Effective Tax Rate (ETR)
What is Effective Tax Rate?
Effective tax rate or ETR is the tax rate that is observed in the income statement. It is based on a company’s annual reported profit before tax figure and its tax expense for the same period. The effective tax rate is sometimes referred to as the long-run tax rate and has many applications including the calculation of Net Operating Profit After Tax (NOPAT) and Return on Invested Capital (ROIC). ETR is expressed as a percentage and is calculated as:
Effective tax rate = Reported tax expense / Reported profit before tax
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 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.
Key Learning Points
- Effective tax rate (ETR) is the tax rate observed in a company’s income statement
- The marginal tax rate or MTR is the rax rate on the next dollar/yen/pound of earnings
- Businesses are required by both IFRS and US GAAP to provide an explanation of the main reasons for the divergence between ETR and MTR
- Tax may be affected by differences in how expenses are expected to be treated and are treated by the tax authority. These differences split into permanent and temporary differences
- Only permanent differences have an impact on the ETR. Temporary differences cause deferred taxes.
Calculating ETR
The income statement for PayPal Holding Company (below) shows that for the 2022 fiscal year ETR is 28.1% (947/3,366). You can find it yourself in Felix, FE’s data provider, by going to this link.
Paypal Holdings, Inc – Extract from the income statement, 2017
Most companies also publish a table showing their tax position, with a helpful reconciliation in either currency (e.g. $, £) or % terms. Companies preparing their financial statements using US GAAP or IFRS will always have a table of this kind. For Paypal 2022 you can follow the link here to see where you’d find the table in their footnotes. We’ll use this reconciliation in the MTR section below to explain ETR vs the marginal tax rate (MTR).
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. The marginal tax rate for US corporations is calculated by adding 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.
Marginal Tax Rate
Understanding ETR means also understanding the marginal tax rate. They’re easy to confuse with each other, and their relationship is helpful to get a deep understanding of the tax expense and liability.
ETR is distinct from 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. For Paypal (see graphic above) the federal pus state taxes are 21% (21+0%). The argument is that all the other items in the table would not be relevant on the next dollar of income. Most analysts use the home country MTR (so for Paypal this would be 21%, it’s US tax), but with a global businesses, there is an argument for using an average MTR weighted by business done in various countries.
The above table allows us to see why the company isn’t paying the MTR on all its profits. For Paypal, it’s paying less on foreign income (it’s seeing a 12.2% reduction in ETR due to this, and makes sense given the lower tax rates of some countries it operates in). Paypal has, however, made some transfers of intellectual property. This has come with a tax charge, and increased its effective tax rate by 10%.
ETR vs MTR
The divergence between ETR and MTR is driven by the difference between the treatment of an income statement item for tax and financial reporting purposes. For example, for Paypal the tax credits are causing a 0.4% tax reduction. Tax reductions are normally caused by expenses. You could simplify this by thinking about two sets of financial statements. One for Paypal, and one for the IRS (the US tax authority). The IRS set of books has an expense on it that isn’t on the company books, causing a lower tax liability. This is a permanent difference. We’ll talk more about permanent and temporary differences later.
MTR is helpful in a range of situations where an isolated variable is being changed, which would then change a small part of the profit of the company.
Permanent Differences
The reasons for divergence between ETR and MTR 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, and this difference will not reverse itself in later financial statements.
A good example is Paypal’s 2022 tax credits, which we looked at earlier.
These have created a tax reduction, which wasn’t implied by the expenses on the financial statements. This difference will never be clawed back by the tax authority. It’s a permanent credit, probably to incentivize investing in the long term success of the company through R&D.
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.
Let’s contrast this against the situation with capital allowances. Capital allowances are the tax authority’s version of depreciation. They normally differ significantly from the depreciation in the financial statements, as the tax authority tends to have a more blanket approach to assets than the company. For example, Paypal may (to illustrate the point, not based in reality!) depreciate its company vehicles over 5 years. The tax authority may allow Paypal to reduce its tax bill by the full value of the vehicle in the first year.
Why would the tax authority do this? It simplifies their job: instead of asking each company what car depreciates at what rate, they just have a blanket assumption for all vehicles of a certain type. The tax authority (and by extension the government) may also want to encourage investment in new cars. This may help the economy by making sure companies don’t keep hold of cars for too long.
The difference between the depreciation, and capital allowances will cause deferred taxes. These will have an impact on the tax expense, and make ETR closer to MTR. They also prevent the difference making its way into the reconciliation we saw before. Deferred taxes are highly complex, and have a blog of their own you can find here.
If you’d like some practice on creating the ETR, and distinguishing permanent from temporary differences, open the excel workbook linked on this page. Answers are included, so you’ll know if you’ve taken in the key messages.
Conclusion
ETR is the tax rate implied by the tax expense and the profit before tax. However, there’s a lot of complexity behind this idea. Financial services professionals should be comfortable describing why ETR is not MTR, and what the differences can be caused by.
This will be valuable when analyzing companies, and creating models for valuations. As noted in the intro to this blog, it should be noted that taxes are specific to countries, and ever changing. Tax experts may need to be consulted if doing detailed work!