Question

1. Create a numerical example of a permanent tax difference and how it is treated on the Company’s books and the tax (IRS) books?

I was hoping to find an example dealing with interest on a municipal bond

Answer 1

Permanent differences do not cause deferred tax liabilities or assets. These occur if a revenue or expense item:

• is recognized for tax reporting but never for financial reporting, or
• is recognized for financial reporting but never for tax reporting.

Therefore, permanent differences result from revenues and expenses that are reportable on either tax returns or in financial statements but not both. Permanent differences arise because the tax code excludes certain revenues from taxation and limits the deductibility of certain expenses.

• In the U.S., for example, interest income on tax-exempt bonds, premiums paid on officer's life insurance, and amortization of goodwill (in some cases) are included in financial statements but are never reported on tax returns.
• Similarly, certain dividends are not fully taxed, and tax or statutory depletion may exceed cost-based depletion reported in the financial statements.
• Tax credits are another type of permanent difference. Such credits directly reduce taxes payable and are different from tax deductions that reduce taxable income.

These differences are permanent because they will not reverse in future periods.

No deferred tax consequences are recognized for permanent differences; however, they result in a difference between the effective tax rate and the statutory tax rate that should be considered in the analysis of effective tax rates.

Interest on municipal bonds:

Municipal bonds are debt instruments a local government issues to fund a project, such as a new highway. Under GAAP, you add this income to net income. For federal tax, it’s generally never taxed (although this may not be true in some states). Likewise, any expenses incurred in obtaining tax-exempt income are deductible for book but not tax purposes.

Example:

A company owns a $50,000 municipal bond with a 4% coupon and has an effective tax rate of 50% and a statutory tax rate of 40%. Calculate the deferred tax created by this bond.

Solution:

The bond does not result in deferred tax, as the difference it causes is a permanent difference that will not reverse. As a result, no deferred tax is recognized.