Saturday, January 20, 2007

Deferred tax liabilities

As noted earlier, deferred taxes exist because of the difference in accounting methods for shareholder income (what the company tells the shareholder) and taxable income (what the company tells the taxman).
In deferred tax liabilities, let's use an example here. If Popeye was always asking for his spinach today in exchange for payment the next week, he is actually getting the benefit upfront while delaying his payment for as long as he can. Like Popeye, businesses want to do the same thing with their taxes. The longer they can defer taxes, the longer they have use of that cash, which means they can use it to make more money - free money without incurring interest.
When companies delay their tax payments, they create deferred tax liabilities accounts (DTL) to reflect future tax obligations. The most common reason for DTL is depreciation. When a business buys property, plant and equipment (PPE), it makes assumptions or estimations that either depreciate this PPE slowly or quickly. To the shareholders, the business will want to impress them with higher income and thus, depreciate it slowly. For the taxman, the company accelerates depreciation which lowers income and tax payments.
In theory, the amount of DTL will reverse over time when the company will eventually have to pay up. As a result of all these, the company books DTL to reflect future tax obligations.
To throw a little confusion into the mix to challenge what is theoretically taught, DTL can be permanent where the situation will not reverse. For example, many companies are growing and continually adding PPE, and the depreciation method remaining the same.
Fairly asset-intensive companies like Kroger, Wal-Mart generally have to build more stores in order to increase revenues. Thus, PPEs of retailers like these increase over time, and the difference in speed between shareholder and taxable depreciation methods tends not to reverse.
In some cases of DTLs, not only does it tends not to reverse but it will never reverse. For example, at Berkshire Hathaway, they are sitting on some very pretty, fat and hefty future capital gain taxes, all thanks to their astute investment selection. Of these astute investments, one of it is Coca Cola which cost them $1.3 billion. Today, it is worth $9.6 billion. The capital gain of $8.3 billion is taxable at 35% if they were to sell today. And if we assume that they would and upon the sale, they would have to set up a deferred tax liability to reflect Berkshire's potential future tax liability. They will have to set aside $2.9 billion. However, because Berkshire may never sell (as you know, their favourite holding period is forever), the DTL on these long-term holdings occupy some sort of netherworld between the nature of an equity (what Berkshire owns) and the nature of a liability (what Berkshire owes).
So, when figuring out DTL, try to understand the source of the difference in shareholder and taxable income, and if the difference is valid. In BH case, obviously, DTL related to permanent equity holdings are unlikely to reverse, so investors can take comfort knowing that they won't get stuck with a huge tax bill anytime as long as the right man is in charge there.