FROM: Penelope Diane Flugher
DATE: November 16, 2013
SUBJECT: Tax Issues We have taken a look at the questions you had and we have done some research and have come up with the following answers:
1. $800 million Deferred Tax Liability (DTL)
DTL: Account due to temporary differences between accounting and tax carry-values and reflects future tax obligations. Depreciation is often accelerated for tax reasons and lowers income amounts and tax payments. Eventually, this will reverse and companies will pay. DTLs can act like equity when growth is continual and the depreciation method never reverses (especially the case for asset intensive companies (Kroger) or for stock purchases with large future capital gains (Berkshire Hathaway)). http://www.fool.com/investing/general/2007/01/12/understanding-deferred-tax-liabilities.aspx
a. Will we be able to pay them?
Paying the $800 million DTL should not be a concern as long as we keep growing and investing in PPE, R&D and M&A
If we keep investing and using the accelerated depreciation method, depreciation will keep accelerating and will not reverse anytime soon
Companies only pay DTL when the acceleration schedule reverses
DTL account is not a cash account, and is only a matter of accounting differences between “book” and “tax”
Therefore, it’s not immediately payable
b. Why is it getting bigger? How does it stop?
The DTL is increasing because we are continuing to grow (10% per year) and investing to support our growth (PPE, R&D, M&A etc.)
When we stop growing and investing/buying new depreciable equipment the accelerated depreciation schedule will begin to decrease and become payable
Therefore, our DTL will stop growing and will not overwhelm us
2. Stable ETR
ETR: Tax specifically collected by the government; (p. 139 Explicit Tax= Pretax return on benchmark (bond) – Pretax return on Tax-exempt bond; Explicit Tax Rate= Explicit Tax/Benchmark (bond))
Yes, the ETR should have increased because of the audit’s $125 million tax deficiency but it was offset by the $125 million Deferred Tax Asset (DTA) account
Therefore, the ETR is unaffected by the audit amount since the net result is zero
3. ETR @ 41.5% vs. FIT @ 35% and SIT @ 10%
The ETR is at 41.5% because of the differences between book and tax accounting regarding the fast write-offs of equipment (DTL account) and FIT/SIT rules vary by jurisdiction
Taxable income varies based on timing of income, tax deductions and what is deemed taxable
The tax rates are progressive and in this case, the company has a larger book income compared to taxable income
Differences in the timing of income or deduction, tax exemptions and disallowance/limitations on certain tax deductions must be disclosed on the Schedule M-3, Form 1120
Since the income need to be taxed at federal and state level, the ETR(MTR) is 35% + 10%*(1-35%) = 41.5%. Therefore, the ETR is 41.5% even though FIT is 35% and SIT is 10%.
4. $1162 cash taxes paid vs. $1245 tax expense
Represents the difference between book and tax accounting and the deferred taxes
Company has more taxes due at a future date while the book income looks better now
There is $83 difference between cash taxes paid and tax expense. The $83 is $200 difference in the BOY and EOY deferred tax liability (800-600) subject to 41.5 % ETR.
5. Impending Tax Issues Regarding 11/18 Meeting
Are manufacturer deductions available?
Section 199 Domestic Production Activities Deduction
Research and experimentation credit for technological improvements
How is seasonality affecting decisions in November since the highest profits are from late October? Could this be misleading? Are projections extrapolated too much?
Should so much growth be considered immediately after the most profitable season? Is this indicative of the yearly outlook?
What is the accounting year end? Earnings management considerations…could the future be manipulated to meet predetermined