Deferred Tax Liability - A Sneaky Form of Free Financing
Lately, I've been trying to dig a little deeper into deferred tax liabilities. The initial spark for my interest was noticing that Intel's deferred tax liabilities jumped by $850M during their most recent quarter, on earnings of $3.16B - a sizable portion of their earnings. My next endeavor was literally tallying the deferred income taxes for the S&P 100 over the past 3 and half years. The sum of deferred income tax liabilities are as follows:
2008: $244.01B (60.55B)
2009: $292.15B +48.14B
2010: $334.68B +42.53B
2011 (so far): $348.90B +13.21B
These numbers are pretty sizable, considering this is only the S&P 100. (These numbers are probably not completely accurate, however. I used Google Finance as my reference to collect these numbers, and I think Google makes some mistakes from time to time in their numbers.)
Companies are steadily bolstering the amount of deferred tax liabilities on their balance sheets to the tune of about 15-20% YOY, with the exception being 2008. Being that I really didn't know what deferred tax liabilities were, I found this intriguing, yet confusing.
In the "Owner's Manual" for Berkshire Hathaway, you'll notice that Warren Buffet says that he uses deferred taxes (along with insurance float) as his primary source for financing because it's literally an interest free loan from the government.
"Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $100 billion. Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest."
So in essence, deferred taxes are, indirectly, money that the government is "lending" to companies. Apparently, this tax deferral is commonly used as financing by corporations who are in the midst of mergers and big buys. As it turns out, Intel happened to buy McAfee in late 2010. And Mr. Buffett, living up to his word, has fully taken advantage of deferred taxes. Due to no shortage of acquisitions over the past year, Berkshire Hathaway's deferred income taxes have jumped from $19B in 2009 to $36B in 2010.
While many, many companies are currently taking advantage of deferred tax liabilities in large fashion (PEP, AAPL, GG) two companies that have taken advantage of this "funding" that I'll elaborate on are Coca-Cola and Exxon. XOM acquired XTO and KO bought and sold some stuff to CCE during 2010. During the 4th quarter of 2010 (the same quarter that KO reported ridiculously good net earnings) a $3B spike in deferred taxes popped up. Historically, KO has kept their deferred taxes near $1B - total. Now it stands at roughly $4.5B. Exxon is no stranger to deferring income taxes. Like BRK, their deferred tax liability balance stands at $36B dollars, partially due to a $10B dollar addition in deferred taxes in the 2nd quarter of 2010. The Total Debt that Exxon carries currently stands at around $16B, just to put things in perspective. They've done a fantastic job of taking the government up on interest-free money to fuel M&A.
While the Federal Reserve purposefully targets 2% inflation YOY, the government allows companies to defer paying taxes free of charge. What a great deal for these large corporations and shareholders - and what a horrible deal for taxpayers!
When I initially saw this spike in deferred taxes, I thought that they were associated with the money hoards that companies keep overseas. However, a PwC report I dug up states that almost all of the money made overseas, that is intended to stay overseas, does not fall into deferred income taxes.
"US GAAP permits a company to overcome the presumption of repatriation and forgo recording a deferred tax liability, as long as it can support the assertion that management has the intent and ability to indefinitely reinvest the profits or otherwise indefinitely postpone taxation in the home country market. This is known as the indefinite reinvestment assertion."
"Asserting indefinite reinvestment traditionally has been a widespread practice among multinational businesses. A majority of companies make the assertion with respect to much, if not all, of their foreign earnings."
"In a recent study of the 2009 list of Fortune 500 companies, it was reported that more than 300 US multinationals asserted indefinite reinvestments and disclosed the amount of undistributed earnings in the notes to their respective 2008 financials."
So from my understanding, these spikes in deferred taxes are not overseas profits that companies refuse to repatriate. Deferred taxes are indeed money that the company "intends" to pay taxes on - at some point in the future.
As an investor in the stock market, the most important question might be: why did companies collectively write down bad assets and reduce their deferred income tax liabilities in 2008 during the middle stages of the credit crisis? Take a look at T, FCX, TWX, GE, and PFE for starters. And speaking of Pfizer, they happened to make a pretty big acquisition in 2009. Its $30B increase in debt was accompanied by a $15B increase in deferred taxes. A third of the debt financing it used was interest free from the government.
Emil Lee points out that the nature of some deferred tax liabilities will prevent a company from likely ever having to pay those taxes back, which is likely the case for Berkshire Hathaway.
But for most companies, I'm guessing that at times, they will need to reduce their deferred income taxes. By writing down all of their crappy assets and recording a huge paper loss, they are able to drastically reduce their deferred tax liability - in one fell swoop. Its a great management strategy for the companies, but it throws the markets for a loop. This seems to be what happened in the fourth quarter of 2008. But my question is why did everyone decide that 4Q 2008 was the time to do it?
As we inevitably go through periods of busts and booms with the economy, should we expect earnings to swing even more wildly to the high side and low side as a result of this sneaky form of cheap financing, and the subsequent need to reduce it from time to time? As Wall Street has completely shunned Balance Sheet valuation methods in complete favor of earnings valuation methods, you can bet huge earnings swings would come with some pretty drastic swings in the stock market as well. Go over to Shiller's website and take a look at the S&P 500 earnings swings that have occurred over the last 10-15 years. You think early 2009 was your only opportunity to get companies on the cheap? Probably not.
[Speaking of earnings valuation methods, what do you plan on using for your risk-free rate in your DCF now? What's the yield on Scandinavian debt?]
While cash as a percentage of debt may be at historically high levels, cash as a percentage of deferred tax liabilities is likely at historically low levels.
I'm also thinking that in the midst of a federal budget crisis, what politician has the intestinal fortitude to step up to the plate and eliminate most deferred income taxes and set a true corporate tax rate? (That's rhetorical) If the S&P 100 collectively has a deferred tax liability of $350B, what does the S&P 500 currently check in at? A trillion dollars? What does the Wilshire 5,000 check in at? The aggregate debt of the S&P 500 is somewhere in the ballpark of $3T, I think. So roughly 25-30% of corporate leverage comes from deferring tax payments to the government. Is our country in any position to be leaving trillions of dollars on the table?
So in summary (and other takeaways):
Deferred taxes are a source of government provided, interest-free financing. Some companies have higher deferred tax liability accounts than total debt (XOM, GG). This appears to be a savvy management strategy.
While there was a collective reduction of deferred income tax liability in 2008, these accounts are significantly on the rise again. Large spikes in deferred tax liabilities typically come with acquisitions and are accompanied by increases in PP&E, goodwill, and/or intangibles. Large reductions in deferred taxes often come with increased debt and the writing down of bad assets.
Deferred tax liabilities have little to do with overseas profits. Overseas profits are almost always considered "indefinite reinvestment" earnings and are not added to deferred taxes. There may be some correlation to the excessive reduction in deferred income taxes in 2008 and the "unusual expense" charges that came in 4Q 2008.
While some companies swapped out their deferred income taxes with actual debt in 2008 and accepted large write-downs on assets (T, PFE, and GE), many companies simply accepted severe write-downs on assets without increasing their debt (FCX, TWX, DVN). Will this collective deferred tax and bad asset reduction simultaneously happen again, decimating the S&P 500 reported net income as it did in 2008?
When companies decided to (or were forced to) shift their deferred tax liabilities to corporate debt in late 2008, it caused a quick spike in bond yields. AAA debt yielded over 6% for merely 2 months - the only chance investors had to pick up AAA debt at that level since 2004. The 40% increase in deferred taxes over the past 2 years has greatly reduced the need for corporate debt, and has driven down interest rates to pathetic levels. If a collective shift from deferred taxes to corporate debt happens again, can we expect another spike in bonds yields?
I feel like I'm in the first inning of learning about deferred income taxes. I realize I've pointed out a lot of correlation with not much causation. Any knowledge or corrections to my train of thought would be very welcomed.