Corporate Income Taxes

Look at Table 6.1, which shows corporate income tax rates in 11 countries. These are the tax rates imposed by the national governments, but corporations may also need to pay tax to a regional government. For example, in Canada, the provincial governments levy an additional tax of between 11% and 16%. In the United States, states and some municipalities also impose an extra layer of corporate tax that averages around 4%. To complicate matters further, in many countries, the first tranche of income may be taxed at a lower rate, or special arrange­ments may apply to some types of business.

Tax rates change over time, sometimes dramatically. For example, the U.K. has cut its corporate tax rate from 30% in 1998 to 19% today. The U.S. reduced its rate from 35% to 21% starting in 2018. This rate reduction was one of several important changes in U.S. corporate income taxes. We summarize the changes now.

U.S. Corporate Income Tax Reform

The U.S. Tax Cuts and Jobs Act was passed in December 2017 and implemented immediately in 2018. Suddenly, the corporate tax rate dropped from 35% to 21%. But there were several other important changes.^[1]

Depreciation Before 2018, when calculating taxable income, U.S. corporations were allowed to deduct an immediate bonus depreciation of 50% of the asset’s cost. The fraction of the investment not covered by this bonus depreciation was then depreciated over the following years using the modified accelerated cost recovery system (MACRS), a form of accelerated depreciation. (“Accelerated” means that depreciation is front-loaded: higher in the early years of an asset’s life but lower as the asset ages. Straight-line depreciation is the same in all years.)

But the new tax law allows companies to take bonus depreciation sufficient to write off 100% of investment immediately—the ultimate in accelerated depreciation. With 100% bonus depreciation, the firm can treat investments in plant and equipment as immediate expenses.

Bonus depreciation is a temporary provision, however. It is scheduled for phase-out starting in 2023. By 2027, it will be gone. We will have to wait and see what depreciation schedules apply to investments not covered by 100% bonus depreciation. Perhaps it will be that old standby MACRS. We discuss MACRS and other forms of accelerated depreciation in the next section.

Investment in real estate does not qualify for bonus or accelerated depreciation. It is depre­ciated straight-line over periods of 15 years or more.

Amortization of Research Expenses U.S. companies can now could write off most outlays for R&D as immediate expenses. Starting in 2022, most R&D investments must be amortized (depreciated) over a five-year period. Many observers were puzzled by this change. If invest­ments in plant and equipment now (2018-2022) qualify for immediate expensing, why must investments in R&D, which used to be expensed, be put on the balance sheet and amortized?

Tax Carry-Forwards When a corporation makes a profit, it pays tax. But what happens when it suffers a loss? In 2017 and earlier, U.S. corporations could carry back losses to recover taxes paid on the prior two years’ income. Starting in 2018, carry-backs are no longer allowed. But corporations can carry forward losses indefinitely, using the losses to offset up to 80% of future years’ income. Suppose, for example, that a manufacturer of gargle blasters loses $100,000 in 2018 but earns $100,000 in 2019 and 2020. It pays no tax in 2018, but carries forward the loss.

In 2019, it uses $80,000 of the loss to offset income, paying tax of $4,200 (21% of $20,000). In 2020, it uses the remaining $20,000 carried forward, paying tax of $16,800 (21% of $80,000).

Limits on Interest Deductions U.S. tax law treats interest on debt as a tax-deductible expense. In Chapters 17 and 18, we will show that the resulting interest tax shields favor debt over equity financing. But interest deductions are now (2018-2021) limited to 30% of taxable income before depreciation and amortization, though unused deductions can be carried for­ward and used in later years. From 2022 on, interest deductions are limited to 30% of taxable income after depreciation and amortization. (There are exceptions for small businesses, car dealerships, farmers, and some other taxpayers.) In other words, the limit from 2018-2021 is 30% of taxable EBITDA (earnings before interest, taxes, depreciation, and amortization); from 2022, it is 30% of taxable EBIT (earnings before interest and taxes). EBIT is smaller than EBITDA, so the restriction on interest deductions is tighter post-2021.

It appears that most large U.S. corporations will be safely below the 30% limits. But those corporations that do hit the limits may have to rethink their valuation methods and financing strategies. We cover these issues in Chapters 18, 19, and 25.

Territorial versus Worldwide Taxation Most countries have territorial corporate income taxes: They tax income earned in their own countries but not outside their borders. The United States switched over to a territorial system in 2018.

Before the switch, the United States taxed U.S. corporations’ worldwide income, which had some unfortunate consequences. To see why it mattered, think of a U.S. and a Canadian com­pany, both operating in the United States and in Canada before the U.S. tax reform. Both compa­nies paid U.S. taxes at 35% on their U.S. income and Canadian taxes at 15% on their Canadian income. But the U.S company owed an additional 20% in U.S. taxes when its Canadian income was repatriated. Thus, the U.S. company’s total tax rate on its Canadian profits added up to 35%, far in excess of the 15% rate paid by the Canadian company on its Canadian profits.

The U.S. company could defer payment of the 20% additional U.S. tax by refusing to bring its Canadian profits home. That is exactly what U.S. corporations did. As we will see in Chapter 30, Apple, Microsoft, Alphabet, and several large pharmaceutical companies stored up mountains of cash in low-tax foreign jurisdictions. Once the U.S. switched to a territorial tax in 2018, these companies had no incentive to make their cash mountains higher. They were, however, subject to a one-time tax of 15.5% on overseas profits accumulated through the end of 2017. For example, Apple announced that it would pay a tax of $38 billion to repa­triate cumulative foreign profits of $252 billion.

U.S. taxation of worldwide income also affected mergers and acquisitions. Suppose the U.S. company in our example bought the Canadian company before 2018, when the United States moved to the territorial system. The Canadian company’s home operations would then be owned by the U.S. company and subject to the U.S. worldwide tax. But if the Canadian company bought the U.S. company, the profits from the Canadian operations that the U.S. company used to own would escape the worldwide tax. Only the Canadian tax of 15% is paid. If there were a merger, it was clearly better for the Canadian company to be the buyer.

Thus, worldwide taxation rewarded foreign acquisitions of U.S. companies. Some U.S. com­panies arranged inversions, which were takeovers designed so that the foreign party was treated as the buyer. For example, Pfizer’s proposed 2016 merger with the smaller Irish company Allergen was designed to move the combined company’s headquarters to Ireland, where the corporate tax rate was only 13%. The deal was abandoned after stubborn resistance by the U.S. Treasury. But if the Pfizer-Allergen deal resurfaced today, there would be no tax motive to move the headquarters to Ireland because the United States no longer taxes Pfizer’s foreign profits.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.