Insult to Injury

Two years ago, Mercury Interactive Corp. was in rapid ascent. Having boosted revenue by more than 30 percent and signed an agreement with SAP that would create hundreds of new sales opportunities, the business-technology-optimization software company nearly tripled its year-over-year earnings for the fourth quarter of 2004. In response, analysts raised their price targets for Mercury, then trading at $44, to as high as $54.

One year later, Mercury crashed to earth. The Securities and Exchange Commission opened a probe into the company's practices for granting stock options, and Mercury subsequently admitted it had backdated options for the CEO, CFO, and general counsel. Those executives resigned in November 2005. Two months later, Mercury was delisted from Nasdaq, unable to file amended financial statements on time. The company finally restated its earnings for 12 years in July 2006, downward by $566.7 million (later amended to $575 million), and was trading below $30 on the pink sheets before being acquired by Hewlett-Packard last November.

But Mercury's headaches haven't ended. Aside from a possible SEC lawsuit against its directors, the company also faces $44 million in additional tax liabilities. While the cash expense is still being negotiated with the Internal Revenue Service, Mercury estimates it will have to withhold an additional $9.1 million to cover employee stock options that lost their tax-favored status as incentive stock options. To add more complications, Mercury reported that some of its executives had fudged option-exercise dates on several occasions to lower their personal tax bills, which could have resulted in the company underreporting its tax liability, exposing it to more penalties. Meanwhile, executive grants that could no longer be considered performance-based (and therefore tax-deductible) by virtue of being backdated have forced Mercury to give up $57.1 million of future tax breaks in the form of net operating loss (NOL) carryforwards.

Backdated stock options have caused potential earnings woes for more than 100 firms, but the possible tax hit has only begun to be quantified. "The focus right now is on looking at measurement dates and deciding whether to change them. As companies get that figured out and move through the [accounting] restatement, many of them are turning to the tax effects," says Lawrence L. Hoenig, a tax partner in the Palo Alto, California, office of Pillsbury Winthrop Shaw Pittman LLP.

Many more companies may share Mercury's dilemma. Altera, Asyst Technologies, Brocade Communications Systems, and Brooks Automation have all announced multi-million-dollar tax adjustments due to stock options that turned out to be backdated. Other companies, including American Tower, Broadcom, F5 Networks, and McAfee, are still hard at work calculating their liabilities. Recent statistical evidence also suggests that Mercury executives were not alone in misreporting exercise dates, upping the tax exposure for an untold number of companies.

No doubt those efforts will be hastened by the IRS, which has announced it will piggyback on the investigative efforts of the SEC and the Department of Justice through the stock options accounting task force set up by Northern District of California U.S. Attorney Kevin Ryan. While no one knows exactly how much the IRS stands to recoup, "I've got to think you're talking hundreds of millions of dollars," says Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants.

The Biggest Punch
Backdated options can raise corporate tax liabilities for at least three reasons. Two of them follow a similar logic: if options were given to executives as performance-based options or to employees as incentive stock options, they initially qualified for a tax write-off by either the company (in the former case) or employee (in the latter). As Mercury discovered, the tax break disappears if it emerges that the options were actually in the money from the beginning. In such cases, any write-offs must be returned to the IRS, along with interest and potential penalties.

Experts say it's the reclassification of performance-based options to executives that has the power to pack the biggest tax punch. "There are probably millions of dollars in compensation for executives that are deductible or have been deducted, so that's where the major corporate exposure will occur," says Larry Langdon, tax partner in the Chicago office of Mayer, Brown, Rowe & Maw LLP and former commissioner of the IRS's Large and Midsize Business Division. Under the applicable tax statute, Internal Revenue Code 162(m), a firm is allowed to deduct only $1 million in compensation to each of its five most highly compensated officers when that compensation is not performance-based. Given the huge gains that many have made or could make with options, it seems likely that many firms will exceed that limit.

Former United Health Group CEO William W. McGuire, for example, made a profit of about $323 million on options he exercised between 2003 and 2006, all of which would be nondeductible if backdated. Although McGuire agreed to have his $1.5 billion–plus in options repriced to the highest trading price in the years they were granted, UHG could still face another $400 million in taxes before computing interest and penalties, estimates Lehman Brothers tax expert Robert Willens.

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