Understanding the effective tax rate can be very helpful in analyzing financial statements.
Let me show you why!
When financial analysts review an income statement, one of the first things they do is calculate
top line growth and bottom line growth.
Here’s the top line (revenue) for three years for Microsoft.
In absolute terms, revenue increased from $97 billion in 2017 on the right to $110 billion
in 2018 in the middle to $126 billion in 2019 on the left.
The growth rate from 2017 to 2018 is 14%.
The growth rate from 2018 to 2019 is 14% as well.
Which growth rates do you expect for Net Income?
Growing faster than revenue?
Growing at the same rate as revenue?
Growing, but slower than revenue?
Or fluctuating more wildly?
Here’s the bottom line (net income) for the same years.
Net income in 2018 declined from net income in 2017 by 35%: from $25 billion to $17 billion.
Net income in 2019 increased by 137% compared to 2018: from $17 billion to $39 billion.
There are two ways to start analyzing this: working our way down the income statement
from revenue through gross margin through operating income, or working our way up the
income statement from net income.
Let’s see what shows up if we go up the income statement starting from the bottom line.
The lines in the income statement straight above net income are income before income
taxes, and provision for income taxes.
Income before income taxes minus provision for income taxes equals net income.
Income before income taxes grew at 22%, and then 20%,
more in line with the revenue growth of 14% per year.
If revenue grows at 14% per year, and costs do not grow at that same rate, then 20 to
22% income before tax growth is a reasonable expectation.
If income before income taxes is growing at stable rates, while net income fluctuates
heavily, then the provision for income taxes is the line item that causes the variability.
Let’s put that provision for income taxes in perspective by calculating the effective
tax rate: simply dividing the provision for income taxes by the income before income taxes,
for each of the years.
In 2017, $4.4 billion divided by $29.9 billion yields an effective tax rate of 14.8%.
In 2018, $19.9 billion divided by $36.5 billion yields an effective tax rate of 54.6%.
In 2019, $4.4 billion divided by $43.7 billion yields an effective tax rate of 10.2%.
Let’s put those effective tax rates per year at the very bottom of the page, and reconcile
from the statutory tax rate (the default of what you expect a company’s tax rate to
be) to the effective tax rate.
We put the US federal statutory tax rate at the top of the page, and need to analyze how
Microsoft got from 35% down to 14.8% in 2017, up from 28.1% to 54.6% in 2018, and down from
21% to 10.2% in 2019.
But wait a minute, the US never had a statutory rate of 28.1%!
It went from 35% to 21%, there was no step in between.
Time to read the small print.
Microsoft’s fiscal year runs from July through June, so 28.1% is the weighted average federal
statutory rate July 2017 – July 2018, very close to the average of the old and new tax
rate (6 months at the old rate, 6 months at the new rate).
Here’s the list of reconciling items between statutory tax rate and effective tax rate
downloaded from the Microsoft annual report.
A recurring line item is foreign earnings taxed at lower rates,
which lowers the effective tax rate.
The vast majority of the foreign, in other words non-US, income before tax is generated
in foreign regional operating centers in Ireland, Singapore and Puerto Rico.
This income is taxed at rates lower than the US statutory rate, both before and after the
US tax law change.
The second line item is the one-time impact of the new US tax law, which actually led
to significant one-time tax expenses, and therefore a higher effective tax rate than
the statutory rate for Microsoft in fiscal year 2018, nearly 38% of income before taxes.
Third line item is the realization of tax benefits attributable to previous Phone business
losses in fiscal year 2017.
Fourth line item is $2.6 billion net income tax benefit (equal to 6% of income before
taxes) related to intangible property transfers.
The remaining line items are much smaller in size than the first four.
If you analyze the statutory tax rate versus the effective tax rate year by year, the main
items in 2017 bringing the effective tax rate in 2017 down from 35% to 14.8% were foreign
earnings taxed at lower rates
and the realization of tax benefits related to Phone business losses.
For 2018, what brought the effective tax rate up from 28.1% to 54.6% were mainly the impact
of the enactment of the new US corporate tax law, partially offset by foreign earnings
taxed at lower rates.
For 2019, what brought the effective tax rate down from 21% to 10.2% was mainly foreign
earnings taxed at lower rates and the impact of intangible property transfers.
In short: effective tax rate analysis can help explain fluctuations in net income, by
providing a reconciliation from the statutory corporate tax rate to the effective tax rate.
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