In August 2022, President Joe Biden signed the Inflation Reduction Act of 2022 into law. One of its provisions was a minimum 15% corporate tax on the book income of large corporations. This is designed to ensure corporations pay taxes on profits even if they reduce their taxable income. Corporations report income in two different ways: book income and taxable income.
Corporations can reduce their taxable incomes using multiple methods. To arrive at a corporation’s taxable income, a corporation begins by adding up all sources of income to get the total income. Income sources may include sales revenue, investment income, rents, and capital gains. The corporation then deducts business expenses and other special deductions, such as salaries and wages, depreciation, advertising costs, and charitable contributions.
The most common ways that corporations reduce their taxable incomes is through net operating losses, accelerated depreciation, tax credits, and profit shifting.
Net operating losses
A net operating loss results when a corporation’s deductions are greater than its taxable income. Firms can carry over net operating losses from previous years to report lower taxable income for the current year. The Inflation Reduction Act of 2022 limits the amount carried over to 80%.
For example, if a corporation’s taxable income is reduced to -$3 million, not only would they not be liable for taxes in the current year, but that loss could also be carried over to the following year's tax returns to reduce taxable income.
Accelerated depreciation
When firms purchase an asset, they can deduct its value over the life of the investment from their taxable income. Under the tax code, firms can deduct a greater percentage of an asset’s value in the early years of the investment, which lets the firm take advantage of the tax deduction sooner. This tax provision is called accelerated depreciation.
For example, a firm buys a machine for manufacturing. The machine has a life of five years, over which the value of the machine decreases. Rather than deducting the cost of the machine over five years, they can deduct the cost of the machine in the initial year of investment from their taxable income.
This provision, which allows companies to immediately write off the full costs of investment, was established in the 2017 Tax Cuts and Jobs Act (TCJA).
Tax credits
Corporations can use tax credits to further reduce their tax liability. The most significant tax credit is the research and development credit. If a company spends $500,000 on research to create innovative technology, it can deduct that amount from their tax liability. The White House estimates that credits for research activities cost the government $18.5 billion in fiscal year 2021. It is estimated to increase to $20.4 billion in fiscal year 2022.
Profit shifting
The TCJA moved the US to a mostly territorial tax system. Under a territorial system, a company is taxed based on where it earns its income.
US-headquartered corporations often move their profits to foreign subsidiaries in countries with low tax rates. Companies that keep profits in foreign subsidiaries pay less in US taxes, however the US still taxes some of these earnings in order to prevent companies from profit shifting.
A Congressional Research Service report estimated that about $80 billion is lost in corporate tax revenue every year due to profit shifting.
How have corporate taxes changed over time?
Corporate tax rates in the US have declined over time. At the same time, the corporate tax base shrank through declining profitability and international profit shifting, according to the Congressional Research Service. A significant portion of business income is not subject to corporate taxes.
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