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Article Excerpt
INTRODUCTION
This paper examines the implications for multinational firms of recent proposals to conform tax and financial reporting (i.e., book-tax conformity). Proponents of book-tax conformity argue that the current dual system in the U.S. allows firms to simultaneously manage their taxable income downward while managing their book income upward. By requiring book-tax conformity, they argue that firms will be forced to trade off their desire to report high earnings numbers to shareholders and the desire to report low earnings to the taxing authority, resulting in improved financial reporting and less tax avoidance. Reduced compliance costs and easier auditing from having a single set of books have also been cited as potential benefits of book-tax conformity.
We describe several possible approaches to implementing book-tax conformity for firms that have both domestic and foreign operations. These approaches include: 1) book-tax conformity while retaining worldwide taxation but with no deferral of foreign income, 2) book-tax conformity while retaining both worldwide taxation and deferral of foreign income, 3) book-tax conformity along with territorial taxation, and 4) book-tax conformity with formulary apportionment. We discuss issues with implementing each system and conjecture at the behavioral responses to each. Using financial statement data for the publicly traded U.S. firms, we simulate the tax consequences of book-tax conformity for the first and third approaches. Specifically, we simulate the effects of book-tax conformity on the mean and variance of tax payments/collections. We are not able to simulate the other approaches in the same manner due to data limitations. However, we attempt to provide a rough estimate of the aggregate effect on tax revenues for option 2 (retaining deferral) using aggregate data on reinvested earnings from the Bureau of Economic Analysis (BEA). We also describe in broad strokes what formulary apportionment would look like if implemented.
As with the current system of taxation, many complications emerge when one begins considering how actually to apply a new tax system to multinationals. The goal of the paper is not to spell out all of the details necessary to implement such a system, but rather to give a sense of how book-tax conformity would play out in terms of the numbers both in aggregate and at the firm level, to describe the stress points in implementation that would require additional rules, and to conjecture where behavioral responses could be expected.
We believe that such a study fills a hole in the literature, as book-tax conformity has emerged in policy circles as a potential means to improve efficiency and curb the perceived ability of firms to "have their cake and eat it too." For example in Professor Mihir Desai's testimony before the House Ways and Mean Committee he states, "More ambitiously, if corporations simply paid taxes on reported GAAP income, significant compliance costs would be nearly eliminated, the top marginal corporate tax rate could be reduced significantly to 15 percent without a loss of revenue, and actions designed to exploit differences between these two reporting systems would be eliminated." (1)
In addition, the recent Tax Reform Panel established by President Bush considered a proposal to tax large entities based on their net income reported on financial statements. The Tax Reform Panel ultimately did not include book-tax conformity in its set of proposals and instead called for additional research to understand better the consequences of adopting book-tax conformity. The objective of this paper is to provide such research, at least in terms of the international effects of book-tax conformity.
There is limited prior research on the implications of book-tax conformity. Most of the prior research is focused on opportunistic reporting, compliance savings, and U.S. capital market costs. For example, Guenther, Maydew and Nutter (1997) examine the impact of book-tax conformity on firms' financial reporting and tax planning activities using a small set of publicly traded firms required to increase conformity after the Tax Reform Act of 1986 (TRA 86). Overall, Guenther et al. (1997) conclude that increasing the extent of book-tax conformity causes firms to defer financial statement income. Hanlon and Maydew (2008) examine the accounting implications of book-tax conformity. Other studies, including Hanlon, Laplante and Shevlin (2005), Hanlon and Shevlin (2005), and Hanlon, Maydew and Shevlin (2008), examine the potential loss of information when firms are required to increase their level of conformity. The evidence suggests that if conformity were increased there would be a loss of information from earnings to the capital markets, thus illustrating one cost to book-tax conformity.
On the other hand, Desai (2005) argues that because the U.S. system of dual reporting allows (indeed, requires) different computations of income for book and tax purposes, the quality of earnings reported to both the capital markets and tax authorities is reduced by opportunistic behavior by managers. In other words, because managers attempt to maximize financial accounting income and minimize taxable income and are "unconstrained" by the rules in the other system (i.e., the tax and book rules are not conformed), they can act opportunistically, thereby reporting lower income to the tax authorities and also misleading shareholders. (2)
Although the U.S. has not implemented an overall regime that closely links the two income measures and, thus, large sample evidence of a regime change is unavailable using U.S. data, several international studies have examined these issues. All and Hwang (2000) examine the relation between measures of information content of financial accounting data and several country-specific factors. All and Hwang (2000) find that the information content of earnings is lower when tax rules significantly influence financial accounting measurements. (3)
Ball, Kothari and Robin (2000) also find that valuation in code-oriented countries (i.e., where tax and book incomes are very closely linked) is much less related to reported earnings. Similarly, Guenther and Young (2000) report evidence consistent with accounting earnings in the U.K. and the U.S. being more closely related to underlying economic activity than accounting earnings in France and Germany, where greater conformity is required. (4,5)
To date, however, no one has studied the international tax implications of the U.S. moving to a conformed system of taxation. Because multinational firms account for a substantial fraction of total economic activity, the implications of book-tax conformity for these firms in terms of tax planning and reporting, the accounting for income taxes, and the reporting of income under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) is of great importance. We note that our analysis assumes that only the U.S. changes to a book-tax con formed system (not any other countries), so that much of the effect of conformity is on domestic income. However, what we discuss and show are some of the complications and issues that arise for U.S. multinational firms with respect to their foreign earnings. Thus, conformity may not be as much of a simplification as some proponents may suggest.
This paper proceeds as follows. The second section provides an overview of how current U.S. Federal taxation differs from U.S. GAAP and describes how taxes, particularly book-tax differences, are reflected in firms' financial statements. The third section describes several possible approaches to applying book-tax conformity to firms that have both domestic and foreign operations. The fourth section simulates the effects of book-tax conformity on U.S. multinationals using firm-level financial data from Compustat. In this section, we examine the effects of book-tax conformity on the mean and variance of tax collections. The fifth section concludes.
DIFFERENCES BETWEEN HOW THE TAX CODE AND GAAP MEASURE INCOME AND HOW THOSE DIFFERENCES ARE REFLECTED IN FINANCIAL STATEMENTS
Although the tax code requires large corporations to use the accrual method, accrual accounting for tax purposes is not necessarily the same as accrual accounting for GAAP purposes. For example, similar to the financial accounting rules, when a firm makes a sale and receives an account receivable in exchange, income is recognized for tax purposes even though no
cash has been exchanged. Likewise, if the firm incurs an expense and does not pay in cash but instead generates an account payable, the amount can still be expensed for tax purposes. However, many differences between accrual accounting for tax purposes and GAAP exist. For example, depreciation is recorded differently for tax purposes, generally following the Modified Accelerated Cost Recovery System, which for many assets results in depreciation at an accelerated pace relative to the straight-line depreciation taken for financial accounting purposes. In addition, there are fewer depreciation methods allowable for tax purposes compared to book purposes.
Some other financial accounting accruals are simply not allowed for tax purposes. For example, the estimates used to record the expense for the warranty expense and bad debt reserve generally are not allowed for income tax purposes. Thus, before deducting an amount for warranty costs the firm must actually pay these costs (the customer must return the product for warranty service and the seller must perform the service). Similarly, bad debts cannot be estimated but rather are only deductible once the debt has actually gone bad (thus, the company is on the specific write-off method for tax purposes).
In terms of international aspects, the tax code operates significantly differently than the rules under GAAP. Under the current U.S. tax system, U.S. resident companies are subject to current U.S. tax on their worldwide income. (6) However, no U.S. tax is owed on the earnings of a foreign subsidiary until those earnings are distributed to the U.S. parent in the form of a dividend. (7) The postponement of U.S. taxes until the time of repatriation is commonly referred to as "deferral." The deferral concept in tax is an important distinction from financial accounting.
For tax purposes, consolidation can be elected, but is not required, when ownership, direct or indirect, of a domestic subsidiary is at least 80 percent in terms of voting power and value. Foreign subsidiaries generally cannot be included in the domestic tax consolidation. (8) Thus, the financial statements will include the income or loss of foreign subsidiaries that are more than 50 percent owned and the representative share of income or loss of foreign entities owned between 20 and 50 percent, while the tax return will not include any of these amounts. Instead the tax return will include any dividends received from these entities while the financial statements will not include these dividend amounts. (9)
Thus, differences between tax and GAAP consolidation can lead to book-tax differences with regards to income from foreign (and domestic) affiliates. If the entity is greater than 50 percent owned by the U.S. parent, the earnings will be part of U.S. worldwide income for financial accounting purposes. However, if the income from the foreign subsidiary is deferred for tax purposes (i.e., not repatriated back to the U.S. and made subject to tax currently), then a book-tax difference will result because book income will include the foreign subsidiary's income and taxable income will not. Because of the significant tax advantages potentially afforded under the deferral rules, a series of anti-abuse rules have been enacted to prevent U.S. taxpayers from deferring U.S. tax on certain classes of income, such as passive income that could easily be shifted to a tax haven. These anti-abuse rules are contained in subpart F of the Internal Revenue Code (IRC). Essentially, these rules act to restrict the benefits of deferral to the active business income of a foreign subsidiary and, as a result, lessen the book-tax difference attributable to the deferral rules in the current U.S. tax system.
Another provision of the tax code that becomes important in the discussion of international book-tax differences is the allowance of tax credits against a firm's U.S. tax liability for foreign taxes paid or accrued. While the tax credits themselves are not book-tax differences, a firm's tax planning in the international arena is often directed toward maximizing the amount of foreign tax credit it can use to offset its U.S. tax liability, all else constant. Because firms have engaged in strategies to shift income to and between foreign sources to maximize the available credit, additional rules have been written in the tax code to 1) prevent the credit from offsetting U.S. tax on domestic-source income, and 2) provide guidance on how to allocate income and expenses between domestic and foreign sources. The tax strategies employed by firms can generate additional book-tax differences and, thus, a discussion of the foreign tax credit rules is necessary here.
Foreign tax credits are allowed to mitigate the double taxation that would occur when foreign-sourced income is earned by a U.S. company because the income would be taxed in both the foreign country in which it was earned and in the U.S., where the company is incorporated. The U.S. also has foreign tax credit limitation rules which, in general terms, limit the foreign tax credit to the U.S. tax rate times the foreign source income calculated according to U.S. tax rules. Thus, the foreign tax credit after limitation is the minimum of foreign income taxes paid and the foreign tax credit limitation (i.e., U.S. tax rate times the foreign source income).
An important consideration for the foreign tax credit limitation is, of course, the delineation of what is foreign source and domestic source income--how are these measures derived for tax purposes and how do they compare to the domestic pretax book income and foreign pre-tax book income reported for financial accounting purposes? There are very detailed rules for the sourcing of income, including expense allocation, for the computation of the U.S. foreign tax credit purposes. (10) Adding such rules to U.S. GAAP (or IFRS) would be a major addition to the accounting...
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