5.1. Permanent differences

Permanent differences are differences caused by transactions and events that under existing tax law will never affect taxable income or taxes payable. The tax-free income will never be reported on the tax return.

Example: Interest received from investments in bonds issued by state and municipal governments is exempt from taxation 

• This interest revenue is reported as revenue on the recipient’s income statement but not on its tax return

• There is a permanent difference between pretax accounting income and taxable income

5.1.1. Differences without deferred tax consequences

• Interest received from investments in bonds issued by state and municipal governments (generally not taxable)

• Investment expenses incurred to obtain tax-exempt income (not tax deductible)

• Life insurance proceeds on the death of an insured executive (not taxable)

• Premiums paid for life insurance policies when the payer is the beneficiary (not tax deductible)

• Compensation expense pertaining to some employee stock option plans (not tax deductible)

• Fines and penalties due to violations of the law (generally not tax deductible)

• Difference in tax paid on foreign income permanently reinvested in the foreign country and the amount that would have been paid if taxed at U.S. rates

• Portion of dividends received from U.S. corporations that is not taxable due to the dividends received deduction

• Tax deduction for depletion of natural resources (percentage depletion) that is allowed in excess of an already full-depleted asset’s cost

5.1.2. Accounting for permanent differences

Taxes payable are calculated according to the tax law, and since permanent differences are never taxable, no deferred tax asset or liability is created.  Plug tax expense, so tax expense = tax payable with respect to permanent differences.

Permanent differences affect the effective tax rate, because they affect the relationship between tax expense and pretax accounting income.

Effective Tax Rate (ETR) = Tax Expense ÷ Pretax Accounting Income