Rating - 3/5

Income tax notes are among the more challenging of the disclosures found in annual reports. They can, however, be a rich source of information on nonrecurring items. Fortunately, our emphasis on the persistence of earnings requires a focus on a single key schedule found in the standard income tax note. The goal is simply to identify nonrecurring tax increases and decreases in this schedule.

The key source of information on nonrecurring increases and decreases in income taxes is a schedule that reconciles the actual tax expense or tax benefit with the amount that would have resulted if all pretax results had been taxed at the statutory federal rate. This disclosure for Archer Daniels Midland Company (ADM) is presented in Exhibit 2.18.

Notice that ADM’s effective tax rate is reduced in 2000 by 17 percentage points as a result of redetermining taxes in prior years. This percentage reduction


is expressed in terms of the relationship of the tax reduction to income from continuing operations before taxes. ADM’s 2000 pretax income from continuing operations is $353,237,000 and its total tax provision was $52,334,000. The 2000 effective tax rate, disclosed in Exhibit 2.18, is derived by dividing the total tax provision by income from continuing operations before taxes: $52,334,000 divided by $353,237,000 equals 14.8%.

The dollar, as opposed to percentage tax savings, is found by multiplying 17% times the 2000 pretax earnings: $353,237,000 × 0.17 = $60 million. ADM explained that “The decrease in income taxes for 2000 resulted primarily from a $60 million tax credit related to a redetermination of foreign sales corporation benefits and the resolution of various other tax issues.” ADM had a dispute with tax authorities over taxes for previous years, and it won. While there may be some ongoing benefit from this outcome, the $60 million should be viewed as nonrecurring in evaluating ADM’s earnings performance. Ongoing tax savings from its foreign sales corporations will continue to be realized and will be reflected in the reduced level of the ADM effective tax rate.

ADM’s 1998 effective tax rate was also increased by 1.4 percentage points as a result of fines and litigation settlements being deducted in arriving at pretax earnings. For income tax purposes, however, these amounts are not deductible, which means that unlike most other expenses these fines and settlements reduce after-tax earnings by the full amount of the expenses. There are no associated income tax savings, and the 1.4-percentage-point increase in the effective tax rate for 1998 is due to the nondeductible character of the litigation settlements and fines. The nonrecurring item in this case is simply the total of the fines and settlements. The tax benefit not realized because of the non-deductibility of the fines and settlements is not a separate nonrecurring item.

ADM’s net income increased from about $266 million in 1999 to about $301 million in 2000. Without the $60 million nonrecurring tax benefit, ADM’s 2000 net income would have declined to $241 million: $301 million − $60 million = $241 million. Identifying and adjusting 2000 earnings for this nonrecurring tax benefit results in a far different message: a decline in earnings in contrast to the reported increase.

The benefit from the tax redetermination is clearly a nonrecurring item. The tax reductions due to the foreign sales corporation feature of the tax law may or may not be sustainable. Any profit component that relies on a specific feature of the current tax law should be viewed as somewhat vulnerable. That is, its continuance requires that (1) this feature of the tax law be preserved and (2) that ADM continues to take the actions necessary to earn these tax benefits.

The ADM disclosures provide one example of a nonrecurring tax benefit plus at least one example of a benefit that may be somewhat more vulnerable than other sources of operating profit. Exhibit 2.19 provides a sampling of other nonrecurring tax benefits and tax charges that were found in recent company tax notes.

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The tax benefits of both Biogen and Dana result from utilizing loss carryforwards whose benefits had not previously been recognized. The losses that produced the tax savings originated in earlier periods. Because the likelihood of their realization was not sufficiently high, the potential tax savings of the losses were not recognized in the income statements in the years in which these losses were incurred. The subsequent realization of these benefits occurs when the operating and capital loss carryforwards are used to shield operating earnings and capital gains, respectively, from taxation. These benefits should be treated as nonrecurring in analyzing earnings performance for the year in which the benefits are realized.

Gerber Scientific’s effective tax rate was reduced as a result of its recognizing benefits from research and development tax credits. This feature of the tax law is designed to encourage R&D spending. As with all other tax credits, continuation of this source of tax reduction requires that the feature continue to be part of the tax law and that Gerber make the R&D expenditures necessary to earn future benefits.

The nonrecurring items of First Aviation Services and Micron Technology both result from adjustments of their tax valuation allowances. The allowance balances represent the portion of tax benefits that have been judged unlikely to be realized. Increasing this balance will create a nonrecurring tax


charge; decreasing it, a benefit. The prospects for realization of the tax benefit must have declined for Micron Technology but improved for First Aviation Services.

Both the Fairchild Corporation and M.A. Hanna Company tax benefits were the result of reducing previously recorded tax obligations. Subsequent information indicated that the liabilities where overstated. The liability reduction was offset by a comparable reduction in the tax provision. This benefit should also be viewed as nonrecurring.

Pall Corporation has a tax reduction that is associated with operations located in Puerto Rico. In fact, most firms with operations in other countries produce such tax benefits. Foreign states offer these benefits to encourage companies, typically manufacturing companies, to locate within their borders. In many cases these benefits are for a limited period of time, though renewals are sometimes possible. As a result, while the benefits are real, there remains a possibility that they will cease at some point. In fact, Pall Corporation disclosed just such a change in its income tax note:

The Company has two Puerto Rico subsidiaries that are organized as “possessions corporations” as defined in Section 936 of the Internal Revenue Code. The Small Business Job Protection Act of 1996 repealed Section 936 of the Internal Revenue Code, which provided a tax credit for U.S. companies with operations in certain U.S. possessions, including Puerto Rico. For companies with existing qualifying Puerto Rico operations, such as Pall, Section 936 will be phased out over a period of several years, with a decreasing credit being available through the last taxable year beginning before January 1, 2006.

This change in U.S. tax law means that previous tax benefits from the operations in Puerto Rico are not sustainable. When a company reports tax benefits because of operations in other countries, the possibility that the benefits might end or be reduced should be considered.

Rating - 3/5