deferred taxes and corporate tax reform

I wrote a couple of posts several years ago explaining in some detail what deferred taxes are.  The short version: when a company makes a gigantic loss, the loss itself has an economic value.  That’s because the firm can almost always use it to shield future earnings from income tax.


The IRS and the Financial Accounting Standards Board have different ways of accounting for deferred taxes.  For the IRS, they only appear on a return when the company has sufficient otherwise taxable income to use them.  At the other extreme, financial accounting rules allow the company to recognize the entire value of these potential savings immediately.  That’s even though the actual use of tax losses may be far in the future.

An example:

A company has pre-tax income of $1,000,000 from ordinary operations.  It also closes down a subsidiary, incurring a pre-tax loss of $11,000,000.  For IRS purposes, the firm has a total pre-tax loss of $10,000,000.  Ignoring the possibility of carrybacks (recovery of previous years’ tax payments because of the current loss), the company has no taxable income.  It also has a loss in the current year of $10,000,000, which it can potentially use to shield future income from taxes.

Financial accounting presents a much rosier picture.  The pre-tax loss of $10,000,000 is the same.  But financial accounting allows the company to recognize the possibility of future tax recovery right away, as a reduction of the current loss.

The financial accounting income statement reads like this:

pre-tax loss        ($10,000,000)

deferred taxes    +$3,500,000

net loss                 ($6,500,000).

The $3.5 million is carried as a deferred tax asset on the balance sheet until used.

Auditors are supposed to certify that it’s actually possible for the company to generate enough future income to use up the tax losses during the limited period of years tax law allows.  I can’t think of a company where auditors have held a firm’s feet to the fire on this point, though.

Where does the  tax bill come in?  The tax rate assumed in writeoffs up until now is 35%.  However, from now on, the top tax rate in the US is going to be 21%.  Therefore, deferred tax assets now being held on corporate balance sheets are only worth 21/35ths (about 57%) of their current carrying value.  Because they’re clearly, and significantly,  overvalued, they must be written down.

This may well throw algorithmic value investors for a loop, since the writeoff of deferred taxes will be reductions to book value.

What sector does this change affect the most?

Major banks.

Banks took major writeoffs in 2008-09 because of speculative trading and lending losses piled up after the Glass Steagall Act was repealed in the late 1990s. These losses were gigantic enough to require a huge government bailout of the industry in 2009.

Note:  Glass-Steagall was passed in the 1930s to prevent a recurrence of the financial meltdown that triggered the Great Depression.  Banks claimed in the 1990s that they were too mature to do anything like this again.  In this instance, it took over a half-century for Washington to forget why the law was in place.  However–and oddly–Washington already appears eager to to dismantle Dodd-Frank.



US corporate tax reform (ii)

There are likely to be losers from corporate income tax reform.  They’re likely to be of two types:

–companies that currently have sweetheart tax deals, which, as things stand now (meaning:  subject to the success of intensive lobbying), will go away as part of reform.  A related group is multinationals who’ve twisted their corporate structures into pretzels to locate taxable income outside the US

–companies making losses currently and/or that have unused tax-loss carryforwards.  The value of those unused losses will likely be reduced by a lot.  This is a somewhat more complicated issue than it seems.  In their reports to public shareholders, money-losing firms can use anticipated future tax benefits to reduce the size of current losses.  The ins-and-outs of this are only important in isolated cases, so I’ll just say that for such firms book value is likely overstated

Another potential consequence of tax reform is that investors may begin to take a harder look at tax-related items on the income and cash flow statements.  Could markets will begin to apply a discount to the stocks of firms that use gimmicks to depress their tax rate?  Thinking some what more broadly, it may mean the markets will take a dimmer view of other sorts of financial engineering (share buybacks are what I personally hope for).  It might also be that companies themselves will reemphasize operation experience rather than financial sleight of hand when choosing their CEOs.

US corporate tax reform (iii)

For years ago I wrote in detail about today’s topic, which is deferred taxes.

The basics:

–deferred taxes are an accounting device that reconciles the cheery face a company typically present to shareholders with the more down-at-the-heels look it gives the IRS, while accurately reporting to both parties the cash taxes paid

–look at the cash flow statement, which, as the name implies, shows the cash moving in and out of the company or in the income tax footnote to get the particulars for a firm you may be interested in.

accounting for a loss

The issue I’m concerned about in this post is what happens when a company makes a loss.

reporting to the IRS

The income statement  for the IRS looks like this:

pre-tax income (loss)      ($100)

income tax due                          0

after-tax income (loss)     ($100).

reporting to shareholders

Financial accounting books, in contrast, look like this:

pre-tax income (loss)         ($100)

deferred tax, at 35%                 $35

after-tax income (loss)        ($65).

what’s going on

The financial accounting idea, other than to cosmetically soften the blow of a loss, is that at some future date the company in question will again be making money.  If so, it will be able to use the loss being incurred now to offset otherwise taxable future income.  Financial accounting rules allow the company to take the future benefit today.

It’s important to note, however, that the deferred tax is an estimate of future tax relief, based on today’s tax rates.

why does this matter?

Profits add to shareholders’ equity; losses subtract from it.  Under the GAAP accounting used for reports to stockholders, a loss-making company only has to write down its shareholders’ equity (aka net worth, book value) by about two-thirds of the actual loss.  To the casual observer, and to the value investor using computer screening, it looks stronger than it probably should.

Financial stocks typically trade on price/book.  This is also the sector that took devastatingly large losses during the financial crisis (that they caused, I might add).

Suppose the corporate tax rate is reduced to 15%.

This diminishes the value of any tax loss carryforwards a firm may have.  It also may require a substantial writedown of book value, making that figure more accurate.  But the writedown may also underline that the stock isn’t as cheap as it appears.


US corporate tax reform: stock market implications (i)

high US corporate taxes

The headline rate for US federal tax on corporate profits is 35%.  That’s higher than just about anyplace else on the planet and, in itself, a deterrent to business formation in the United States.  It’s also the reason for the big business of advising corporations on how to finesse the tax code that has sprung up over the past decade or so.  In addition, it’s also why tax havens such as Ireland, Switzerland, Hong Kong and assorted islands in the Atlantic Ocean have become so popular with Americans.

A generation ago, world stock markets paid particular attention the rate at which a given company paid corporate tax.  The assumption back then, which has turned out to be incorrect, was that a firm could only sustain a low tax rate for a limited period of time.  So no matter what the rate shown in the financial statements, professional securities analysts would “normalize” it  to the top marginal rate.  Portfolio managers wouldn’t pay a full price for a low tax payer, either.

Not so in today’s world.  As far as I can see, Wall Street has long since stopped believing that the “quality” of earnings taxed at below the statutory tax rate is less than those same earnings taxed at a higher one.

Trump’s proposed reform

Given that the Republican party controls both houses of Congress and the presidency, it seems to me that the corporate tax reform championed by Donald Trump has a good chance for becoming law.  This would mean that for a company having $100 in fully-taxed pretax US income, after-tax profit would rise from $65 to $85–a 30+% boost.

big stock market implications

A change like this would have enormous implications for US-traded stocks.  In particular:

–investor interest would rotate toward purely domestic companies.  This would favor mid- and small-caps over large, and dollar earners over multinationals.  I think this is already starting to happen

–to the degree that they could be, elaborate tax avoidance schemes that have become common for US firms will be unwound.  Tax havens will suffer.  On the other hand, profits from future earnings that would otherwise be held in tax-haven banks will begin to be repatriated to the US.  Trump is also proposing to allow money now “trapped” in tax havens to be brought back to the US on payment of a 10% income tax.

–tax inversions by US-based companies–that is, flight of high-rate US taxpayers to tax havens abroad (or, actually, just about anywhere else) will come to a halt.  Arguably, companies that have recently inverted may begin to trade at discounts to un-inverted peers

–the price US firms would be willing to pay for foreign companies using funds parked abroad should fall

–it’s possible that US investors will begin to become interested once again in the ins and outs of the tax line on the income statement.  That might mean that 1980-style quality-of-earnings differentials will be in vogue again

–there are also possible negative implications for firms that have substantial tax loss carryforwards or who benefit from the many industry-specific tax preferences of the current tax code.


More tomorrow.

what the big Sony writeoff means

Sony’s fiscal 2010 results

Sony reported its fiscal year 2010 earnings (the company’s fiscal year ends, as is customary with Japanese companies, on March 31st) in Japan overnight.  Tokyo Stock Exchange requires that all listed firms both make an official estimate of anticipated results.  The TSE also requires companies to publish a revision–prior to releasing the actuals–as/when it realizes the actual results will differ from the official estimate by more than 30%.  In line with this requirement, Sony announced a downward revision to earnings last Monday.

the writeoff

The issue is deferred taxes in Japan.  Sony wrote off US$4.3 billion.

The company points out that:

–the writeoff is a non-cash charge,meaning no money has been lost,

–this doesn’t preclude use of  tax-loss carryforwards in the future, and

–the charge “does not reflect a change in Sony’s view of its long-term corporate strategy.”

what this means

Unlike most Japanese firms, Sony keeps its official financial reporting books according to US Generally Accepted Accounting Principles.  GAAP uses deferred taxes.

Let’s say a company loses money this year–thereby establishing a tax-loss carryforward that can be used to offset taxes on future income.  GAAP tells the company that it should record a credit for this possible future tax benefit in this year’s financials.  In other words, if you have a loss of $100 this year, but anticipate that you will have enough profit, say, five years from now to employ this loss to offset $30 in income tax that would otherwise be payable, you should take the $30 gain in the current year.  You record a loss of $100 on your income statement plus a deferred tax benefit of $30.  The net loss you report to shareholders is $70, not the full $100 amount.

One proviso, though.  You have to have a reasonable basis for thinking that you’ll have enough future profit to use the potential tax benefit that today’s loss represents.  And your auditor has to agree with you.

Sony has been in loss in Japan for three years now.  The writeoff means that Sony’s accountants no longer think the company will be able to generate enough taxable income to use $4.3 billion of future tax credits it had previously expected to enjoy.

my thoughts

Sony cites the March earthquake/tsunamis as a reason for this re-evaluation.  But at the same time it notes that the damage to its businesses in Japan haven’t been that great, are mostly covered by insurance, and that it’s confident it will collect on its policies.

The benign reading of the big writeoff would be that Sony’s overall internal profit projections haven’t changed much and the important thing to note is the “in Japan” part of the company statement.  It could be the writeoff means that Sony is going to make a major shift of production away from Japan.  It will continue to make the same profits, just not in its home country.

In my experience, though, events rarely follow the benign path.  I don’t know today’s Sony well enough to judge in this case, but typically a firm’s accountants notice business deterioration and propose a writeoff–and management reluctantly (sometimes, very reluctantly) falls in line.  It may be that the operative word in Sony’s statement of confidence in its prospects is “long term.”

SNE as a stock

I don’t know the company well enough to have an opinion.  I know what I’d look for, though.

Sony has two main businesses:  consumer electronics and video games.  The company has lost ground in the first to Samsung and Apple.  In the current generation of game consoles, Sony has regained past form after turning first-mover advantage over to X-Box, allowing MSFT to gain a market share I don’t think it could otherwise have achieved.  But rival Nintendo is already talking about a new game console.  And the game business is morphing into one favoring simple games played on a cellphone or through a social network.  What are Sony’s plans?

Ideally, one would like to see both main businesses in sync and operating profitably–not strength in one being offset by weakness in the other.