Why Investors Need Better Corporate Tax Disclosures- Part I

In part I, using Ford Motor Company as an example, I argue that the sheer opacity of current tax disclosures makes it virtually impossible for even an informed investor to forecast a sustainable tax rate.

The FASB announced in their November 2022 meeting that they will expand disclosures of income taxes paid, disaggregated by jurisdiction on the basis of a quantitative threshold of 5 percent of total income taxes paid. They have also asked for more details in the rate reconciliation table such as reconciling items by nature and by jurisdiction, on the basis of a quantitative threshold of 5 percent, within the foreign tax effect category.

This is certainly an improvement over what we currently have although 5 percent of total income tax paid is an odd threshold to mandate as a tripwire for disclosure given that most companies would want to minimize income taxes paid and hence the consequent disclosure of material tax maneuvers that facilitate such tax minimization.

Even if this change is adopted in its entirety, I believe we have a long way to go before investors get the corporate tax disclosures they need to forecast the effective tax rate of a firm for the next year or even understand the factors that affect the effective tax rates of the last three years. Needless to say, the sustainable effective tax rate is needed to future cash flows or earnings after tax, which is the most important input for a valuation model.

I argue we need more disclosure for two main reasons: (i) existing disclosures are so opaque that forecasting a firm’s sustainable tax rate, a key number needed to value a company, is very difficult; (ii) we know virtually nothing about corporate tax shelters in overseas tax havens from a firm’s financial statements.

In part I, using Ford Motor Company as an example, I argue that the sheer opacity of current tax disclosures makes it virtually impossible for even an informed investor to forecast a sustainable tax rate. In Part II, I review commonly used techniques by US firms to shelter profits in overseas low tax havens and why an ESG investor might want to push for more transparent jurisdiction by jurisdiction data.

Existing disclosures are opaque

Let us consider the case of Ford Motor Company’s tax disclosures, brought to me by my excellent Columbia Business School Executive MBA student Adrian Ludwig.

The objective of the class assignment in the last week of class was to forecast a sustainable effective tax rate (tax expense divided by pretax income) for the year 2022 from the 10K for the year 2021. Let us start with note 7 of the 2021 10-K for Ford which discusses income taxes for the three years 2019 to 2021. As you can see from the excerpted portion of note 7 below, in 2019, Ford reported a modest GAAP (Generally Accepted Accounting Principles) based profit in their financial statements (in the US of $2.656 billion but an overseas loss of $3.296 billion erased that profit. More important, this profit number is not the same as that reported by Ford in its tax returns and that number is not publicly known, especially by jurisdiction related to both states within the US and overseas.

Coming back to the pre-tax GAAP income disclosures, in 2020, both the US and overseas divisions lost money, summing up to losses of $1.116 billion most likely due to Covid, and in 2021, the US and overseas divisions reported bumper profits, totaling to $17.78 billion.

The tax expense number that shows up in Ford’s income statement related to these three years has fluctuated quite a bit as well as can be seen in the above excerpt. The three columns, left to right, relate to the fiscal years 2019, 2020 and 2021. These columns suggest that the tax expense for 2019 was a tax benefit of $724 million leading to a positive effective tax rate of 113.1% (tax benefit of $724 million/losses of $640 million). Digging a bit deeper, the Federal effective tax rate appears to a tax benefit of 48% or $1.29 billion (-101-1190) on profits of $2.656 billion. The overseas effective tax rate of 20% appears to involve a tax expense of $668 million (738-70) on pre tax overseas losses of $3.296 billion. It is not clear why we observe tax benefits for positive GAAP income here in the US and taxes due for overseas losses. We cannot access Ford’s tax returns as they are not publicly disclosed. For completeness, note that the analogous effective tax rate for 2020 is -14.3% (tax expense of $160 million relative to a loss of $1.116 billion) and -0.07% (tax benefit of 130 million relative to profits of $17.78 billion). The rate reconciliation table discussed below is meant to explain why the company’s statutory tax rate of 21% differs from the effective tax rate.

Rate reconciliation table

The effective tax rate for these three years was 113.1%, -14.3% and -0.7%. To understand why these effective tax rates differ from 21%, the US statutory tax rate, consider the relatively wild fluctuations in the line titled “non-US tax rates under US rates” from 46.9% to 1.3% from 2019 to 2021. That cryptic line item likely reflects the non-US tax rate (say in a tax haven) that Ford owes on overseas profits.

The 46.9% number in 2019 suggests that approximately 47% of (losses of) $640 million or $300 million represents the “refund” based on the overseas tax rate that Ford will have to pay. This line needs to be read with the line “U.S. tax on non-U.S. earnings.” The “U.S. tax on non-U.S. earnings” line likely picks up the difference between the US tax rate and foreign tax rate on profits that Ford intends to repatriate back to the US (there is a lot of overseas profit they don’t intend to repatriate as we will see in part II). The reported number for 2019 was -49.2%. The 46.9% rate almost offsets the 49.2%. So, one interpretation is that the repatriable “losses” are effectively tax free.

In 2020, -2.6% represents “non-US tax rates under US rates” whereas 27% represents “U.S. tax on non-U.S. earnings.” Given that 2020 was a lossmaking year, these lines likely suggest that the US will allow a tax benefit from these repatriated losses but the overseas tax authorities will potentially not recognize these losses given the negative 2.6% rate. The alternate interpretation is that Ford reports profits in its tax returns in which these interpretations would not hold. It is unclear what is really going on.

Note how the state tax rates fall radically from 12.4% to 0.5%. It is not entirely clear why. These are meant to be statutory local and state tax rates and hence these rates should be relatively constant irrespective of income levels unless some state gave Ford massive tax breaks. It is not clear whether that happened. Did Ford leave states with tax rates and relocate to Florida or Texas? I am not sure.

There are several other changes in the rate reconciliation table that are pretty opaque and hard to understand and hence to forecast. For instance, what are general business credits? What tax incentives is Ford referring to? What does the “others” category stand for? How long will these credits and incentives last?

A line item called “dispositions and restructurings” has erased taxes equivalent of 18.8% of total income in 2021. The referenced footnote “a” says “includes a benefit of $2.9 billion to recognize deferred tax assets resulting from changes in our global tax structure in 2021.” What exactly was done here? I could raise more questions on this table but in the interest of simplicity and time, let us transition to the deferred tax footnote.

Deferred tax assets

For the uninitiated, think of deferred tax assets as a difference between GAAP and tax return income this year that will reduce tax return income in the future. A textbook example of a deferred tax asset is a net operating loss (NOL) carryforward that loss making public firms have. These NOLs can be used to reduce future taxable profits of such a loss making firm. Of course, deferred tax assets can get infinitely complicated beyond NOLs as we will see for Ford.

To understand Ford’s disclosures, we begin by comparing changes in deferred tax assets line by line in the excerpt below from Ford’s deferred tax footnote. The interpretation of these changes is rendered particularly challenging by the somewhat vague and obscure captions related to the numbers. Let us try and understand the three largest changes in the deferred tax asset (DTA): (i) the DTA related to employee benefit plans fell by $2.44 billion from $4.76 billion to $2.32 billion; (ii) the DTA related to net loss carryforwards increased by $2.583 billion from $1.584 billion to $4.163 billion; and (iii) other foreign deferred tax asset increased by $ 1.276 billion from $0.729 billion to $2.005 billion.

What do I really know about these changes? I know that the tax authorities, by and large, follow the cash basis of accounting. Hence, a decrease of the DTA of employee benefit plans potentially means that $2.44 billion/21% related to the federal rate or roughly $11.6 billion of employee benefits accrued in GAAP income in the past were actually paid for in cash in 2021. How do I forecast the extent of such benefits that will be paid in 2022?

The DTA increase of $2.583 billion suggests that net loss carryforwards increased by approximately $12.3 billion in 2021 ($2.583/21% federal rate). Ford clarifies that “operating loss carryforwards for tax purposes were $11.4 billion at December 31, 2021, resulting in a deferred tax asset of $4.2 billion.” This is odd because Ford reported large GAAP profits in 2021. Of course, they could have still reported tax losses in their tax returns that we cannot publicly observe but there is not much here to say for sure, one way or the other. Needless to say, predicting next year’s generation of loss carryforwards or the reversal of such loss carryforwards to offset against future taxable profits is difficult.

I don’t know what transactions underlie the increase in the foreign deferred tax asset let alone trying to predict the impact of this item in 2022.

Deferred tax liability

Deferred tax liabilities are the opposite of deferred tax assets. In other words, these represent differences between GAAP income and tax return income that increase the company’s tax return income in the future. A textbook example: straight line depreciation under GAAP for an asset at say 20% per annum for 5 years relative to accelerated depreciation of 100% under tax rules written by Congress to promote investments by the corporate sector.

Let us try and understand the three largest changes in the deferred tax liability (DTL) for Ford: (i) DTL on leasing transactions fell by $1.196 billion from $3.299 billion to $2.103 billion; (ii) DTL related to carrying value of investments increased by $2.005 billion from $0.144 billion to $2.149 billion; and (iii) DTL related to depreciation and amortization fell by $0.337 billion from $3.218 billion to $2.881 billion.

Ford’s finance arm is a lessor that books revenues on leasing. A DTL, given this context, suggests that leasing revenue is recognized as GAAP income but the IRS recognizes revenue only when cash is collected later. A fall in DTL suggests that leasing revenue booked under GAAP earlier is now collected and taxed by the IRS to tune of $5.69 billion ($1.196/21% federal rate). The DTL related to investments is the easiest to explain as the underlying transaction most likely reflects unrealized gains of approximately $9.54 billion ($2.005/0.21) on investments, booked as income in GAAP, but not taxed. This effect is almost unpredictable unless the analyst can forecast how stock and bond markets in the investments held by Ford will do in the future. The DTL decline related to depreciation potentially denotes reversal of accelerated depreciation under tax rules allowed earlier. Forecasting these declines is not easy either.

In sum, deferred tax footnotes and rate reconciliation tables are hard to decipher. Hence, anyone who wants less disclosure or no change to the current regime would have to ideally explain how a diligent analyst can make sense of what the company is really up to in its tax affairs. A professional investor that I showed Ford’s tax footnote said, “seems complicated to me. However, when forecasting cash flows, I typically use the highest statutory rate to be conservative. In fact, I try to make all of my assumptions conservative because I’m not trying to determine what a stock is worth. I’m trying to determine what it is worth at a minimum. If the market price is below that minimum value, I feel more comfortable buying it.”

Fair enough. Except, I bet that this investor would actually use information in tax footnotes if they were less opaque.

In part II to follow, I argue that financial statements tell us very little about corporate abuse of overseas tax havens.