Technology giant International Business Machines (NYSE:IBM) produced $13.59 in adjusted earnings per share in 2016, above its guidance calling for EPS of at least $13.50. But a quick look at the income statement reveals that an effective tax rate of just 3.6% in 2016 gave a significant boost to the bottom line. The tax rate in 2015 was a far higher 16.2%, a discrepancy which rightfully raises questions about the quality of IBM's earnings.

Because IBM doesn't back out one-time items from its adjusted earnings, unlike most other companies that report an alternative to GAAP figures, the results can be noisy. There were other items that swung the numbers in the opposite direction, making it dubious to view the low tax rate in isolation.

Image source: International Business Machines.

A messy year

IBM's non-GAAP operating earnings backs out only two items: acquisition-related charges, like amortization of intangibles, and non-operating charges related to its retirement plans. Everything else, including discrete tax items and restructuring charges, remain. This is in contrast to most companies that back out anything one-time in nature, as well as some recurring items like stock-based compensation.

The main reason for IBM's low tax rate in 2016 was a discrete tax benefit booked during the first quarter. IBM filed a lawsuit in 2011 challenging a decision made by the Japanese tax authorities regarding foreign tax losses. IBM won the lawsuit in 2014, and after multiple appeals the issue was put to rest in early 2016. IBM received a refund of previously paid taxes totaling $1 billion along with an additional $200 million of interest.

There were other discrete tax benefits throughout the year, including a $91 million benefit during the third quarter related to foreign tax audit activity. A favorable shift in the geographic distribution of revenue also played a role in bringing the tax rate down.

While these beneficial tax items boosted the bottom line, various one-time charges worked in the other direction. During the first quarter, IBM booked expenses related to its workforce transformation as well as real estate actions and restructuring efforts in Latin America. These items totaled $1.5 billion on a pre-tax basis, essentially cancelling out the largest discrete tax benefit on a post-tax basis.

An increase in income from intellectual property and custom development in 2016, which shows up as a reduction in expenses on the income statement, further muddled IBM's results. All of these moving parts make it difficult for investors to judge the progress of IBM's transformation. A low tax rate acted as a tailwind for IBM in 2016, but other one-time items blunted the impact.

Earnings growth and tax headwinds

IBM expects to grow operating EPS to at least $13.80 in 2017. A tax rate, excluding potential discrete items, of 15% plus or minus 3% is expected for this year, with a wide range due to uncertainty surrounding tax reform in the United States. During IBM's conference call, CFO Martin Schroeter said that all tax scenarios will produce a headwind for the company this year, not surprising given the tailwind in 2016.

The main takeaway: IBM expects to grow per-share earnings in 2017 despite a tax headwind. The guidance implies that pre-tax margin will grow this year, with tax headwinds partially offsetting that growth. That's good news, because pre-tax margin slumped in three of IBM's four reportable segments during the fourth quarter. Stabilizing and then growing those margins will be the strongest sign yet that IBM's transformation is progressing.

Investors shouldn't be too worried about IBM's low tax rate in 2016. Considered in a vacuum, it boosted the bottom line significantly. But considered with all the other one-time items, the net impact was far smaller. Taxes will work against the company this year, but if IBM hits its guidance, improved profitability will still lead to higher earnings.