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Taxes
1
Session Overview
•
A robust measure of after-tax operating profit is required to determine
return on invested capital (ROIC) and free cash flow (FCF). But how
should you calculate operating taxes?
•
Unfortunately, reported taxes on the income statement combines
operating, nonoperating, and financing items. Company disclosures rarely
provide all the information required to build the operating taxes.
•
In this session, we examine how to analyze company taxes.
– In the first section, we estimate operating taxes using company disclosures.
Since disclosure is incomplete, we provide multiple estimation techniques.
– In the second section, we examine deferred taxes. We recommend converting
accrual operating taxes to a cash basis for valuation, because accrual taxes
typically do not reflect the cash taxes actually paid.
2
An Example with Full Disclosure
•
•
•
To start our analysis, consider
the internal financials of a global
company for a single year.
The company generated $2,000
million in domestic earnings
before interest, taxes, and
amortization (EBITA) and $500
million in foreign EBITA.
The company pays a statutory
(domestic) tax rate of 35
percent on earnings before
taxes, but only 20 percent on
foreign operations.
Income Statement by Geography
$ million
1
EBITA
Amortization
1
EBIT
Interest expense
Gains on asset sales
Earnings before taxes
Domestic
subsidiary
2,000
(400)
1,600
Foreign
subsidiary
500
−
500
(600)
−
1,000
−
50
550
Taxes
Net income
(350)
650
(110)
440
Tax rates (percent)
Statutory tax rate
Effective tax rate
35.0
20.0
R&D
tax credits
One-time
credits
Company
2,500
(400)
2,100
(600)
50
1,550
40
40
25
25
(395)
1,155
25.5
1
EBITA is earnings before interest, taxes, and amortization; EBIT is earnings before interest and taxes.
3
An Example with Full Disclosure
R&D Tax Credits
Income Statement by Geography
$ million
1
EBITA
Amortization
1
EBIT
Interest expense
Gains on asset sales
Earnings before taxes
Domestic
subsidiary
2,000
(400)
1,600
Foreign
subsidiary
500
−
500
(600)
−
1,000
−
50
550
Taxes
Net income
(350)
650
(110)
440
Tax rates (percent)
Statutory tax rate
Effective tax rate
35.0
20.0
1
R&D
tax credits
One-time
credits
Company
2,500
(400)
2,100
(600)
50
1,550
40
40
25
25
(395)
1,155
25.5
EBITA is earnings before interest, taxes, and amortization; EBIT is earnings before interest and taxes.
The majority of taxes are related to
earnings, but the company also
generates $40 million in ongoing
research and development (R&D) tax
credits (credits determined by the
amount and location of the company’s
R&D activities), which are expected to
grow as the company grows.
One-Time Credits
The company also has $25 million in
one-time tax credits, such as tax
rebates related to historical tax
disputes.
4
1. Operating Taxes with Full Disclosure
•
Operating taxes are computed as if the company were financed entirely with equity.
To compute operating taxes, apply the local marginal tax rate to each jurisdiction’s
EBITA, before any financing or nonoperating items. In this case, apply 35 percent to
domestic EBITA of $2,000 million and 20 percent to $500 million in foreign EBITA.
Operating Taxes and NOPLAT by Geography
$ million
EBITA
Operating taxes
NOPLAT1
Tax rates (percent)
Statutory tax rate
Operating tax rate
Domestic
Foreign
R&D
subsidiary subsidiary tax credits
2,000
500
(700)
(100)
40
1,300
400
35.0
20.0
One-time
credits
Company
2,500
(760)
Since R&D tax credits
are related to operations
and expected to grow
with revenue, they are
included in operating
taxes as well.
1,700
30.4
1
Net operating profit less adjusted taxes.
5
The Challenge of Limited Disclosure
•
•
•
In practice, companies do not give a
full breakout of the income statement
by geography, but provide only the
corporate income statement and a tax
reconciliation table.
The tax reconciliation table, which is
found in the notes of the annual report,
reconciles the taxes reported on the
income statement with the taxes that
would be paid at the company’s
domestic statutory rate.
For instance, the company paid 5.3
percent ($82.5 million) less in taxes
than under the statutory rate of 35
percent because foreign geographies
were taxed at only 20 percent.
Income Statement and Tax Reconciliation Table
Company income statement
Tax reconciliation table (in notes)
$ million
EBITA
Amortization
EBIT
2,500
(400)
2,100
Interest expense
Gains on asset sales
Earnings before taxes
(600)
50
1,550
Taxes
Net income
(395)
1,155
percent
Taxes at statutory rate
Foreign-income adjustment
R&D tax credits
Audit revision etc.
Effective tax rate
35.0
(5.3)
(2.6)
(1.6)
25.5
6
Comprehensive Method for Operating Taxes
•
The most comprehensive method for computing operating taxes from public
data is to begin with reported taxes and undo financing and nonoperating
items one by one.
Comprehensive Approach for Estimating Operating Taxes
$ million
•
Reported taxes
Audit revision etc.
Reported taxes: operating only
395
25
420
Remove nonoperating
taxes found in
reconciliation table.
Plus: Amortization tax shield (at 35%)
Plus: Interest tax shield (at 35%)
Less: Taxes on gains (at 20%)
Operating taxes
140
210
(10)
760
Remove taxes related to
nonoperating income or
expense at appropriate
marginal tax rate.
Operating tax rate on EBITA(percent)
30.4
This is the most theoretically sound method for computing operating taxes.
However, it relies heavily on properly matching each nonoperating item with
the appropriate marginal tax rate—a very difficult achievement in practice.
7
A Simple Method to Determine Operating Taxes
1. Find and convert the tax reconciliation table. Search the footnotes
for the tax reconciliation table. For tables presented in dollars, build a
second reconciliation table in percent, and vice versa. Data from both
tables are necessary to complete the remaining steps.
2. Determine taxes for “all-equity” company. Using the percent-based
tax reconciliation table, determine the marginal tax rate. Multiply the
marginal tax rate by adjusted EBITA to determine marginal taxes on
EBITA.
3. Adjust “all-equity taxes” for operating tax credits. Using the dollarbased tax reconciliation table, adjust operating taxes by other operating
items not included in the marginal tax rate. The most common
adjustment is related to differences in foreign tax rates.
8
Operating Taxes: Step 1
•
To start, multiply each reported percentage on the tax reconciliation
table by “earnings before taxes” found on the income statement.
Tax reconciliation table (in notes)
percent
Taxes at statutory rate
Foreign-income adjustment
R&D tax credits
Audit revision etc.
Effective tax rate
•
35.0
(5.3)
(2.6)
(1.6)
25.5
$ million
Taxes at statutory rate
Foreign-income adjustment
R&D tax credit
Audit revision etc.
Reported taxes
543
(83)
(40)
(25)
395
For instance, 35.0 percent times $1,550 in earnings before taxes
equals $542.5 million.
9
Operating Taxes: Step 2 and Step 3
•
Step 3: Using data from the converted tax
reconciliation table computed earlier, subtract
the dollar-denominated foreign-income
adjustment ($83 million) and the R&D tax
credit ($40 million).
Result: The estimate for operating taxes,
$753 million, is close but not equal to the
$760 million computed using the
comprehensive method. The difference is
explained by the fact that gains on the asset
sales of $50 million were taxed at 20 percent,
not at the statutory rate.
Simple Approach for Estimating
Operating Taxes
Step 2
•
Step 2: The domestic statutory rate (35
percent) is applied to EBITA ($2,500 million),
resulting in statutory taxes on EBITA of $875
million.
Statutory tax rate (percent)
× EBITA
Statutory taxes on EBITA
35.0
2,500.0
875.0
Step 3
•
Foreign-income adjustment
R&D tax credit
Estimated operating taxes
(82.5)
(40.0)
752.5
Estimated operating tax rate
(percent)
30.1
10
Alternative Method: Global Tax Rate
•
•
•
If you believe the company reports interest
expense and other nonoperating items in
various geographies proportional to each
geography’s profits (typical for companies in
countries with low tax rates), multiply a
blended global rate by EBITA, and adjust for
other operating taxes.
A blended global rate of 29.7 percent is
applied to $2,500 million in EBITA. The
blended global rate is the statutory tax rate
(35 percent) adjusted by the foreign-income
adjustment (–5.3 percent) found in the
company’s tax reconciliation table.
Simple Approach for Estimating
Operating Taxes
"Blended" global rate (percent) 1
× EBITA
Global taxes on EBITA
R&D tax credit
Estimated operating taxes
Estimated operating tax rate
(percent)
29.7
2,500.0
741.9
(40.0)
701.9
28.1
Once again, estimated operating taxes are
not quite equal to actual operating taxes.
11
Operating Cash Taxes
• In the previous section, we estimated accrual-based operating
taxes as if the company were all-equity financed. In actuality,
many companies will never pay (or at least will significantly
delay paying) accrual-based taxes. Consequently, a cash tax
rate (one based on the operating taxes actually paid in cash to
the government) represents value better than accrual-based
taxes.
• To convert operating taxes to operating cash taxes, subtract the
increase in net operating deferred tax liabilities from operating
taxes.
Cash Taxes = Operating Taxes − Increase in Operating Deferred Tax Liabilities
But which deferred taxes are operating?
12
2. Deferred Taxes on the Balance Sheet
•
To determine the portion of deferred taxes related to ongoing operations, investigate
the income tax footnote.
•
The company has two operating-related
deferred tax assets (DTAs) and deferred tax
liabilities (DTLs):
1. Warranty reserves (a DTA): The
government recognizes a deductible
expense only when a product is
repaired, so cash taxes tend to be
higher than accrual taxes.
2. Accelerated depreciation (a DTL): The
company uses straight-line depreciation
for its GAAP/IFRS reported statements
and accelerated depreciation for its tax
statements (because larger depreciation
expenses lead to smaller taxes).
Deferred Tax Assets and Liabilities
$ million
Prior
year
Current
year
550
250
800
600
300
900
3,600
850
2,200
6,650
3,800
950
2,050
6,800
1
Deferred tax assets
Tax loss carry-forwards
Warranty reserves
Deferred tax assets (DTAs)
Deferred tax liabilities
Accelerated depreciation
Pension and postretirement benefits
Nondeductible intangibles
Deferred tax liabilities (DTLs)
1
Deferred tax assets are consolidated into a single line item on the balance sheet. If
small, they are typically included in other assets.
13
Reorganized the Deferred Tax Account
•
To convert accrual-based operating taxes
into operating cash taxes, subtract the
increase in net operating DTLs (net of
DTAs) from operating taxes.
Deferred Tax Asset and Liability Reorganization
$ million
•
•
Determine the increase in net operating
DTLs by subtracting last year’s net
operating DTLs ($3,350 million) from
this year’s net operating DTLs
($3,500 million).
During the current year, operating-related
DTLs increased by $150 million. Thus,
to calculate cash taxes, subtract
$150 million from operating taxes of
$760 million.
Operating DTLs, net of operating DTAs
Accelerated depreciation
Warranty reserves
Operating DTLs, net of operating DTAs
Nonoperating DTAs
Tax loss carry-forwards
Nonoperating DTAs
Prior
year
Current
year
3,600
(250)
3,350
3,800
(300)
3,500
550
550
600
600
850
2,200
3,050
950
2,050
3,000
Nonoperating DTLs
Pensions and postretirement benefits
Nondeductible intangibles
Nonoperating DTLs
14
Valuing Deferred Taxes
•
Deferred tax assets and liabilities classified as operating will flow through
NOPLAT via cash taxes. As part of NOPLAT, they are also part of free cash
flow, and therefore are not valued separately. For the remaining nonoperating
DTAs and DTLs:
1. Value as part of a corresponding nonoperating asset or liability: The value of
DTAs and DTLs related to pensions, convertible debt, and sales/leasebacks
should be incorporated into the valuation of their respective accounts.
2. Value as a separate nonoperating asset: When a DTA such as tax loss carryforwards, commonly referred to as net operating losses (NOLs), does not have a
corresponding balance sheet account like pensions, it must be valued separately.
3. Ignore as an accounting convention: Some DTLs, such as the kind of
nondeductible amortization described earlier in this chapter, arise because of
accounting conventions and are not actual cash liabilities. These items should be
valued at zero.
15