UC Irvine

This paper introduces new evidence on the extent to which non-financial firms use financial derivatives to avoid taxes. In particular, I use the fair value of derivatives segregated by hedging and non-hedging designation to identify derivative activities that are used to benignly and/or aggressively avoid taxes. I use new derivative disclosures required by SFAS 161 to collect detailed information about firms’ use of derivatives. I find a negative association between cash effective tax rates and the fair value of hedging derivative assets. This finding implies that firms defer recognition of gains on hedging derivatives to lower cash taxes. Furthermore, I find an association between cash effective tax rates and both non-hedging derivative assets and liabilities. This finding is consistent with firms aggressively avoiding cash taxes using non-hedging derivatives by selectively choosing when to recognize gains and losses. In addition, I find no association between GAAP effective tax rates and derivatives, implying that firms in my sample do not use derivatives to manage earnings through the tax expense.