Taxation is a significant expense for most companies and an important driver of profitability and value. Differences in the effective tax rate matter in equity analysis, but how should you calculate this metric and what rate should you use as a basis for forecasting?
We explain the different calculations of effective tax rates, why it is important to examine the tax rate reconciliation footnote, the impact of exceptional gains and losses, and how intangible amortisation complicates the analysis. Understanding these effects is important to determine the correct tax rate for use in NOPAT and DCF calculations.
The effective tax rate is defined as the tax expense divided by pre-tax profit. For most companies this rate will differ from the statutory or marginal tax rate due to differences in international tax rates, different rates applying to different sources of profit, reliefs and allowances, and changes in estimates. However, only some of these factors will be persistent and relevant for forecasts of post-tax operating profit (often referred to as NOPAT – net operating profit after tax) that is used in many aspects of equity analysis and valuation.
To complicate matters, the tax expense comprises two components: the current tax charge and the effect of deferred tax. Many investors seem to be unclear exactly which component of the tax charge is relevant when calculating an effective tax rate, and even whether it is better to focus on cash tax payments rather than what appears in profit and loss.
Which effective tax rate?
There are essentially three tax amounts that could be the basis for an effective tax rate:
- Total tax expense reported in profit and loss: This includes both the tax payable for that period and any deferred tax adjustments to reflect the tax effects of current period transactions but where the tax payments or savings actually occur in earlier or later periods.
- Current tax component of the tax expense: This is the tax that becomes payable in respect of the current period and excludes any deferred tax adjustment. It also includes any adjustment to the current tax reported in prior periods.
- Cash tax paid: This is the actual tax amount paid during the current period that appears in the cash flow statement. It mainly differs from current tax in terms of the timing of payment.
Each can produce very different results, as illustrated by the data below for global pharma company AstraZeneca1AstraZeneca is headquartered in the UK and reports under IFRS. Everything in this article is also applicable to US GAAP..
AstraZeneca effective tax rates
AstraZeneca financial statements. Tax rates based on reported pre-tax profit.
Cash taxes may appear to be the most objective, and of course cash taxes combined with other components of free cash flow ultimately determine value and should feature in DCF analysis. However, we do not think cash tax is the best approach when calculating effective tax rates. Combining a tax cash flow with an accruals-based profit results in a mismatch, with unpredictable results. Furthermore, this mismatch is exacerbated because the cash tax amount may include amounts related to gains and losses reported in Other Comprehensive Income (OCI).
Do not use cash tax paid when calculating effective tax rates
Although cash taxes avoid some of the complications arising from taxation estimate changes and adjustments, it is better to use a tax amount that is accruals-based and reflects the tax consequences of profit recognised in the same period – in other words, the profit and loss tax charge. However, should this include the effects of deferred tax?
Many investors seem to distrust deferred tax adjustments, regarding them as non-cash and somewhat unpredictable. In addition, deferred tax in profit and loss can often be significantly affected by changes in estimates, particularly where there is uncertainty over the recovery of deferred tax assets. Nevertheless, we think it is always best to include deferred tax and separately allow for any non-recurring components.
Deferred tax adjustments ensure that the tax reported in profit and loss correctly reflects the tax consequences of gains and losses recognised in that period. If the taxable gain or loss arises in a different period from the transaction itself, the current tax charge is likely to be misleading and not capture the full economic tax expense or saving.
For example, if an expense is recognised in profit and loss in year 1, but the tax deduction (and therefore tax saving) is obtained in year 2, current tax will appear high in year 1 relative to reported profit and artificially low in year 2. The deferred tax adjustment in this case produces a tax credit in profit and loss in year 1, with a related deferred tax asset reported in the balance sheet, and a reversal in year 2.
To see a more comprehensive illustration about the mechanics of deferred tax, see our article ‘Deferred tax and temporary differences’.
Headline effective tax rates can be misleading – you need to analyse the footnotes
Although the best effective tax rate calculation is simply the profit and loss tax charge divided by pre-tax profit, you need to delve into the footnotes to properly understand this metric and obtain data needed to produce forecasts. This need for further analysis is particularly evident from the AstraZeneca effective tax rates above, where there is significant variability in each of the rates calculated.
The tax reconciliation note is what you need to analyse:
AstraZeneca tax reconciliation
AstraZeneca financial statements 2023
The tax reconciliation note reconciles the tax charge reported in profit and loss to what the expense amount would have been had it been calculated at the statutory tax rate (time apportioned when tax rates change) for the jurisdiction of the parent company. For year ending December 2023, the average UK statutory tax rate was 23.5%. Applying this to the AstraZeneca reported pre-tax profit of $6,899m gives a hypothetical tax charge of $1,621m. The difference between this amount and the reported tax charge of $938m that produces the effective tax rate of 13.6%, is explained and disaggregated in the table.
Several components of the reconciliation could be non-recurring
It is important to identify which components of this reconciliation are likely to be persistent and therefore relevant when forecasting effective tax rates for use in equity valuation. Many of the reconciling items above appear to be one-off, or adjustments to correct estimates made in prior periods. Although estimate corrections could be persistent to an extent (such as if there is an underlying conservative bias when making the initial estimates), we think you should assume that the best forecast of all seemingly one-off tax amounts and corrections of past estimates is zero.
Most amounts reported in financial statements are estimates to a greater or lesser extent, with the correction or ‘truing-up’ when these estimates are resolved or updated being an ongoing process. In many cases the impact of these adjustments is not material to your analysis, but for taxes the impact is often much greater. The table below shows our analysis of the tax reconciliation of AstraZeneca to highlight likely persistent differences compared with the statutory tax rate.
The key differences to look for are those arising due to a difference in the foreign tax paid on earnings outside the parent company jurisdiction, plus the impact of reliefs and allowances, including non-taxable and non-tax-deductible components of net profit.
Analysis of AstraZeneca tax reconciliation
AstraZeneca financial statements and The Footnotes Analyst estimates
While the above indicates that the best forecast of an effective tax rate is below the statutory rate, the impact of the ‘persistent differences’ clearly varies over time. Nevertheless, for an effective tax rate to apply in NOPAT and enterprise free cash flow calculations, the adjusted effective tax rate calculation, as illustrated above, should provide a better basis for forecasting. For NOPAT, use the current statutory rate and adjust for the persistent differences based on an investigation of their variation over several periods.
However, simply adjusting effective tax rates for one-off tax items is not enough, you also need to consider the impact of exceptional items and financing.
Tax disaggregation, exceptional items and financing
The disaggregation of the tax expense and deferred tax assets and liabilities is important for DCF valuations. Tax is generally not included as a single item in DCF, but components of taxation are used in different elements of the calculation. Tax related to financing is included in cost of capital, deferred tax assets and liabilities related to investments and (some) liabilities are included in the enterprise to equity bridge as part of those adjustments, and tax related to operating activities is included in forecast free cash flows. The tax expense and deferred tax amounts need to be analysed to correctly include taxation in DCF.
Unfortunately, the extent of tax disaggregation in financial statements is limited. The above tax reconciliation note provides a disaggregation of sorts, but it does not identify the tax related to different components of profit. There is a required disaggregation where gains and losses are reported in Other Comprehensive Income (OCI), with the tax amounts separately presented in OCI. However, the only requirement to disaggregate tax in profit and loss applies to discontinued activities. The rest of taxation is simply one amount – unless companies provide voluntary disclosures about exceptional items.
Taxation and exceptional items
It is common for companies to provide alternative performance (non-GAAP) measures where certain gains and losses are omitted or modified. If this measure is post-tax, the tax amount will likely be provided for each of the adjusting items. Under the new IFRS 18 Presentation and Disclosure in Financial Statements, which becomes effective in 2027, companies must provide disaggregated tax amounts whenever ‘management performance measures’ are disclosed.
Here is the AstraZeneca tax disaggregation related to exceptional items and their adjusted “core” performance measures.
AstraZeneca adjusted performance measures
AstraZeneca 2023 financial statements
Below the table we have added the implied effective tax rate applicable to each adjusting item and the adjusted “core” result. Notice that the effective tax rate for the adjustments is closer to the statutory rate (23.5% for 2023). This is not surprising since the measurement of these is likely to be on a ‘with and without’ basis2Tax allocations are difficult (and to an extent arbitrary), with different methods possible, including the application of the statutory rate, the overall effective tax rate and a with and without basis. Under the new IFRS 18, there is now a requirement to disclose the tax effect of each adjustment included in a management performance measure (as done already by AstraZeneca). However, there is no specified method, which means you may find a lack of comparability in practice.. The tax rate applied to the intangible amortisation and impairments is somewhat lower, which may be due to goodwill impairments not affecting tax, due to the lack of deferred tax recognition for goodwill. However, whatever the reason for the variations, the impact of removing these exceptional items is to produce a higher effective tax rate for the remaining adjusted profit.
Consider both the tax reconciliation and exceptional items disclosures when analysing effective tax rates
The above information about exceptional items needs to be considered together with the tax reconciliation note above. Part of the changes in estimates and non-recurring elements of taxation in the reconciliation may also be included in the calculation of adjusted performance measures. In the above they are most likely part of the ‘other’ column.
We have included the explanation of ‘other’ provided by AstraZeneca. While this indicates that some of the non-recurring tax items were indeed included in this table in 2022, there is no indication a similar adjustment is made in 2023, the period covered by the adjusted profit table.
We think you should adjust the reported effective tax rate to remove:
- The impact of changes to estimates and other one-off items shown in the reconciliation note; and
- The tax effect of exceptional items to the extent not already identified from the tax reconciliation and included above, and also only to the extent you believe that they should be excluded from underlying profit3We would not remove all the items identified by AstraZeneca when calculating historical performance measures for use as a basis for forecasting. For example, we believe that, while restructuring costs may be volatile from period to period, for most large companies these are a recurring expense and need to be reflected in forecasts. Therefore, they should not be ignored in any historical measure of performance. Similarly, we would not exclude the interest accretion of acquisition related liabilities from post-interest measures of performance..
This is the approach we apply in our calculation below.
Effective tax rates and intangible amortisation
A common, and often highly material, adjustment in measuring non-GAAP adjusted performance metrics is the add-back of amortisation related to intangible assets recognised following a business combination. In the case of AstraZeneca, the add-back increases adjusted core operating profit by over 50% in 2023. We think such adjustments have merit – for more about this aspect of non-GAAP reporting see our article ‘Should you ignore intangible amortisation?’.
The tax effect of this intangible amortisation is unusual because the related deferred tax does not sum to zero, which creates an ongoing difference between the total and current effective tax rates. Notice that in the above tax reconciliation for AstraZeneca how the current tax effective tax rate (from which deferred tax is excluded) is much higher than the total effective tax rate. It is most obvious in 2023, but the effect is present in other years, even if somewhat concealed by other factors, and will most certainly continue in the future.
Recognition of most intangible assets in a business combination creates a deferred tax liability
In a purchase price allocation, fixed assets, including intangibles that were not previously recognised by the subsidiary, must be recognised at their fair value in the consolidated financial statements. Most intangibles recognised as a result of a business combination will have a tax base of zero because there is no tax deduction obtained for the amortisation. This is because the asset and amortisation only exist in the group financial statements, whereas tax is calculated at the individual company level. The difference between the carrying value (the intangible fair value in the purchase price allocation) and zero tax base creates a temporary difference and deferred tax liability when the intangibles are first recognised. At the time of acquisition this liability is a component of the net assets acquired and increases goodwill4The same issue also applies to other fair value adjustments applied in the purchase price allocation. However, the effect is generally most noticeable for intangibles assets that are recognised at their fair value at the time of an acquisition, but which were not previously recognised in the subsidiary’s individual financial statements. Newly recognise intangibles are often very significant and have a major impact on the consolidated financials – as is the case for AstraZeneca..
There is no profit and loss effect when this deferred tax first arises. However, in subsequent periods the deferred tax liability is progressively reversed, creating a tax credit in profit and loss. This creates the impression that the amortisation is tax deductible (see the tax effect in the AstraZeneca adjusted earnings note above), whereas in reality the tax ‘saving’ is merely a non-cash deferred tax credit.
Although this may seem odd, and the tax effect artificial, the deferred tax arising on initial recognition in a business combination plays an important role in correctly determining the amount paid for goodwill. The adjustment makes sense, even if it can be somewhat confusing for investors.
The impact can also be seen in the deferred tax footnote:
AstraZeneca 2023 deferred tax roll-forward note
AstraZeneca 2023 financial statements
In 2021 the acquisition of Alexion resulted in a significant addition to AstraZeneca’s intangible assets, which resulted in an increase in deferred tax liabilities. Although the $3,744m highlighted above relates to all fixed assets acquired in business combinations in 2021, the majority of this is likely to relate to intangibles. In 2023 the $1,518m reduction in the deferred tax liability produces a credit to the income statement, and is partly due to the amortisation of intangibles.
The current effective tax rate can be particularly misleading where intangible amortisation is material – the 35.4% rate we calculated for AstraZeneca is largely meaningless. Always use the total tax charge and adjust both pre-tax profit and the taxation amount if you wish to focus on pre-amortisation performance metrics.
Effective tax rates, financing and investing
Where an effective tax rate is used to calculate NOPAT (either for use in valuation multiples or in DCF valuations), the rate must exclude the effects of financing and investments that are not part of operating activities and therefore separately included in enterprise value. If the effective tax rate for interest expense and investment income differs from the aggregate effective tax rate, the tax rate applicable to NOPAT will require adjustment.
For example, if investment income is taxed at a lower rate than operating profit, the effective tax rate applicable to NOPAT would be higher than that based on aggregate pre-tax profit. This effect can be particularly important if a company has investments in associates or joint ventures. Under equity accounting it is the share of associate post-tax profit that is included in group pre-tax profit. This effect, plus the (general) lack of recognition of deferred tax in respect of undistributed earnings of the associate, results in a zero effective tax rate for most or all profit recognised under the equity method. Consequently, if income from associates is material, the effective tax rate applicable to aggregate earnings may be significantly below what you should apply when calculating NOPAT.
You can generally assume that the effective tax rate for income from associates is zero. However, you will rarely see disclosures about tax applicable to other income and expenses that are not part of operating profit. We suggest using either the marginal rate of tax applicable to the parent company jurisdiction or after adjusting this rate for the effect of differential foreign tax rates.
Estimated adjusted effective tax rate for NOPAT
Here is our final estimate of the 2023 effective tax rate for AstraZeneca that applies to its adjusted operating profit. In other words, the rate we think is applicable to NOPAT.
AstraZeneca 2023 adjusted effective tax rate and NOPAT
AstraZeneca 2023 financial statement data and The Footnotes Analyst estimates
(1) There is no way to objectively determine the tax rate to apply to the net interest expense. We have applied the statutory rate given in the tax reconciliation. Income from associates, which should be treated separately, and which will generally have no tax impact, is not material.
(2) We assume that all the exceptional items specified by AstraZeneca, and excluded from their core profit measures, are also adjusted in our NOPAT measure. This may not necessarily always be desirable.
For NOPAT forecasts, base your effective tax rate on this calculation (supported by similar results for prior periods), but with adjustment to allow for known future effects, such as expected changes to corporate tax rates.
Insights for investors
- Calculate effective tax rates based on the total tax charge, including deferred tax. Current tax and cash taxes are inconsistent with pre-tax profit.
- Use the tax reconciliation footnote to identify why the effective tax rate differs from the statutory rate. Consider what elements are one-off, including changes to estimates, and what are likely to be persistent.
- Use any tax disaggregation provided in disclosures about management performance measures to refine your estimate of the underlying effective tax rate.
- The apparent tax savings related to intangible amortisation are likely to be mainly the reversal of a deferred tax liability and not actual cash tax savings. If so, current and cash tax are likely to be higher than total tax and not a realistic basis for effective tax rates.
- Investment income (particularly income from associates and joint ventures) and financing expenses may produce tax effects at a different rate from that applicable to operating profit. Adjust for this effect when calculating an effective tax rate for use in NOPAT.