April 16, 2007

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Tech Titans' Tax Picture
Is Clouded by Options

Many of the biggest and most profitable technology companies, including Yahoo Inc. and Google Inc., are paying little or no corporate income tax, according to an analysis of recently filed annual reports.

Yet the low tax rates -- which stem largely from favorable corporate-tax treatment long given to employee stock options and restricted stock -- aren't clearly shown in financial statements filed to shareholders, which often indicate the companies are paying far greater sums to tax authorities.

The companies aren't doing anything wrong. The issue stems partly from an accounting oddity that wasn't fully addressed in the overhaul of stock-options accounting that took effect last year.

Yahoo, for example, said in its annual 10-K report filed with the Securities and Exchange Commission in February that its "provision for income taxes" last year was 42% of its $1.1 billion in pretax profits. But in reality, Yahoo likely won't end up owing any income taxes from last year's earnings, according to an analysis by The Wall Street Journal.

The government isn't losing much, if anything, because of the option-related tax benefits enjoyed by these companies. Employees who exercise stock options must include the gains as income they report to tax authorities. So, to a large degree, the tax burden is being shifted from companies to executives and other employees -- although the government may still lose out because some individuals owe taxes at rates lower than the 35% statutory levy applied to big companies.

Still, the gap between some companies' reported and actual tax rates shows stock-option accounting remains an area for potential investor confusion. The discrepancy also raises some questions, including whether the revamping of stock-options accounting practices went far enough, and whether shareholders are being given meaningful information about the true profitability of companies that issue lots of options.

The amount shown as a tax expense on some companies' financial statements includes a large portion related to options that "is never ever going to be paid; it's not an expense by any stretch of the imagination," said Albert Meyer, a former accounting professor and now president of Bastiat Capital, a Dallas investment-advisory firm. "I cannot find in accounting theory any reason for it -- other than it fulfills the function of creating the impression these companies are paying their taxes."

A Yahoo spokeswoman said the company provides investors tax information in its annual report, and gives additional information about cash paid to the government for taxes in its quarterly earnings calls.

The recently filed annual reports covering 2006 results are the first disclosed since the new rules took effect, and show that the tax gap due to benefits from stock-based pay options is still sizable for some companies.

Stock options, a form of compensation for many companies, give employees the right to buy shares at a preset "strike" price. For years, accounting regulators treated options as though they were essentially free, permitting companies to dole them out liberally, generally with no hit to their bottom lines -- and to get a tax deduction in the process.

That changed last year, when new rules forced companies to estimate the long-term value of an option, and to deduct that amount from its income in its financial reporting over the period the options become exercisable.

But when it comes to tax returns, for most options a company has to wait until the option is actually exercised by the employee -- often years later -- at which point it deducts the difference between the exercise price and the current stock price. For example, if an employee exercises the option with a strike price of $40, and the stock is trading at $60, the company deducts $20 from its return. In effect, the Internal Revenue Service counts the $20 as compensation for the employee, a deductible expense.

In their annual reports, companies disclose a "tax provision," which is the amount they accrue to pay expected tax bills. But because of the accounting quirk, companies include an amount they never actually pay -- the tax-return benefit they receive from options exercised by their employees. The result for big issuers of options with rising share prices is a tax provision that can overstate the company's true tax obligation.

For instance, in a news release announcing 2006 earnings, Google said it had an "effective tax rate" of 23%. But Google's stock price helped generate a $611 million tax benefit from restricted stock that vested, as well as options exercised last year -- which cut its actual effective tax rate to about 8.8%, according to a Journal estimate.

The problem with this discrepancy, critics say, is shareholders may not be getting information about Google's true profitability. Is the tech giant more profitable than it might seem, because it owes less in taxes than its income statement would indicate? Or is it less profitable, because Google is giving away much of its income to its own employees in the form of stock-option gains that aren't fully reflected on its income statement? Google declined to comment.

The Journal calculated adjusted effective tax rates by subtracting the tax benefit related to stock-based pay from a company's tax provision.

While that benefit is presented in a company's statement of cash flows -- and sometimes in its tax footnotes -- it generally isn't clear that it effectively reduces the company's reported taxes.

The Journal methodology, reviewed by three accounting experts, can lead to results that are different from the actual cash taxes paid by a company in a given year for several reasons, including the effect of reserves and payments related to previous tax years.

Stock options aren't the only things driving companies' true tax rates below the statutory 35% rate. For example, many companies attribute earnings to subsidiaries in countries with lower tax rates. For example, Qualcomm Inc., a San Diego wireless technology company, said in its most recent 10-K report that its "effective tax rate" was 22%, primarily because of "foreign earnings" in countries with lower tax rates.

But that doesn't take into account the tax benefits Qualcomm received from stock options exercised by its employees, which drops the tax rate to an estimated 8.3%.

Richard Grannis, Qualcomm's senior vice president and treasurer, said the Journal's analysis "does move toward an estimate of a company's total effective tax obligation for a given year. However, it would not necessarily be predictive of a company's effective cash tax obligation in other years."

To be sure, if the stock price falls for any company that issues options or restricted stock, that could lead to the opposite scenario: A company's true taxes could be higher than its recorded income-tax provision.

The Financial Accounting Standards Board debated the possibility of requiring companies to expense options in ways that would effectively be similar to the way they expense them for tax purposes. But the standards body determined such a rule would violate the principle of not permitting companies to recognize expenses or income related to changes in their own stock prices.

FASB board member Edward Trott said investors are provided with sufficient information, but conceded the accounting body faced a challenge with this issue. Tax laws "create complexities that the accounting system has to deal with," he said. "That's not complexity we create. [But] we've got to struggle with how to get that reported."

Jennifer Blouin, a tax-accounting professor at the University of Pennsylvania's Wharton School, said there should be some better way of alerting investors to the true expected income-tax payments of a company.

Write to Jesse Drucker at jesse.drucker@wsj.com¹