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Tax Reform Update Series: Tax Reform and the Impact to Your ETR

Public Companies|Tax|Tax Reform

By Evan Ogrodnik

House Republicans released their long-awaited tax reform bill on Thursday, November 2, the Tax Cuts and Jobs Act (“Act”).  As promised by Republican House leaders for many months, the Act reduces the corporate tax rate from the current maximum of 35% to a flat 20% effective for tax years after 2017.

By lowering the corporate tax rate, the Act is expected to reduce cash tax expense for most corporations; however, all aspects of the Act should be considered to determine the extent of tax savings.  If the bill is enacted, the impact of the rate reduction will likely be realized by corporations prior to the filing of their first post-enactment federal income return in their annual audited financial statements.

Accounting Standard Codification Topic 740, Income Taxes (previously known as FAS 109 for us old-timers) requires that corporations record current and deferred income taxes in their audited financial statements.  The current provision, as the name implies, records the estimated tax impact of the current year’s results, which is pretty straightforward.  The deferred tax provision, however, is usually where the confusion sets in.

The deferred tax provision estimates the impact of currently nondeductible or nontaxable items that will be realized in future tax years.  Examples include reserves, depreciation and amortization, which may have different treatment for tax purposes than for GAAP.  Additionally, corporations estimate the benefit of certain tax attributes such as net operating losses and tax credits that are expected to be utilized in future tax years.  Items that are expected to have a favorable impact on taxable income/tax liabilities in future years are recorded on the balance sheet as deferred tax assets.  Similarly, the items that are anticipated to have an unfavorable impact are recorded on the balance sheet as deferred tax liabilities. 

Both the current and deferred tax provisions are calculated by taking a balance sheet approach.  The current prepaid tax or tax payable is recorded based on the expected overpayment or balance due, respectively, in the current tax year.  The deferred tax assets and liabilities are recorded based on the cumulative nontaxable and nondeductible items and tax attributes multiplied by the tax rate at which the items are expected to be realized (based on enacted tax rates).  The current and deferred tax assets and liabilities are adjusted through current and deferred tax expense, respectively, to arrive at the end- of-year balances.

Ultimately, the current and deferred provisions are used to calculate a corporation’s effective tax rate (ETR) for the year.  While many people believe the ETR represents a cash tax rate,  that is incorrect.  In the GAAP world, the ETR is, quite simply, just math – the sum of the current and deferred tax expenses divided by pre-tax book income.  And why is this amount important?  Because of its impact on net income, or more importantly for publicly traded companies, earnings per share.

So, at this point, you’re asking what this has to do with the Act? Well, a reduction in the corporate tax rate from 35% to 20% (a 42.8% decrease) will require corporations to tax-effect their deferred tax assets and liabilities at the reduced rate, the effect of which will be recorded in the income statement.  Companies with a net deferred tax asset will see increased tax expense as the value of those assets are diminished, while companies with net deferred tax liabilities will see a reduction in tax expense (income pickup) as the future tax liabilities are lessened. 

This rate reduction results in a one-time income statement impact that all C corporations with audited financial statements will feel the effect of, as deferred tax assets and liabilities are adjusted for the newly enacted rate.  While the ETR effect will be easily explained in the quarterly and annual reporting, company management and audit committees should begin to quantify the potential impact of the reduced corporate tax rate as they communicate expectations to the “Street.” 

Keep in mind, this is only a proposal at this point, and we are a long way from enactment.  However, the Act is a critical first step towards tax reform, and the likely eventual reduction of the corporate tax rate.

Please return to the Our Thoughts On...Tax Reform blog for more updates as they become available. 

Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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