As capital-intensive companies in the United States put the brakes on capital spending, it’s likely that their taxable income will climb — and so will their tax bill. That’s because the slowdown in spending is likely to eat away at any deferred tax benefit that might have offset taxable income, says a new study released today by the Georgia Tech Financial Analysis Lab.
The trend may become worrisome as the recession deepens, according to the study’s author, Charles Mulford, a Georgia Tech accounting professor and director of the Financial Analysis Lab. Indeed, capital-intensive companies — including those operating in the mining, pulp and paper, utility, railroad, communication, and airline industries — traditionally have sizable deferred tax liabilities, which are paid in the future but are used to offset current taxable income.
These tax benefits are linked to the depreciation schedules of capital equipment and can exist indefinitely, says Mulford, as long as companies continue to purchase new equipment. But once capital expenditure (capex) spending stops, deferred tax liabilities begin to come due, and the associated payment to the IRS reduces cash flow.
“This is not about earnings, but rather about cash flow pain,” Mulford tells CFO.com. The connection between capex spending, deferred tax benefits, and ultimately cash flow is largely ignored by corporate managers, he says. However, the link is not missed by lenders.
To be sure, Mulford says that many banks have quizzed him about potential corporate clients with large deferred tax liabilities. “In the past, commercial lenders have asked me whether it is likely that companies with large deferred tax liabilities will run into cash flow problems, and I always respond, ‘only if they stop capex spending.’ “
The new study, co-authored by research assistants Jason Blake and Sohel Surani, looks at the 2007 financial statements of two sets of North American companies that are both capital-intensive in nature and have “significant” deferred tax liabilities, meaning that the liabilities are well above the national average. The companies fell into three industry categories: large distribution networks such as electricity, gas, telecom, and broadcast providers; mining companies, including precious metals, minerals, oil and gas exploration, and production companies; and transportation companies (trucking, railroad companies) or those that maintain large fleets, like Coca-Cola Enterprises.
The tax deferral is based on a U.S. tax code rule that allows companies to accelerate their depreciation of capital equipment. Mulford explains that deferred tax liabilities are taxes that companies can avoid paying in the current period with the understanding that they will be paid in the future. In general, the liabilities arise when there is a difference between the income a company reports to the IRS and the income it reports in its financial statements for accounting purposes.
The single largest contributor to deferred tax liabilities is the difference in depreciation charges between the two types of reported income, says the report. As a way to encourage companies to increase their capex spending, the federal government allows them to accelerate the depreciation of long-lived or capital assets. In practice, depreciation of a capital asset is sped up during the early years of the asset’s life. So, as a company receives the tax benefit, it can plow the tax savings back into more capital equipment and start the deferred tax benefit cycle again.
The net result is that companies report higher depreciation charges on their tax returns than they report in their financial statements during the early years of the asset’s life. In practical terms, the deferred tax liability acts like a temporary interest-free loan from the government, something no company wants to turn down. Eventually, however, the taxable income and accounting income have to match up over the lifetime of the asset.
The true-up period occurs during the later years of the asset’s life when the depreciation expense recorded on the tax return declines, pushing taxable income higher than the financial statement income. At that time, the “loan” must be repaid when depreciation differences between taxable income and financial statement income reverse. That usually happens when companies stop capex spending, and therefore stop amassing the related tax deferral benefits.
The study cites more than 40 capital-intensive companies that have reduced capex spending in 2007 (see table). Oil company Anadarko Petroleum topped the list with $10 billion in net deferred tax liabilities, representing nearly 21 percent of the company’s total assets.
Mulford says that the cash flow affects of reduced capex spending likely won’t be evident in the 2008 numbers, which he will be examining soon. Rather, the consequences of slowed spending will come into focus when 2009 and 2010 numbers are released, if purchases don’t pick up.
The study also looks at 50 capital-intensive companies that have large deferred tax liabilities, but increased capital spending. Those companies are as diverse as Norfolk Southern, Harry Winston Diamond, Consolidated Edison, and MGM Mirage, and in some cases show increased spending of 700 percent (Cano Petroleum) and 600 percent (Freeport-McMoran Copper & Gold).
Mulford doesn’t think the current stimulus bill wending its way through Congress will do much to spark capital spending in these industries. By his lights, the stimulus package needs a “Reaganesque type” tax break in which companies are permitted to write off fixed assets on a shorter depreciation schedule. That would result in more tax write-offs up front, creating more deferred tax assets with which companies could offset their taxable income — and increase cash flow.