APB 11 was the accounting profession's initial solution to handling 'book depreciation'
(reflecting the company's estimate of assets' economic life) versus 'tax depreciation' (reflecting tax legislation). Let's look at the impact as it relates to BRK's purchase of Burlington Northern.
Deferred tax adjustments can be, by nature, temporary - or essentially permanent. We can't tell which, though, just by looking at the balance sheet. An example of a temporary adjustment might be fixed asset depreciation, once again, where the total 'expense' under both calculations is the same over the life of the assets, but not by year. Tax depreciation might be far higher in the early years (hence the temporary tax benefit), but book depreciation would be higher later on. The P&L expense (and the tax impact) would be spread out, not shown suddenly in the periods of the tax benefit, only to then have years with no expense (or indicated tax) impact.
Looking at this past year's Burlington Northern 10K, we see that their deferred tax liability was pretty much all related to equipment and other fixed assets. Without seeing more detail, this would suggest that the tax liability might be caused by these timing differences between tax and book depreciation. If so, then the benefit is 'temporary,' at least for those assets.
As long as new equipment purchases continue along at equal or greater levels, the 'mix' of assets for tax depreciation purposes is fairly steady, and Congress allows the same accelerated depreciated treatment, this can be effectively be a 'permanent' benefit. Again though, for individual assets it isn't.
However, the carryover benefit (or lack thereof) of the deferred tax benefit that we think we might have received with the purchase is not automatic. More directly: Berkshire doesn't get that benefit.
Let me explain: if Berkshire had paid book value for Burlington Northern, we could argue that the deferred tax liability allowed us to essentially buy assets on that float. But we paid a premium (reflected in purchase accounting adjustments, including a ramp-up in goodwill). That goodwill 'asset' effectively cranked up our book value and effectively offset the 'benefit' of that deferred tax liability. If that's the case, the folks Berkshire purchased from got the benefit, in the premium-to-book price that was paid.
Going forward from the date of purchase, any increased 'float' benefit (beyond purchase-accounting-adjusted deferred tax liability levels) is Berkshire's. And we're getting it. In 2010, Burlington Northern's statements included a 'normal rate' 35% charge for taxes. Of that, they actually paid 16% to Berkshire for 'real' taxes (about $0.5B) and added 19% ($0.6B) to their deferred taxes. Their effective actual tax rate - again, apparently benefiting mostly fixed asset depreciation timing - is 16%.
http://www.sec.gov/Archives/edgar/data/934612/000093461211000005/d10k.htm
Continuing the thread...
Prior to the Burlington purchase, Berkshire had about $19B in net deferred tax liabilities. About $11B was related to 'unrealized appreciation and cost basis differences' on investments. This has been long-running, of course, and controllable from our end.
Berkshire also had $8B of deferred liabilities related to fixed assets. This most likely was where we got a tax benefit from accelerated depreciation on assets. We purchased the the assets, got an early tax benefit (relative to the economic life of those assets) and were ahead of the game in terms of cash flow. We could use that cash - the tax savings from that faster, allowable depreciation or from our management of investments so as to minimize investments - for other business purposes, including buying companies.
Our cash flow would have been better than our 'book earnings' for these tax deferrals. We could redeploy that cash.
Now let's consider this from a purchased company perspective. Burlington got some tax benefits from equipment purchases, early on in the equipment's life - before our purchase. Their cash flow benefited from these tax savings back then. They have a 'deferred tax liability' on their books that recognizes that the cash they received was greater than the 'book benefit' - their tax rate times their book depreciation in those years.
When the accelerated tax depreciation on those purchased assets expired (for tax purposes the assets were carried at 'zero', but they still had an economic life - some tangible 'book value') they no longer got the tax benefit of those write-offs - even though they would still be recording (book, not tax) depreciation expense. At that point, they'd tap into that non-cash 'deferred tax liability reserve' and credit income, smoothing out the book impact of the benefit. The reserve itself did not have a cash benefit at that point, it was a vehicle for smoothing out earnings. The cash benefit had already come to the company.
This 'tax reserve' would continually be replenished as the new owner purchased additional qualifying assets. But at the time we purchased Burlington, those tax benefits to cash-flow had already been realized.
In Berkshire's case, we're still using those earlier-year tax savings. In Burlington's case, we bought the company, including the assets. We also recognized that some of those assets - while having an economic life - had already been depreciated for tax purposes. So we kept that 'book' reserve. We'll continue drawing on the reserve for book purposes as we continue to use those (fully tax-depreciated but not yet book-depreciated) assets. But we get no further cash-flow (tax savings) benefit.
Also, since we paid more than book value for those assets, it's hard to argue that we got a fully-depreciated-asset bargain - or funding for our purchase from deferred tax float. We could try to make a case that we priced the previously-obtained-and-now-reserved tax benefit into the purchase price. If we had paid book value (with its baked-in reserve) I might buy into that. But we didn't.
We do get a benefit from new (qualifying) purchases, however. And we continue to get that 'float benefit' from our Berkshire deferred taxes. That's a deferral - a tax savings - that improved our cash flow and that we benefited from directly in real, cash terms. Likewise the benefit from the Burlington 2010 asset purchases.
And slogging onward....
We may conclude then that despite some conventional wisdom, the pre-acquisition portion of the BNSF 'deferred tax liability' has little or no economic benefit for us. That deferred tax liability balance does allow us to show lower indicated taxes on our P&L going forward, but it has no future cash flow benefit, ie, no actual reduction in future taxes or other 'real' benefit. Again, that's the pre-acquisition component.
Post-acquisition it's a different matter. We are already seeing the real cash benefit from Burlington's it's effective tax rate - just under half the corporate benchmark 35% rate - since the acquisition. The tax deferred portion can be reinvested as we like.
So far we’ve been discussing Burlington's deferred tax liability.
On the other hand, Berkshire's deferred tax liability has been valuable and useful, especially the larger and more dependable investment-derived portion (the smaller asset-purchase-derived portion cycles out and must be continually renewed, or it vanishes).
We have been focusing on 'deferred tax liabilities.' But what about the smaller (but still $9 billion) 'deferred tax assets'?
Do Berkshire's and Burlington's deferred tax assets have any value? In the two companies’ 10k's and in our discussion, the references so far have been to net deferred tax liabilities. The $9B asset component is netted there. Are these assets good things, as 'asset' moniker implies, or are these offsets to sometimes-good deferred tax liabilities 'bad?'
Berkshire’s 10K indicates that its deferred tax assets are derived principally from ‘accrued liabilities and other’ – these deferred tax benefits typically arise when there are ‘book’ losses that we haven’t ‘realized’ for tax purposes. The P&L takes the hit, we anticipate the resulting tax reduction, but we don’t get that actual ‘cash benefit’ on our tax returns yet. In Berkshire’s world, that’s not good of course.
Burlington’s much smaller ($1B) pre-acquisition deferred tax benefit, however, does very likely have future ‘cash value’. Burlington booked the expenses and losses in pre-acquisition periods, but they have not yet taken those tax credits on their tax returns. (In order for Burlington to have reported these as it has on its balance sheet, these tax credits have to be usable). This $1B asset that we has a future cash value to Berkshire.
________
Skipping back a second, while Burlington’s actual cash tax rate benefits from its continually replenished accelerated depreciation, non-Burlington Berkshire’s single biggest ‘tax adjustment’ off of the 35% rate is the credit, or reduced tax rate, corporations get on the dividends they receive from companies in which they have more than a 20% interest. This is the ‘dividends received deduction.’
Just as a refresher, corporations pay taxes on the dividends they receive on a scale off of their 35% rate, depending on their percentage of ownership. At under 20% ownership, it’s 70% off ( effectively a 10.5% rate). At 20% to 80%, it’s effectively a 7% rate, and at over 80% ownership there is no tax.
Dividends are still at least double-taxed by the time they get from the company that earned the money to the individual shareholder – they are just not triple-taxed.
For Berkshire, this component was worth 2.5% off its overall tax rate in 2010. Back in 2008 it was worth 5%. While dividends received were up in 2010 from 2008, other (full-tax) components of Berkshire’s non-Burlington income grew much faster.
______________________________________________
So let’s break for a moment and recap what we have so far:
• Self-generated deferred tax liabilities provide float
----• This float is more desirable if it’s long-term or permanent, rather than needing continual regeneration (eg, accelerated depreciation).
----• Unlike insurance premium-derived float, with tax-derived float you have to spend more to get more ‘savings’.
• Acquired deferred tax liabilities typically allow you to show better after-tax earnings than your future tax payments will indicate – but they have no cash-flow value
• Self-generated deferred tax assets basically mean you are owed tax ‘refunds’ that you can’t collect for some time yet
• Acquired deferred tax assets are essentially refund checks that the old owner 'earned,' that will now be coming to you.
___________________________________________
Carrying on....
From Berkshire’s 2010 10K:
“We have not established deferred income taxes with respect to undistributed earnings of certain foreign subsidiaries. Earnings expected to remain reinvested indefinitely were approximately $4.1 billion as of December 31, 2010. Upon distribution as dividends or otherwise, such amounts would be subject to taxation in the U.S. as well as foreign countries. However, U.S. income tax liabilities could be offset, in whole or in part, by tax credits allowable from taxes paid to foreign jurisdictions….”
That also touches on another popular topic these days:
http://michaelservet.blogspot.com/2011/02/us-corporate-taxes.html
If Berkshire brought back Iscar’s earnings to redeploy here, it would presumably have to ante up that additional 10% tax differential. Berkshire, being rational and fairly tax-efficient - and open to further international diversification, anyway - is saying it fully expects to look outside the US for redeployment of those earnings.
That’s fine for Berkshire - we wanted more overseas exposure anyway - but we can easily see where this becomes problematic for companies that already get most of their earnings from overseas subsidiaries. Why look here first for investment opportunities?
Unfortunately, we are the only developed country that has this repatriation tax arrangement.
So why don't we just tax US-owned Iscar at 35% now? For one thing, we’d make it less competitive versus where it was pre-acquisition, and versus its peers in that part of the world. Already, some more aggressive multinationals are looking at their corporate structures to head this off.
The overseas-cash-rich companies listed above - predominantly tech and pharmaceutical companies - fill a fair portion of their product pipelines through acquisitions. The tax structure that we have encourages them to do this elsewhere. Since the recession the US has only been seeing something like 15% of the world's IPO and M&A investment dollars coming here. Look for more overseas M&A activity in these cash-rich companies' business segments. (Repatriation taxes aren’t the only problem in all this, of course.)
But back to deferred tax liabilities: Berkshire hasn't recorded any relative to its foreign business, because it does not anticipate ever reinvesting those earnings here. Interesting.
(reflecting the company's estimate of assets' economic life) versus 'tax depreciation' (reflecting tax legislation). Let's look at the impact as it relates to BRK's purchase of Burlington Northern.
Deferred tax adjustments can be, by nature, temporary - or essentially permanent. We can't tell which, though, just by looking at the balance sheet. An example of a temporary adjustment might be fixed asset depreciation, once again, where the total 'expense' under both calculations is the same over the life of the assets, but not by year. Tax depreciation might be far higher in the early years (hence the temporary tax benefit), but book depreciation would be higher later on. The P&L expense (and the tax impact) would be spread out, not shown suddenly in the periods of the tax benefit, only to then have years with no expense (or indicated tax) impact.
Looking at this past year's Burlington Northern 10K, we see that their deferred tax liability was pretty much all related to equipment and other fixed assets. Without seeing more detail, this would suggest that the tax liability might be caused by these timing differences between tax and book depreciation. If so, then the benefit is 'temporary,' at least for those assets.
As long as new equipment purchases continue along at equal or greater levels, the 'mix' of assets for tax depreciation purposes is fairly steady, and Congress allows the same accelerated depreciated treatment, this can be effectively be a 'permanent' benefit. Again though, for individual assets it isn't.
However, the carryover benefit (or lack thereof) of the deferred tax benefit that we think we might have received with the purchase is not automatic. More directly: Berkshire doesn't get that benefit.
Let me explain: if Berkshire had paid book value for Burlington Northern, we could argue that the deferred tax liability allowed us to essentially buy assets on that float. But we paid a premium (reflected in purchase accounting adjustments, including a ramp-up in goodwill). That goodwill 'asset' effectively cranked up our book value and effectively offset the 'benefit' of that deferred tax liability. If that's the case, the folks Berkshire purchased from got the benefit, in the premium-to-book price that was paid.
Going forward from the date of purchase, any increased 'float' benefit (beyond purchase-accounting-adjusted deferred tax liability levels) is Berkshire's. And we're getting it. In 2010, Burlington Northern's statements included a 'normal rate' 35% charge for taxes. Of that, they actually paid 16% to Berkshire for 'real' taxes (about $0.5B) and added 19% ($0.6B) to their deferred taxes. Their effective actual tax rate - again, apparently benefiting mostly fixed asset depreciation timing - is 16%.
http://www.sec.gov/Archives/edgar/data/934612/000093461211000005/d10k.htm
Continuing the thread...
Prior to the Burlington purchase, Berkshire had about $19B in net deferred tax liabilities. About $11B was related to 'unrealized appreciation and cost basis differences' on investments. This has been long-running, of course, and controllable from our end.
Berkshire also had $8B of deferred liabilities related to fixed assets. This most likely was where we got a tax benefit from accelerated depreciation on assets. We purchased the the assets, got an early tax benefit (relative to the economic life of those assets) and were ahead of the game in terms of cash flow. We could use that cash - the tax savings from that faster, allowable depreciation or from our management of investments so as to minimize investments - for other business purposes, including buying companies.
Our cash flow would have been better than our 'book earnings' for these tax deferrals. We could redeploy that cash.
Now let's consider this from a purchased company perspective. Burlington got some tax benefits from equipment purchases, early on in the equipment's life - before our purchase. Their cash flow benefited from these tax savings back then. They have a 'deferred tax liability' on their books that recognizes that the cash they received was greater than the 'book benefit' - their tax rate times their book depreciation in those years.
When the accelerated tax depreciation on those purchased assets expired (for tax purposes the assets were carried at 'zero', but they still had an economic life - some tangible 'book value') they no longer got the tax benefit of those write-offs - even though they would still be recording (book, not tax) depreciation expense. At that point, they'd tap into that non-cash 'deferred tax liability reserve' and credit income, smoothing out the book impact of the benefit. The reserve itself did not have a cash benefit at that point, it was a vehicle for smoothing out earnings. The cash benefit had already come to the company.
This 'tax reserve' would continually be replenished as the new owner purchased additional qualifying assets. But at the time we purchased Burlington, those tax benefits to cash-flow had already been realized.
In Berkshire's case, we're still using those earlier-year tax savings. In Burlington's case, we bought the company, including the assets. We also recognized that some of those assets - while having an economic life - had already been depreciated for tax purposes. So we kept that 'book' reserve. We'll continue drawing on the reserve for book purposes as we continue to use those (fully tax-depreciated but not yet book-depreciated) assets. But we get no further cash-flow (tax savings) benefit.
Also, since we paid more than book value for those assets, it's hard to argue that we got a fully-depreciated-asset bargain - or funding for our purchase from deferred tax float. We could try to make a case that we priced the previously-obtained-and-now-reserved tax benefit into the purchase price. If we had paid book value (with its baked-in reserve) I might buy into that. But we didn't.
We do get a benefit from new (qualifying) purchases, however. And we continue to get that 'float benefit' from our Berkshire deferred taxes. That's a deferral - a tax savings - that improved our cash flow and that we benefited from directly in real, cash terms. Likewise the benefit from the Burlington 2010 asset purchases.
And slogging onward....
We may conclude then that despite some conventional wisdom, the pre-acquisition portion of the BNSF 'deferred tax liability' has little or no economic benefit for us. That deferred tax liability balance does allow us to show lower indicated taxes on our P&L going forward, but it has no future cash flow benefit, ie, no actual reduction in future taxes or other 'real' benefit. Again, that's the pre-acquisition component.
Post-acquisition it's a different matter. We are already seeing the real cash benefit from Burlington's it's effective tax rate - just under half the corporate benchmark 35% rate - since the acquisition. The tax deferred portion can be reinvested as we like.
So far we’ve been discussing Burlington's deferred tax liability.
On the other hand, Berkshire's deferred tax liability has been valuable and useful, especially the larger and more dependable investment-derived portion (the smaller asset-purchase-derived portion cycles out and must be continually renewed, or it vanishes).
We have been focusing on 'deferred tax liabilities.' But what about the smaller (but still $9 billion) 'deferred tax assets'?
Do Berkshire's and Burlington's deferred tax assets have any value? In the two companies’ 10k's and in our discussion, the references so far have been to net deferred tax liabilities. The $9B asset component is netted there. Are these assets good things, as 'asset' moniker implies, or are these offsets to sometimes-good deferred tax liabilities 'bad?'
Berkshire’s 10K indicates that its deferred tax assets are derived principally from ‘accrued liabilities and other’ – these deferred tax benefits typically arise when there are ‘book’ losses that we haven’t ‘realized’ for tax purposes. The P&L takes the hit, we anticipate the resulting tax reduction, but we don’t get that actual ‘cash benefit’ on our tax returns yet. In Berkshire’s world, that’s not good of course.
Burlington’s much smaller ($1B) pre-acquisition deferred tax benefit, however, does very likely have future ‘cash value’. Burlington booked the expenses and losses in pre-acquisition periods, but they have not yet taken those tax credits on their tax returns. (In order for Burlington to have reported these as it has on its balance sheet, these tax credits have to be usable). This $1B asset that we has a future cash value to Berkshire.
________
Skipping back a second, while Burlington’s actual cash tax rate benefits from its continually replenished accelerated depreciation, non-Burlington Berkshire’s single biggest ‘tax adjustment’ off of the 35% rate is the credit, or reduced tax rate, corporations get on the dividends they receive from companies in which they have more than a 20% interest. This is the ‘dividends received deduction.’
Just as a refresher, corporations pay taxes on the dividends they receive on a scale off of their 35% rate, depending on their percentage of ownership. At under 20% ownership, it’s 70% off ( effectively a 10.5% rate). At 20% to 80%, it’s effectively a 7% rate, and at over 80% ownership there is no tax.
Dividends are still at least double-taxed by the time they get from the company that earned the money to the individual shareholder – they are just not triple-taxed.
For Berkshire, this component was worth 2.5% off its overall tax rate in 2010. Back in 2008 it was worth 5%. While dividends received were up in 2010 from 2008, other (full-tax) components of Berkshire’s non-Burlington income grew much faster.
______________________________________________
So let’s break for a moment and recap what we have so far:
• Self-generated deferred tax liabilities provide float
----• This float is more desirable if it’s long-term or permanent, rather than needing continual regeneration (eg, accelerated depreciation).
----• Unlike insurance premium-derived float, with tax-derived float you have to spend more to get more ‘savings’.
• Acquired deferred tax liabilities typically allow you to show better after-tax earnings than your future tax payments will indicate – but they have no cash-flow value
• Self-generated deferred tax assets basically mean you are owed tax ‘refunds’ that you can’t collect for some time yet
• Acquired deferred tax assets are essentially refund checks that the old owner 'earned,' that will now be coming to you.
___________________________________________
Carrying on....
From Berkshire’s 2010 10K:
“We have not established deferred income taxes with respect to undistributed earnings of certain foreign subsidiaries. Earnings expected to remain reinvested indefinitely were approximately $4.1 billion as of December 31, 2010. Upon distribution as dividends or otherwise, such amounts would be subject to taxation in the U.S. as well as foreign countries. However, U.S. income tax liabilities could be offset, in whole or in part, by tax credits allowable from taxes paid to foreign jurisdictions….”
That also touches on another popular topic these days:
http://michaelservet.blogspot.com/2011/02/us-corporate-taxes.html
If Berkshire brought back Iscar’s earnings to redeploy here, it would presumably have to ante up that additional 10% tax differential. Berkshire, being rational and fairly tax-efficient - and open to further international diversification, anyway - is saying it fully expects to look outside the US for redeployment of those earnings.
That’s fine for Berkshire - we wanted more overseas exposure anyway - but we can easily see where this becomes problematic for companies that already get most of their earnings from overseas subsidiaries. Why look here first for investment opportunities?
Unfortunately, we are the only developed country that has this repatriation tax arrangement.
So why don't we just tax US-owned Iscar at 35% now? For one thing, we’d make it less competitive versus where it was pre-acquisition, and versus its peers in that part of the world. Already, some more aggressive multinationals are looking at their corporate structures to head this off.
The overseas-cash-rich companies listed above - predominantly tech and pharmaceutical companies - fill a fair portion of their product pipelines through acquisitions. The tax structure that we have encourages them to do this elsewhere. Since the recession the US has only been seeing something like 15% of the world's IPO and M&A investment dollars coming here. Look for more overseas M&A activity in these cash-rich companies' business segments. (Repatriation taxes aren’t the only problem in all this, of course.)
But back to deferred tax liabilities: Berkshire hasn't recorded any relative to its foreign business, because it does not anticipate ever reinvesting those earnings here. Interesting.
