The effective tax rates of companies like Amazon.com have drawn criticism — and tax proposals — from presidential candidates Elizabeth Warren, Bernie Sanders and Joe Biden, left to right, who took part in a Democratic debate Feb. 19 in Las Vegas. (AP)
When a company reports large profits and low tax payments in a given year to its shareholders, it's tempting to assume it reveals tax dodging or some other accounting trick. But it ultimately comes down to two different systems — the income tax rules and financial accounting standards — with divergent goals. And those systems use different methods to calculate the gain of revenue, the incurrence of loss, the timing of expenses, and all the other factors that constitute the elusive conceptual notion of profit.
"They're fundamentally different. The purpose of financial accounting is to measure profits, to try to understand the economic reality of the firm," said Jeff Hoopes, a professor of accounting at the University of North Carolina. "The goal of the Internal Revenue Code is to create a tax base, and from that base we have to raise revenue. And Congress often tries to use that base to motivate and change economic behavior."
In February 2019, Amazon.com issued its annual report for 2018, revealing a current U.S. federal tax provision — roughly speaking, its best estimate of tax liabilities for that year — of minus $129 million. The online retailer, which has often pursued aggressive and controversial tax structures, almost immediately became grist for the burgeoning 2020 presidential race.
In June, former Vice President Joe Biden wrote on Twitter that "no company pulling in billions of dollars of profits should pay a lower tax rate than firefighters and teachers." The tax bill became a recurring theme in the campaign stump speeches of Sen. Bernie Sanders, I-Vt., who also criticized Amazon.com's labor practices. As recently as the Feb. 19 Democratic debate, former South Bend, Indiana, Mayor Pete Buttigieg decried a playing field "where a company like Amazon or Chevron is paying literally zero on billions of dollars in profits" while competing with local small businesses.
The spotlight on Amazon and others only intensified when the Institute on Taxation and Economic Policy, a left-leaning D.C. think tank, issued a report in December stating that the 379 profitable companies in the Fortune 500 reported an effective tax rate of only 11% in 2018. And 91 of those companies didn't pay taxes at all.
To critics, the figures show that the 2017 Tax Cuts and Jobs Act , President Donald Trump's signature legislative accomplishment, failed in one of its key goals: to broaden the tax base and block companies from using offshore havens and other accounting maneuvers to avoid taxes.
Aside from vowing to roll back much of the TCJA, some of the 2020 candidates have proposed taxing companies based on their reported financial earnings, on top of the traditional income tax system. Sen. Elizabeth Warren, D-Mass., unveiled in April the "Real Corporate Profits Tax," a 7% levy on companies' total worldwide income as determined through their statements to the Securities and Exchange Commission.
In television interviews, Biden has also called for a "15% minimum corporate tax," which would also be based on book income, according to published reports the campaign has promoted.
The financial reports themselves reveal a more complex picture than that promoted on the campaign trail, however.
The low effective tax rates may have less to do with the Tax Cuts and Jobs Act than with the booming stock market. Experts say that one key driver of dwindling tax payments is deductions for employee stock options, which were mostly unaffected by the TCJA. The issue also doesn't present a clear-cut case of tax-dodging.
Stock options allow employees to purchase a company's stock at a fixed price — which, depending on when the employee exercises them, could be much lower than the current stock price, giving him or her an instant windfall.
Because stock options can be a highly lucrative form of compensation, but do not cost the company an immediate cash expense, they present a tricky challenge for accountants. Current accounting principles, outlined by the Financial Accounting Standards Board, require companies to estimate the eventual cost of a stock option at the time it is granted. After all, the potentially massive discount the company is obligated to honor will dilute the value of other shares — something shareholders would want to know.
For tax purposes, however, the cost isn't measured as a deduction until the employee uses the option. The company can deduct the difference between the stock's current value and its value at the price available to the employee, which can be a sizable amount. And often that amount can dwarf the cost that the company initially estimated for its financial books, creating a disparity between its reported profit and its taxable income.
In its 2018 report, Amazon.com said stock options reduced its tax liability by more than $1 billion, accounting for nearly half of what it would have paid in taxes at a flat 21% rate. In its 2019 annual report, released Jan. 31, Amazon said stock option deductions reduced its taxes by $466 million.
While this policy can seem decidedly favorable to corporations, that's not necessarily true, notes J. Richard Harvey, a professor of accounting at Villanova University and a former official with the U.S. Department of the Treasury. Companies with underperforming stocks could end up with smaller deductions than they initially estimated.
"They're almost always going to be different, but it can cut either way," Harvey said. "It just happens that with a lot of these tech companies, they've been so successful, and their stock has been so off the charts, the tax expense has been greatly in excess of the book expense."
It's also not necessarily a bad deal for the Treasury Department. Those employees must claim the value of the options as taxable income at the same time that the company is claiming the deduction. As the individual tax rate could be higher than the corporate rate of 21%, the government could come out ahead in terms of overall revenue.
"I think employee options are a good case where the tax rules are better than the book rules, at least for purposes of timing and reporting income," said Steven Rosenthal, a senior fellow at the Tax Policy Center, a D.C. think tank co-created by the Brookings Institution and the Urban Institute, and a former counsel with the Joint Committee on Taxation. "And just because the tax rules sometimes give a different answer than the book rules doesn't mean the tax rules are wrong."
In its December report, ITEP noted that as far back as 1997, Sen. John McCain, R-Ariz., and Sen. Carl Levin, D-Mich., proposed legislation to limit stock option deductions to the amount reported in the financial books.
"It does not make sense for companies to treat stock options inconsistently for tax purposes versus shareholder-reporting or 'book' purposes," ITEP said. "This stock option book-tax gap is a regulatory anomaly that should be eliminated."
Stock options aren't the only reason that financial reports and taxable income can differ.
Many disparities amount to timing differences — different rules about when to record expenses and revenue gains, which ultimately determine profit. For instance, the TCJA allowed companies to more quickly claim deductions for new investments, such as immediate 100% bonus depreciation for qualified property from 2018 to 2022.
Supporters claimed that allowing immediate expensing, rather than requiring deductions to be spread out according to a depreciation schedule, encourages companies to invest. Critics said it tilted the tax code in favor of some industries and sectors. But regardless of who is right, the policy doesn't reduce how much revenue the U.S. government collects — it only delays the collection.
The tax code has long encouraged spending, which the TCJA continued through accelerated depreciation, enhancement of the research and development tax credit, and other policies. This may tend to benefit companies in the spendthrift Silicon Valley business environment, where investors often encourage startups and new giants to forgo immediate profits in favor of constant expansion and innovation.
But accounting principles, with the goal of giving investors a clear picture of a company's finances, still require corporations to spread costs out through depreciation schedules. While companies must record the amount they'll be paying without the deduction as a deferred tax expense, in doesn't affect the current year's profit margin.
Effects of the TCJA — including the benefits of accelerated depreciation — reduced Amazon's tax bill by $850 million in 2019, according to its annual report.
Matt Gardner, a senior fellow at ITEP and co-author of its report, said timing differences can still be an indication that companies are gaming the system.
"Accruing a million dollars of deferred income tax expense is simply not the same thing as paying a million dollars of income tax," Gardner said. "Deferred income taxes are, in any given year, an accounting fiction: They're cash that will, according to a company's best forecast, be used someday to pay income taxes. But there is absolutely no guarantee that these taxes will ever get paid."
Companies will likely continue to spend and claim future deductions, Gardner noted, and eventual changes to the law could wipe out those delayed tax payments.
"One year's deferred liability is replaced with the next," he said.
There are times when a company may actually pay more in cash taxes than what the current tax provision indicates. That figure isn't an exact match for the payment on a company's income tax return. It's a division of the company's overall tax liability, which includes potential adjustments in the future.
For instance, Internal Revenue Code Section 163(j) , enacted by the TCJA, sought to block earnings-stripping through excessive intercompany borrowing, by limiting the amount of interest for which companies could claim deductions. Interest deductions are disallowed if the amount of interest is above a threshold set by the company's earnings before interest, taxes, depreciation and amortization. But companies can carry forward that disallowed interest indefinitely, to use when interest is below that threshold in a future year.
FASB rules don't require companies to report those lost deductions on their books, because the possibility of claiming them later may mean it doesn't have a permanent increase in tax liability.
George Callas, a managing director with Steptoe & Johnson LLP and former Republican chief tax counsel for the House of Representatives Ways and Means Committee, said that as lawmakers looked for ways to pay for the TCJA's drastic cut in the corporate tax rate, they gravitated toward policies that would raise revenue while limiting the impact on book taxes.
"All else being equal, Congress believed it would face more opposition to a $100 billion revenue raiser that increases book-effective tax rates than a $100 billion revenue raiser that leaves effective tax rates unchanged," Callas said. "But companies are paying the government $100 billion either way."
Another example is a new rule that limits how much in net operating losses a company can claim in one year but allows those losses to be carried forward indefinitely.
In a Jan. 31 blog post pushing back on criticism of its tax strategies, Amazon.com noted that its most recent annual report for 2019 showed an overall tax provision of $1.076 billion for federal income taxes. The company said it paid a total of $2.4 billion in "other federal taxes," including payroll taxes and custom duties. The company's 2019 report showed a current federal tax provision of $162 million.
Given these nuances and distinctions, accounting and tax experts differ on whether effective tax rates can be useful in discussions about policy.
"If you compare one number from one system, and another number from another system, it seems surprising," said Hoopes of UNC. "But it's because it's from two different systems."
Others say it's not a bad impression of the overall tax situation.
"Focusing on book income is an excellent way to get a basic, broad-brush sense of to what extent the tax law is reaching highly profitable companies," said Daniel Shaviro, a professor at New York University School of Law and a former attorney with JCT. "In any particular case, one would need to know more to reach firm conclusions."
ITEP's Gardner, too, emphasized that it ought to be the beginning of a debate on how to retool the tax code.
"Until you establish that a problem exists, no one is going to prioritize solving it," he said. "Another way of putting this is that in many cases, all the analysts can do is assess whether a company appears to be paying income taxes. While the rebuttable presumption is that these companies are using legal means to do so, all too often we simply don't know what the mechanisms are."
Stronger disclosure rules could allow for better measures to evaluate corporate tax behavior, Gardner added.
The proposals from Warren and Biden to tax book income, though, raise concerns across the ideological spectrum about administrability.
While it is an intuitive way to ensure that corporations are taxed, critics note that it would give the nonprofit organization FASB — unaccountable to Congress or voters — significant control over the income tax system. It could diminish the reliability of financial reports to shareholders. It raises significant challenges for the Internal Revenue Service to match the two systems and ensure that companies aren't double-taxed.
And it has been tried before, with the 1986 tax overhaul, which created an alternative minimum tax based on financial reporting that lasted for only three years .
"This sounds easy, but it's harder than you think," said Mark Mazur, director of the Tax Policy Center and assistant secretary for tax policy at Treasury in former President Barack Obama's administration. "The amount of revenue they can get from this is highly speculative."
--Editing by Robert Rudinger and John Oudens.
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