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Online Tutorial #6: How Do You Calculate A Company's Cash Tax Rate?

In this session, we focus on defining cash tax rate, explaining where to obtain data to
calculate it, and walk through a sample calculation. As with previous sessions, we
will use Domino's Pizza, as of September 2020, as a case study. Readers who want to
calculate cash tax rates while reading this tutorial may wish to download the
accompanying spreadsheet. 

What Does Cash Tax Rate Mean?

To understand what we mean by cash tax rate, let's break this phrase down into its
component parts:

• Cash. This means that we want to look at the cash a company pays annually in
taxes. This may differ from the income tax provision companies report on their
income statements.

• Tax. This means we look at the amount a company pays to governments in

exchange for the privilege of doing business in their jurisdictions.

• Rate. This means that we want to calculate the percent of pre-tax profit that a
company pays in cash taxes.

Also, though it is not explicitly in the phrase, we need to consider one more word:

Unlevered. A company's taxes are influenced by how much debt a company has, as
interest payments on that debt shield pre-tax profit from taxation. When calculating
cash taxes, we remove this distortion by calculating a company's tax burden
assuming a company was 100% equity financed with no debt. (*)

Putting this together, we can define the cash tax rate as the percent of pre-tax
operating profits a company would pay in cash taxes to governments assuming it was
100% equity financed.

How Do We Calculate a Company's Cash Tax Rate?

We can use two methods:
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A. Simplified Approach.
Online This approach
Tutorials just substitutes
and Other Resources a company's book tax rate as a
proxy for its cash tax rate. However, as we note in the book on page 26:

The tax expenses in the income statement, book taxes, is often greater than the
actual payments, or cash taxes, during a given period. This is because companies can
recognize some revenue and expense items at different times for book versus tax
purposes.

In addition, as we noted above, the book tax rate reflects a company's use of
leverage. An unlevered cash tax rate removes the influence of debt on a company's
tax rate.

B. Advanced Approach. In this approach, we make a number of detailed adjustments.

1. Book taxes. We start with a company's income tax provision found on the
income statement.

2. Change in deferred taxes. Next, we add the year-to-year increase in a

company's deferred income tax liability (or subtract the increase in a company's
deferred tax asset). These line items can be found on a company's balance
sheet. However, sometimes, this liability is not separately broken out. In those
cases, there are two alternate sources for a company's change in deferred taxes:

Adjustments to reconcile net income to net cash provided by operating activities

in the "Cash flows from operating activities" section of the Cash Flow
Statement. A deferred tax liability occurs when a company pays less in cash
taxes than it reports in book taxes. Thus, an increase in a company's deferred
tax liability represents a source of cash. Conversely, a deferred tax asset occurs
when a company pays more in cash taxes than it reports in book taxes. Thus, an
increase in a company's deferred tax asset represents a use of cash.

3. Unlevering income taxes. Finally, we increase the tax onus by the taxes
shielded by debt (in the case of net interest expense). For example, if a company
had interest expense of $100 million and a 20% marginal tax rate, we would add
back $20 million in taxes (that would have been paid if that interest expense
had not shielded the company from paying taxes).

We can see how all this fits together by returning to our Domino's case study:
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(*) In the U.S., the Tax Cuts and Jobs Act of 2017 limits the interest deduction at 30%
of EBITDA through 2021, and from 2022 on the interest deduction is capped at 30
percent of EBIT.

(**) For Domino's, we assumed that deferred taxes were the difference between the
tax provision and cash taxes paid.

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