Bridging the book-tax accounting gap.

• Author: Whitaker, Celia

INTRODUCTION I. A TALE OF TWO SYSTEMS A. The Book-Tax Gap in Theory and Practice B. Nine Justices and the Gaping Divide II. LURKING IN THE GAP A. Tax Shelters B. Fuzzy Numbers C. Killing Two Birds with One Stone III. WHAT WILL NOT WORK A. Unhappy Precedents B. Disclosure IV. ANSWERING THE CRITICS A. Market Efficiency B. Conservatism C. Tax Preferences D. Applicability V. CLOSING THE GAP A. The Slippery Slope of Tax Politics B. Tricky Transactions and Limited Preferences 1. Reconciliation Mechanisms 2. Limited Tax Preferences CONCLUSION 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) INTRODUCTION

Corporations in the United States use two different sets of accounting rules when preparing their financial statements for investors and their tax returns for the Internal Revenue Service (IRS). The so-called book-tax accounting gap that results from the differences between the rules allows firms to shelter income from tax authorities while inflating earnings in reports to investors. In 1999, the U.S. Department of the Treasury (Treasury) released data indicating a rise in the ratio of reported book income to taxable income in the 1990s, which it interpreted as evidence of increased tax-shelter activity. (2) Although scholars have not conclusively verified Treasury's interpretation, (3) the data and their implications are clear. Whether corporations are using abusive tax shelters or simply taking greater advantage of deliberate disparities between tax and financial-accounting standards, they have increasingly demanded tax-favored investing and financing activities that "create noise in the estimation of financial and taxable income." (4)

As Treasury, Congress, and numerous scholars and practitioners have recognized, when the law severs the tax consequences of a transaction from its economic consequences, the results can be pernicious. (5) Accounting gimmicks create shelters for sophisticated taxpayers to reduce their tax liability, decreasing government revenue and increasing the tax burden on the rest of the citizens. And, as recent financial scandals have demonstrated, the book-tax divide also hurts capital market investors because it creates opportunities for businesses to mislead shareholders and investors about firms' actual economic health. Moreover, the complexity of maintaining two separate sets of books (three, for those firms potentially subject to the corporate alternative minimum tax (AMT)) generates tremendous compliance costs and incentives for cutting corners. As one commentator has stated, the presence of two different sets of accounting rules, each plagued by imprecision and subject to multiple interpretations, gives corporations "two different bites at the apple." (6) What used to be seen as an economically advantageous distinction between tax and financial accounting may now be considered a "credibility gap." (7)

Where did the dangerous book-tax divide come from, and why do Congress, regulators, and accountants continue to tolerate it? The most common justification--endorsed by businesses and all three branches of government, including the Supreme Court--is that financial accounting and tax accounting have different goals and thus require discrete methodologies. Federal income taxation is intended primarily to raise money for the government. Legislators also use the tax code to provide economic incentives for socially beneficial activities. Financial accounts, meanwhile, must provide current and potential investors with an accurate picture of a corporation's economic position. Defenders of the divide have argued that a unified system cannot accommodate these differing objectives. (8)

This Note, by contrast, 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 fairness of U.S. income tax laws. This Note proposes a system of near-total accounting conformity. Such a regime would compromise neither the tax system's primary goal of raising revenue, nor the financial accounting system's primary goal of providing investor information--although legislators would no longer be able to use the tax code as a wide-ranging social policy tool (and a means of giving favors to preferred constituents). Under this Note's proposal, the starting point for taxable income should be financial income as reported to investors, which more closely approximates economic income than does current taxable income. (9) A few of the most important tax provisions--for example, 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 should remain limited in order to prevent tax preferences and exceptions from eroding the system.

This Note proceeds in five parts. Part I traces the history of the book-tax divide, unraveling the theoretical, institutional, and doctrinal reasons for its existence. Part II discusses the two major problems that result from the gap: tax sheltering and accounting fraud. Part III examines past reforms that have aimed to partially close the book-tax gap. None of these reforms has been fully successful, but each offers important lessons about book-tax conformity. Part W addresses and rebuts each of the major objections to book-tax conformity. Finally, Part V lays out a proposal to conform the two accounting systems that would cut down on tax sheltering and accounting fraud without endangering the government's attempts to raise revenue equitably or the Financial Accounting Standard Board's (FASB) attempts to regulate financial accounting standards.

1. A TALE OF TWO SYSTEMS

   Early endorsements of the book-tax gap relied on the idea that the book and tax accounting systems had different objectives. Changes over time, however, have eroded these original justifications and have undermined the institutional and doctrinal support for maintaining two separate systems.

   1. The Book-Tax Gap in Theory and Practice

      Today, it is easy to talk about the book-tax gap as a fact of life. Yet the existence of two different income-reporting systems was not preordained. The computation of taxable income begins (and has long begun) (10) with "the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books." (11) In the post-World War II period, however, the tax code has not adopted generally accepted accounting principles (GAAP) as the mandatory, or even presumptive, starting point for calculating corporate taxable income. Rather, the modern Treasury has "recognized that no uniform method of accounting can be prescribed for all taxpayers," (12) and the IRS has stated that any method that "clearly reflects income" is permissible. (13) In evaluating a given method, the IRS favors consistency over any specific methodology. (14) Although IRS regulations declare that income calculated using GAAP will "generally" be considered a clear reflection of income, (15) the IRS has denied taxpayers' attempts to interpret this provision as creating a presumption in favor of income calculated under GAAP standards. (16) Courts interpreting the tax code follow the same rule. When GAAP treatment does not reflect the current-year economic reality of the transaction, the taxpayer "finds no shelter beneath an accountancy presumption." (17)

      With no clear and simple way of translating amounts between the two systems, corporations can elect how to report income to investors and to the IRS. Analysts have shown that the GAAP rules prescribing methods for reconciling financial-statement income to reported taxable income can lead to significant inaccuracies in estimating actual corporate taxes paid and effective tax rates. (18) Under FASB guidelines, firms report a current-year "tax expense" based on current book income. They also delineate the portions of that expense currently owed and those portions that are deferred either temporarily or indefinitely. (19) Yet this tax expense bears little relation to the actual taxes a corporation pays in any given year, due to differing tax and financial-reporting rules regarding corporate consolidation, disparate treatment of foreign income and taxes paid, discrepant accounting periods, and net-operating-loss carrybacks and carryforwards. Subsequent tax reassessments may also bias the book-tax comparison. (20) Because of this complicated reconciliation method, the information reported to the IRS on the Schedule M-3 (the schedule that reconciles book income to taxable income) (21) may not, in fact, represent the actual dollar-value difference between economic income and income subject to tax. This disconnect between income measurements under the two systems led to the infamous and unanswered question: "Did Enron pay taxes?" (22)

      Nevertheless, supporters of separate book and tax accounting have justified the distinction based on the two systems' differing goals. As the tax code mushroomed over the twentieth century, Congress deviated from imposing taxes on actual economic income on the assumption that "tax preferences" or "tax expenditures" would stimulate economic activity or other socially useful behaviors. Thus, the corporate tax return is aimed at measuring only the items of economic income deemed "taxable" under U.S. law--in other words, those that are not the subject of an explicit exemption or tax preference. Financial statements, by contrast, should give investors and the public access to accurate, reliable information about a corporation's economic income, its ongoing activities, and its financial...