Major Factors Causing the Change in the Effective Tax Rate over the 3-Year Period Essay
Major Factors Causing the Change in the Effective Tax Rate over the 3-Year Period Some companies go as far as planning out and implementing the establishment of a significant chunk of their operations in countries that impose lower tax rates to benefit from such lower rates and to therefore have a lower effective tax rate based on their aggregate income tax expense and pretax income figures. Indeed, to some companies, the savings generated by locating in countries that charge more benign tax rates are reason enough to overrule whatever disadvantages and difficulties may be presented by such move. 3Stooges, Inc. can be cited as an example of these companies. 3Stooges, Inc., as a multinational conglomerate, has its parent company in the US. Through its parent company, it stands as the majority owner of various US subsidiaries and of one German subsidiary. On top of the prevailing differences in the Generally Accepted Accounting Principles of the two countries, there is the substantial difference in their tax rates.
While 35% is the imposed rate in the US, its equivalent in Germany turns out to be only 20%. This 15%-difference in the tax rates of the two countries can undoubtedly be viewed as an attractive means to save on taxes without having to break rules. In the finance world, analysts consider the effective tax rate of a company as an important input for forecasting its future income and cash flows. Investors also tend to compare the effective tax rates of companies in the same industry in the course of their analysis and decision-making. The smaller the effective tax rate, then, the more favorable the company becomes in the eyes of the investors and analysts. Needless to say, smaller effective rates also concretely bring in savings in the form of decreased income taxes due. But this can be accomplished only if everything goes as planned and if the company operations will report at the end of the year actual income and expense figures that are approximately the same, if not better than, the figures projected and targeted during the planning stage of the expansion.
Thus, 3Stooges, Inc. embarked on such plans to set up operations in Germany where the income tax rate at only 20% can serve as a brilliant way to increase their aggregate net income after tax. And so the management of 3 Stooges, Inc.
drew up plans of gradually increasing the size of their operations in Germany while undertaking no moves for the expansion of any of their US subsidiaries. Through this move, the company management targeted the steady year-on-year increases of the Germany subsidiary’s income, both in terms of face amounts and of the percentages it represents as a portion of the company’s aggregate income. While ever focused on their projected increasing income and growing size of operations in Germany, the company management never entertained the possibility of incurring losses in Germany and generating higher earnings in the USA. With such contingency being totally absent in the company’s formulated plans and strategies for its Germany subsidiary, it turned out to be something that the company management was sadly unprepared for. In year 1, 3 Stooges, Inc.
earned $400,000 in US and $128,000 in Germany, respectively comprising 76% and 24% of the company’s aggregate income. Despite the company’s bid to increase the income figure generated by its Germany subsidiary and despite its resolve to not encourage growth in any of its US subsidiaries, the year 2 income figures turned out to defy the company management’s plans. Year 2 brought in net income of $450,000 from USA operations and then of $59,000 from its Germany subsidiary, respectively comprising 88% and 12% of the company’s aggregate income.
Thus, the income from the USA subsidiaries turned out to have increased its portion of the company’s total income, from 76% in year 1 to 88% in year 2. Similarly, the income from the Germany subsidiary turned out to have a smaller portion of the company’s total income, from 24% in year 1 to 12% in year 2. Year 3 has turned out to be a disastrous year for 3 Stooges, Inc. There was a sweeping decrease in the company’s income both in USA and in Germany. In fact, the Germany subsidiary operations ended up with a net loss.
The USA operations earned only $350,000, which stands to be 22% lower than the previous year’s equivalent figure of $450,000. The Germany subsidiary, on the other hand, incurred a loss of $46,700. The year 3 figures, thus, show the 3 Stooges, Inc.’s USA subsidiaries as the generator of 100% of the company’s aggregate income. The Germany subsidiary – the very one that was foreseen to be the company’s key to huge savings from taxes – became the culprit for the increase in the company’s effective tax rates from 33.4% in year 1 to 37.
5% in year 2 and to 41.4% in year 3. The company management’s great plans have indeed backfired. As early as the third year, the damage in the company’s financial performance was too glaring to be missed.
Instead of the decreasing effective tax rates that the company management wanted to see, they were confronted by consequences that were even worse than the originally prevailing scenario. Indeed, it is an obvious fact that smaller tax rates offer zero benefits to companies when their operations result to net losses. The savings projected from being charged smaller rates for income taxes came to naught. In the end, there were no savings to be enjoyed.
For one, the management should have kept close watch of the Germany operations of their company. Other than the actual operations, the differences in the generally accepted accounting principles of Germany and those of USA should as well have been studied as to their implications to the company’s financial statements. Other factors like the effect of the fluctuation of currencies also come into play. While it is secondary to the result of operations – net loss – as the culprit behind the company’s increasing effective tax rates, matters like the accounting systems and procedures of the company can also contribute to the problem. The effective tax rate is generally computed as follows: Income Tax Expense ____________________ Pretax Income The effective tax rate, therefore, is influenced by both the income tax expense and the total pretax income reported by the company. These two are significantly affected by choices that management make regarding the revenue and expenses recognition methods to apply in the updating of their books. Thus, it would help to know the prevailing rules regarding acceptable accounting methods and how deferred assets and liabilities are treated in the accounting realm. All these, as explained, serve to trigger the changes in the company’s effective tax rate.
SFAS 109, which took effect in 1992, covers the deferred taxes consequences of temporary differences in the year-on-year taxes due computed using the tax basis and the accounting basis. “The standard mandates the recognition of deferred tax liabilities for all temporary differences expected to generate net taxable amounts in future years.” These differences arise from the inconsistencies between prevailing taxation laws of the countries where companies hold segments of their operations and the financial accounting standards that they adhere to. Thus, companies for each year arrive at their taxable income figures and then their pretax financial income figures – these would be two different amounts. Furthermore, the tax bases of their assets or liabilities are not the same as their reported amounts in the financial statements of the companies. (FASB website) The differences between the computed taxes due using the tax basis and the accounting basis are mostly due to timing inconsistencies which in later years are expected to be ironed out. Differences are also caused by the use of different depreciation methods for finance reporting and for tax return reporting, which leads to differences between the carrying amount of the asset and its tax basis.
Other factors contributing to such differences include the tax credits that reduce the tax basis figure, the recording of investment tax credits using the deferred method, the application of indexing which increases the tax basis figure of a foreign subsidiary. The temporary differences that form the basis for recognizing deferred assets and liabilities are expected to reverse and to offset future taxable income and corresponding tax payments of the company. There are instances, though, when the reversal are caused by entirely new transactions of the same nature. And sometimes, there will be no reversal forthcoming.
Recognition of this probability should encourage the writing off of these deferred assets or liabilities items. This should not be done, though, to manipulate the reported income figures of the company. Many things that seem small can inflict considerable harm when overlooked. Accounting practices can lead to huge setbacks for companies.
Many stories like that of Enron can attest to this fact. A snag in expansion plans – like the mistaken assumption of profitable results of operations – can lead to huge disappointments as well. The story of 3 Stooges, Inc. is proof of this fact.
ReferenceFinancial Accounting Standards Board (FASB). (2008). Statement of Financial Accounting Standards No. 109: Accounting for Income Taxes.
Retrieved November 18, 2008 from http://www.fasb.org/pdf/fas109.pdf.