The first key ingredient of any successful organization is a sound and successfully implemented strategy. Tax management should work to enhance the firm’s strategy and should not cause the firm to engage in tax-minimizing transactions that deter it from its strategic plan. As an extreme example, a firm could earn zero profits and pay no taxes, but this would be inconsistent with sound strategy. The second key success is firm’s attempt to anticipate the actions of their competitors, markets, and governments. Tax-managing firms adjust the timing of transactions in anticipation of expected tax changes. This post discusses these 2 key ingridients sucess in the tax planning. Enjoy!
In a business setting, strategy can be thought of as the overall plan for deploying resources to establish a favorable position. The resulting strategy, derived from the firm’s objective appraisal, is often referred to as SWOT: matching internal “Strengths and Weaknesses” to external “Opportunities and Threats”. A strategic management imperative results from this analysis. Strategy provides a vision of where the firm wants to go, typically represented by a mission statement. For example: a mission statement might be “to be the global leader in gadget manufacture”. A more specific business-level strategy is a way to gain an advantage over competitors by attracting customers to the firm and away from competitors. Such strategies typically boil down to doing things better, cheaper, or faster than the competition.
The firm’s business-level strategy is typically detailed in operations-level, corporate-level, and international-level strategies. At the operations level, the firm’s strategy involves gaining advantage over competitors to create value for its customers through its products or services. The operations focus has resulted in many firms reengineering the process by which they execute their business-level strategy. In its competitive analysis, the firm needs to understand whether it has a tax advantage or disadvantage in relation to its rivals. Corporate strategy focuses on diversification of the business. Ideally, diversification strategies improve the structural position or process execution of existing units, or, in a new business unit, stresses competitive advantage and consumer value. International strategy focuses on taking advantage of corporate and business strengths in global markets. It requires an understanding of local countries and relies on working with foreign governments. As part of the firm’s strategy, it needs to deal with the threats.
How Does Effective Tax Management Interact With Strategy?
- First, a firm should not alter the form of a transaction in order to manage taxes, if the change is inconsistent with its strategy. For example: if a firm wants to acquire another business that is unrelated to its core competency, to obtain tax benefits [e.g., net operating loss [NOL] carryovers], it should not do so unless it is clear that the pretax economics make sense.
- Second, a firm’s competitive strategy may be shaped, in part, by its tax status. Put simply, if a firm is structured so that it has a more favorable tax status than that of its competitors, this can give the firm an overall cost advantage over its competitors. Effective tax management is an important tool in obtaining this kind of competitive edge.
Suppose the U.S. government announces a 20% income tax deduction for purchasing new equipment. Both a firm and its biggest competitor are thinking about acquiring new equipment. The firm is in the 35% tax bracket; the competitor will be in an NOL situation for several years (i.e., it is in the 0% tax bracket). If new equipment costs $1 million, the firm’s after-tax cost is less than this because it enjoys the tax deductions related to purchasing the equipment.
The benefit of the new deduction, for example, is 20% of the $1 million cost times the 35% tax rate, or $70,000. Even ignoring other deductions (like depreciation), the firm’s after-tax cost of the equipment is only $930,000, whereas the competitor’s after-tax cost is $1 million. The firm can use this cost advantage to buy more equipment, cut prices (and undercut the competitor), or invest in new projects. The same sort of tax-related competitive advantage can be applied to new entrants and substitute products. It also can be used in developing new products, as discussed next.
Often firms budget their overall advertising and research and development (R&D) expenses either as fixed amounts or by pegging them as percentages of sales. Taking a competitive analysis into account may be more effective, however. Suppose a firm expects to be in a NOL situation for the few years and its major competitor is in the 35% bracket. Both are contemplating major product research. For such research, each dollar spent would generate $.20 of tax benefits through two tax savings rules. The first is a tax credit for R&D, and the second is rapid depreciation of R&D equipment. For the competitor, such benefits would yield an after-tax cost of $.80 per dollar spent. If both firms have a $20 million R&D budget, the competitor can spend $25 million of cash and still be on budget. This is because the tax credit will generate $5 million of tax savings ($25 million × 20%) to pay for the extra spending. If R&D is in a race to be the first to develop a patentable product, the firm might be better off staying out of the R&D game (and investing the $20 million elsewhere) until it goes into a positive tax bracket in a few years. However, where net profits (as opposed to just expenditures) are concerned, the net advantage goes to the NOL firm.
Assume two competitor firms have $20 pretax unit contribution margins. Each sells a product for $40 and has fixed costs consisting solely of depreciation of $100,000. Firm A has an NOL carryforward, and firm B is in the 34% tax bracket. Assuming there is a 25% write-off for the depreciable equipment, the strategic advantage goes to the NOL carryforward firm, because it achieves break-even sales at a much lower volume:
FIRM A: $100,000/$20 = 5,000 units
FIRM B: [$100,000 – (100,000) × (1 – 0.34) × (1 – 0.25)]/$20(1 – 0.34) = 5,694 units
Anticipations On Tax Changes
Firms operate in a dynamic environment in which they must attempt to anticipate the actions of their competitors, markets, and governments. Tax-managing firms adjust the timing of transactions in anticipation of expected tax changes [Note that while tax law changes are debated before being enacted, many are applied retroactively]. Firms adjust the timing of their transactions when they are certain of their future tax status or when there is a known change in tax rules. For example, they might know that they have an NOL this year, which will be used next year.
Anticipation and Certain Tax Changes
Suppose it is known that tax rates will rise substantially next January. If it is now December, the rate change can be anticipated. Assuming it is not otherwise harmful, simply delaying December expenses until January means they will have more “bang for the buck” that month by being deducted at a higher tax rate. Examples of such tax management by timing abound. In December 1986, U.S. corporations delayed billions of dollars in taxable income because of the decrease in the federal tax rate scheduled to begin in January 1987. Similarly, in anticipation of a rate increase on individuals, Disney CEO Michael Eisner exercised several million dollars in stock options in late 1986 to accelerate income into a lower-tax-rate year.
At the corporate level, timing usually focuses on shifting income to lower-tax-rate years and deductions into higher-rate years.
What if a company is considering replacing its computer system? The new system would cost $500,000 and would generate first-year depreciation deductions of $70,000. Suppose the firm is currently in the 35% tax bracket, but next year it expects to go into the 0% tax bracket (say, due to various tax credits and losses). If the firm waits until next year, it will receive no tax benefits. However, if it adjusts the timing of the transaction to buy the equipment during the current year, it will get a tax benefit of 35%($70,000) = $24,500.
A corporation is considering selling some unimproved land to generate cash flows. The land would generate a $1 million taxable gain. This year the corporation is in the 35% bracket, but next year it will be in the 0% bracket. The corporation should adjust the timing of the sale so that it occurs next year. This will save the company (35%)($1 million) = $350,000 in taxes.
Effects of Net Operating Losses
For U.S. income tax purposes, corporate NOLs carry back 2 years and forward 20. If the firm generates an NOL in the current year and the loss can be carried back and used in its entirety in the previous years, the NOL should have only minor influence on how the firm adjusts the timing of its current income and deductions. To see this, assume a large firm has an NOL that can be carried back and used in its entirety. Therefore, both its current taxable income and its tax rate are exactly zero. If it is contemplating whether to accelerate $500,000 of income into the current year versus waiting until next year when it is in the 35% bracket, there is no tax difference: The current year’s income would be effectively taxed at the standard 35% rate either way.
If the $500,000 were instead an expense, timing would make a slight difference. The expenditure could not be deducted until the next year, so the firm would lose the present value of a one-year deferral. As discussed in detail later in this post in the section entitled “Value-Adding, Cash Flows, and Time Value,” because one can earn interest on cash received earlier, the value of being paid later is less than the value of being paid sooner.
Present value is a mathematical technique that can be used to quantify the benefit of being paid earlier. However, timing can be very important if the NOL is not used up in offsetting prior years’ income but is expected instead to carry forward for a number of years. Here the discounted value (i.e., the difference between present value and future value) can be significant.
Referring to the $500,000 of income in Example-4, assume that the NOL will not be used for 10 years and that the firm’s cost of capital is 10%; the present value of the tax is only about 40% of what the tax would be without the NOL carryforward. The point is:
The presence of an NOL carryforward, particularly one that is large enough to remain unused for a number of years, has an impact on strategic tax planning.
Anticipation and Uncertain Tax Changes
The tax-managed firm can anticipate tax changes before they become official. For example: Ronald Reagan campaigned to be U.S. president in 1980 promising rapid write-offs for plant and equipment as part of sweeping tax reform. In anticipation of the Reagan election and subsequent tax act, a number of firms delayed acquisitions of equipment from late 1980 to 1981.
Employing this anticipation strategy entails assigning a probability to the likelihood of tax legislation being enacted. For example: suppose the firm assigns a 50% probability that tax rates will rise to 37% next year from the current 35% rate. The anticipated tax rate increase would be 1%, calculated as 50%(37% – 35%). If it can accelerate $1 million of income from next year to this year, the firm’s expected tax savings would be $10,000, calculated as 1% of $1 million. (Keep in mind, however, that the expected tax benefits of implementing this strategy would be reduced by any related transaction costs).
In recent years, other U.S. tax law changes have caused anticipation effects like this. These changes include several extensions of the 20% tax credit for R&D and the exemption of electronic commerce sales from states’ sales and use taxes. For the former, each year the credits have been renewed by Congress for a short period. Therefore, an R&D firm must predict whether the credit will be extended and plan how this will affect what it will spend for R&D this year versus next year.
Suppose Intel Corporation has a budget of $1 billion per year for R&D. The firm’s lobbyists estimate that there is a 30% probability that the 20% R&D credit will not be extended for the next year. If the firm’s two-year R&D budget is $2 billion, then the expected tax benefit is $340 million, calculated as (.2)($1 billion) + (.2)(1 –.3)($1billion). If the firm accelerates next year’s R&D into this year, however, the tax benefits will be (.2)($2 billion) = $400 million. Of course, the firm needs to consider whether the acceleration makes good business sense.
Suppose Land’s End Corporation is trying to assess the tax costs of mail-order sales into various states. The company is trying to decide whether to establish a Web site with servers in various states to capture some of these sales. A number of states have attempted to subject such sales to sales taxes. However, the U.S. Congress has enacted a moratorium that prohibits states from assessing such taxes this year. Management believes that there is a 50% chance that the law will be extended into the next year. Therefore, the company may want to postpone Internet sales until next year, when the anticipated tax would be less.
Anticipation and Price Effects
Competitors can also react to expected tax changes. At a minimum, a widespread reaction has supply-and-demand effects in some markets, causing a price change. Tax cuts cause prices to rise, and tax increases cause prices to fall [In this way, changes in market prices can mute the effects of tax policy]. This price effect has become known as implicit taxes.
Firms should attempt to anticipate price effects resulting from tax changes. The magnitude of price effects depends on a number of conditions. These include the elasticities of supply and demand and whether additional suppliers can enter the market [This can occur to some degree in the long run]. In practice, such elasticities may not be known, although marketing departments of large firms often have data on price sensitivities to their own products. The point here is that some sort of a price response is likely to occur no matter what types of goods, services, or investments receive the tax break.
A well-known example of the price effects of tax breaks is the case of municipal bonds. Because the interest income from them is tax free, the demand for municipal bonds is pushed up. Because they are typically sold in even-dollar increments (e.g., $1,000 per bond), the price effect does not directly occur. Instead, the effect occurs indirectly. The stated interest rates are lower than those for comparable taxable bonds. This can easily be seen by comparing the yields of taxable bonds listed in The Wall Street Journal to the yields of state and local bonds listed in its Daily Bond Buyer section.
If there is a tax increase on some goods, services, or investments, the opposite effect occurs: Prices drop. What do these price effects mean to managers? The astute manager should attempt to anticipate such price movements. There is a well-known principle in economics that the incidence of a tax (or a tax benefit) falls only in part on the entity directly affected by the tax. This effect depicts the hypothetical price effects resulting from a new tax on computers.
Imagine that demand drops due to an import tax on computers. Market prices drop, too, so part of the tax increase is passed on to computer suppliers via lower prices [Suppliers can anticipate tax law changes as well. However, for a supply curve to shift, existing suppliers must leave or additional suppliers must enter the marketplace, which typically occurs over a much longer time period than that for demand curve shifts].
The tax decreases quantity demanded because the after-tax price of computers has increased. This demand decrease pushes the market price down to P from P’. Thus, part of the tax is effectively passed onto suppliers through a lower sales price. Alternatively, suppose a tax break (say, very rapid depreciation) is given for the purchase of computers. What will happen in the marketplace? Because more computers will be demanded, prices will go up, and part of the tax credit will be bid away to suppliers in the form of higher prices. The manager must anticipate such price changes in deciding whether to buy or sell something that is subject to a change in tax rules.
Suppose a manager knows that on January 1 of next year, a 10% tax credit will be given for the purchase of a new computer system. The manager expects to spend $100,000 on a networked system of PCs to replace an existing system. Assume an additional $8,000 must be spent in programmer time to get the system up and running. The manager hopes the tax savings on the new system of $10,000 (10% × $100,000) will pay for the $8,000 programming costs. However, if the market price, (from increased demand) jumps to around $103,000, then even with the tax break, the anticipated net benefit will be negative: ((10% × $103,000) – $3,000 additional cost) – $8,000 = ($700). The more familiar managers are with the market, the more accurately they can anticipate and navigate through the price effects. If there is a huge supply market (e.g., PCs), it will take some time before demand pushes the price up. A sharp manager would make a purchase very early on. However, if there is only one supplier (say, Cray Supercomputers), price hikes might occur almost immediately as stockouts occur and marginal costs rise. Thus, unless the manager can effectively negotiate, much of the tax benefit will be lost when dealing in a private market.