Permanent differences

Permanent differences are income and expenses included in the accounting income that will never be included in a company’s taxable income, or vice versa. Permanent differences do not give rise to deferred tax assets and liabilities but they should be considered when computing the taxable income, which is used to compute the current income tax expense. Unlike temporary differences, which reverse and create deferred tax, permanent differences never reverse: non-deductible expenses raise the effective tax rate above the statutory rate, and non-taxable income lowers it below.

Example: Permanent differences and the effective tax rate

Book income of $\$200,000$, minus $\$5,000$ non-taxable muni bond interest, plus a $\$10,000$ non-deductible fine, equals taxable income of $\$205,000$. Neither adjustment reverses, so neither creates deferred tax. At a statutory rate of $21\%$, current tax expense is $\$205,000\times 21\%=\$43,050$, for an effective tax rate of $\$43,050/\$200,000=21.5\%$ - above the $21\%$ statutory rate, because the $\$10,000$ non-deductible fine outweighs the $\$5,000$ of non-taxable interest, leaving taxable income a net $\$5,000$ higher than book income.

Answer: current tax expense $\$43,050$; effective tax rate $21.5\%$

Examples of permanent differences are as follows.

Non-taxable income

Interest income from state and municipal bonds is exempt from federal income tax. It creates a permanent difference because it is included in accounting income as finance income but never in taxable income. (Interest on U.S. Treasury securities, by contrast, is federally taxable.)

Proceeds from life insurance policy are not taxable but are included in the accounting income as financial income.

A portion of dividends received from investments are deductible/non-taxable:

• 50% of dividends are non-taxable when the investor company owns less than 20% of the qualifying investee company
• 65% of dividends are non-taxable when the investor company owns at least 20% but less than 80% of the qualifying investee company
• 100% of dividends are non-taxable when the investor company owns 80% or more of the qualifying investee company

Non-deductible expenses

Fines and penalties are not deductible when they are incurred as a result of violating the laws.

Entertainment expenses are fully non-deductible for tax purposes, while meal expenses are generally only 50% deductible - the non-deductible half is the permanent difference, even though the full amount is expensed in the accounting income.

Life insurance premiums paid on a company officer when the company is a beneficiary are not deductible but are included in the accounting income as an expense.