QUALIPORT
The Qualiport's Rough Guide To Tax

By Maynard Paton (TMFMayn)
February 12, 2004

Corporation Tax is one of the many accounting items investors must evaluate in an annual report. A low taxation charge can unfairly flatter a company's profits, growth rate and valuation.

Effective tax

All UK resident companies are liable to Corporation Tax on income and capital gains. The Corporation Tax liability created during an accounting period is found in the main profit and loss account under the heading 'taxation'. A similar entry is found in the main cash flow statement, which reflects the Corporation Tax paid in the period. An entry will also be found in the 'creditors falling within one year' note, which shows how much Corporation Tax is due to be paid in the next twelve months. All these items have nothing to do with other forms of taxation, such as VAT, PAYE or excise duty.

The most important tax ratio for investors is a company's 'effective' tax rate:

                      Corporation Tax liability
Effective tax rate =  -------------------------
                            Pre-tax profit

When making the calculation, the 'underlying' profit and taxation figures (which strip out the effects of goodwill and exceptional items) ought to be used. The effective tax rate should then be compared to the standard Corporation Tax rate, which currently stands at 30%. If there's a significant divergence (especially if it's much lower), investors need to know why.

There are two principle reasons for 'abnormal' tax rates.

1. Timing differences: This occurs when a company is liable to pay the full rate of tax at some point, but not in the period being reported. Timing differences often involve capital expenditure, whereby capital allowances (determined by the Treasury) are set against profits for Inland Revenue tax calculation purposes, but depreciation (determined by the company) is charged for accounts tax purposes. The difference in the amount of tax calculated in this situation is transferred to the balance sheet as a deferred tax provision.

Note that, under the old SSAP15 regime, companies didn't have to provide for deferred tax if they could show their future capex plans would cause the liability not to crystallise in the foreseeable future. The recent introduction of FRS19 did away with such practices, not least because companies could very well change their expansion plans at a future date.

2. Permanent differences: These include:

Disallowed expenses: Though charged against accounting profits, some costs such as entertainment expenses are not deemed to be an allowable expense by the Revenue.

Overseas income: Profits from foreign subsidiaries are subject to local tax rates, which may differ to that levied in the UK.

Losses: Companies can carry losses back for a limited time and recover tax already paid or, alternatively, can carry losses forward indefinitely to offset against future profits.

Capital gains: A company may have made a taxable profit from the sale of an asset, but indexation reduces the tax liability.

Loans: Gains and losses on loans are not normally included in Corporation Tax calculations.

Watch list tax

This table lists the effective tax rates of all the shares on the Qualiport's watch list:              

With a 19% rate, it's worth highlighting Renishaw's accounting tax notes:

The intricacies all boil down to this:

The $64,000 question, though, is whether Renishaw's low rate can continue. With the (seemingly) ongoing benefit of lower overseas tax rates, plus the new research and development credit, the answer appears to be a tentative 'probably'. That said, there's a lot going on with Renishaw's tax bill, especially the somewhat mysterious 'other timing differences', all of which management don't really explain. Also worth considering is that, with a full 30% charge, Renishaw's earnings would have been 13% lower in 2003.

Half-year results

Renishaw published its interim results last month. Though sales improved 14% to £59m, operating profits edged just 4% higher to £5.6m, of which £1.2m was deemed a 'currency profit'. Earnings inched 2% higher to 7.6p per share (aided by a 17% tax rate), while the interim dividend was lifted 5% to 5.61p per share.

On the assumptions earnings are reflected as free cash and the low tax regime will continue, Renishaw produced free cash of 17.4p per share during the twelve months to December 2003. Taking into account a 40p per share cash pile, demanding a 7.5% free cash flow yield requires a 273p entry price. Valuing the company on a recovery basis, a 338p entry price is needed. Either way, with Renishaw's shares actually trading at 500p, there's no obvious value even with the low tax rate.

Where next? Renishaw Results 2003

The author owns shares in Carpetright, DFS Furniture, Games Workshop, GlaxoSmithKline, Halma, Johnston Press and London Stock Exchange.