Imagining a World with a (Mostly) GAAP-Based Income Tax

Part II of II

This is the second of a two-part article (read Part I) related to the proposed (mostly) GAAP-based income tax in the (perhaps fatally wounded) Build Back Better Act. While the Build Back Better Act may be dead, the GAAP-based income tax is a polarizing concept that may be resurrected soon. The first part focused on why there is a push by some—and pushback by others—on such a tax. The second part imagines some changes that may occur in a world where big companies pay taxes based (mostly) on GAAP income. Here, the author envisions many items that could change in a world where big companies must pay income taxes in large part based on their GAAP-based income. This article focuses on a few potential changes that (a) are large enough to matter and (b) potentially plausible enough to become effective. While the author is not a GAAP expert, here, he only identifies the types of changes that could come as a thought exercise.

This is the second of a two-part article related to the proposed (mostly) GAAP-based income tax in the (perhaps fatally wounded) Build Back Better Act. While the Build Back Better Act may be dead, the GAAP-based income tax is a polarizing concept that may be resurrected soon. The first part focuses on why there is a push by some—and pushback by others—on such a tax. The second part imagines some changes that may occur in a world where big companies pay taxes based (mostly) on GAAP income.

Introduction

There are probably many items that could change in a world where big companies must pay income taxes in large part based on their GAAP-based income. This article focuses on a few potential changes that (a) are large enough to matter and (b) potentially plausible enough to become effective. I am not a GAAP expert and am only identifying these types of changes as a thought exercise.

Potential Change #1: Depreciation

Depreciation is a great example for why there can be a legitimate difference between GAAP financial reporting and tax purposes. On the one hand, expenses should be recognized over time to match the life of the asset. GAAP financial reporting uses this matching principle. On the other hand, deferring the recognition of previously spent money over many years reduces the present value of the tax deduction. It is not logical to penalize long term investments relative to short term investments, which is why the tax code allows accelerated or bonus depreciation to mitigate this effect. Thus, it is very logical for depreciation to be faster for tax than GAAP financial reporting purposes.

Perhaps there will come a time when companies simply use tax depreciation in GAAP. It would be reasonably easy to explain to investors and counterparties why such a switch was made. Simply put, ‘cash is king’ so changes that increase cash flows (e.g., larger tax deductions) are easy to follow.

As a practical matter, there might not be a large reduction in relevant information if companies made this switch for two reasons. First, many users of financial statements already ignore depreciation because they focus on EBITDA, which excludes depreciation. Second, a sizable subset of analysts who do not ignore depreciation already focus on tax depreciation because it is the form that matters for cash flow purposes.

Alternatively, there may come a time when companies use ‘tax’ depreciation in their official GAAP-based financial statements and ‘old GAAP’ depreciation in non-GAAP measures. On the one hand, this approach seems highly cynical as companies get the best of both worlds: use higher tax depreciation to pay lower taxes while still preserving the ability to communicate profits based on lower ‘old GAAP’ depreciation. On the other hand, it is hard to credibly argue that such non-GAAP reporting is baseless because it was previously the standard for GAAP reporting purposes.

Potential Change #2: Employee Stock Options

Differences in accounting for employee stock options is a big reason why some companies report significantly higher pre-tax earnings for GAAP reporting than they do for tax reporting purposes in some years.

• Employee stock options are valued (a) on a forward-looking basis (b) when issued for GAAP reporting purposes. For example, the option to purchase 1,000 shares five years in the future may be worth $3,500 using a forward-looking option pricing model. There is logic to this accounting treatment because it reflects the expected value at the time the options were granted, which is consistent with GAAP’s matching principle.
• Employee stock options are valued (a) on a backward-looking basis (b) when exercised for tax purposes. For example, the actual proceeds from exercising the option to purchase 1,000 shares five years in the future may turn out to be $10,000 with the benefit of hindsight. There is logic to this accounting treatment for companies too because it is consistent with how the employee who exercised the option is taxed.
• This inconsistency at the company level has two clear results. First, expenses are incurred sooner for GAAP reporting purposes (when issued) than tax purposes (when exercised). Second, expenses will (on average) be larger for tax reporting than GAAP purposes due to cost of capital considerations.[1] The expenses can be much higher (or lower) for tax purposes if the stock performs substantially better (or worse) than expected.[2]

This inconsistency between GAAP and tax books turns into a Rorschach test:

• Some will see these companies as being hypocrites. Companies have a “heads I win, tails you lose” perspective as they report lower expenses for GAAP reporting purposes and higher expenses for tax purposes. This is a key talking point for proponents of the CPMT.
• Others will see the proponents of the CPMT as hypocrites. Proponents of the CPMT also have a “heads I win, tails you lose” perspective as the U.S. treasury gets tax income from recipients at the typically higher ‘when exercised’ value, yet it would make companies use the typically lower ‘when issued’ value as the tax deduction in the AMT calculation. (This may be a hypocrite-squared situation because the U.S. treasury is already a net winner of this situation that uses ‘when exercised’ as the basis for taxing recipients and providing deductions for issuers because personal tax rates are typically higher than corporate tax rates.)    
• A third group may think this is too complicated and that the same methodology should be used for all purposes. This view may have surface logic, but it opens the door to new problems. For example, recipients of employee stock options would have to pay income taxes without having the cash from exercising the option if they are taxed on the when issued date.

A pragmatic solution for companies may be for them to use the ‘when exercised’ value in their financial statements and the ‘when issued’ value when discussing Adjusted EBITDA within management’s discussion and analysis. This approach would reduce companies’ taxable income within the CPMT while still providing the same information they used to provide to their stakeholders. I am not a GAAP expert and cannot comment on the probability that such a change would be allowed for (a) GAAP and (b) non-GAAP reporting. However, if a change is made for GAAP to harmonize with tax, it may be logical to also allow companies to report on a methodology that they previously could use within their non-GAAP disclosures.

Potential Change #3: Intangible Assets

There can be all sorts of issues when considering intangible assets. I will attempt to address a few of them.

On one level, amortization of intangible assets is like depreciation of fixed assets. Companies want to amortize intangible assets as slowly as possible (or not at all) for GAAP purposes and as quickly as possible (upon acquisition if possible) for tax purposes.

However, intangible assets turn the tax vs. GAAP issue up several notches.

• First, a fixed asset (e.g., a building) clearly depreciates over time but some intangible assets (e.g., a trade name) may not lose much, if any, economic value over time. It is for this reason that some intangible assets are not amortized but are instead tested for impairment under GAAP.
• Second, there is a strong temptation to assign as low an estimated useful life as possible to intangible assets for tax purposes. Recognizing this concept, the tax code assigns a 15-year life to many types of intangible assets.
• Third, some intangible assets (and their related expenses) are not recognized for tax purposes due to the form in which whey were acquired (e.g., stock vs. asset purchase).

Thus, there would appear to be ample room to use intangible assets as a tool to reduce reported GAAP (and thus taxable) income under the CPMT. Examples include:

• An easy way to reduce pre-tax income is to report an (large) impairment of intangible assets. Of course, such an impairment would have to be supportable and would communicate negative information to users of the company’s financial statements. In some instances, the negative information may already be known (e.g., certain companies that trade below book value of equity) so the impairment should have been taken regardless of tax motivations. In other instances, companies may try to thread a needle by arguing the existing intangibles declined in value, but unrecorded intangibles increased in value.
• Accelerate amortization. Like the discussion regarding fixed assets, it might be logical to harmonize GAAP and tax if companies had to pay income tax based on GAAP income.
• Bring back 1990s-style in process research and development (IPR&D). What is old would become new again with this concept. Some technology companies in the 1990s would allocate a substantial portion of the purchase price to IPR&D and then expense this amount. For example, if a company paid $1 billion for a company that was 50% IPR&D, the company would only account for $500 million of assets because it would report a $500 million expense on the acquisition date. 1990s-style IPR&D accounting was based on the tension between purchase price accounting (capitalize acquired assets) and research and development accounting (expense R&D). This tension was addressed by sort of doing both: identify the value that would be capitalized (the $500 million in the example above), but then expense it. Companies liked this concept because it reduced amortization going forward while the large expense at acquisition was explained away as a one-time cost that was not really a cost. Thus, IPR&D was essentially a ‘free lunch’ from a buyer’s accounting perspective.

1990s-style IPR&D could be a renewable source of instant impairments. Losses could be manufactured when needed to reduce taxable income. Of course, some (perhaps many) would not like such an outcome because it would revert to practices that fell out of favor.

Conclusion

There may be many other items that change in a world where big companies pay taxes based on their GAAP income. The only limitation is one’s imagination (and the word count maximum that a publisher sets).

Note that this article contains the author’s opinions, which are not the opinions of the author’s employer.

 

[1] A stock that is worth $100 on the issue date is expected to be worth $110 in one year if the cost of capital is 10% ($100 * 1.10¹ = $110) and $161 in five years if the cost of capital is 10% ($100 * 1.10⁵ = $161). Thus, the nominal value of the stock—while using the same present value—is very different if valued at the issue date (e.g., $100) or a subsequent date (e.g., $161 five years after the issue date) in this example.

[2] As discussed in the prior footnote, there is no difference in present value if the stock is valued at $100 on the issue date or $161 five years after the issue date if the cost of capital is 10% (and no dividends were paid over this five-year period). Of course, there is a difference in present value if the stock is worth more or less than $161 five years after the issue date. For example, if the stock price turns out to be $200 five years after the issue date, $61 of the increase is cost of capital-related whereas the remaining $39 is due to the stock performing better than expected.

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Michael Vitti, CFA, joined Kroll(formerly Duff & Phelps) in 2005. Mr. Vitti is a Managing Director in the Morristown, NJ office and is a member of the Expert Services practice. He focuses on issues related to valuation and credit analyses across a variety of contested matters.

Mr. Vitti can be contacted at (973) 775-8250 or by e-mail to michael.vitti@kroll.com.