| The inclusion of financial derivatives in numerous tax shelters suggests tax avoidance is an economically significant, yet previously underexplored, aspect of their use. Accordingly, this study investigates the role of derivatives in corporate tax avoidance. First, the study develops a framework describing why the fundamental, transactional, tax reporting and cognitive features of derivatives are useful for avoiding taxes, and then demonstrates how by using the framework to dissect two derivative-based tax shelters. The discussion reveals that by allowing taxpayers to design transactions that alter the timing, character, and source of gains and losses, derivatives provide opportunities to exploit ambiguity in the tax code with a seemingly low probability of detection by tax authorities. Thus, derivatives are sophisticated tax planning tools that can work in isolation or concomitantly with other tax planning strategies.;Second, the study investigates the extent to which derivatives facilitate tax avoidance and whether this aspect is detectable from recently enhanced financial statement disclosures. The results indicate that new derivative users experience reductions in tax burden following the implementation of a derivatives program. These benefits increase with the magnitude of derivatives employed and do not depend on effective hedging of economic risks. Further analyses reveal firms' ex ante preferences for aggressive tax strategies have a positive relation with the underlying implementation decision. This evidence suggests tax avoidance is both a determinant and outcome of derivative use. However, similar to the opacity of corporate tax shelters, there is no indication of either aspect in footnote disclosures explaining why and how firms use derivatives.;Overall, this study contributes to the extant literature by highlighting tax avoidance as a previously unexplored incentive for derivative use. In doing so, it connects academic literature on an increasingly important tax and accounting issue to that of practitioners and regulators. Additionally, the study provides evidence on why, how, and the extent to which derivatives are used to facilitate corporate tax avoidance. |
