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.