1. Profitability Indicator Ratios: Introduction
  2. Profitability Indicator Ratios: Profit Margin Analysis
  3. Profitability Indicator Ratios: Effective Tax Rate
  4. Profitability Indicator Ratios: Return On Assets
  5. Profitability Indicator Ratios: Return On Equity
  6. Profitability Indicator Ratios: Return On Capital Employed

The effective tax rate is the simple tip of a complicated iceberg.

The simple explanation: Thumb (or scroll) to the income statement and divide “Provision for income taxes” by “Income before income taxes” and you’ve got it. Note that nomenclature may vary, so we’ll show an alternative set of terms in this graphic. But it’s all the same thing.

Keeping consistent with the WD-40 2016 10-K we’ve been using in this series:

WD-40’s effective tax rate = $20.161m/$72.789m = 27.7%

So where’s that iceberg?

For starters, WD-40 didn’t actually pay that $20.161 million in taxes in 2016.

Relative to much of the world, the U.S.’ tax and accounting rules are lengthy and complex enough to create an industry of lobbyists and loophole specialists. And while we as investors and analysts don’t need to geek out on taxes per se, it’s smart to know the principles at play.

Apart from the formula itself, the main thing to know is that the effective tax rate isn’t a company’s only tax rate. It’s part of a posse of tax rates and tax rate-related concepts that live on – and in some cases, off – a company’s financial statements, feeding into and off of each other.

Marginal Tax Rate

The marginal tax rate is technically the tax rate on the very last dollar (or euro, or peso, etc.) of taxable income. American corporations have an incremental tax bracket system just like individuals do, although big, publicly traded companies tend to get into the upper tax brackets pretty quickly. Here are the US federal rates from the 2017 tax year.

If taxable income is over

but not over

the tax is

plus

of the amount over

$0

$50,000

$0

15%

$0

$50,000

$75,000

$7,500

25%

$50,000

$75,000

$100,000

$13,750

34%

$75,000

$100,000

$335,000

$22,250

39%

$100,000

$335,000

$10,000,000

$113,900

34%

$335,000

$10,000,000

$15,000,000

$3,400,000

35%

$10,000,000

$15,000,000

$18,333,333

$5,150,000

38%

$15,000,000

$18,333,333

____

35%

$

Although the intent is to keep the top federal tax rate in the neighborhood of 35%, US tax policy – which is set more by politicians than by analysts – does so in a herky-jerky sort of way. For example, a businesses earning $100,002 in taxable profit would technically pay 39% on those last two marginal dollars. The 39% is a "bubble rate" designed to quickly raise the average tax rate by counterbalancing the earlier lower-tier rates. Likewise, the 34% rate that follows gives a little back, whereas the 38% takes some away again. Yes, there are other ways of doing this, but this happens to be the way codified into law.

Statutory Tax Rate

Whereas the marginal rate is the rate on the last dollar of taxable income, the statutory rate is the overall average rate after the incremental brackets have been applied. Whereas the business earning $100,002 paid 39% on the marginal $2, its total tax, per the table above, would be $22,250.78, which is roughly 22% of $100,002. For high rollers like WD-40, the tax table’s lumpy-looking adjustments do bring the overall statutory rate in line with the intended federal marginal rate: WD-40’s Note 12 on page F-20 shows that its 2016 statutory federal taxes would have been $25.476 million, which is 35% of its pre-tax income.

Effective Tax Rate

Now things get fancy. Staying with WD-40 for illustration, Note 12 starts with the statutory $25.476 million, then adds state income taxes, subtracts would-be US tax on repatriated foreign earnings that WD-40 promises it won’t actually ever repatriate (taxing foreign subsidiary earnings in the US is another US quirk, although companies can avoid tax on the portion they tell the US they’ll “permanently reinvest” overseas), subtracts a bonus-perk deduction for doing manufacturing in the US, along with the cryptic “other” before arriving at the $20.161 million Provision for income taxes that’s shown on the official income statement and supplies the numerator in our 27.7% effective tax rate.

Cash Taxes Paid

Brace yourself: Everything we just discussed has been accounting version of augmented reality, only indirectly related to the actual cash taxes companies pay in real life. Jump over to WD-40’s cash flow statement and you’ll see that it paid just $16.494 million (“cash taxes paid”) to the IRS in 2016.

What Happens With the IRS Stays With the IRS (Almost)

If you’re not from the tax accounting world, point (4) will seem bizarre. The backstory is that U.S. companies keep two sets of books: One to show the public, and one to show the IRS. Companies have opposing motivations for each set.

Companies want to look like big chest-thumping King Kongs on their public financial books, oozing profit to impress investors. For the IRS, they want to come across like scrawny capuchins because a low pre-tax income means a low tax bill. (The IRS tax bill is the one companies actually pay in a given year.)

Luckily, they can do both, thanks to differences in how Generally Accepted Accounting Principles (GAAP, or the guidelines for US accounting) and IRS tax accounting rules treat accruals. Accruals, a key concept in accounting, are the accountant’s way of spreading out lump-sum payments (or inflows) to better match the life what’s bought or paid for.

For a simple example, imagine a company pays $100,000 for a long-term asset – a truck, a permanent hairdo machine, or something else – that it expects to last 10 years. GAAP “book” rules might allow the company to record an income statement expense of $10,000 per year for 10 years (this is called straight line depreciation). To show those King Kong earnings, companies want to spread expenses over as many years as humanly possible, so they employ straight line depreciation over long time periods.

They also benefit from the fact that the IRS lets them do just the opposite. IRS accounting rules might allow a 7-year accelerated depreciation. Even better, they let the company take bigger charges at the beginning, such as (hypothetically) a $40,000 expense the first year, $20,000 the second, and so forth, allowing the company to take the biggest hits to income early on when those hits are most valuable in present value terms.

One thing to make clear: While U.S. tax code and accounting rules have evolved strangely, their intent isn’t to fool anyone. Although the numbers a company reports to the IRS are indeed secret, the notes inside each company’s financial statements at least broadly explain the key points of difference among its different tax numbers.

Plenty of people still find US tax accounting needlessly complex, so significant debate persists around whether US tax code is a reasonable lever for policy tweaks, or if a simpler tax system with incentives handled some other way is better.

We Didn’t Forget About the Effective Tax Rate

The saving grace is that except for a few little things like interest from municipal bonds, legal fines, and certain tax credits, expenses that pass through the “book” tax provision eventually do get paid to the IRS. Just as how straight line and accelerated depreciation both end up depreciating the same amount, but just over different time periods, the “book vs. tax” difference is mostly timing. Balance sheet accounts called deferred tax assets and deferred tax liabilities are where these timing differences hide until they’re used on the IRS statements; an asset here means a company paid more to the IRS than it’s currently able to show in its public income statement tax expense, whereas a liability means it recorded a tax expense that it hasn’t actually paid to the IRS yet.

This makes the effective tax rate a flawed-but-not-unreasonable tax rate for investors valuing companies by projecting future profits. Investors often start with effective tax rates and model a drift toward marginal rates over time if the effective rate is temporarily low. In particular, because the IRS and GAAP each have separate accounting rules, the effective tax rate computed under the GAAP accrual system arguably better matches income computed under GAAP as well, and same for the IRS system, which, though full of accruals, also leans closer to a cash system than GAAP.

In Practice

As with virtually any number used for historical comparisons, industry comparisons, or projections in the financial statement, the effective tax rate can be temporarily thrown off kilter. For example, net operating loss and carryforwards​ commonly skew companies’ tax rates low in a way that won’t last forever. Impermanent differences are likely also in play if a company is acquiring or disposing of a subsidiary in a lower-tax regime.

Small year-to-year changes will happen with virtually every multinational company as its profit sourcing mix moves around: Page 26 of WD-40’s 10-K notes that the company’s effective tax rate dropped from 29% in 2015 to 27.7% in 2016 as the company’s portion of earnings from the lower-tax UK grew.

Don’t forget that anything that affects the effective tax rate will also affect net income, as it’s essentially the only downstream profit figure on the income statement.

If there’s one takeaway, it should be that a company’s tax situation is all but a living, breathing organism in its own right. Between the accounting aranca and the tendency of tax policies in democratic nations to change fairly often, investors hoping for a quick-fire, “just gimme the number”-type solution risk missing bigger economic truths in pursuit of nonexistent simplicity. But if you must be given just one number for taxes, make it the effective tax rate.


Profitability Indicator Ratios: Return On Assets
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