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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

Income Statement by Geography
the internal financials of a
global company for a single $ million

year. Domestic Foreign R&D One-time

subsidiary subsidiary tax credits credits Company
1
EBITA 2,000 500 2,500
• The company generated $2,000 Amortization (400) − (400)
1
EBIT 1,600 500 2,100
million in domestic earnings
Interest expense (600) − (600)
before interest, taxes, and Gains on asset sales − 50 50
Earnings before taxes 1,000 550 1,550
amortization (EBITA) and $500
Taxes (350) (110) 40 25 (395)
million in foreign EBITA. Net income 650 440 40 25 1,155

Tax rates (percent)

• The company pays a statutory Statutory tax rate 35.0 20.0
Effective tax rate 25.5
(domestic) tax rate of 35
1
EBITA is earnings before interest, taxes, and amortization; EBIT is earnings before interest and taxes.
percent on earnings before
taxes, but only 20 percent on
foreign operations.

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 An Example with Full Disclosure

R&D Tax Credits

The majority of taxes are related to
Income Statement by Geography
earnings, but the company also
$ million
generates $40 million in ongoing
research and development (R&D) tax
Domestic Foreign R&D One-time
subsidiary subsidiary tax credits credits Company credits (credits determined by the
1
EBITA 2,000 500 2,500
Amortization (400) − (400)
amount and location of the company’s
EBIT
1
1,600 500 2,100 R&D activities), which are expected to
Interest expense (600) − (600) grow as the company grows.
Gains on asset sales − 50 50
Earnings before taxes 1,000 550 1,550

Taxes (350) (110) 40 25 (395)

Net income 650 440 40 25 1,155 One-Time Credits
Tax rates (percent) The company also has $25 million in
Statutory tax rate 35.0 20.0
Effective tax rate 25.5 one-time tax credits, such as tax
1
rebates related to historical tax
EBITA is earnings before interest, taxes, and amortization; EBIT is earnings before interest and taxes.
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 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 Since R&D tax credits

are related to operations
$ million
and expected to grow
Domestic Foreign R&D One-time
subsidiary subsidiary tax credits credits Company
with revenue, they are
EBITA 2,000 500 2,500 included in operating
Operating taxes (700) (100) 40 (760)
taxes as well.
NOPLAT1 1,300 400 1,700

Tax rates (percent)

Statutory tax rate 35.0 20.0
Operating tax rate 30.4

1
Net operating profit less adjusted taxes.

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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. Income Statement and Tax Reconciliation Table

• The tax reconciliation table, which is Company income statement Tax reconciliation table (in notes)

found in the notes of the annual report, $ million

EBITA 2,500
percent
Taxes at statutory rate 35.0

reconciles the taxes reported on the Amortization

EBIT
(400)
2,100
Foreign-income adjustment
R&D tax credits
(5.3)
(2.6)

income statement with the taxes that Interest expense (600)

Audit revision etc.
Effective tax rate
(1.6)
25.5
Gains on asset sales 50
would be paid at the company’s Earnings before taxes 1,550

domestic statutory rate. Taxes (395)

Net income 1,155
• 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.

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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

$ million

Reported taxes 395 Remove nonoperating

Audit revision etc. 25 taxes found in
Reported taxes: operating only 420 reconciliation table.

Plus: Amortization tax shield (at 35%) 140 Remove taxes related to
Plus: Interest tax shield (at 35%) 210 nonoperating income or
Less: Taxes on gains (at 20%) (10) expense at appropriate
Operating taxes 760 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.

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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.

Tax reconciliation table (in notes)

percent $ million
Taxes at statutory rate 35.0 Taxes at statutory rate 543
Foreign-income adjustment (5.3) Foreign-income adjustment (83)
R&D tax credits (2.6) R&D tax credit (40)
Audit revision etc. (1.6) Audit revision etc. (25)
Effective tax rate 25.5 Reported taxes 395

• 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
Simple Approach for Estimating
million. Operating Taxes
• Step 3: Using data from the converted tax
Statutory tax rate (percent) 35.0

Step 2
reconciliation table computed earlier, subtract × EBITA 2,500.0
the dollar-denominated foreign-income Statutory taxes on EBITA 875.0

adjustment ($83 million) and the R&D tax Foreign-income adjustment (82.5)

Step 3
credit ($40 million). R&D tax credit (40.0)
Estimated operating taxes 752.5
• Result: The estimate for operating taxes,
$753 million, is close but not equal to the Estimated operating tax rate 30.1
(percent)
$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.

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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
geography’s profits (typical for companies in Simple Approach for Estimating
Operating Taxes
countries with low tax rates), multiply a
blended global rate by EBITA, and adjust for "Blended" global rate (percent) 1 29.7
other operating taxes. × EBITA 2,500.0
Global taxes on EBITA 741.9
• A blended global rate of 29.7 percent is
applied to $2,500 million in EBITA. The
R&D tax credit (40.0)
blended global rate is the statutory tax rate Estimated operating taxes 701.9
(35 percent) adjusted by the foreign-income
adjustment (–5.3 percent) found in the Estimated operating tax rate 28.1
(percent)
company’s tax reconciliation table.
• Once again, estimated operating taxes are
not quite equal to actual 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
Deferred Tax Assets and Liabilities
liabilities (DTLs):
$ million
1. Warranty reserves (a DTA): The Prior Current
year year
government recognizes a deductible Deferred tax assets
1

Tax loss carry-forwards 550 600

expense only when a product is Warranty reserves 250 300
Deferred tax assets (DTAs) 800 900
repaired, so cash taxes tend to be higher
Deferred tax liabilities
than accrual taxes. Accelerated depreciation 3,600 3,800
Pension and postretirement benefits 850 950
2. Accelerated depreciation (a DTL): The Nondeductible intangibles 2,200 2,050
Deferred tax liabilities (DTLs) 6,650 6,800
company uses straight-line depreciation
1
Deferred tax assets are consolidated into a single line item on the balance sheet. If
for its GAAP/IFRS reported statements small, they are typically included in other assets.

and accelerated depreciation for its tax

statements (because larger depreciation
expenses lead to smaller taxes).

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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 Deferred Tax Asset and Liability Reorganization

DTAs) from operating taxes. $ million

Prior Current
• Determine the increase in net operating year year
Operating DTLs, net of operating DTAs
DTLs by subtracting last year’s net Accelerated depreciation 3,600 3,800
operating DTLs ($3,350 million) from Warranty reserves (250) (300)
Operating DTLs, net of operating DTAs 3,350 3,500
this year’s net operating DTLs
Nonoperating DTAs
($3,500 million). Tax loss carry-forwards 550 600
Nonoperating DTAs 550 600
• During the current year, operating-related
Nonoperating DTLs
DTLs increased by $150 million. Thus, Pensions and postretirement benefits 850 950
to calculate cash taxes, subtract Nondeductible intangibles 2,200 2,050
Nonoperating DTLs 3,050 3,000
$150 million from operating taxes of
$760 million.

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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:
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 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.
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.

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