Everyone loves accounting, right? You have debits and credits that change the balance of assets, liabilities, and equity on the balance sheet and report cash flows and accruals on the income statement. The rules are complex. To make matters worse, the accounting rules for taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. are different than for financial accounting used to generate reports for shareholders.
Well, if that thrilling intro isn’t enough to get you excited to read the rest of this blog, maybe learning about a new accounting method included in the model rules for the global minimum tax will pique your interest.
A simple comparison of the results from tax calculations, financial accounting methods, and the global minimum tax shows that the effective tax rate results are rather different under the various approaches.
Companies calculate their tax liability according to the tax rules set by Congress, and that determines how much the company pays in taxes to the IRS each year. Then companies use financial accounting rules (also known as Generally Accepted Accounting Principles, or GAAP) to present their assets, liabilities, equity, and net income (and taxes) to their shareholders.
Because financial accounting rules require firms to report financial effects when they occur, not simply when they are paid, and because different types of income and expenses are recognized under the two systems, the tax expense reported in the financial statements will be different than the tax paid to the IRS.
Often these differences arise because tax rules allow companies to deduct expenses for investments faster than accounting rules allow. These timing differences create deferred tax assets and liabilities on financial statements.
Usually over the course of time the taxes reported to the IRS roughly equal the taxes reported to shareholders.
Currently the federal corporate tax rate in the United States is 21 percent. If you include an average of state-level corporate tax rates, the total rate is closer to 26 percent, applying both for tax and financial accounting purposes.
Deductions for expenses (like a purchase of new equipment) reduce income and thus tax liability. For example, a $100 expense will reduce income by $100 and thus reduce a company’s tax liability by $26 at a 26 percent corporate tax rate.
The higher the tax rate, the more tax savings from a given expense. The lower the tax rate, the less valuable the deduction will be.
This is where the global minimum tax model rules come into play. Even though companies will calculate their tax and accounting income using the tax rate applicable in the appropriate country, the minimum tax rules use a rate of 15 percent. (It is not clear why the domestic corporate tax rate was not used instead.)
This means a company that has income and deductions could have a 15 percent effective tax rate according to the minimum tax rules, even if it faces a higher corporate tax rate in the country that it operates. Any expenses that the minimum tax rules do not allow to be deducted or any tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s a company might be eligible for will push the company below the 15 percent rate and potentially trigger a top-up tax.
A $100 expense that might lower taxes by $26 based on the combined statutory tax rate would only lower taxes by $15 when following the global minimum tax calculations.
For example, let’s assume a company purchases a new machine for $1,500. U.S. tax rules allow that entire amount to be deducted when the machine is purchased, creating a $1,500 deduction. This generates a tax saving of $390 at a 26 percent corporate tax rate.
Accounting rules require the deductions for that machine to be split equally across the three years the machine can be used. Equal $500 deductions in three years lower tax liability by creating tax savings of $130 in each year as the company recognizes its costs. Over those three years, though, $390 in total reduced tax liability will be achieved.
This is purely a timing difference between the tax rules and the accounting rules about when a company can claim a deduction for buying the $1,500 machine.
The global minimum tax rules would turn those $500 deductions into tax savings of just $75 because of the lower tax rate of 15 percent. In total, $225 in tax savings is realized.
|Tax Value of Deductions for a $1,500 piece of equipment that lasts 3 years|
|Year 1||Year 2||Year 3||Total|
|Global Minimum Tax Value||$75||$75||$75||$225|
Source: Author’s calculations.
The implications of this can be further explored by studying a company’s effective tax rate if the company both benefits from deducting the expense associated with the $1,500 machine and is eligible for some tax credits.
If the company earns $2,000 in revenue in the same year it buys the $1,500 machine it will have $1,500 in deductions for tax purposes, and $500 in deductions both for the purposes of accounting and the global minimum tax. Deductible expenses for equipment are also known as “depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. expenses” as they are shown in Table 2.
Let’s say the company also benefits from $75 of tax credits for research and development. After accounting for the tax credits, the company will owe the IRS $55 and have a 11 percent effective tax rate. In future years, the lack of depreciation expenses will mean that the company should expect a higher effective tax rate with respect to its calculations for the IRS.
Because the accounting rules only allow a $500 deduction, the company will show a higher tax liability ($315) and effective tax rate (21 percent) on its financial statements.
The global minimum tax rules show a rather different picture. Even though the company has an effective tax rate of 21 percent using accounting rules, the effective tax rate following the global minimum tax approach is 13.7 percent.
|Tax Calculation||Accounting Calculation||Global Minimum Tax Calculation|
|Pretax Income (Revenue – Depreciation Expense)||$500||$1,500||$1,500|
|Tax Before Credits (See Note)||$130||$390||$280|
|Tax Liability (Tax Before Credits – Tax Credits)||$55||$315||$205|
|Effective Tax Rate (Tax Liability/Pretax Income)||11.0%||21.0%||13.7%|
Note: Tax Before Credits is calculated differently for each method. For the Tax Calculation, it is the Tax Rate x Pretax Income. For the Accounting Calculation, it is the Tax Before Credits for the Tax Calculation, $130, + $1,000 x the Tax Rate to account for the deferred tax expense on the $1,500 machine of which only $500 was depreciated in the first year. So, $130 + $1000 x 26% = $390. For the Global Minimum Tax Calculation, it is Tax Before Credits for the Tax Calculation, $130, + $1,000 x the Tax Rate to account for the deferred tax expense on the $1,500 machine of which only $500 was depreciated in the first year. So, $130 + $1000 x 15% = $280.
Source: Author’s calculations.
The 13.7 percent tax rate could be a problem for this company. It may mean the company will have to pay additional taxes either to the U.S. government or a foreign government. There are other complex rules that will impact the true top-up tax rate, but for now seeing how the tax rate can be below 15 percent for the purposes of the global minimum tax is important.
Using the 15 percent rate lowers the value of the deductions for investing in machinery to the point that it makes much of the $75 in tax credits essentially worthless to the company.
Similar examples would show how this impacts loss deductions and credits like the Research and Development Credit or the Work Opportunity Tax Credit.
Even though the company would benefit from certain tax credits when it files taxes to the IRS, the global minimum tax will make those credits much less valuable and expose the company to the minimum tax.
This will render many U.S. tax credits less effective at a time when policymakers are otherwise supporting business activities that would make them eligible for tax credits for research and development or clean energy investment.
Not all deductions get treated equally under the minimum tax rules. In some cases, an allowable deduction for tax and normal accounting purposes will be disallowed when calculating the minimum tax. One example is deductions for things (like a long-term lease) that take more than five years to be fully written off.
An important insight of this exercise is that the company may be at risk of paying the global minimum tax even if it reports a high tax rate to its shareholders.
One way to fix this distortion would be to allow companies to use the global minimum tax rules but apply the same tax rate used for both tax and accounting calculations. Other nuances with the global minimum tax will still likely result in a slightly different final tax rate for companies, but the distinction is likely to be smaller.
As policymakers across the world work to implement the global minimum tax, it is important to understand these results and the possibility for a company to pay taxes twice—once under normal rules and once under the global minimum tax rules—even if the company has a high effective tax rate. Double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. impacts the ability of companies to invest valuable things like improving their supply chains, developing new products, and hiring workers, and it can be fixed if the minimum tax uses a country’s own tax rate.
Errata: A prior version of this blog showed an example that did not correctly calculate the tax liability for the global minimum tax. The example has been adjusted in light of this error.