Impact of Multinational Operations on a Company’s Effective Tax Rate

Accounting standards require companies to explain the relationship between tax expense and accounting profit. This explanation is presented as a reconciliation between the average effective tax rate and the applicable statutory rate. The effective tax rate is computed as the tax expense in the income statement divided by the pretax accounting profit. Contrarily, the statutory rate is provided by the tax code of the home country.

Information on the effect of multinational operations can be obtained from a company’s disclosure on the effective tax rates. The disclosure enables the users of the financial statements to establish whether the effective tax rate used in a particular financial year is unusual. Additionally, it helps them to understand significant factors, such as the effect of foreign taxes that could affect the effective rate in the future.

Example: The Impact of Multinational Operations on Companies’ Effective Tax Rate

The following are effective tax rate reconciliation disclosures for two consumer products companies, Amul Ltd. and PepsiCo Ltd., based in India and the US, respectively. We will use the disclosures to answer the following questions:

1. Which company’s home country has a lower statutory tax rate?
2. What was the impact of multinational operations on each company’s 2016 effective tax rate?
3. What do Amul’s disclosures suggest about the geographic mix of its 2016 profit?

$$ \textbf{Selected Information and Notes from Consolidated Financial Statements of Amul Ltd. in millions of INR} $$

$$\small{\begin{array}{l|cc} {}&\textbf{Income tax expense (excerpt)}&{}\\ \hline{}&\textbf{Reconciliation of the effective tax rate}&{}\\ \hline{} & \textbf{2016} & \textbf{2015}\\ \hline\text{Profit before income tax} & 3,000 & 2,500\\ \hline{\text{Share of associates’ and joint ventures’}\\ \text{net profit}} & (500) & (400)\\ \hline {\text{Profit before income tax excluding share of profit}\\ \text{of associates and joint ventures}} & 2,500 & 2,100\\  \end{array}}$$

$$\small{\begin{array}{l|r|r|r|r} {}& \textbf{%} & \textbf{2016} & \textbf{%} & \textbf{2015}\\ \hline\text{Income tax at Amul’s domestic tax rate} & 28.0\% & 700 & 30.0\% & 630\\ \hline\text{Effect of tax rates on non-domestic jurisdictions} & 5.0\% & 125 & 3.4\% & 71\\ \hline\text{Unrecognized current year tax losses} & 1.0\% & 25 & 0.8\% & 17\\ \hline\text{Effect of tax incentives and exempt income} & -10.0\% & (250) & -14.0\% & (294)\\ \hline\text{Effect of changes in the tax rate} & 2.8\% & 70 & 3.0\% & 63\\ \hline\text{Other reconciling items} & 3.0\% & 75 & 5.0\% & 105\\ \hline\textbf{Effective Tax Rate} & \textbf{29.8%} & \textbf{745} & \textbf{28.2%} & \textbf{592}\\  \end{array}}$$

The difference between the statutory US federal income tax rate and PepsiCo’s global effective tax rate as reflected in the Consolidated Statements of Income is as follows:

$$ \textbf{Notes from Consolidated Financial Statements of PepsiCo Ltd.} $$

$$\small{\begin{array}{l|r|r|r} \textbf{Income tax expense (excerpt)}&{}&{}&{}\\ \hline\text{Percentage of income before income taxes} & \textbf{2016} & \textbf{2015} & \textbf{2014}\\ \hline\text{Tax at United States statutory rate} & 35.5\% & 35.5\% & 35.5\%\\ \hline\text{State income taxes, net of federal benefit} & 0.5\% & 1.6\% & 0.6\%\\ \hline\text{Earnings taxed at other than United States statutory rate} & -2.0\% & -5.8\% & -2.6\%\\ \hline\text{Iran hyperinflationary transition charge} & 0.0\% & 3.2\% & 0.0\%\\ \hline\text{Other, net} & -1.5\% & -2.0\% & -1.8\%\\ \hline\text{Effective tax rate} & 32.5\% & 32.5\% & 31.7\%\\  \end{array}}$$

The solution to 1: Amul’s home country rate of 28.0% in 2016 is lower than PepsiCo’s home country tax rate of 35.5%.

The solution to 2: The line of tax item labeled “Effect of tax rates on non-domestic jurisdictions” shows that multinational operations increased Amul’s effective tax rate by 5%.

On the other hand, the line on item “Earnings taxed at other than the United States statutory rate” indicates that multinational operations decreased PepsiCo’s effective tax rate by 2.0% in 2016.

Solution to 3: Multinational operations’ impact on effective tax rates can often be explained by changes in profit mix between countries with higher or lower marginal tax rates.

It can be seen from Amul’s disclosure that multinational operations increased its effective tax rate by 5% in 2016 as compared to 3.4% in 2015. The more significant impact in 2016 could indicate that Amul’s profit composition in 2016 shifted to foreign subsidiaries with higher marginal tax rates. Moreover, the change might indicate that the marginal tax rates increased in the foreign subsidiaries in which Amul earns profits.

Question

P&G is a hypothetical multinational corporation based in the US. Assume that it only has two subsidiaries, ABC Ltd. based in Spain and XYZ Ltd based in Canada. The foreign subsidiaries have different functional currencies. ABC uses Euro (EUR), and XYZ uses the Canadian dollar (CAD). P&G’s presentation currency is US dollar (USD).

You are further provided with the following information:

$$ \textbf{Selected Information and Notes from Consolidated Financial Statements of P&G (in USD millions)} $$

$$\small{\begin{array}{l|r|r} \textbf{Income Statement} & \textbf{2018} & \textbf{2017}\\ \hline\text{Revenue (1)} & 2,000 & 1,965\\ \hline\text{Profit before tax} & 300 & 275\\ \hline\text{Income tax expense (2)} & (100) & (98)\\ \hline\text{Net profit} & 200 & 177\\ \hline\text{Balance Sheet} &{} &{}\\ \hline\text{Cash (3)} & 500 & 458\\ \hline\text{Intangibles (4)} & 600 & 595\\ \end{array}} $$

$$ \textbf{Note 2: Income Tax Expense Excerpt (In USD Millions)} $$

$$\small{\begin{array}{l|r|r} {}& \textbf{2018} & \textbf{2017}\\ \hline\text{Income tax at P&G’s domestic tax rate} & 106 & 96\\ \hline\text{Effect of tax rates on non-domestic jurisdictions} & -12 & -9\\ \hline\text{Unrecognized current year tax losses} & 6 & 11\\ \hline\text{Income tax expense} & 100 & 98\\ \end{array}}$$

Based solely on the above information, the change in P&G’s consolidated income tax rate from 2017 to 2018 most likely resulted from a:

    A. More profitable business mix in its subsidiaries.

    B. Decrease in P&G’s domestic tax rate.

    C. Stronger US$ relative to the currencies of its subsidiaries.

Solution

The correct answer is A.

The consolidated effective tax rate is computed as the tax expense in the income statement divided by the pretax accounting profit. Note 2 shows that P&G’s consolidated income tax rate decreased by 2.31%, from 35.64% =\((\frac{98}{275})\) in 2017 to 33.33% =\((\frac{100}{300})\) in 2018.

The most significant component of the decrease stems from the 0.73% difference in the effect of tax rates in non-domestic jurisdictions. It lowers P&G’s consolidated income tax rate in 2017 by 3.27% =\((\frac{9}{275})\) and in 2018 by 4.00%= \((\frac{12}{300})\).

The decrease in 2018 could indicate that P&G’s business mix shifted to countries with lower marginal tax rates, resulting in more profit and a lower consolidated income tax rate. This change may mean that the marginal tax rates decreased in Spain and Canada in which P&G earns profits.

B and C are incorrect. From the calculation in the answer above, the most significant component of the consolidated income tax rate decrease stems from the 0.73% change in the effect of tax rates in non-domestic jurisdictions.

Reading 13: Multinational Operations

LOS 13 (h) Describe how multinational operations affect a company’s effective tax rate.