Minimum tax on books to build better

The Build Back Better Act (BBBA) would increase taxes to pay for social spending programs. But the design of some of the tax increases can end up hurting private pensions, among other issues. By relying on measures of income reported in companies’ financial statements, i.e. accounting income, the proposed alternative minimum corporate tax and limiting interest charges might be more difficult for companies that use mark-to-market accounting for their pension plans. This would create yet another industry and company specific distortion in the BBBA tax proposals.

The first big problem concerns the gains and losses associated with defined benefit pension plans in companies’ financial statements. Defined benefit plans, or pensions, provide guaranteed retirement benefits to employees, but are less common today due to the rise of defined contribution plans like the 401 (k) s. Although they are less and less offered to new employees, many companies still have legacy plans that involve large sums of obligations to employees and retirees, and in many cases these pension plans are under. -capitalized.

Over the past decade, more than a dozen firms have chosen to use mark-to-market accounting for defined benefit plans, which recognizes actuarial gains or losses in the year they occur. rather than keeping track of changes over time. Mark-to-market accounting gives investors a more intuitive picture of pension obligations, but simultaneously introduces year-over-year volatility in financial statement income exceeding $ 1 billion for some companies, mainly due to fluctuations in the value of pension plan investments. than interest rates.

The BBBA’s proposal for a minimum tax of 15 percent on the corporate accounting income of certain large corporations would interact particularly with mark-to-market pension accounting. In financial statements, gains on pension plan assets are recorded as income, but the reality is that companies cannot use pension funds for their operations.

It makes sense that changes in pension obligations are factored in to provide investors and markets with a snapshot of a company’s financial health in the financial statements, but it doesn’t make sense to incorporate the changes. in pension assets (or pension costs) in the tax base. This could create “ghost income,” where a company’s income under the minimum accounting tax could increase when its pension plan increases (or decrease when it decreases). These effects could be exacerbated for companies that use mark-to-market accounting, as it can lead to particularly volatile changes in a company’s reported profits.

The limitation proposed by the BBBA on corporate interest expense would also pose problems for the accounting of pension plans. Under proposed Rule 163 (n), member companies of an international financial reporting group would face a limit on their interest deductions based on their estimated share of the group’s overall net interest expense. The interaction with pension accounting occurs because the calculations are based on a measure of income from the financial statements (earnings before interest, taxes, depreciation and amortization, or EBITDA).

The attached table illustrates how a business that recognizes a loss due to its pension plan would face a stricter interest deduction limit than a business that did not use mark-to-market accounting. Both hypothetical companies report the same interest expense and profit before considering pensions. If Company B had a defined benefit pension with an actuarial loss, its national income would decline – and since the limitation on the interest deduction is based on a ratio of national income to total income, Company B’s eligible interest would only fall. because of the way his pension obligations are reported in his financial statements.

Table 1. Accounting for pension plans affects the result of a company’s financial statements
Company A
(No defined benefit pension)
Company B
(Defined benefit pension with mark-to-market accounting)
National Foreigner Total National Foreigner Total
Net interest charges $ 800 $ 200 $ 1,000 $ 800 $ 200 $ 1,000
EBITDA $ 7,500 $ 2,500 $ 10,000 $ 7,500 $ 2,500 $ 10,000
Mark-to-market pension gain (loss) n / A n / A n / A -1,500 $ $ 0 -1,500 $
EDITBA after Mark-to-Market $ 7,500 $ 2,500 $ 10,000 $ 6,000 $ 2,500 $ 8,500
Share of attributable interest (Domestic share of EBITDA) 75% 71%
Permissible percentage (Share of attributable interest * Total interest expenditure / National interest expenditure) 94% 88%
110% of authorized percentage 103% 97%
Company limit 163 (n) (110% of the authorized percentage * national net interest charges) $ 825 $ 776
Net national interest charges $ 800 $ 800
Difference $ 25 deductible limit – $ 24 of interest charges not allowed

Source: author’s calculations.

In theory, the new rules on interest charges are supposed to target over-leveraged companies or companies engaged in tax planning. This ignores a number of factors, including the interaction with pension plan accounting. Prior to the Tax Cuts and Jobs Act of 2017, the corporate tax rate in the United States was not in line with international standards, leading to the recognition of interest charges below the corporate tax rate. higher to maximize tax savings and shift profits. Under current law, however, the corporate tax rate in the United States is near average, and businesses face new limits on interest charges due to other changes to the Act of 2017. As such, it is not clear that another limitation on interest charges is necessary. It is more likely that the new limitation will apply primarily to companies that borrow to finance their investments rather than recognizing interest charges in the United States to maximize tax savings.

Another shortcoming of the 163 (n) rules is that, although they are designed to target overleveraged companies, the rules can in fact target interest rate differentials between countries. Consider that instead of implementing a corporate debt-to-equity or debt-to-asset ratio, the rules target a company’s interest expense. While interest charges are indeed a function of debt levels, they are also a function of interest rates.

Imagine two companies with the same domestic and foreign EBITDA shares and the same domestic net interest expense; the only difference is that they operate in foreign countries with different interest rates and therefore have different foreign net interest charges (see table 2). Company D, which operates in a foreign country with relatively low interest rates, such as Germany, would face a more restrictive limitation on its domestic interest deduction because its foreign interest charges are low. Company C, operating in a foreign country with a relatively higher interest rate, such as Brazil, does not face the same restrictions.

Table 2. Differences in borrowing rates abroad could exacerbate interest deductions in the domestic market
Company C Company D
National Foreigner Total National Foreigner Total
Net interest charges $ 800 $ 200 $ 1,000 $ 800 $ 100 $ 900
EBITDA $ 7,500 $ 2,500 $ 10,000 $ 7,500 $ 2,500 $ 10,000
Share of attributable interest(Domestic share of EBITDA) 75% 75%
Permissible percentage(Share of attributable interest * Total interest expenditure / National interest expenditure) 94% 84%
110% of authorized percentage 103% 93%
Company limit 163 (n)(110% of the authorized percentage * national net interest charges) $ 825 $ 743
Net national interest charges $ 800 $ 800
Difference $ 25 deductible limit – $ 57 of interest charges not allowed

Source: author’s calculations.

The Build Back Better Act proposals to add a new alternative minimum tax on corporate accounting income and a new limit on interest charges raise several red flags. By relying on accounting income, the new alternative minimum tax could increase the tax burden on defined benefit pensions, issues that would also be included in the new limits on interest charges. Lawmakers’ current approach to new and untested tax ideas would place undue burdens on American businesses and create distortions between, and even within, American industries.

December 17 update: An updated version of the Build Back Better plan amends the minimum accounting tax to exempt accounting adjustments for mark-to-market pension plans. The above analysis refers to the House Build Back Better Act originally passed on November 19.

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