The Inflation Reduction Act imposed a 15% minimum tax based on an entity’s net income (subject to a $1 billion gross receipt threshold) presented on its financial statement. The payment of such tax (amount in excess of ordinary tax liabilities) will become tax credits. These tax credits can be carried forward to offset future regular corporate tax liabilities to the extent the tax liability is not below the minimum tax.
Under the earlier version of the minimum tax provision, the Modified Accelerated Cost Recovery System significantly increases the temporary difference in cost recovery on certain industries’ tax books and financial statements. Businesses with a higher proportion of fixed depreciable assets would likely be subject to significant tax hikes once the minimum book tax is implemented. In addition, this tax regime might potentially undermine the current administration’s policy objectives, such as affordable housing, green energy, infrastructure, increasing manufacturing competitiveness, etc. Although the final version of the tax carved out the depreciation, which allows the companies to use tax depreciation to calculate their minimum tax, it is unclear whether the government will attempt to fully or partially resurrect the earlier version of minimum tax due to policies or expenditure proposals that may require a significant increase in revenue without directly increasing the corporate tax rate. In this article, I will explain why I believe the book minimum tax is not the best revenue source.
Book Cost Recovery v. Tax Cost Recovery
Cost recovery refers to businesses’ ability to recover the cost of acquiring capital assets through depreciation over the service life of the capital assets. Although both financial and tax accounting allow straight-line and accelerated depreciation methods, there are significant differences in the rules regarding depreciation periods. As a result, the corporation will have the incentive to adopt different depreciation methods in its financial statement and tax book. The company will try to prolong the depreciation period in its book to reduce depreciation expense in the Income Statement to produce a higher net income and earnings per share. However, they will try to depreciate the asset quickly to reduce taxable income, which will decrease their tax owed.
A public company’s book depreciation is governed by Accounting Standard Codification (“ASC”) 360-10-35-1 to ASC 360-10-35-7. Under ASC 360-10-35-3 and 360-10-35-4, depreciation is calculated based on the initial capitalized amount, salvage value, and the useful life of the assets. The estimation of useful life must take into account multiple factors such as “wear and tears, obsolescence, and maintenance and replacement policies.” (ASC 360-10-35-8). In the company’s tax book, the depreciation period is governed by the Internal Revenue Code (“IRC”) Sec. 168(c) with applicable conventions under IRC. Sec. 168(d), which assigns the starting days of the depreciation period rather than using the actual date of acquisition. IRC Sec. 168(c) groups assets into separate classes and assign arbitrary cost recovery periods (details of asset classes are laid out in Revenue Procedure 87-56 and IRS Publication 946). However, ASC 360-10-35-9 disallows using the tax depreciation period if such period is not within the reasonable range of the asset’s useful life under the Generally Accepted Accounting Principle (“GAAP”). For example, if a corporation purchases machinery, which could last two years, for manufacturing products, the corporation likely will deprecate the machinery for two years. However, machinery is a five-year property under the tax rule. GAAP likely will disallow the corporation to use the five-year deprecation period for financial reporting purposes because it may artificially inflate the corporation’s annual net income (profit) and mislead investors and creditors who rely on the financial statement to make investment and loan decisions.
Moreover, IRC Sec. 168(k), which is to phase out between 2023 and 2026, allows corporations to potentially depreciate 100% of the cost of the assets in the first year of acquisition, and Sec. 179 allows business to take immediate deduction (not an accelerated depreciation) of up to $1,080,000 related to the acquisition costs of depreciable business assets. Although the current minimum tax provision allows the company to use tax depreciation to calculate minimum tax, Sec. 179, which is applied before bonus depreciation, could still generate significant temporary differences for companies carrying a large number of depreciable personal property.
Early Version of The Book Minimum Tax Should Never Be Resurrected
The enacted book minimum tax, even with the depreciation carve out, would already hinder investment and economic growth. Bringing back the earlier version, which does not carve out tax depreciation in calculating minimum tax, would not only further undercut the growth opportunities and kill employment opportunities but may also, under certain circumstances, defeat the revenue-raising objective. The tax accelerated depreciation will generate the highest deduction in the earlier years after the investment. Suppose the business is expected to be subject to ordinary income tax when it invests in depreciable assets and to shift to book tax a few years later. In that case, there is a chance that the most beneficial accelerated deductions are taken when the business is subject to a higher 21% regular corporate rate, and when the business shift to the 15% book minimum tax, the tax depreciation is already below the book depreciation, resulting in more profits being subject to a lower 15% rate, which reduces the business’s overall effective tax rate. Moreover, under such circumstances, the assets may have already been fully depreciated on the tax schedule but continue to depreciate on the company’s book due to a longer useful life estimation under GAAP. As a result, the company may have the opportunity to over-depreciate the same asset and further reduce its effective tax rate.
Book Minimum Tax may hinder Critical Investments
President Biden campaigned on achieving net zero by no later than 2050 by investing in building “new American infrastructure”. He also pledged to ease the burden of housing costs for American people by deploying “new financing mechanisms to build and preserve more housing” and “work with the private sector to address supply chain challenges and improve building techniques to finish construction in 2022 on the most new homes in any year since 2006.” In October, the president released his Strategy To Strengthen Health Security and Prepare for Biothreats, which requires significant investment in strengthening the current medical research facilities to improve the capabilities of early detection, prevention, and recovery. None of the president’s objectives can be achieved without working with the private sector.
However, the book minimum tax probably will disproportionately affect industries that are quintessential to achieving the administration’s campaign promises and policy objectives. For example, the rental and leasing sector will likely bear the most significant tax hike. In addition, companies in construction, utilities, gasoline, natural gas, healthcare, medical equipment, and pharmaceutical products will all bear the costs of the tax hike due to their large holding of depreciable equipment and machinery. In light of the energy crisis, housing crisis, and record-high inflation, adding tax burden to the companies in the industries mentioned above likely will not improve the costs of living of the American people because the added costs of the company will only shift to the consumers and worsen the already-high inflation.
The logic behind the accelerated cost recovery system and Sec. 179 immediate deduction allowed by the internal revenue code is to encourage the private sector to invest in their business, which is essential to growing the economy and reducing unemployment. However, such a provision, intended to increase government revenue, may instead constrain business investment activities and the country’s long-term economic growth. According to Tax Foundation, a think tank for tax policies, the book minimum tax is the most damaging provision in the bill, which itself could reduce 0.1% of GDP and eliminate 20,000 full-time jobs.
Therefore, although the final enacted minimum tax provision exempts tax depreciation, using the book net income of a corporation as an alternative minimum tax is still not the best revenue source the government can get due to its unintended complications. The policymakers may consider reducing or eliminating or reducing certain tax deductions and credits that are not essential to corporations’ business decisions to achieve the effective corporate tax rate, which they deem fair and equitable for large corporations.
Ray Fang is a second-year law student at Cornell Law School. Ray studied financial accounting in college and earned a Master of Accounting emphasizing in taxation before coming to Cornell Law.