Effective Tax Rate, Statutory Tax Rate, and Cash Tax Rate

Income taxes payable are mainly influenced by the geographic distribution of taxable income of the company and the corresponding tax rates in each location, but the nature of the business can also have an impact. For instance, some companies receive favorable tax treatment, such as R&D tax credits or accelerated depreciation for fixed assets.

Types of Tax Rates

Variations in tax rates can significantly influence a company’s value. Generally, three types of tax rates are essential for analysts:

1. Statutory Tax Rate: The corporate income tax rate in the country where the company is based.
2. Effective Tax Rate: It is calculated by dividing the reported income tax expense on the income statement by the pre-tax income.
3. Cash Tax Rate: The tax paid in cash during the period, divided by pre-tax income.

Forecasting Tax Expenses and Rates

Recall that differences between cash taxes and reported taxes usually arise from discrepancies between financial accounting standards and tax laws, as well as from changes in deferred tax assets or liabilities.

When predicting tax expenses and cash taxes, the effective tax rate and cash tax rate are crucial. Moreover, understanding the operational factors and financial structure of a company is beneficial for forecasting these tax rates.

Differences between the statutory tax rate and the effective tax rate can occur for various reasons, such as tax credits, withholding tax on dividends, adjustments to prior years, and non-deductible expenses. Effective tax rates may also vary when companies operate internationally, as the effective tax rate becomes an average of the tax rates of the countries where the company operates, weighted by the profit (before tax) generated in each country.

Consequently, if a company earns higher profits in countries with higher tax rates and lower profits in countries with lower tax rates, the effective tax rate will be a weighted average, typically higher than the simple average of the tax rates.

Additionally, consistently lower effective tax rates compared to statutory rates or the rates reported by competitors is not necessarily unusual but may require further analysis when forecasting future tax expenses. Financial statement notes should provide a reconciliation between the statutory tax rate and the effective rate, highlighting items that cause significant variations in the effective tax rate.

The cash tax rate is useful for forecasting cash flows, while the effective tax rate is relevant for projecting earnings on the income statement.

When developing an estimated tax rate for forecasts, analysts should adjust for one-time events.  For instance, if income from equity-method investees constitutes a large and volatile part of pre-tax income, excluding this amount from the effective tax rate calculation may provide a better estimate of future tax costs.

A good starting point for estimating future tax expense is a tax rate based on normalized operating income. Normalized operating income implies excluding results from associates and special items to provide a reliable indication of future tax expense, adjusted for special items, in an analyst’s earnings model.

Creating a model allows the calculation of the effective tax amount in profit and loss projections and the cash tax amount in the cash flow statement or as supplemental information. Note that the difference between the profit and loss tax amount and the cash flow tax figures should correspond to changes in deferred tax assets or liabilities.

Example: Analyzing Effective Tax Rates

Dolcie, a confectionery manufacturer, operates in countries C and E. Table 1 contains information on both countries’ tax rates. In year one, both countries’ earnings before tax (EBT) are the same.

$$ \textbf{Table1: Tax rates in different jurisdictions.} \\
\begin{array}{l|c|c|c}
& \textbf{Country C} & \textbf{Country E} & \textbf{Total} \\ \hline
\text{EBT} & 250 & 250 & 500 \\ \hline
\text{Effective tax rate} & 15\% & 35\% & 25\% \\ \hline
\text{Tax} & 37.5 & 87.5 & 125 \\ \hline
\text{Net profit} & 212.5 & 162.5 & 375
\end{array} $$

If earnings before tax for country C increase by 10 percent per year while earnings before tax for country E remain the same for the next three years, what will happen to the effective tax rate?

Solution

Consider the following table:

$$ \textbf{Table 2: Tax Estimate Problem} \\
\begin{array}{l|c|c|c|c}
\text{Year}& 0 & 1 & 2 & 3 \\ \hline
\text{EBT, Country C} & 250 & 275 & 302.5 & 332.75 \\ \hline
\text{Growth rate} & & 10\% & 10\% & 10\% \\ \hline
\text{EBT, Country E} & 250 & 250 & 250 & 250 \\ \hline
\text{Growth rate} & & 0\% & 0\% & 0\% \\ \hline
\text{Total EBT} & 500 & 525 & 552.5 & 585.75 \\ \hline \\ \hline
{\text{Effective tax rate,} \\ \text{Country C}} & 15\% & 15\% & 15\% & 15\% \\ \hline
{\text{Effective tax rate,} \\ \text{Country E}} & 35\% & 35\% & 35\% & 35\% \\ \hline \\ \hline
\text{Total tax} & 125 & 128.75 & 132.88 & 137.41 \\ \hline
\text{Total effective tax rate} & 25\% & 24.5\% & 24\% & 24.5\% \end{array} $$

The effective tax rate will gradually decline since a higher proportion of EBT is generated in the country with the lower tax rate.

Note that the total effective rate is the average of the effective tax rates of the countries where the company operates, weighted by the profit (before tax) generated in each country.

For instance, the total effective tax for year 0 is calculated as:
$$\begin{align}\text{Effective tax rate}&=\frac{250}{500}\times 15\%+\frac{250}{500}\times 35\%\\ &=25\%\end{align}$$

Question 1

AlphaTech, a hypothetical company based in Canada, also has significant operations in Germany. The statutory tax rate in Canada is 26%, while the statutory tax rate in Germany is 15%. Assume AlphaTech earns CAD 2,000 in profit before taxes in each country during year 20X1.

On January 1 of the following year, 20X2, AlphaTech acquires Beta Corp, which is domiciled in Japan. The statutory tax rate in Japan is 23%. Beta Corp earns CAD 1,000 in profits in 20X2. Assuming that Canadian and German operations each increase pre-tax profits by 20%, the effective tax rate in 20X2 for the consolidated entity is closest to:

1. 18.4%
2. 19.8%
3. 20.9%

The correct answer is C.

Recall that the effective tax rate is calculated by dividing the reported income tax expense on the income statement by the pre-tax income.As such,the effective tax rate in 20X2 for the consolidated Alphatec is calculated in the table below:

$$\begin{array}{l|c|c|c}
\textbf{Country} & \textbf{Taxable Income} & \textbf{Statutory Rate} & \textbf{Taxes} \\ \hline
\text{Canada} & \text{CAD 2,400} & 26\% & \text{CAD 624.00} \\ \hline
\text{Germany} & \text{CAD 2,400} & 15\% & \text{CAD 360.00} \\ \hline
\text{Japan} & \text{CAD 1,000} & 23\% & \text{CAD 230.00} \\ \hline
\textbf{Total} & \textbf{CAD 5,800} & & \textbf{CAD 1,214.00} \\
\end{array}$$

Therefore, the effective tax rate is:

$$\text{Effective tax rate}=\frac{1,214}{5,800}=20.9\%$$

Question 2

When might an effective tax rate consistently lower than statutory or competitors’ rates warrant additional analyst attention?

1. When forecasting future tax expenses.
2. When it is reported in the financial statements.
3. When it is consistently lower than statutory rates.

Solution

The correct answer is A.

An effective tax rate consistently lower than statutory or competitors’ rates might warrant additional attention when forecasting future tax expenses.