David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: minimum depth.
On August 7, after 15 hours of vote-a-rama, the Senate passed the Inflation Reduction Act via the budget reconciliation process, with Vice President Kamala Harris casting the tie breaking vote. Although it's a scaled down version of the Build Back Better Act, this legislative win for the Democrats addresses healthcare and climate change priorities while introducing new tax provisions to pay for them.
As we're recording this on August 10, the bill's awaiting its expected passage by the house later this week.
Joining me now to talk more about the tax provisions and their importance is Kyle Pomerleau, a senior fellow at the American Enterprise Institute. Kyle, welcome to the podcast.
Kyle Pomerleau: Thanks for having me.
David D. Stewart: So first, could you give us your overall impressions of the bill?
Kyle Pomerleau: First, I was somewhat surprised that they were able to bring something together last minute.
I think, politically, we thought that the discussion over the Build Back Better Act was dead and that Biden was not going to be able to put forth climate and healthcare policies that he had campaigned on and a lot of his tax provisions were ultimately going to die with them. But surprisingly, about a week and a half ago, it seemed to be resurrected and they were able to put something together.
Now, on the tax side it's certainly not as robust as what they had hoped at the beginning. It leaves out a lot of important tax policies that the Biden Administration had been pushing for, chiefly the global tax deal. But it does have some significant revenue raisers and some of them that were originally proposed back during the campaign.
There are four major revenue provisions. There's a minimum tax on large multinational corporations, there's a 1 percent stock buyback tax, there's additional IRS funding for tax enforcement, and then there is a extension of the excess loss limitation on non-C corporate businesses.
David D. Stewart: All right, so to your mind, is this an improvement over what we were seeing in Build Back Better? Or did we lose some of the important pieces?
Kyle Pomerleau: I think that there are some pieces here that are totally reasonable policy. I think the IRS funding is something that lawmakers needed to do a while ago to improve enforcement.
On the other hand, there are some policies that I wish had been left out. I'll highlight the book minimum tax. This is one that we'll probably discuss in more depth here, but it's not one that's very popular amongst tax experts. And I'm frankly surprised that this lasted all the way until it was able to cross the finish line.
David D. Stewart: Well, let's get into that. So how does this book minimum tax work?
Kyle Pomerleau: So this proposal was originally put forth by the Biden administration. The way this works is a reintroduction, effectively, of an alternative minimum tax for corporations.
Corporations will be paying the greater of their ordinary tax liability or 15 percent of their adjusted financial statement income. Financial statement income is the income that they report on their statements to their shareholders. This is not a taxable income concept developed by the IRS, but rather something that is regulated by FASB, the Financial Accounting Standards Board.
This book minimum tax only applies to the very largest corporations, corporations with net income of $1 billion or more. And there are adjustments, so it's not purely on book income or financial statement income.
Companies can offset financial statement income with net operating losses. And then at the last minute, they also added a carve out for accelerated depreciation and purchases of spectrum for certain companies.
And politically they needed to carve out general business credit so companies can offset their book tax liability with credit, such as the research and development credit and green energy credits.
David D. Stewart: Now, I guess the question there is, is this a practical method of taxation or is it just going to add complexity and not necessarily raise revenue that it's expected to?
Kyle Pomerleau: I think it's probably going to raise revenue. So the Joint Committee on Taxation expects that this would raise about $222 billion over 10 years, I believe. And that's down from about $313 billion from the original proposal due to these carve outs that they put forth.
Now, your first point, however, I agree with that. I think it's going to be adding complexity. Minimum taxation, I think, is always second, third or fourth best in terms of tax policy. You'd much rather have lawmakers examine the current corporate income tax, ask themselves, "Does this deduction make sense, does this credit make sense?" Debate that. And then either repeal that or keep that in the tax code.
Putting a parallel tax in place simply does add a lot of complexity. And it's especially complex because the base of this tax is financial accounting income, not another definition of taxable income. So this is going to require additional rules and a lot of rules put forth by Treasury.
If you look at the legislative text, there is a lot of, "The secretary shall determine X, Y, and Z." And that's because the starting point for this tax is not a tax base. That definition of income is meant for something else, it's meant to provide information to capital markets, to shareholders about the performance of a firm. It's not meant to set equitably set tax liability for corporations.
David D. Stewart: Now, how far apart are the tax accounting rules from these book accounting rules?
Kyle Pomerleau: I don't know if there is any overall metric we can use to determine that, but there are tons of differences that matter for this tax and how it's going to impact the incentives of firms and also taxes.
So when we talk about this minimum tax and the effective tax rates that corporations are paying, we talk a lot about book tax differences, and this is differences between income defined under book and income defined under tax. And some of the major ones that people point to is the accounting of depreciation for new capital investment. Companies that invest in new machinery or factories, they generally have to deduct the cost of that asset over its expected life. If they think that a factory's going to produce income over 30 years, they're going to deduct that over 30 years for book tax purposes.
Taxable income purposes, on the other hand, those assets are deducted over schedules defined by the tax law under modified accelerated cost recovery system or makers. And there can be differences that arise, especially with shorter life assets. Assets like machines, they can be fully expensed or deducted fully in the first year for tax purposes, but they have to be deducted over a longer period for book purposes. So that creates differences where one definition of income may be broader than the other in certain years and vice versa.
Then there are other major differences. The treatment of stock option compensation for employees of businesses, that's different for tax purposes and book purposes. The tax treatment of interest expense, the tax code limits the amount of interest that companies can deduct against taxable income. For financial accounting purposes, those expenses are fully deducted. The treatment of losses can be different.
Now this proposal makes sure that losses are treated the same in both, but the starting point for financial statement income, there's a difference there. And the list goes on, so I don't want to keep on going here, but there are quite a few differences here between these two definitions of income.
David D. Stewart: Now that covers differences that exist today, but accounting rules get updated periodically. What's going to happen as accounting rules are adjusted over time?
Kyle Pomerleau: This brings up another potential concern with this tax that right now financial statement income is defined as X, but FASB may deem it necessary to make changes or improvements to the definition of financial statement income, so that definition could change over time. And that could ultimately impact the amount of federal revenue that is collected, because if a portion of federal tax collections have been outsourced to this definition of income, FASB, in a sense, has control over a portion of that revenue. So, that is a potential concern there.
Another is that financial accounting income is more flexible than taxable income. I brought up depreciation before. Under the tax code, depreciation is determined by fixed schedules. A factory is going to be deducted the same, whether it's in the hands of company A or company B. But for financial statement purposes, a factory could be deducted at different rates based on the determination of the managers there who believe that, "Well, this factory's only going to be in service for 25 years versus 30 years." And that can change the levels of income for these companies.
And that brings up a potential, what economists call, horizontal equity issue. That you may have two companies that are in roughly the same economic position, but their potential book tax liability might be different because of these choices they make with respect to financial accounting.
David D. Stewart: Is it possible that the book accounting process is going to start looking more like tax accounting or will one infect the other as people are trying to make the system make more sense?
Kyle Pomerleau: Another potential behavioral effect related to that is that we know currently in the world, companies try to minimize their revenues and maximize their expenses to the extent legally allowable for tax purposes to minimize their tax liability. And a potential behavioral effect under the book minimum tax is we may see that same effect. Where revenues might be somewhat understated relative to where they are now and expenses overstated in order to minimize book tax liability.
There is some evidence from the late '80s suggesting that this is a potential effect. The 1986 Tax Reform Act briefly had a provision that required companies to use financial statement income, and research found that sales were timed in a way to minimize book income in order to minimize the effect of this provision in the tax code.
David D. Stewart: So are companies really going to be reporting lower revenue in the future in order to avoid these taxes, potentially?
Kyle Pomerleau: It's possible. And it might be a timing effect.
So companies may be changing the timing of revenues and expenses to game this. They may be changing the timing of investments in order to game this, but I don't know if the effect in the macro sense is going to be very large. After all this minimum tax is only affecting, according to the Joint Committee on Taxation, roughly 150 companies in any given year. So it's not a huge number of companies.
While those companies are large and they account for a large share of economic output, we're not talking about a minimum tax that applies to every single company in the economy. But I think that there are areas in which companies may change their behavior at the margin in order to minimize tax liability.
David D. Stewart: So now this minimum tax is happening at the same time that we're talking globally about a different minimum tax. So how are those two going to coexist?
Kyle Pomerleau: Unsure. So, just to make it clear here, where we are talking about a 15 percent minimum tax that passed as part of the Inflation Reduction Act that is entirely different than the other 15 percent minimum tax that is currently being discussed under the global tax deal or pillar 2.
So that proposal, while also 15 percent, and also starts with financial statement income to some degree, I think, from there, the similarities end. While the book minimum tax is more of a domestic alternative minimum tax for corporations, pillar 2 is more of a wholesale change to the taxation of foreign profits in order to reduce the incentive to shift profits to low tax jurisdictions. And it's part of this deal that other countries are going to go in on this, in that the goal is to stop what is referred to as the race to the bottom. Countries are reducing their tax burden on corporations in order to attract highly mobile income. So totally different beasts here.
It is an open question of how these are going to interact, or if they're going to interact at all, how the OECD is going to view this corporate alternative minimum tax in the context of pillar 2. The reason this is an open question is that United States currently has a minimum tax on foreign profits. GILTI, Global Intangible Low-Taxed Income, this is a minimum tax of roughly 10.5 percent to 13.125 percent. And the Biden administration has been pushing for reforms to GILTI to align it with this OECD deal.
And I think there may be a question as to whether this book minimum tax, which does to some degree apply to foreign profits, so when companies calculate their book minimum tax liability, they are looking at their foreign profits, is this going to count in any way? How is this going to interact? And I don't think that's been resolved.
I am on the side of this that thinks that this is entirely unrelated and that I don't think that this looks very much like pillar 2. In a sense, this book tax looks more like current law GILTI than it does the pillar 2 reforms, especially with regard to how this tax is calculated.
GILTI is a worldwide calculation. Companies look at their total foreign profits and total foreign taxes in calculating their minimum tax liability under that tax. That's similar to the book minimum tax, where you're looking at worldwide profits and worldwide taxes. Pillar 2 on the other hand requires the country-by-country calculation.
So those are significant differences between the two. So I don't know how you square that circle at the end of the day.
David D. Stewart: Is it possible that the Biden administration and Congress will go back and introduce a pillar 2 compliant version of GILTI or the minimum tax?
Kyle Pomerleau: It's going to depend on the makeup of Congress. We know that Republicans have been very skeptical of this process and if Republicans take the House, it's hard to see a path for the Biden administration to get pillar 2 reforms through.
Now that doesn't mean it's dead forever. There are scheduled tax changes that could spur lawmakers to make reforms and also it depends on what other countries do.
So if other countries enact pillar 2, this could encourage the United States to enact pillar 2 reforms itself, because the way pillar 2 works is that if you don't tax these low-tax profits, someone else will. So it tries to create this incentive that, "Well, it's being taxed, anyway, we might as well collect the revenue."
So down the road, there's a potential, but I'm still skeptical that, at least in the near term, there's a path to getting these reforms through.
David D. Stewart: Now, I understand there were some last minute changes made to the book minimum tax spurred on by concerns over, I think it was investment in startups. Could you explain that?
Kyle Pomerleau: There were a couple changes to the book minimum tax. And I think the biggest of which was due to concerns about manufacturers and the impact that the book minimum tax would have on accelerated depreciation.
We talked about this, a significant book tax difference is the treatment of depreciation. Book minimum tax requires assets to be depreciated over a longer period of time. So if you're a company that's perpetually subject to the book minimum tax, you could face a higher cost of capital. And this could impact capital intensive industries like manufacturing.
So they went back and they allowed companies to use accelerated depreciation when figuring their book tax income and book tax liability. So if you're now a capital intensive company that uses accelerated depreciation above the $1 billion threshold, you are less likely to be subject to the tax.
And then there were also changes to what others have called this "aggregation rule" that could impact whether companies hit the threshold. This, I think, gets into partnerships and a part of the tax law that I am less familiar with, and probably a lawyer is a better person to ask, but the very short of it is that it changed a rule for how companies that may own other companies attribute that income back up to the top in figuring whether you hit that $1 billion threshold.
David D. Stewart: The other change that came out kind of late in the process was that we saw this new excise tax on stock buybacks. What is the purpose of this tax?
Kyle Pomerleau: Part of scaling back the book minimum tax was to replace that revenue with a new tax and the new tax is this 1 percent excise tax on stock buybacks. This is a proposal that's been floating around for a little more than a year, coming from the Senate Finance [Committee].
And the idea behind this tax is that— Well, I think there might be a couple ideas. There's a political perception that buybacks are bad and taxing them will discourage them and that will be better. And then I think that there are tax implications that because capital gains are based on the realization principle, stock buybacks have a slight tax advantage over a similar economic activity, which is paying dividends. And the excise tax is a very rough justice way of trying to bring those tax burdens closer together.
There's also an issue with foreign tax. Foreign shareholders may face withholding taxes at the border when a dividend's paid out from the United States, but they don't face any withholding tax when there is a capital gains realization through a buyback. This 1 percent tax, again, rough way of trying to address these concerns.
David D. Stewart: Do you expect to see any behavioral changes? Companies shifting more toward dividends?
Kyle Pomerleau: Certainly. There is research suggesting that companies are aware of the taxes that their shareholders pay and that changing the relative tax treatment of one or the other can shift the behavior of companies. And you may see a slight shift over to dividends relative to current law due to this 1 percent excise tax.
David D. Stewart: Does that change the amount that this gets scored or was that factored in as they were trying to figure out how much this would raise?
Kyle Pomerleau: The Joint Committee on Taxation generally includes behavioral effects when they score these things. So they assume that the size of the economy is fixed, but taxpayers can change their behavior to minimize tax liability. And this is an area where they likely incorporated that effect.
David D. Stewart: So turning to the sort of last major piece of tax policy in this bill is new funding for the IRS. So how much more money are they getting and how are they expected to use it?
Kyle Pomerleau: The new funding for IRS it's about $80 billion over a decade. This money is going to be used for a combination of things. Primarily enforcement, but also IT and taxpayer services. And this has been scored as raising an additional, roughly $200 billion over a decade.
So on net, after accounting for that upfront investment, this is about a $120 billion revenue raiser for the federal government.
David D. Stewart: Now, do you expect that this sort of money can significantly close the tax gap?
Kyle Pomerleau: It's not going to significantly close the tax gap, but it's going to be working in that direction.
So the concern over the last decade has been that IRS funding has been declining in real terms. This has been impacting real activity at the IRS. Hiring, enforcement, audits, those things have been declining. The IRS also is known to have ancient IT and that affects services as well.
And this additional funding is meant to address those concerns and part of that is going to be increased tax collections from enforcement. Both directly from audits that change people's tax liability, but also indirectly from behavioral effects that people know that the IRS is paying closer attention so people are going to do a little bit less tax evasion.
David D. Stewart: All right. So I guess that leads to my final question. It's called the Inflation Reduction Act. Does this bill reduce inflation?
Kyle Pomerleau: Not really. So I think the bill, at best, will have a minimal impact on the price level in either direction.
So just very basic model here is that fiscal policy can impact prices by changing the demand for goods and services in the economy. And when the economy is closer to capacity, it's running more normally, increases in government spending cuts and taxes can increase demand for goods and services, and that can bid up prices.
Now looking at the Inflation Reduction Act, it has, on an annual basis, nearly a minimal impact on the budget deficit. I think in the first couple of years, there are a couple years where it reduces the deficit, a couple years where it increases the deficit, so it kind of waivers. And then in the latter half of the decade, it's reducing the deficit. So there you might have downward pressure on prices. But the effects, again, may be minimal.
If you're looking at the type of taxes that the federal government will be levying under this proposal, minimum tax on book income, stock buyback tax, these are the type of taxes that impact very high income households. And these households are less likely to spend each additional dollar that they receive or reduce spending for each additional dollar that they lose in after tax income. So the effect on spending is going to be small, even with the deficit reduction.
And then after all of that, it depends on what the Federal Reserve does. Ultimately, the Federal Reserve is mandated with keeping the price level consistent, and the Federal Reserve is going to see this fiscal policy and if it believes that fiscal policy is going to have an impact on prices, it's going to react in a way to keep prices consistent. So, again, I think ultimately, close to zero, I think is the right answer.
David D. Stewart: All right. Well, Kyle, thank you for being here. This has been fascinating.
Kyle Pomerleau: Thank you very much for having me.
David D. Stewart: And now, coming attractions. Each week we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?
Paige Jones: Thanks, Dave. In Tax Notes Federal, Peter Richmond proposes regulatory reforms to improve the federal income tax treatment of corporate stock buybacks. Lawrence Axelrod explores opportunities to harvest losses while minimizing the financial risk and avoiding application of the wash sale rule. In Tax Notes State, David Uri Ben Carmel explores two recent state decisions in which tax planning did not go well. Robert Willens looks at the developing conflict between the way the federal courts and California evaluate partner guarantee arrangements. In Tax Notes International, Mindy Herzfeld offers suggestions for future work on international tax reform. She writes stakeholders would be well advised to begin with smaller projects and work their way up rather than try to make bold sweeping changes first. Four KPMG practitioners explore how the recent changes in the foreign tax credit regulations have introduced several possibly unintended consequences to the engineering and construction industry. In Featured Analysis, Nana Ama Sarfo reviews recent developments in the ongoing discourse over digital services taxes. And finally, on the Opinions page, Marie Sapirie examines what the IRS funding in the Inflation Reduction Act means for taxpayers.
David D. Stewart: That's it for this week. You can follow me online @TaxStew. That's S-T-E-W. And be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.
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