Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
How to Build a Bridge: Eliminating the Book-Tax Accounting Gap
Associate, Sullivan & Cromwell, LLP; Harvard University, A.B., 1999; Yale Law School, J.D., 2006.
Accounting is no longer a way to provide an accurate and unified view of a company’s finances. Instead, it has become a means to an end. For the public books, the goal is to achieve smooth and steady earnings growth that will lift the value of the company’s stock . . . . For the IRS, the goal is the exact opposite—keeping income, and thus taxes, to a minimum. 1
In 1999, Treasury released data indicating a rise in book-tax differences in the late 1990s, which it interpreted as evidence of increased tax shelter activity. 2 Although the latter contention remains unproven, 3 the implications of the data are clear. Whether corporations are engaging in abusive tax shelters or simply taking advantage of deliberate disparities between the tax and financial accounting systems, there has been increased “demand for tax-favored investing and financing activities, specific factors that generate timing and permanent differences between financial and taxable income, and factors that may create noise in the estimation of financial and taxable income.” 4
Since that 1999 report, a deluge of financial scandals has drawn increased public and governmental attention to the accounting methods used by U.S. corporations and their professional advisers. Corporations in the United States produce two sets of accounts each year. The financial statements given to investors and the public are prepared according to Generally Accepted Accounting Principles (GAAP), which include guidelines established by the private
sector Financial Accounting Standards Board (FASB) and governed by the
Securities and Exchange Commission (SEC). Tax law appears to base income reporting on financial reporting: “Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” 5 In fact, however, the starting point for taxable income is vague. There is no requirement that the books used to calculate taxable income be the same as those used to produce the financial statements. A corporation may use different accounting methods for items within the same business, 6 may combine cash and accrual methods, 7 and may use different methods for different trades or businesses. 8
This Article argues that the asserted benefits of the book-tax divide no longer justify its substantial costs in terms of tax compliance, revenue collection, economic policy, and the perceived unfairness of the U.S. income tax laws. As Treasury, Congress, and numerous scholars and practitioners have recognized, 9 when the tax consequences of a transaction are severed from the economic consequences, the results can be pernicious. The book-tax divide in particular opens an enormous gap within which corporations seeking to reduce tax liabilities can shelter reported financial income. To the extent that they do, the government and citizens are the victims. The resulting accounting gimmicks can often create a tax shelter for sophisticated taxpayers to reduce their tax liability—increasing the burden that the rest of the citizens must bear. Capital market investors also fall prey to the book-tax divide, since it creates opportunities for businesses to mislead shareholders and investors about a firm’s actual economic health. Moreover, as discussed further below, the complexity of maintaining two separate sets of books (three for those firms potentially subject to the corporate alternative minimum tax) generates tremendous compliance costs and incentives for cutting corners.
So where did the book-tax gap come from, and why do Congress, regulators, and accountants continue to perpetuate it? The most common justification, put forth by businesses and all three branches of government, including the Supreme Court, is that financial accounting and tax accounting require separate methodologies to serve their differing goals. Federal income taxation is primarily supposed to raise money for the government. It is also used to provide economic incentives for socially beneficial items such as home ownership, retirement savings, and health care. Financial accounts, by contrast, must provide investors (current and potential) with an accurate picture of a corporation’s economic position: its assets, liabilities, ongoing activities, revenue trends, and profitability prospects. Thus, some have argued that a unified system cannot accommodate these differing objectives.
This Article, in contrast, considers that neither the tax system’s primary goal of raising revenue nor the financial accounting system’s primary goal of providing investor information would be compromised under a system of near-total accounting conformity. To be sure, under a radically revised accounting system such as the one proposed herein, legislators will have to give up the myriad tax preferences that currently litter the Code. The starting point for taxable income will be financial income as reported to investors, which should ideally be a close approximation of economic income. Then, a few of the most important tax provisions—for example, the credits for research expenses and for foreign income taxes paid—should be retained as selected departures from reported financial income. But the scale and scope of those departures will have to remain limited to prevent erosion of the system. This Article will argue that the current Schedule M-3, the form upon which corporations reconcile financial statement income to taxable income, can be used as a template for such a system.
A secondary, more recently voiced objection to book-tax conformity concerns the potential loss of valuable information contained in having two sets of data. Yet the pathologies of the current system—tax shelters, financial misrepresentations, loss of taxpayer confidence, and high compliance costs—far outweigh any benefits achieved from the comparison. Moreover, those benefits are largely academic ones for the consumption of economists and tax professors; how many investors are going to sit down and compare a corporate tax return against a financial statement, with each document numbering perhaps into the hundreds of pages?
Finally, even those who might favor book-tax conformity as an abstract concept one day might ask, why now? The answer, if not found in the increasingly alarming data regarding tax and accounting fraud, lies in the corridors of power in Washington. Tax reform will be a hotly contested issue in the mid-term congressional elections of 2006, as well as the presidential election of 2008. The need for tax reform is there. If anything is going to be accomplished, now is the time to do it.
Whatever shape the reform proposals will take in the closing months of 2006, the Bush administration has made clear its intent to lower corporate tax rates. Already in the American Jobs Creation Act of 2004 (AJCA), 10 Congress lowered the top rate on domestic manufacturing and small corporations 11 and extended the liberal section 179 rules that allow small businesses to expense many otherwise depreciable investments. 12 In the conference report, legislators noted that “[t]he conferees . . . expect that the tax-writing committees will explore a unified top corporate tax rate in the context of fundamental tax reform.” 13 In other words, a unified and lower corporate tax rate designed to help U.S. multinationals compete on a global scale is on the agenda.
In an age of soaring federal deficits, and given the political imperative of revenue neutrality, any such rate reduction must be offset by base broadening measures. Modified book-tax conformity would achieve the base broadening objective by disallowing the vast majority of tax preferences (relative to financial accounting treatment) for corporate business transactions. Moreover, the present book-tax difference provides a harbor for abusive tax shelters that would be swept away in a system of near uniformity of accounting standards. 14 Such a change would help ensure that revenue neutrality would not require more politically difficult increases in personal income taxes (another area in which the second Bush administration wants to make permanent rate cuts) 15 and would help remedy the perceived inequities of the corporate tax.