Net of Tax

Net of tax describes an amount that has been reduced by the income tax effect associated with it. If a gain of $100,000 would increase a company's tax bill by $21,000, the gain is $79,000 net of tax. The phrase is used throughout financial reporting, in investment analysis and in personal finance to show the amount that actually remains after taxes. The general idea of measuring income or returns after tax is covered in the entry on after-tax figures; this entry focuses on how accountants present items net of tax in financial statements.

In financial statements, presenting items net of tax is part of intraperiod tax allocation: the total income tax expense for a period is divided among continuing operations, discontinued operations, other comprehensive income and certain items recorded directly in equity, so that each item is shown with its own tax effect.

The basic formula is:

Here $\text{Pre-tax amount}$ is the gain, loss, income or expense before tax, and $t$ is the applicable tax rate, usually the company's combined federal, state and foreign rate on that kind of item. For a loss, the tax effect is a benefit, so the net-of-tax loss is smaller than the pre-tax loss.

• Discontinued operations: the results of a business segment that has been sold or is held for sale are shown as a single line, net of tax, below income from continuing operations.
• Other comprehensive income: items such as foreign currency translation adjustments, unrealized gains on available-for-sale debt securities and certain pension remeasurements are reported net of tax, or before tax with the total tax shown separately, in the statement of comprehensive income.
• Accumulated other comprehensive income: the balance in equity is carried net of the related deferred taxes.
• Cumulative effect of accounting changes: where a new standard is adopted by adjusting opening retained earnings, the adjustment is shown net of tax.
• Prior period adjustments to correct errors are also recorded net of their tax effect.

A food company with a 25 percent tax rate sells its frozen desserts division during the year. Before the sale, the division made an operating loss of $3,000,000, and the company recognized a pre-tax loss on disposal of $1,000,000. The total pre-tax loss from discontinued operations is $4,000,000. Its tax benefit is $4,000,000 times 0.25, or $1,000,000, so the loss from discontinued operations, net of tax, is $3,000,000. The company reports income from continuing operations of, say, $18,000,000, then a line reading "loss from discontinued operations, net of tax of $1,000,000" of $3,000,000, and net income of $15,000,000. Presenting the discontinued loss net of tax keeps the tax expense on continuing operations consistent with the results it relates to, which helps readers forecast future earnings.

Managers and analysts use net-of-tax figures to compare options on an after-tax basis. Interest on debt is tax-deductible, so the after-tax cost of debt is the interest rate times one minus the tax rate. Capital budgeting uses cash flow net of tax, including the tax savings from depreciation, which is a noncash expense. The relevant rate is usually the marginal tax rate, the rate on the next dollar of income, rather than the average rate.

A common mistake is to apply the statutory rate to items that are taxed differently, such as goodwill impairments that are not deductible, or gains in a country with a different tax rate. Another is to forget that the tax effect of an item may be deferred rather than current; the tax still counts in the net-of-tax figure, but it is recorded through deferred income taxes rather than taxes payable. Readers should check the tax note to see how the company has allocated tax among its reported items.