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Tax Week Special: Dare we ignore taxes the other 51 weeks? April 12, 2010

Posted by Bob Cook in Financial Planning & Analysis, Silicon Valley.
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It’s tax week. Oops. There goes 35% of my marginal income – or actually even more considering the state tax. “Why,” I ask myself rhetorically, “did I bother working those last few hours last year? I should have left for the New Year’s Eve party early.”

Likewise, I wonder, why do corporations burdened with a 35% Federal tax and additional state taxes fret so much about all the little cost savings they pursue when billions of dollars flow out the door as tax, sometimes with nary a look? Tax expense is one of the largest expenses companies have – yes, sometimes more than real estate and facilities, sometimes even more than salaries – yet companies do a miserable job of managing it. Most don’t even really try.

Many people think tax expense is not manageable, that the amount you’ll pay is predestined, inevitable – that you’re going to send 35 percent of your before-tax-income to the Feds and whatever percent to your state, no matter what. Not true. If it were, the tax paid as a percent of income-before-tax would be pretty much the same across companies. But take a look, below. I present the overall three-year-average tax rate shown on the income statements of some large California companies. All are headquartered within a few miles of one another, and all are in high-tech such that they are inherently similar (albeit, they have over time chosen different models for production, geography, financing, etc – but that, of course, is the point!)

 

Income-before-tax (3-yr average)         Tax (3-yr average) Tax as % of Income-before-tax
HP 9,688,333 1,937,333 20%
Cisco 9,136,333 1,963,333 21%
Google 6,636,255 1,652,580 25%
Intel 7,518,667 1,973,000 26%
Oracle 7,218,000 2,088,667 29%
Apple 8,673,000 2,723,333 31%

 

There’s an 11% point spread from high to low. Apply that to a multibillion-dollar-plus income-before-tax and you’re talking serious money. Granted, the GAAP accounting for taxes may skew things a bit as do things like tax losses being carried forward (although, the 3-year average should ameliorate this), but it’s nevertheless clear that the tax rate is not inevitable and that some companies pay much less than others. Whether the large spread in their tax rates is caused by conscious tax-planning or dumb luck can’t be known, and one shouldn’t jump to the conclusion that high-tax-rate companies are doing a poorer planning job because they might be making intelligent choices taking into account tax and other factors. The wide point spread should, though, open one’s eyes to the scope of opportunity available if one were to consciously pursue tax-planning.

(In case you’re wondering: while the Federal plus California marginal tax rate for corporations is 44%, the threshold for reaching this rate is very low, so the lower-than-44% overall tax rate of these companies cannot be explained by an overall-vs-marginal-tax-rate argument; there are other things going on that cause it.)

A company’s tax rate is determined by the business decisions – the big ones and the many, many small ones – made throughout the company. The way to manage income tax expense, therefore, is to routinely take taxes into account in decision-making – or at least for those decisions that can be identified as impacting tax.

That’s easier said than done. Tax analysis can be complex, and more importantly …. few, if any, managers in a corporation have an incentive to take taxes into account in decision-making. Budgets are almost always before-tax with bonuses based on before-tax performance. (I might add that they’re also based on “before-capital-cost” budgets and performance goals – an even bigger topic that merits a future blog post.)

Many of the decisions impacting a corporation’s tax rate have corporate real estate execs as participants – sometimes even as decision-makers. Location decisions are obvious examples. Should the facility be on this side of the state line or that? Should we own there or lease? Invest more there or here? These decisions affect individual state’s claims on how much of a corporation’s income is from their respective states and hence how much income is taxable in their state. It can make a big difference. Some state’s (NV, WY, SD) have no corporate income tax at all; some have rates close to 10% (PA, CA).

Even more obvious examples of how location decisions affect tax position are decisions to locate facilities overseas to significantly-lower tax-regime nations – Singapore and Hong Kong come to mind – particularly if the plan is to never bring the profits back to the U.S.

There are also everyday financial-type decisions being made in corporate real estate departments that affect income taxes. In these departments, it is convenient to assume that all cash flows and all P&L statement numbers would be affected by taxes similarly so that an an after-tax analysis would simply echo that of the before-tax analysis and be unnecessary – but this is not always true. Consider for example, the decision to purchase Bldg A or Bldg B which are priced identically. Before-tax, the economics of both seem identical. If, however, the allocation of price between land and building differs between the two buildings, an after-tax analysis would show them to have different costs. The one with the lower land value and higher building value would be less expensive because the deductible depreciation expense would be higher.

There are many other situations where before-tax and after-tax analysis point to different courses of action – from big decisions such as own-vs-lease to common decisions such as whether to accept a landlord’s offer to pay for tenant improvements. It is unfortunate that so much effort often goes into fine-tuning before-tax financial analysis when it leaves out such a weighty thing as tax. Before-tax analysis is ok as a preliminary, quick-and-dirty, back-of-the-envelope calculation based on WAG’s, but …. for a final decision?

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Comments»

1. Why Financial Accounting is Very Important | inblog.net | Accountancy Business Wisdom - April 13, 2010

[…] Tax Week Special: Dare we ignore taxes the other 51 weeks … […]

2. Richard L. Podos - May 15, 2010

Amen from the TI finance and sale-leaseback guy!! (both mentioned above… good job!)

One more point: EARNINGS ARE AFTER-TAX.


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