc) as either of these two variables could increase firm complexity and/or tax avoidance.

We defined all variables in the Appendix.

Columns (1)(3) of Table 3 present the results of estimating equation (1), where Split is the

dependent variable. For each of the three measures pertaining to firms tax rates (ET R5, CET R5,

and Delta5), we find a statistically significant relation between tax avoidance and the likelihood

of bond rating disagreement in the predicted direction. In columns (1)(3), for ET R5, CET R5,

and Delta5, 1 > 0 we estimate coecients of 0.193, 0.208, and 4.715, respectively. All estimated

coecients are statistically significant below the 0.01 level under a two-sided hypothesis test.9 Our

results suggest that the likelihood of bond rating disagreement increases as firms more eectively

exploit tax avoidance strategies that reduce their eective tax rates. In terms of economic sig-

nificance, a decrease from the third quartile to the first quartile in a firms ET R5 (CET R5) is

associated with an increase in the likelihood of rating agency disagreement of approximately 0.5

(0.6) percentage points, while a similar interquartile range decrease in a firms Delta5 is associated

with an increase in the likelihood of rating agency disagreement of approximately 1.1 percentage

points. Compared to the likelihood of a split rating at the median value of these tax avoidance
9
In untabulated tests, we find a significant positive association between ETR volatility and each of our dependent
variables.

14
proxies, these interquartile range decreases in eective tax rates (Delta5) generate increases in the

likelihood of rating disagreement that are roughly one (two) percent of the sample average likelihood

of rating agency disagreement.

While examining the association between tax avoidance and the likelihood of rating agency dis-

agreement is meaningful, it is important to consider the magnitude of rating agency disagreement

that can arise from tax avoidance. Greater magnitude of rating agency disagreement (information

asymmetry), using SplitM ag as a proxy, can impose greater costs on firms via greater incremental

borrowing costs, and potentially lower access to capital markets as heightened disagreement mag-

nitudes can lead investors to more heavily rely on the more conservative rating agency. These are

important concerns as Livingston et al. (2008) show that bonds with split ratings are more likely

to suer from future rating deterioration than non-split bonds, increasing the probability of future

rating downgrades. In addition, because bonds with initial split credit ratings typically fail to con-

verge over time (Livingston et al., 2007, 2008), the incremental costs that accompany rating agency

disagreement can persist over long periods of time.

We present the results of estimating equation (1) in columns (4)(6) of Table 3, where SplitM ag

is the dependent variable. For each of the three measures pertaining to firms tax rates (ET R5,

CET R5, and Delta5), we find a statistically significant relation between tax avoidance and the

magnitude of bond rating disagreement in the predicted direction. In columns (4)(6), for ET R5,

CET R5, and Delta5, 1 > 0 with estimated coecients of 0.259, 0.294, and 3.362, respectively. All

estimated coecients are statistically significant below the 0.01 level under a two-sided hypothesis

test. Our results suggest that the magnitude of bond rating disagreement increases as firms more

eectively exploit tax avoidance strategies that lower their eective tax rates. In terms of eco-

nomic significance, an interquartile range decrease in a firms ET R5 (CET R5) is associated with

an increase in the magnitude of rating agency disagreement of approximately 0.010 (0.013) rating

notches, while a similar interquartile range decrease in a firms Delta5 is associated with an increase

in the magnitude of rating agency disagreement of approximately 0.013 notches. Based on the pre-

dicted rating disagreement magnitude at the median level of the these tax avoidance proxies, these

interquartile range decreases in eective tax rates (Delta5) generate increases in rating disagreement

magnitudes that are roughly two (two) percent of the sample average rating agency disagreement

magnitude. The evidence presented in columns (4)(6) of Table 3 suggests that tax avoidance is

15
sucient to increase rating agencies information asymmetry with respect to issuers claims-paying

abilities and, hence, the magnitude of rating disagreement between Moodys and S&P.

4.2 The moderating influences of tax uncertainty via complexity or disclosure

on rating agency disagreement over tax avoidance

Our initial results in Table 3 show that credit rating agencies disagree over tax avoidance, suggesting

that credit analysts find tax avoidance challenging to interpret in terms of its implications for

satisfying future borrowing obligations. Prior research reveals the diculty in estimating a firms

actual tax expense and taxable income (i.e., as reported on its tax return) from the information

available in its financial statements (McGill and Outslay, 2004; Hanlon, 2003; Hanlon and Heitzman,

2010). Even with the benefit of confidential tax return data, dierences in consolidation rules and

the U.S.-only approach of the U.S. federal tax return combine to make it extremely dicult to

relate tax return information to the financial statements (Donohoe et al., 2012). This is consistent

with evidence presented by Donohoe and Knechel (2014) and Hasan et al. (2014), which show

that auditors and private lenders, respectively, act on overall measures of tax avoidance. Taken to

the extreme, even given full, material nonpublic information about the firms positions, it is often

dicult to determine the legality of a given tax position (Weisbach, 2002).

However, more certain tax transactions should not be dicult to interpret (e.g., municipal bond

interest, interest deductions related to leverage, dierences in depreciation methods across firms).

Given this, credit rating agencies are theoretically more likely to disagree on the interpretation of

tax avoidance when its potential outcomes are relatively more uncertain, and more likely to agree on

the interpretation of tax avoidance when its outcomes are relatively more certain. We empirically

examine this conjecture in several ways. We begin by replacing our tax rate measures (e.g., ET R5,

CET R5, and Delta5) with binary variables equal to one if the measure in question is in the highest

or lowest two-digit SIC industry-year quartile, and zero otherwise. Thus, variables in the lowest

(highest) industry-year quartile are termed LowT axAvoidance (HighT axAvoidance). To measure

the level of tax uncertainty, we also include a binary variable equal to one if a firm has year-end

unrecognized tax benefits (UTBs) scaled by lagged total assets in the highest two-digit SIC industry-

year quartile, and zero otherwise (HighU T B). We use only UTB values reported in Compustat (i.e.,

16
we do not replace missing values).10 The average UTB balance for firms coded as HighU T B = 1

is approximately 4.1 percent of lagged total assets while for firms coded as HighU T B = 0 the

average UTB balance is approximately 0.3 percent of lagged total assets. This measure captures

tax uncertainty in the form of positions that may or may not be allowed under relevant tax law.

We then re-estimate equation (1) but now replace the level of tax avoidance with these binary

variables and their interactions. Because firms were not required to disclose their uncertain tax

positions prior to the implementation of Financial Accounting Standards Board Interpretation No.

48 (FIN 48), we conduct this analysis over the 20072013 time period. We predict that credit rating

agencies will find it more dicult to agree on firms tax avoidance in the presence of greater relative

tax uncertainty as indicated by HighU T B, leading to greater rating disagreement magnitudes for

firms with higher tax uncertainty. That is, we predict a positive coecient on the interaction term,

HighU T B HighT axAviodance.

Panel A of Table 4 presents our results. In columns (1)(3) we find that the coecients on

the main eects of HighU T B are positive and statistically significant below the 0.01 level under

a two-sided hypothesis test, indicating that a relatively high level of tax uncertainty is associated

with more rating agency disagreement in firms with moderate levels of tax avoidance. In addition,

in columns (1)(3) we also find estimated coecients of 2.148, 1.988, and 1.073, respectively, for

HighU T B HighT axAvoidance, suggesting that rating agency disagreements are incrementally

more pronounced in firms with high levels of tax avoidance. These coecients are statistically

significant below the 0.01 level under a two-sided hypothesis test. Furthermore, F -tests of the

sums of the coecients of HighU T B HighT axAvoidance and HighT axAvoidance are positive

and statistically significant below the 0.01 level under and two-sided hypothesis test. These results

indicate that rating agencies are incrementally more likely to disagree on firms overall credit risk

pertaining to tax avoidance in firms with high tax uncertainty and high tax avoidance compared

to firms with moderate tax avoidance and little tax uncertainty, based on HighU T B as a proxy

for tax uncertainty. Conversely, we fail to find consistent evidence that suggests rating agencies are

incrementally less likely to disagree on firms credit risk when firms have low tax avoidance but high
10
We rely on disclosed UTBs to proxy for tax uncertainty, but disclosed UTBs are probabilistic estimates that
require managerial discretion. It is possible that underreporting of UTBs creates a bias in our results, but it would
likely bias against our prediction as it would move firms that should be coded HighUTB = 1 to HighUTB = 0.
Audit functions and SEC enforcement should reduce the risk of misreporting. Our foreign activity and research and
development tests in Panels B and C of Table 4 should be less subject to managerial discretion.

17
tax uncertainty.

Tax complexity can also contribute to uncertainty, for instance, when firms shift taxable income

across various tax jurisdictions.11 Firms with foreign presence and research and development activ-

ities are likely to have more opportunities to shift income. Foreign presence gives firms access to

cross-border tax rate dierentials, while research and development activities create intangible assets

that can be placed in tax-favored jurisdictions to initiate a system of inter-company payments that

shift taxable income from high-tax jurisdictions to low-tax jurisdictions. The ownership structures

and inter-company payments used to shift income can be very complex (Wagener and Watrin, 2014),

which we expect to make assessment by credit rating agencies more dicult.

To test whether this type of complexity makes tax avoidance more dicult for rating agencies

to interpret, we also re-estimate equation (1) but now interact our binary variables that repre-

sent high and low tax avoidance (HighT axAvoidance and LowT axAvoidance) with two binary

variables equal to one if firms have foreign income or research and development expenses in the

highest (lowest) two-digit SIC industry-year quartiles, and zero otherwise (HighT axComplexity or

LowT axComplexity). Panels B and C of Table 4 present our results when F oreignInc or R&D,

respectively, are our proxies for tax complexity. In both panels, we find that the coecients on

HighComplexity HighT axAvoidance are positive and statistically significant at the 0.05 level

or below under a two-sided hypothesis test. In Panel B, the results are consistent with complexity

resulting from foreign activities adding to rating agencies diculty in interpreting tax avoidance,

while in Panel C the results are consistent with complexity resulting from research and development

activities making tax avoidance relatively more dicult to interpret. Based on an F -test of the sum

of the coecients on HighComplexity HighT axAvoidance and HighT axAvoidance, we find that

there is more disagreement between rating agencies when both tax complexity and tax avoidance

are high compared to firms with moderate tax avoidance and tax complexity across both panels. On

the other hand, an F -test of the sum of the coecients on LowComplexity HighT axAvoidance

and HighT axAvoidance is statistically insignificant at conventional rejection levels, providing no

evidence that there is more rating agency disagreement for high tax avoidance firms with low levels
11
For example, Caterpillar undertook relatively aggressive eorts to avoid U.S. tax by restructuring its international
supply chain, ultimately creating tax uncertainty when the IRS challenged Caterpillars positions. This prompted
analysts to state that there was insucient information to predict Caterpillars future eective tax rates (Hagerty,
2015).

18
of tax complexity compared to firms with moderate tax avoidance and complexity. We also find

some evidence that that rating agencies disagree less on firms overall credit risk for low tax com-

plexity firms when they are low tax avoidance firms relative to benchmark firms with moderate

tax avoidance and complexity. Collectively, these findings shed light on the diculty rating agency

analysts have during the rating process when faced with greater tax complexity.

We continue our examination of why rating agencies find tax avoidance dicult to interpret with

an investigation of tax footnote disclosures found in firms annual reports. We expect that clearly-

written tax footnotes containing more explanation and more quantitative detail will aid credit rating

agencies in understanding firms tax avoidance, and all else equal, lead to less rating disagreement.

We follow Bozanic et al. (2014) to construct several measures of tax footnote transparency, such

as: Log(T axF N _Sent), defined as the natural log of the number of sentences within the tax

footnote, Log(T axF N _N ums), defined as the natural log of the number of numbers within the

tax footnote (e.g., quantitative content), and InvT axF N _F og, defined as the Fog Index of the tax

footnote, multiplied by negative one.12 These variables are then transformed into binary variables

when Log(T axF N _Sent), Log(T axF N _N ums), or InvT axF N _F og is in the highest or lowest

quartile of the firms two-digit SIC industry in a given year, and zero otherwise (HighDiscQual

and LowDiscQual).

To test our hypothesis, we interact our tax avoidance binary variables (HighT axAvoidance

and LowT axAvoidance) with our proxies for tax related disclosure quality (HighDiscQual and

LowDiscQual). We also include Inv10K_F og and Log(10K_W ords) as additional control vari-

ables to account for the possibility that firms tax footnote disclosures are influenced by firms

overall disclosure quality. Panels D, E, and F of Table 4 present our results. The coecients

on the interactions between HighDiscQual and HighT axAvoid are negative and statistically

significant below the 0.05 level under a two-sided hypothesis test across all panels. This sug-

gests that more transparent tax disclosures relatively reduce rating agency disagreement for high

tax avoidance firms. Conversely, the coecients on the interactions between LowDiscQual and

HighT axAvoid are positive and statistically significant below the 0.01 level under a two-sided

hypothesis test across all panels. This suggests that less transparent tax disclosures relatively

increases rating agency disagreement for high tax avoidance firms. When turning to F -tests of
12
We are grateful to Je Hoopes for sharing this tax footnote data with us.

19
the sums of HighDiscQual HighT axAvoidance or LowDiscQual HighT axAvoidance and

HighT axAvoidance, we find that relative to moderate tax avoidance firms with moderate tax dis-

closure quality, high tax avoidance firms with high quality tax disclosures experience either less

rating disagreement or a statistically indistinguishable dierence, while high tax avoidance firms

with low quality tax disclosures consistently experience more rating disagreement. This evidence is

consistent with credit analysts using tax footnotes to help interpret issuers tax avoidance as part

of their rating process. These findings also suggest that tax avoidance is relatively more straight-

forward to interpret in firms that have informative, clearly written tax footnotes.

Collectively, the results presented in Table 4 suggest that credit rating agencies struggle relatively

more to disentangle the impact of tax avoidance when it is accompanied by greater tax uncertainty,

tax complexity, or opaque disclosures. Thus, our results provide insights into the use of tax-related

information in capital markets by highlighting not only whether market participants fail to fully

understand firms tax avoidance activities but also why they fail to fully understand tax avoidance.

4.3 Changes in tax avoidance and rating agency convergence

Credit rating agencies aim to assign credit ratings that do not typically fluctuate unless firms

credit risk changes (Cantor and Packer, 1995; Covitz and Harrison, 2003). This suggests that rating

disagreements are somewhat sticky over time.13 However, split bond ratings can be costly for firms.

This is due to the fact split bond ratings carry higher credit spreads than non-split bonds, are

more likely to suer from negative credit rating events over time, and can cause bond investors

to undertake more due diligence to disentangle the cause of rating agency disagreement (Due

and Lando, 2001; Gagliardini et al., 2009; Livingston et al., 2008; Livingston and Zhou, 2010).

These arguments suggest that firms can respond to split bond ratings by altering their levels of tax

avoidance or by altering their tax disclosures in an eort to achieve ratings convergence over time.

To examine our third and final hypothesis, we follow a model similar to Hasan et al. (2014) by

first examining whether firms alter the amount of tax avoidance they engage in, as well as their tax

disclosures, after receiving a split bond rating by estimating the following OLS model:
13
In untabulated analyses, we find that roughly 20.3 percent of the initial split ratings in our primary analyses
converge in the year subsequent to issuance. The frequency of convergence increases to 40.2 and 49.0 percent in the
three- and five-year periods subsequent to issuance, respectively. These findings are consistent with Livingston et al.
(2008) who show that roughly 30 percent of initial split bond ratings converge in the subsequent four-year period.

20
 X
T axAvoid(Disclosure)t = 0 + 1 Splitt + i Controlsi,t 1 +" (2)

in which T axAvoid(Disclosure) is the annual change in our tax avoidance proxies or our tax

disclosure proxies. We follow Hasan et al. (2014) and include the following additional control

variables: ROA, defined as the change in operating income before depreciation scaled by lagged

total assets; Leverage, defined as the change in long-term debt scaled by lagged total assets;

N OL, defined as the change in net operating loss carry forwards scaled by lagged total assets;

F ixedAssets, defined as the change in property, plant, and equipment scaled by lagged total

assets.14 All other variables are defined as previously.

We present our results in Table 5. In columns (1)(3) we find 1 > 0 with estimated coecients

of 0.152, 0.085, and 0.003, respectively. These coecients are statistically significant below the 0.01

level under a two-sided hypothesis test. These findings suggest that firms that receive a split bond

rating from Moodys and S&P in year t reduce their tax avoidance activities in subsequent periods.

In columns (4)(6) we find 1 > 0 with estimated coecients of 0.115, 0.089, and 0.566, respectively.

These coecients are statistically significant below the 0.01 level under a two-sided hypothesis test.

These findings suggest that firms that receive a split bond rating also increase the informativeness

of their tax footnotes, while also reducing the ambiguity within these footnotes. Collectively, these

findings provide initial evidence that firms with split bond ratings attempt to reduce rating agency

uncertainty, and therefore disagreement, over time.

Changes in complexity or opacity with respect to tax avoidance can cause rating agencies

interpretations about firms risk profiles to change, resulting in subsequent credit rating changes.

Therefore, because rating agencies can disagree over the credit risk implications of tax avoidance,

firms assigned credit ratings can converge (or diverge) over time as changes in tax avoidance occur.

In addition, because tax disclosures are an integral component of the rating process that have been

shown to influence rating agencies interpretation of tax avoidance, changes in these disclosures can

also aect the likelihood of rating convergence over time. Given this, we predict a negative (positive)
14
While Hasan et al. (2014) examine the three-year period both before and after loan initiation, our analysis
examines the year of and before a bond issuance. Our inferences remain unchanged when we examine the three-year
period before and after a bond issuance.

21
association between changes in tax avoidance (disclosure) and rating convergence subsequent to bond

issuance for bonds that initially have split ratings from Moodys and S&P.

We examine this relationship by estimating the following logit model:

Converget+1 = 0 + 1 T axAvoid + 2 Log(T axF N _Sent) + 3 Log(T axF N _N ums)

+ 4 InvT axF N _F og + " (3)

in which Converget+1 is an indicator variable set equal to one if Moodys and S&Ps assigned credit

ratings reach agreement within the one-year period subsequent to the bond oering date, and zero

otherwise. All other variables are defined as previously.

We present our results in Table 6. In columns (1)(3) we find 1 < 0 with estimated coecients

of -0.265, -0.408, and -33.669, respectively. These coecients are statistically significant below

the 0.01 level under a two-sided hypothesis test across all columns. These results suggest that

increases (decreases) in firms tax avoidance are negatively (positively) associated with ratings

convergence over the one-year period after the initial credit rating was assigned. In addition, in

columns (1)(3) the coecients on Log(T axF N _Sent) and Log(T axF N _F og) are positive and

statistically significant below the 0.01 level under a two-sided hypothesis test, while the coecient

on InvT axF N _N ums is indistinguishable from zero. These results suggest that credit rating

agencies respond to changes in firms information environments with respect to tax disclosures,

resulting in greater rating agency convergence when firms tax footnotes provide more information

or are more readable, and vice versa.

Collectively, the results in Table 6 suggest that credit rating agencies respond to changes in firms

tax uncertainty or opacity, which impacts the rating agencies ability to reach consensus concerning

the risk relevance of firms tax avoidance over time. The results also suggest that firms with split

ratings are able to change their behavior in an eort to eliminate rating disagreement.15
15
Our inferences remain unchanged when we measure ratings convergence for the three- and five-year periods
subsequent to the bond oering date.

22
4.4 Additional analyses

4.4.1 Impact of tax avoidance on credit rating accuracy

Credit rating agencies are charged with assigning both accurate and reliable credit ratings. Ac-

curacy is a precursor for reliability as inaccurate ratings have little value to investors, regulators,

or contracting counter-parties (Cantor and Packer, 1995; Covitz and Harrison, 2003; Jung et al.,

2012). Therefore, it is important that credit ratings provide an accurate measure of default risk.

To better understand the role of tax avoidance on rating accuracy we examine whether a dierence

in overall rating accuracy exists for firms that engage in higher versus lower levels of tax avoidance.

To examine this conjecture, we estimate credit rating accuracy using Receiver Operating Charac-

teristic (ROC) curves. Specifically, we estimate the area under the curve for both low tax avoidance

firms and high tax avoidance firms, where Above (Below) Median Tax Avoidance is an indicator

variable equal to one if a firms respective tax avoidance proxy is lower (higher) than the sample

median for a given year, and zero otherwise. We present our findings in Table 7. In columns (1)(3)

we show that low tax avoidance firms areas under the ROC curve are greater than those for high

tax avoidance firms. These dierences are statistically significant below the 0.01 level across all

columns. Collectively, this evidence suggests that firms that engage in greater tax avoidance have

less accurately assigned credit ratings compared to firms that engage in less tax avoidance activities.

4.4.2 Initial tax avoidance estimation and ratings convergence

When rating agency convergence occurs, it suggests that initial rating agency disagreement occurred

because one rating agency underestimated or overestimated the costs or benefits associated with tax

avoidance to a greater extent than the other. Identifying which rating agency initially underesti-

mated or overestimated the costs or benefits of tax avoidance is dicult as these initial assessments

require assumptions not only about the future magnitudes of tax avoidance, but also about the

persistence of these tax positions. However, unless one rating agency is more willing than the other

to adjust their assigned credit ratings when changes in tax avoidance occur, we expect the conser-

vative (favorable) rating agency to be more likely to upgrade (downgrade) their ratings to match

those of the favorable (conservative) rating agency when firms reduce (increase) tax avoidance or

when firms increase (decrease) their tax disclosures. This assumption is consistent with the Morgan

23
(2002) framework, which predicts that the conservative rating agency errs less pessimistically when

uncertainty is lower.

To examine this conjecture we re-estimate equation (3) for a sample of observations that achieved

ratings convergence over the one-year period subsequent to the bond oering date. In addition, we

replace our dependent variable with Conserveupgrade , which is set equal to one when the conservative

rating agencys upgraded credit rating matches the favorable rating agencys assigned credit rating,

and zero when the favorable rating agencys downgraded credit rating matches the conservative

rating agencys assigned credit rating.

We present our results in Table 8. In columns (1)(3) we find 1 < 0 with estimated coecients of

-1.439, -1.504, and -56.654, respectively. These coecients are statistically significant at or below the

0.01 level under a two-sided hypothesis test for each column. Ultimately, the results in columns (1)

(3) show that the conservative (favorable) credit rating agency is more likely to upgrade (downgrade)

firms assigned credit ratings to match those of the favorable (conservative) credit rating agency

when firms reduce (increase) their tax avoidance activities. In addition, in columns (1)(3) the

coecients on Log(T axF N _Sent), Log(T axF N _N ums), and InvT axF N _F og are positive

and statistically significant below the 0.10 level under a two-sided hypothesis test. These findings

suggest that the conservative (favorable) credit rating agency is more likely to upgrade (downgrade)

firms assigned credit ratings to match those of the favorable (conservative) credit rating agency

when firms increase (reduce) the quality of their tax disclosures.16

In addition, in untabulated analyses we examine whether one rating agency is more likely to

adjust their assigned credit ratings than the other based on quartile ranking of the change in tax

avoidance. With respect to ET R5, we find that 24 percent of ratings convergence observations

occur when the conservative rating agency upgrades their assigned credit ratings for firms in the

lowest quartile of tax avoidance changes (increases in tax avoidance), while 77 percent of ratings

convergence observations occur when the conservative rating agency upgrades their assigned credit

ratings for firms in the highest quartile of tax avoidance changes (decreases in tax avoidance). Similar

statistics are found when CET R5 and Delta5 are our proxies for tax avoidance. Collectively, these

findings suggest that ratings convergence is due to dierences in how rating agencies account for
16
Our inferences remain unchanged when we examine the three- and five-year periods subsequent to the bond
oering date.

24
the risk relevance of tax avoidance at the initial rating date, and also with respect to changes in tax

avoidance over time.

4.4.3 Impact of the 2007 - 2009 financial crisis

The financial crisis of 20072009 wreaked havoc on both firms and credit rating agencies by increas-

ing the level of general uncertainty in the marketplace. Because prior research has shown that rating

agency disagreement occurs as a result of dierences between how rating agencies handle opaque-

ness during the rating process (Morgan, 2002; Livingston et al., 2007), the possibility exists that

our findings are partially driven by the heightened uncertainty that existed during the 20072009

financial crisis. Therefore, to rule out this possibility we re-estimate our regressions in Tables 3 and

4 but exclude observations from December 2007 thru June 2009, the period of the recession.17 Our

inferences remain unchanged when we exclude these observations (untabulated).

5 Conclusion

Tax avoidance often requires highly complex and opaque positions, making it dicult for market

participants to adequately assess the impact of the costs and benefits of tax avoidance on firms

financial positions and performances (Desai and Dharmapala, 2006; Balakrishnan et al., 2012). As a

result, we hypothesize that tax avoidance creates significant non-tax costs in the form of heightened

information asymmetry, which is reflected in the form of a higher likelihood of obtaining and the

magnitude of split ratings on newly issued bonds.

Of course, not all forms of tax avoidance should be dicult for sophisticated information in-

termediaries to interpret because certain transactions are not overly complicated. However, when

firms engage in both certain and uncertain tax avoidance, rating agencies can struggle to disentangle

the eect of certain tax avoidance from uncertain tax avoidance as both aim to lower firms tax

liabilities. In addition, because firms tax disclosures play a vital role in the rating process, rating

agencies likely respond to variation in the transparency tax disclosures. Given this, our second

hypothesis predicts an incremental association between tax avoidance and ratings disagreement for

firms that engage in relatively more uncertain tax avoidance, as well as for firms that have less
17
We thank an anonymous reviewer for this recommendation.

25
transparent disclosures.

The non-random nature of tax avoidance-related disagreement suggests that credit rating agen-

cies do not evaluate credit risk from tax avoidance uniformly. This likely stems from the conservative

behavior of one credit rating agency compared to the other, suggesting that each rating agency has

dierent relative costs of over- versus under-rating firms bonds. However, changes in firms tax

avoidance characteristics can cause rating agencies to reconsider their assigned ratings, which could

lead to convergence or divergence of previously split bond ratings over time. Therefore, our third

and final hypothesis predicts a negative (positive) association between changes in tax avoidance

(tax disclosure transparency) and ratings convergence.

We find results consistent with our three hypotheses. In addition, in supplemental tests we

show that firms that engage in greater (lower) tax avoidance suer from less (more) accurately

assigned initial credit ratings, and that lower (higher) uncertainty from the reduction (increase) of

tax avoidance leads the conservative (favorable) rating agency to adjust their assigned ratings to

match those of favorable (conservative) rating agency over time.

Our study complements prior research which examines the impact of tax avoidance on so-

phisticated intermediaries (Hasan et al., 2014; Donohoe and Knechel, 2014) by highlighting why

sophisticated intermediaries have diculty interpreting tax avoidance. Specifically, our results sug-

gest that sophisticated intermediaries have greater diculty understanding tax avoidance when it

contains relatively uncertain or complex positions, or is more opaquely disclosed. By disentangling

these issues, our study provides new evidence as to how market participants cope with the previ-

ously documented challenges of assessing tax avoidance, and why even certain tax avoidance can be

dicult for sophisticated information intermediaries to interpret.

Our study also has implications for firms and market participants as our findings highlight that

firms can take specific actions to reduce rating agency disagreement resulting from tax avoidance.

This is significant given the costs associated with rating disagreement. In addition, our study also

helps explain why Ayers et al. (2010) find that book-tax dierences are informative to credit rating

agencies primarily as a proxy for earnings quality, but not tax avoidance.

26
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29
Appendix Variable definitions

Variable Description
Indicator variable set equal to one if Moodys and S&P dis-
Split
agree on their initial bond rating, and zero otherwise
Absolute dierence between the initial rating given by
SplitM ag
Moodys and that given by S&P (|M oody 0 s S&P |)
Average of GAAP income tax expense divided by pre-tax in-
ET R5
come before special items over the prior five years
Average of cash taxes paid divided by pre-tax income before
CET R5
special items over the prior five years
Sum of taxes paid minus the product of the statutory rate and
Delta5 pre-tax income excluding special items, scaled by the market
value of assets
Ending balance of unrecognized tax benefits divided by lagged
UTB total assets for the most recent fiscal year prior to a bond
issuance
The natural logarithm of the number of sentences within a
Log(T axF N _Sent)
tax footnote
The natural logarithm of the number of numbers within a tax
Log(T axF N _N ums)
footnote
The Fog Index for a firms tax footnotes, multiplied by nega-
InvT axF N _F og
tive one
Indicator variable set equal to one if Moodys and S&Ps as-
Converget+1 signed credit ratings reach agreement in the one-year period
subsequent to the bond oering date, and zero otherwise
Indicator variable set equal to one when the conservative rat-
ing agencys upgraded credit rating matches the favorable rat-
ConservU pgrade ing agencys assigned credit rating, and zero when the favor-
able rating agencys downgraded credit rating matches the
conservative rating agencys assigned credit rating
Indicator variable set equal to one if a firms year-end un-
recognized tax benefits divided by lagged total assets is in
HighU T B
the upper quartile by two-digit SIC industry-year, and zero
otherwise
Indicator variable set equal to one if a firms respective tax
LowT axAvoidance avoidance proxy is in the lower quartile of its two-digit SIC
industry-year, and zero otherwise
Indicator variable set equal to one if a firms respective tax
HighT axAvoidance avoidance proxy is in the upper quartile of its two-digit SIC
industry-year, and zero otherwise
Indicator variable set equal to one if a firms F oreignInc (see
Panel B of Table 4) or R&D (see Panel C of Table 4) is in
LowComplexity
the lower quartile of its two-digit SIC industry-year, and zero
otherwise
Indicator variable set equal to one if a firms F oreignInc (see
Panel B of Table 4) or R&D (see Panel C of Table 4) is in
HighComplexity
the upper quartile
30 of its two-digit SIC industry-year, and zero
otherwise
Variable Description
Indicator variable set equal to one if a
firms Log(T axF N _Sent) (see Panel D of 4),
Log(T axF N _N ums) (see Panel E of Table 4), or
LowDiscQual
InvT axF N _F og (see Panel F of Table 4) is in the
lower quartile of its two-digit SIC industry-year, and zero
otherwise
Indicator variable set equal to one if a
firms Log(T axF N _Sent) (see Panel D of 4),
Log(T axF N _N ums) (see Panel E of Table 4), or
HighDiscQual
InvT axF N _F og (see Panel F of Table 4) is in the
upper quartile of its two-digit SIC industry-year, and zero
otherwise
Indicator variable set equal to one if a firms tax avoidance
BelowM edianT axAvoidance
proxy is below the sample median, and zero otherwise
Indicator variable set equal to one if a firms tax avoidance
AboveM edianT axAvoidance
proxy is above the sample median, and zero otherwise
The natural logarithm of lagged total assets (not logged in
Size
Table 2)
MB The ratio of book value of equity to the market value of equity
Intangible Intangible assets divided by lagged total assets
The natural logarithm of the number of months from a bonds
M at
oering date to its final maturity (not logged in Table 2)
Average daily bid-ask spread for the equity of the issuing firm
BASpread
during the year prior to the bond issuance
The natural logarithm of the number of equity analysts fore-
casting annual earnings for the fiscal year ending prior to a
bonds oering date using the most recent forecast at least
F ollow
nine months prior to the end of the fiscal year, divided by
market capitalization nine months prior to the fiscal period
end (we include unscaled number of analysts in Table 2)
The standard deviation of equity analysts forecasts of annual
earnings for the fiscal year ending prior to a bonds oer-
Disp ing date using the most recent forecast at least nine months
prior to the end of the fiscal year, divided by stock price nine
months prior to the fiscal period end
Rating The average initial bond rating between Moodys and S&P
Francis et al. (2005) measure of accruals quality for the fiscal
AQ
year ended prior to the bonds oering date

31
Variable Description
R&D Research and development expenses divided by revenues
F oreignInc Foreign pre-tax income divided by total pre-tax income
The Fog Index for a firms most recent 10-K filing prior to a
Inv10K_F og
bond issuance, multiplied by negative one
The natural logarithm of the number of words in a firms most
Log (10K_W ords)
recent 10-K filing prior to a bond issuance
The change in the ratio of operating income before deprecia-
ROA
tion scaled by lagged total assets
The change in the ratio of long-term debt scaled by lagged
Leverage
total assets
The change in the ratio of net operating loss carry forwards
N OL
scaled by lagged total assets
The change in ratio of property, plant, and equipment scaled
F ixedAssets
by lagged total assets

32
 Table 1: Sample construction
Selection Criterion Observations Lost Remaining Observations

Corporate bond issues during 1994 2013 92,281

Initial ratings from Moodys and S&P (47,090) 45,191
Available Compustat, CRSP, and IBES identifiers (15,479) 29,712
Non-financial institutions and regulated utilities (16,074) 13,638
Only one bond per firm-month (5,864) 7,774
Non-missing control variables (2,442) 5,332
Maximum observations for analysis with profitable firm-years (552) 4,780
Table 1 highlights our sample selection procedure.

33
 Table 2: Descriptive statistics

Panel A: Descriptive statistics for variables of interest

Mean Std. Dev. Q1 Median Q3

Split 0.453 0.498 0.000 0.000 1.000
SplitM ag 0.559 0.714 0.000 0.000 1.000
ET R5 0.253 0.197 0.185 0.274 0.344
CET R5 0.234 0.190 0.155 0.244 0.324
Delta5 -0.004 0.007 -0.007 -0.004 -0.000
UTB 0.013 0.014 0.003 0.009 0.017
Log(T axF N _Sent) 3.263 0.950 2.639 3.367 3.970
Log(T axF N _N ums) 4.626 0.447 4.382 4.654 4.898
InvT axF N _F og -19.029 3.609 -20.592 -18.518 -16.802
Size 26,772.019 56,751.774 1,655.087 6,214.904 24,145.727
MB 1.749 0.900 1.226 1.463 1.936
Intangible 0.134 0.163 0.013 0.064 0.203
M at 118.730 98.049 61.033 109.650 122.233
BASpread 0.007 0.008 0.001 0.004 0.010
F ollow 20.675 11.453 11.000 20.000 29.000
Disp 0.017 0.024 0.004 0.009 0.020
Rating 13.312 4.081 10.000 14.000 16.000
AQ 0.277 0.517 0.030 0.070 0.235
R&D 0.019 0.032 0.000 0.002 0.030
F oreignInc 0.264 0.417 0.000 0.115 0.481
Inv10K_F og -19.991 1.187 -20.630 -19.915 -19.260
Log (10K_W ords) 10.526 0.583 10.185 10.564 10.888

34
 Table 2 continued

Panel B: Mean Dierences

Split = 1 Split = 0 Di. t-stat

ET R5 0.241 0.260 -0.019 -3.46***
CET R5 0.224 0.241 -0.017 -3.34***
Delta5 -0.004 -0.003 -0.001 -2.88***
UTB 0.013 0.012 0.001 2.36**
Log(T axF N _Sent) 3.246 3.278 -0.032 -1.83*
Log(T axF N _N ums) 4.611 4.639 -0.028 -1.53
InvT axF N _F og -19.162 -18.912 -0.250 -1.70*
Size 8.383 8.694 -0.311 -1.82*
MB 1.789 1.713 0.076 1.52
Intangible 0.146 0.128 0.018 2.02**
M at 4.543 4.464 0.079 1.76*
BASpread 0.008 0.007 0.001 1.02
F ollow 19.814 19.535 0.279 0.35
Disp 0.018 0.016 0.002 2.38**
Rating 12.168 13.672 -1.504 -4.23***
AQ 0.289 0.267 0.022 0.86
R&D 0.017 0.018 -0.001 -0.70
F oreignInc 0.219 0.268 -0.049 -2.67***
Inv10K_F og -20.025 -19.961 -0.065 -1.03
Log (10K_W ords) 10.546 10.508 0.037 1.11

Table 2 presents descriptive statistics. Panel A presents descriptive statistics for the variables used in our study while
Panel B presents mean dierences for the variables used in our study for firms with a split bond rating versus firms
without a split bond rating. *, **, and *** denote two-sided statistical significance at the 0.10, 0.05, and 0.01 levels,
respectively. Please refer to the Appendix for variable definitions.

35
 Table 3: Tax avoidance and the likelihood and magnitude of credit rating agency disagreement

Split SplitM ag
(1) (2) (3) (4) (5) (6)
ET R5 1 CET R5 1 Delta5 1 ET R5 1 CET R5 1 Delta5 1
T axAvoidance 0.193*** 0.208*** 4.715*** 0.259*** 0.294*** 3.362***
(5.69) (5.94) (2.87) (5.55) (6.08) (2.82)
Size -0.027 -0.028 0.015 0.009 0.007 0.044
(-0.86) (-0.90) (0.48) (0.29) (0.22) (1.42)
MB 0.098*** 0.098*** 0.076*** 0.064*** 0.063*** 0.028**
(3.93) (3.91) (2.94) (5.12) (5.05) (2.25)
Intangible 0.295*** 0.288*** 0.500*** 0.155*** 0.142*** 0.397***
(4.50) (4.38) (7.80) (4.13) (3.79) (11.12)
M at -0.064 -0.063 -0.067 -0.059 -0.058 -0.061
(-1.55) (-1.54) (-1.62) (-1.46) (-1.45) (-1.52)
BASpread 4.654 4.804 5.948 0.231 0.450 2.127
(0.67) (0.69) (0.91) (0.04) (0.07) (0.35)
F ollow -2.068** -2.108*** -4.518*** -2.207*** -2.257*** -4.696***
(-2.54) (-2.59) (-5.52) (-2.94) (-3.01) (-6.24)
Disp 0.901*** 0.937*** 1.995*** 0.689*** 0.745*** 3.041***
(6.26) (6.53) (5.55) (9.75) (3.01) (7.83)
Rating -0.115*** -0.115*** -0.127*** -0.117*** -0.116*** -0.126***
(-8.14) (-8.13) (-9.21) (-8.74) (-8.72) (-9.58)
AQ -0.058 -0.059 -0.092 -0.005 -0.007 -0.034
(-0.72) (-0.74) (-1.20) (-0.06) (-0.09) (-0.44)
R&D -0.354 -0.378 1.700 -0.213 -0.246 2.419
(-0.22) (-0.23) (1.05) (-0.13) (-0.15) (1.57)
F oreignInc -0.037 -0.033 -0.008 0.025 0.031 0.035
(-0.41) (-0.37) (-0.10) (0.26) (0.31) (0.41)

Industry Fixed Eects Yes Yes Yes Yes Yes Yes

Year Fixed Eects Yes Yes Yes Yes Yes Yes
Observations 4,780 4,780 4,914 4,780 4,780 4,914
Firms 974 974 987 974 974 987
Pseudo R2 0.110 0.110 0.119 0.110 0.111 0.116
AUC 0.816 0.816 0.818
LR 2 481.597*** 481.686*** 535.291*** 491.095*** 491.505*** 544.218***
Hosmer-Lemeshow 2 9.515 8.559 12.430

Table 3 examines the relation between tax avoidance and the likelihood and magnitude of rating agency disagreement.
The appropriate tax avoidance proxy is listed below the column number in each column. To limit the influence of
outliers, we winsorize all continuous variables at the 1st and 99th percentiles. Standard errors are heteroskedasticity
consistent. Industry and year fixed eects are included. *, **, and *** denote two-sided statistical significance at the
0.10, 0.05, and 0.01 levels, respectively. Please refer to the Appendix for variable definitions.

36
Table 4: The eects of tax uncertainty via complexity or disclosure on credit rating agency dis-
agreement over tax avoidance
Panel A: Tax complexity: Unrecognized tax benefits

SplitM ag
(1) (2) (3)
ET R5 1 CET R5 1 Delta5 1
HighU T B 0.715*** 0.822*** 0.620***
(3.59) (4.08) (3.14)
LowT axAvoidance -0.335* -0.332** -0.295**
(-1.87) (-2.00) (-2.10)
HighT axAvoidance 0.289* 0.109 0.072
(1.82) (0.66) (0.50)
HighU T B LowT axAvoidance 0.691* 0.391 0.360
(1.71) (1.08) (1.07)
HighU T B HighT axAvoidance 2.148*** 1.988*** 1.073***
(5.50) (4.88) (3.20)
Size 0.085 0.091 0.071
(1.42) (1.48) (1.33)
MB 0.262*** 0.245*** 0.233***
(6.79) (6.30) (6.47)
Intangible 0.064 0.210*** 0.310***
(1.18) (3.91) (6.58)
M at -0.040 -0.047 -0.040
(-0.43) (-0.50) (-0.45)
BASpread 8.544 24.270 40.500**
(0.23) (0.66) (2.05)
F ollow -1.419*** -1.779*** -4.366***
(-6.49) (-4.96) (-2.60)
Disp 0.703*** 0.794*** 0.092
(7.32) (4.14) (0.19)
Rating -0.157*** -0.168*** -0.159***
(-5.88) (-6.25) (-6.54)
AQ -0.036 -0.050 -0.071
(-0.24) (-0.34) (-0.57)
R&D 0.100 0.451 2.186
(0.04) (0.17) (0.91)
F oreignInc -0.347** -0.353** -0.193
(-2.30) (-2.34) (-1.51)
F -Test:
HighU T B HighT axAvoidance + HighT axAvoidance = 0 45.08*** 30.28*** 14.57***

Industry Fixed Eects Yes Yes Yes

Year Fixed Eects Yes Yes Yes
Observations 1,411 1,411 1,635
Firms 554 554 624
Pseudo R2 0.098 0.096 0.088
LR 2 276.547*** 271.878*** 301.910***

37
 Table 4 continued

Panel B: Tax complexity: Foreign income

SplitM ag
(1) (2) (3)
ET R5 1 CET R5 1 Delta5 1
HighComplexity 0.387*** 0.872*** 0.322***
(3.87) (8.50) (3.20)
LowComplexity -0.594*** -0.544*** -0.529***
(-3.81) (-3.38) (-3.75)
LowT axAvoidance -0.210** -0.242*** -0.032
(-2.41) (-2.75) (-0.38)
HighT axAvoidance 0.182* 0.144 0.046
(1.76) (1.43) (0.51)
HighComplexity LowT axAvoidance -0.145 -0.650*** 0.076
(-0.83) (-3.66) (0.45)
HighComplexity HighT axAvoidance 0.721*** 0.590*** 0.894***
(3.72) (3.13) (5.15)
LowComplexity LowT axAvoidance -0.626*** -0.713*** -0.501**
(-2.58) (-2.86) (-2.48)
LowComplexity HighT axAvoidance -0.002 -0.217 -0.022
(-0.01) (-0.86) (-0.09)
Size 0.002 -0.001 0.027
(0.05) (-0.02) (0.93)
MB 0.099*** 0.084*** 0.074***
(7.98) (6.83) (6.52)
Intangible 0.085** 0.106*** 0.303***
(2.31) (2.91) (9.15)
M at -0.056 -0.056 -0.065*
(-1.39) (-1.39) (-1.68)
BASpread 0.518 0.138 2.310
(0.08) (0.02) (0.41)
F ollow -2.437*** -2.804*** -3.042***
(-3.21) (-3.68) (-4.51)
Disp 0.196*** 0.251*** 2.565***
(11.42) (14.39) (178.15)
Rating -0.107*** -0.112*** -0.109***
(-7.86) (-8.30) (-8.91)
AQ -0.012 -0.021 0.026
(-0.14) (-0.25) (0.35)
R&D -0.092 -0.132 -0.427
(-0.06) (-0.08) (-0.30)
F -Tests:
HighComplexity HighT axAvoidance + HighT axAvoidance = 0 30.62*** 21.66*** 40.37***
LowComplexity HighT axAvoidance + HighT axAvoidance = 0 0.56 0.10 0.01
HighComplexity LowT axAvoidance + LowT axAvoidance = 0 5.36** 33.43*** 0.08
LowComplexity LowT axAvoidance + LowT axAvoidance = 0 13.53*** 16.78*** 8.27***

Industry Fixed Eects Yes Yes Yes

Year Fixed Eects Yes Yes Yes
Observations 4,780 4,780 4,914
Firms 982 982 1,087
Pseudo R2 0.123 0.119 0.104
LR 2 554.591*** 536.622*** 534.889***

38
 Table 4 continued

Panel C: Tax complexity: Research and development expense

SplitM ag
(1) (2) (3)
ET R5 1 CET R5 1 Delta5 1
HighComplexity 0.276** 0.768*** 0.512***
(2.48) (6.70) (4.45)
LowComplexity -0.712*** -0.588*** -0.399**
(-3.91) (-3.37) (-2.52)
LowT axAvoidance -0.173** -0.125 -0.006
(-2.05) (-1.45) (-0.07)
HighT axAvoidance 0.385*** 0.390*** 0.139*
(4.18) (4.41) (1.70)
HighComplexity LowT axAvoidance -0.087 -0.370** -0.079
(-0.47) (-1.98) (-0.46)
HighComplexity HighT axAvoidance 0.599** 0.509** 0.583***
(2.41) (2.25) (2.74)
LowComplexity LowT axAvoidance -0.475* -0.258 -0.200
(-1.75) (-0.93) (-0.78)
LowComplexity HighT axAvoidance -0.691** -0.582* -0.523*
(-2.38) (-1.96) (-1.95)
Size 0.012 0.004 0.031
(0.39) (0.13) (1.06)
MB 0.071*** 0.073*** 0.052***
(5.75) (5.94) (4.54)
Intangible 0.139*** 0.178*** 0.324***
(3.76) (4.81) (9.70)
M at -0.073* -0.069* -0.076*
(-1.79) (-1.71) (-1.95)
BASpread 0.688 1.531 2.531
(0.10) (0.23) (0.45)
F ollow -2.311*** -2.521*** -3.207***
(-3.11) (-3.38) (-4.78)
Disp 0.431*** 0.795*** 2.986***
(24.57) (45.60) (208.60)
Rating -0.102*** -0.107*** -0.107***
(-7.44) (-7.78) (-8.59)
AQ -0.020 -0.019 0.014
(-0.23) (-0.23) (0.19)
F oreignInc 0.009 0.019 -0.002
(0.09) (0.19) (-0.02)
F -Tests:
HighComplexity HighT axAvoidance + HighT axAvoidance = 0 18.12*** 18.56*** 13.39***
LowComplexity HighT axAvoidance + HighT axAvoidance = 0 1.23 0.46 2.25
HighComplexity LowT axAvoidance + LowT axAvoidance = 0 2.56 9.02*** 0.30
LowComplexity LowT axAvoidance + LowT axAvoidance = 0 6.24** 2.11 0.71

Industry Fixed Eects Yes Yes Yes

Year Fixed Eects Yes Yes Yes
Observations 4,780 4,780 4,914
Firms 982 982 1,087
Pseudo R2 0.120 0.115 0.102
LR 2 542.636*** 519.102*** 527.780***

39
 Table 4 continued

Panel D: Tax disclosure: Length of the tax footnote

SplitM ag
(1) (2) (3)
ET R5 1 CET R5 1 Delta5 1
HighDiscQual -0.285** -0.389*** -0.236*
(-2.31) (-3.09) (-1.94)
LowDiscQual 0.546*** 0.575*** 0.627***
(2.68) (2.59) (3.32)
LowT axAvoidance -0.389** -0.004 -0.032
(-2.00) (-0.02) (-0.19)
HighT axAvoidance 0.371** 0.294* 0.180
(2.20) (1.74) (1.18)
HighDiscQual LowT axAvoidance -0.239 -0.019 -0.076
(-1.07) (-0.08) (-0.39)
HighDiscQual HighT axAvoidance -0.785*** -0.488** -0.987***
(-3.77) (-2.36) (-5.28)
LowDiscQual LowT axAvoidance 0.733** 0.421 0.476*
(2.19) (1.26) (1.66)
LowDiscQual HighT axAvoidance 0.914*** 1.742*** 1.709***
(2.60) (4.90) (5.51)
Size -0.092** -0.114** -0.052
(-1.97) (-2.44) (-1.27)
MB 0.154*** 0.153*** 0.124***
(9.98) (9.93) (8.68)
Intangible 0.365*** 0.276*** 0.042
(8.74) (6.69) (1.13)
M at -0.020 -0.012 -0.016
(-0.38) (-0.23) (-0.31)
BASpread 5.408 3.652 0.343
(0.60) (0.41) (0.05)
F ollow -2.781*** -3.186*** -5.182***
(-2.60) (-2.97) (-5.54)
Disp 1.022*** 0.674*** 3.110***
(11.33) (7.46) (5.31)
Rating -0.102*** -0.107*** -0.121***
(-5.28) (-5.55) (-7.12)
AQ 0.086 0.076 0.072
(0.90) (0.81) (0.87)
R&D 0.718 0.680 0.805
(0.38) (0.37) (0.49)
F oreignInc 0.039 0.055 -0.006
(0.33) (0.46) (-0.06)
Inv10K_F og -0.181*** -0.099*** -0.127***
(-4.91) (-2.70) (-3.61)
Log(10K_W ords) 0.059 0.089 0.109
(0.65) (0.99) (1.27)
F -Tests:
HighDiscQual HighT axAvoidance + HighT axAvoidance = 0 10.44*** 2.52 54.56***
LowDiscQual HighT axAvoidance + HighT axAvoidance = 0 16.90*** 43.43*** 47.63***
HighDiscQual LowT axAvoidance + LowT axAvoidance = 0 31.64*** 0.04 1.05
LowDiscQual LowT axAvoidance + LowT axAvoidance = 0 1.58 2.28 3.44*

Industry Fixed Eects Yes Yes Yes

Year Fixed Eects Yes Yes Yes
Observations 3,345 3,345 3,793
Firms 793 793 888
Pseudo R2 0.152 0.145 0.126
LR 2 480.357*** 456.849*** 469.204***

40
 Table 4 continued

Panel E: Tax disclosure: Quantitative content of the tax footnote

SplitM ag
(1) (2) (3)
ET R5 1 CET R5 1 Delta5 1
HighDiscQual -0.287** -0.410*** -0.266**
(-2.27) (-3.20) (-2.19)
LowDiscQual 0.317* 0.089 0.497***
(1.67) (0.46) (2.60)
LowT axAvoidance -0.075 -0.217 -0.137
(-0.40) (-1.21) (-0.85)
HighT axAvoidance 0.560*** 0.298* 0.363**
(3.29) (1.76) (2.27)
HighDiscQual LowT axAvoidance -0.151 -0.203 -0.370*
(-0.69) (-0.96) (-1.96)
HighDiscQual HighT axAvoidance -3.318*** -0.791*** -0.695***
(-15.85) (-3.85) (-3.59)
LowDiscQual LowT axAvoidance 0.194 0.296 0.282
(0.57) (0.90) (0.95)
LowDiscQual HighT axAvoidance 0.866*** 1.331*** 1.274***
(2.63) (3.99) (4.22)
Size -0.090* -0.110** -0.047
(-1.96) (-2.36) (-1.16)
MB 0.145*** 0.136*** 0.124***
(9.52) (8.95) (8.74)
Intangible 0.324*** 0.291*** 0.070*
(7.79) (7.02) (1.88)
M at -0.016 -0.011 -0.011
(-0.31) (-0.21) (-0.22)
BASpread 6.476 4.348 0.702
(0.72) (0.49) (0.10)
F ollow -2.777** -3.000*** -5.163***
(-2.54) (-2.74) (-5.47)
Disp 0.973*** 0.615*** 3.214***
(10.88) (6.78) (7.07)
Rating -0.101*** -0.106*** -0.122***
(-5.26) (-5.51) (-7.15)
AQ 0.088 0.078 0.075
(0.92) (0.82) (0.91)
R&D 0.983 0.823 0.815
(0.54) (0.45) (0.51)
F oreignInc 0.043 0.069 -0.006
(0.36) (0.59) (-0.06)
Inv10K_F og -0.141*** -0.066* -0.140***
(-3.83) (-1.80) (-3.99)
Log(10K_W ords) 0.079 0.097 0.124
(0.87) (1.07) (1.44)
F -Tests:
HighDiscQual HighT axAvoidance + HighT axAvoidance = 0 463.56*** 16.37*** 9.18***
LowDiscQual HighT axAvoidance + HighT axAvoidance = 0 24.99*** 31.90*** 40.14***
HighDiscQual LowT axAvoidance + LowT axAvoidance = 0 4.15** 13.91*** 23.41***
LowDiscQual LowT axAvoidance + LowT axAvoidance = 0 0.17 0.08 0.32

Industry Fixed Eects Yes Yes Yes

Year Fixed Eects Yes Yes Yes
Observations 3,345 3,345 3,793
Firms 793 793 888
Pseudo R2 0.151 0.145 0.125
LR 2 478.331*** 457.358*** 462.490***

41
 Table 4 continued

Panel F: Tax disclosure: Readability of the tax footnote

SplitM ag
(1) (2) (3)
ET R5 1 CET R5 1 Delta5 1
HighDiscQual -0.310** -0.481*** -0.271**
(-2.43) (-3.72) (-2.16)
LowDiscQual 0.518*** 0.386** 0.660***
(2.70) (2.01) (3.55)
LowT axAvoidance -0.271 -0.099 -0.264
(-1.31) (-0.53) (-1.58)
HighT axAvoidance 0.446*** 0.537*** 0.622***
(2.61) (3.05) (3.91)
HighDiscQual LowT axAvoidance -0.046 -0.174 -0.539***
(-0.20) (-0.79) (-2.77)
HighDiscQual HighT axAvoidance -0.781*** -0.422** -0.493**
(-3.71) (-2.01) (-2.58)
LowDiscQual LowT axAvoidance 0.638* 0.334 0.487*
(1.92) (1.02) (1.72)
LowDiscQual HighT axAvoidance 1.146*** 0.879*** 1.314***
(3.68) (2.79) (4.58)
Size -0.094** -0.109** -0.045
(-2.01) (-2.33) (-1.10)
MB 0.156*** 0.143*** 0.128***
(10.18) (9.35) (8.99)
Intangible 0.367*** 0.295*** 0.080**
(8.80) (7.10) (2.14)
M at -0.020 -0.012 -0.011
(-0.37) (-0.23) (-0.21)
BASpread 4.937 3.463 0.213
(0.55) (0.39) (0.03)
F ollow -2.835*** -2.877*** -5.091***
(-2.63) (-2.67) (-5.37)
Disp 0.917*** 1.054*** 3.036***
(10.28) (11.69) (44.57)
Rating -0.103*** -0.108*** -0.125***
(-5.34) (-5.62) (-7.33)
AQ 0.084 0.068 0.069
(0.88) (0.72) (0.84)
R&D 0.856 0.580 0.832
(0.46) (0.31) (0.51)
F oreignInc 0.036 0.062 -0.001
(0.30) (0.53) (-0.01)
Inv10K_F og -0.134*** -0.114*** -0.152***
(-3.66) (-3.11) (-4.34)
Log(10K_W ords) 0.065 0.093 0.114
(0.72) (1.04) (1.33)
F -Tests:
HighDiscQual HighT axAvoidance + HighT axAvoidance = 0 6.55** 0.92 1.39
LowDiscQual HighT axAvoidance + HighT axAvoidance = 0 36.31*** 28.69*** 64.73***
HighDiscQual LowT axAvoidance + LowT axAvoidance = 0 8.20*** 5.99** 57.88***
LowDiscQual LowT axAvoidance + LowT axAvoidance = 0 1.99 0.78 0.92

Industry Fixed Eects Yes Yes Yes

Year Fixed Eects Yes Yes Yes
Observations 3,345 3,345 3,793
Firms 793 793 888
Pseudo R2 0.150 0.145 0.126
LR 2 474.584*** 456.945*** 468.760***

42
Table 4 examines the interaction eect of tax uncertainty (e.g., complexity or disclosure) on the magnitude of bond
rating disagreement between Moodys and S&P. The appropriate tax avoidance proxy is listed below the column
number in each column. HighT axAvoidance and LowT axAvoidance are binary variables equal to one if ET R5 1,
CET R5 1, or Delta5 1 is in the upper or lower quartile by two-digit SIC industry-year, respectively, and zero
otherwise. Panel A presents results when HighU T B is our proxy for tax uncertainty, which is a binary variable
equal to one if a firms UTBs are in the upper quartile by two-digit SIC industry-year, and zero otherwise. Panel B
presents results with HighComplexity and LowComplexity, which are binary variables equal to one if F oreignInc
is in the upper or lower quartile by two-digit SIC industry-year, respectively, and zero otherwise. Panel C presents
results with HighComplexity and LowComplexity, which are binary variables equal to one if R&D is in the upper
or lower quartile by two-digit SIC industry-year, respectively, and zero otherwise. Panel D presents results with
HighDiscQual and LowDiscQual, which are binary variables equal to one if Log(T axF N _Sent) is in the upper
or lower quartile by two-digit SIC industry-year, respectively, and zero otherwise. Panel E presents results with
HighDiscQual and LowDiscQual, which are binary variables equal to one if Log(T axF N _N ums) is in the upper
or lower quartile by two-digit SIC industry-year, respectively, and zero otherwise. Panel F presents results with
HighDiscQual and LowDiscQual, which are binary variables equal to one if InvT axF N _F og is in the upper or
lower quartile by two-digit SIC industry-year, respectively, and zero otherwise. To limit the influence of outliers, we
winsorize all continuous variables at the 1st and 99th percentiles. Standard errors are heteroskedasticity consistent.
Industry and year fixed eects are included. *, **, and *** denote two-sided statistical significance at the 0.10, 0.05,
and 0.01 levels, respectively. Please refer to the Appendix for variable definitions.

43
 Table 5: Split bond ratings and changes in tax avoidance or tax disclosures
(1) (2) (3) (4) (5) (6)
ET R5 CET R5 Delta5 Log(T axF N _Sent) Log(T axF N _N ums) InvT axF N _F OG
Split 0.152*** 0.085*** 0.003*** 0.115*** 0.089*** 0.566***
(5.63) (4.67) (4.94) (8.08) (9.25) (5.71)
Size -0.071 -0.335 -0.000 0.168** 0.052 -0.457
(-0.54) (-2.05) (-0.37) (3.61) (2.17) (-1.38)
ROA -0.443*** 0.921*** -0.015*** -0.160 -0.419** -0.198
(-5.26) (6.24) (-11.50) (-0.87) (-4.16) (-0.22)
Leverage -0.181* -0.270*** 0.004*** 0.590*** 0.115* 2.807***
(-2.83) (-5.36) (6.92) (7.26) (3.40) (5.55)
M/B -0.004** -0.005*** 0.000 0.001 -0.002** 0.028***
(-4.00) (-4.53) (2.41) (1.59) (-4.15) (5.11)
N OL -1.416** -0.511** 0.008*** 0.342* 0.133* -0.439
(-3.52) (-3.93) (11.45) (2.90) (2.91) (-1.17)
Intangible 0.120*** 0.211*** 0.003** -0.670*** -0.124 -5.634***
(4.92) (6.91) (4.22) (-4.98) (-1.25) (-6.22)
F ixedAssets 0.122** 0.290*** -0.001 0.611* 0.712*** 11.552*
(3.47) (7.40) (-0.96) (2.36) (6.20) (2.98)
F oreignInc 0.051*** 0.038** 0.000*** -0.012 -0.028*** 0.131**
(4.87) (3.50) (4.56) (-1.41) (-4.82) (3.29)
Constant -0.079 0.048 -0.000*** 0.097*** 0.016 0.053
(-0.93) (1.19) (-3.09) (4.61) (1.07) (0.38)

Observations 5,322 5,322 4,529 2,083 2,083 979

Firms 1,627 1,627 1,405 845 845 538
Adjusted R2 0.012 0.014 0.086 0.006 0.008 0.060

Table 5 examines the relation between split bond ratings and changes in tax avoidance or tax disclosures. To limit
the influence of outliers, we winsorize all continuous variables at the 1st and 99th percentiles. Standard errors are
heteroskedasticity consistent. *, **, and *** denote two-sided statistical significance at the 0.10, 0.05, and 0.01 levels,
respectively. Please refer to the Appendix for variable definitions.

44
 Table 6: Relation between changes in tax uncertainty and ratings convergence

Converget+1
(1) (2) (3)
(ET R5 1) (CET R5 1) (Delta5 1)
T axAvoidance -0.265*** -0.408*** -33.669***
(-5.83) (-4.06) (-2.75)
Log(T axF N _Sent) 0.552*** 0.553*** 0.560***
(3.34) (3.34) (3.66)
Log(T axF N _N ums) 0.018 0.018 0.044
(0.07) (0.07) (0.20)
InvT axF N _F og 0.100*** 0.101*** 0.115***
(3.16) (3.19) (3.67)
Constant -1.365*** -1.366*** -1.334***
(-14.04) (-14.06) (-13.41)

Observations 721 721 676

Firms 357 357 335
Pseudo R2 0.048 0.047 0.071
AUC 0.744 0.745 0.741
LR 2 17.160*** 16.885*** 24.395***
Hosmer-Lemeshow 2 9.531 11.556 10.440

Table 6 examines the relation between changes in tax uncertainty and ratings convergence over the one-year period
subsequent to the bond oering. The appropriate tax avoidance proxy is listed below the column number in each
column. To limit the influence of outliers, we winsorize all continuous variables at the 1st and 99th percentiles.
Standard errors are heteroskedasticity consistent. *, **, and *** denote two-sided statistical significance at the 0.10,
0.05, and 0.01 levels, respectively. Please refer to the Appendix for variable definitions.

45
 Table 7: Tax avoidance and credit rating accuracy across the uncertainty of tax positions

(1) (2) (3)

Area under ROC ET R5 CET R5 Delta5
BelowM edianT axAvoidance 0.782 0.755 0.736
AboveM edianT axAvoidance 0.611 0.661 0.604

Industry Fixed Eects Yes Yes Yes

Year Fixed Eects Yes Yes Yes
Observations 2,920 2,920 2,584
2 test of dierence 20.95*** 6.75*** 11.35***

Table 7 examines the relation between tax avoidance and credit rating accuracy using Receiver Operating Charac-
teristic (ROC) curves. To limit the influence of outliers, we winsorize all continuous variables at the 1st and 99th
percentiles. Industry and year fixed eects are employed. *, **, and *** denote two-sided statistical significance at
the 0.10, 0.05, and 0.01 levels, respectively. Please refer to Appendix A for variable definitions.

46
 Table 8: Initial tax avoidance estimation and ratings convergence

ConservU pgrade ConservU pgrade ConservU pgrade

(1) (2) (3)
(ET R5 1) (CET R5 1) (Delta5 1)
T axAvoidance -1.439*** -1.504*** -56.654***
(-5.37) (-4.31) (-3.54)
Log(T axF N _Sent) 0.927*** 1.022*** 0.893***
(3.39) (3.68) (3.29)
Log(T axF N _N ums) 2.729*** 2.875*** 2.454***
(3.83) (3.96) (3.48)
InvT axF N _F og 0.215*** 0.217*** 0.194***
(4.51) (4.54) (4.06)
Constant -0.128 -0.130 -0.118
(-0.69) (-0.70) (-0.62)

Observations 133 133 130

Firms 95 95 90
Pseudo R2 0.185 0.189 0.156
AUC 0.774 0.796 0.835
LR 2 33.849*** 34.683*** 28.007***
Hosmer-Lemeshow 2 10.136 8.948 6.684

Table 8 examines the relation between changes in tax avoidance and ratings convergence. The appropriate tax
avoidance proxy is listed below the column number in each column. To limit the influence of outliers, we winsorize all
continuous variables at the 1st and 99th percentiles. Standard errors are heteroskedasticity consistent. *, **, and ***
denote two-sided statistical significance at the 0.10, 0.05, and 0.01 levels, respectively. Please refer to the Appendix
for variable definitions.

47