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.