Forget death. For profitable companies, it sometimes seems that the only certainty is taxes. Within that framework, however, adroit management can make a profound difference. And finance departments across America are seeing that, even beyond the welcome boost to earnings, sustainable tax efficiency in a highly valued stock market can add to market capital.
With the spotlight shining more frequently on this once-hidden corner of finance, what progress does it illuminate in tax management? In an effort to identify efficient corporate taxpayers, CFO magazine asked experts at KPMG LLP to devise a means of benchmarking. It was, of course, a complex challenge. While tax information is readily available--as provisions on income statements, as deferred assets and liabilities on balance sheets, as cash taxes on statements of cash flows, and often as footnoted items--the data resists comprehensive analysis. Further, little of it is reported in a consistent manner, even within industry groups. For these reasons, we confined our inquiry to corporate income statements. Thus, the 1999 Tax Efficiency Scoreboard compares effective tax rates of 615 companies in 35 industry groups. Companies that were unprofitable during the three-year period were excluded, as were finance companies, utilities, and small industry samples. To soften the impact of one-year spikes and dips, each individual ranking rests on three-year weighted average effective tax rates.
Our scoreboard does not aim to place the laurel wreath on every company recording the lowest rate in its peer group. That would hardly be fair, for similar companies can post different effective tax rates for many reasons--and often benefit from tax-friendly jurisdictions where they generate revenues, or from fortuitous decisions by local revenue authorities. Tax advantages are most evident among companies doing substantial business outside the United States, where some countries vie to attract big employers. (Equally visible, on the other hand, are the disadvantages in such key overseas markets as Japan, France, and Germany, where tax rates exceed those in the United States.) Indeed, all variations in tax treatment present both burdens and opportunities. And companies that unravel their intricacies not only reap a short-term windfall, but also position themselves for favorable developments.
A Tip of the Cap to a Bottler
Comparing tax-efficiency data within industries is intended to launch companies down the path of discovery. "It can't help but add to an area that hasn't gotten a lot of focus," notes Lynn Oliver, vice president, tax, for the $13.4 billion soft-drink bottler Coca-Cola Enterprises Inc., in Atlanta. Thanks in large part to tax benefits bestowed on Coke Enterprises's U.K. operation, its 21.1 percent average effective tax rate sharply undercut the 31.7 percent industry figure. Without the U.K. benefits, Oliver notes, his company's effective tax rate would align more closely with other beverage companies'. Nevertheless, scrutinizing its competitors' rates helps Coke Enterprises put into perspective its toughest benchmark: its own historical performance. "How are we doing compared to how we did? That's the ultimate hurdle," he says.
Were pretax income to govern incentives, then employees with bonuses on their minds would pay far less attention to favorable tax implications, notes Colgate- Palmolive Co. CFO Stephen Patrick. But because incentive compensation reflects aftertax earnings at the $9.5 million consumer-products company, in New York, managers are rewarded when taxes are lowered. "It's a very high priority. Managing taxes is a job for everyone at Colgate," he says, noting that each year, tax executives set specific tax-rate targets as part of the budget-planning process. And, within legal and regulatory guidelines, Colgate managers routinely watch for ways to time remittances from overseas, maximize research and development tax credits, and ensure assets are written up to maximum levels for purposes of depreciation. The payoff? Collectively, Colgate, which leads our soap and cosmetics category, has lowered its effective tax rate each year since 1992.
At many companies these days, there's a similar refrain, as top executives elevate the status of tax management from an afterthought to a part of advanced planning. "Our people think it's a competitive advantage," insists Lester Ezrati, vice president of tax, licensing, and customs at Hewlett-Packard Co., the $47 billion computer company in Palo Alto, California. "It's just like managing any other expense, so long as you do it legitimately." Carol Garnant, vice president of taxes at Sears, Roebuck and Co., in Hoffman Estates, Illinois, who also chairs the corporate tax management committee for the Tax Executives Institute, in Washington, D.C., observes that "there is more attention being placed on driving effective tax rates as low as possible--obviously within legal constraints."
Getting Involved Early
Finance executives who once thought only of tax compliance now spend much of their time researching ways to lower taxes. Decisions about where capital will be raised can have the most pronounced effect on tax rates. Consider, for example, an opportunity spawned by the nontaxable treatment of preferred stock dividends in Europe. Because of this, investors there are willing to settle for lower rates than taxable securities demand. Nevertheless, notes one executive, dividends paid are tax-deductible to issuers. By structuring affairs in the most advantageous tax jurisdiction, companies can enjoy low yields and high tax deductions. One multinational sliced its aftertax borrowing costs from 4 percent to 1.5 percent by managing tax jurisdictions.
The scramble to reduce effective tax rates has also spawned a host of elaborate tax shelters--many of them eventually negated by Internal Revenue Service rulings. Sold by many top investment banks and accounting firms, these shelters often produced whopping tax savings by exploiting loopholes in the tax code, without the economic justification for the tax treatment the IRS insists upon. After enjoying a few days in the sun, these schemes began to suffer from a string of adverse decisions. There was a distinct "loss of appeal" for tax shelters in general, notes tax expert Robert Willens of Lehman Brothers.
In September, for instance, the tax court ruled against Compaq Computer Corp.'s efforts to transform capital gains into intercorporate dividends, which received favorable tax treatment. The gains initially resulted from the 1992 sale of Compaq's equity interest in Conner Peripherals. Afterward, Twenty-First Securities Corp., an investment firm, approached Compaq, suggesting "a number of strategies that take advantage of a capital gain," according to the tax court. Specifically, Compaq tested a "dividend stripping" arrangement, involving the purchase of stock the day before an ex-dividend date, with sale of the stock occurring the next day. With such a transaction, the market price falls generally by the magnitude of the dividend, which ostensibly receives the favorable tax treatment. The tax court, however, concluded that Compaq's transaction "lacked economic substance," and disallowed the tax credit.
As a result of such findings, more often than not, CFOs and tax managers nowadays are quick to disavow corporate tax shelters lacking any underlying business merit.
Most shrewd tax managers rely less on rocket science and more on broad knowledge of the rules and early involvement in transactions-- in everything from mergers and acquisitions to routine purchases of equipment or real estate. "It's not reinventing the wheel, but you certainly have to have competent people who know the lay of the land," says Coke Enterprises's Oliver. Myriad laws and regulations can tie tax planning in knots if lots of attention isn't paid. Some jurisdictions restrict tax deductions for companies that are thinly capitalized, for example, while others impose excessive withholding taxes, undermining perceived tax benefits.
Can Low Rates Be Sustained?
For most tax-efficient companies, the emphasis is on the record of reductions over time. "With today's high price/earnings multiples, a long-term sustainable reduction in a company's effective tax rate can have a significant impact on market capitalization and shareholder value," says Michael S. Burke, KPMG's global managing partner of total tax minimization services. While it has always been true that a penny on the bottom line lifts market capital by the prevailing market multiple, nowadays the effect transforms a mere 3.5 cents of incremental net profits into one dollar of capital gain for the average S&P 500 company. Thus, a dollar saved represents a full $28 of market capital. On the other hand, companies seldom win points for earnings improvements that rely on one-time tax advantages. In fact, if it looks like a ruse to analysts, earnings expectations and resulting stock prices can suffer penalties.
"By taking the driver's seat and directing the company toward lower tax rates, the CFO can steer the organization and its shareholders toward elevated market returns," says Burke.
In a very few instances, the 1999 Tax Efficiency Score-board leaders reported negative effective tax rates. Host Marriott, Farmland Industries, CellStar, Quantum, and Cummins all met the primary scoreboard criteria: overall profitability during the three years the scoreboard encompasses. Yet each recorded a negative tax rate in 1998 because a tax benefit accompanied positive earnings.
Host Marriott Corp., for example, had been carrying $11.1 million of unused business-combination tax credits. In 1998, following an internal review of the company's earnings track record, budgeted sales, and expiration dates of carryforwards, management concluded that it could put the tax credits to work. As a consequence of its company review, Host Marriott reduced a valuation allowance that had been established for use if the credits were not realized. An additional $1.5 million adjustment by the IRS added to the favorable tax effects, leading to the negative effective tax rate for 1998.
Farmland Industries Inc.'s negative tax rate that year appears to stem from the company's cooperative structure. "Patronage refunds" in each of the three periods covered bestowed significant tax benefits on the company. Co-ops routinely receive tax deductions for earnings redistributed to members according to the volume of business. Refunds are taxable to members. In 1998, this deduction, plus a loss in nonpatronage business, caused the negative tax rate.
CellStar Corp.'s overall tax benefit relates to its income mix. Pretax profits in 1998 reflect a $48.4 million loss in the United States and $55.3 million of profits from abroad. The U.S. tax benefit CellStar recorded, combined with foreign operations taxed at rates lower than those at home, create the negative tax rate.
A tax expense on a small pretax income caused an enormous negative 1998 effective tax rate at Quantum, although its three-year average was only higher than that for the computer- peripherals industry. And, finally, Cummins recorded a $4 million tax expense against a $6 million loss last year. The company attributed this to two factors: a nondeductible Environmental Protection Agency penalty and differences in rates and taxability among foreign subsidiaries.
The Cash Question
Still, in most cases the scoreboard seems to recognize solid progress by finance departments driven to hold down the tax burden. "The findings of the survey reinforced what we at KPMG see in the marketplace," says Burke. "Companies that place a strong strategic focus on managing and reducing their effective tax rates see bottom-line results and increased shareholder value. Meanwhile, companies that have not yet undertaken this strategic focus maintain a higher effective tax rate."
Great minds differ over the significance of cash taxes as reported on cash-flow statements. To begin with, companies do not report cash taxes in the same fashion, which hampers comparability. But even when cash taxes are reported, there are doubts about what, if anything, they communicate to outsiders.
"This particular benchmark is nearly impossible to calculate with public information because the relevant information is either not available across the board or is not necessarily comparable," says Sears's Garnant. Her attempts to benchmark a cash-effective tax rate that can be benchmarked against retailing rivals have revealed little if anything, she says. Yet disparities between reported cash tax and tax provisions are often telling, Colgate's Patrick insists. In his industry, when a company looks competitive from a book standpoint, but not from a cash standpoint, "a light should go on that something is not right," Patrick says. Moreover, managing taxes with an eye to cash is critical. Over time, says Patrick, driving down the tax rate is much more important on a cash basis than on a book basis.
Albert Einstein, famous for pondering the imponderable, once observed that "the hardest thing in the world to understand is income tax." Of course, he was talking only about personal taxation, a good deal less complex than the multifaceted world of corporate tax.
While the 1999 Tax Efficiency Scoreboard may fall short of producing insights on a par with general relativity, we suggest that finance executives may still find it relatively useful.