There are three realities that you cannot avoid in business and investing. The first is that your returns and value are based upon the cash flows you have left over after you pay taxes. The second is that the taxes you pay are a function of both the tax code of the country or countries that you operate in and how you, as a business, work within (or outside) that code. The third is that the tax code itself can change over time, as countries institute changes in both rates and rules. The upcoming year looks like it will be more eventful than most, especially for US companies, as there is talk about major changes coming to both corporate and individual taxation.
Why taxes matter
While we are often casual in our treatment of taxes, the value of a business is a affected substantially by tax policy, with our measures of expected cash flows and discount rates both being affected by taxes.
- In the numerator, you have expected cash flows after taxes, where the taxes you pay will reflect not only where in the world you generate income (since tax rates and rules vary across countries) but how the country in which you are incorporated in treats that foreign income. The US, for instance, requires US companies to pay the US tax rate even on foreign income, though the additional tax is due only when that income is remitted back to the US, leading to a predictable result. Multinational US companies leave their foreign income un-remitted, leading to the phenomenon of trapped cash (amounting to more than $2 trillion at US companies at the start of 2017).
- The denominator, which is the discount rate, is also affected by the tax code. To the extent that tax laws in much of the world benefit debt over equity, using more debt in your financing mix can potentially lower your cost of capital. In computing this tax benefit from debt, there are two points to keep in mind. The first is that interest expenses save you taxes at the margin, i.e., your dollar in interest expense offsets your last dollar of income, saving you taxes on that last dollar, making it imperative that you use the marginal tax rate when computing your tax benefit from borrowing. The second is that companies have a choice on where to borrow money and not surprisingly choose those locations where they get the highest tax benefit (with the highest marginal tax rate). Is it any surprise that while Apple generates its income globally and finds ways to pay an effective tax rate of 21% on its taxable income in 2016, almost all of its debt is in the United States, saving taxes at an almost 40% marginal tax rate?
Following up, then, the values of all companies in a country can change, some in positive and some in negative ways, when tax codes get rewritten. Even if the corporate tax codes don’t change, a company’s decisions on how to structure itself and where geographically to go for growth will affect its cash flows and discount rates in future years.
Marginal Tax Rates
If the marginal tax rate is the rate that a business pays on its last dollar of income, where in its financial statements are you most likely to find it? The answer in most companies is that you do not, and that you have to look in the tax code instead. Fortunately, KPMG does a yeoman job each year of pulling these numbers together and reporting them and the most recent update can be found here. The map below lists marginal tax rates by country and you also download a spreadsheet with the latest numbers at this link:
As you survey the world’s marginal tax rates, you can see why trapped cash has become such a common phenomenon at US companies. The US has one of the highest marginal tax rates in the world at 40% (including a federal tax rate of 35%, topped off with state and local taxes) and is one of only a handful of countries that still insist on taxing companies incorporated in their domiciles on their global income, rather than adopting the more defensible practice of territorial taxation, where you require businesses to pay taxes in the countries that they generate their income in. As Congress looks at what to do about “trapped cash”, with many suggesting a one-time special deal where companies will be allowed to bring the cash back, they should also realize that unless the underlying reason for it is fixed, the problem will recur. That will mean either lowering the US marginal tax rate closer to the rest of the world (about 25%) or changing to a territorial tax model.
The marginal tax rate is the number that you use to compute your after-tax cost of debt but that practice is built on the presumption that all interest expenses are tax deductible (and that you have enough taxable income to cover the interest deduction). That is still true in much of the world but there are parts of the world, where you either cannot deduct interest expenses (such as the Middle East) or you have taxes computed on a line item like revenues (thus nullifying the tax benefit of debt), where you will have to alter the practice of giving debt a tax benefit. For multinational companies that face different marginal tax rates in different operating countries, my recommendation is that you use the highest marginal tax rates across countries, since that is where these companies will direct their borrow.
Effective Tax Rates: Country Level Differences
If the marginal tax rate is the tax rate on your last dollar of income, what is the effective tax rate, the number that you often see reported in financial statements? In most cases, it is a computed tax rate that comes directly from the income statement and is computed as follows:
Effective Tax Rate = (Accrual) Taxes Payable / (Accrual) Taxable Income
Both number are accrual income number and thus can be different from cash taxes paid, with the differences usually visible in the statement of cash flows. Let’s start with looking at what companies pay as effective tax rates in the United States, a country with a marginal tax rate of 40%. In the most recent twelve months leading into January 2017, the distribution of effective tax rates paid by tax-paying US companies is captured below.
The most interesting numbers in this distribution are the average effective tax rate of 26.42% across profitable US companies, well below the marginal tax rate of 40%. and the fact that 88% of US companies have effective tax rates that are lower than the marginal. The most important reason for this difference, in my view, is foreign operations with those firms that generate revenues outside the United States paying lower taxes, simply because the tax rate on income outside the United States is much lower (and that differential tax is not due