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Online Tutorial #7: How Do You Calculate A Company's Cash Tax Rate?

In this session, we focus on defining cash tax rate, explaining where to obtain data to calculate it, and walk through a sample calculation. As with previous sessions, we will use Gateway, Inc., as of April 21, 2000, as a case study. Readers who want to calculate cash tax rates while reading this tutorial may wish to download the accompanying spreadsheet

What Does "Cash Tax Rate" Mean?

To understand what we mean by "cash tax rate," let's break this phrase down into its component parts:

  • Cash. This means that we want to look at the cash a company pays annually in taxes. This may differ from the income tax provision companies report on their income statements.
  • Tax. This means we look at the amount a company pays to governments in exchange for the privilege of doing business in their jurisdictions.
  • Rate. This means that we want to calculate the percent of pre-tax profit that a company pays in cash taxes.

Also, though it is not explicitly in the phrase, we need to consider one more word:

  • Unlevered. A company's taxes are influenced by how much debt a company has, as interest payments on that debt shield pre-tax profit from taxation. When calculating cash taxes, we remove this distortion by calculating a company's tax burden assuming a company was 100% equity financed with no debt.

Putting this together, we can define "cash tax rate" as "the percent of pre-tax operating profits a company would pay in cash taxes to governments assuming it was 100% equity financed."

How Do We Calculate a Company's Cash Tax Rate?

We can use two methods:

A. Simplified Approach. This approach just substitutes a company's book tax rate as a proxy for its cash tax rate. However, as we note in the book on page 23:

The tax expenses in the income statement, book taxes, is generally greater than the actual payments, or cash taxes, during a given period. Why? Because companies can recognize some revenue and expense items at different times for book versus tax purposes.

In addition, as we noted above, the book tax rate reflects a company's use of leverage. An unlevered cash tax rate removes the influence of debt on a company's tax rate.

B. Advanced Approach. In this approach, we make a number of detailed adjustments.

1. Book taxes. We start with a company's income tax provision found on the income statement.

2. Change in deferred taxes. Next, we add the year-to-year increase in a company's deferred income tax liability (or subtract the increase in a company's deferred tax asset). These line items can be found on a company's balance sheet. However, sometimes, this liability is not separately broken out. In those cases, there are two alternate sources for a company's change in deferred taxes:

  • "Adjustments to reconcile net income to net cash provided by operating activities" in the "Cash flows from operating activities" section of the Cash Flow Statement.  A deferred tax liability occurs when a company pays less in cash taxes than it reports in book taxes. Thus, an increase in a company's deferred tax liability represents a source of cash. Conversely, a deferred tax asset occurs when a company pays more in cash taxes than it reports in book taxes. Thus, an increase in a company's deferred tax asset represents a use of cash.
  • The Income Taxes section of the Notes to the Consolidated Financial Statements, where the 10-K will list the "components of the provision for income taxes". We subtract the sum of the annual U.S. and Foreign deferred income taxes from a company's income tax provision. When annual U.S. and foreign deferred taxes are positive, the company has increased its net deferred tax liability, which reduces the tax onus. Conversely, when annual U.S. and foreign deferred taxes are negative, the company has increased its net deferred tax asset, which increases the tax onus. (Note: the sum of U.S. and Foreign deferred income taxes should be identical to the number in the Cash Flow Statement.)

3. "Unlevering" income taxes. Finally, we remove taxes paid (in the case of positive interest income) or add back taxes shielded by debt (in the case of interest expense). For example, if a company had $100 million in interest income and an estimated 35% marginal tax rate, we would subtract $35 million. If a company had $100 million interest expense, we would add back $35 million in taxes (that would have been paid if that interest expense had not shielded the company from paying taxes).

We can see how all this fits together by returning to our Gateway case study:

1994 1995 1996 1997 1998 1999
               Income tax provision

50.1

89.1

132.0

93.8

194.8

235.5

               Increase in deferred tax asset

1.1

23.8

13.4

63.3

58.4

2.9

          Current income taxes

51.2

112.9

145.4

157.1

253.3

238.4

               Other income

5.1

13.1

26.6

27.2

47.0

67.8

          Taxes paid on other income

1.8

4.6

9.3

9.5

16.5

23.7

     Unlevered cash taxes

49.4

108.3

136.1

147.6

236.8

214.7

     EBITA

141.0

249.0

356.1

176.5

494.2

595.7

Cash tax rate (%)

33.5%

43.5%

38.2%

83.6%

47.9%

36.0%

Source: Income Tax Provision, Other Income, and EBITA obtained from Gateway's Income Statements (click the appropriate year for three year income statements for 1996 and 1999. Change in deferred taxes can be obtained from Gateway's Cash Flow Statements (click the appropriate year for three year cash flow statements for 1996 and 1999.

The average Cash Tax Rate from 1994 to 1999--excluding the 1997 outlier which was distorted by large Nonrecurring Expenses--equals 40.6%. The Cash Tax Rate in 1999, however, equaled 36.0%. Our projected cash tax rate for the Price-Implied Expectations (PIE) analysis detailed in the book equals 35.0%, roughly equal to 1999 levels.

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