In understanding corporate taxable income, it is a must know that there are many areas in which companies are permitted to use different methods of accounting for financial statements and tax purposes. These differences may arise from mandated methods of accounting for tax purposes (e.g., depreciation) or from the deductibility of certain expenses for the determination of income for one but not the other (e.g., goodwill). The result of these differences is a “timing difference” between “reported tax expense” and “actual tax expense”. If the reported tax expense exceeds the actual tax expense, the difference is a “deferred tax liability” and if the reported tax expense is less than the actual tax expense, the difference is a “deferred tax asset”. The deferred tax asset or liability therefore reflects a temporary difference between expense and revenue recognition for an accounting period. Those are only some to understand in the corporate taxable income.
Through this post, I am going to discuss the corporate taxable income in a clooser look; at the dividends-received deduction, interest deduction, depreciation for tax purposes, and capital gains taxation. It’s not a plain overview, case examples that bring a fundamental understanding how different features of the tax law affect a firm’s taxes and, hence, its cash flows.
There are much greater issues to know compare to taxable income of an individual income tax. If you are clueless about corporate taxable income and want to know more, this post maybe your best bet. Follow on…
As I mentioned on the preface, there are many potential sources of differences between income per accounting statements and taxable income. Examples of temporary sources of differences between accounting income and taxable income include the methods of recognition for accruals and reserves, depreciation deductions, and tax loss carryovers. The sources of the deferred tax liability or asset are summarized in the company’s income tax note to the financial statements.
Recognizing that some temporary differences persist over time, statement of FASB No 109 requires that deferred taxes be adjusted for the expected permanent difference in tax liability per financial statements and tax books; this adjustment is referred to as a “valuation allowance”. The result of including the valuation allowance is a deferred tax liability or asset that better reflects temporary differences between accounting and tax books.
In addition to these temporary differences, there are permanent differences between financial and tax income. For example: dividends received from other corporations are included fully in the financial income (discussed below), but are permitted to be deducted in whole or part for tax purposes, which results in a permanent difference between taxable income and accounting income. Permanent differences such as this do not affect the deferred tax accounts.
Calculation of Corporate Taxable Income
The basic calculation of a corporation’s taxable income is shown below. To better understand how different features of the tax law affect a firm’s taxes and, hence, its cash flows, I take a closer look at the dividends-received deduction, interest deduction, depreciation for tax purposes, and capital gains taxation.
– Cost of goods sold
+ Dividend income
+ Interest income
+ Gross rents
+ Gross royalties
+ Capital gain income
+ O t h e r i n c o m e
– Salaries and wages
– Repairs and maintenance
– Bad debt expense
– Taxes and licenses
– Charitable contributions
– Pension, profit-sharing plans
– Employee benefit programs
– O t h e r d e d u c t i o n s
T o t a l d e d u c t i o n s
I do not aim to discuss all the above elements as I have discussed about them a lot in other posts of mine. Instead, I am going to bring you into a closer look at the: the dividends-received deduction, interest deduction, depreciation for tax purposes, and capital gains taxation which make corporate tax.
Corporate income distributed to shareholders (in the form of dividends) is taxed twice—first as corporate income and then as shareholder’s income—and then if the shareholder is another corporation, that income could be taxed a third time.
To minimize the chance of triple (or even quadruple) taxation of the same income, the tax laws permit a dividends-received deduction: a corporate recipient of dividends may deduct a portion of its dividend income from its taxable income.
With respect to dividend income received by corporations, the tax law specifies deductions of either 100%, 80%, or 70%, as follows:
- Deduction of 100% of dividends received if the corporation is (1) a small business investment company operated under the small business investment act or (2) a member of an affiliated group of corporations, as in the case of a parent corporation and its wholly owned subsidiaries.
- Deduction of 80% if the dividends are received from a 20% or more owned corporation.
- Deduction of 70% if none of the conditions above applies.
The dividends-received deduction either eliminates the tax on dividend income or reduces the effective tax rate considerably.
Suppose a corporation has a marginal tax rate of 34% and the dividends it receives qualify for the 70% deduction. Then the effective tax rate on that dividend income is 30% of 34%, or 10.2%.
The dividends-received deduction has implications for managing short-term investments by the corporate treasury department. When a corporation has excess funds to invest temporarily, it will look for a suitable short-term investment instrument in which to park those funds.
One investment candidate is the short-term debt of the U.S. government or issued by a corporation with a high credit rating. The interest will be fully taxed by the corporation receiving the payment. An alternative investment instrument is preferred stock with a short-term maturity issued by a corporation with a high credit rating. The important feature of preferred stocks is that it is a form of equity and therefore the dividends received by a corporation qualify for the dividends-received deduction. Hence, the preferred stock as an investment outlet for short-term funds would be a tax-advantaged investment compared to investing in short-term debt instruments.
Interest Expense Deduction
For corporations, the IRC allows interest paid on debt to be deducted in deriving taxable income. The benefit of the interest deduction is that it shields income from taxation and we refer to this benefit as the interest tax shield.
Given the marginal tax rate and the dollar amount of the interest deduction, the interest tax shield is computed as:
Interest Tax Shield = (Marginal Tax Rate) × (Interest Expense)
In contrast to interest expense, the dividends paid by a corporation are not deductible for the purpose of determining taxable income. The reason is that dividends paid represent a distribution of profits to the owners of the corporation. The deductibility of interest expense and the non-deductibility of dividends paid have important implications for the use of debt and equity in financing by a corporation and its cost of capital. The mix of debt and equity is referred to the “firm’s capital structure”.
There is another implication of the different treatment of interest expense and dividends paid under the tax code. This has to do with the classification of a financing instrument as debt rather than equity. Some corporations have issued instruments that have the contractual provisions that can best be characterized as equity but they label these instruments “debt”. The advantage of doing so from a tax perspective is that payments made on the instrument to their owners would be treated as interest and therefore deductible. The IRS is aware of this practice and can re-characterize debt as equity and adjust taxable income accordingly.
Depreciation for Tax Purposes
For accounting purposes, a firm can select a method of depreciation based on a number of factors, including the expected rate of physical depreciation of its asset and the effect on reported income. For federal income tax purposes, however, businesses are limited by law with regard to both the depreciation method and the period of time over which an asset can be depreciated.
The current depreciation tax laws are the result of an ongoing trend to create more uniformity in depreciation methods among business taxpayers while at the same time simplifying the calculations and allowing accelerated depreciation and shorter asset lives.
Currently, the two methods of depreciation available to business taxpayers are an accelerated method and straight-line. The accelerated method, referred to as the modified accelerated cost recovery system (MACRs), has four features:
- The depreciation rate used each year is either 150% or 200% of the straight-line rate (referred to as “150 Declining Balance (DB)” and “200 DB“, respectively), depending on the type of property, applied against the un-depreciated cost of the asset. Since the rate is applied against a declining amount, this method is a declining balance method, but not the same declining balance method as that used for financial statement reporting purposes.
- The salvage value of the asset is ignored; so the depreciable cost is the original cost and the asset’s value is depreciated to zero.
- The half-year convention is used on most property, that is, a half-year of depreciation is taken in the year the asset is acquired, no matter whether it is owned for one day or 365 days.
- The depreciation method is switched to the straight-line method when straight-line depreciation produces a higher depreciation expense than the accelerated method.
Because the MACRs is an accelerated method, it yields greater depreciation expenses in earlier years and thus reduces taxable income and taxes relative to straight-line depreciation. However, the law allows some firms to use straight-line depreciation if they don’t have the income necessary to take advantage of the faster depreciation of the MACRSs. The use of MACRs for tax purposes and straight-line for financial reporting purposes, which is often the case for U.S. corporations, results in a difference in income for tax and financial accounting. This difference gives rise to deferred tax liabilities because actual taxes (calculated using MACRs depreciation) are less than reported taxes (calculated using straight-line depreciation) when MACRs results in a greater amount of depreciation, as in the earlier years of an asset’s life.
Two below tables outline the depreciable life for each class of assets and the depreciation rates used for assets of each classified life, respectively.
Modified Accelerated Cost Recovery System (MACRs): Classified lives
- 3-year: tractor units, racehorses over two years old, special tools
- 5-year: Cars, light and heavy trucks, computer and peripheral equipment, semiconductor manufacturing equipment
- 7-year: office furniture and fixtures, railroad property
- 10-year: means of water transportation, fruit trees, nut trees
- 15-year: municipal wastewater plants, depreciable land improvements, pipelines, service station buildings
- 20-year: Farm buildings, municipal sewers
- 27.5-year: residential rental property
- 31.5-year: nonresidential real property, such as elevators and escalators
- 50-year: railroad grading and tunnel bores
These rates reflect depreciation calculated using the 200% (for 3-year, 5-year, 7-year, and 10-year property) or 150% (for 15-year and 20-year property) declining-balance method, with a switch to straight-line, using the half-year convention.
The first above table shows the depreciable lives are assigned to the various classes of assets that might be used by businesses. The second table shows the depreciation rates to be applied to the asset’s cost for each year in the life of each class of asset.
Notice in the second that each asset type is depreciated over its life plus one year: there are four years of depreciation for a 3-year asset, six years of depreciation for a 5-year asset, and so on. This is because of the half-year convention: only half a year’s depreciation is used up at the start, leaving half a year’s depreciation to be taken after the asset’s life is over for tax purposes.
Let’s see how depreciation expense is calculated using the information in below.
Suppose a firm buys a fleet of trucks for $500,000. According to the previous first table, the truck has a 5-year class life. According to previous second table, the first year’s depreciation rate is 20%, the next year’s is 32%, and so on. The results of applying these rates to the cost of the truck over six years are shown in the above table. The total cost is recouped over the six years, with most of the depreciation expense taken in the earlier years.
Understanding current and expected depreciation rates is important because depreciation, while not itself a cash flow, affects a corporation’s taxes and hence its cash lows. If the corporation has a depreciation expense of $100 million and a 35% marginal tax rate, the benefit from the depreciation deduction for tax purposes is to reduce taxable income by $100 million and hence reduce taxes by 35% times $100 million, or $35 million. This reduction in taxes of $35 million is referred to as the depreciation tax-shield.
Over the life of an asset, the total dollar amount of depreciation is the same regardless of the rate of depreciation. However, changes in depreciation rates affect the timing of the depreciation tax-shield and hence their value today.
The term “capital gain” is loosely used to mean an increase in the value of an asset. In the tax law a capital gain is defined more specifically. It is a realized gain that results when an asset is sold for more than what was paid for it. Because tax rates are progressive, taxing capital gains in one lump in one year at higher rates seems unfair, so Congress has traditionally granted special treatment—via lower effective tax rates—to capital gains.
Special treatment for capital gains has come in either of two ways:
- an exclusion of a portion of the gain; or
- a cap on the tax rate applied to capital gains.
A cap is a ceiling on the tax rate applied to capital gains and is lower than the tax rate applied to other income. In 2009, for example, the tax rate cap on capital gains was 35% for corporations.
Suppose that in 2009 the Putra Corporation has ordinary taxable income (that is, taxable income not including capital gains) of $50,000 and a capital gain of $10,000. Putra’s tax bracket is 25%, which is below Year 6’s corporate capital gains rate of 35%. So Putra’s tax on its $60,000 of income is:
Tax on $60,000 = $7,500 + 0.25($60,000 – $50,000) = $10,000
Suppose instead that Putra has ordinary income of $200,000 and a capital gain of $10,000. Putra’s tax is:
The other way of giving special treatment to capital gains for tax purposes is via an exclusion. A capital gains exclusion excludes a portion, say 60%, of the capital gain from taxation and taxes the remainder at the ordinary tax rate.
Consider Putra Corporation’s income. If 60% of its capital gain is excluded, only 60% of the $10,000, or $6,000 is included in taxable income.
For a depreciable asset, a part of the gain may really be the result of “over-depreciating” it (for tax purposes) during its life; that is, depreciation expenses taken over the life of the asset (which reduced taxable income and taxes) do not represent the actual amount the asset depreciated in value. So, there are provisions in the tax laws that require breaking the gain into two parts:
- The recapture of depreciation, the difference between (a) the lower of the original cost or the sales price and (b) the under-depreciated portion of the asset’s cost for tax purposes.
- The capital gain, which is the sales price less the original cost.
The recapture portion of the gain is taxed at ordinary rates, and the capital gain portion is given special treatment (so effectively, it is taxed at less than ordinary rates).
Suppose Dharma Inc. bought a depreciable asset 10 years ago for $100,000, and its book value (cost less accumulated depreciation) for tax purposes is now $30,000. This means that the firm has taken $70,000 of depreciation expense over the 10 years and has reduced its taxable income by that amount. If it now sells this asset for $125,000, it has a capital gain of $25,000 (sale price of $125,000 less the cost of $100,000).
But Dharma has also recaptured its entire depreciation expense by selling the asset. The tax code requires that recaptured depreciation be added to ordinary income and therefore taxed at the ordinary income tax rate.
Dharma would have to pay ordinary income tax on the recaptured $70,000 of depreciation and capital gains tax on $25,000.
Original Cost $100,000
Less: Book Value 30,000
Recapture (taxed as ordinary income) $70,000
If only part of the asset’s depreciation is recaptured when it is sold, only the recaptured part is taxed, and there would be no capital gain. The recaptured portion is the difference between sales price and tax basis. For example, if Dharma sold the asset for $75,000, instead of $125,000, it would have:
Sales Price $75,000
Less: Tax Basis 30,000
Recapture (taxed as ordinary income) $45,000
As you can see, taxes, depreciation, and capital gains are all mutually related. Furthermore, they all become considerations in investment decisions, which almost always deal in some way with the purchase and sale of assets, and in cash flow, which is directly affected by tax law.
From time to time Congress allows business credits against calculated income tax. One such credit that has popped up now and then in the tax law is the investment tax credit (ITC). The ITC may or may not exist at the time you read this post.
A tax credit is a direct reduction of the computed income tax. Suppose, for example, that the tax code allows an ITC of 10%. If a company invests $100 million, say, in new machinery, it is entitled to a direct reduction in taxes based on the cost of the machinery: 10% of $100 million, or $10 million.
The ITC is not the only tax credit that Congress has offered businesses. At one time or another there have been energy tax credits, targeted job credits, alcohol fuel credits, disabled access credits, and more.
Tax Credit versus Tax Deduction
Deductions and credits both reduce taxes payable. A deduction reduces taxable income and thus indirectly reduces the tax liability. A tax credit is subtracted from the tax liability in the absence of the tax credit, and thus directly reduces taxes.
Net Operating Loss [NOL] Carrybacks and Carryovers
A net operating loss (NOL) is an excess of business deductions over business gross income in a tax year. The internal revenue Code allows businesses to carry back a net operating loss to preceding years and to carry forward the loss to future years to reduce the taxes payable for those years. The current tax law, for example, permits NOLs of corporations to be carried back two years from the year of the loss and carried over (forward through time) 20 years.
Here’s how carrybacks and carryovers work. Suppose that in 2009 a corporation has a $100 million NOL. To simplify the calculations, let’s also assume that the corporate tax rate is a lat 40% of income. Suppose further that the corporation paid taxes on income as follows in the two years prior to 2009:
Year Taxable Income Taxes Paid
2007 $10,000,000 $4,000,000
2006 $50,000,000 $20,000,000
To use the loss in 2009, the corporation begins by carrying it back to the earliest year (2007 in this example), applying it to reduce that year’s taxable income, and then re-computing the tax. Any loss that is left over is carried to the next year (2008). The tax law allows a 2-year carryback, so the computation would look like this:
The corporation would then apply for a $24 million refund of 2007 and 2008 taxes on the basis of its current year (2009) NOL. The balance of the NOL that is not applied to those two years, $40 million, can be carried forward for 20 years.