By Joyce Beebe, Ph.D.
Fellow in Public Finance
President Biden signed the Inflation Reduction Act of 2022 into law last week, initiating sweeping changes to tax, climate and health care policies. The package boasts approximately $430 billion of investments and is expected to reduce the federal deficit by more than $300 billion over a decade. One of its key revenue-raising provisions is the 15% corporate minimum tax, which is projected to generate over $200 billion of tax revenue between 2022 and 2031. This blog post reviews the background, operating mechanism and different perspectives associated with implementing the corporate minimum tax.
The Corporate Minimum Tax Mechanism
The law imposes a minimum tax of 15% on the average annual adjusted financial statement income of domestic corporations if such “income” exceeds $1 billion over a three-year period. This minimum tax functions similarly to the corporate alternative minimum tax (AMT) that was repealed in the Tax Cuts and Jobs Act of 2017 (commonly known as the TCJA), meaning that in-scope companies will need to calculate their corporate tax liability under two different systems. First, companies gather information about their revenue, expenses, deductions and credits to calculate their taxable income under the 21% corporate income tax rate regime (including the base erosion and anti-abuse tax, if applicable), which is similar to all other corporate taxpayers. Second, companies apply the 15% tax rate to book income, which is what companies typically use to report earnings to shareholders. Book income is generally associated with financial statement reporting. For large publicly traded corporations, book income is used to compile an annual report filed with the Securities and Exchange Commission through Form 10-K. After figuring out tax liabilities under both calculations, companies will pay the higher of the two. For U.S. businesses with foreign parent companies, the tax would apply to income earned in the United States over $100 million if the entire multinational group has book income that exceeds $1 billion.
The biggest difference between the two systems, besides the tax rate, is the tax base. Taxable income is generally calculated in accordance with tax laws and regulations, whereas financial statement income follows accounting rules, or the generally accepted accounting principles. For a variety of policy, economic development, and other reasons, tax rules include numerous deductions, credits and incentives that reduce corporations’ tax liabilities. In the end, companies may report highly profitable results to shareholders but owe limited taxes. For instance, at the Senate Finance Committee’s request, the Joint Committee on Taxation (JCT) found that roughly 175 to 200 companies reported an average book income of $8.2 billion in 2019 but paid a book income tax of less than 15%. Within this group, 100 to 125 companies paid less than 5% but reported an average of $8.8 billion of book income.
Challenges to the Minimum Tax Implementation
This seemingly innocuous minimum tax provision appears to be a good solution: It prevents profitable companies from not paying taxes, raises revenue to reduce the federal deficit, avoids the political pressure of raising the corporate income tax rate and only affects fewer than 150 companies. However, several issues remain and require careful discussion from an implementation perspective.
First, there is a major issue the corporate minimum tax does not address: If companies have not been paying enough taxes because the tax incentives are overly generous, why not just change the tax code? Instead of subjecting companies to a complex AMT system, a proper solution should be to curtail these tax benefits instead of looping in a different tax base.
As indicated, taxable income and book income do not converge because they follow different sets of rules that serve different purposes. In addition to raising revenue, tax rules often have embedded social, economic and redistribution objectives. On the other hand, financial accounting rules are set by the Financial Accounting Standards Board (FASB), which is a private-sector, not-for-profit organization. The most important goal for financial reporting is to present a company’s operational and financial health to relevant stakeholders in a transparent, consistent manner. Using book income as a basis for tax collection will not only put stress on the integrity of financial reporting, it will also remove Congress’ ability to define the tax base.
Supporters of the minimum tax point out that, for a given company, book income is usually higher than tax income; therefore, it can be a broader measure to capture a company’s income given all the deductions and credits that offset a company’s taxable income. This was indeed the rationale used in the Tax Reform Act of 1986 when a minimum tax on book income was included as part of the corporate AMT. This measure was used as a proxy, a “catch-all adjustment” intended to capture items that were not in the AMT base but should have been included as income. However, it was designed to be temporary: A broad-based tax system, properly defined by the tax code and aligned with economic principles, replaced the book income tax in 1989.
Although the minimum tax on book income was short lived in the 1980s, studies did find that businesses adjusted their financial accounting choices to reduce their book income with the goal of lowering their taxes. As such, companies that face the 15% minimum tax under the Inflation Reduction Act may similarly change their behaviors to reduce tax liabilities. The magnitude of companies’ behavioral responses will affect the revenue the minimum tax is able to collect. And because book income now has tax consequences, companies that are subject to the minimum tax may be incentivized to influence the accounting standard-setting process. Supporters of the minimum tax argue that the FASB can still maintain its independence and ensure that financial information is not tainted by political and business pressure. Moreover, they believe that paying taxes is an element of doing business and affects a company’s bottom line; as such, it is reasonable for a company to be mindful of its tax liabilities.
An additional consideration that may affect revenue collection is that some general corporate income tax credits and deductions are still allowed under the minimum tax. For example, foreign tax credits and R&D tax credits are allowed (the latter with a 75% limit when it comes to offsetting the combined regular and minimum tax). For deductions, loss carryforwards are also permitted but capped at 80% of the taxable income, and accelerated tax depreciation was preserved as a last-minute inclusion.
Another dimension of the debate is whether the minimum tax will reduce real economic activity. Lawmakers who oppose the tax believe the law will negatively impact innovation and domestic business expansion because the tax serves as a disincentive for investment. It may also distort investment allocation because of the unevenly distributed burden across industries (discussed further below). Supporters disagree; they indicate that corporate income tax changes usually have small effects on gross domestic product, jobs and investment. As such, the negative impacts, if any, will not be significant. Some analyses show the minimum tax may impact certain industries more than others. A JCT analysis finds that manufacturing and technology companies (before the adjustment for including accelerated depreciation) will be most heavily affected. Another study shows that the most affected industries are generally the ones with the largest book-tax differences, including manufacturing, mining, agriculture and utilities. However, it is unclear whether the Inflation Reduction Act intends to target book-tax differences that are caused by temporary differences (e.g., attributable to timing differences). Some disagree that the uneven effects are particularly harmful to certain industries. They believe the manufacturing industry appears to bear most of the burden because it has been benefitting the most from the current incentives.
Finally, the 15% minimum tax still does not align the U.S. corporate income tax mechanism with the OECD’s global minimum tax, although both use a 15% rate and apply the book income idea. For instance, the threshold for in-scope companies under the OECD agreement includes business entities with €750 million or more in revenue, a much lower threshold than the U.S. minimum tax. In addition, the OECD agreement aims to stop corporate profit shifting to low-tax jurisdictions through global harmonization, with U.S. companies likely paying more taxes in foreign jurisdictions as an end result. However, the objective of U.S. Inflation Reduction Act is to increase domestic corporate tax revenue. Finally, its detailed rules — such as loss carryforward, depreciation deduction, and treatment of certain credits — are inconsistent across the two systems. All of this means that the U.S. rules do not conform to OECD agreements, but they will affect each other when it comes to calculating final tax liabilities.
Conclusion
The Inflation Reduction Act’s provisions are extensive; however, its overall impact on the economy is still uncertain. Several estimates show that, despite the name, the bill may have a limited effect on reducing inflation. Lawmakers from both parties have also already begun considering modifications to certain provisions, depending on the outcome of the upcoming midterm elections. On the one hand, Democratic congressional members want to increase the corporate income tax rate and pass additional provisions that were a part of the original Build Back Better Act but were not included in the current bill (e.g., child tax credits and Medicare and Medicaid expansion). Republican lawmakers, on the other hand, would like to repeal the tax increases and redirect IRS funds toward customer services instead of additional enforcement. However, several things are certain: Corporate income tax compliance is going to be very complex, and corporate taxpayers are going to start more carefully managing their book income. Additionally, because the tax takes effect in 2023, it is going to require a lot of heavy lifting from the Treasury Department to clarify issues through regulations and ensure proper implementation.