Sen. Elizabeth Warren speaking in Salt Lake City on Wednesday at a rally for her presidential campaign. She has proposed a 7% tax on companies' worldwide earnings over $100 million as reported on financial statements. (AP)
Because companies are under pressure by shareholders to report strong earnings, they would likely be reluctant to use maneuvers to cut back on earnings to reduce taxes under the plan. But it could also present new problems for administrators and could disadvantage some groups of companies.
"You put the tax planning and financial reporting planning, and you play them off each other," said Daniel Shaviro, a tax professor at the New York University School of Law and a former legislative attorney for the Joint Committee on Taxation. "That's one of the huge advantages of it."
For years, book income and tax income statements have run on parallel but mostly unrelated tracks. While tax income is defined through the Internal Revenue Code and confirmed through Internal Revenue Service audits, book income is largely set by generally accepted accounting principles, or GAAP, outlined by the Financial Accounting Standards Board, a private nonprofit industry organization that answers not to Congress but to professionals in the field.
The tax code defines the corporate income base through a variety of factors reflecting various policy preferences, while financial accounting is singularly focused on the goal of economic accuracy. For that reason, financial accounting doesn't include accelerated depreciation of assets and many other deductions that can reduce a company's taxable income.
Employing FASB standards, which have avoided giving preferential treatment to different types of income or spending, could be a main benefit of the Warren plan.
"We need corporate tax reform, but we also need to recognize that enormous companies with armies of lawyers and accountants will always try to exploit any deductions and exemptions that remain," Warren wrote in a Medium post outlining the plan. "To raise the revenue we need — and ensure every corporation pays their fair share — we need a new kind of tax that big companies can't get around."
But FASB would also be mostly unaccountable to voters, except through the SEC, which has designated the organization as its standards-setter. That raises issues about whether it's an ideal body to set tax policy, and whether it could withstand that new political pressure.
"Taxing a number politicizes it," said Jeffrey Hoopes, an assistant professor of accounting at the University of North Carolina at Chapel Hill. "If we tax book income, we will politicize it."
Some adjustments may be warranted or necessary — but if Congress adds one exception, will it ever be able to stop?
"Presumably you'd have companies lobbying, saying we shouldn't be taxed on this thing, let's change financial accounting or take it out of the base," Shaviro said. "Once you started down that path, you wouldn't be that confident that they would do the right ones."
On the other hand, FASB's status as an impartial arbiter could mitigate the influence of lobbyists and politics, Shaviro noted.
As the adage goes, one person's loophole is another's legitimate deduction. Many of the deductions in the corporate code weren't added in secret but were meant to achieve an outcome. Supporters of deductions for expensing and accelerated depreciation say they encourage investment, and their absence in financial reporting is one reason the conservative-leaning Tax Foundation estimated that Warren's plan would decrease economic output by 1.9%, more than if the plan had simply raised the corporate tax by the same amount.
While financial reporting and tax have mostly been separate, the U.S. tax system did once briefly take book income into account. Congress enacted a corporate alternative minimum tax as part of the Tax Reform Act of 1986, and included a book income adjustment
. But following pushback from the taxpayer community, Congress also included a three-year sunset on that provision. The entire corporate AMT was repealed with the 2017 Tax Cuts and Jobs Act.Enacting the three-year adjustment rule involved a lot of complex decisions for the Treasury Department, including how to ensure that book and tax income figures were matched up correctly, and how the rule should apply to private companies that do not report to the SEC.
"For public companies, it was pretty easy to figure out which statement you looked to," said J. Richard Harvey, who drafted the regulations as a senior accountant for Treasury's Office of Tax Policy. "For private companies, you had to figure out, do you look to financial statements that are audited, do you look to unaudited statements? Do you look to financials to creditors?"
Harvey said the rules created a hierarchy of statements for private companies to use.
The Warren proposal would look to financial statements that private companies prepare for their investors, but her presidential campaign did not publicly release further details. Private companies have much more freedom to decide how to compile their financial information and to whom to show it, and may use standards other than U.S. GAAP.
Despite the headaches, Harvey, who is now a law professor at Villanova University, said the rules ultimately worked despite their brief lifespan.
There is some evidence that companies responded to the new rule by reducing their reported earnings. A 1991 paper by Charles Boynton, Paul Dobbins and George Plesko found that many companies subject to the AMT took "unusual, income-decreasing discretionary accruals" in 1987, the first year it was in effect.
If companies were to manipulate their financial earnings to reduce their tax bills under Warren's plan, that would work against — although maybe not entirely thwart — its goal. But financial accounting experts worry that it would also decrease the reliability of financial reporting, undermining the entire system and potentially distorting the stock market and investment decisions.
"We're going to have a lower-quality financial accounting system," said Hoopes at the University of North Carolina.
Another key attraction of Warren's plan is that it would apply to worldwide profits, eliminating the benefit of moving income to low-tax jurisdictions. It would be a dramatic U-turn for U.S. tax policy after the TCJA exempted most worldwide income from taxation. Advocates of a worldwide system claim it is an effective way to deal with base erosion, while critics claim it's unrealistic and unfeasible for the IRS to try to grasp all world income, and say such a system would lead companies to seek ways to establish tax residency elsewhere. Most of the world has shifted to territorial systems.
"There are some pretty good arguments that the U.S. does have the ability to tax multinationals to a greater degree than other countries," said David Kamin, a law professor at New York University. "The question is, how much market power do we have?"
The Warren campaign said a rush of expatriations would be prevented by enforcement of inversion-discouraging rules set by the Obama administration. Gabriel Zucman, a professor of economics at the University of California, Berkeley, said the 7% tax wasn't high enough to provoke the high-profile expatriations seen under the old tax system's 35% rate. Zucman advised the Warren campaign on the proposal.
Warren's plan would also attempt to mitigate the incentive for companies to escape the 7% tax by taxing foreign companies on a similar basis. In that sense, it bears some resemblance to rules that tax outbound transactions by foreign corporations, such as the base erosion and anti-abuse tax in the TCJA and provisions under consideration by the Organization for Economic Cooperation and Development in its project on digital taxes.
But it's a lot easier said than done. Practitioners often describe BEAT as the most complex and problematic part of the TCJA. And foreign companies follow accounting systems different from GAAP, such as the International Financial Reporting Standards.
Warren's plan would apply only to the U.S. income of foreign companies, creating yet another accounting headache, as current rules do not require them to break out their earnings by jurisdiction.
"That will literally require a whole new financial accounting system," Hoopes said.
Warren's proposal is one of many indications that Democrats plan to take aim at the international framework in the TCJA as the 2020 election approaches.
Sen. Bernie Sanders, I-Vt., expected to be a leading contender in the Democratic primaries, has advocated for a pure worldwide tax system in the past. Sen. Amy Klobuchar, D-Minn., proposed an infrastructure plan that would be paid for, in part, by "closing loopholes that encourage U.S. companies to move jobs and operations overseas."
That is likely a reference to legislation she co-sponsored that would remove a 10% exemption for tangible assets in the tax on global intangible low-taxed income or GILTI and apply a minimum tax on a country-by-country basis on a company's foreign profit.
--Editing by Robert Rudinger and John Oudens.
For a reprint of this article, please contact reprints@law360.com.
