INTERVIEW: Michelle Hanlon

Michelle Hanlon is a professor of accounting at the Massachusetts Institute for Technology Sloan School of Management. An author of textbooks about both financial accounting and tax, she has testified before the Senate Finance Committee and the U.S. House Ways & Means Committee as an expert on both topics. We spoke on March 29, focusing on new tax policies that incorporate rules from financial accounting statements, such as the corporate alternative minimum tax enacted by the Inflation Reduction Act and the Pillar Two 15% global minimum tax agreed to at the Organization for Economic Cooperation and Development.

One of the reasons I wanted to talk to you is because from my reporting on this, I learned that there are really few people who understand both the world of tax and the world of accounting. And that's become so much more important since both the passage of CAMT and Pillar Two being implemented. So I'm curious, what's that like, being at this juncture that has suddenly become so important?

That's a good question. On the one hand I think it’s really fun, in a sense, because they’re things I've studied for a long time, and now, it is important and people are adopting these things. But on the other hand, I'm not a fan of the actual policy. I think it's a mistake to intertwine these two so closely. So I think it's both sides of that.

And I remember you had been vocal about that when those policies were being drawn up. Now that we’re maybe a year or so into it, how do you think it's going? I mean, is it confirming your fears of what was going to happen?

I think it's too soon to say, honestly. I think the complexity certainly has borne out. And I think the notices we've seen, just trying to, on the CAMT side, deal with consolidation, even identifying which financial statement to use, what all you include in the [adjusted financial statement income], what companies do you include? All those issues, I think are really just the beginning. It's one of those propositions or proposals that might sound really simple. “Hey, let's just tax this book income over here, we already have the number.” But it's actually very complicated. And your point before that not many people know both sides–unless you know both sides, I think it would be hard to see that it's actually very complicated to tax these book earnings like these new policies are trying to do.

And they even had the example of the 1986 [business untaxed reported profits tax in the 1986 tax reform bill]. And that was used by both sides of the argument. But I don't know if that helped them at all, in terms of implementing it.

I guess it might have been a way. But I think the world is just so much more complicated now than it was back in ‘86. And the companies are much more complicated, more global, more intangible-based and more complicated themselves, with a lot bigger, more complicated structures. And I don't think all that many people that were working there then are still around, certainly not most positions.

Why is this so complicated? Why isn’t it as simple as people would think?

The purposes of the two types of measurement are very different. So financial accounting, what that system is trying to do is provide information about firm performance, basically from firm management, to outside stakeholders. And so they're going to be looking at it from the perspective of trying to get information to creditors and investors. And that's what the rules are based around, and that's what management is trying to do. And it's going to be a much more, in a way, comprehensive system because you want to get all this information out to investors. And so, in other words, the way that consolidation is done, it's a worldwide consolidation for financial accounting. Because obviously, if an investor is investing in that company, they're investing in the worldwide company. They want information on everything.

Whereas the tax code is going to be more jurisdiction-specific. One notion with a consolidation is that financial accounting consolidates all the worldwide entities, and the tax consolidation will be domestic only. And then they would deal with the international operations in a different way. And financial accounting, the consolidation rule, the proxy is 50%, but it's technically just based on control. So if the parent company controls another entity, they should be consolidated. And we proxy for that with 50%. So say they own 51%, they're going to be consolidated into that group, whereas for tax that wouldn’t happen, it’s an elective consolidation that starts at 80%.

And financial accounting also has rules to include income from what we call equity method investees. That's ownership of between 20% and 50%, the proportion of income that that owner company has in the investee company will be included in the owner’s income. And that doesn't exist for tax.

So just the way we do things is very different, because the purposes for those two measures are very different. The other thing, I think related to that is how we do merger and acquisition accounting. For tax, there are both taxable transactions and what we call tax-free transactions. Non-recognition transactions, they might call it. But for financial accounting, everything is recorded in one way. And so the rules are very different for M&A. And we saw that in the notices that Treasury has released, they had to deal with those non-recognition transactions early on. And so there's just a lot of differences between the two that need to be considered.

Something else that just sticks out to me is the timing issue. That seems to get to the same point. Investors want a very long view of the company, but the tax system is much more tilted towards, what is the operation right now?

Exactly. And the tax code will have very specific rules, and the financial accounting rules are more subject to management discretion. Managers are supposed to estimate a lot of expenses in advance, because they want to tell shareholders, that we incurred expenses this period that are matched to the revenues we’re earning. For example, bad debt. Managers have to estimate how much of their accounts receivable will not be collected, and record that as a bad debt reserve. Managers have to estimate how much they think, of their products, will be returned or need to be serviced and estimate those costs on warranties. And they do that in advance of them actually knowing what that warranty expense is. For tax, they have to wait until those expenses are paid, essentially, before they can deduct them. Because the IRS and the government obviously don't want companies just estimating these expenses. But for financial accounting, we're going to give managers that discretion, because we want them to tell us their private information and tell us what they think are the actual expenses related to the income that they're earning. Because we don't want them to overstate their assets or their income and mislead investors in that way.

And that’s also true with the stock-based compensation issue, that it’s based on an estimate for accounting?

Yes, it's very different, both in timing, and in amount. The way that we account for equity-based compensation for financial accounting is different than tax on both those dimensions. So that's why when you look at financial statements, there's often a temporary difference and a permanent difference. The other big difference between the two is the extent that financial accounting has mark-to-market accounting. And so in financial accounting, we use fair value measures for many more things than would happen in the tax code. For example, when a company owns stock in another company, and they own less than 20%, they're just a passive investor in the other company, what they have to do for financial accounting is basically mark that investment to market every reporting period. And so that gain or loss, that really is unrealized–they haven't actually sold the stock–it needs to be recorded at fair market value on the balance sheet for financial accounting. The way the rules work now is that a change in value, that also goes through the income statement. There will be an unrealized gain or loss in the financial accounting income statement. But that won't exist in the tax rules, because we haven't sold the stock yet. So that's a big difference also.

Although there are some advocates of having more mark-to-market systems in the tax space. [Sen.] Ron Wyden has a proposal for taxation of unrealized capital gains. And there's a lot of questions about how feasible that would be. Could the system for mark to market in accounting be used in tax more?

I would not be a fan of that. Because, for accounting, you don't actually have to pay cash out because of your change in value. You're reporting that change in the value to shareholders, but it doesn't cost you anything. Whereas on the tax code, if I say my investment in Company X increased by $2 million this period, and I record that increased value to the IRS, I would have to actually pay tax on that amount. And so, I would have to probably liquidate some of those shares to pay that tax. I don't agree with that type of policy.

I don't know if you saw President Biden’s State of the Union, he did talk, as he often talks, about the 55 companies that allegedly did not pay taxes. That they were profitable is based on their accounting statements. Do you think that's like an accurate, or misleading way to look at it?

If we know those two measures have different purposes, then, is it the case that if they're profitable on one measure, they would necessarily be expected to be profitable on another measure? When we know they get accelerated depreciation or bonus depreciation for tax but not for book, depending on the time period?

We know they get different deductions for stock options. So there's, there's quite a few things in the tax code, depreciation being one of them, where the government is trying to provide incentives for certain behavior. So then it's not surprising in those cases that the income is different on one measure than it is on the other measure. And so then, if it’s questioning whether the tax treatment is correct, and if we don't think the tax treatment is correct, then we should just change the tax treatment. In my opinion, it's not correct to look across the way and say, “financial accounting income is positive or large, therefore, taxable income should be large.” If we know there's these different provisions in the code that require them to be different. And we know there's different accounting rules trying to get different information to investors. So it seems to me if you want to change it, or if the government wants to change it, they should just go item by item. Or if they want to keep those items, and they think a company shouldn't get too many of them at once–if they shouldn't get depreciation, or R&D expensing, and all these things that might make their taxable income "too low," they think there should be some cap, then just cap the deductions.

It just seems to make it much more complicated to interact these two, or combine these two types of reporting. The way they're trying to do that, it just makes it so much more complicated. And it doesn't really seem like it's a good goal, either, because we know those two income measures are meant for different purposes.

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