Lesson 7 of 9
The tax note
The effective rate reconciliation names every reason a company pays a different rate from the statutory one, which is a map of where its profit is earned.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The tax note starts at the statutory rate and itemises the main reasons the actual rate differs, and each line is a fact about the business.
- A deferred tax liability that keeps growing while the company keeps investing may never unwind, and can work like interest-free funding rather than debt.
- A one-time item, like the 2017 rate change, can break a ratio rule for a reason that is legislation, not performance.
The income tax note starts at the statutory rate and itemises the main reasons the company's actual rate differs from it. Each line is a fact about the business: where the profit was earned, what will never be taxed or deducted, and what happened once and will not happen again.
From the statutory rate to the rate actually reported
- Statutory rate20.0%
- Profit earned where the rate is lower−6.0%
- Costs that are never deductible+2.0%
- Release of a valuation allowance, this year only−9.0%
- Effective rate reported= 7.0%
What each line tells you
The reconciliation begins with tax at the statutory rate, then itemises the deviation from it, line by line.
| Line | What it tells you |
|---|---|
| Rate differential on foreign earnings | Profit was earned where the rate differs |
| A permanent difference | Never reverses: an item never taxed, or never deductible |
| A change in a valuation allowance | Management restating what it expects to earn |
| A discrete item | Something that happened this year only |
A discrete item belongs to its year. Carrying it into next year's expected rate is a common mistake a reader makes with this table.
Deferred tax, in the direction it runs
A deferred tax liability arises where a deduction was already taken on the tax return but not yet in the accounts, most often accelerated depreciation. The textbook description is that it reverses over time.
A deferred tax asset is the reverse: a deduction the company can use later, often a past loss. If management doubts it will earn enough to use it, it books a valuation allowance against it. Releasing that allowance cuts one year's tax charge.
Whether it reverses is the interesting part. A company that keeps buying assets keeps generating new differences, and the new ones replace the reversing ones, so the balance never unwinds while the asset base grows. A liability that never unwinds behaves like a permanent, interest-free source of funding rather than like debt, and reasonable people disagree about which side of a capital calculation it belongs on.
A rate change, not a business
The Tax Cuts and Jobs Act of 2017 changed the federal statutory rate and forced a one-time remeasurement of deferred tax balances. Many companies reported an unusual tax charge or benefit in a fiscal year ending in 2017 or 2018 that had nothing to do with their operations.
A reader holding a return-on-equity rule across those years would have watched it break for a reason that was legislation, not performance. And because a company chooses its own fiscal year end, the same legislative event landed in different fiscal years for different companies. So a same-year comparison can set one company that had already absorbed the remeasurement beside one that had not.
Check yourself
A deferred tax liability keeps growing every year while the company keeps buying assets. What does that tell you?
- The company is underpaying its taxes
- It can work like interest-free funding for as long as the company keeps investing
- The liability will reverse within one year
Show the answer
Answer: B.
New timing differences replace the reversing ones as the asset base grows, so the balance may never unwind while investment continues.A company's tax note shows a valuation allowance release that lowered this year's rate by 9 percentage points. What should a reader assume about next year?
- The lower rate continues
- The release is a one-time item, and the recurring rate is higher
- Tax charges never repeat from one year to the next
Show the answer
Answer: B.
A discrete item belongs to the year it happened in. Carrying a one-time release into next year's expected rate is a common mistake with this table.Why did the Tax Cuts and Jobs Act of 2017 break a return-on-equity rule for many companies in a way that had nothing to do with performance?
- It forced a one-time remeasurement of deferred tax balances
- It banned deferred tax accounting entirely
- It only affected companies with no foreign earnings
Show the answer
Answer: A.
The one-time remeasurement moved net income for a legislative reason, not an operating one, and it landed in different fiscal years depending on when each company's year ended.Sources
- ASC 740, Income Taxes: the effective tax rate reconciliation, deferred tax assets and liabilities, and the valuation allowance.
- The Tax Cuts and Jobs Act of 2017: the one-time remeasurement of deferred tax balances at the new federal rate.
What this leaves out
- This lesson quotes no tax rate. The statutory rate in the figure and the worked example is an invented round number, chosen so nothing here expires.
- It describes the reconciliation a US domestic filer produces under US GAAP; a company reporting under another framework presents its own.
- Whether a long-lived deferred tax liability behaves like debt or like equity is a judgement, not a rule this lesson settles.
- Nothing here is advice about any security.