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The ATA Journal of Legal Tax Research American Accounting Association
Volume 13, Issue 1 DOI: 10.2308/jltr-51088
2015
Pages 54–85
ATA Tax Policy Committee Report—
Book-Tax Differences
Debra A. Salbador, Susan E. Anderson, William A. Raabe, and Michael S. Schadewald
ABSTRACT: This monograph examines the history of selected important book-tax
differences since the inception of the income tax and the financial and tax reporting that
has evolved over time that addresses these differences. The purpose is to provide a
framework for discussion of policy issues regarding tax reporting and its relation to
financial reporting. The focus of this paper is financial and tax reporting requirements.
Because the starting point for tax reporting is financial reporting, changes in one have an
immediate impact on the other. With movement toward corporate tax reform and
continuing consideration of possible convergence with IFRS, it is important to engage in a
discussion of this relation and its impact on tax reform.
Keywords: book-tax differences; book-tax conformity; income tax reporting; financial
reporting.
INTRODUCTION
Differences between tax and financial accounting have existed since the enactment of the
current-day federal income tax in 1913. Over time, the number and complexity of these differences
have grown exponentially due to several factors, including, but not limited to, the increasing
complexity of financial instruments and transactions, the increasing use of taxation to affect public
policy, and the globalization of the economy. Further, International Financial Reporting Standards
Debra A. Salbador is an Associate Professor at Virginia Polytechnic Institute and State University, Susan E. Anderson
is a Professor at Elon University, William A. Raabe is a Professor at the University of Wisconsin–Whitewater, and
Michael S. Schadewald is an Associate Professor at the University of Wisconsin–Milwaukee.
The authors thank Ed Outslay, Ken Orbach, Andy Cuccia, Tony Curatola, Bob Gardner, Ron Worsham, the ATA
Trustees, and the ATA Tax Policy committees for their comments and support. Any errors or omissions are solely the
responsibility of the authors.
This is a monograph submitted by the ATA Tax Policy Subcommittee of the American Accounting Association.
This report has been authorized by the ATA Trustees and the ATA Tax Policy Committee. The views expressed are
those of the authors and do not reflect an official position of the American Accounting Association (AAA) or the
American Taxation Association.
Published Online: March 2015
(IFRS) have been adopted by an overwhelming number of countries around the globe while the U.S.
continues to follow U.S. Generally Accepted Accounting Principles (GAAP). As a result, even though
the two standards have not yet converged, the Financial Accounting Standards Board (FASB), which
promulgates U.S. GAAP, has been greatly influenced by IFRS in recent modifications to U.S. GAAP.
Meanwhile, the Internal Revenue Service (IRS) has continued to grapple with how best to audit firms
with numerous book-tax differences, as these differences often reflect aggressive tax reporting. All of
these factors have led to book-to-book reconciliations within multinational firms and the further
reconciliation between book and tax for tax reporting purposes, including additional tax reporting
requirements such as the Schedules M-3 and Uncertain Tax Positions (UTP) that have been
developed in recent years. At the same time, both financial regulators and government tax
administrations struggle to monitor and control potential overly aggressive reporting in both domains.
This monograph examines the history of selected important book-tax differences since the
inception of the income tax and the financial and tax reporting that has evolved over time that
addresses these differences. The purpose is to provide a framework for discussion of policy issues
regarding tax reporting and its relation to financial reporting. The focus of this paper is financial and
tax reporting requirements. Because the starting point for tax reporting is financial reporting,
changes in one have an immediate impact on the other. With movement toward corporate tax
reform and continuing consideration of possible convergence with IFRS,
1
it is important to engage
in a discussion of this relation and its impact on tax reform.
CHAPTER 1—HISTORY OF BOOK-TAX DIFFERENCES
The historical arguments for the divergence between book and taxable income can be grouped
into three categories. The first category includes situations where taxpayers receive income before
it is earned, thus creating concerns for future tax collection. While a matching principle applies for
financial reporting purposes, the government is concerned with collecting taxes when the funds are
actually received, i.e., when there is a greater wherewithal to pay (for example, prepaid rents
received). Second, the financial reporting standards require that anticipated future liabilities be
accrued as soon as they are known. However, for tax purposes, the Treasury is concerned with
allowing a deduction for liabilities that have been incurred rather than for estimated liabilities (for
example, reserves for contingencies). Third, the current income tax system, from early on, has been
used to affect public policy. The special treatment of capital gains and losses for tax purposes, to
mitigate the fact that gains and losses are actually realized over time, not just at the point of sale,
and the exemption of state and local bond interest from taxation are examples of divergence from
financial reporting practice that relate to this objective.
2
Actual tax return data show that, historically,
the largest sources of book-tax differences are consolidation differences, deferral of foreign income,
stock options, depreciation, and tax shelters (Mills and Newberry 2001;Manzon and Plesko 2002).
Accounting Methods
Initially, Congress did not recognize the problems inherent in using financial accounting
income as a base for determining a corporation’s income tax liability. The Revenue Act of 1913
(TRA 13) did not address how corporations should compute taxable income. Three years later, the
1
At this point in time, however, complete convergence is probably a long way off, except for areas such as
revenue recognition.
2
Smith and Butters (1949,12).
Salbador, Anderson, Raabe, and Schadewald 55
The ATA Journal of Legal Tax Research
Volume 13, Issue 1, 2015
Revenue Act of 1916 (TRA 16) authorized taxpayers to calculate taxable income using the same
method as for books, provided that income was clearly reflected and complied with Treasury
Regulations.
3
Treasury Decision (T.D.) 2433 interpreted this provision to permit corporations to
deduct all accruals and reserves if the tax return included accrued income and reflected ‘‘true
income.’’ If the return did not reflect ‘‘true income,’’ then the Commissioner had the right to require
that the return be made on the basis of receipts and disbursements.
4
Thus, TRA 16 marked a
recognition that book income may not always, or for all items of income and expense, be the
appropriate basis for determining taxable income.
The Revenue Act of 1918 specifically empowered the taxing authority to determine taxable
income differently from that used for financial accounting, stating as follows:
5
The net income shall be computed upon the basis of the taxpayer’s annual accounting
period in accordance with the method of accounting regularly employed in keeping the
books of such taxpayer, but if ... the method employed does not clearly reflect the
income, the Commissioner can determine income.
Book-Tax Differences Motivated by Wherewithal to Pay
Both tax and financial accounting are concerned with recording revenues as earned. However,
there are situations where the need to assure that the taxpayer will have the wherewithal to pay the
taxes due actually outweighs the need to record revenues as earned. Thus, the all-events test is
applied for tax purposes to determine when revenues are recognized. This test is met once the amount
of revenue can be determined with reasonable accuracy on the earliest of the three following dates:
6
1. When services have been provided or when title passes to goods provided, or
2. When payment is due, or
3. When payment is received.
This results in revenue being recognized at different times for book and tax purposes, particularly
in the case of prepayments. Receipts for prepaid rent and prepaid interest are explicitly required to
be included in taxable income when received, rather than when earned, as is the case for financial
reporting. Further, if prepayments are received for services, then they must be recognized
immediately for tax purposes with one exception. The recognition can be deferred to the year
following receipt unless (1) the income was earned in the year of receipt, (2) the income is
recognized for financial purposes in the year of receipt, or (3) the prepayment was for rent, interest,
insurance premiums, certain warranty and guaranty contracts, certain property transferred in
connection with the performance of services, and income not connected with a United States
business subject to withholding.
7
If prepayments are received for goods, then two methods are
allowable. The full inclusion method provides that the income be included when received. The
deferral method allows deferral of recognition until the earlier of the time when the income would
be recognized for tax purposes if an advance payment had not been received, or when the income
is recognized for financial reporting purposes.
3
Section 13(d), Revenue Act of 1916.
4
Anderson v.U.S., 269 U.S. 422, 1 USTC }155 (1926). The phrase ‘‘true Income’’ was used by the Court.
5
Section 212(b), Revenue Act of 1918.
6
Rev. Rul. 74-607, 1974-2 C.B. 149.
7
Rev. Proc. 2004-34, 2004-1 C.B. 991.
Salbador, Anderson, Raabe, and Schadewald 56
The ATA Journal of Legal Tax Research
Volume 13, Issue 1, 2015
The House Ways and Means Committee expressed concern for the divergence between tax
and accounting income in 1954:
8
as a result of court decisions and rulings, there have developed many divergences
between the computation of income for tax purposes and income for business purposes
as computed under generally accepted accounting principles. The areas of difference are
confined almost entirely to questions of when certain types of revenue and expenses
should be taken into account in arriving at net income.
In response to this concern, Congress enacted Internal Revenue Code (IRC) §§462 and 463.
These provisions overruled the policy of the Service and the Courts disallowing deferral of income.
One year later, Congress repealed these provisions retroactively.
9
Book-Tax Differences Motivated by Economic Performance Concerns
The second category addresses the time at which a deduction is allowed. Financial accounting is
primarily concerned with matching revenues and expenses. Conversely, tax accounting seeks to
prevent taxpayers from manipulating the timing of tax deductions to receive the greatest tax reduction.
Congress enacted the economic performance requirement in 1984 to alleviate this problem (IRC Sec.
461(h)). This test is specific with respect to the liability associated with the expense.
If the liability arose from receiving goods or services from another party, then the expense is
deductible as the other party provides the goods or services. If that party hires a third party to
provide the services, and if the taxpayer pays the liability and expects performance within 3.5
months after payment, then the expense is deductible as paid. Liabilities for contingencies often fall
under this category and, thus, are not deductible until the expenses are actually incurred.
10
If the
liability arose from use of property, renting or leasing, then the expenses are deductible over the
rental or lease period. If the liability arises from providing goods or services to another party, then
the expense is deductible as that liability is satisfied. Finally, if the liability is for what is called a
payment liability, then the expense is deductible as paid. A payment liability is one for which
payment is considered equivalent to economic performance. Specific categories of payment liability
are enumerated in Reg. §1.461-4(g) and include, but are not limited to, such items as insurance,
taxes, and certain warranty and service contracts. However, if these liabilities are prepaid, as for
insurance, then the 12-month rule applies. This rule states that the expense is immediately
deductible if it creates a right or benefit that does not extend beyond 12 months or the end of the
next taxable year; otherwise, it must be capitalized and expensed over the contract period.
11
There is an exception to the economic performance rule called the recurring item exception.
12
A taxpayer can elect to deduct currently those expenses expected to persist over time, such as
utilities. This is allowable as long as economic performance occurs within a reasonable time or 8.5
months after year-end. However, all events must have occurred to establish liability and the
amount of the liability must be determinable with reasonable accuracy. Finally, the liability must be
recurring in nature and either not material or the accrual of the liability in the current year results in
8
House Ways and Means Committee Report, H. R. Rep. No. 1337, 83rd Congress, 2d Session 48.
9
See American Automobile Association, 288 U.S. 687, 61-2 USTC }9517, for a discussion.
10
IRC §461(h).
11
IRC Treas. Reg. §1.263(a)-4(f).
12
IRC Sec. 461(h)(3).
Salbador, Anderson, Raabe, and Schadewald 57
The ATA Journal of Legal Tax Research
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a better matching of the liability to the income to which it relates than would result if the liability
were accrued in the year in which economic performance occurs.
Other examples of specific tax accounting rules that result in asymmetric reporting for financial
and tax purposes are bad debts, which are only deductible as written off rather than as reserved,
13
and uniform capitalization rules, which result in the capitalization of more costs into inventories for
tax than for book purposes.
14
Congress first addressed the timing of deductions and credits in 1924, stating that deductions
and credits should be taken in the year ‘‘paid or accrued’’ or ‘‘paid or incurred’’ unless, in order to
clearly reflect income, the deductions should be taken in a different period.
15
As with the specific
tax accounting rules for income items, these rules for expense deduction often result in book-tax
differences. These rules also lead to differences in interpretation between taxpayers and the IRS.
Book-Tax Differences Motivated by Policy Issues
World War I forced the government to enact several tax provisions to raise revenue. These
changes also introduced book-tax differences more related to policy concerns than to revenue
generation that have remained in the Internal Revenue Code to the present day. In debates over the
Revenue Act of 1918, the Senate introduced an exclusion for state and local bond interest after the
House of Representatives voted to tax such interest. Some in the Senate questioned the
constitutionality of the House provision. As a result of the ongoing debate as to whether the
Constitution actually prohibited the taxation of state and local interest by the federal government and
to assure investors that the interest would not be taxed, the Conference Committee included the
exclusion in the final version of the law.
16,17
The exclusion for state and local bond interest was the
first major book-tax difference enacted due to public policy, and it has remained in the law since 1918.
Favorable treatment for dividends received predates the income tax. The Corporate Income
Tax Act of 1909 established an excise tax on corporate income, but excluded dividends received in
its calculation.
18
This provision continued under the income tax, reflecting the desire to prevent the
triple taxation of income. In 1935, President Franklin Roosevelt suggested that the dividends
received deduction be limited to 90 percent of the dividends received from domestic corporations
based on a concern that corporations were establishing affiliated corporations to avoid the
graduated income tax (Smith and Butters 1949). The result was the restricted dividends received
deduction based on the percentage of ownership. Today, the dividends received deduction is
limited to 70 percent for dividends received from less than 20 percent owned domestic
corporations, 80 percent for dividends received from 20 percent but less than 80 percent owned
domestic corporations, and 100 percent for dividends received from 80 percent or more owned
domestic corporations.
19
There are also restrictions on dividend exclusions for certain debt-
13
IRC Sec. 166(a).
14
IRC Sec. 263A.
15
Sec. 200(d), Revenue Act of 1924 (June 2, 1924), H. R. 6715, 68th Congress, 43 Stat. 253.
16
Senate Report No. 617, 65th Congress, 3d Sess. (December 6, 1918).
17
The issue of constitutional protection was finally resolved in 1988 when the U.S. Supreme Court, in South
Carolina v. Baker (485 U.S. 505 [1988]), rejected the assertion that any federal taxation of interest income
derived from state or local debt is unconstitutional because the exemption is protected by the Tenth
Amendment and the doctrine of intergovernmental tax immunity. The Court found that tax exemption is
dependent upon statute and regulation.
18
Sec. 38, Act of 1909, H. R. 1438, 61st Congress, 1st Sess., 1909.
19
IRC §243.
Salbador, Anderson, Raabe, and Schadewald 58
The ATA Journal of Legal Tax Research
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financed stock of domestic and foreign corporations, certain industries, and foreign corporations.
20
This tax treatment of dividends differs from that for financial accounting purposes. For
companies owned less than 20 percent, the full amount of the dividend is included in book income.
For those entities for which ownership is between 20 percent and 50 percent, the percent owned of
investee income is included in book income rather than the amount of dividends received. If
ownership of an entity exceeds 50 percent, then the entities are consolidated, thus eliminating the
dividend from book income.
Consolidation of Foreign Subsidiaries
Since 1932, the earnings of foreign corporations owned by a U.S. corporation have not been
included in the U.S. consolidated tax return.
21
In general, a foreign corporation’s earnings are not
subject to U.S. taxation until paid as dividends to U.S. shareholders (this is generally referred to as
‘‘deferral’’). However, these foreign earnings are generally included in multinationals’ financial
accounting income in the year earned. In 1962, the Kennedy Administration proposed restricting
deferral to reduce outflows of U.S. capital. However, Congress was concerned about the potential
negative effect on U.S. multinationals’ competitiveness. Congress and the Administration
compromised by enacting Subpart F,
22
which was directed at taxpayers who used deferral to
accumulate funds in tax havens (Witte 1985). In general, deferral is only allowable for income from
active businesses; however, in recent years, these deferral provisions, along with the corporate tax
rate, have come under fire, again for encouraging migration of capital away from the U.S. and
putting U.S. companies at a competitive disadvantage in the global marketplace. These rules have
led to various temporary and permanent differences between tax and book, some of which have
been addressed through increased book and tax disclosures in recent years, as will be discussed
later.
Capital Losses
The tax treatment of capital losses is dictated by the federal government’s desire to avoid
large variations in tax revenue from year to year. Corporate capital gains were initially treated as
ordinary income until the Revenue Act of 1932. Likewise, capital losses were deductible in full.
Beginning in 1932, capital losses were only deductible to the extent of capital gains due to the
revenue losses created by the 1929 stock market crash.
23
This provision was quickly revised,
however. In 1934, capital losses were allowed to the extent of capital gains plus $2,000.
24
This
treatment continued until the Revenue Act of 1942 introduced a five-year carryover for net capital
losses in lieu of the allowance of $2,000 of capital losses in excess of capital gains. Under current
law, a net capital loss is carried back three years and forward five years.
25
Conversely, for financial
accounting, there is no limitation on recognition of capital losses as incurred.
20
IRC §§243–246A.
21
Revenue Act of 1932, §141(e). Consolidated returns were first permitted under the Revenue Act of 1918, which
allowed consolidation with foreign entities if a majority of its voting stock was owned by a domestic corporation
or resident taxpayer(s) (Sec. 240(c)). The ownership requirement was changed to 95 percent in 1924, whether
the company was organized in the U.S. or not (Secs. 240(c) and (d) of the Revenue Act of 1924). The 1932
committee reports contain no explanation for excluding foreign corporations from consolidations.
22
IRC §§951–965.
23
Section 23(r), Revenue Act of 1932.
24
Section 117(d) of the 1934, 1936, and 1938 Revenue Acts.
25
IRC §1212(a).
Salbador, Anderson, Raabe, and Schadewald 59
The ATA Journal of Legal Tax Research
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Depreciation
Although today, tax depreciation is used as an economic policy tool, this was not the case in
the early days of the income tax. TRA 13 allowed depreciation deductions, but there was little
uniformity in practice. Since depreciation deductions were permitted in the computation of the pre-
1913 corporate excise tax, the Department of the Treasury had published depreciation guidelines
in 1909. The Bureau of Internal Revenue revised these guidelines in 1931. While not mandatory,
these guidelines represented depreciable lives under normal business conditions (Smith and
Butters 1949). During the late 1950s and early 1960s, Congress began using the depreciation
provisions to stimulate the economy by reducing asset lives for tax purposes. Further, in 1958,
Congress enacted the predecessor to Section 179 expensing. Then, in 1962, the IRS first
established arbitrary lives for large groups of diverse assets via the class life system.
26
The asset
depreciation range (ADR) classification, included in the Revenue Act of 1971, further increased the
disparities between book and tax depreciation.
As part of the general change in attitudes toward taxation ushered in by the Reagan
Administration, the Economic Recovery Tax Act of 1981 created the Accelerated Cost Recovery
System (ACRS),
27
again significantly reducing asset lives. The 1980s brought multiple revisions to
depreciable lives for taxation, culminating in the enactment of the Modified Accelerated Cost
Recovery System (MACRS)
28
in 1986. In recent years, in response to the economic downturns of
the early 2000s and again in 2008 to 2010, Congress has enacted temporary 50 percent and 100
percent immediate expensing provisions in an attempt to spur economic activity.
29
In contrast, for financial accounting purposes, GAAP allows the use of straight-line, units of
production, or accelerated methods of depreciation. Expected useful lives and salvage values are
often arbitrary in that they are not specifically related to the manner in which assets are used up
and/or decline in value over time. The methods and useful lives often differ from those mandated
Salbador, Anderson, Raabe, and Schadewald 60
