Criticism of Pfizer Tax Accounting Unwarranted
There has been a great deal of public debate regarding the U.S. corporate tax rate and the impact it has on tax compliance, so-called tax inversions, and economic policy, and inevitably some of this has had strong political coloration. Unfortunately, there appears to still be much confusion, and even misinformation, regarding provisions of tax law, particularly when compounded by lack of understanding of financial reporting rules governing public company annual and quarterly reporting.
A recent Wall Street Journal article (“Pfizer Piles Profits Abroad,” by Richard Rubin, 9 November, page B1) may be adding to the confusion by perhaps inadvertently suggesting that Pfizer engaged in accounting maneuvers to increase its effective tax rate in the U.S., thereby implicating the veracity of Pfizer’s financial reporting.
Under U.S. GAAP (and all other major financial reporting regimes), companies must adhere to accrual accounting principles, which require that revenues and expenses be recognized when earned and incurred, respectively, without regard to when cash is collected or paid. Because tax laws vary from GAAP in many regards, the GAAP financial statements will present taxes appropriately determined on an accrual basis, notwithstanding that actual tax payments may occur in earlier or later periods. This accounting practice, referred to as interperiod tax allocation (also called deferred tax accounting), has been required for many decades and, although somewhat complicated, has been reasonably well understood by analysts, preparers, users, and auditors for generations.
U.S. tax law, as has been widely discussed, imposes tax on U.S. corporations based on worldwide earnings. Credits are provided for foreign taxes paid, but because the U.S. statutory rate, 35%, exceeds that of all other developed nations, even if the taxpayer pays foreign income tax, it will be at a lower rate, and the spread between that rate and the 35% U.S. rate will still be payable to our Treasury.
One special rule is that U.S. income taxes are not imposed on foreign earnings until they are repatriated. As is well known, U.S. corporations, responding to this tax code provision, often keep foreign earnings abroad, for, e.g., reinvestment in foreign operations, thus deferring – but not avoiding – ultimate U.S. tax liability. Under GAAP, however, a deferred tax liability (and corresponding tax expense in the current period) is not recognized (under rules dating from the 1960s) for financial reporting purposes if, and only if, the company expresses its intent to keep those earnings abroad indefinitely.
All of this must be clearly set forth in the company’s financial statements, certified by the independent accountants, although auditing “management intent” is indeed notoriously challenging. (Auditors’ willingness to continue to accept such management representations is contingent on its actions not being materially inconsistent with such expressions of intent, however.)
Pfizer, in common with many other multinational U.S.-based companies, had previously expressed the intent to not repatriate all of its foreign earnings; hence, no U.S. taxes were provided, making its overall, blended effective tax rate, including foreign taxes, significantly lower than the U.S. statutory rate. Again, the financial statement footnotes explain all this, for those willing to wade through such details. Apparently, Pfizer management is now planning to repatriate more of these earnings (and may also be anticipating negative implications of recent tax rules designed to discourage or punish so called “tax inversions,” which Pfizer may now be planning to execute), and accordingly is making less use of the “indefinite reversal” provision. Accordingly, its effective tax rate (appropriately driven by accrual basis tax expense, not by cash payments) has increased.
Finally, the article makes much of the fact that tax expense is greater than actual tax payments. As noted, this is the simple and necessary consequence of using accrual accounting. For the same reason, “sales” does not correspond to cash collected from customers, “cost of sales” does not correspond to cash paid to vendors, and so forth. However, as has long been the rule, the statement of cash flows, a required basic financial statement, does show as a mandated supplementary disclosure the cash actually paid for taxes in the period, which can readily be compared to tax expense on the income statement.
Thus, Pfizer’s 2014 annual report on Form 10-K shows that its effective tax rate on continuing operations was 25.5% in 2014 (2013: 27.4%; 2012: 19.8%), with actual expense of $3.12 billion (2013: $4.3 billion; 2012: $2.2 billion), and its cash flow statement reveals that cash paid during the period for income taxes for 2014 was $2.1 billion (2013: $2.9 billion; 2012: $2.4 billion).
Note 5 to Pfizer’s 2014 financial report clearly explains the application of the indefinite reversal criteria, stating that of total tax expense of $3.12 billion, fully $2.2 billion was provided on foreign earnings not repatriated but to which the indefinite reversal criterion could no longer be applied.
The tone of the Wall Street Journal article clearly is accusatory in regard to Pfizer tax accounting, but the truth is that Pfizer is seemingly being managed prudently in the face of disincentives in the U.S. tax code for repatriation; its financial statements fully explain its actions and the accounting therefor; and there is no hint of any accounting impropriety here. This putative scandal is a non-event.