The Wrinkles in Taxes

Should illegal bribes be tax-deductible?

It doesn’t seem like the answer to this should be very complicated. Tax law gets interesting when it comes to the proceeds and costs of illegal activities, as Al Capone discovered and as marijuana dispensaries are re-learning. But there’s no good reason to offer a tax benefit for bribery.

And yet, the Organization for Economic Cooperation and Development’s recent commentary on Pillar 2, the 15% global minimum tax, has a section with 500-some words looking into this very question, as well as other problematic costs such as fines and penalties for illegal activities.

It’s not because of some radical rethinking of this basic notion. Rather, it’s due to the fact that Pillar 2 is a tax based on book income, or profit as recorded in financial accounting statements, as opposed to the tax code. And basic financial accounting does account for costs such as bribery–a shareholder would want to know if their firm’s use of bribes is cutting into its profits. The guidance notes that most countries disallow tax deductions for bribery, “for public policy reasons as part of the fight against corruption,” and a 2009 declaration from the OECD officially advises them to do so. It also notes that most countries don’t allow deductions for significant criminal penalties, “to limit the economic cost to only the person that committed the act.”

Because of these reasons, such costs are also disallowed under the Pillar 2 system.

The Inflation Reduction Act, currently on a fast track toward passage in the Senate, has a 15% alternative minimum tax that is also based on book income–although not for exactly the same reasons. What’s interesting, though, is that it does not have any section dealing the bribery issue.

This is an alternative minimum tax, that corporations would only pay if their annual tax rate, measured against financial income, falls below 15%. The situation is a little different than with Pillar 2–a company isn’t going to pay less in taxes than it’s paying now because of a bribe. But if a corporate taxpayer already knows it’s going to be paying the IRA’s 15% book min tax, it could see a tax saving through costs from bribery, criminal penalties or a legal settlement.

This is perhaps a public policy problem, but not a huge one. (It’s hard to imagine a CEO or board pulling the trigger on a bribe just because of the tax savings.) In terms of politics, however, it’s not hard to see why it could be a much bigger issue. Congress has often negated relatively small tax benefits for toxic issues--for instance, in the wake of the #MeToo movement, the Tax Cuts and Jobs Act disallowed deductions for settlements of sexual harassment allegations.

The attraction of the book min tax is the idea that a company’s financial books paint a more accurate picture of its profitability than its income tax return. A firm’s accountants have every incentive to boost its quarterly earnings statements, and to downplay its taxable income. When President Joe Biden rails against 55 profitable companies which pay no income tax, he implies that there isn't much doubt about their profitability. Taxable income can be manipulated, though--there are countless deductions built into the tax code which a company can use to pay less than the 21% rate. Comparatively, financial profit can seem like a nice, clean alternative.

But the issue of problematic payments is just one of the potential complications with this notion. Already, the book min tax includes several exceptions or adjustments–for general business credits like the R&D credit, for green energy incentives, and for defined benefit pensions.

If it’s passed, taxpayers and lawmakers will no doubt uncover other situations that seem unfair or immoral, and will push for remedies at Congress or the Department of the Treasury. The law does give Treasury broad power to implement the rules and make potential adjustments, but it’s a stretch to imagine the department tackling public policy issues like these. And the Congressional procedure for enacting technical corrections has turned into a haphazard and unpredictable vehicle.

One other potential rule-maker is the Financial Accounting Standards Board, a quiet Connecticut non-profit that sets the rules for Generally Accepted Accounting Principles as used in regulatory filings, and is expected to be the focus of much more political pressure under this new regime.

FASB has a somewhat baroque and confusing leadership structure, meant to insulate against pressure from interest groups. There’s little in the way of public accountability, as it’s supposed to be an internal industry standards organization. Its board members aren’t appointed by elected officials, and the Freedom of Information Act does not apply to its proceedings. It’s not officially a government body at all–its only power comes from its designation as the rule-setter for the Securities and Exchange Commission, an independent government entity which also dislikes the political limelight.

It’s not a total stranger to politics, though. In the 90s FASB buckled under pressure from Congress, led by then-Democratic Sen. Joe Lieberman of Connecticut, to delay a proposal requiring the recognition of costs from stock-based compensation. (Even after it enacted the policy change, stock-based compensation is the source of some of the biggest discrepancies between book income and tax income.)

With all of these potential pressure points, after time will the book min tax's measurement of income ultimately look any less loophole-ridden than our current tax code?

This all isn’t necessarily a reason to oppose the tax. If lawmaking is like sausage-making, then making tax policy has always been akin to making hamburger, or maybe foie gras. But it does complicate the conceptual simplicity that seems to be one of the major attractions of the book min tax. Whatever happens over the next week, the complexity isn’t going anywhere.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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