As public debate over taxation of big business gathers steam, Teva Pharmaceutical Industries' financial statements reveal the meager taxes paid in Israel. Despite the country's statutory 24% tax rate for 2011, Teva reported an effective tax rate of merely 4%.
The tax expense shown on an income statement would theoretically represent pre-tax income multiplied by the statutory tax rate. However, there are often timing differences relating to recognition of certain revenues and expenses for tax purposes, but accounting rules require these to be covered by deferred taxes such that there is full reconciliation between theoretical and effective tax rates, particularly in the case of a profitable company.
When differences between theoretical and effective rates nevertheless occur, like when certain sales or income is tax exempt, accounting rules require companies to explain these in the note on tax expense in their annual financial statements.
Perpetual tax deferrals
Teva also operates through subsidiaries in Israel and abroad, and to get a grasp of its special circumstances, it is important to first become familiar with the group's tax environment. Most of the Israeli parent company's industrial projects, and some for its Israeli subsidiaries, have been granted the status of "approved enterprise" in the framework of Israel's Law for the Encouragement of Capital Investments. Group companies have chosen an alternate track - effectively forfeiting government grants in favor of tax exemptions on undistributed profits - for the great majority of their approved enterprises.
Tax exemptions on undistributed profits are granted for a limited period of between two and 10 years, depending on the plant's location. In the case of dividend distributions from tax-exempt profits, however, group companies are required to pay tax at the rate for approved enterprises on the underlying income. Ostensibly this is merely a tax deferral, but perpetual deferral is effectively equivalent to an exemption.
One particular exception to all this is an approved enterprise of one of Teva's Israeli subsidiaries that enjoys special "strategic investment track" benefits. The profits from this track, including dividends paid from it, are tax exempt in Israel throughout the benefits period.
Teva is deemed a foreign investment company and, as such, is entitled to further reductions in its tax rate beyond those normally applicable to approved enterprises. This is a function of the percentage of foreign ownership in any given year, and the tax rate ranges from 10% - for foreign ownership exceeding 90% - to 25% when foreign ownership in higher than 49%. This has particular significa
nce on taxes to which Teva is subject when distributing profits from approved enterprise on the alternative track.
It is noteworthy that Teva, whose shares are held by many Israelis and are even dubbed "the nation's stock," is inevitably in the lowest (10% ) tax bracket. Clearly the appropriate benchmark for comparing the company's effective tax rate, however, shouldn't be Israel's statutory rate but a much lower rate. Nonetheless, Teva's profits not arising from approved enterprises are subject to the usual rate - 24% in 2011 - but these constitute a negligible part of the group's overall profits.
In 2011 17% out of the 20% gap between the statutory tax rate and Teva's effective rate arose from tax benefits in Israel for Teva itself and its local subsidiaries. Moreover, not including the 2% of effective tax contributed by provisions for tax contingencies, the effective rate reflecting actual tax was a mere 2% paid into state coffers at this point.
Tax Authority issued warrants which Teva disputes
Although presumably tax deferrals, in this case deferred taxes aren't being created to complement current tax expense and reconcile this to theoretical tax. The reason is that Teva, as permitted by accounting rules, doesn't create deferred tax liabilities for taxes payable in the event of dividend distributions, arguing that it permanently intends to invest its accumulated earnings rather than distribute them as dividends.
Teva consequently reports that, should such dividends be distributed, they would be subject to an additional 15% tax payment - to be reflected in its tax expense for that period - and that this could have a substantial effect on its capital equity. Accounting rules are lenient in this respect, adopting the approach that dividend distributions are within the company's control, but this should be taken into account when analyzing the operations of a company like Teva, including its potential resulting tax liability.
In Teva's case, the issue of transferring funds from undistributed profits to foreign investment has also been a bone of contention with Israel's tax authorities. Teva reports that following its tax liability audit for 2005 and 2006, the Israel Tax Authority issued warrants totaling $750 million disputed by the company. These partly reflected the authority's disapproval of the use of tax-exempt approved enterprise profits for foreign investment without payment of corporate tax.
According to media reports, the issue revolves around the enormous amount paid by Teva in 2005 to acquire Ivax Corporation, which the taxman views as a dividend payment from exempt earnings. In any case, Teva's balance of provisions for tax contingencies totaled $900 million at the end of 2011 and is included in its effective tax rate calculation.
Most of Teva's consolidated pretax profits derive from the company itself and its Israeli subsidiaries - 70% in the past three years. Meanwhile its foreign subsidiaries are taxed according to rates in their home countries, with several enjoying tax benefits there. But it's hard to ignore the fact that the proportion of tax attributable to Israel is consistently and significantly lower than the share of pretax earnings originating in Israel out of the group's overall profits.
The Israeli portion of Teva's consolidated pretax income in 2011 was 69% but only 56% of its tax expense went to Israel's treasury, although a more precise comparison differentiating between various profits sources - like financing activities - can't be performed on the basis of financial statements alone. The higher rate of tax paid by Teva abroad continues to be reflected in its first quarter statements and is even greater than in 2011, mainly because of changes in the company's product and geographical mix.
A true dilemma
It seems there is no better example for the intricate consequences of the Encouragement of Capital Investments Law than Teva, a symbol of Israeli pride but one that barely contributes to the state's coffers: Implications not only reflecting the high price of attracting capital investment in Israel but also the potential for aberrations. Teva's exploitation of profits generated in Israel, that until now remain untaxed, to serially gobble up businesses overseas over the years could undermine the rationale behind stimulating local investment.
The dilemma might be solved by amendment to the aforementioned law which will set reduced mandatory tax rates for future enterprises regardless of dividend payments. The amendment will also completely abolish the tax exempt "strategic investment track."
In any case, with all due respect to Zionism, it must be noted that a company that is global both in operations and ownership, like Teva, will always strive to minimize taxes based on offers received throughout the world, and this could lead to operations leaving Israel: That is the true dilemma for Israel's decision makers.
The writer is an AFRS consultant and deputy dean (accounting ) of the Arison School of Business, Interdisciplinary Center (IDC ) Herzliya.
