Chapter 25 Taxes Instructors: Please do not post raw PowerPoint files on public website. Thank you! Chapter 25 Taxes

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.

An Example with Full Disclosure To start our analysis, consider the internal financials of a global company for a single year. The company generated $2,000 million in domestic earnings before interest, taxes, and amortization (EBITA) and $500 million in foreign EBITA. The company pays a statutory (domestic) tax rate of 35 percent on earnings before taxes, but only 20 percent on foreign operations. Income Statement by Geography $ million Domestic Foreign R&D One-time subsidiary tax credits credits Company EBITA 1 2,000 500 2,500 Amortization (400) − EBIT 1,600 2,100 Interest expense (600) Gains on asset sales 50 Earnings before taxes 1,000 550 1,550 Taxes (350) (110) 40 25 (395) Net income 650 440 1,155 Tax rates (percent) Statutory tax rate 35.0 20.0 Effective tax rate 25.5 EBITA is earnings before interest, taxes, and amortization; EBIT is earnings before interest and taxes.

An Example with Full Disclosure R&D Tax Credits The majority of taxes are related to earnings, but the company also generates $40 million in ongoing research and development (R&D) tax credits (credits determined by the amount and location of the company’s R&D activities), which are expected to grow as the company grows. Income Statement by Geography $ million Domestic Foreign R&D One-time subsidiary tax credits credits Company EBITA 1 2,000 500 2,500 Amortization (400) − EBIT 1,600 2,100 Interest expense (600) Gains on asset sales 50 Earnings before taxes 1,000 550 1,550 Taxes (350) (110) 40 25 (395) Net income 650 440 1,155 Tax rates (percent) Statutory tax rate 35.0 20.0 Effective tax rate 25.5 EBITA is earnings before interest, taxes, and amortization; EBIT is earnings before interest and taxes. One-Time Credits The company also has $25 million in one-time tax credits, such as tax rebates related to historical tax disputes.

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. Since R&D tax credits are related to operations and expected to grow with revenue, they are included in operating taxes as well. Operating Taxes and NOPLAT by Geography

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. The tax reconciliation table, which is found in the notes of the annual report, reconciles the taxes reported on the income statement with the taxes that would be paid at the company’s domestic statutory rate. 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. Income Statement and Tax Reconciliation Table

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 Audit revision etc. 25 Reported taxes: operating only 420 Plus: Amortization tax shield (at 35%) 140 Plus: Interest tax shield (at 35%) 210 Less: Taxes on gains (at 20%) (10) Operating taxes 760 Operating tax rate on EBITA (percent) 30.4 Remove nonoperating taxes found in reconciliation table. Remove taxes related to nonoperating income or expense at appropriate marginal tax rate. 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.

A Simple Method to Determine Operating Taxes 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. 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. 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.

Operating Taxes: Step 1 To start, multiply each reported percentage on the tax reconciliation table by “earnings before taxes” found on the income statement. For instance, 35.0 percent times $1,550 in earnings before taxes equals $542.5 million.

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 million. Step 3: Using data from the converted tax reconciliation table computed earlier, subtract the dollar-denominated foreign-income adjustment ($83 million) and the R&D tax credit ($40 million). Result: The estimate for operating taxes, $753 million, is close but not equal to the $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. Simple Approach for Estimating Operating Taxes Step 2 Step 3

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 countries with low tax rates), multiply a blended global rate by EBITA, and adjust for other operating taxes. A blended global rate of 29.7 percent is applied to $2,500 million in EBITA. The blended global rate is the statutory tax rate (35 percent) adjusted by the foreign-income adjustment (–5.3 percent) found in the company’s tax reconciliation table. Once again, estimated operating taxes are not quite equal to actual operating taxes. Simple Approach for Estimating Operating Taxes

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?

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 liabilities (DTLs): Warranty reserves (a DTA): The government recognizes a deductible expense only when a product is repaired, so cash taxes tend to be higher than accrual taxes. Accelerated depreciation (a DTL): The company uses straight-line depreciation for its GAAP/IFRS reported statements and accelerated depreciation for its tax statements (because larger depreciation expenses lead to smaller taxes). Deferred Tax Assets and Liabilities $ million Prior Current year Deferred tax assets 1 Tax loss carry-forwards 550 600 Warranty reserves 250 300 Deferred tax assets (DTAs) 800 900 Deferred tax liabilities Accelerated depreciation 3,600 3,800 Pension and postretirement benefits 850 950 Nondeductible intangibles 2,200 2,050 Deferred tax liabilities (DTLs) 6,650 6,800 Deferred tax assets are consolidated into a single line item on the balance sheet. If small, they are typically included in other assets.

Reorganized the Deferred Tax Account To convert accrual-based operating taxes into operating cash taxes, subtract the increase in net operating DTLs (net of DTAs) from operating taxes. Determine the increase in net operating DTLs by subtracting last year’s net operating DTLs ($3,350 million) from this year’s net operating DTLs ($3,500 million). During the current year, operating-related DTLs increased by $150 million. Thus, to calculate cash taxes, subtract $150 million from operating taxes of $760 million. Deferred Tax Asset and Liability Reorganization

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: 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. 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. 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.