Corporate Income Tax: Effective Tax Rates Can Differ Significantly from the Statutory Rate
Released: 2013-07-01T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: Proponents of lowering the U.S. corporate income tax rate commonly point to evidence that the U.S. statutory corporate tax rate of 35 percent, as well as its average effective tax rate, which equals the amount of income tax corporations pay divided by their pretax income, are high relative to other countries. However, GAO's 2008 report on corporate tax liabilities ( GAO-08-957 ) found that nearly 55 percent of all large U.S.-controlled corporations reported no federal tax liability in at least one year between 1998 and 2005.

Given the difficult budget choices Congress faces and its need to know corporations' share of the overall tax burden, GAO was asked to assess the extent to which corporations are paying U.S. corporate income tax. In this report, among other things, GAO (1) defines average corporate ETR and describes the common methods and data used to estimate this rate and (2) estimates average ETRs based on financial statement reporting and tax reporting. To conduct this work, GAO reviewed economic and accounting literature, analyzed income and expense data that large corporations report on the Schedules M-3 that they file with Internal Revenue Service (IRS), and interviewed IRS officials.

section_title: What GAO Found
paragraphs: Effective tax rates (ETR) differ from statutory tax rates in that they attempt to measure taxes paid as a proportion of economic income, while statutory rates indicate the amount of tax liability (before any credits) relative to taxable income, which is defined by tax law and reflects tax benefits and subsidies built into the law. Lacking access to detailed data from tax returns, most researchers have estimated ETRs based on data from financial statements. A common measure of tax liability used in past estimates has been the current tax expense--either federal only or worldwide (which comprises federal, foreign, and U.S. state and local income taxes). The most common measure of income for these estimates has been some variant of pretax net book income. GAO was able to compare book tax expenses to tax liabilities actually reported on corporate income tax returns.

For tax year 2010 (the most recent information available), profitable U.S. corporations that filed a Schedule M-3 paid U.S. federal income taxes amounting to about 13 percent of the pretax worldwide income that they reported in their financial statements (for those entities included in their tax returns). When foreign and state and local income taxes are included, the ETR for profitable filers increases to around 17 percent. The inclusion of unprofitable firms, which pay little if any tax, also raises the ETRs because the losses of unprofitable corporations greatly reduce the denominator of the measures. Even with the inclusion of unprofitable filers, which increased the average worldwide ETR to 22.7 percent, all of the ETRs were well below the top statutory tax rate of 35 percent. GAO could only estimate average ETRs with the data available and could not determine the variation in rates across corporations. The limited available data from Schedules M-3, along with prior GAO work relating to corporate taxpayers, suggest that ETRs are likely to vary considerably across corporations.

section_title: What GAO Recommends
paragraphs: GAO does not make recommendations in this report. GAO provided a draft of this report to IRS for review and comment. IRS provided technical comments which were incorporated as appropriate.

section_title: Letter
paragraphs: Proponents of lowering the U.S. corporate income tax rate commonly  point to evidence that the U.S. statutory federal corporate income tax rate  of 35 percent, as well as its average effective tax rate (ETR), which  equals the amount of income tax corporations pay divided by their pretax  income, are high relative to other countries. However, our 2008 report on  corporate income tax liabilities found that nearly 55 percent of all large  U.S.-controlled corporations reported no federal tax liability in at least one  year between 1998 and 2005.

Statutory tax rates provide only a limited measure of the share of income  that businesses pay in taxes because many other aspects of the tax  system, such as exemptions, deferrals, tax credits, and other forms of  incentives, also determine the amount of tax that a business ultimately  pays on its income. The average effective tax rate reflects the combined  effects of all these tax system components. However, obtaining the data  to calculate ETRs is challenging. The two typical sources, tax returns and  financial statements, both have limitations.

Given the difficult budget choices Congress faces and its need to know  corporations’ share of the overall tax burden, you asked us to assess the  extent to which corporations are paying U.S. corporate income tax. In this  report, we (1) explain the definition of average corporate ETR and the  common methods and data used to estimate this rate, (2) estimate  average ETRs based on financial statement reporting and tax reporting,  and (3) describe the largest sources of the differences in income reported  on financial statements and tax returns.

To explain how the average corporate effective tax rate is defined and to  describe the common methods and data used to estimate this rate, we  reviewed and summarized the relevant economic literature. (See app. I  for a summary of past studies that used financial statement data to  estimate average effective tax rates.)

To report what available data indicate about the difference between  average effective tax rates based on financial statement reporting versus  those based on tax reporting, we computed a variety of such rates using  income and expense data that large corporations report on the Schedules  M-3 that they file with the Internal Revenue Service (IRS). (These  schedules reconcile income and expense amounts the corporations  report for financial statement purposes to amounts they report for tax  purposes.) These data, which the joint Treasury-IRS M-3 First Look Team  compiles for a large sample of taxpayers, enabled us to estimate and  compare U.S. and worldwide effective tax rates on worldwide income  using only financial statement data; U.S. effective tax rates on worldwide  income using only data reported for tax purposes; and U.S. and  worldwide effective tax rates on worldwide income using income data  from financial statements and tax return data for the amount of taxes  paid. Our estimates of effective tax rates are limited to corporations with  assets of $10 million or more (which are the ones that file Schedule M-3)  and primarily to tax years 2008 through 2010 because those are the only  years for which IRS has compiled data separately for corporations that  had nonnegative values for net income on their financial statements.

To identify common differences between financial statement reporting  and tax reporting, we reviewed the relevant economic and accounting  literature and obtained data from IRS on the dollar magnitude of those  differences that are reported in detail on Schedule M-3. The data we  report on differences between financial statement and tax return items  cover tax years 2006 through 2010. While there are limitations to the data  provided on the Schedule M-3 and general reporting problems with tax  return data, we determined that the data were reliable for our purposes  after reviewing relevant documentation and discussing quality control  procedures with IRS officials.

We conducted our work from March 2012 to May 2013 in accordance with  all sections of GAO’s Quality Assurance Framework that are relevant to  our objectives. The framework requires that we plan and perform the  engagement to obtain sufficient and appropriate evidence to meet our  stated objectives and to discuss any limitations in our work. We believe  that the information and data obtained, and the analysis conducted,  provide a reasonable basis for any findings and conclusions in this  product.
subsections: section_title: Background
subsections: section_title: Corporate Income Tax
paragraphs: The base of the federal corporate income tax includes net income from  business operations (receipts, minus the costs of purchased goods, labor,  interest, and other expenses). It also includes net income that  corporations earn in the form of interest, dividends, rent, royalties, and  realized capital gains. The statutory rate of tax on net corporate income  ranges from 15 to 35 percent, depending on the amount of income  earned. The United States taxes the worldwide income of domestic  corporations, regardless of where the income is earned, with a foreign tax  credit for certain taxes paid to other countries. The timing of the tax  liability depends on several factors. For example, income earned not by  the domestic corporation, but by a foreign subsidiary is generally not  taxed until a distribution—such as a dividend—is made to the U.S.  corporation.

At about $242 billion, corporate income taxes are far smaller than the  $845 billion in social insurance taxes and $1.1 trillion in individual income  taxes that the Office of Management and Budget (OMB) estimates were  paid in fiscal year 2012 to fund the federal government.  Figure 1 shows the relative distribution of federal taxes.

Figures 1 and 2 show the trend in corporate income tax revenues since  1950. According to tax experts, corporate income tax revenues fell from  the 1960s to the early 1980s for several reasons. For example, corporate  income became a smaller share of gross domestic product (GDP) during  these years, partly due to the fact that corporate debt, and therefore  deductible interest payments, increased relative to corporate equity,  reducing the tax base. In addition, tax expenditures, such as more  generous depreciation rules also grew over that period.1980s, the corporate income tax has accounted for about 6 to 15 percent   Since the early  of federal revenue. Consequently, although not the largest, it remains an  important source of federal revenue. Relative to GDP, the corporate  income tax has ranged from a little over 1 percent to just under 2.7  percent during those same years, as shown in figure 2. The  Congressional Budget Office (CBO) recently projected that despite the  recent uptick, corporate income tax revenue for the next 10 years as a  percentage of GDP is expected to stay within this same range.

Businesses operating as publicly traded corporations in the United States  are required to report the income they earn and the expenses (including  taxes) they incur each year according to two separate standards. First,  they must produce financial statements in accordance with generally  accepted accounting principles (GAAP), based on standards established  by the Financial Accounting Standards Board. Income and expense items  reported in these statements are commonly known as book items.  Second, in general, domestic corporations, including publicly traded  corporations, must file corporate income tax returns on which they report  income, expenses, and tax liabilities according to rules set out in the  Internal Revenue Code (IRC) and associated Department of Treasury  regulations.

The measurement of business net income is inherently difficult and some components  of both tax and book net income are estimates subject to some imprecision. (Net income  equals total income minus expenses.) One important source of imprecision is the difficulty  of measuring costs associated with the use of capital assets. Both book and tax  depreciation rules allocate capital costs over the expected useful lives of different types of  assets. The actual useful life of specific assets may differ from the expected lives used for  purposes of either book or tax depreciation. reported on their federal tax return for that year. In financial statements,  income tax expense includes the estimated future tax effects attributable  to temporary differences between book and tax income.

Prior to 2004, corporations were required to reconcile their book net  income with tax net income reporting on Schedule M-1 of their income tax  returns by comparing the book and tax return amounts of a limited  number of income and expense items. Concern over the growing  difference observed between pretax book net income and tax net income  and the lack of detail available from the Schedule M-1 on the sources of  these differences led to the development of the more extensive reporting  on book-tax differences that is now required on Schedule M-3. One  important concern with Schedule M-1 arose from the fact that GAAP  governing which components of large multinational corporate groups  need to be included in financial statements differ from tax rules that  specify which of those components need to be included in consolidated  tax returns. Consequently, the financial statement data that taxpayers  reported on their M-1s could relate to a much different business entity  from the one covered by the tax return. A Schedule M-3 filer is now  required to report the worldwide income of the entity represented in its  financial statements and then follow a well-defined series of steps— subtracting out income and losses of foreign and U.S. entities that are  included in the financial statements but not in consolidated tax returns;  adding in the income and losses of entities that are included in  consolidated tax returns but not in financial statements; and making other  adjustments to arrive at the book income of tax-includible entities. The  Schedule M-3 also requires filers to report many more specific income  and expense items according to both financial statement and tax rules  than the M-1 required. The items causing the largest book-tax differences  are identified later in this report. (See app. II for a copy of the Schedule  M-3.)

section_title: Past Studies Estimating Corporate Effective Tax Rates Used a Range of Data Sources and Methodologies for a Variety of Reasons
subsections: section_title: Alternative Corporate Effective Tax Rates Are Designed to Address Different Questions
paragraphs: Effective tax rates on corporate income can be defined in a variety of  ways, each of which provides insights into a different issue. These rates  fall into two broad categories—average rates and marginal rates. An  average corporate effective tax rate, which is the focus of this report, is  generally computed as the ratio of taxes paid or tax liabilities accrued in a  given year over the net income the corporation earned that year; it is a  good summary of the corporation’s overall tax burden on income earned  during that particular period. “Burden” in this context refers to what the  corporation remits to the Treasury, also called statutory burden. However,  statutory burden may differ from economic burden, which measures the  loss of after-tax income due to a tax. The economic burden of some or all  of the taxes on a corporation may be shifted to the firm’s customers or  workers, as well as to other firms and other workers. Any remaining  burden is borne by the corporation’s shareholders or other owners of  capital. A marginal effective tax rate focuses on the tax burden associated  with a specific investment (usually over the full life of that investment) and  is a better measure of the effects that taxes have on incentives to  invest. Effective rates differ from statutory tax rates in that they attempt  to measure taxes paid as a proportion of economic income, while  statutory rates indicate the amount of tax liability (before any credits)  relative to taxable income, which is defined by tax law and reflects tax  benefits and subsidies built into the law. The statutory tax rate of 35  percent applying to most large U.S. corporations is sometimes referred to  as the “headline rate,” because it is the rate most familiar to the public.

section_title: Data from Schedule M-3 of the Federal Corporate Income Tax Return Allow for More Accurate Comparisons of Effective Tax Rates Based on Alternative Reporting Rules
paragraphs: Until recently, data constraints have inhibited comparisons of effective tax  rate estimates based on the alternative reporting systems. Access to tax  return data is tightly restricted by law; consequently, most researchers  who have estimated average effective tax rates for U.S. corporations  have used either firm-level or aggregated data compiled from corporate  financial statements for their measures of both tax liability and income.  Even those with access to tax data could not easily determine how  effective tax rates based on financial statements would differ from those  based on actual tax returns because, as noted above, the scope of the  business entity represented in a corporation’s financial statement can be  quite different from that covered by its consolidated federal tax return.

Researchers with access to data from Schedule M-3 and other parts of  corporate income tax returns will now be able to directly compare  effective tax rates based on the different data sources for a consistent  population of large corporate income taxpayers, as we do in the following  section.

section_title: Various Measures of Taxes and Income Have Been Used to Estimate Effective Tax Rates
paragraphs: The two essential components of a methodology for estimating an  average effective tax rate are the measure of tax liabilities to be used as  the numerator of the rate and the measure of income to be used as the  denominator.

A common measure of tax liability used in estimates based on financial  statement data has been the current tax expense—either federal only or  worldwide (which comprises federal, foreign, and U.S. state and local  income taxes); however, some studies have used the total tax expense,  and others have used cash taxes paid during the year. Corporations  that filed Schedules M-3 for tax year 2010 reported a total of $185 billion  in current U.S. federal income tax expense and $225 billion in total  federal income tax expense, compared to the total of $187 billion in actual  tax paid after credits that they reported owing IRS for that year.data from IRS do not include a measure of cash taxes paid.

The typical measure of income for effective tax rate estimates based on  financial statements has been some variant of pretax net book income.  Figure 3 shows the value of this book income measure for corporations  that filed Schedules M-3 for tax year 2010 and shows the separate values  for profitable and unprofitable filers. Profitable filers had aggregate  pretax net book income of $1.4 trillion while unprofitable filers had losses  totaling $315 billion, resulting in total net book income of $1.1 trillion for  the full population. As these numbers suggest, average effective tax  rates can vary significantly depending on the population of corporations  covered by the estimate. The inclusion of unprofitable firms, which pay  little if any actual tax, can result in relatively high estimates because the  losses of unprofitable corporations greatly reduce the denominator of the  effective rate. Such estimates do not accurately represent the tax rate on  the profitable corporations that actually pay the tax. Some prior studies  have excluded unprofitable corporations; others have not.

Figure 3 also shows the value of two income measures defined by tax  rules for the same population of taxpayers. The first measure, income  (loss) before net operating loss deductions and special deductions, is the  tax return measure to which Schedule M-3 filers are required to reconcile  their net book income (we refer to this measure as net tax income). It  represents total income minus all deductions, except for losses carried  over from other tax years and the special deductions relating to  intercorporate dividends. The positive values of this measure for  profitable filers, negative values for unprofitable filers, and net value for all  filers are all of a lower magnitude relative to book net income.measure shown in figure 3 is taxable income, which equals net tax  income minus losses carried over from other years and special  deductions. Taxable income is higher than tax net income for the full  population of Schedule M-3 filers, even after the additional deductions,  because it is defined to be no less than zero. Therefore there are no  current-year losses to offset positive income amounts. For the profitable  subpopulation taxable income is lower than net tax income.

section_title: The Average Effective Tax Rates for Profitable Large Corporations Were Well Below the Statutory Rate and Well Below the Effective Rates for All Large Corporations in Tax Years 2008 through 2010
paragraphs: For tax year 2010, profitable Schedule M-3 filers actually paid U.S.  federal income taxes amounting to 12.6 percent of the worldwide income  that they reported in their financial statements (for those entities included  in their tax returns). This tax rate is slightly lower than the 13.1 percent  rate based on the current federal tax expenses that they reported in those  financial statements; it is significantly lower than the 21 percent effective  rate based on actual taxes and taxable income, which itself is well below  the top statutory rate of 35 percent.tax rate cannot be explained by income taxes paid to other countries.  Even when foreign, state, and local corporate income taxes are included  in the numerator, for tax year 2010, profitable Schedule M-3 filers actually  paid income taxes amounting to 16.9 percent of their reported worldwide  income.
subsections: section_title: The Average Effective Tax Rates Based on Book Income Are Lower When Unprofitable Corporations Are Excluded
paragraphs: All of the effective tax rates based on book income for profitable filers are  lower than the equivalent measures computed for all Schedule M-3 filers,  shown on the right side of figure 4, because the inclusion of losses  reduces the aggregate income for all Schedule M-3 filers. This difference  was particularly large for tax year 2009 because the aggregate losses of  unprofitable filers were considerably larger in that year than in 2010.  Aggregate book losses were even larger for tax year 2008; however,  because these losses more than offset the income of profitable  corporations, resulting in an overall net loss, we could not compute  meaningful average effective tax rates based on book income for all  corporations for that year.

With access to only aggregated data, we were not able to provide any  information on the distribution of effective rates across individual filers;  however, past work we have done suggest that there could be significant  variation in effective rates across taxpayers.effective tax rates for different types of corporations, such as U.S.  controlled corporations and foreign controlled corporations.

section_title: The Average Effective Tax Rates for Profitable Corporations Were Well Below the Federal Statutory Rate Even When Foreign and State and Local Income Taxes Were Included
paragraphs: Past empirical studies comparing average effective tax rates across  countries have focused on worldwide taxes (which add foreign and state  and local income taxes to federal income taxes in the numerator). Our  estimates for these worldwide rates ranged between 2 to 6 percent higher  than the U.S. federal rates we present above, but the relationships  between the different measures (total, current, and actual) within each  year remained similar. (See fig. 5.) It is difficult to make close  comparisons between our results and estimates from prior studies based  on financial statement data because most of the latter estimates are  averaged over multiple years for which we have no data. (See fig. 9 in  app. I.) Our estimated rates for the full population of filers for tax year  2010 are generally lower than the estimates presented in earlier studies  while our estimated rates for other years are generally higher.

section_title: Financial and Tax Reporting Differ in Terms of Entities Included, Fundamental Treatment of Other Items, and Periods in which Certain Income and Expense Items Are Recorded
paragraphs: As noted above, it can be difficult to compare financial statements with  tax returns because entities included under each type of reporting can  differ. IRS developed Schedule M-3 Part I to help delineate book-tax  differences related to consolidation and to standardize the definition of the  financial, or book, income of the tax consolidated group. As shown in  figure 6, for tax year 2010 Schedule M-3 filers reported that they earned a  total of $1.3 trillion from U.S. and foreign entities that were included in  their consolidated financial statement but not in their consolidated tax  returns (which, therefore, had to be subtracted out on the Schedule M-3).  They also reported $420 billion in losses from such entities. (These  losses also had to be subtracted out, meaning that net income increased  by $420 billion.) In contrast, they reported less than $10 billion in either  income or losses from entities that are included in their tax returns but not  in their financial statements. These corporations also reported $762 billion  in positive adjustments and $20 billion in negative adjustments relating to  transactions between excluded and included entities. The corporations  must also report several other types of adjustments, such as for any  difference between the time period covered by their financial statements  and the period covered by their tax years, that they make in order to  arrive at a final amount that represents the net book income or loss of all  of their entities that are included in their tax returns. For tax year 2010,  this population of Schedule M-3 filers reported a total of $1.1 trillion in net  book income for entities included in their tax returns and a total of $300  billion in losses for such entities.

Schedule M-3 Parts II and III report book-tax differences related to  income and expenses, respectively, for the tax consolidated group only.  The largest category of differences for both income and expense items  was “other.” IRS officials told us that their reviews of the detailed  documentation that filers are required to submit along with their  Schedules M-3 indicate three broad subtypes of reporting in these other  categories:  1.  Some common income and expense categories have no line of their  own on the M-3, so they have to be reported as other. This was the  case for research and development expenses prior to 2010; those  expenses now have their own line.  2.  Taxpayers report miscellaneous items in these categories but do not  provide details on what they include.  3.  Taxpayers record items in these categories that clearly should have  been reported on more specific lines of the M-3. The officials  suggested some taxpayers do this because they do not take the time  or trouble to fill out the form properly; others may be trying to hide  details from the IRS.

As a consequence, there is over-reporting in the two “other” categories  and under-reporting in some of the more specific categories. Figures 7  and 8 identify the 10 largest categories of book-tax differences for both  income and expense items in tax year 2010.

Book-tax differences caused by the inclusion of an income or expense  item by one accounting system but not the other are known as permanent  differences. One of the largest permanent book-tax income differences  reported in tax year 2010 arose from the section 78 gross-up, as shown in  figure 7. Section 78 of the IRC requires U.S. corporations electing to  claim the foreign tax credit to gross-up (i.e., increase) their dividend  income by the amount of creditable foreign income taxes associated with   Given that corporations are not required to  the dividends they received. make this type of adjustment for book income purposes, the amount of  any gross-up is a permanent positive difference between tax income and  book income.

26 U.S.C. § 78. Section 902 of the IRC permits a U.S. corporation that owns at least 10  percent of the voting stock of a foreign corporation to take an indirect credit for foreign  income taxes associated with dividends that it receives from that foreign corporation. 26  U.S.C. § 902.  particular category. Similarly, the negative differences represent the sums across all filers with net  negative differences.

The magnitudes of some book-tax differences varied significantly  between 2006 and 2010.For example, the excess of tax depreciation over  book depreciation increased from about $69 billion in 2006 to over $145  billion in 2010. As another example, the excess of tax income over book  income relating to the section 78 gross-up increased from about $36  billion in 2006 to over $77 billion in 2010.

As the details presented in figures 7 and 8 indicate, the direction of the  book-tax differences in all of the income and expense categories varies  across corporations. The book amount is greater for some corporations,  while the tax amount is greater for others. As a consequence, the  aggregate net difference in many categories (shown in tables 1 and 2 in  app. III) are significantly smaller than the absolute value of the  differences. Moreover, the net difference is positive for some categories  and negative for others. The offsetting of negative and positive  differences across categories and across corporations within categories  means that the relatively small difference between aggregate net book  income ($833 billion) and aggregate net tax income ($737 billion) for the  population of Schedule M-3 filers for tax year 2010 may hide considerable  differences between book and tax income and between effective tax rates  based on book income and those based on tax income for individual  corporations. Given the aggregate nature of our data, we were not able to  examine the range of potential differences across corporations.

section_title: Agency Comments
paragraphs: We provided a draft of this report to IRS on April 25, 2013, for review and  comment. After reviewing the draft report, IRS provided technical  comments which we incorporated as appropriate.

As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to interested congressional  committees, the Secretary of the Treasury, the Commissioner of Internal  Revenue, and other interested parties. In addition, the report also will be  available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact  me at (202) 512-9110 or whitej@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made major contributions to this report  are listed in appendix V.

section_title: Appendix I: Summary of Selected Past Estimates of Average Effective Tax Rates Based on Financial Statement Data
paragraphs: Results from past studies, presented in Figure 9, use financial statement  data to estimate average effective tax rates for U.S. corporations,  employed pretax worldwide book income as the denominator of their  effective rate, and covered at least one tax year since 2001. As indicated  in the figure, these studies used a variety of measures of worldwide taxes  for their numerator. Five of the estimates were based on data that  excluded all corporations with negative book income. Most of the studies  reported their results as averages across multiple years.

Other recent studies used aggregate measures of tax receipts received  by the U.S. Treasury and profits before taxes from the Bureau of  Economic Analysis’s (BEA) National Income and Product Account (NIPA)  data to estimate average corporate effective tax rates. The BEA profits  measure is created using an aggregate income amount using tax data  adjusted by two components: inventory valuation adjustment and capital  consumption adjustment. Due to the aggregate nature of the profits  before taxes, the denominator includes corporations with positive and  negative profits before taxes. Another recent study by Citizens for Tax  Justice and the Institute on Taxation and Economic Policy used financial  statement data but focused on the effective rate of the federal income tax  on U.S. domestic income, rather than worldwide taxes on worldwide  income. They estimated a three-year (2008 to 2010) average effective tax  rate of 18.5 percent for a sample of 280 of the largest U.S. corporations.

section_title: Appendix II: Copy of IRS Form 1120, Schedule M-3 (Tax Year 2010)
paragraphs: Appendix II: Copy of IRS Form 1120, Schedule  M-3 (Tax Year 2010)

section_title: Appendix III: Detailed Data on Book-Tax Differences for Tax Year 2010
subsections: section_title: Book amount temporarily lower than tax amount

section_title: Appendix IV: Descriptions of Income and Expense Items with the Largest Book-Tax Differences
paragraphs: Appendix IV: Descriptions of Income and  Expense Items with the Largest Book-Tax  Differences Description  Differences in this category and the one below relating to Form 4797 arise from differences in book  and tax reporting of gains or losses arising from the sale or other disposition of business assets. One  such difference arises when accumulated tax depreciation for an asset is higher than accumulated  book depreciation, which would make the gain upon sale higher for tax purposes than book  purposes.

Certain qualified interest income, such as that from municipal bonds, is exempt for tax purposes but  must be reported as income in financial statements. Also some items may be treated as interest  income for tax purposes but as some other form of income for financial accounting purposes.

Cost of goods sold comprises numerous items, some of which have their own lines on the M-3, like  depreciation and stock options expense, and other which do not. Among the differences reported on  this line are those relating to differences in inventory accounting.

This line includes any difference between the amount of foreign dividends that corporations report on  their tax returns and the amounts they report in their financial statements, unless those dividends  have already been taxed by the United States.

This line relates to differences between the book and tax treatment of any interest owned by the filer  or a member of the U.S. consolidated tax group that is treated as an investment in a partnership for  U.S. income tax purposes (other than an interest in a disregarded entity).

This line relates to differences between the treatment of income and losses from equity investments  under financial statement rules and tax accounting rules .

See description relating to income statement disposition of assets.

Section 902 of the Internal Revenue Code (IRC) permits a U.S. corporation that owns at least 10  percent of the voting stock of a foreign corporation to take an indirect credit for foreign income taxes  associated with dividends that it receives from that foreign corporation. Section 78 of the IRC  requires U.S. corporations electing to claim the foreign tax credit to gross up (i.e., increase) their  dividend income by the amount of creditable foreign income taxes associated with the dividends they  received.

This line covers differences in the book and tax reporting of capital gains, other than those arising  from partnerships and other pass-through entities.

One reason for differences on this line is that certain amounts that are treated as tax deductions for  tax purposes are treated as some other form of expense for financial accounting purposes, or vice  versa.

For tax purposes a firm depreciates its assets using the modified accelerated cost recovery system  method, which allows the write-off of an asset at a much faster rate than straight-line depreciation,  the most commonly used method for financial accounting purposes.

This category covers differences in book and tax amortization rules for items other than those relating  to goodwill or acquisition, reorganization and start-up costs.

Under Generally Accepted Accounting Principles, firms are required to estimate the proportion of  sales that will ultimately become uncollectible and expense this amount in the same period as the  recognition of the sale in revenue. In contrast, for tax purposes firms must wait until a specific  receivable is known to be uncollectible before it can be deducted.

Description  Prior to 2002, goodwill was amortized over a maximum of 40 years for book purposes; after 2001  financial accounting changed to the impairment method, whereby goodwill is only written down if it is  judged by management and auditors to be impaired. For tax purposes, goodwill was not deductible  prior to 1994; since 1994 goodwill must be amortized over 15 years. These differences between book  and tax treatments can be either temporary or permanent.

This line covers all expenses attributable to any pension plans, profit-sharing plans, or any other  retirement plans.

A stock option expense generally is recorded in a financial statement as the estimated fair value of  the option over the period of time that the stock option vests. The exercise of the stock option does  not affect the corporation’s net book income. In contrast, the IRC recognizes two types of stock  options—qualified and nonqualified stock options. Firms cannot take deductions for qualified stock  options (unless the stock is held for less than 2 years), although recipients get special beneficial tax  treatment. For nonqualified stock options, the firm granting the option can deduct the fair market  value when the recipient has an unrestricted right to the property and the fair market value can be  reasonably ascertained.

This line shows the difference between the amounts of foreign income taxes that corporations report  as expenses in their financial statements and the amounts that they claim as deductions for tax  purposes. U.S. corporations typically claim foreign tax credits, rather than deductions, for most of the  foreign income taxes they pay. Consequently, the book tax expenses typically far exceed the tax  deductions.

Examples of the types of compensation that taxpayers are required to report on this line are  payments attributable to employee stock purchase plans, phantom stock options, phantom stock  units, stock warrants, stock appreciation rights, and restricted stock, regardless of whether such  payments are made to employees or non-employees, or as payment for property or compensation for  services.

section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact

section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, James Wozny (Assistant  Director), Elizabeth Fan, Robert MacKay, Donna Miller, Karen O’Conor,  Max Sawicky, and Andrew J. Stephens made key contributions to this  report.


Question-summary annotations: questions: question: What is the difference between effective tax rates and statutory rates?
answer: Effective tax rates (ETR) differ from statutory tax rates in that they attempt to measure taxes paid as a proportion of economic income, while statutory rates indicate the amount of tax liability (before any credits) relative to taxable income, which is defined by tax law and reflects tax benefits and subsidies built into the law.
child_questions: question: How do researchers estimate ETRs?
answer: Lacking access to detailed data from tax returns, most researchers have estimated ETRs based on data from financial statements.

question: What is a common measure of tax liability?
answer: A common measure of tax liability used in past estimates has been the current tax expense--either federal only or worldwide (which comprises federal, foreign, and U.S. state and local income taxes).

question: What is a common measure of income?
answer: The most common measure of income for these estimates has been some variant of pretax net book income.

question: How has GAO compared tax expenses with tax returns?
answer: GAO was able to compare book tax expenses to tax liabilities actually reported on corporate income tax returns.

questions: question: Why has GAO assessed corporate income tax?
answer: Given the difficult budget choices Congress faces and its need to know corporations' share of the overall tax burden, GAO was asked to assess the extent to which corporations are paying U.S. corporate income tax.
child_questions: question: What does GAO address in its report?
answer: In this report, among other things, GAO (1) defines average corporate ETR and describes the common methods and data used to estimate this rate and (2) estimates average ETRs based on financial statement reporting and tax reporting.

question: What was GAO's methodology for the report?
answer: To conduct this work, GAO reviewed economic and accounting literature, analyzed income and expense data that large corporations report on the Schedules M-3 that they file with Internal Revenue Service (IRS), and interviewed IRS officials.