Online Tutorial #6: How Do You Calculate A Company's Cash Tax Rate?

In this session, we focus on defining cash tax rate, explaining where to obtain data to calculate it, and walk through a sample calculation. As with previous sessions, we will use Domino's Pizza, as of September 2020, as a case study. Readers who want to calculate cash tax rates while reading this tutorial may wish to download the accompanying spreadsheet. 

What Does Cash Tax Rate Mean?

To understand what we mean by cash tax rate, let's break this phrase down into its component parts:

• Cash. This means that we want to look at the cash a company pays annually in taxes. This may differ from the income tax provision companies report on their income statements.

• Tax. This means we look at the amount a company pays to governments in exchange for the privilege of doing business in their jurisdictions.

• Rate. This means that we want to calculate the percent of pre-tax profit that a company pays in cash taxes.

Also, though it is not explicitly in the phrase, we need to consider one more word:

Unlevered. A company's taxes are influenced by how much debt a company has, as interest payments on that debt shield pre-tax profit from taxation. When calculating cash taxes, we remove this distortion by calculating a company's tax burden assuming a company was 100% equity financed with no debt. (*)

Putting this together, we can define the cash tax rate as the percent of pre-tax operating profits a company would pay in cash taxes to governments assuming it was 100% equity financed.

How Do We Calculate a Company's Cash Tax Rate?

We can use two methods:

A. Simplified Approach. This approach just substitutes a company's book tax rate as a proxy for its cash tax rate. However, as we note in the book on page 26:

The tax expenses in the income statement, book taxes, is often greater than the actual payments, or cash taxes, during a given period. This is because companies can recognize some revenue and expense items at different times for book versus tax purposes.

In addition, as we noted above, the book tax rate reflects a company's use of leverage. An unlevered cash tax rate removes the influence of debt on a company's tax rate.

B. Advanced Approach. In this approach, we make a number of detailed adjustments.

1. Book taxes. We start with a company's income tax provision found on the income statement.

2. Change in deferred taxes. Next, we add the year-to-year increase in a company's deferred income tax liability (or subtract the increase in a company's deferred tax asset). These line items can be found on a company's balance sheet. However, sometimes, this liability is not separately broken out. In those cases, there are two alternate sources for a company's change in deferred taxes:

Adjustments to reconcile net income to net cash provided by operating activities in the "Cash flows from operating activities" section of the Cash Flow Statement. A deferred tax liability occurs when a company pays less in cash taxes than it reports in book taxes. Thus, an increase in a company's deferred tax liability represents a source of cash. Conversely, a deferred tax asset occurs when a company pays more in cash taxes than it reports in book taxes. Thus, an increase in a company's deferred tax asset represents a use of cash.

3. Unlevering income taxes. Finally, we increase the tax onus by the taxes shielded by debt (in the case of net interest expense). For example, if a company had interest expense of $100 million and a 20% marginal tax rate, we would add back $20 million in taxes (that would have been paid if that interest expense had not shielded the company from paying taxes).

We can see how all this fits together by returning to our Domino's case study:

(*) In the U.S., the Tax Cuts and Jobs Act of 2017 limits the interest deduction at 30% of EBITDA through 2021, and from 2022 on the interest deduction is capped at 30 percent of EBIT.

(**) For Domino's, we assumed that deferred taxes were the difference between the tax provision and cash taxes paid.