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The Tax Law Is About to Make Analyzing Earnings Trickier

By newadmin / Published on Monday, 12 Feb 2018 14:36 PM / No Comments / 4 views


The ‘transition tax’ is being assessed on profits that U.S. companies have generated overseas for years and held there, rather than having them taxed at the old U.S. corporate tax rate of up to 35%. A McDonald's restaurant in Shanghai in January 2017.
The ‘transition tax’ is being assessed on profits that U.S. companies have generated overseas for years and held there, rather than having them taxed at the old U.S. corporate tax rate of up to 35%. A McDonald’s restaurant in Shanghai in January 2017.
Photo:

johannes eisele/Agence France-Presse/Getty Images

The new U.S. tax law could throw a monkey wrench into a method many analysts and investors use to gauge the strength of companies’ earnings.

A provision of the tax overhaul enacted in December assesses a one-time tax on companies’ accumulated earnings from outside the U.S. But while the tax is typically charged to companies’ 2017 earnings, firms have the option of stretching the actual tax payment over the next eight years, interest free.

That decision, which companies need to make this year, could throw off the comparison of a company’s earnings to its cash flow, a traditional way of assessing earnings quality.

The Tax Law Is About to Make Analyzing Earnings Trickier

Investors like to see a company’s earnings fully backed by the cash its operations are generating. It demonstrates the company has the money to pay shareholder dividends and invest in its own future. But stretching out payments of the “transition tax” on foreign earnings will muddy that comparison, accounting experts say.

Many companies, including

Microsoft Corp.
MSFT 0.88%

and  

Johnson & Johnson,

have already made the choice to stretch out the tax bill. That meant their 2017 earnings were reduced, but the year’s cash flow wasn’t, making it appear earnings were more fully backed by cash flow. Then, for the next several years, the companies’ cash flow will take a hit, while earnings aren’t affected, making it appear earnings are less backed by cash flow than they really are.

Microsoft, for example, says it will pay a transition tax of $17.8 billion. That amount was assessed against last year’s earnings, but cash flow wasn’t affected. But starting this year, it will be. Under the law, companies can make payments over eight years on a back-loaded schedule that puts the maximum burden, 25% of the total, in year eight.

For Microsoft, that will cut as much as $4.45 billion off the company’s yearly operating cash flow, which would be a significant portion of the $39.5 billion in operating cash flow Microsoft posted in its most recent fiscal year that ended last June. A Microsoft spokesman declined to comment.

The Tax Law Is About to Make Analyzing Earnings Trickier

The disconnect between earnings and cash flow will force analysts and investors to do some reverse-engineering of company numbers to make sure they’re comparing apples to apples. If they don’t do so—or are unaware of the need to—they could be misled.

“This is something investors need to pay attention to,” said

Sandra Peters,

head of the financial-reporting policy group at the CFA Institute, which represents chartered financial analysts who work with individual investors.

The mismatch could be particularly important when analyzing companies whose operating cash flow is below their earnings.

Mondelez International Inc.,

for instance, said when it announced fourth-quarter 2017 earnings in January that it had a $1.3 billion tax on its accumulated foreign earnings, payable over eight years. That suggests its highest annual payment would be about $325 million, or 13% of the $2.6 billion in operating cash flow Mondelez posted in 2017, an amount already short of its $2.9 billion in net income.

Similarly,

McDonald’s Corp.

had a $1.2 billion charge for the transition tax, suggesting it will pay a yearly maximum of $300 million if it pays over eight years. The company had $5.3 billion in operating cash flow for the 12 months ended in September, compared with $5.7 billion in net income.

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A Mondelez spokesman said the company is “continuing to evaluate the accounting impact of the legislation.” A McDonald’s spokeswoman declined to comment.

The transition tax is being assessed on profits that U.S. companies have generated overseas for years and held there, rather than having them taxed at the old U.S. corporate tax rate of up to 35%. As part of the tax overhaul, the U.S. is relinquishing its right to tax those profits and shifting to a “territorial” tax system, which will levy taxes only on profits generated in the U.S.—but not before assessing a one-time tax on past earnings from the old system.

There are yet other complicating factors. Apple Inc., for instance, had previously accrued a big obligation for U.S. taxes on foreign earnings, anticipating it would repatriate some of those profits someday, so in effect it had already accounted for much of the $38 billion in taxes it owes.

And some companies are also realizing gains from deferred tax liabilities, which take less of a bite for a company now that the U.S. has lowered its corporate tax rate.

It’s also likely that companies’ earnings and cash flow will both rise by the time the bulk of the transition-tax payments become payable. J&J is scheduled to pay about $10 billion over the next eight years, implying a maximum yearly payment of $2.5 billion that would take a slice from the $21.6 billion it reported in operating cash flow for the 12 months ended Oct. 1. A spokesman said the company thinks an increase in its cash flow because of the lower tax rate will help “offset” the tax payment by the time it’s due.

Write to Michael Rapoport at Michael.Rapoport@wsj.com

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