Corporate tax reform: listening to corporate America.

Author:Hanna, Christopher H.
 
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  1. INTRODUCTION II. BACKGROUND ON FINANCIAL INCOME A. General Principles B. The Focus of Corporate Management III. VARIOUS TYPES OF CORPORATE TAX PREFERENCES A. Expensing and Accelerated Depreciation B. Deductions with No Economic Outlay C. Exclusions from Gross Income D. Tax Credits E. Deferral of Income IV. THE EFFECTIVENESS OF CORPORATE TAX PREFERENCES A. In General B. Accelerated Depreciation, Manufacturing Deduction and Research Credit C. Tax-Exempt Interest D. Deferral of Income and APB 23 V. CORPORATE TAX RATE CUT VI. GENERAL REFLECTIONS ON VARIOUS TYPES OF CORPORATE TAX PREFERENCES A. In General B. Permanent Differences Versus a Corporate Tax Rate Cut C. Differences Among Permanent Differences D. The Importance of Temporary Differences VII. PRINCIPLES FOR REFORM OF CORPORATE TAX PREFERENCES VIII. CONCLUSION I. INTRODUCTION

    On a typical hot and humid Washington summer day in 2004, representatives from a handful of America's leading manufacturing companies trekked to the Longworth House Office Building on Capitol Hill. On the second floor, the tax staffs of the Ways and Means Committee of the United States House of Representatives were hard at work on a huge tax bill that many in the business community believed was on the brink of enactment. The representatives walked the famed halls of the Longworth building, forever known as Gucci Gulch, (1) for a scheduled meeting with the tax staffs with one goal in mind: to try and prevent Congress from enacting a corporate tax rate cut for American manufacturing companies. The representatives knew that almost all public corporations in the United States desired a corporate tax rate cut. In fact, it was probably the single most desired tax item of Corporate America. However, the representatives also knew that of critical importance to public corporations were their quarterly (and annual) income statements. A corporate tax rate cut would cause a small group of manufacturing companies, on behalf of which the representatives were lobbying, to take an immediate charge (or "hit") to earnings--thereby reporting lower quarterly net income and lower earnings per share (EPS). (2) So even though a rate cut would benefit these manufacturing companies in future years, a current charge to earnings was unacceptable to this small but influential group of manufacturing companies. (3)

    The representatives of the manufacturing companies asked the tax staffs to enact a tax benefit for American manufacturing companies in the form of a new deduction rather than a corporate tax rate cut, in the same manner that the Finance Committee of the United States Senate did in its tax bill. (4) And if the Ways and Means Committee consented to the tax benefit in the form of a deduction, the representatives requested that the deduction not look like a tax rate cut. If the manufacturing deduction looked too much like a rate cut, the Financial Accounting Standards Board (FASB) would likely treat it as such for Generally Accepted Accounting Principles (GAAP), and the companies would still have to reduce earnings and EPS. The tax staffs understood the request and conveyed it to the leading members of the Ways and Means Committee. In October 2004, the leading members of the Ways and Means Committee and the Senate Finance Committee convened. As part of their conference agreement, the Ways and Means Committee members agreed to the Senate Finance Committee's approach: enactment of a new manufacturing deduction, rather than a tax rate cut, coupled with a number of requirements that must be met in an attempt to avoid having the deduction viewed as a tax rate cut by FASB.

    On October 22, 2004, President George W. Bush signed the American Jobs Creation Act of 2004 into law. (5) One of the centerpieces of the legislation was the new deduction designed specifically to benefit American manufacturing companies. (6) At that point, the representatives of the manufacturing companies had achieved half of their objective. Almost two months later, on December 21, 2004, they achieved the second half of their objective. FASB issued a staff position in which the FASB staff commented that the manufacturing deduction should not be treated as a tax rate cut, but rather as a special deduction for GAAP purposes. (7)

    In the last few years, academics, practitioners, and government officials have engaged in serious discussions about reforming the U.S. corporate income tax system. (8) Some, if not much, of the discussion has focused on maintaining the competitiveness of U.S. corporations in a global economy. (9) As a result, some have argued that the United States needs to reduce its top corporate tax rate from 35%, which is currently among the highest of the 30 Organization for Economic Cooperation and Development (OECD) countries, to a rate around 30% or even lower. (10) Others have maintained that the United States needs to enact specific or targeted tax incentives, such as expensing of all equipment purchases. (11) In discussing reform of the U.S. corporate income tax system, one aspect of reform seems to be consistently overlooked, ignored, or marginalized: the impact reform will have on the financial statements of the Fortune 500 (public) companies and other public corporations, which I focus on and refer to as "Corporate America." In Corporate America, the overwhelming emphasis is on a corporation's net income, earnings per share (EPS), and effective tax rate. (12) The different types of corporate tax reform may have a significantly different impact on these three financial indicators. Consequently, because of Corporate America's focus on net income, EPS, and the effective tax rate, the effectiveness of the various types of corporate tax reform may be greatly impacted by the form. For example, if economists agree that a directed tax preference is needed to stimulate economic expansion, the form of the tax preference and its impact on Corporate America's financial statements may significantly affect the effectiveness of the tax preference. Or, if economists agree that a directed tax preference is needed to stimulate research and development activities, whether the preference is enacted in the form of a deduction or credit may impact the effectiveness of the tax preference.

    Part II of this Article will provide some background regarding financial accounting income and taxable income and explore some of the differences between the two types of income. In addition, some background will be provided on financial statements issued by public corporations and the importance of various components of the financial statements.

    Part III of this Article will discuss the major categories of corporate tax preferences and the impact these preferences have on the financial statements of Corporate America. Part IV will discuss the effectiveness of the major corporate tax preferences. Part V of this Article will discuss the advantages and disadvantages to Corporate America of a corporate tax rate cut. Part VI of the Article will include some observations on permanent differences, temporary differences, and a corporate tax rate cut. Finally, Part VII of this Article will include some principles for corporate tax reform.

  2. BACKGROUND ON FINANCIAL INCOME

    1. General Principles

      A public corporation is required to compute its income for financial accounting purposes each year in accordance with GAAP. The resulting income figure is generally referred to as pretax financial income. (13) The corporation will also compute its income tax expense for the year, which is subtracted from pretax financial income, resulting in the corporation's net income. (14) In addition, a corporation's income is generally subject to taxation by federal, most state, and several local taxing authorities. As a result, a corporation must also compute its income for tax purposes in accordance with the applicable tax statutes and regulations of these various jurisdictions. The resulting income figure is referred to as taxable income. (15) In almost all cases, a corporation's taxable income will differ from its pretax financial income. In fact, the determinations of taxable income for these various jurisdictions almost always differ from each other and also from pretax financial income. These differences primarily reflect the different objectives behind the various taxing authorities and the accounting rules. (16)

      The tax rules are designed to provide equitable and efficient determination of tax liability and subsequent collection of revenue and also to provide incentives for corporations and individuals to engage in a particular activity based upon the priorities and revenue needs of the various taxing authorities. (17) The financial accounting rules are designed to paint a picture of the corporation's operations that is consistent in its measurement on both an annual basis and across entities such that creditors, shareholders, management, and any other properly interested persons can evaluate the absolute and relative performance of the corporation. (18) The Financial Accounting Standards Board (FASB) has written:

      The objectives begin with a broad focus on information that is useful in investment and credit decisions; then narrow that focus to investors' and creditors' primary interest in the prospects of receiving cash from their investments in or loans to business enterprises and the relation of those prospects to the enterprise's prospects; and finally focus on information about an enterprise's economic resources, the claims to those resources, and changes in them, including measures of the enterprise's performance, that is useful in assessing the enterprise's cash flow prospects. (19) While the rules for determining pretax financial income are fairly rigorous and are based upon underlying economic assumptions and principles, the various taxing authorities have promulgated laws and regulations for determining taxable income that do not necessarily follow rules...

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