The Odd Couple

+(,121/,1(
Citation: 58 Tax L. Rev. 111 2004-2005
Content downloaded/printed from

HeinOnline (http://heinonline.org)
Thu Oct 29 10:06:25 2015
-- Your use of this HeinOnline PDF indicates your acceptance
of HeinOnline's Terms and Conditions of the license
agreement available at http://heinonline.org/HOL/License
-- The search text of this PDF is generated from
uncorrected OCR text.
-- To obtain permission to use this article beyond the scope
of your HeinOnline license, please use:
https://www.copyright.com/ccc/basicSearch.do?
&operation=go&searchType=0
&lastSearch=simple&all=on&titleOrStdNo=0040-0041
The David R. Tillinghast Lecture

The Odd Couple: A Common Future
for Financial and Tax Accounting.?
WOLFGANG SCHON*
I.
INTRODUCTION
In the 1968 movie "The Odd Couple" 1 actors Walter Matthau and
Jack Lemmon are forced to share their daily life in the same apartment although their characters and ways of life could not be more
different. Matthau plays Oscar, who is proletarian, down to earth, his
habits a bit shabby, with a big mouth and a big heart-just like a tax
lawyer. Lemmon is Felix, a middle-class office employee, who cares
about every detail of his surroundings, a timid but morally impeccable
character who cleans up Oscar's poker cards. For him, every deviation from his well-planned daily routine makes him feel nervous-just
like an accountant. Is it possible that these types can get along together? On the face of it one would answer this question in the negative. So does the movie: Oscar throws Felix out of the house. But not
for a long time. Television made "The Odd Couple" one of the most
successful long-running sitcoms of the 1970's, which has been rebroadcast every year since.
The same holds true for the issue of book-tax conformity when it
comes to the computation of business profits for tax reasons. There is
a longstanding and prevalent opinion in many countries that the different goals of taxation and accounting render it impossible to rest the
assessment of a person's taxable income on the results of financial
accounting. 2 Nevertheless, comprehensive or limited book-tax con* Professor and Director, Max Planck Institute for Intellectual Property, Competition
and Tax Law, Department of Accounting and Taxation, Munich; Honorary Professor,
Ludwig-Maximilians-Universitat Munich. Delivered at NYU School of Law on October 4,

2004.
1 The Odd Couple (Paramount Pictures 1968).
2 For an overview of the European debate, see Wolfgang Schon, International Accounting Standards-A "Starting Point" for a Common European Tax Base?, 44 Eur. Tax'n 426
(2004) [hereinafter Starting Point]; for the U.K. debate, see Judith Freedman, Aligning
Taxable Profits and Accounting Profits: Accounting Standards, Legislators and Judges, 2
eJournal Tax Res. 71 (2004) [hereinafter Aligning]; for the U.S. debate, see Michelle Hanlon, What Can We Infer About a Firm's Taxable Income From its Financial Statements?,
56 Nat'l Tax J. 831 (2003); Michelle Hanlon & Terry Shevlin, Book-Tax Conformity for
111
Images with the Permission of N.Y.U. Tax Law Review
TAX LAW REVIEW
[Vol. 58:
formity is not only a common feature in many tax laws around the
globe but its introduction (or abolition) is subject to debate nearly

everywhere. The pros and cons include both political and technical
issues and cover the full range of law and economics. Moreover, as
tax and accounting rules and principles themselves have changed over
the years, the issue of book-tax conformity has proven to be a moving
target.
The current debate on book-tax conformity has heated up in different parts of the world for quite different reasons. I take as examples
the ongoing controversies in Germany, the United Kingdom, and the
United States. This comparative view shows the broad range of perspectives taken on this issue. Moreover, international developments,
in particular a recent initiative by the European Commission, provide

ample reason for a launch of the book-tax conformity debate at the
international level. Stretching beyond the boundaries of the European Union are other aspects of book-tax conformity that address
global issues like transfer pricing or corporate governance, both of
which are discussed in OECD circles.

II.
THE GLOBALIZATION OF ACCOUNTING RULES
The analysis of the current tax debate on book-tax conformity has

to start from the fact that we are witnessing an accelerated global convergence of financial accounting rules. At the beginning of this devel-
opment in financial accounting, in the early 1990's, the assumption

was widely shared in the European corporate sector that access to international capital markets-most notably the New York Stock Ex-
change-would be a basic prerequisite for economic success in the

future.3 In order to get access to the NYSE or NASDAQ, a foreign
company is obliged to file consolidated accounts conforming to U.S.
GAAP with the SEC. 4 Multinational companies from Europe soon
Corporate Income: An Introduction to the Issues (2004), available at www.nber.org/book/
tpel9hanlin-shevlinlO-25-04.pdf; Alvin D. Knott & Jacob D. Rosenfeld, Book and Tax: A
Selective Exploration of Two Parallel Universes (pts. 1 & 2), 99 Tax Notes 865 (May 12,
2003), 99 Tax Notes 1043 (May 19, 2003); Gil B. Manzon Jr. & George A. Plesko, The
Relation Between Financial and Tax Reporting Measures of Income, 55 Tax L. Rev. 175
(2002); Lillian F. Mills & George A. Plesko, Bridging the Reporting Gap: A Proposal for
More Informative Reconciling of Book and Tax Income, 56 Nat'l Tax J. 865 (2003).
3 For an overview of the development in Europe during the 1990's, see Axel Haller,
Financial Accounting Developments in the European Union: Past Events and Future
Prospects, 11 Eur. Acct. Rev. 153, 160-68 (2002). For an analysis of the interaction between regulators and international business in this context, see Sharokh M. Saudagaran &
Gary C. Biddle, Financial Disclosure Levels and Foreign Stock Exchange Listing Decisions, 4 J. Int'l Fin. Mgmt. Acct. 106 (1992).
4 15 U.S.C. 78(m)(a)(2002); see Thomas Lee Hazen, 2 Treatise on the Law of Securities Regulation 9.3, at 15-22 (4th ed. 2002).
2005]
FINANCIAL AND TAX ACCOUNTING
learned that full compliance with U.S. GAAP (and additional SEC
rules) led to hefty overhead costs as they were not relieved from the
obligation to draw up their accounts back home under the rules harmonized by the Fourth and the Seventh European Company Law Directive. 5 In addition to this doubling of compliance costs, companies
found it hard to explain the diverging results to capital markets.
When Daimler Benz was admitted to the NYSE in 1993, the difference between U.S. and EU results accumulated to several hundred
6
million dollars.
Against this background, the European Commission tried to persuade the SEC to accept European-style consolidated accounts for
U.S. securities law purposes according to the principle of "mutual recognition."' 7 When the SEC did not agree, the European Commission
changed its strategy.8 They opted for a growing influence of the International Accounting Standards Committee (IASC), a London-based
private standard-setting body composed of representatives from leading economies around the world. 9 It was a major step forward when
in 2000 the IOSCO, an international association of financial markets
regulators including the SEC, committed itself to support the standard-setting work of the IASC as a basis for internationally accepted
accounting standards.10
Currently the situation is as follows. The principal body within the
IASC, the International Accounting Standards Board (IASB), has issued a broad range of International Accounting Standards (IAS) and
International Financial Reporting Standards (IFRS). n1 Countries all
over the world-most recently Australia, New Zealand, and Russiahave accepted the IAS/IFRS as compulsory standards under their securities laws.1 2 The European Institutions in 2002 passed the IAS
5 See Fourth Council Directive 78/660, 1978 O.J. (L 222) 11; Seventh Council Directive
83/349, 1983 O.J. (L 193) 17.

6 Karlheinz Kiiting, US-amerikanische und deutsche Bilanzierung im Vergleich-unter
besonderer BerUcksichtigung der Konzernrechnungslegung und des Daimler-Benz-Listing
in New York, 45 Betriebswirtschaftliche Forschung und Praxis 357, 369 (1993).
7 Karel van Hulle, Harmonisation of Accounting Standards-A View From the European Community, 1 Eur. Acct. Rev. 161, 171 (1992).
8 See Communication From the Commission-Accounting Harmonisation: A New
Strategy vis-A-vis International Harmonisation, COM95(508) final, $ 5.
9 As to the legal basis of the IASC, see International Accounting Standards Board, International Financial Reporting Standards 1-2, C-1 to C-14 (IASC Foundation Constitution) (2003) [hereinafter IFRS].
10International Organization of Securities Commissions, IASC Standards-Assessment
Report, Report of the Technical Committee of the IOSCO (2000), available at
www.iosco.org/pubdocs/pdf/IOSCOPD109.pdf.
11See IFRS, note 9, at 9.
12 For Australia, see Adoption of International Accounting Standards by 2005, Bull. Fin.
Reporting Council, available at www.frc.gov.au/contentfbulletins/bull-2002_4.asp; for New
Zealand, see Hon. Margaret Wilson (Minister of Commerce) Address to Accounting Stan-
TAX LAW REVIEW
[Vol. 58:
Regulation, which requires all companies admitted to a stock ex-
change within the EU to draw up their consolidated accounts according to IAS/IFRS, effective January 1, 2005.13 According to Article 5
of the IAS Regulation, it is up to the Member States to decide freely
whether the IAS/IFRS also shall be compulsory for consolidated ac14
counts of nonlisted companies and for individual company accounts.
Meanwhile the IASB and the Financial Accounting Standards Board
(FASB), to which the SEC has delegated the power to set accounting
standards for U.S. capital markets, are working on a convergence project, which is meant to abolish most of the differences between IAS/
IFRS on the one hand and U.S. GAAP on the other hand in the short
term. 15 In this context it should not go unnoticed that in the

Sarbanes-Oxley Act, the U.S. Congress announced a possible shift of
U.S. accounting from a rule-based to a principle-based system, which
would lead to further alignment of U.S. accounting standards and European accounting standards. 16 That act even reminds the U.S. stan-
dard setter to "consider[ ], in adopting accounting principles, the need

to keep standards current in order to reflect changes in the business
environment, the extent to which international convergence on high
quality accounting standards is necessary or appropriate. . . .;-17 It
should not be called simply wishful thinking that the IAS/IFRS will
grow into a globally accepted set of accounting standards covering
capital markets in the United States, the EU, and other industrialized
countries, from Switzerland to Japan and China.
dards Review Board (Nov. 24, 2004), available at www.asrb.co.nz/documents/MargaretWilson24November2004.doc; for Russia, see Deloitte-IAS Plus, Country Update Russia,
available at http://www.iasplus.com/country/russia.htm.
13Council Regulation 1606/2002, 2002 O.J. (L 243) 1.
14 Id. art 5. For an overview of the legislative practice in this context given by the European Commission, see Planned Implementation of the IAS Regulation (1606/2002) in the
EU and EEA (2005), available at www.europa.eu.int/comm/internal-market/accounting/
docs/ias/ias-use-of-options-en.pdf.
15Joint FASB/IASB Press Release (Oct. 29, 2002), and Memorandum of Understanding
(Oct. 29, 2002), available at www.iasb.org/docs/press/2002prl5.pdf. As to the current progress of this project, see Hearing Before the Senate Comm. on Banking, Housing and
Urban Affairs, 108th Cong. (Sept. 9, 2004) (statement of Sir David Tweedie) (available at
www.iasb.org/uploaded-files/documents/8129 040409-dpt.pdf); FASB Releases Four Exposure Drafts Aimed at International Convergence, 102 Tax Notes 234 (Jan. 12, 2004).
16 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 108(d), 116 Stat. 745, 769. See
William W. Bratton, Enron, Sarbanes-Oxley and Accounting: Rules Versus Principles Versus Rents, 48 Villanova L. Rev. 1023 (2003) (expressing concern about the discretion given
to management and auditors in the context of a broad-brush, principle-based approach to
financial accounting). Meanwhile the FASB has committed itself to an objective-oriented
standard setting approach that is meant to combine rules and principles. See ObjectivesOriented Standards, World Acct. Rep., Sept. 2004, at 7-8.
17 Sarbanes-Oxley Act, note 16, 108(a)(2), 116 Stat. at 768.
2005]
This change of paradigm proves to be important for the background

of my topic. When we talk about the strengthening of book-tax conformity in the future, we have to envisage a linkage of income measurement to internationally accepted accounting rules, which
eventually would lead to an international alignment of the computation of taxable profits.
III.
A TALE OF THREE
A.
COUNTRIES
Germany
German law is said to provide for the most comprehensive linkage

between the computation of taxable corporate income and the profit
and loss statement shown in the financial accounts. 18 Indeed, since
the second half of the 19th century, when the first tax codes in the
Member States of the German Empire (for example Saxony and Prussia) were drafted, income tax law referred to the profit and loss computed under "sound accounting practice" generally accepted in
business circles. This basic concept was not seriously challenged for
more than a century. Both the taxpayers and the tax administration
were content. The taxpayer did not run into additional compliance
costs and the tax inspector found a reliable basis for the tax assessment in the commercial bookkeeping of the business. 19
This linkage of book and tax has been reinforced by two additional
legislative measures under German law. First, it is not simply the
rules laid down in accounting law that have to be followed for tax
purposes ("material dependence"), but it is also compulsory that the
specific items shown in the taxpayer's balance sheet for the respective
fiscal year have to be recognized for tax purposes as well ("formal
dependence"). Elections laid down in the accounting rules have to be
exercised uniformly both for commercial and tax purposes. Moreover, even tax incentives like accelerated depreciation or tax-free
reserves are accepted under German tax law only if they are equally
shown in the financial accounts. 20 This principle of "reverse depen18 For an overview see Wolfgang Sch6n, Eine Zukunft fur das MaBgeblichkeitsprinzip,
in Steuerliche Mafgeblichkeit in Deutschland und Europa, (Wolfgang Schon ed., forthcoming 2005) [hereinafter Eine Zukunftl.
19 Heinrich Beisse, Die paradigmatischen GoB, in Festschrift Welf Muiler 731 (Peter
Hommelhoff, Roger ZAtzsch & Bernd Erie eds., 2001); Georg Do1lerer, MaBgeblichkeit
der Handelsbilanz in Gefahr, in 26 Betriebs-Berater 1333 (1971); Brigitte Knobbe-Keuk,
Zum Verfall der Steuergesetzgebung-am Beispiel der beabsichtigten Streichung von JubiI umsriickstellungen, in 43 Betriebs-Berater 1086 (1988); Adolf Moxter, Georg Dollerer
bilanzrechtliches Vermachtnis, in 71 Steuer und Wirtschaft 97 (1994).
20 German Einkommensteuergesetz 2002 (EStG 2002), v. Oct. 19, 2002, Bundesgesetzblatt (Federal Gazette) 5(1) 2d sent. pt. 1, 2002, at 4210).
TAX LAW REVIEW
[Vol. 58:
dence" (which is known in U.S. accounting in particular with respect

to the LIFO rule) for a long time has been criticised both by German 21 and international 22 commentators as a major distortion of the
information value of financial accounts drawn up by German compa-
nies. Nevertheless, for many decades the business community was

happy with this linkage of commercial and taxable profits for both
procedural and substantive reasons. It led to a massive reduction of
compliance costs and it extended the traditional principle of "con-
servative" or "prudent" financial accounting to the tax assessment,

thus establishing a tendency to understate corporate profits for tax
purposes.
In recent years, we find a growing tendency in Germany to abolish
the principle of dependence altogether. 23 To be sure, this principle of
book-tax conformity never led to full identity of accounting and taxable income as tax law tended to include some specific rules on the
recognition and valuation of items for income tax purposes. The number of these adjustments has increased since the late 1990's, when tax
legislation started to erode the inherent "conservatism" of accounting
law, which was felt not to be in line with general principles of taxation
like the ability-to-pay principle. 24 This increase in modifications to
the financial accounts for tax purposes gradually has reduced the ad-
ministrative advantage of book-tax conformity. Today, the true challenge to the principle of dependence is found in the introduction of
the IAS/IFRS, which brings about a change of paradigm for German
accounting in general. 25 The German Ministry of Finance commis21Brigitte Knobbe-Keuk, Das Steuerrecht-eine unerwuinschte Rechtsquelle des Gesellschaftsrechts? 25 (1986); Arndt Raupach, Das Steuerrecht als unerwuinschte Rechtsquelle
der Handelsbilanz, in Festschrift Adolf Moxter 101 (Wolfgang Ballwieser, Hans-Joachim
Bocking, Jochen Drukarzcyk & Reinhard H. Schmidt eds., 1994).
22Christopher Nobes & Robert Parker, Comparative International Accounting 11.4.1
(8th ed. 2004).
23 The most prolific author in this context is Heinrich Weber-Grellet, judge of the
Federal Tax Court. See Heinrich Weber-Grellet, Argumente fur die Abschaffung des
Mafgeblichkeitsprinzips oder Pladoyer fur eine steuerrechtskonforme und rechtsstaatliche
Gewinnermittlung, in Die Mafgeblichkeit der handelsrechtlichen Gewinnermittlung fur
das Steuerrecht 267 (Romuald Bertl, Anton Egger, Wolfgang Gassner, Michael Lang &
Christian Nowotny eds., 2003).
24 The biggest change was effected by the Steuerentlastungsgesetz 1999/2000/2002. The
relevant legislative materials are found in Bundestags-Drucksache 14/23, available at
www.bundestag.de.
25 There are many German publications on this subject. For an overview, see Frank
Daniel Broer, Mal3geblichkeitsprinzip und Harmonisierung der Rechnungslegung (1999);
Sebastian Drescher, Zur Zukunft des deutschen Maf3geblichkeitsgrundsatzes (2002); Robert Groning, Steuerbilanzielle Gewinnermittlung nach US-GAAP? (2002); Holger Kahle,
Internationale Rechnungslegung und ihre Auswirkungen auf Handels- und Steuerbilanz
(2002); Andreas Oestreicher & Christoph Spengel, Mal3geblichkeit der International Accounting Standards fur die steuerliche Gewinnermittlung? (1999); Stefan Rahlf, IAS-Bi-
2005]
sioned a study on the impact of IAS/IFRS on German tax accounting,

which was published in 2004.26 In this study, Norbert Herzig, a Cologne tax professor, pleads for autonomous rules on income measurement strictly for tax purposes, cutting off the traditional linkage to
financial accounting. The main reasons for this result of his study are:
The private character of standard setting by the IASB. It is hard to
accept that German tax legislation should defer to the rules and principles laid down by a London-based international association.
The restricted field of application of IAS/IFRS. As long as these
international standards are binding only for listed companies, they
cannot form the basis for the corporate or personal income tax, which
also addresses privately held companies, commercial partnerships, and
sole entrepreneurs.
The information purpose of accounting standards. These standards
are framed in order to provide useful information to investors and do
not envisage the transfer of liquidity to the public sector. Moreover,
as financial accounts are intended to supply the capital markets with
indicators for the future economic development of an enterprise, they
are bound to give room for managerial discretion when it comes to the
assessment of an inflow or outflow of future economic benefits. This
leeway and uncertainty might run afoul of the necessity to build a tax
assessment on reliable numbers not subject to manipulation by the
taxpayer.
The German government and business community seem to support
this change of paradigm. For the German Ministry of Finance, the
codification of an autonomous set of tax accounting rules would imply
greater independence from other institutional players like standardsetting bodies. For German business, the most important reason for a
reassessment of dependence seems to be the fact that IAS/IFRS do
not follow the conservative principles of traditional German financial
accounting but take a more symmetric view when it comes to the recognition of revenues and expenses. They fear that a linkage of tax
accounting to international accounting standards inevitably would
lead to a higher tax bill.
This current debate in Germany is echoed by developments in many
other European countries where traditionally a strong linkage be27
tween financial accounts and tax accounts is in place. In Austria,
lanzierung und Besteuerung (2000); Robert SchUtz, Der MaBgeblichkeitsgrundsatz gemalB
5 Abs.1 EStG-ein Fossil? (2002).
26 Norbert Herzig, IAS/IFRS und steuerliche Gewinnermittlung (2004).
27 See the contributions in Die Malgeblichkeit der handlesrechtlichen Gewinnermittlung fir das Steuerrecht, note 23.
TAX LAW REVIEW
Belgium
28
and
France 29
[Vol. 58:
the abolition of book-tax conformity is under
scrutiny. Switzerland has halted its current financial accounting reform in order to find a consensus on the tax consequences of a broad
application of international accounting standards in the Swiss corporate sector. 30 Even in Spain, where book-tax conformity was enacted
as late as 1996, a recently published study has opted for a move away
from the principle of dependence if IAS/IFRS forms the basis of this
31
concept in the future.
B.
United Kingdom
When we look at the debate in the United Kingdom we find quite

the opposite development. England has understood itself for a long
time as a prime example of a tax jurisdiction where income measurement is done without reference to financial accounting. 32 The detailed
rules and principles of British commercial accounting laid down in
professional standards, however, over time have proven to be a valuable instrument in solving practical problems of income tax assessments. The courts have played a decisive role in this process. 33 In
several decisions, the U.K. Courts have accepted British GAAP as a
cornerstone of tax accounting. Most notably, in the Herbert Smith
case 34 the High Court relied on U.K. accounting standards in order to
recognize a provision for future losses in the tax assessment.

The British Parliament has taken up this movement. Section 42 of
the 1998 U.K. Finance Act 35 provided explicitly that profit and loss
measurement under tax law should follow the "true and fair view prin-
ciple" in accordance with financial accounting standards if the tax

code does not say otherwise. 36 The advent of the International Ac28 Conseil sup~rieur des Finances, Sections Fiscalit6 et Parafiscalit6, La Reforme de
l'Impot des Socidtds, Le Cadre, les Enjeux et les Scdnarios Possibles 9 (2001).
29 Eric Delesalle, Fiscalit6 et Normes Comptables Internationales, in Bull. Fisc. Francis
Lefebvre 247 (2003).
30 Lukas Scheidegger & Ralph Lehmann, Umstellung der Rechnungslegung, in Schweizer Treuhander 727, 728 (2004).
31 E. S~nz Gadea, Ley 62/2003, Impuesto sobre Sociedades (I). La reforma contable y el
impuesto sobre sociedades, CEF, ntim.251, 81 (2004).
32 The current legal situation is laid out in John Tiley, Revenue Law ch. 21.1 (4th ed.
2000).
33 Judith Freedman, The Role of Realisation: Accounting, Company Law and Taxation,
in The Influence of Corporate Law and Accounting Principles in Determining Taxable
Income, 21b IFA Congress Seminar Series 29 (1996); Richard Teather, Ways and Means:
The Impact of Political Philosophy on the Calculation of Taxable Profits in the UK, 19
Austl. Tax F. 23 (2004).
34 Herbert Smith v. Honour [1999] B.T.C. 44.
35 Finance Act 1998, 66, available at http://www.hmso.gov.uk/acts/acts1998/80036e.htm#42.
36 Freedman, Aligning, note 2, at 78.
2005]
counting Standards has fuelled the discussion as to whether U.K. legislation should further engage on this path. In 2002, a study
commissioned by the Institute for Fiscal Studies and written by
Graeme McDonald showed strong sympathy for aligning taxable income with accounting income. 37 He welcomed the positive influence
of the nonpartisan and professional judgment of financial standard
setters on the confrontational relationship between the taxpayer and
the government. From this starting point, the British government in
2003 published a consultation document on "Reform of Corporation
Tax,"' 38 which expressly asked the public to advise on a closer alignment of taxable and business profits under U.K. law. The response
was mixed. Most critical was a study by Christopher Nobes 39 on behalf of the Association of Chartered Certified Accountants, which
proposed a movement towards autonomous rules on tax accounting.
One of his main arguments against linkage is the fear of "pollution" of
the independent, capital-market-oriented standard-setting process by
40
tax policy issues.
In the end, the U.K. government decided to move forward on their
way towards book-tax conformity. In 2004 the British Parliament enacted a provision, 4 1 which refers the measurement of business profits
42
under U.K. income tax law to the new established IAS/IFRS.
C.
United States
There is a remarkable similarity in relevant provisions of the German, the U.K., and the U.S. tax code on the relationship between financial accounting and the measurement of taxable income.
According to the German Income Tax Act 43 a taxable business entity
has to comply with the generally accepted rules of accounting practice
when computing its taxable profit subject to further modifications. In
the United Kingdom taxable profits must be computed on a tax basis
37 Graeme McDonald, The Taxation of Business Income: Aligning Taxable Income
With Accounting Income (IFS Working Papers DP2, 2002), available at http://www.ifs.org.
38 H. M. Treasury, Corporation Tax Reform: A Consultation Document IT 1.10, 2.6
(2003), available at http://www.inlandrevenue.gov.uk/consult-new/cort-tax-reform.pdf.
39 Christopher Nobes, A Conceptual Framework for the Taxable Income of Businesses,
and How to Apply it under the IFRS, ACCA (2003), available at http://
www.accaglobal.com/pdfs/miscellaneous/TECH TPN03.pdf.
3.4.
40 Id. at
41 Finance Act 2004, 50, available at www.legislation.hmso.gov.uk/acts/acts2004/
20040012.htm.
42 Gillian Wild, IFRS-Increasing the Urgency?, Tax J., Feb. 2, 2004, at 7 (pointing out
that the choice between U.K. GAAP and IAS/IFRS under Article 5 of the IAS Regulation
(and the respective national provision) will lead to different tax profiles of taxpayers with
similar economic situations).
43 German Einkommensteuergesetz, note 20, 5 (1).
120
TAX LAW REVIEW
[Vol. 58:
giving a "true and fair view" in the commercial sense subject to adjustments in the tax code. 44 Not very far from this is the U.S. rule, which
requires that "[t]axable income shall be computed under the method
of accounting on the basis of which the taxpayer regularly computes
his income in keeping his books. '45 This common starting point, however, should not disguise the fact that U.S. tax accounting has moved
far away from this residual principle of book-tax conformity (which
was never restricted to financial accounting only46 ). This is due not
only to a huge array of legislative and administrative deviations from
the rules relevant for financial accounting, but also because the law
itself only accepts book-tax conformity if the chosen method of accounting "clearly reflects income. '4 7 In its landmark decision Thor
Power Tool Co. v. Commissioner,48 the Supreme Court in 1979 has
gone so far to express the view that the different goals of tax and
financial accounting lead to a fundamental antagonism of the respective concepts of income. Only in a few cases-such as LIFO accounting-does tax law require taxpayers to employ the same method of
49
accounting both for capital market information and for tax purposes.
Therefore, the United States is regarded to have moved towards the
most advanced separation between the different sets of books.
Nevertheless, in the United States as well the tide seems to move in
the direction of a closer alignment of book and tax profits. For example, in Bank One Corp v. Commissioner, the Tax Court relied on financial accounting rules in the application of mark-to-market
valuation for securities under 475.50 At the level of legislation the
51
driving force seems to be the concern over corporate tax shelters
Finance Act 2004, 50(4); Finance Act 1998, 42.
IRC 446(a).
Knott & Rosenfeld, pt. 1, note 2, at 876-87.
47 IRC 446(b). For an overview, see Jennifer C. Root, The Commissioner's Clear Reflection of Income Power Under 446(b) and the Abuse of Discretion Standard of Review: Where Has the Rule of Law Gone, and Can We Get it Back?, 15 Akron Tax J. 69
44
45
46
(2000).
439 U.S. 522, 542-44 (1979).

IRC 472(c), (e).
Bank One Corp. v. Commissioner, 120 T.C. 174 (2003); see Yoram Keinan, Book Tax
Conformity for Financial Instruments, 6 Fla. Tax Rev. 676 (2004); Alan B. Munro & Yoram
Keinan, The Case for Book-Tax Conformity for Mark-to-Market Valuation, 16 J. Tax'n Fin.
Inst. 5 (2003); Steven M. Rosenthal, Bank One, A Mark-to-Market Roadmap, 16 J. Tax'n
Fin. Inst. 18 (2003). For a critical assessment, see Linda M. Beale, Book-Tax Conformity
and the Corporate Tax Shelter Debate: Assessing the Proposed Section 475 Mark-To-Market Safe Harbor, 24 Va. Tax Rev. 301, 351 (2004) [hereinafter Conformity].
51 For an overview, see Linda M. Beale, Law Professor Offers Suggestions for Fighting
Shelters, 103 Tax Notes 125 (Apr. 5, 2004) [hereinafter Suggestions]; Linda M. Beale, Putting SEC Heat on Audit Firms and Corporate Tax Shelters: Responding to Tax Risk With
Sunshine, Shame and Strict Liability, 29 Iowa J. Corp. L. 219 (2004) [hereinafter SEC
Heat]; Andrew Immerman & Andrea Lane, New IRS Proposals Attempt to Close Down
48
49
50
2005]
which started in the mid-1980's and found its recent climax in the re-
port of the Joint Committee on Taxation on the tax issues raised by

the Enron debacle.5 2 One of the main findings of the Joint Committee
was the fact that the corporate tax shelters used by Enron mostly resulted in huge differences between the financial accounts and tax ac-
counts in a way that seemed to be a true double-dipping. 53 The

company was able to impress investors by showing enormous profits
to the capital market while reducing income tax liability at the same
54
time through alternative methods employed for tax accounting.
Moreover, the expectation of future tax benefits was included in the

financial accounts, thus giving rise to even higher commercial results.
In 2001 George Yin 55 raised the question whether a more comprehensive book-tax conformity would force corporate managers to choose a
single method of accounting, which would prevent them from this sort
of cherrypicking and lead to a trade-off between benefits in the tax
sector and in the financial sector. This proposal not only found bitter
resistance 56 and strong support 57 but also several commentators who
take intermediary positions. Mitchell Engler has proposed to draw a
line between intended tax incentives like accelerated depreciation,

which should not be subject to book-tax conformity, and unwelcome
tax shelters, which could be tackled by a closer alignment of taxable
and business profits.5 8 Others have pointed to the rules of securities
Tax Shelters, 7 Int'l Tax Rev. 50 (2004); Knott & Rosenfeld, pt. 2, note 2, at 1057; Governmental Attempts to Stem the Rising Tide of Corporate Tax Shelters, in DevelopmentsCorporations and Society, 117 Harv. L. Rev. 2249 (2004).
52 Joint Comm. on Tax'n, 108th Cong., Report of Investigation of Enron Corporation
and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (Comm. Print 2003), available at http://www.house.gov/jct/s 3 03 Voll.pdf;
see also Jane Gravelle, The Enron Debacle: Lessons for Tax Policy, pt. IV (Urban-Brookings Tax Pol'y Ctr., Discussion Paper No. 6, 2003), available at http://
www.taxpolicycenter.org; Gary A. McGill & Edmund Outslay, Lost in Translation: Detecting Tax Shelter Activity in Financial Statements, 57 Nat'l Tax J. 739 (2004).
53 Joint Committee Report, note 52, at 5, 8.
54 The general tendency of rising book-tax differences during the 1990's in the accounts
of U.S. corporations is described in Mihir A. Desai, The Divergence Between Book and
Tax Income, 17 Tax Pol'y & Econ. 169 (2003).
55 George K. Yin, Getting Serious About Corporate Tax Shelters: Taking a Lesson
From History, 54 SMU L. Rev. 209, 224 (2001).
56 Beale, Conformity, note 50, at 359; Knott & Rosenfeld, pt. 2, note 2, at 1058-60; Lee
A. Sheppard, Financial Accounting Conformity: Not the Silver Bullet, 101 Tax Notes 676
(Nov. 10, 2003) [hereinafter Silver Bullet].
57 Reuven Avi-Yonah, Corporations, Society, and the State: A Defense of the Corporate Tax, 90 Va. L. Rev. 1193, 1251 (2004); Mihir A. Desai, Reading Off the Same Page,
The Harvard Crimson, May 5, 2003, Opinion section, available at http://
www.people.hbs.edu/mdesai/MDHCrimson05O5O3.pdf; Anthony J. Luppino, Stopping the
Enron End-Runs and Other Trick Plays: The Book-Tax Accounting Conformity Defense,
2003 Colum. Bus. L. Rev. 35.
58 Mitchell L. Engler, Corporate Tax Shelters and Narrowing the Book/Tax "GAAP,"
2001 Colum. Bus. L. Rev. 539, 559-70.
TAX LAW REVIEW
[Vol. 58:
law and tax law, which oblige the company to show and explain any
59
book-tax difference to the capital markets and to the tax authorities.
These measures have been expanded, thus forcing corporate taxpayers to disclose tax shelter structures and other tax benefits arising
from book-tax differences. 60 It has even been argued that corporate
tax returns should be made public to the capital market, a proposal
61
that touches the limits of privacy in tax matters.
IV.
INTERNATIONAL DEVELOPMENTS
A.
European Union
In October 2001, the European Commission released a Communication and a study of its services on the future of company taxation in
the Common Market. 62 One of the basic goals of their analysis was to
strike a balance between a healthy competition of national tax legislators on the one hand and the abolition of tax obstacles to cross-border
allocation of goods, services, labor and capital within Europe. The
Commission opted for a tax regime where the Member States would
be free to decide on the corporate income tax rate but where multinational enterprises would be able to rely on identical rules for the com59 Edward D. Kleinbard & Peter C. Canellos, Disclosing Book-Tax Differences, 96 Tax
Notes 999 (Aug. 12, 2002); Mills & Plesko, note 2, at 865; George A. Plesko, Corporate Tax
Avoidance and the Properties of Corporate Earnings, 57 Nat'l Tax J. 729 (2004). On the
disclosure of tax effects in the financial accounts, see Hanlon, note 2. Even in the past,
large book-tax differences regularly resulted in tax audit adjustments. See Lillian F. Mills,
Corporate Tax Compliance and Financial Reporting, 49 Nat'l Tax J. 421 (1996).
60 Kenneth A. Gary, Treasury, IRS Propose New Corporate Tax Form, 102 Tax Notes
568 (Feb. 2, 2004); Charles S. Lewis III & Kevin T. Pearson, The 2003 "Confidential Transaction" Regulations: Another Chapter in the Tax Shelter Regulation Saga, 31 Corp. Tax'n
3 (2004); David K.C. Spencer, Tax Disclosure Boilerplate and the Confidentiality Conundrum, 101 Tax Notes 1203 (Dec. 8, 2003). For further developments, see Treasury Dep't,
General Explanations of the Administration's Fiscal Year 2005 Revenue Proposals 111
(2004), available at http://www.savingforcollege.com/.../529_pro solutions/resourcejlibrary/
files/fy2005-treasury-budget/pdf. For a similar approach by the U.K. legislature, see Stephen Edge, Disclosure of Tax Avoidance Schemes: First Legislative Shots Following the
Preliminary Skirmishes, Tax J., Apr. 19, 2004, at 5.
61 Knott & Rosenfeld, pt. 2, note 2, at 1063; David Lenter, Joel Slemrod & Douglas
Shackleford, Public Disclosure of Corporate Tax Return Information: Accounting, Economics, and Legal Perspectives, 56 Nat'l Tax J. 803 (2003).
62 Communication From the Commission to the Council, the European Parliament and
the Economic and Social Committee, An Internal Market Without Tax Obstacles: A Strategy for Providing Companies With a Consolidated Corporate Tax Base for Their EU Wide
Activities, COM (2001) 582 final, available at http://europa.eu.int/commI/taxationcustoms/
taxation/company-tax/key documents/indexen.htm [hereinafter Commission Communication]; Commission Staff Working Paper, Company Taxation in the Internal Market, SEC
(2001) 1681, available at http://europa.eu.int/comm/taxationcustoms/taxation/company-taxlkeydocuments/indexen.htm [hereinafter Commission Study].
2005]
putation of the tax basis all over Europe. 63 Thus, a U.K.-based parent
company would be in a position to draw up uniform consolidated tax
accounts for the whole range of EU activities, including branch establishments in Spain or subsidiaries in France. The net group profit
would be split up according to some "formula" between the involved
Member States and taxed under the corporate income tax rate set by
the domestic legislator. This procedure-it is hoped-will not only
lead to a massive reduction of compliance costs for European business, it also could do away with existing obstacles to cross-border activities in the field of loss-compensation, transfer pricing, exit taxation,
restructuring, dividend taxation, and the like.
Apart from the manifold political caveats that surround this proposal, one of the basic topics for further discussion is the concept of a
"common consolidated tax base" applicable to multinational business
activities. The first step to be taken on the road to such a common
framework for company taxation in Europe is to find a Euro-wide
consensus on such a tax base. Logically, there are three alternatives.
The Commission could try to invent from scratch a uniform code on
income measurement for taxable corporate business profits in Europe.
This is what they tried when they put forward a draft directive on a
common tax base in 1988, which ran into such heavy fire from the
Member States that it was not even officially proposed to the Council
of Ministers and the European Parliament. 64 Another option would
be to refrain from the concept of a uniform set of accounting standards for tax purposes altogether. This is the starting point of "Home
State Taxation," an innovative proposal elaborated by a private group
of tax experts from different European Member States. 65 They argue
that for most large (or small) European enterprises it would be sufficient to apply the tax rules laid down in the country of residence of
the parent company to all subsidiaries and branches of the group in
other EU Member States. This even could be done without any formal EU legislation on the basis of "mutual recognition" by the Member States. One practical and political argument against this concept
is that it will lead to an accelerated competition for the location of
parent companies and will distort the competitive situation of subsidiId.
64 See Reinhold Kreile, Zum Vorentwurf einer EG-Richtlinie uber die Harmonisierung
der steuerrechtlichen Gewinnermittlungsvorschriften, in 41 Der Betrieb app. 18 (1988);
Willem G. Kuiper, EC Commission Proposes a Directive on the Harmonization of Rules
for the Determination of Taxable Profits of Enterprises, 28 Eur. Tax'n 319 (1988).
65 Malcolm Gammie, Taxation Issues for the European Company, 7 EC Tax Rev. 159
(1998); Sven-Olof Lodin & Malcolm Gammie, The Taxation of the European Company, 39
Eur. Tax'n 286 (1999); Sven-Olof Lodin & Malcolm Gammie, Home State Taxation (2001);
Malcolm Gammie, Corporate Taxation in Europe-Paths to a Solution, 2001 Brit. Tax Rev.
233.
63
TAX LAW REVIEW
[Vol. 58:
aries and permanent establishments in other Member States due to

66
the tax rules of the respective parent company.
In this dilemma, the European Commission has found the advent of

the IAS/IFRS to be a gift from heaven. There it is: a common set of
rules for financial accounting of business profits that must be obeyed
by several thousands of companies from all over Europe, including all
of the big players in the tax game. The IAS/IFRS, the Commission
wrote in 2001, could serve as a "starting point" for the development of
a Common Consolidated Tax Base. 67 This proposal has been discussed in several fora since, including two high-level conferences organized by the Commission in 2002 and 200368 and the 2004 meeting
of the European Association of Tax Law Professors in Paris. 69 In September 2004 the ECOFIN Council decided to set up a working group
of government officials, which will be assisted by tax experts in order

to find out what a common tax base derived from IAS/IFRS would
70
look like and which adjustments would have to be made.
B.
Transfer Pricing
The notion of book-tax conformity as a solution to problems of international tax allocation does not stop at the boundaries of the European Union. The value of a common tax base as a starting point for
the resolution of transfer pricing conflicts has been a part of the international discussion since the early days. The 1933 Carroll report addressed the dichotomy between a "transactional" approach on
transfer pricing issues and "formulary apportionment" of business

66 Wolfgang Sch6n, The European Commission's Report on Company Taxation: A
Magic Formula for European Taxation?, 42 Eur. Tax'n 276, 281, 284-85 (2002); Bjorn
Westberg, Consolidated Corporate Tax Bases for EU-Wide Activities: Evaluation of Four
Proposals Presented by the European Commission, 42 Eur. Tax'n 322, 328-30 (2002).
67 Commission Communication, note 62,
5; Commission Study, note 62, pt. IV, [
13.2, 16.8; see also Summary Report on the Results of the DG Taxation and Customs
Union Open Consultation on the Application of International Accounting Standards
(IAS) in 2005 and the Implications for the Introduction of a Consolidated Tax Base for
Companies' EU-wide Activities, 2003, available at http://europa.eu.int.
68 See Joann M. Weiner, European Officials Consider Importance of Coordinating EU
Company Tax Policies, 32 Tax Notes Int'l 1001 (Dec. 15, 2003).
69 See Huub Bierlaagh, Jan de Goede, Kevin Holmes & Joanna Wheeler, European
Association of Tax Law Professors Meets in Paris, 44 Eur. Tax'n 328 (2004); Judith Freedman, Accounting Standards: A Panacea?, Tax J., Oct. 18, 2004, at 2; Sch6n, Starting Point,
note 2; Lee A. Sheppard, Financial Accounting Conformity for European Corporate Taxation?, 34 Tax Notes Int'l 1375 (June 28, 2004).
70 Results of Informal Meeting of Economics and Finance Ministers, The Hague, 10l1th September 2004-Banking and Company Taxation, MEMO/04/214, available at http://
europa.eu.int/commltaxation customs/common/archive/news/indexen.htm; see also two
Commission nonpapers that prepared this topic for the ECOFIN, published in EU Spurs
Discussion on Common Consolidated Tax Base, 35 Tax Notes Int'l 1199 (Sept. 27, 2004).
2005]
profits. 7 1 Tax experts appointed by the League of Nations voted

against the "fractional approach," bearing in mind not only political
difficulties in agreeing on a formula but also complications introduced
by differences in domestic accounting rules. 72 Nevertheless, the current transactional methods-like "cost plus"-have to rely on the
documentation of revenue and expenses in the respective income
statements. Moreover, any "profit split" must first make clear how to
identify a "profit" resulting from a cross-border activity as part of the
overall financial results of the business carried on by a company or
group of companies. The OECD Guidelines are of little help in stating that "[g]enerally, the profit to be combined and divided under the
contribution analysis is operating profit. '73 Would some common
ground in internationally agreed accounting standards be helpful in
this context? In its most recent publication on the international tax
treatment of employee stock options the OECD deplores that
[a]nother difficulty stems from the lack of uniform accounting treatment of stock option plans. Accounting rules differ
from jurisdiction to jurisdiction, and it is not always possible
to identify stock options in company accounts as salaries or
even as expenses. The lack of uniformity in the accounting
treatment of such plans mainly has consequences for ensuring comparability between the controlled and the uncontrolled transactions and for the application of transfer pricing
methods (... ) and is liable to introduce certain distortions
74
into transfer pricing.
In the U.S. proposed regulations on services under 482, Treasury
states that "[g]enerally accepted accounting principles or income tax
accounting rules may provide a useful starting point for determination
71 The League of Nations published the report in four volumes: 1 Taxation of Foreign
and National Enterprises, League of Nations Doc. C.73.M.38.1932.II.A. (1932); 2 Taxation
of Foreign and National Enterprises, League of Nations Doc. C.425.M.217.1933.II.A.
(1933); 3 Taxation of Foreign and National Enterprises, League of Nations Doc.
C.425(a).M.217(a).1933.II.A. (1933); 4 Taxation of Foreign and National Enterprises,
League of Nations Doc. C.425(b).M.217(b).1933.II.A. (1933); see Stanley I. Langbein, The

Unitary Method and the Myth of Arms Length, 30 Tax Notes 625, 631-38 (Feb. 17, 1986).
72 Fiscal Committee, Report to the Council on the Fourth Session of the Committee,
League of Nations Doc. C.399.M.204.1933.II.A. (1933), reprinted in 4 Joint Comm. on Internal Rev. Tax'n, Legislative History of United States Tax Conventions 4241 (1962); see
Michael C. Durst & Robert E. Culbertson, Clearing Away the Sand: Retrospective Methods and Prospective Documentation in Transfer Pricing Today, 57 Tax L. Rev. 37, 45
(2003).
73 OECD, Transfer Pricing Guidelines for Multination Enterprises and Tax Administrations, reprinted in 9 Tax Notes Int'l 155, 181 (July 18, 1994).
74 OECD, Employee Stock Option Plans: Impact on Transfer Pricing
A3 (2004),
available at http://www.oecd.org.
TAX LAW REVIEW
[Vol. 58:
of total services costs."' 75 Moreover, the recent U.S. regulation on

qualified cost-sharing agreements even provides that, with regards to
compensation of stock, only the amount determined and reported in a
company's financial statement may provide useful information for an
intercompany cost-sharing agreement. 76 If tax legislation or double
taxation treaties all over the world would employ the International
Accounting Standards as a starting point for the computation and allocation of business profits, this could take some steam out of the confrontational issues between jurisdictions and taxpayers in the
multinational arena.
V.
A.
CONCEPTUAL ISSUES OF BOOK-TAX CONFORMITY
The Purpose of Tax Accounting-Raising Revenue
The main argument brought forward against any sort of book-tax

conformity lies in the notion that the goals of taxation and financial
accounting simply do not match. The Court drew this conclusion most
impressively in Thor Power:
The primary goal of financial accounting is to provide useful
information to management, shareholders, creditors, and
others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The
primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the
77
Internal Revenue Service is to protect the public fisc.
From the perspective of EC law, a case in point is BIAO decided by
the European Court of Justice in 2003.78 The Hamburg tax court had
requested a preliminary ruling on an issue concerning the interpretation of the Fourth Council Directive, 79 which had arisen in a tax dispute under the auspices of the German linkage between tax
accounting and commercial accounting.8 0 Advocate General Jacobs
urged the Court not to hear the case; he found it not advisable to give
a ruling on an issue of harmonized accounting law that would have
75 Preamble to Notice of Proposed Rulemaking, 68 Fed. Reg. 53,448-01 J 10 (Sept. 10,
2003).
76 Reg. 1.482-7(d)(2); see Ronald B. Schrotenberger, Arm's Length in Wonderland, 33
Tax Notes Int'l 351, 357 (Jan. 26, 2004).
77 Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542 (1979).
78 Banque internationale pour l'Afrique occidentale SA (BIAO) v. Finanzamt fir
Groaunternehmen in Hamburg, [2003] E.C.R. I-1, 2003 WL 99729.
79 Reference for a Preliminary Ruling From the Finanzgericht Hamburg at C 333/13-C
333/14, BIAO.
80 Id.
2005]
consequences in the field of nonharmonized tax law. 81 He said, evidently against the background of British legal thinking,
It is clear from what has been said above that the aims and
the material and personal scope of the Fourth Directive are
radically different from those of the fiscal legislation at issue
in the main proceedings. That difference of context brings
me to my second point, namely that the present case perfectly illustrates the principle that apparently identical provisions may have different meanings in different contexts.
Company law rules regulating company accounts - now
harmonised at Community level - seek to protect shareholders and third parties (for example, actual and potential creditors and employees) by the mandatory disclosure of
prescribed information. National rules concerning the drawing up of accounts for fiscal purposes seek on the other hand
to enhance and protect State revenue. The two contexts are
thus manifestly different; indeed in several Member States
wholly separate accounts are drawn up for tax purposes and
82
company accounts purposes.
Nevertheless, the European Court of Justice took a more relaxed
stance and decided to adjudicate on the matter, stating that:
The Fourth Directive is not designed to lay down the condi-
tions in which the annual accounts of companies may or must

serve as a basis for the determination by the tax authorities
of the Member States of the basis for assessment and the
amount of taxes, such as the trade tax at issue in the main
proceedings. However, it is in no way excluded that annual
accounts might be used by Member States as a reference
83
base for tax purposes.
The main problem with this argument lies in the question of
whether the pure fiscal aim of raising revenue gives us some guidance
how to shape the rules on the measurement of taxable income. This is
not the case. In a statement sounding comical to some ears, the
Grand Senate of the German Federal Tax Court, in a 1969 landmark
case, tried to draw the line between financial accounting and tax ac-
counting by pointing out that financial accounting rules determines

81 Opinion of A.G. Jacobs, BIAO (No. 699C0306).
82
Id.
60.
83 BIAO, [2003] E.C.R. 1 70. For further developments in this case, see Wolfram Schef-
fler, Europaisierung des Bilanzsteuerrechts, Steuern und Bilanzen, Aug. 2004, at 776.
TAX LAW REVIEW
[Vol. 58:
the "profit" of a company while tax accounting rules determines its

"full profit."8' 4 What's the difference between the "profit" and the
"full profit"? The Court's reasoning in Thor Power does not provide
additional help. Can it be true-as I found in U.S. tax literature-that
"the fundamental objective of the tax accounting system, as we are all
aware, is revenue collection such that the system strives to enhance
the net (or taxable) income and, to this end, income items are accelerated while expenses, wherever possible, are deferred"? 85 Is it convincing that-under the claim of right doctrine-prepayments lead to
unearned but taxable income while-under the all events test deductions for expenditures that most probably will occur will be deferred
as long as possible? 6 The pure aim of raising revenue is not in the
position to supply us with any guidance when it comes to the measurement of income. It always will have an unjustified bias against the
taxpayer and his economic position.
We should bear in mind that the most far-reaching legislative step
towards book-tax conformity in the United States, the recognition of
contingent liabilities and the introduction of accounting treatment for
prepayments in 1954, were well founded systematically but were abolished after a short time for simple budgetary reasons.8 7 Do we find a
convincing rationale for the statement of the Court in INDOPCO,
88 I
"that 'an income tax deduction is a matter of legislative grace?"
could give more examples from the European tax arena. This fiscal
approach does not seem to be in line with the principles of equity and
efficiency, which should be our guiding light in the framing of a set of
rules on the measurement of taxable profits and losses in the corporate sector.
84 Bundesfinanzhof, Judgment of Feb. 3, 1969, Bundessteuerblatt (Federal Tax Gazette)

pt. 2, 1969, at 291.
85 Robert Willens, Loan Origination: Getting Tax and Financial Accounting to Mesh,
CFO.com, Aug. 31, 2001, at http://www.cfo.com/article.cfm/3000697?F=advancesearch.
Beale defends this approach, pointing to the necessity of "overtaxation" in order to avoid
"manipulation" of the tax base by the structuring of revenue and expense by the taxpayer.
Beale, Conformity, note 50, at 356.
86 See Knott & Rosenfeld, pt. 1, note 2, at 877-84 (regarding this to be a systematic
difference between tax and financial accounting).
87 See Luppino, note 57, at 116-18; Sheppard, Silver Bullet, note 56, at 677-78. This
approach has been criticized by the dissenting minority in American Automobile Association v. United States, 367 U.S. 687, 698 (1961) (Stewart, J.,
dissenting). On the time value
of money in the case of accelerated and deferred payments, see Daniel I. Halperin, Interest
in Disguise: Taxing the "Time Value of Money," 95 Yale L.J. 508-25 (1986).
88 INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992) (citing various prior cases).
2005]
B.
Ability To Pay
Looking at income taxation from the equity perspective, the abilityto-pay principle represents a limited international consensus on the
definition of the tax base. This principle has led to the comprehensive
notion of income, first developed by the German Georg von Schanz at
the turn of the 20th century,8 9 and later refined and improved by Robert Murray Haig and Henry Simons in the United States. 90 At the
outset one finds the idea that people engage in economic activities in
order to enhance their consumption. Following this concept, one can
describe income as the increase in consumption power-that is, the
increase of the value of property rights in the hands of the taxpayer
during a certain period. Property rights are those individual entitlements of the taxpayer that he can use for consumption. If one accepts
that in the case of a taxpayer's investment in the corporate sector, he
will expect cash or cash equivalents like dividends or capital gains in
order to transform them into consumption, one further reaches the
conclusion that for business taxation purposes, income is the increase
of property rights that will generate cash or cash equivalents for later
consumption. This is completely in line with the basic goal of the International Accounting Standards, which are meant to give the investor all the relevant information about the economic outlook of his
investment. Paragraph 15 of the IAS Framework states: "The economic decisions that are taken by users of financial statements require
an evaluation of the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their generation." 91
This shows a deeply rooted interdependence of tax and financial
accounting. Both look at the consumption power of a person-tax
law in order to describe his ability to pay to the tax inspector, and
accounting law in order to improve the investor's knowledge about
the economic merits of his investment. This means that both financial
accounting rules and income measurement under tax law try to picture the same economic reality. The notion of book-tax conformity
therefore does not simply look to connect two diverging fields of law
in order to reduce compliance costs of business corporations or to im89 Georg von Schanz, Der Einkommensbegriff und die Einkommensteuergesetze, 13 Finanz-Archiv 1 (1896).
9oRobert M. Haig, The Concept of Income-Economic and Legal Aspects, in The Federal Income Tax 1 (Robert M. Haig ed., 1921), reprinted in Am. Econ. Ass'n, Readings in
the Economics of Taxation 54 (Richard A. Musgrave & Carl Shoup eds., 1959); Henry C.
Simons, Personal Income Taxation (1938). This evolution of the "notion of income" is
described by Kevin Holmes, The Concept of Income-A Multi-disciplinary Analysis 35-83
(2001).
91 IFRS, note 9, at F-10 (citing to Framework for the Preparation and Presentation of
Financial Statements).
TAX LAW REVIEW
[Vol. 58:
prove the control of the tax administration. Book-tax conformity tries

to build on the fact that both tax and financial accounting refer to a
common economic goal-that is, the accurate description of the economic strength of a person. It seems to be no accident that the Tax
Court in Bank One92 came to the conclusion that mark-to-market valuation for financial instruments is not only the "state of the art" in the
field of financial accounting but also a perfect implementation of the
income tax concept put forward by Haig and Simons.
Let me give another example for this common ground of tax and
financial accounting: Under tax law one must examine whether a sum
paid by the taxpayer out of his revenue may be expensed fully in the
current fiscal year or whether the expenditure must be capitalized and
written off over several tax periods. Under 162 and 263 of the
Code this depends on the nature of the benefit created by this expen93
diture. If the expenditure will lead to a "significant future benefit"
that extends over one fiscal year, it has to be capitalized and written
off over its useful life. This is not far away from the jurisprudence of
the German Federal Tax Court, which does not allow the full deduction of an expense leading to an advantage for the business that
stretches over the current fiscal year. 94 Financial accounting rules
move in the same direction. The definition of an "asset" under par.
49(a) of the IAS Framework runs as follows: "An asset is a resource
controlled by the enterprise as a result of past events and from which
'95
future economic benefits are expected to flow to the enterprise.
Of course it is easy to find examples in current accounting and tax
practice in the United States, in Europe, and in other countries that
show a broad range of different answers to the question of when there
actually is a future economic benefit financed out of past expenditure
that must be capitalized for accounting or tax purposes. An example
is INDOPCOwhere the notion of a "separate and distinct asset" was
deemed not to be essential for capitalization. 96 Yet these practical
problems and distinctions should not divert us from the assumption
that there is no fundamental difference between the basic goals envisaged by tax and financial accounting-that they try to identify the economic strength of a person by looking at the power of her investment
to generate future economic benefits.
Bank One Corp. v. Commissioner, 120 T.C. 174, 291-97 (2003).
Michael J. Graetz & Deborah H. Schenk, Federal Income Taxation, Principles and
Policies 292 (rev. 4th ed. 2002).
94 See, e.g., Federal Tax Court (Bundesfinanzhof), judgment of 6th December 1990, Federal Tax Gazette, pt. II, 346, 347 (1991).
95 IFRS, note 9, at F-19.
96 INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 87 (1992).
92
93
2005]
Moreover, it is a common feature of tax laws all over the world that
many differences between book and tax income arise in situations
where tax law addresses nontax policy issues, giving preferential or
disadvantageous treatment to a specific investment or other economic
behavior of the taxpayer. 97 Here we find tax incentives (for example,
accelerated depreciation), pure fiscally motivated rules (for example,
bad debts) or provisions that are meant to pursue distributive aims
(for example, specific rules for small and medium-sized business). It
has been argued that the introduction of these tax preferences should
not be prohibited by comprehensive book-tax conformity. 98 Yet these
rules not only deviate from the financial accounting treatment, they
also infringe the ability-to-pay principle. Therefore there are good arguments to do away with these exceptions, which distort the tax base
and violate the equitable treatment of taxpayers in general. Even if
they do exist, book-tax conformity makes it easy to define the rule and
the exception, thus making it easier to control the political dimension
of tax income measurement.
C.
Efficiency
Economic theory for decades has strived to build the definition of

taxable income based on efficiency. The tax base-it is said-should
not distort the economic decisions of the taxpayer with respect to the
allocation of resources like human labor or capital. In the end there
are only two approaches that address this requirement in a systematic
way. One is cash flow taxation, which merely looks at the inflow and
outflow of cash and cash equivalents. Cash flow taxation, taken as a
tax on consumption, would do away with the accrual concept of income that currently forms the basis of financial accounting and tax
accounting in most countries, and also would try to achieve inter-temporal efficiency by relieving the reinvestment of profits of any excess
burden. The merits of such cash flow taxation cannot be discussed
here at length. It suffices to say that its introduction would exclude
any reference to the financial accounts of a business because the fundamental distinction between current expense and capitalized expense, which lies at the heart of the definition of assets and liabilities
that form the basic elements of the balance sheet under financial accounting rules, would be discarded.
The other approach that has been described as an efficient format
for taxable income measurement was developed by Sven-Erik Johans97 Knott & Rosenfeld, pt. 2, note 2, at 1059-62.
98
Engler, note 58.
TAX LAW REVIEW
[Vol. 58:
son 99 and Paul Samuelson 00 in the 1960's and calls for a full inclusion
of all elements of economic power in the hands of a person at fair
value. Income is defined as the amount of economic power that the
taxpayer may consume during a given period without reducing his economic funds. This approach is quite opposite to the cash flow
method as it forces the taxpayer to show at full fair value all the assets
and liabilities in the context of a relevant source of income. It is quite
similar to the framework of financial accounting, which supplies the
investor with full information about the future inflows and outflows of
benefits in the context of his investment. Nevertheless, this comprehensive approach does not seem to be feasible either in the world of
tax accounting or financial accounting. The full recognition and valuation of all elements that influence the economic power of a person
stretches far beyond the administrative and cognitive capacities that
can be devoted to the task of measuring profits and losses for capital
market and fiscal purposes. If we would embark on this road, we
would witness a loss of objectivity, which would deeply damage the
goal of comparability under financial securities law and the goal of
objectivity under tax law. Therefore, we have to find some practical
solutions, which will supply business, auditors, and tax inspectors with
reliable instruments to determine the computation of profits and
losses.
To be sure, the goal to achieve efficiency in the definition of the tax
base also should be relevant in the development of second-best solutions. There should be a symmetric recognition of revenue and expenditure items to provide for nondistorted investment decisions. There
should be a mechanism to provide for intertemporal loss compensation in order not to distort the choice between high-risk and low-risk
investments. There should be no distinction between tangible and intangible assets at the outset-here we find huge differences between
Germany (which does not provide for the capitalization of self-created
intangibles at all) and the United Kingdom and the United States
(where self-created intangibles can be capitalized but are subject to
specific incentives, for example, for R&D or film production). To give
another example: Under the rules of the International Accounting
Standards, participations in listed companies are subject to fair-value
accounting while participations in private companies are not. 10 1 In the
tax world, this different treatment would lead to a distortion of the
99 Sven-Erik Johansson, Income Taxes and Investment Decisions, 71 Swed. J. Econ. 104
(1969).
100 Paul A. Samuelson, Tax Deductibility of Economic Depreciation to Insure Invariant
Valuations, 72 J. Pol. Econ. 604 (1964).
101 International Accounting Standards Board, IAS 39, Financial Instruments: Recognition and Measurement 43.
2005]
taxpayer's decision to invest in listed vs. nonlisted companies. One of

the most problematic issues is tax neutrality as to the legal form of a
company because tax incentives or disincentives might lead to a distorted choice by the taxpayer that does not fully reflect the best organizational and corporate governance solution for an enterprise.
D.
Certainty
One of the criticisms regularly brought forward against book-tax

conformity is the argument that the rules on financial accounting give
management too much leeway in describing the economic situation of
the company. Tax income measurement-it is said-needs to boil
down to hard numbers while investors may be satisfied with unclear
information. 10 2 I do not think this criticism is well-founded. First, full
certainty will only exist in a pure cash flow tax world and perhaps not
even there. If we start to distinguish between the immediate expense
and the capitalization and amortization of costs, we will have uncertainty. If we try to give a true picture of the economic situation of a
company, we have to account for liabilities-including contingent liabilities. What about impairment and other extraordinary losses-they
have to be identified both for tax and accounting purposes. On the
other hand, the information purpose of financial accounting urges the
accounting rules to provide for comparability and objectivity of resuits. 10 3 It is also an aim of standard setting in the accounting world to
reduce more and more the discretion granted to management when
informing the public about the situation of the enterprise. Both book
and tax have to cope with the same difficulties in ascertaining the true
economic profit of the taxpayer-but it would be unwise to strive for
"certainty" if this means to deliberately build the income tax assessment on wrong numbers.
E.
1.
Information, Liquidity, and Taxation
General
We have reached the intermediary result that the aim of financial

accounting and the aim of tax accounting are by no means completely
different but that they tend to picture the same elements of economic
102 Freedman, Aligning, note 2, at 75; Herzig, note 26, at 25; Knott & Rosenfeld, pt. 2,
note 2, at 1059; Lenter et al., note 61, at 819; Sheppard, Silver Bullet, note 56, at 676.
Beale, Conformity, note 50, at 357, adds that financial accounts only need comparability
over time periods, not reliability as to the precise numbers for a given period, but this
seems not to be in line with the concept of IAS as described in the IAS Framework.
103 International Accounting Standards Board, Framework,
31 et seq. ("reliability"),
39 et seq. ("comparability").
TAX LAW REVIEW
[Vol. 58:
reality. Nevertheless, there still remains one major distinction between the income statement under financial accounting standards and
under tax law. The information given by a business to its shareholders
and stakeholders does not result in an immediate outflow of cash or
cash equivalents; it merely assists the investor in deciding whether to
put money into a company or to withdraw funds or to change the
management. The same information if given to the tax authorities
leads to a tax liability that must be met without any deferral. Thus,
tax accounting immediately affects the liquidity of a company while
the information purpose of financial accounting does not. This gives
rise to some further thoughts.
2.
The Shifting Focus of FinancialAccounting
First, the one-dimensional focus of financial accounting on investor

information is of recent origin. In prior times, the rules on financial
accounting were principally meant to determine the profit of a company, which the managers were free to distribute among the shareholders. In the United States, this "distribution purpose" of financial
accounting turned obsolete when, in accordance with the Revised
Model Business Corporation Act of 1980, most states changed their
company law during the 1980's and 1990's, and left the concept of "legal capital" behind.1 0 4 In Europe, however, the concept of "legal capital" is still alive; it is not only enshrined in many national company
laws but also in the Second Company Law Directive of the European
Community. 10 5 Following this concept, financial accounting is meant
to define the profit that can be taken out of the company without
stripping assets from the funds, which are required to serve as collateral for the creditors of the company. This aim of "creditor protection" is still at the heart of accounting law in many continental legal
systems like Germany, France, Austria, Switzerland, and Italy.10 6 Of
course, rules on financial accounting that try to protect the claims of
the creditors against the withdrawal of assets from the company's
funds tend to be conservative; that is, profits will be shown as late as
104 James
D. Cox & Thomas Lee Hazen, Corporations 504-5 (2d ed. 2003).
Company Law Directive, Directive 77/91, 1977 O.J. (L 26) 1. On the pros
and cons of this concept in the European perspective, see Luca Enriques & Jonathan R.
Macey, Creditors Versus Capital Formation: The Case Against the European Legal Capital Rules, 86 Cornell L. Rev. 1165 (2001); Peter 0. MUlbert & Max Birke, Legal Capital-Is
There a Case Against the European Legal Capital Rules?, 3 Eur. Bus. Org. L. Rev. 695
(2002); Wolfgang Schon, The Future of Legal Capital, 5 Eur. Bus. Org. L. Rev. 429 (2004);
see Gdrard Hertig & Hideki Kanda, Creditor Protection, in The Anatomy of Corporate
Law 71 (Reinier H. Kraakman ed., 2004) (presenting a comparative view).
106 Nobes & Parker, note 22, at
2.4.
105 Second
2005]
possible, losses as early as possible. 10 7 This results in an asymmetric

picture of the company's financial situation that exaggerates the
downside potential and underscores its upside potential.
In looking at the current debate on book-tax conformity, therefore
one has to acknowledge the fact that book-tax conformity under financial accounts, which are governed by the aim of "creditor protection," means something quite different from book-tax conformity in
the era of "investor information." Investor information standards-as
found in U.S.-GAAP and IAS/IFRS-tend to give a symmetric picture of the company's financial situation, matching both revenue and
expense according to the same criteria. Creditor protection means
that an asset will be recognized only if it has fully materialized and a
profit will be shown only if it has been realized by a transaction, while
losses and impairments have to be included in the balance sheet if
they are only probable to occur in the future. Therefore, in the context of German tax and company law, the effect of book-tax conformity would change completely if the old creditor-protecting financial
accounting rules were replaced by the modern investor-oriented IAS/
IFRS. There is a widespread fear among German practitioners that
any reference of the taxable income to IAS/IFRS will lead to a higher
tax bill when compared to the traditional conservative rules.10 8 On
the other hand, the criticism of the U.S. Supreme Court in Thor
Power'0 9 against the "conservative" attitude of financial accounting,
which led to a fundamental break-up between the two sets of accounting rules in the United States, was justified with respect to the traditional accounting rules that vested in management the power to
deliberately understate the company's profit and to create at will "hidden reserves" in the balance sheet. The same criticism is no longer
valid from the tax point of view because modern financial accounting
rules try to give a faithful and symmetric picture of the financial situation of the company to its investors. 10
107 For a theoretical justification of this concept, see Alfred Wagenhofer, Accounting
and Economics: What We Learn From Analytical Models in Financial Accounting and
Reporting, in The Economics and Politics of Accounting 5 (Christian Leuz, Dieter Pfaff &
Anthony Hopwood eds., 2004).

108 Ulrich Prinz, Reform der deutschen Rechnungslegung, 41 Deutsches Steuerrecht
1359, 1363 (2003).
109 Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542 (1979); see Knott & Rosenfeld, pt. 1, note 2, at 880.
110 The necessity of "symmetrical" accounting rules for contractual relationships is
stressed by David F. Bradford, Fixing Realization Accounting: Symmetry, Consistency
and Correctness in the Taxation of Financial Instruments, 50 Tax L. Rev. 731, 748-49
(1995); Wolfgang Schon, Die Steuerbilanz zwischen Handelsrecht und Grundgesetz, 72
Steuer und Wirtschaft 366 (1995).
TAX LAW REVIEW
[Vol. 58:
Against this background we must address the impact of the fact that
tax law takes away liquidity from the company on the question of
book-tax conformity. There are two issues that must be addressed in
this context: One is "valuation" and the other is liquidity.1 1 '
3.
Valuation
While investor information can be ambiguous as long as it transfers

to the receiver of the information the relevant points, tax accounting
has to result in a single specific number that defines the liability of the
taxpayer. There is no room for a bandwidth of tax bills from which
the taxpayer may choose. On the other hand, unless there is a cash
flow tax, there always will be uncertainty in the tax sector in trying to
recognize and evaluate assets or estimate the amount of a liability.
The problem is how to address this "uncertainty." Taking a closer
look, one finds that financial accounting may help. Under conservative financial accounting rules, any ambiguity has to be solved by understating a profit, for example by the application of the "lower of
market or cost" principle or by the inclusion of provisions for future
losses and risks into the balance sheet. 112 From the tax perspective
one might accept this conservative approach by referring to the general concept that the "benefit of doubt" should not be with the government who wants to extract money from a private firm but with the
taxpayer who should be entitled to show an item of income only in the
tax accounts when we can be sure that he has definitely earned it.
Under "modern" U.S.-GAAP or IAS/IFRS, any uncertainty as to the
upside or the downside economic potential of a firm will be shown
symmetrically in the financial accounts. This is also a line that can be
used for tax reasons because it leads to a symmetric description of the
ability to pay of the taxpayer. In any case this is not a situation where
tax should deviate from book rules.
The most problematic issue in this context is the tendency of the
IAS/IFRS to rely on "fair values." Under the heading of "certainty"
this is fully acceptable if we try to identify the tax value of financial
instruments that have a quoted market price.11 3 In other cases, the
"fair value" of an asset will be subject to estimates and discretion, for
example, when the "mark to model" approach is employed. Economists also have asked what models are admissible and what the realisM1See generally Deborah H. Schenk, A Positive Account of the Realization Rule, 57
Tax L. Rev. 355, 359 (2004) (evaluating both valuation and liquidity as arguments supporting the realization rule).
112 Another example for this book-tax difference is the treatment of "contingent payment instruments." See Keinan, note 50, at 735.
113 See IRC 475.
2005]
tic parameters are.1 14 The legislative option to draw a line between
assets that are easy to revalue on an annual basis and those that are
not (partial mark-to-market taxation 1 5 ) would bring new distortions
to the tax world.'1 6 This seems to be a strong argument against con-
formity of financial and tax accounts in the future" 7 but one should
not forget that the loss of certainty in the world of "fair value" is not
only a problem for taxation but also for commercial accounting.11 8
4.
Liquidity-Taxation and the Capital Markets
The bigger problem is liquidity."
It has long been said that an
income tax that would take into account any increase or decrease of
the value of a business asset would provide for efficiency. As a trans-
action would not lead to a realization of a profit not yet shown in the
balance sheet, there would be no lock-in effect preventing the taxpayer from selling his assets at the right time. 120 On the other hand,
any taxation without realization could force the taxpayer to sell an
asset only to obtain liquidity to meet his tax liabilities, which could be
an inefficient result as well. This would deprive him from the future
upside and downside potential inherent in this asset. 121 What does
this mean for the book-tax conformity debate?

In the German discussion, the issue of liquidity has long been employed to strengthen the conformity of the tax accounts with "con-
servative" accounting rules. 122 As the tax authority tries to extract

money from the company's funds, it should wait as long as any other
shareholder of the company until a profit is "realized" according to
commercial accounting rules and can be withdrawn without doing
damage to the company or its creditors. In this context, the govern114 See, e.g., Wolfgang Ballwieser, The Limitations of Financial Reporting, in The Economics and Politics of Accounting, note 107, at 58, 65.
115 See David A. Weisbach, A Partial Mark-to-Market Tax System, 53 Tax L. Rev. 95
(1999).
116 Edward A. Zelinsky, For Realization: Income Taxation, Sectoral Accretionism, and
the Virtue of Attainable Virtues, 19 Cardozo L. Rev. 861, 917-18 (1997).
117 For a more optimistic view on valuation, see Schenk, note 111, at 370.
118 Is Fair Value Fair? (Henk Langendijk, Dirk Swagerman & Willem Verhoog eds.,
2003).
119 But see David J. Shakow, Taxation Without Realization: A Proposal for Accrual
Taxation, 134 U. Pa. L. Rev. 1111, 1167-76 (1986) (arguing that in practice the liquidity
problem can be solved).
120 See Schenk, note 111, at 384-88; Daniel N. Shaviro, An Efficiency Analysis of Realization and Recognition Rules Under the Federal Income Tax, 48 Tax L. Rev. 1, 24-26
(1992).
121 On the pros and cons of the realization requirement, see generally David M. Schizer,
Realization as Subsidy, 73 N.Y.U. L. Rev. 1549 (1998). The subsidy effect also is stressed
by Schenk, note 111, at 365.
122 Schon, Eine Zukunft, note 18.
TAX LAW REVIEW
[Vol. 58:
ment is regarded as a "dormant partner" who should share the risks

and obligations of the company with respect to third parties and cannot ask for preferential treatment. 12 3 Therefore, book-tax conformity
under the old rules was well founded. The advent of the International
Accounting Standards, which move in the direction of full fair-value
accounting and minimize the formerly decisive role of realization in
the accounting world, seems to argue for a dissolution of existing links
124
between book and tax income.
Yet one also could find a hidden link between the modern investororiented perspective on financial accounting and the liquidity problem
under tax law. The liquidity problem arises when an increase in the
value of an asset does not supply a taxpayer with the funds necessary
to meet the tax liability on this appreciation. This is due to inefficiencies in the financial markets, which make it difficult for the taxpayer
to raise funds from third parties as debt or equity. Therefore, the government takes on the role of the "superior borrower." 125 But one
should not forget that the true aim of financial accounting is just to
overcome these inefficiencies in the capital market. 126 If financial accounting works as it should, it would show investors the increase in
the fair value of an asset, thus influencing outside investors to put extra money into the firm that can be used for the fulfillment of the tax
bill. 127 If it does not work, we do not have a problem of book-tax
conformity; we have a problem for financial accounting in general.
Therefore the decision on the future of book-tax conformity is fundamentally dependent on one's view of the future of financial accounting in its own territory. If U.S.-GAAP or IAS/IFRS succeed in giving
to the markets a full and fair view of the company's situation, we can
build a tax assessment on the same results, as the capital markets will
provide the company with the funds necessary to pay the tax bill. If
U.S.-GAAP or IAS/IFRS do not help in the creation of a workable
financial market, they will not be very helpful in the tax arena either.
We would fall back into the world of "conservative accounting" because the taxpayer has to rely on the realization of profits in the market before he will be able to satisfy any tax liabilities. The question of
123 Dollerer, note 19, at 1334.
124 See Freedman, Aligning, note 2, at 75-77; Schoen, Starting Point, note 2, at 438-40;
Herzig, note 26, at 222.
125 See Zelinsky, note 116, at 889.
126 See, e.g., Carol A. Frost & Kurt P. Ramin, Corporate Financial Disclosure: A Global
Assessment, in International Finance and Accounting Handbook 13.7 (Frederick D.S. Choi
ed., 3d ed. 2003).
127 The alignment of financial and tax reporting could even overcome the popular notion
that unrealized profits are mere "paper gains." See Terrence R. Chorvat, Perception and
Income: The Behavioral Economics of the Realization Doctrine, 36 Conn. L. Rev. 75, 99111 (2003); Schenk, note 111, at 377-83.
2005]
book-tax conformity therefore does not depend on the different

"goals" of tax and securities law but on the practical effectiveness of
financial accounting rules as a means of raising money from the capital markets.
VI.
POLICY ISSUES OF
TAX
ACCOUNTING AND FINANCIAL ACCOUNTING
Contrary to popular wisdom, there is no fundamental antagonism

between the goals of tax accounting and financial accounting that
would render the task of aligning financial and taxable income impossible from the start. But when it comes to the drafting and application
of a common set of standards for tax and capital market purposes,
there are practical problems that are rooted in public choice and behavioral aspects of accounting.
A.
"Pollution" of the Standard-Setting Process
In the process of drafting new accounting standards-rules or principles-one of the major arguments against book-tax conformity is the
danger of "pollution" of the standard setting procedure and outcome. 128 The fear is that business interests will exert political pressure
on the standard-setting process if the result is likely to affect the tax
burden of the corporate sector. This fear is not only strong where the
rules on commercial accounting are subject to political legislationsuch as in Europe where the Fourth and the Seventh Directives on
annual and consolidated accounts1 2 9 and (in some countries) domestic
legislation have provided until recently the framework for commercial
accounting-but also in countries where the standard-setting process
is in the hands of private experts-like in the United Kingdom or the
United States. It even has been argued that under comprehensive
book-tax conformity, the U.S. Congress would take the standard-setting process out of the hands of private experts in order to further its
130
tax policy goals.
The perspective that pollution will be on the rise under the auspices
of book-tax conformity runs into two counter-arguments. First, even
without taxation, the shaping of accounting standards is of high political relevance.13 1 Prominent examples are the accounting treatment of
128 See, e.g., Freedman, Aligning, note 2, at 76; Nobes, note 39, at 49-52.
129 Fourth Council Directive 78/660, 1978 O.J. (L 222) 11; Seventh Council Directive 83/
349, 1983 O.J. (L 193) 1.
130 See, e.g., Hanlon & Shevlin, note 2, at 4-5; Knott & Rosenfeld, pt. 2, note 2, at 106162.
131 See generally Dieter Ordelheide, The Politics of Accounting: A Framework, in The
Economics and Politics of Accounting, note 107, at 269; see also Stuart McLeay, Dieter
Ordelheide & Steven Young, Constituent Lobbying and its Impact on the Development of
TAX LAW REVIEW
[Vol. 58:
mergers and acquisitions under the "pooling method," the amortization of goodwill according to the newly established impairment test
and the accounting of financial instruments-like hedges-according
to their fair value. There is no standard setting in the accounting area

that occurs under strictly nonpolitical circumstances. Second, the tax
pressure on the drafting of accounting standards could be relieved if
we accept that in reality-in the past and in the future-there never

was and there never will be a full and comprehensive alignment of tax
and commercial accounting rules. The tax legislator in any case will
have the power to deviate from the accounting treatment proposed
under commercial rules. 132 This is common practice both in most

countries of continental Europe and in the United Kingdom, where
the alignment of taxable and business profits has been strengthened

during the last years. It also is proposed for the European arena-it
would be up to the European Commission or another supranational
body to decide on the application of International Accounting Standards for tax purposes. 13 3 Thus, the political pressure of the corporate
sector will tend to concentrate on the tax legislator in order to achieve
specific preferential treatment under the tax rules.

B.
"Privatization"and "Internationalization"of Tax Legislation

and Adjudication?
The standard-setting process also will be important from an institutional point of view. For tax legislators it will be hard to accept the
product of a private standard-setting process as a basic element of the
domestic tax base. The reluctance to give up any sovereignty in this
sector will become even bigger if the standard setter is an international organization.13 4 In some member states of the European
Union-for example, in Spain 135 or Germany136-it
even seems
Financial Reporting Regulations: Evidence From Germany, in Economics and Politics of

Accounting, note 107, at 285.
132 See Luppino, note 56, at 144-64; Yin, note 55, at 224.
133 See SchOn, Starting Point, note 2, at 428-30.
134 See Knott & Rosenfeld, pt. 2, note 2, at 1060. German writers have expressed the
opinion that the difference in the importance of accounting standards between the United
States and Germany is rooted in the purely private character of U.S. standards as opposed
to the legal force of German standards. Ulrich Schreiber, Hat das MaBgeblichkeitsprinzip
noch eine Zukunft?, in Festschrift fur Heinrich Beisse 491, 507 (Wolfgang Dieter Budde et
al. eds., 1997).
135 Instituto de Contabilidad y Auditorid de Cuentas (ICAC), Informe Sobre la Situaci6n Actual de la Contabilidad en Espana y Lfneas Bisicas para Abordar su Reforma
1 11.2.2 (2002); Josd Gonzalo & Anne Garvey, Accounting Reform in Spain: "In Medio,
Virtus," World Acct. Rep., Apr. 2003, at 12; Josd Gonzalo & Anne Garvey, Spanish Reform Part 2: Institutional Recommendations, World Acct. Rep., May 2003, at 10.
136 Herzig, note 26, at 15.
2005]
doubtful whether the constitution allows the tax legislator to defer for
the tax sector to the decisions taken by a private body on accounting
rules. This subordination seems to run a foul of basic democratic principles enshrined in many European constitutions. Britain, where the
linkage of tax accounting with the International Accounting Standards
was introduced in 2004,137 does not have a written constitution and is
therefore not in this group of countries.
Yet these political and constitutional doubts can be overcome if the
national parliaments retain the power to decide whether there are
good reasons to follow the route laid down by a national or international standard-setting body. They simply employ the expertise enshrined in the accounting standards and decide whether tax law
should provide otherwise due to compelling political reasons. There
will never be an anticipated full deference to the standards developed
in the commercial accounting community.
On the other hand, the topic of "privatization" does not stop here.
Once the accounting standards are in place and tax law refers to them,
there will be legal disputes arising out of the interpretation of these
standards in the context of tax assessments. Who will give a binding
interpretation of the existing standards? In tax matters there is a
longstanding tradition in all countries known to me that the courts
have the final word. In accounting matters, there is no clear picture.
In Germany, the competence to give interpretation on accounting
standards gradually has shifted from professional bodies to the courts.
This development has been confirmed by the codification of all major
accounting principles in the German Commercial Code in 1986.138 In
the end, the German tax courts had an enormous influence on the
practice not only of tax accounting but also of financial accounting. In
the Anglo-American tradition, it is up to the private standard-setting
bodies (such as the Financial Accounting Standards Board in the
United States) to give clarifications and interpretations or their own
standards. 139 This tradition recurs in the institutional concept of the
International Accounting Standards where the International Financial
Reporting Interpretations Committee (IFRIC) has the task of giving
advice on the application of the standards drafted by the International
Accounting Standards Board.
This leads to the following issue: Is it possible that the tax administration and the taxpayer have to refer their case to the FASB or the
IFRIC and ask for the interpretation of financial accounting standards
137 Finance Act 2004, note 41, 50.
138 Bilanzrichtliniengesetz (Accounting Directives Act) of Dec. 19, 1985, Bundesgesetzblatt (Federal Gazette) pt. 1, 1985, at 2355.
139 On the interaction of courts and standard setters under U.K. law, see Freedman,
Aligning, note 2, at 77-87.
TAX LAW REVIEW
[Vol. 58:
in the tax context? I would not dare to comment on the U.S. situation 140 but in the European arena the answer is quite clear: According
to the IAS Regulation passed by the European Institutions in 2002, no
international accounting standard gains binding force within Europe
141 This
unless it is formally "endorsed" by the European Commission.
"endorsement" leads to a transformation of the standard-it leaves its
private character behind and becomes a part of the corpus of EC law.
The interpretation of EC law is up to the European Court of Justice in
Luxembourg and the national courts of the member states. 142 This is
true in the field of financial accounting and it also will be followed in
the field of tax accounting where the government tries to extract
money out of the taxpayer under the rule of law. This will strengthen
the position of the courts in accounting matters in relation to the standard-setting bodies. On the other hand, the statements of interpretation released by IFRIC also need "endorsement" by the European
Commission in order to become binding for the users and preparers of
financial accounts in Europe. Once this endorsement is in force, the
courts have to follow these official interpretations, and the only problem left is the question of whether the endorsed interpretation has
retroactive power in the context of financial and tax rules.
The German example of the role of the courts in the process of
interpretation of accounting rules is valuable for several reasons. The
existence of independent courts in this field not only has provided a
broad range of relevant case material for practitioners, it also has
helped to strengthen the backbone of the auditors in the financial accounting world, who could rely on explicit decisions by the courts in
order to fend off questionable accounting practices of their clients. As
the corporate governance discussion still has not found a remedy for
the dangers to auditor independence, not only the prospect of court
review but also the perspective of closer examination of the financial
143
accounts by the tax authorities could have a positive effect.
C.
Strategic Management Behavior
Another aspect of linkage between financial and tax accounts concerns the individual behavior of management when they draw up the
For the current role of the courts under U.K. law, see id. at 87-96.
(EC) 1606/2002 of the European Parliament and of the Council of 19th
July 2002 on the Application of International Accounting Standards, art. 3 par. 2, 2002 O.J.
(L 243/1) (IAS-Regulation).
142 See Wolfgang Schon, Gerichtskompetenzen und Auslegung von IAS/IFRS, 59 Betriebs-Berater 763 (2004).
143 As to the problem of auditor independence, see generally Theodore Eisenberg &
Jonathan R. Macey, Was Arthur Andersen Different?: An Empirical Examination of Major Accounting Firm's Audits of Large Clients, 1 J. Empirical Leg. Stud. 263 (2003).
140
141 Regulation
2005]
accounts for a certain period. The discussion of the merits of book-tax

conformity contains two different approaches to this issue. On the
one hand there is the view that the linkage of tax income measurement to the financial account will produce a bias towards conservatism. The discretion granted to management under the reign of the
accounting standards will be employed to reduce the tax burden of the
company even if that will distort the fair presentation of the company's economic situation. This is one of the main arguments against
any sort of book-tax conformity. 144 Given the manifold uncertainties
laid down in accounting rules (Will there be a future inflow or outflow
of resources? Do we have to account for contingent liabilities?) any
linkage of tax accounts with commercial accounts seems to damage
both the comparability and reliability of commercial accounts for capital market purposes and the equity of the tax assessment.
On the other hand, it cannot be ignored that even without book-tax
conformity, management has ample motivation to form an over-optimistic bias in their financial accounts. It goes without saying that in
the case of stock options and other performance-related compensation systems, management is interested in showing shareholders and
possible investors the best of all possible outcomes. From this point of
view, book-tax conformity could lead to a balance between the overoptimistic management bias in the capital market context and the
over-conservative estimates of management in the tax context. 14 5 This
"book-tax trade-off" causes a substantial "friction" with respect to aggressive tax planning. 1 46 German writers call it a general conflict-solving mechanism. 14 7 Recent research has shown that the gradual
disconnection of tax and book accounting under German law has led
to a dramatic loss of "prudence" in the drafting of financial accounts;
provisions for future losses were heavily reduced and depreciation pe148
riods massively extended.
Of course one must accept the fact that the impact of the effects of
a specific accounting practice on the capital market side and the tax
144 See Beale, Conformity, note 50, at 357-58 (discussing the influence of the tax rules on
LIFO accounting in financial reports); Hanlon & Shevlin, note 2, at 21; Calvin Johnson,
Using GAAP Instead of Tax Accounting Is a Bad Idea, 83 Tax Notes 425, 427 (Apr. 19,
1999); Knott & Rosenfeld, pt. 2, note 2, at 1059.
145 See David A. Guenther, Edward L. Maydew & Sarah E. Nutter, Financial Reporting,
Tax Costs, and Book-Tax Conformity, 23 J. Acct. Econ. 225 (1997) (providing an empirical
analysis of the changes following increased book-tax conformity enacted in 1986).
146 David M. Schizer, Frictions as a Constraint on Tax Planning, 101 Columb. L. Rev.
1312, 1333 (2001) [hereinafter Frictions].
147 Roland Euler, Steuerbilanzielle Konsequenzen der Internationalen Rechnungslegung, 75 Steuer und Wirtschaft 14 (1998).
148 Adolf Moxter, Missverstandnisse um das MaBgeblichkeitsprinzip, 88 DStZ 157, 160
(2000); Alfred Wagenhofer, Internationale Rechnungslegungsstandards-IAS/IFRS 190
(4th ed. 2003).
TAX LAW REVIEW
[Vol. 58:
side of an enterprise will be different. There is evidence that some

firms that desperately need a good performance in the capital market
accept a tax bill on exaggerated profits if this is the only way to show
good results to investors. Others prefer a "big bath," that is, a big
one-year loss in order to enhance future earnings as a result of their
operations. 149 In closely held corporations the situation might be the
opposite: If the company is able to rely on the financial power of
individual shareholders or a single big lender, they will be able to provide the relevant information to these individuals without the need to
show impressive results to the capital markets in general. 150 It is even
possible that investors anticipate that a firm's true profits exceed the
results shown in the books due to tax reasons. But this would require
highly sophisticated investors in an efficient capital market. 151
Germany provides a good example for this conflict of interest. Formerly it was common for most German companies-big and smallto finance new investment out of retained profits or bank loans but
not from the equity market. Management tended to apply conservative accounting rules both in the financial and in the tax accounts.
This behavior not only reduced the tax bill, it also denied the shareholders access to the company's true profits, which could be hidden in
the books in order to enlarge the discretionary power of management.
Today it can be said that the general tendency in many countries to
rely on open capital markets in order to procure debt or equity funding to businesses will strengthen the necessity to strike a reasonable
balance between the capital market and the tax side of the accounts.
The same holds true for debt financing when low book profits result in
152
the violation of a debt covenant.
D.
Book-Tax Conformity and the Corporate Tax Shelter Debate
One of the main features of the U.S. debate on book-tax conformity

is the role of financial accounting in the battle against tax shelters. I
do not go into the intricate question of how to identify a tax shelter
and to separate it from mere tax planning. 153 Rather I concentrate on
the question of whether it is advisable to opt for an alignment of tax
and financial accounting or whether it suffices to force enterprises to
149 Johnson, note 144, at 427; Lillian F. Mills & Kaye J. Newberry, The Influence of Tax
and Nontax Costs on Book-Tax Reporting Differences: Public and Private Firms, 23 J.
Am. Tax'n Ass'n. 1, 2 (2001).
150 See Mills & Newberry, note 149 (discussing empirical evidence from the United
States).
151 See Schizer, Frictions, note 146, at 1333.
152 See Mills & Newberry, note 149, at 6-7.
153 E.g., David P. Hariton, Kafka and the Tax Shelter, 57 Tax L. Rev. 1 (2003) (attempting to distinguish tax shelters from business transactions).
2005]
disclose tax-avoiding structures and to strengthen the power of the tax

administration to examine these structures. At first glance one might
think that disclosure of tax-avoiding structures seems to be better
targeted while full book-tax conformity appears to be over-inclusive.
On the other hand, only book-tax conformity would truly reduce the
incentive to enter into artificial constructions that are meant to enable
the company to live in the best of both worlds-exaggerating financial
profits, reducing taxable income. The mere disclosure of tax avoidance will provide some administrative help but it will not change the
substantial conflicts at the heart of the tax shelter debate.
One of the major elements of financial accounting that might prove
relevant in the tax shelter debate is the substance over form principle,
which is laid down both in U.S.-GAAP and in the International Accounting Standards. Book-tax conformity would lead to a strengthening of this principle in the tax sector.1 54 A case in point is leasing; the
different tax and book treatment of "synthetic leases" was at the heart
of one of the most aggressive structures established by the Enron
management. 155 In this context we have to bear in mind that the tax
courts in many countries have been reluctant in the past to apply a
broad brush substance-over-form approach to tax avoidance. 156 In
general, I am sympathetic to that cautious approach. Yet in the context of business profit measurement, which tries to identify the true
economic performance of an enterprise, substance over form seems to
be a sensible direction.
Also in this context, there is a hidden nexus between the problems
that financial accounting and tax accounting try to solve. Financial
accounting rules try to give the shareholders and potential investors a
transparent view of the current economic situation of the enterprise.
This is part of the overall aim of good corporate governance, which is
to ensure the efficient use of capital by management and shareholders
in the corporate sector. This transparency goal is endangered if tax
law offers an incentive for management to embark on complicated
structures that the public is unable to control. 15 7 The loss of transparency gives management the power to divert corporate funds.
Therefore, the complicated structures in the Enron case not only led
to unjustified tax benefits, they also damaged the governance strucSee Keinan, note 50, at 698, 717.
Luppino, note 56, at 68-73.
156 See, e.g., Catherine Brown & Christine Manolakas, The United States and Canada:
A Comparison of Corporate Nonrecognition Provisions, 30 Case W. Res. J. Int'l L. 1, 15
(1998) (arguing that courts in the United States are reluctant to apply the substance-overform doctrine).
157 Mihir A. Desai, Alexander Dyck & Luigi Zingales, Theft and Taxes (NBER Working
Paper No. 10978, 2004).
154
155
TAX LAW REVIEW
[Vol. 58:
tures of the enterprise. Book-tax conformity would require transparency in both respects.
VII.
THE INTERNATIONAL PERSPECTIVE
Book-tax conformity is an old issue; the international dimension is

the new issue. The gradual international convergence of accounting
standards leads to the question whether the gradual evolution of a
common set of standards in the financial accounting world will provide additional reasons to opt for a closer alignment of taxable income
and business profits. From my point of view, the international character of accounting rules and principles may prove to tilt the balance in
the direction of a closer linkage between tax and financial accounts.
First, a common relationship between taxable income and international accounting standards in different parts of the world would lead
to more transparency for investors. If internationally operating firms
knew that taxable income would be close to accounting income under
the rules they apply to their foreign subsidiaries and branches, it
would be easy to identify (under the tax aspect) the best location for
any investment by simply looking at the tax rates applicable in the
respective countries. Moreover, specific tax incentives easily could be
identified when comparing the general accounting rules and tax law
deviations.
From the point of view of the involved governments, this transparency also could have positive effects. WTO law and EC law restrict the power of their member states to grant tax incentives to
specific enterprises and products. 158 The jurisprudence of the European Court of Justice on state aid and the WTO arbitration bodies on
export subsidies both support the notion that a tax provision may be
called a "tax subsidy" if it constitutes an "exception to the rules" of
the respective tax system. 159 Therefore, both the European Court of
Justice and the WTO try to distinguish the "normal level of taxation"
in the domestic setting from any preferential treatment. This task of
identifying the normal level of taxation would be made easier if we
could refer to a common set of accounting standards that would supply a generally accepted yardstick for income measurement. Thus,
book-tax conformity could contribute to fiscal discipline in many
countries.
158 See Paul R. McDaniel, Trade and Taxation, 26 Brook. J. Int'l L. 1621, 1633 (2001).
159Case 70/72, Commission v. Fed. Rep. of Germany, 1973 E.C.R. 813, 833-834 (1973);
GATT Dispute Appellate Body Report on United States-Tax Treatment for "Foreign
Sales Corporations," WT/DS108/AB/R, para. 91 (Feb. 21, 2000), available at http://
www.wto.org (last visited May 31, 2005).
2005]
The bus does not stop here. In cross-border situations, different approaches to income measurement lead to economic double taxation.
A case in point is cross-border loss compensation, which becomes difficult when the existence and the amount of a loss are set differently
by the tax rules in the involved countries. Another case would be the
application of tax credits on certain parts of foreign income where the
recognition and timing of revenue and expense is subject to huge differences. A common starting point in financial accounting rules at
least could reduce the economic double taxation faced in these
situations.
Another field of application could be transfer pricing. In their recently published study on income tax treaty arbitration, William Park
and David Tillinghast point out that "[t]ransfer pricing disputes proba'160
bly top the list of treaty controversies that concern multinationals.
Again, it is income measurement that matters in these situations. Of
course we have to be cautious in our approach here. The financial
accounts do not tell us anything about the "arm's length" price of any
transaction in the market (only insofar as similar transactions with
third parties have been executed by the taxpayer). Moreover, financial accounts do not refer to individual projects or transactions but to
the company as a whole or to large segments of a group. In the end,
the cost of a transaction is calculated according to the internal accounting system, which is not necessarily in line with the standards
governing external accounting. 16 1 Nevertheless, it would be valuable
for the resolution of transfer pricing conflicts if tax authorities in the
involved states could start from a similar set of accounts for the parent
and the subsidiary or branch in order to find common ground for the
identification and resolution of specific deviations.
From the perspective of the EC, the framing of a common consolidated tax base starting from the recently adopted International Accounting Standards might even pave the way for far-reaching
integration of corporate tax systems in Europe. Of course, the most
advanced proposal-the introduction of formulary apportionment
under a pan-European formula-would do away with major tax impediments to cross-border business activities in Europe. But even if
we do not opt for formulary solutions, a common tax base would
make tax life easier in many ways-cross-border loss compensation,
transfer pricing, foreign tax credits, and so on. The current international convergence of financial accounting standards perhaps in retro160 William W. Park & David R. Tillinghast, Income Tax Treaty Arbitration 16 (2004).
161 See Tim Baldenius, Nahum D. Melumad & Stefan Reichelstein, Integrating Managerial and Tax Objectives in Transfer Pricing, 79 Acct. Rev. 591 (2004) (discussing the relationship between arm's length pricing for tax purposes and internal managerial pricing).
TAX LAW REVIEW
spect will be regarded as a major opportunity for the strengthening of

the international tax system-it is our task not to miss it.

The Odd Couple

Transféré par

Informations du document

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

The Odd Couple

Transféré par

Droits d'auteur :

Formats disponibles

+(,121/,1(

Citation: 58 Tax L. Rev. 111 2004-2005

Content downloaded/printed from

The David R. Tillinghast Lecture

Ludwig-Maximilians-Universitat Munich. Delivered at NYU School of Law on October 4,

Images with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW

globe but its introduction (or abolition) is subject to debate nearly

in particular a recent initiative by the European Commission, provide

which are discussed in OECD circles.

THE GLOBALIZATION OF ACCOUNTING RULES

The analysis of the current tax debate on book-tax conformity has

opment in financial accounting, in the early 1990's, the assumption

change-would be a basic prerequisite for economic success in the

Images with the Permission of N.Y.U. Tax Law Review

FINANCIAL AND TAX ACCOUNTING

83/349, 1983 O.J. (L 193) 17.

Images with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW

Regulation, which requires all companies admitted to a stock ex-

Meanwhile the IASB and the Financial Accounting Standards Board

term. 15 In this context it should not go unnoticed that in the

dard setter to "consider[ ], in adopting accounting principles, the need

Images with the Permission of N.Y.U. Tax Law Review

FINANCIAL AND TAX ACCOUNTING

This change of paradigm proves to be important for the background

German law is said to provide for the most comprehensive linkage

Images with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW

dence" (which is known in U.S. accounting in particular with respect

nies. Nevertheless, for many decades the business community was

servative" or "prudent" financial accounting to the tax assessment,

Images with the Permission of N.Y.U. Tax Law Review

FINANCIAL AND TAX ACCOUNTING

sioned a study on the impact of IAS/IFRS on German tax accounting,

Images with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW

the abolition of book-tax conformity is under

When we look at the debate in the United Kingdom we find quite

case 34 the High Court relied on U.K. accounting standards in order to

recognize a provision for future losses in the tax assessment.

ciple" in accordance with financial accounting standards if the tax

Images with the Permission of N.Y.U. Tax Law Review

FINANCIAL AND TAX ACCOUNTING

Images with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW

439 U.S. 522, 542-44 (1979).

Images with the Permission of N.Y.U. Tax Law Review

FINANCIAL AND TAX ACCOUNTING

port of the Joint Committee on Taxation on the tax issues raised by

counts in a way that seemed to be a true double-dipping. 53 The

Moreover, the expectation of future tax benefits was included in the

line between intended tax incentives like accelerated depreciation,

Images with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW

Images with the Permission of N.Y.U. Tax Law Review

FINANCIAL AND TAX ACCOUNTING

Images with the Permission of N.Y.U. Tax Law Review

TAX LAW REVIEW

aries and permanent establishments in other Member States due to

In this dilemma, the European Commission has found the advent of

of government officials, which will be assisted by tax experts in order

transfer pricing issues and "formulary apportionment" of business

Images with the Permission of N.Y.U. Tax Law Review