At Firms, Dual Profit Pictures; The Gap Grows Between What's Earned, What's Taxed

Jonathan Weisman
Washington Post Staff Writer
1,609 words
10 October 2002
The Washington Post
FINAL
A01
English
Copyright 2002, The Washington Post Co. All Rights Reserved

Two years ago, International Business Machines Corp. reported to its shareholders a healthy pretax profit of nearly $5.7 billion, but to Uncle Sam, the high-tech giant painted a decidedly different picture. At roughly $546 million, Big Blue's taxable profit that year was a shadow of the gaudy earnings on display in its annual report, according to the Institute on Taxation and Economic Policy.

The discrepancy is not unique to IBM. The gap between the profits that companies show their shareholders and their income subject to federal taxation has been widening steadily for a decade. Now, at a time of burgeoning corporate scandals, a growing federal budget deficit and new security demands on federal tax dollars, the phenomenon is attracting new scrutiny from the Internal Revenue Service, the Treasury Department and Congress.

"When investors hear only of rosy earnings while at tax time Uncle Sam only hears of regrets and red ink, something is very wrong," said Rep. Lloyd Doggett (D-Tex.), who has drafted legislation requiring companies to disclose and explain the gap between booked and taxable income. "A corporate culture of creative accounting and reporting abuses weakens our economy, allows some to dodge paying their fair share of our national security needs, and increases the taxes paid by honest Americans."

Sen. Charles E. Grassley (R-Iowa) sent a letter to President Bush on Monday urging him to consider mandating such disclosures, after he said he received mixed signals from Treasury Secretary Paul H. O'Neill and Securities and Exchange Commission Chairman Harvey L. Pitt on whether more disclosure is warranted.

"We're asking the president to take the split out of the personality," Grassley said.

And the Treasury Department is considering ways to make now-private corporate tax returns more public.

The gap began growing in the 1990s. By 1998, according to newly released Internal Revenue Service data, the gulf between booked and taxable income had grown to $159 billion, up 72 percent from the $92.5 billion gap reported just two years earlier.

And the trend appears to be continuing two years after the boom went bust. The Congressional Budget Office says the amount of federal income taxes that corporations paid on a dollar of income claimed on their balance sheets dropped 18 percent in just the past 12 months. In the fiscal year that ended Sept. 30, companies paid 20 cents in federal taxes on a dollar of "book income," compared with nearly 25 cents paid the year before.

Meanwhile, the share of federal taxes paid by corporations has fallen every year since 1996. By 2001, corporate income taxes made up just 8.7 percent of the government's total tax take, down from 12.6 percent in 1996. Once they are tallied, individual income tax receipts for the 2002 fiscal year are expected to have fallen nearly 13 percent from the previous fiscal year, according to CBO. But corporate income taxes will have fallen 29.3 percent.

What has caused the gap, and whether it even represents a problem to be solved, have become subjects of fierce debate in academic and tax circles. The IRS's large to mid-size business division has assembled a research team to explain the variance. The Brookings Institution plans to focus on the issue at an academic forum next spring.

"I think the problem is significant," said Jonathan C. Talisman, an assistant Treasury secretary for tax policy during the Clinton administration, who attributes much of the gap to illegal or improper tax shelters. The government's revenue losses "run into the tens of billions if not hundreds of billions of dollars," he said.

Some tax experts contend the gap is a cyclical surge growing out of the boom years that will correct itself as economic growth slows and stock prices decline.

"From time to time, the gap narrows and widens and narrows again," said Kenneth J. Kies, a former director of Congress's Joint Committee on Taxation who now lobbies for business on tax matters. Indeed, he noted, the gap came to the attention of economists in the mid-1980s before it disappeared in 1991.

"Anyone who says he has scientific evidence that something is wrong here, I respectfully submit does not have the whole story," Kies said.

Corporations tend to dismiss the gap as an unavoidable byproduct of the need to compile earnings numbers based on two sets of rules: one set by the SEC, the other by the IRS.

"IBM is no different from other companies, in that we are required by different government and regulatory bodies to use specific accounting methods for recognition of income and expense for our financial statements to shareholders -- accounting-standards driven -- and for our corporate tax return for the IRS -- tax-law driven," said Carol J. Makovich, IBM's vice president for worldwide media relations. "Corporations don't set these regulations and guidelines; the government does."

Other tax experts say that legitimate tax deductions explain only a fraction of the gap, and that tax sheltering -- that is, manipulating corporate earnings simply to avoid taxation -- must be at play. U.S. tax courts consider any transaction that shields earnings from taxation but has no other economic benefit to be an illegitimate tax shelter. Mihir A. Desai, an assistant professor at the Harvard Business School, determined in a recent paper that more than half of the 1998 gap could not be explained by common tax deductions.

"Even if some small fraction of the gap is associated with tax sheltering, it's an enormous figure," Desai said. "It's a really disturbing trend."

An IRS economist looking into the issue says one cause of the gap is the widespread use by many large companies of "special-purpose entities" or "independent partnerships" to move debt off their balance sheets -- a practice used by Enron Corp. and one that contributed to its bankruptcy. The debt is then ignored when the company calculates its profits for its income statements, but the tax deductions the vehicles generate -- through losses and interest on loans taken out to keep them afloat -- are readily applied to the company's tax return.

If companies are routinely minimizing their taxable earnings, they may also be routinely inflating their shareholder earnings, experts say. In a letter to Pitt last week, Rep. Robert T. Matsui (D-Calif.) highlighted a new way companies may be overstating earnings.

Because corporations are permitted to report earnings based on expected rather than actual investment returns from pension-fund assets, some companies appear to be ignoring the stock market swoon. According to Matsui, one company, which he did not name, reported $4.2 billion of earnings from its pension fund for fiscal 2001, although it had actually lost $2.4 billion on those assets. Had the company used its actual results, more than $6 billion of its $7.7 billion in earnings would have disappeared, according to Matsui.

All sides of the debate do concur on the three biggest factors that pushed book income and taxable income apart over the past decade: profits from foreign subsidiaries, depreciation allowances lingering from the business investment boom of the 1990s, and the expanded use of stock options.

First, globalization and the increasing complexity of multinational corporations have allowed companies to record overseas profits on their balance sheets immediately, but until profits are brought back to the United States, they are not subject to taxation. A broad study of nearly 1,600 companies, published in the journal Tax Notes in August, found that the discrepancy between taxable and booked income was vastly larger for multinational corporations than for primarily domestic ones, and was most dramatic in the 15 largest firms examined.

"If you had a company that was primarily U.S. operations, that earned its money in the U.S. and paid this amount in taxes, it's easier to explain than for a global company like GM," agreed Mark A. Tanner, a General Motors spokesman. The bigger a company is, "the more complicated it is," he said.

Second, the late-1990s boom in investment -- especially in computers and telecommunications -- has given companies a powerful tool to lower their tax burdens, since the tax deduction for the depreciation costs of those investments can be spread over several years.

Third, companies can deduct from their income taxes the cost of stock options, once they are exercised, even though they do not have to record the issuance of stock options as a cost to their balance sheets. For high-tech companies, the tax savings from that alone can be enormous. In 2000, for instance, Microsoft Corp. booked $14 billion in profits for its shareholders but received a $731 million tax refund in large part because of options, said the University of Michigan's Michelle Hanlon, who co-authored a study of stock-option deductions with the University of Washington's Terry J. Shevlin.

"There's no question the trend is growing because of stock options," said Douglas A. Shackelford, an accounting professor at the University of North Carolina's Kenan-Flagler Business School.

But if those three issues explain much of the gap, most experts say they do not explain it all. In truth, the growing gap between profits shown to shareholders and profits shown to the IRS is something of a mystery, said George A. Plesko, a Massachusetts Institute of Technology management professor who has studied the issue for the IRS.

Says Plesko: "We know less about what is happening than people think we know."

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