20 Dec 2006  Views on News

Investors Hurt by Dual-Track Tax Reporting

What corporations report in profit to the IRS and what they report to shareholders are often two different numbers—sometimes wildly so. That's why the IRS and Securities and Exchange Commission are proposing that companies publicly report taxes paid—and Professor Mihir Desai thinks this is only a first step. Key concepts include:

  • Corporations are allowed to report different profit figures to capital markets and to tax authorities, creating large, unexplained gaps that potentially confuse investors.
  • The IRS and SEC have jointly called for a simple but controversial proposal: Companies would be required to disclose how much they pay in taxes, an amount not now decipherable from public filings.
  • More ambitious alternatives should be considered, including making corporate tax returns public, an end to the dual-book system, and a lower corporate tax rate on profits reported to capital markets.

 

Since when do the taxman and the shareholder agree? IRS Commissioner Mark Everson and SEC Chairman Christopher Cox (HBS MBA '76) have advanced a simple, but controversial proposal. Companies would be required to disclose how much they pay in taxes—an amount, remarkably enough, impossible to decipher from public filings. Their proposal, which will likely meet fierce opposition from accountants, lawyers, and managers, is a laudable first step in restoring sanity to U.S. corporate profit reporting.

When the corporate tax was introduced, making the reporting of profits more credible was a central goal. Profits reported to tax authorities and to capital markets were essentially the same. Over time, well-considered exceptions—expensing of investments, for example—were introduced to advance policy goals such as stimulating investment.

In the last decade, the two reporting systems diverged into parallel universes. Large, unexplained gaps—more than $100 billion—have developed between the profits reported to capital markets and to tax authorities. These discrepancies can no longer be explained by accepted differences between the two reporting systems.

We shouldn't be surprised by these developments. Imagine if you were allowed to represent your income on your tax forms and on your mortgage application differently. In a moment of weakness, you might portray your economic situation in two distinct ways.

Unlike individuals, American corporations find themselves in the curious situation of being able to characterize their income separately depending on the audience. Something as simple as interest expense can be engineered to be an expense for tax authorities and a dividend for capital markets.

Investors on the short end

This confusing state of affairs has naturally drawn the attention of the IRS, given the loss of tax revenues, but why is the SEC interested? First, this dual-reporting system creates significant confusion. In effect, one-third of costs (the tax claim on pretax profits) is not reported clearly to investors. Second, lower taxes are thought to benefit investors but this logic overlooks the fact that managers don't always do the right thing for shareholders. If managers are opportunistic, then the extra latitude provided by the dual-reporting system can be costly to investors.

Imagine if you were allowed to represent your income on your tax forms and on your mortgage application differently.

Indeed, research shows just that: Corporate tax avoidance is not valued by the market unless the firms are well-governed. The actors in various corporate scandals, including Enron, Tyco, and Parmalat, were expert in exploiting the dual-tax system to manufacture accounting earnings. Corporate tax shelters that reduce book income are rarely, if ever, undertaken, and the main benefit of many shelters is the book income they produce.

The proposal to publicly report taxes paid is an eminently sensible idea. More ambitious alternatives should also be considered, including making corporate tax returns public so shareholders can benefit from the additional information. More ambitiously still, the United States could junk the dual-book system and require corporations to pay taxes, at a considerably lower rate, on profits reported to capital markets. Such a change would save the considerable resources now dedicated to dual-reporting system compliance and allow for a lower marginal rate. Rough estimates are that a 15 percent tax on reported GAAP profits would be revenue-neutral for the government. A tax with a lower rate on a more sensible base is a central lesson of economics. Legislators would also be restricted to changes in rates as opposed to tinkering through myriad preferences.

Publicly reporting taxes paid is a sensible first step in restoring some sanity to these parallel universes. With luck, these strange bedfellows will be productive ones as well.

About the author

Mihir Desai is the Rock Center Associate Professor in the Finance and Entrepreneurial Management units and the MBA Class of 1961 Fellow at Harvard Business School.

Reprinted with permission from "Strange Bedfellows," HBS Alumni Bulletin, Vol. 82, No. 3, September 2006.