Last Corporate Tax Provision Standing: The Corporate Minimum Tax

This blog briefly describes the book corporate minimum tax in the proposed reconciliation deal, explains how implementation challenges are manageable, and considers the proposal’s impact on financial statements.

By Chye-Ching Huang, Peter Richman, and Sophia Yan

Part of the reconciliation deal struck by Senators Manchin and Schumer in the proposed Inflation Reduction Act of 2022 is the so-called book corporate minimum tax imposed on the largest corporations operating in the US (the CMT). Briefly, this is what it entails:

• Why? The basic goal of the CMT is to ensure that, if a large corporation reports profits on its financial statement but reports low or no income to the IRS, it must pay some amount of tax on the difference.
• Who? The CMT would generally apply only to corporations reporting average annual income over $1 billion on their financial statements. Foreign-parented groups would be subject to the tax as long as they have at least $100 million of financial statement income from US operations. The Joint Committee on Taxation estimates that the CMT would affect only about 150 companies annually.
• What? The CMT would generally apply a 15% tax on the income reported on a corporation’s financial statement to the extent it exceeds its tax on the income reported under normal tax rules.
• How? The CMT operates in the occasionally murky space created by so-called “book-tax differences” — that is, items that are treated differently for financial statement (book) accounting and tax returns, such as depreciation and equity compensation. However, the CMT would not impair the value of general business credits (such as those for renewable energy, low income housing, and microchips). And some timing differences would be addressed by the ability to carry forward financial statement losses and a credit for CMT paid in prior years.
• How much? The CMT would raise an estimated $313 billion over ten years.

President Biden proposed a minimum tax based on book income during his presidential campaign. The concept was further developed in the Biden Administration’s “Green Book” budget proposals for fiscal year 2022 and a bill from Senators Warren, King, and Wyden. On November 19, 2021, the House passed a reconciliation package that included a minimum tax based on a corporation’s book income, and the CMT released earlier this week largely follows that text.

The proposal would raise revenues in a progressive manner to support worthwhile investments, as part of a package that would lower the costs of health insurance and prescription drugs for millions of people, fund investments in clean energy, adequately resource the IRS, and reduce the deficit. While there may be better ways to raise corporate tax revenue, those alternatives did not survive (or even enter into) protracted reconciliation negotiations. Given the political constraints, the CMT is a sound compromise and a step forward, despite its imperfections.

If the CMT is enacted, the public debate will surely shift to a more fine-grained assessment of these imperfections. This post addresses two criticisms that appear likely to rise to the surface. First, the complexity of the CMT presents real implementation challenges avoided by simpler revenue raising proposals (such as increasing the corporate tax rate). But as explained more below, there are precedents to learn from and a clear path forward to implementing the CMT on the timeline prescribed by the reconciliation bill. Second, critics of the CMT have noted its potential effect on financial statements. However, this influence could be a positive attribute of the CMT, and should be considered carefully during implementation.

Precedents for implementation

Some criticisms of the CMT have characterized it as a novel outlier, but using book accounting to compute corporate tax would not make the US unique. In fact, the world is heading further in that direction:

• Many other countries — including the United Kingdom, France, Germany, and Austria — use financial accounts as a starting point to calculate corporate taxes. Several have already implemented minimum taxes that are based at least in part on book income.
• Key parts of the Inclusive Framework deal (the IF deal), a joint effort of more than 130 countries and jurisdictions, including the US, committed to modernize a century-old framework, will drive off book accounting. Under Pillar One of the IF deal, “[t]he relevant measure of profit or loss of the in-scope [multinational enterprise] will be determined by reference to financial accounting income, with a small number of adjustments.” Pillar Two will use financial accounting income as the tax base for the top-up tax. While the US will not implement Pillar Two in this reconciliation deal, if other countries move ahead, large US multinationals will face tax regimes in foreign countries that drive off financial accounting.

Although the implementation challenges of the IF deal should not be discounted, the fact is that more than 130 countries have agreed that modernization of the global corporate tax framework should use an architecture that drives off financial statement income, and the process of grappling with implementation and compliance challenges under that agreement is well underway as countries move towards implementation.

Furthermore, the US has its own experiences to draw from:

• The Tax Reform Act of 1986 enacted the Business Untaxed Reported Profits (BURP) rules for tax years beginning in 1987 through 1989. The BURP rules adjusted the amount of a corporation’s income subject to the AMT based on the difference between adjusted pre-tax book income and the otherwise computed AMT base. After 1989, the AMT converted to a minimum tax on a base of profits calculated without certain tax preferences, as scheduled under the 1986 Act. The text of the CMT released earlier this week borrows and updates much of the language of the BURP rules. This history offers both the government and the public an opportunity to learn from their prior experience with the BURP rules, including with the implementing regulations issued by Treasury and the IRS.
• The CMT also relies heavily on the architecture built under the 2017 “Tax Cuts and Jobs Act” (TCJA), which introduced a timing rule for the recognition of taxable income based on book accounting.

The mechanics of the CMT today will of course pose some novel challenges and questions, but the basic concept of the CMT has been around for decades. Moreover, recent efforts domestically, in foreign countries, and in the multilateral context offer many opportunities for learning and improvement.

Adequate runway for implementation

The CMT would apply to tax years beginning in 2023, but corporate tax returns for those years generally will not be due until 2024, giving Treasury and the IRS more than a year to issue guidance and prepare for those returns. By contrast, the TCJA was passed less than two weeks before 2018, and many of its provisions were effective in that year, with some even applying in 2017. And a silver lining of a dramatically stripped down tax package is that Treasury and the IRS would be able to focus much more attention on CMT guidance than after the TCJA, when their attention was pulled in many different directions.

The implementation task should not be underestimated — the bill appropriately delegates significant authority to Treasury to fill gaps, refine definitions, and otherwise translate the legislative text into an administrable regime — but this is precisely the type of task the government has been required to do many times over the last five years. The reconciliation proposal, if enacted, will also provide much needed resources to the Administration that can help ease the implementation of significant policy changes such as the CMT.

In terms of compliance, the CMT applies to only some of the largest — and most well-resourced and well-advised — companies in the world. They will be well placed to weigh in on guidance addressing any issues that should be considered in ensuring that the proposal is implemented effectively and efficiently. These companies and their advisors are also quite used to navigating complexity (and sometimes even argue for it when it benefits them).

Implications for financial statements

Critics of the CMT have also argued that it could affect financial statements and standards in a way that reduces their utility for understanding the financial situation of companies. The idea is that the CMT could create an incentive for companies to report lower book income (which would in turn lower their CMT liability), and could likewise create incentives for them to lobby the Financial Accounting Standards Board (FASB) for rules that permit them to report lower current book income. This, the critics say, would reduce the quality of financial statements and invite inappropriate politicization of FASB.

But it is uncertain whether financial statements and FASB lobbying would be affected by the CMT — or that any such effects would reduce, rather than increase, the quality of financial statements.

Some proponents of the proposal argue that such responses could in fact make financial statements more accurate, because currently, companies have incentives to inflate current book income — and to lobby FASB to enact rules that make doing so easier. (Indeed, lobbying of FASB by companies, the accounting profession, and politicians, would be nothing new. Accounting historian Stephen A. Zeff of Rice University describes FASB as “besieged by political lobbying” from its foundation in 1973.)

It’s difficult to predict the size of any such responses or assess whether they would make financial statements a better or worse description of companies’ financial profile. Some empirical studies found that companies responded to the 1986 Act’s BURP rules by reducing reported financial statement income, though later studies questioned the reliability of some of the earlier findings, arguing that they rested on methodological errors.

Even the studies that concluded the BURP rules prompted changes to financial statements did not answer the critical question of whether those changes made financial statements more or less representative of companies’ finances. It is even more difficult to predict the size of any impacts on FASB lobbying. Thus, caution seems warranted about both the most optimistic and most pessimistic views of these potential responses.

Regardless, the CMT’s potential impact on financial statements is important to think about as it raises real implementation challenges. Tax and securities regulators will need to address the possibility of attempts at tax avoidance through financial statement manipulation and pressure on standards. For example, what will happen when a financial statement is revised, and can rules be written to prevent avoidance (or abuse) through statement revisions? What happens when a financial statement is called into question by financial (rather than tax) regulators?

Whatever the answers should be, these are the types of questions that regulators are faced with routinely when implementing new law. Fortunately, there are lessons to be gleaned from other efforts that link book income with tax. Indeed, if current trends continue, those lessons may prove valuable for reasons beyond just the CMT.

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