US corporate income tax reform (ii)

To summarize yesterday’s post:

firms with taxable income

Lowering the corporate tax rate in the US, while eliminating special interest tax preferences/exemptions, will benefit companies that have a high current tax rate.  It will boost such a firm’s earnings by as much as 30%.

On the other hand, companies that have a low income tax rate will receive little or no benefit.  Continuing to spend resources on what are in effect tax shelters for themselves will make no sense.  To the extent that they are able to unwind these arrangements, they will benefit by doing so.  If, however, they are recipients of special interest tax reduction deals, they may be absolute losers, as well as relative ones, if/when these special preferences are eliminated.

The greatest uncertainty here is whether industries that are recipients of large tax breaks, like real estate and oil and gas, will have their special interest preferences eliminated.  This will be a key indicator of whether the “Drain the Swamp” rhetoric is more than an empty slogan.

firms with losses

This case is not as straightforward, thanks to wrinkles in the Generally Accepted Accounting Principles used by publicly traded companies in their reports to shareholders.

for the IRS

Let’s assume a firm makes a pre-tax loss in the current year.


The company has a limited ability to use this loss to offset taxes paid in past years ( it carries the loss back).  It restates its past returns and gets a refund.

If it still has a portion of the loss that can’t be used in this way, it carries the loss forward to potentially use to shield income in future years from tax.

If the corporate income tax rate drops from 35% to 15%, the amount of pre-tax income that can be sheltered from tax by loss carryforwards remains the same.  But the value of the carryforward is reduced by 60%.

for financial reporting

That’s tomorrow’s topic.


IRS: new rules for corporate tax reporting

setting the stage–or maybe just stuff I thought was interesting

According to the Bureau of Economic Analysis in the Commerce Department, the federal government collected $1.14 trillion in income tax from individuals and $231 billion from corporations last year.  That compares with recent highs of $1.5 trillion for individuals (2006–although the highs continue pretty much through 4Q08) and $454 billion from corporations (2005).

(As a matter of general economic interest, though not important for what follows, the BEA data show that the low point for corporate income tax receipts was the fourth quarter of 2008, when taxes were being collected at a $192 billion annual rate.  That compares with inflow at a $417 billion rate for 2Q10.  For individuals, the change has been less dramatic.  The low point was 2Q09 at $1,112 billion.  Currently the annual rate is $1,136 billion.)

the new rules for corporates

Unlike individuals, corporations have to let the IRS know when they think they’re doing something on their tax returns that may not sit well with the agency.  The “something” can be any of a multitude of potential sins.  To mention just a few possibilities, it could involve transfer pricing (improperly recognizing profit in a low tax rate country rather than in the US), expensing items that should be capitalized, recording sales as capital gains other than ordinary income.

The oddity about today’s rules is that the corporation has to tell the IRS that there are items they’re not highly confident would be approved of if audited, and the dollar amount involved, but not what the items are.

According to a recent article in the New York Times about this topic,  IRS agents assigned to looking at corporate returns can spend a quarter of their time trying to locate–presumably without much success–these questionable items.  So the IRS is changing the rules.  From now on, corporates will have to file a special form, Form UTP (uncertain tax positions) that will provide the IRS with a list of the items where they may have underreported income or overstated expenses.

what’s at stake?

According to the Times, publicly traded companies in the US paid $138 billion in income tax last year (the BEA number cited above includes all corporations, including ones not publicly traded).  Those firms also reported questionable tax positions amounting to about 150% of what they paid.

We won’t really know how solid a number that is until reporting under the new rules commences.  At present, it seems to me there’s no penalty for classifying tax treatment of a particular item as questionable, since the IRS isn’t going to find it anyway.  If it’s your bad luck that the IRS does happen to stumble on your uncertain item, at least you have some private record of your honest intentions to help deflect possible accusations of tax fraud.  Now the game has changed.  By listing an item on Form UTP you call attention to it.  But if you don’t, your protestations of good intentions are going to ring hollow.  If I had to guess, mine would be that the UTP number will shrink, but not by much.

who are the biggest UTP players?

The Times points us to The Ferraro Law Firm,  a Washington, DC-based company whose specialty is representing whistleblowers who report cases of corporate tax evasion to the IRS in return for a percentage of taxes recovered.  FLF has created the Ferraro 500, a listing of the US publicly traded companies with the largest UTPs.   Until we see reporting under the new rules, we won’t know whether the firms high up on the list have the most aggressive accountants or the most conservative ones, though.

The Ferraro 500 is constructed by taking the Fortune 500, a ranking of the largest US corporations by sales, and reordering them according to who has the largest absolute amount of UTPs.  The list isn’t perfect.  For one thing, 21 members of the Fortune 500 don’t disclose UTPs.  Also, some firms end up lessening the UTP number by allocating a portion to SG&A; some don’t (see the footnote at the very end of the Ferraro 500 list).

Then, there’s the question of what metric to use in analyzing the data.  I decided, at least partly because it’s simple to do, to look at the spread between a company’s ranking in the Fortune 500 and in the Ferraro 500.  Possible firms with very aggressive tax accounting would rank low on the Fortune 500 but high on the Ferraro 500.  “Good” firms would be the opposite.

There are 20 corporations in the Fortune 500 that have no reported UTPs.  The full list is at the tail end of the Ferraro 500, but they tend to be insurance companies or firms like Southwest Airways and the Washington Post.

Generally speaking, the companies with the smallest reported UTPs relative to their size are in the consumer discretionary and staples sectors.  The ones with comparatively large amounts of UTPs tend to be public utilities, particularly energy transmission and distribution, or financial companies ex the large commercial banks.

The companies with the greatest spread between their Fortune and Ferraro rankings, meaning small sales but large UTPs, sorted by the Ferraro ranking, are:

Starwood Hotels     Ferraro  41, Fortune 438

Agilent     43, 461

Amerigroup     47, 404

Avis     69, 409

Western Union     83, 413

Broadcom     100, 460

Century Telecom     114, 423

CA     115, 482

Applied Materials     116, 421

NCR     128, 451

Blackrock     130, 441

Electronic Arts     134, 494

ElPaso     144, 447.

A significant number of the members of this list, all of whom rank 300 places or more lower on Fortune’s compilation than on the large UTP one, are technology firms.  Yahoo was very close to inclusion, as well.  I’m not sure it’s right to make industry conclusions from this sample, however, since technology firms also feature prominently among those with relatively low UTPs.

My guess is that the stock market won’t pay any near-term attention to this change in IRS rules.  I think it’s something to keep a close eye on, however. Not only could some firms have a step change down in reported earnings next year as they reassess their tax strategies, but since the IRS has three years from filing date to initiate an audit, the IRS may well use Form UTP as a roadmap for examining prior year filings as well.