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

Income taxes payable are determined by the mix of income locations and local tax rates, potentially influenced by business-specific tax benefits like R&D credits. Analysts must track governmental and business changes affecting tax rates.

For analysts, three key tax rates matter:

1. Statutory tax rate: The corporate income tax rate in the company’s home country.
2. Effective tax rate: Calculated by dividing reported income tax expense by pre-tax income.
3. Cash tax rate: Calculated by dividing the cash tax paid during a period by pre-tax income.

These rates often diverge due to differences in accounting standards and tax laws influenced by deferred tax assets or liabilities. Understanding the effective and cash tax rates and their operational drivers is crucial in predicting tax expenses and cash taxes.

Differences between statutory and effective tax rates stem from various factors like tax credits, withholding on dividends, and non-deductible expenses. Effective tax rates also vary when companies operate internationally, blending tax rates from different countries where they do business. This blend is based on profits generated in each country.

An effective tax rate consistently lower than statutory rates or competitors’ rates isn’t necessarily unusual but warrants attention when forecasting tax expenses. The financial statements should disclose how the statutory rate reconciles with the effective rate and explain significant factors behind high or low effective rates.

When estimating future tax rates for forecasts, analysts should adjust for one-time events and consider equity-method investee income’s volatility. A normalized tax rate based on typical operating income, excluding special items, is a good starting point for estimating future tax expenses in an earnings model. This model helps project effective tax amounts in the profit and loss and cash tax amounts in the cash flow statement, with changes in deferred tax assets or liabilities as a key reconciliation point.

Example

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

$$ \textbf{Exhibit 1: Tax rates in different jurisdictions.} \\
\begin{array}{l|c|c|c}
& C & E & \text{Total} \\ \hline
\text{EBT} & 250 & 250 & 500 \\ \hline
\text{Effective tax rate} & 15\% & 35\% & 25\% \\ \hline
\text{Tax} & 37.5 & 87.5 & 125 \\ \hline
\text{Net profit} & 212.5 & 162.5 & 375
\end{array} $$

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?

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

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

Question

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

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

Solution

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