On August 5, 2022, U.S. Senator Kyrsten Sinema (Ariz.) agreed to support the Inflation Reduction Act, allowing Democrats to pass the $750 billion act – a scaled-back version of the Build Back Better Act. President Biden signed the act into law on August 16th. The law increases spending on sustainable energy and climate change programs and funds the expenditures, in part, via two unique tax increases relevant to businesses and accountants.
Poole College faculty members Don Pagach, professor of accounting and director of research for the Enterprise Risk Management Initiative, and Rob Whited, associate professor of accounting, critique these two tax changes, as well as one proposed tax issue that was removed from the final act as a condition of Sinema’s support.
15% Minimum Tax on Adjusted Financial Statement Income
This tax imposes a corporate minimum tax equal to 15% of adjusted financial statement income. The minimum tax applies to corporations with $1 billion or more in average annual earnings (calculated over a three-year period) and will be calculated by multiplying the company’s reported net income (with several adjustments) by the 15% rate. This amount would be compared to the IRS tax liability, which is calculated by multiplying taxable income by the 21% corporate tax rate. The company would pay the greater of the two amounts. Based on projections of $4,755 billion in corporate revenues for FY2023-FY2032 by the Congressional Budget Office, the $222 billion revenue projection indicates an increase in corporate tax revenues of 4.7% over the ten-year period.
Accounting-based income determined following Financial Accounting Standards and taxable income differ because the objectives of financial reporting and tax reporting differ. The objective of financial reporting is to provide useful information to decision-makers about companies’ financial performance, resources and obligations. By design, this leads to situations where the income impact of an economic event precedes or follows the cash flows – such as depreciation or stock-based compensation. By contrast, the objective of companies’ tax reporting is to measure and report their taxable income to the government. In stipulating tax laws and rules in the Internal Revenue Code, the government’s objective is to generate funds for government expenditures but considers public policy goals when determining how best to do so – stimulating investment in clean energy, for example.
Differences between book and tax income occur due to the differences in objective. For example, companies deduct stock compensation expenses for financial reporting purposes during the vesting period because this is the point at which the company incurs the economic cost. However, companies deduct stock compensation for tax purposes after the compensation vests, which aligns the timing of the deduction with the timing of the taxable income for the employee. This difference in accounting and taxable income reflects the differing goals of tax and financial reporting, and not a company’s failure to pay taxes on income earned.
Other differences, which are often the source of low effective tax rates, are specifically allowed as adjustments to accounting income when calculating the alternative corporate minimum tax. For example, under the act, accounting income is still adjusted for loss carryforwards, accelerated depreciation and tax credits, as well as income and expense related to pensions before calculating the alternative minimum tax.
By allowing adjustments to book income for certain items, such as loss carry forwards, when calculating the minimum tax, Congress has implicitly acknowledged that valid reasons exist for differences between book and tax income.
By allowing adjustments to book income for certain items, such as loss carry forwards, when calculating the minimum tax, Congress has implicitly acknowledged that valid reasons exist for differences between book and tax income. Legislation aimed at specific items in the tax code Congress wishes to change, like stock compensation – for example, would represent a fairer, more targeted approach than a minimum book tax that may or may not affect the taxing of certain transactions.
One Percent Excise Tax
The second tax change is a one percent excise tax on the fair value of net stock repurchases by public corporations beginning in 2023. The decision to implement this tax appears to reflect a desire to decrease share buybacks in favor of dividend payments as a way of distributing cash to shareholders. The excise tax is expected to generate $74 billion in tax revenue over ten years, based on an expected average of $740 billion of net stock repurchases per year. From the corporation’s perspective, there is not a fundamental difference between dividends and share buybacks, as each is a method of returning firm profits to owners. The net effect of both transactions for the corporation are the same: a reduction in cash and a reduction in the firm’s market capitalization.
Share buybacks are often preferred to dividends by investors because they allow investors flexibility as to when to realize their gains (or losses). Dividend payments trigger tax liabilities immediately for all shareholders while share buy-backs only trigger tax liabilities for those investors who chose to sell shares back to the company. The decision to tax buybacks reflects Democrats’ increasingly vocal opposition to buybacks. For example, U.S. Senator Elizabeth Warren (Mass.) suggested that firms buying back shares do “not… give it back to (their) investors” and buybacks simply increase the wealth of the company’s top shareholders. In addition, U.S. Senate Majority Leader Chuck Schumer stated prior to the signing of the act: “I hate stock buybacks, I think they’re one of the most self-serving things that Corporate America does instead of investing in workers and in training and in research and in equipment.”
These perceptions reflect misunderstandings of corporate finance. Firms are, in fact, returning cash to shareholders in buybacks and buybacks do nothing to increase shareholder wealth relative to dividends. The one percent tax may discourage buybacks in favor of either dividends or firms retaining, rather than distributing, cash to shareholders via buybacks. The dividend is simply a different form of cash distribution to owners that provides owners with less flexibility, while the second option can lead to investment inefficiency by encouraging companies not to distribute profits to owners, which is precisely the type of behavior about which Senators Warren and Schumer were concerned.
Tax Treatment of Carried Interest
The third area of controversy relates to the tax treatment of carried interest. Carried interest occurs when an investment fund compensates a partner based on a percentage of the fund’s profits – often 20 percent of the total profits. Thus, the partner’s compensation, while based on investment performance, is not a gain on that partner’s invested capital. Rather, it resembles other incentive/performance-based compensation. Unlike other incentive and performance-based compensation, this compensation is treated as a capital gain and taxed at the lower capital gains tax rate if the fund’s investment is held for at least three years. This allows partners in private equity and venture capital to enjoy a lower rate on the majority of their compensation.
An earlier version of the bill would have lengthened the holding period for capital gains treatment of carried interest to five years, from the current period of three years. Holdings of less than that period would be treated as ordinary income. However, in the final revision to the bill to pass the Senate, Senator Simena removed this provision. Unlike the first two features we discussed above, treating income earned by investment professionals as ordinary income seems like a reasonable change to the tax code to increase revenues and tax fairness.
Overall, the Inflation Reduction Act made two large, but questionable changes to the tax code aimed to increase revenues but failed to make a third.
Overall, the Inflation Reduction Act made two large, but questionable changes to the tax code aimed to increase revenues but failed to make a third. The minimum tax on book income and the excise tax on share buybacks seem to be motivated by public misperceptions about accounting and corporate finance. If raising revenues were truly the goal, a better approach would be to close individual tax loopholes via changes to the Internal Revenue Code, or to simply raise the corporate tax rate. A tax on financial accounting income and distributions to owners are a blunt instrument that will likely have unintended consequences.
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