Corporate tax directors are tasked with both managing cash tax obligations and anticipating changes in the effective tax rate (ETR)—the former being critical to planning for cash flow needs, the latter being critical to forecasting earnings and facilitating investor communications. New accounting guidance will make that second objective more challenging for many companies. Over the course of the next two years, companies will need to institute incremental processes to attempt to forecast the impact of stock option exercises (and other stock-based compensation) on income tax expense. In addition, companies will likely want to consider the impact on the ETR of any planned or potential intercompany asset sales, which may affect their plans around timing of those transactions.
Companies with significant stock-based compensation programs will likely experience greater income tax expense volatility, as well as a meaningful impact on net income and earnings per share. While it’s possible to model the potential effects, the forecast’s accuracy will depend on the precision of the assumptions, which will vary by company. For example, companies would need to estimate the timing of option exercises and award settlements or expirations, the expected payout levels for awards with performance contingencies, the expected changes in stock price, and the level of pretax earnings.
As companies grant new awards or establish new programs, they may consider redesigning them in a way that enhances their ability to more accurately forecast their future effects on income tax expense. For example, the tax consequences of restricted stock units (RSUs) are recorded when the awards vest, not when they are exercised, as is the case with stock options. Issuing RSUs instead of stock options makes the timing of the tax effects more predictable. Unfortunately, other assumptions, in particular the company’s share price, would still need to be estimated.
Companies transfer assets between entities within a consolidated group for both business and tax planning reasons. The pretax effects of those transactions are eliminated in consolidation. Previously, the P&L income tax consequences of those transactions—both the seller’s tax cost and the buyer’s deferred tax benefit—have been deferred and recognized either (a) when the asset is sold to a third party (such as with inventory), or (b) over time as the asset is used (depreciated/amortized) by the related party. Either way, the impact on the effective tax rate—equal to the difference between the buyer’s and seller’s tax rate—tended to be minimal in any given period because the seller’s and the buyer’s tax effects were recognized at the same time or over the same period of time.
Starting in 2018, companies will be required to record the tax effects of intercompany asset sales (other than inventory) on the date of transfer. The seller will record current tax expense for the income on the sale, and the buyer will record a deferred tax benefit for the additional tax basis in the buyer's jurisdiction. Since the transaction has no impact on consolidated pre-tax income, if the buyer’s tax rate is lower than the seller’s, the consolidated company’s effective tax rate in the period of transfer would increase.
Thus, to the extent that the timing of intercompany assets sales is within the company’s control, advanced planning may provide more time to mitigate the anticipated effective tax rate impacts and incorporate those impacts into earnings guidance.