Taxes

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Chapter 25
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• Taxes

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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.

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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
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An Example with Full Disclosure
RD Tax Credits The majority of taxes are related
to earnings, but the company also generates 40
million in ongoing research and development (RD)
tax credits (credits determined by the amount and
location of the companys RD activities), which
are expected to grow as the company grows.
Income Statement by Geography
One-Time Credits The company also has 25 million
in one-time tax credits, such as tax rebates
related to historical tax disputes.
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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 jurisdictions 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.

Since RD tax credits are related to operations
and expected to grow with revenue, they are
included in operating taxes as well.
Operating Taxes and NOPLAT by Geography
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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 companys
  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
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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

• 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 ratea
  very difficult achievement in practice.

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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 dollar-based 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.

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Operating Taxes Step 1

• To start, multiply each reported percentage on
  the tax reconciliation table by earnings before
  taxes found on the income statement.

• For instance, 35.0 percent times 1,550 in
  earnings before taxes equals 542.5 million.

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Operating Taxes Step 2 and Step 3

• Step 2 The domestic statutory rate (35 percent)
  is applied to EBITA (2,500 million), resulting
  in statutory taxes on EBITA of 875 million.
• Step 3 Using data from the converted tax
  reconciliation table computed earlier, subtract
  the dollar-denominated foreign-income adjustment
  (83 million) and the RD 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 3
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Alternative Method Global Tax Rate

• If you believe the company reports interest
  expense and other nonoperating items in various
  geographies proportional to each geographys
  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 companys tax
  reconciliation table.
• Once again, estimated operating taxes are not
  quite equal to actual operating taxes.

Simple Approach for Estimating Operating Taxes
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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?
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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)
• 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.
• 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
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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.
• Determine the increase in net operating DTLs by
  subtracting last years net operating DTLs
  (3,350 million) from this years 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.

Deferred Tax Asset and Liability Reorganization
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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
• 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.
• Value as a separate nonoperating asset When a
  DTA such as tax loss carry-forwards, commonly
  referred to as net operating losses (NOLs), does
  not have a corresponding balance sheet account
  like pensions, it must be valued separately.
• 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.