We penalise companies which report a low level of cash flow tax relative to income statement tax as it suggests a company is reporting a larger accounting profit to shareholders than it is to the tax authorities. Arguably, if the tax authorities do not consider certain profit to be of high enough quality to be taxed, shareholders should not attach a demanding valuation to it.
Two types of company are likely to persistently report low levels of cash flow tax, real estate and capital intensive ones. Real estate companies revalue their investment properties and the gains generate a theoretical tax charge through the income statement which results in a deferred tax liability. Meanwhile, capital intensive companies, such as electricity utilities, often depreciate their fixed assets at a faster rate for tax purposes than for accounting purposes. This lowers reported profits to the tax authorities relative to shareholders.
The median average cash flow tax comes in at 96% of income statement tax for our sample of 16,000 companies, which is pretty close to where we would expect it to be. As Figure 77 shows, real estate and electricity utility sectors have some of the lowest levels of cash flow tax relative to income statement tax, at 80-90%, which is once again what we would expect. However, it’s worth bearing in mind that there can be large swings in cash flow tax relative to income statement tax in any given year. As Figure 78 shows, the typical variance is between 40-60% of income statement tax. This volatility is likely due to the lumpy nature of tax payments.
Our accounting screen is set to trigger a red flag when cash flow tax relative to income statement tax exceeds the 80th percentile (i.e. it is very low) relative to GICS industry peers, and/or when there is an abnormally large decrease relative to the normal rate of change amongst GICS industry peers over one and three years. This latter red flag is triggered when the fall in cash flow tax relative to income statement tax exceeds the 80th percentile relative to the change experienced by GICS industry peers between 2010 and 2015.
