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

Letter

Background

Corporate Income Tax

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.)

Past Studies Estimating Corporate Effective Tax Rates Used a Range of Data Sources and Methodologies for a Variety of Reasons

Alternative Corporate Effective Tax Rates Are Designed to Address Different Questions

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.

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

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.

Various Measures of Taxes and Income Have Been Used to Estimate Effective Tax Rates

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.

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

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.

The Average Effective Tax Rates Based on Book Income Are Lower When Unprofitable Corporations Are Excluded

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.

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

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.

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

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.

Agency Comments

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.

Appendix I: Summary of Selected Past Estimates of Average Effective Tax Rates Based on Financial Statement Data

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.

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

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

Appendix III: Detailed Data on Book-Tax Differences for Tax Year 2010

Book amount temporarily lower than tax amount

Appendix IV: Descriptions of Income and Expense Items with the Largest Book-Tax Differences

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.

Appendix V: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

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.