Verizon's Deferred Tax Liabilities Too High?

By James S. Granelli

Jan. 20, 2005 12 AM PT

Times Staff Writer

As the nation’s biggest telephone company, Verizon Communications Inc. has wrestled with growing competition from cable operators, a slowdown in its conventional land-line business, costly network upgrades and a weakened stock price.

Now, some Wall Street analysts are questioning the rapidly rising amount of money Verizon could owe Uncle Sam.

For years, Verizon has deferred certain taxes, helping the company’s financial statements look rock solid. Those deferred taxes have grown fivefold in five years to $22.1 billion, the highest in the Dow Jones index of 30 industrial companies.

So when Chairman Ivan G. Seidenberg insists that Verizon enjoys the “strongest balance sheet in company history,” analysts like Daniel Berninger of Tier 1 Research aren’t necessarily persuaded.

“This is going to be a big story this year for a number of companies because they can’t get around paying it off,” said Berninger, who wrote a recent report on Verizon’s tax situation. “The problem is that it’s a manipulation of the balance sheet and a lack of transparency. This is a terrific rock to hide things under.”

He and others wonder whether Verizon’s publicly reported earnings have been too rosy and whether the potential tax bill might drag down future earnings. The deferred liabilities amount to an interest-free government loan, they say, and the company will have to pay it back at some point.

Perhaps so, but probably not in cash and probably not soon, if ever, according to Verizon executives. And the potential tax obligations were amassed at the federal government’s urging, they say, noting that Washington wants companies to invest in equipment and spur the economy.

“Deferred taxes arise out of the normal course of business,” said company spokesman Robert A. Varettoni. Anyway, he added, the liability will remain more or less steady for years.

That’s because a company that is growing and spending money on property, equipment, leases and other assets can depreciate the value of those assets much faster on income tax forms than on public financial statements. The resulting timing difference generates deferred tax liabilities.

Confused?

Welcome to the world of deferred tax liabilities, “one of the most complicated parts of the entire financial statement,” said Jill Lehman, a senior analyst at the Center for Financial Research & Analysis.

Typically, public companies want to show investors that they are making huge profits -- but want to show the Internal Revenue Service that they are barely breaking even so they can reduce their tax bills.

Verizon, for instance, used accelerated depreciation, along with losses from the sale of properties and other tax benefits, to get a refund of $713 million from the IRS in 2003 -- while it reported in public Securities and Exchange Commission statements that it earned $3.1 billion and deferred $2.2 billion in taxes.

That was an unusual year, according to the company. In the previous two years, it paid a total of $1.5 billion in taxes.

Still confused? Here’s one way deferred taxes work.

A company buys a service truck for $20,000. The government, wanting to encourage more capital equipment purchases, create more jobs and invigorate the economy, lets the company deduct a portion of the purchase price from taxable income each year for four years.

Under tax accounting, the company depreciates, say, 75% or $15,000 of the purchase price in two years, giving it more cash and a higher income in those initial years. But in its public filings, it would deduct 25% each year from taxable income, or $10,000 after two years.

At that point, the company has taken more deductions on its tax forms than the truck is worth, creating a deferred tax liability.

Should it then sell the truck for $10,000, it would owe taxes on the $5,000 difference. Should it keep the truck for four years, it would take much less of a tax deduction in the final two years, meaning it would have less of a deduction and pay more in taxes.

After four years, the value on both tax and public filings would be zero, and the company could junk the truck and owe nothing in taxes, or it could sell it and pay taxes on the sale price.

Companies usually don’t write checks to the IRS to pay deferred taxes. Instead, they take fewer deductions on future tax filings and, therefore, pay more taxes then.

And when the value of their properties drops, they can write off the amount as an impairment, creating tax benefits that can be used to reduce deferred taxes.

Although such corporate accounting is normal, what worries some experts is that the aggressive use of deferred taxes can mask actual income.

“Potentially, you may have been overstating [publicly reported] income to shareholders,” said Jim A. Seida, assistant professor of accountancy at University of Notre Dame in Indiana. “There could be legitimate reasons for the differences, but I would want to investigate.”

A large amount of deferred taxes also could mean that future earnings will drop as a company pays more in actual taxes, said Seida, who testified before Congress about how Enron Corp., the bankrupt energy trading firm, abused deferred tax liabilities, tax shelters and other accounting procedures.

Adding to the confusion, the federal government allowed a “bonus” depreciation to spur investments and the sagging economy after the Sept. 11, 2001, terrorist attacks.

The bonus allowed companies to subtract 44% of an asset’s value from income, more than twice the normal amount allowed, in the initial year. The bonus expired at the end of last year.

Verizon has said little in its quarterly and annual SEC filings about its mounting deferred tax liabilities.

By contrast, the company has delved into the paring of its interest-bearing long-term debt, which stood at $37.3 billion at the end of September. Its cash from operations is so huge that it can pay down that debt, spend $12 billion to $13 billion a year on capital equipment and still give hefty dividends to its shareholders.

A big chunk of its deferred tax liabilities -- nearly $10 billion -- arose from depreciation of its wireless licenses. That amount won’t go away unless the company sells its 55% stake in Verizon Wireless, which spokesman Varettoni said was an unlikely event.

The next-biggest block, more than $9 billion, stems from depreciation for improving its network, gear and other properties.

As it builds a new fiber optic network and improves its wireless network, the continued spending will keep generating deferred tax liabilities, the spokesman said.

“In the big picture, this means Verizon has about $22 billion in future tax obligations that may or may not be offset from one year to the next,” Varettoni said.

“Most investors would put this in perspective in light of Verizon’s strong annual cash flow,” which amounted to $22.5 billion in 2003.

Verizon, which serves Southern California’s beach communities, isn’t alone in accumulating large amounts of deferred taxes, but it gets more scrutiny on Wall Street as one of the component companies of the Dow Jones industrial average.

Exxon Mobil Corp., a Dow Jones component with four times the revenue of Verizon, had $19.7 billion in deferred tax liabilities, lower than a year earlier but the second-highest on the index.

Phone and cable companies spend a lot of money to keep up with technology. That, in turn, helps drive deferred taxes.

SBC Communications Inc., also a Dow Jones index member, had $15.9 billion of deferred taxes and $16.5 billion in long-term debt at the end of September.

Cable companies have invested a total of $95 billion in the last eight years to upgrade their networks and offer phone service. Comcast Corp., the largest, has accumulated $26.4 billion in deferred taxes and its long-term debt was $22.1 billion at the end of September.

Looming cable competition led Verizon’s stock on a downturn for 13 straight trading sessions on the New York Stock Exchange before it gained 84 cents Tuesday. Shares dropped $1.03 on Wednesday to $36.65.

Verizon is scheduled to release last year’s financial results next Thursday.

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Tax liabilities on the Dow

Largest reported deferred tax liabilities among the 30 Dow industrials

(In billions)

Verizon $22.1

Exxon Mobil 19.7

SBC 15.9

General Electric 15.7

Altria 13.4

Pfizer 12.0

American Intl. Group 6.6