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Warren, the OECD, and Book-Tax Conformity

Posted on Oct. 21, 2019

Underpinning the proposed global profit allocation system in the OECD’s recent consultation document for revising international tax rules is a tax base that relies not on government-enacted tax laws, but on earnings reported on financial statements. The idea of using financial statement profits as a new basis for taxable income isn’t unique to the OECD; its proposal shares similarities with the real corporate profits tax introduced in April by Democratic presidential candidate Sen. Elizabeth Warren of Massachusetts.

Either proposal raises the specter of true double taxation. Warren’s would impose a supplemental tax on a company’s surplus profits as reported in its global financial statements — applicable to approximately 1,200 companies — while the OECD is vague on thresholds. Both proposals also hint at a larger trend of shifting away from legislatively enacted tax bases toward ones set by private, unelected regulators that can be heavily influenced by industry. Grandiose ideas that appeal to activists hoping to tax seemingly unclaimed pots of money could have unforeseen consequences. Moving from law-based calculations of taxable income to ones based on rules set by accounting regulators should be carefully considered before upending existing systems, and policymakers might want to note academic accountants’ strong opposition to the idea.

The Warren Proposal

Warren, who has been rising in the polls, has big ideas for how to increase social equality. Some, including the real corporate profits tax, involve imposing new and higher taxes on high-income individuals and large corporations. (Prior analysis: Tax Notes Int’l, May 6, 2019, p. 577.) Warren’s rhetoric suggests that the way taxable income is calculated for corporate tax returns is false and misleading, and that only profits reported on financial statement are “real.” In developing her idea, Warren was advised by economists Emmanuel Saez and Gabriel Zucman of the University of California, Berkeley, whose writings about the need to increase taxes on the wealthy have been increasingly influential. (Their recent book, The Triumph of Injustice, which argues that billionaires now pay lower effective tax rates than most U.S. citizens, has received a lot of media attention. Related coverage.)

Warren’s proposed 7 percent surtax would apply on top of the corporate tax, with similarities to the recently repealed alternative minimum tax but without a credit for foreign or domestic taxes already paid. It would exempt a company’s initial $100 million of reported earnings — meaning that it’s supposed to apply only to large corporations.

Saez and Zucman say the proposal would generate approximately $1 trillion over a 10-year period, an estimate they claim is conservative. They say that because Warren’s idea is based on global consolidated financial statement income, it eliminates opportunities for, and benefits of, income shifting, and because it doesn’t allow any deductions or credits against gross reported earnings, it limits possibilities for tax avoidance. Saez and Zucman argue that companies would be able to avoid the surtax in only three ways: by inverting, by splitting up to get below the $100 million threshold, and by manipulating financial statement earnings. They’re confident that U.S. Treasury regulations could address those abuses, but their revenue estimate also includes an assumption of 15 percent avoidance.

Because the proposed surtax can’t be offset by any credits or deductions, it has the potential for pure double taxation: The profits will be subject to U.S. tax even if they’ve been taxed overseas. For that reason, the tax potentially conflicts with U.S. treaty obligations (which would need to be modified for the OECD’s proposal anyway). It’s also unclear why Warren would want to limit the surtax to U.S.-based multinationals, as the brief outline of her proposal seems to suggest.

Warren’s idea has raised questions from both the left and right. Professor Daniel Shaviro of New York University has questioned the introduction of rate graduation in the corporate tax (especially because the Tax Cuts and Jobs Act just eliminated that feature), whether the use of financial statements as the basis for the tax could disproportionately affect public companies, and whether having financial accounting decisions affect tax liabilities could distort managerial incentives. He’s also asked how the proposal will interact with congressional desire to retain control over the tax base and how companies whose profits fluctuate annually would be treated.

Regardless, Warren’s corporate surtax is little more than a theoretical concept unless and until she becomes president (and even then it would face strong head winds). Of much more immediate relevance for multinationals is a similar idea in the OECD’s proposal for reallocating corporate profits, released October 9.

The OECD Proposal

Warren’s proposal is purely domestic. It essentially assumes the United States is an isolated entity and — aside from the possibility of inversions acknowledged by Saez and Zucman — ignores any possible interaction between corporate decision-making and other countries’ tax rates and laws. In contrast, the OECD notes that its unified approach proposal would really work only if adopted by all countries. But by moving away from a law-based definition of taxable corporate profits toward one based on financial statements, it parallels Warren’s idea.

The OECD proposes a three-step approach that requires separate calculations of amounts designated A, B, and C. Amount A is described as a new taxing right for market jurisdictions over a portion of multinationals’ deemed residual profit (as determined under the proposal). The OECD has said that amount could be calculated on a business-line basis (but it’s then unclear whether the size thresholds apply to the group as a whole or are based on the business line to which the schema applies). The profit to be reallocated under that formula is that which remains after allocating a deemed routine profit to the countries where routine marketing and distribution functions occur. The discussion document says that amount would be determined by simplifying conventions, and that for the system to work, there must be agreement among countries on the proportion of the deemed residual profit that should go to the market. That amount is to be allocated to markets that meet a new (nonphysical) nexus standard, in accordance with a sales-based formula.

The OECD says those percentages — a crucial part of the system and ripe for contention — remain to be determined and will be part of a consensus-based agreement among inclusive framework members. It has acknowledged that it’s unclear whether mechanisms for eliminating double taxation, including domestic and treaty rules, will be able to continue to operate effectively.

Agreement on how to rewrite international tax rules to determine the profits to be allocated among jurisdictions requires a universally agreed-on tax base. Here, the OECD looks to the same source as Warren. In identifying a multinational’s profits, which is the starting point for calculating Amount A, the discussion document says the relevant measure could be derived from a company’s consolidated financial statements prepared under the accounting standards of the headquarters’ jurisdiction. The OECD says the advantages of that approach include that consolidated financial statements are normally readily available and not easily manipulated. It also acknowledges that to better approximate a proxy of residual profit, further consideration must be given to the appropriate measure of profits and potential standardized adjustments to profits reported on financial statements. And it points out that because a company’s profitability can vary widely across business lines, regions, or markets, the relevant profit measures may need to be determined using different bases in different situations.

Reallocating residual profits requires a multistep approach. A company with profits over a stipulated level (an amount to be agreed on by the inclusive framework) will have those profits split between portions attributable to the market jurisdiction and to other factors (the OECD lists as examples trade intangibles, capital, and risk). How that split will be performed also requires agreement by the inclusive framework; the discussion document says the number could vary by industry. The final step requires splitting the amount among eligible market jurisdictions, a calculation that’s to be based on an agreed-on allocation key, using variables such as sales. The OECD says the selected variables would attempt to approximate the appropriate profit resulting from the new taxing right.

The proposal faces technical challenges, including how to write rules and determine the various factors going into the calculation of the multistep process. Political difficulties include developing formulas, which requires agreement at each step of the process. But underpinning the proposal is a reimagined starting point for the taxable income base to be reallocated among countries. Although not stated as starkly, the OECD’s underlying rationale for moving to a financial statement calculation of profits and away from domestic tax laws is the same as Warren’s, and is based on the belief that taxable income calculations aren’t providing governments with an appropriate amount of multinationals’ taxes. For both Warren and the OECD, financial statement earnings provide a better tax base.

Accountants’ Objections

According to a recent informal survey, academic accountants universally panned the senator’s idea. Understanding the basis for such strong opposition is worth exploring before adopting a plan like Warren’s.

Scholars have emphasized that book and taxable income are not intended to serve the same purpose: While financial accounting income is intended to provide the market with information on company performance, taxable income is prescribed by the government to meet budgetary needs, provide incentives for preferred activities, and deter undesirable activities (Michelle Hanlon and Terry Shevlin, “Book-Tax Conformity for Corporate Income: An Introduction to the Issues,” Working Paper 11067 (2005)). Accountants worry that using financial statement earnings as the basis for taxable profits will jeopardize the ability of financial statements to achieve their intended purpose. Moving from a congressionally enacted concept of taxable income to one that’s determined by financial regulators shifts the incentive for manipulating taxable profits from the tax return to the earnings statement. That increases the risk that companies will manipulate reported earnings, making that information less valuable to investors.

Efforts to better reconcile the calculations of financial statement earnings and taxable income aren’t new. When the United States enacted the corporate alternative minimum tax (which for a brief time partly took as its base earnings reported on financial statements), accountants were concerned that the change would lead to distortions in financial earnings; evidence on that is mixed. Partly in response to the accounting scandals of the early 2000s, the idea was considered as part of President George W. Bush’s advisory panel on tax reform. Its proponents argued that “taxing book income instead of income defined by tax law could provide a simpler, fairer, and more pro-growth corporate income tax.” (Prior analysis: Tax Notes, Feb. 19, 2007, p. 779.)

As part of the debate, it’s worth understanding why the differences between the two calculations arose, a history extensively explored by McClelland and Mills. They note that financial accounting has moved from historical cost accounting toward greater reliance on fair market values. While the SEC generally doesn’t challenge a company’s valuations if there’s a reasonable basis for them and independent auditors have confirmed the validity of the company’s financial statements, the IRS has greater incentives to challenge taxpayer valuations to protect revenue. McClelland and Mills argue that using financial accounting valuations puts government revenue at risk.

Book-Tax Differences

There are important reasons why the rules for calculating taxable income differ from those governing financial statement earnings.

Encouraging Growth

Congress sometimes enacts special provisions to encourage growth and investment. Accelerated depreciation — or, under the TCJA, immediate expensing — is the best example of that. Allowing an immediate full deduction for investment expenses is seen as an important way to encourage businesses to invest in productive assets even before their costs are recognized as an offset against revenues for financial statement purposes. Moving to a cash-based taxable income base was part of the 2005 presidential advisory panel’s considerations and a key element of the 2016 House Republican tax reform blueprint.

Rejecting incentives for immediate expensing or even accelerated depreciation would presumably have the opposite result of that intended by Congress by discouraging investment. In the international area, and as applied to U.S. companies, it would mean that amounts potentially invested in the United States that currently offset taxable income would be eliminated, resulting in greater worldwide profits to be allocated to other countries.

Managing Downturns

Adapting the tax code is an important government method for managing fiscal policy, especially during downturns. For example, in response to the 2008 financial crisis, Congress allowed greater carryback of net operating losses specifically to free up cash for companies experiencing financial hardship. If the tax base moves to financial statement earnings, a company’s ability to claim NOL deductions to offset a tax bill could be lost, an especially harsh result in a downturn. And relying on that tax base for a global allocation of profits removes valuable policy tools for managing a country’s own financial situation as its legislature sees fit.

Encouraging Innovation

The tax code is generally seen as an important tool for encouraging innovation, a key aspect of boosting economic productivity and growth. The United States offers a credit for research and development and allows NOL carrybacks and carryforwards, benefits that could be characterized as corporate giveaways. However, economists generally take the view that by limiting the ability to claim losses to those that offset profits from an existing business, the tax code fails to do enough to encourage investment in innovation and risk-taking. That suggests that the research credit and NOL deductibility allowances should be expanded, not diminished — yet that is precisely what a tax base that conforms to financial earnings would do.

Investments in New Locales

The OECD and Warren proposals are meant to apply only to profitable companies. But the OECD proposal, being global in nature, mostly ignores that a company could have losses in one jurisdiction and be profitable in another (it does acknowledge that some regions might be more profitable by suggesting that the formula could contain adjustments for different areas).

Key to the U.N.’s sustainable development goals — and for global economic stability generally — is encouraging additional investment in low-income countries. Yet it’s in those jurisdictions that multinationals are most likely to incur large losses when starting operations there. A company that realizes it will never be able to recoup losses incurred in a jurisdiction will be less interested in investing there, further limiting opportunities for future market access and economic growth.

Changing Incentives

Advocates for moving to financial statement earnings as the basis for taxing corporate profits say that risks for profit manipulation are minimized because managers have numerous personal incentives to inflate corporate profits. But those arguments may be based on overly simplistic views of how financial statement earnings are priced into the market. There are many ways that businesses can explain losses or departures from reported profits to the investor community, and if there are enough incentives to do so, they may adopt an approach that deflates financial statement profits to produce cash tax savings.

The idea that relying on financial statement earnings is more reliable because it’s less likely to be corrupted by political goals and industry lobbying also seems naïve. Legislative enactment may be influenced by corporate lobbying, but it provides for some measure of transparency, and lawmakers are accountable to both voters and campaign donors. In contrast, the process for developing financial regulations is mostly a black box, and the individuals involved are generally chosen for their industry expertise. That means that private regulatory bodies have as much — if not more — chance to be influenced by those they regulate as do lawmakers who write tax rules.

Consider the watering down of the Financial Accounting Standards Board’s proposals for greater disclosure of overseas earnings and taxes paid by country — largely at the behest of corporations subject to the rules and against the wishes of investors. (Prior analysis: Tax Notes Int’l, Nov. 26, 2018, p. 862.) The same interests would presumably have strong incentives to influence financial statement reporting to ensure the formulas chosen don’t result in additional taxes.

Ceding that much power to a private regulatory body is problematic enough when one country is involved. However, the OECD’s proposal would put the treasuries of many countries at the whims of another country’s regulatory rulemaking process. Although today’s financial statements might suggest there’s a pot of gold to be reallocated, the rules could change such that the pot diminishes over time in a process that governments have no control over.

Conclusion

A key concept underlying the OECD proposal for revolutionizing international tax rules by reallocating a portion of companies’ profits to market jurisdictions is that financial statement earnings present a more reliable base for calculating taxable profits than domestic laws do. Countries that have the tools to determine their own taxable income bases could find that putting all that power in the hands of a private regulatory body comes back to haunt them.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker Chtd., and a contributor to Tax Notes International.

Follow Mindy Herzfeld (@InternationlTax) on Twitter.

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