Taxes Owed vs. Taxes Paid: Tax Rates Explained

Investing

The U.S. corporate tax rate is 35% for companies making more than $18.3 million per year, which includes almost every large public company, many of which earn hundreds of billions of dollars per year.  Yet many companies report income tax “expenses” of only half that and actually pay less than 10%.  How can this be?

Let’s start with some terminology:

  • Statutory Tax Rate: The official rate set by the government.  The U.S. federal tax rate for large corporations is currently 35%.
  • Effective Tax Rate:  The rate actually owed after allowable deductions.  This includes taxes due to both domestic and foreign governments.  It also includes both the amount due in the current period and the amount the company is allowed to defer and pay later.  This number is reported on a company’s financial statements as “Income Tax Expense” or “Provision for Income Taxes.”
  • Tax Rate Paid: The amount actually paid to the U.S. government as a percentage of pre-tax earnings.
The NerdWallet Corporate Tax Rate Tool reports both Effective Tax Rate & Tax Rate Paid.

 

A typical example:

  • A company earns $100 in pre-tax income.
  • The statutory tax rate in the U.S. is 35%.
  • The company theoretically owes $35 (35% of $100).
  • But the company is allowed to take a $40 deduction for research & development to encourage American investment in scientific innovation.
  • Taxable income decreases to $60 ($100 – $40 = $60)
  • The statutory rate is applied to the taxable income to calculate $21 is owed ($60 x 35% = $21)
  • The effective rate (21%) is calculated as the amount owed after all deductions ($21) divided by the income earned ($100)
  • But the company is allowed to defer paying $11 of those taxes until next year or later due to timing differences between the accounting and tax codes.
  • Current taxes owed decrease to $10 ($21 – $11 = $10)
  • The tax rate paid (10%) is calculated as the amount actually paid to the government this year ($10) divided by the income earned ($100)

Adjustments to income that cause differences between Statutory and Effective Tax Rates

  • Research & Development Credits
  • Foreign earnings tax rate differences/Income already taxes outside the U.S.
  • Tax Exempt Interest
  • Non-controlling interests
  • Domestic Production Activities deduction
  • IRS Settlements
  • Manufacturing deductions
  • Basis differences for asset sales
  • Life insurance tax differences
  • Changes in valuation allowance
  • Goodwill Impairment

Adjustments to income that cause differences between Effective and Actually Paid Tax Rates

  • Timing Differences between the Accounting & Tax Code
    • Income Tax Expense is calculated using Accounting standards which can differ from the official tax code
      • Revenue recognition differences:  The accounting standards recognize income when earned, not when money is collected, but the tax code may not always require payment until cash is in hand.
      • Asset valuation differences: The allowable methods for depreciating a long-lived asset are different for financial reporting (accounting) purposes and tax purposes.
    • These timing differences lead to “deferred” tax assets & liabilities on financial statements (accounting reports) that can come due to taxing authorities many years later or be wiped out by future losses.
  • Income is taxable in a foreign country and exempt from U.S. taxes
    • Country of domicile is often chosen intentionally to minimize taxes owed
    • The U.S. tax rate is higher than almost any country in the world so some U.S. corporations attempt to recognize income in foreign countries with lower tax rates