tax notes international - Tuck School of Business - Dartmouth College

HIGHLIGHTS
from the tax accounts in the financial statements can
lead to erroneous and misleading inferences.’’
The confidentiality of corporate tax returns, however,
places researchers in an unenviable position.
Either they apply to the IRS for permission to use confidential
data, as many researchers have done, or they
develop ways to tease tax information out of the financial
reports. Shackelford and his coauthors chose the
latter path and suggest ways to use this imperfect public
information to better approximate information in
the confidential tax return.
Book-Tax Differences
As Shackelford noted, accountants and the IRS frequently
take different views of what constitutes income.
For a given accounting definition, the differences
in book and tax treatment largely arise from tax legislation
designed to encourage a specific behavior, such as
additional investment spending or simplification.
These differences may be permanent or only temporary.
For example, the tax law exempts municipal bond
income from tax, while accounting rules include the
income in book income. This creates a permanent difference
between book and tax income and will drive
down the reported effective tax rate (the income tax
expense divided by net income before taxes) in the financial
statements. The income tax expense is the
product of the statutory tax rate and book income adjusted
for permanent differences.
Temporary differences in book and tax income generally
do not cause effective and statutory tax rates to
differ. However, because permanent differences in book
and tax income reduce the effective tax rate, corporate
managers likely value transactions that reduce permanent
income more highly than those that reflect only
temporary differences in tax payments.
Those differences have drawn the attention of many
researchers. David Weisbach 2 and George Plesko 3 have
argued that firms seek to enter tax shelters precisely
because they permanently reduce income reported to
the government while having no impact on financial
statement earnings. Mihir Desai 4 suggests that the unexplained
growth in book-tax differences may largely
be explained by the growth in tax shelters. Jeri
2 David Weisbach, ‘‘Ten Truths About Tax Shelters,’’ 55 Tax
Law Review, 215-253 (2002).
3
George Plesko, ‘‘Corporate Tax Avoidance and the Properties
of Corporate Earnings,’’ LVIII National Tax Journal, 729-737
(2004).
4
Mihir Desai, ‘‘The Divergence Between Book Income and
Tax Income,’’ Tax Policy and the Economy 17, edited by James M.
Poterba, National Bureau of Economic Research and MIT Press
(Cambridge, Mass.), 169-206 (2003).
Seidman5 examined data from 1995 to 2004 and found
that after narrowing during the 2001 economic downturn,
the book-tax gap significantly widened in 2003
partly because of earnings management.
These book-tax differences are not inconsequential.
As the Senate Homeland Security and Governmental
Affairs Permanent Subcommittee on Investigations6 noted when investigating the collapse of Enron, the
firm regularly showed positive financial earnings while
reporting losses for tax purposes. The committee’s report
concluded that:
some U.S. financial institutions have been designing,
participating in, and profiting from complex
financial transactions explicitly intended to help
U.S. public companies engage in deceptive accounting
or tax strategies. This evidence also
shows that some U.S. financial institutions and
public companies have been misusing structured
finance vehicles, originally designed to lower financing
costs and spread investment risk, to carry
out sham transactions that have no legitimate
business purpose and mislead investors, analysts,
and regulators about companies’ activities, tax
obligations, and true financial condition.
While no one has yet accused any of the companies
involved in the current financial crisis of engaging in
Enron-style abuses, I believe something seems wrong
when a company can regularly report high, positive
earnings to the financial community while reporting
low or no taxable income to the tax authorities.
The Treasury Department had already placed booktax
differences under suspicion in its 1999 tax shelter
study. (See Doc 1999-22641 or 1999 WTD 128-43 and Doc
1999-22867 or 1999 WTD 128-44.) Whether tax shelters
or other, innocuous tax planning explains today’s booktax
differences has yet to be determined. I believe the
IRS is years away from providing the data necessary to
determine the extent to which a favorable interaction
between financial and tax reporting contributed to the
current financial crisis.
Shining a Spotlight on the Accounts
Because corporate tax returns are not public, it is
difficult to determine whether book-tax differences indicate
that the firm is participating in a tax shelter or
whether it has legitimate tax deductions. Researchers
without access to tax data have had to look elsewhere.
5
Jeri Seidman, ‘‘Interpreting Fluctuations in the Book-Tax
Income Gap as Tax Sheltering: Alternative Explanations,’’ working
paper, University of Texas (2008).
6
U.S. Congress, Senate Committee on Governmental Affairs,
‘‘Report on Fishtail, Bacchus, Sundance, and Slapshot: Four Enron
Transactions Funded and Facilitated by U.S. Financial Institutions,’’
Permanent Subcommittee on Investigations, Jan. 2,
2003. For a reference to the study, see Doc 2003-511 or 2003 TNT
2-22.
372 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL
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