US corporate income tax reform (ii)

To summarize yesterday’s post:

firms with taxable income

Lowering the corporate tax rate in the US, while eliminating special interest tax preferences/exemptions, will benefit companies that have a high current tax rate.  It will boost such a firm’s earnings by as much as 30%.

On the other hand, companies that have a low income tax rate will receive little or no benefit.  Continuing to spend resources on what are in effect tax shelters for themselves will make no sense.  To the extent that they are able to unwind these arrangements, they will benefit by doing so.  If, however, they are recipients of special interest tax reduction deals, they may be absolute losers, as well as relative ones, if/when these special preferences are eliminated.

The greatest uncertainty here is whether industries that are recipients of large tax breaks, like real estate and oil and gas, will have their special interest preferences eliminated.  This will be a key indicator of whether the “Drain the Swamp” rhetoric is more than an empty slogan.

firms with losses

This case is not as straightforward, thanks to wrinkles in the Generally Accepted Accounting Principles used by publicly traded companies in their reports to shareholders.

for the IRS

Let’s assume a firm makes a pre-tax loss in the current year.

 

The company has a limited ability to use this loss to offset taxes paid in past years ( it carries the loss back).  It restates its past returns and gets a refund.

If it still has a portion of the loss that can’t be used in this way, it carries the loss forward to potentially use to shield income in future years from tax.

If the corporate income tax rate drops from 35% to 15%, the amount of pre-tax income that can be sheltered from tax by loss carryforwards remains the same.  But the value of the carryforward is reduced by 60%.

for financial reporting

That’s tomorrow’s topic.

 

one company, three sets of accounting records

In almost all countries publicly traded companies maintain three sets of accounting records.  They are:

–tax books in which the firm keeps track of the taxable income it generates, and the taxes due on that income, according to the rules of the appropriate tax authority.

Keeping the tax records may also involve a tax planning element.  A company may, for example, decide to recognize profits, to the extent it can, in a low-tax jurisdiction.  Or, as is often the case with US companies, it may decide not to repatriate profits earned abroad, at least partially because they would thereby become subject to a 35% tax.

Tax considerations can also have operational consequences.  For instance, a firm may choose to locate factories or sales offices in low tax jurisdictions over similar high tax alternatives mostly for tax reasons.

–financial reporting books, in which publicly traded firms keep track of profits, and report them to shareholders, according to Generally Accepted Accounting Principles (GAAP).

If the purpose of tax accounting is to yield the smallest amount of taxable income, and thereby the smallest amount of tax, the intent of financial reporting books can be seen as trying to present the same facts in the rosiest possible manner to shareholders.

The main difference between the two accounting systems comes in how long-lived assets are charged as costs against revenue.  Financial accounting rules allow such costs to be spread out evenly over long periods of time.  Tax accounting rules, which may be specifically designed to encourage investment, typically allow the firm to front-load a large chunk of the spending into one or two years.

The end result is that for most publicly traded companies, the net income reported to shareholders is far higher than that reported to the tax authorities.

management control books, kept according to cost accounting rules.  These are the records that a company’s top executives use to organize and direct the firm’s operations.  They set out company objectives and incentives, and are used to assess how each of its units are performing against corporate goals.  Not all parts of a firm are supposed to make profits.  Some may have the job of making, at the lowest possible cost, high quality components used elsewhere in the company.  A mature division may not have the job of growing itself anymore,  but of generating the largest possible amount of cash.

investment implications

Investors normally don’t get to see either a company’s tax books or its management control books.

Financial reporting books can sometimes give a picture that’s too rosy.  The two main culprits are deferred taxes and capitalized interest.  “Capitalized” interest is usually the interest on construction loans taken out for a project than’s underway but not yet finished.  Even though money is going out the door, under GAAP it’s not shown as a current expense.   I’ll explain deferred taxes next week.

In a very practical sense, you don’t need to understand either one too much (although it might be nice to).  Turn to the company’s cash flow statement in its latest SEC earnings filing.  Are there deferred tax or capitalized interest entries?  Do they add to cash flow or subtract from it?   …by how much?  If the answer is no, or that they add to cash flow, there’s nothing to worry about.  If they subtract–and a lot, on the other hand, there’s a potential problem.