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Tax expense should be assessed like any other expense item, although, by nature, it is more complex than most expenses. It is driven by the legislation in the jurisdictions within which the business operates. The complexity is further compounded by taxation agreements between jurisdictions, and also by the rules surrounding the treatment of businesses within the same family or group of companies. Any detailed analysis should always be undertaken with the advice of an appropriate tax expert.

However, there are two metrics which are commonly used by analysts: effective tax rate (ETR) and marginal tax rate (MTR). ETR is the effective tax rate that is observed in the income statement. ETR is expressed as a percentage and is calculated as:

(Reported tax expense) / (Reported profit before tax)

The income statement for PayPal Holding Company (below) shows that for the 2017 fiscal year ETR is 18.4% (405/2,200).

PayPal Holding, Inc – Income Statement Extract

ETR is normally compared with the marginal tax rate (MTR). MTR is the tax on the next dollar/euro/yen of earnings and is typically the statutory tax rate in the relevant country. Marginal tax rate for US corporations is calculated by adding the federal and state tax rates. Most analysts use the home country MTR, but with global businesses there is an argument for using an average MTR weighted by business done in various countries.

ETR vs MTR

The divergence between ETR and MRT is driven by the difference between the treatment of an income statement item for tax and financial reporting purposes. For example, income from a particular manufacturing plant may attract a lower than normal tax rate in order to incentivize employment in the area. This will reduce the average tax rate suffered by this business (ETR), when compared with the headline statutory tax rate for the jurisdiction as a whole (MTR).

Permanent Differences

The reasons for divergence between ETR and MRT are called permanent differences. Permanent difference refers to situations where the tax accounting treatment of an item is different from the treatment in the financial statements.

Under both US GAAP and IFRS, businesses are required to provide an explanation of the main reasons for the divergence between ETR and MTR. This may be provided in monetary amounts or in percentage terms. PayPal Holdings, Inc is a US corporation and its statutory tax rate is based on both federal and state taxes. The federal rate is 35% and the state taxes are 0.8% (highlighted in purple), giving an MTR of 35.8% (35% + 0.8%). MTR is significantly higher than the ETR of 18.4% and it can be seen that this reduced rate is almost exclusively driven by the impact of foreign income taxed at different rates (highlighted in green).

PayPal Holdings, Inc – Extract from footnote 17

Tip: An important note is that line items above tax expense in the income statement are assumed to be pre-tax and those below are assumed to be post tax, unless there is evidence to the contrary.

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