A particularly useful measure for companies operating in jurisdictions that use a progressive tax system, the effective tax rate (ETR) is a measure of the average rate of tax paid on total corporate income. The ETR can also be used as a comparative measure of profitability – for example, average effective tax rates can help determine whether firms in similar circumstances are paying approximately the same level of tax, therefore indicating whether their taxable income is in a similar bracket.
How is it calculated?
A company’s simple ETR, expressed as a percentage, can be calculated using the following formula:
The income tax expense and pre-tax income figures can be found in the company’s income statement, also known as the profit & loss (P&L) statement.
Example
For the 2008 tax year, company XYZ had a provision for income taxes of $385,007,598. The company’s pre-tax income over that period was $1,321,857,606. Using the above formula, we can calculate the company’s ETR to be:
If a company can reduce its ETR, it can thereby increase its net profit margin as less tax expenditure is required. Although the use of aggressive accounting tactics may be employed to do this, this would not necessarily be seen as a good idea. Operationally-based measures should certainly be considered.
Companies may, for example, maximise profits in lower tax countries in order to reduce their taxable income – this is particularly true in jurisdictions where progressive tax systems are in place. See the table for an example of how the US corporate tax rate varies and will change a company’s ETR.
Taxable income ($)
US tax rate
First $50,000
15%
Next $25,000
25%
Next $25,000
34%
Next $235,000
39%
Next $9,665,000
34%
Next $5,000,000
35%
Next $3,333,333
38%
Remaining income
35%
Moving profits may entail setting prices for transactions between subsidiaries, known as ‘transfer pricing’. Tax authorities are well aware that this can be used to move profitability from one country to another so they carefully monitor this aspect.
Another way that companies can look at decreasing their ETR is by ‘shopping around’ for tax concessions. In large countries, such as the United States and China, there may be tax incentives available in certain areas of the country, as individual provinces or states offer incentives to attract companies to operate in their areas. This research would be best done before an operation is set up as a change of location can turn out to be more costly then the potential tax saving.
Tax planning is a complex subject which every international company should consider with the aim of minimising but not evading a fair level of taxation.
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