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Insult to Injury

Already bruised by backdating scandals, companies may face an unexpected tax hit as well.
Alix Stuart, CFO Magazine
January 10, 2007

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.

The third reason why backdated options can increase taxes is IRC Section 409A. Enacted in 2004 to deal with various perceived deferred-compensation abuses, the statute requires that if options are granted at a discount, the gain must be recognized when the options vest, even if they are never exercised.

Section 409A "has a broad reach," says Pillsbury Winthrop's Hoenig, and it carries a big sting: back taxes and interest, plus a standard 20 percent penalty. Although the IRS is still formulating guidance, the income and recognition and penalty rules will generally apply to discounted options granted to any employee, executive or not, if they vested after December 31, 2004, or were not exercised by December 31, 2005.

There are ways to fix the 409A problem, however. One cure is to replace discounted options with ones having a grant price equal to the fair-market value as of the actual grant date, thus raising the strike price in most cases. To keep employee morale up, many companies are offering employees cash to compensate for the potential lost earnings (which will also be taxable). A second way to work around 409A is to cancel the options entirely and simply give employees the current Black-Scholes value in cash.

Some companies are using a hybrid approach. Brocade, for example, launched a tender offer for shares granted after August 14, 2003, in order to amend them to fair-market value, increasing strike prices and giving employees the difference in cash. Shares granted before that date were canceled in exchange for a cash payment of the current Black-Scholes value of the option. Cash payments to true up amended shares totaled $3.3 million, according to the company's September 10- Q, and the additional noncash stock-based compensation expense associated with the tender offer was $2.1 million.

Looking for Loopholes
How these taxing prospects will play out for other companies is hard to determine. Besides the administrative effort involved in figuring out if and how to change grant dates, another reason it's taking companies so long to calculate tax adjustments is that they're looking for loopholes. "There are a number of exceptions that apply under some very complex grandfather rules, so many companies are asking their accountants and lawyers to take a look at those," says Hoenig. For example, some of the discounted option grants may be grandfathered into immunity from 162(m) if the company didn't change its stock-option plan for several years after going public.

Also uncertain is the extent of the tax penalties a company may face. With the IRS relatively new to the game of imposing fines, it will have to "come up with reasonable rules for how and when to apply them," says Langdon.

That could be a complex calculation. "There's a small minority of cases where clearly inappropriate behavior occurred and CEOs and CFOs have been asked to leave," Langdon says. "But I suspect that for an overwhelming majority, it will be the case of, 'Well, maybe we could have done it better, but there was no intention of defrauding.'" Plus, it could be two to four years until the IRS finishes its audits, at which point companies will still be able to appeal.

So far, the tax-adjustment figures that companies have reported haven't hit their cash-flow statements in a huge way. The fallout from 162(m), the $1 million cap on deductible compensation, appears minimal, perhaps because many companies (including Mercury) had previous operating losses that cushioned their cash stash. Meanwhile, Brocade and Asyst say that 162(m) had no material impact on their tax bills after correcting their stock-option dates. Lawyers also say they have seen few situations in which companies could prove that executives fudged exercise dates, and that the impact would be ambiguous in any case.

Some companies have even reported tax benefits. These arise when incentive options lose their tax-favored status, increasing both an employee's taxable income and a company's tax deduction. Brooks Automation, for example, saw a $1.8 million tax benefit, while Altera expects to reap $12.5 million. A $1.6 million tax benefit in 2002 helped offset a $4.9 million tax expense in 2003 for Asyst, for a net $3.3 million noncash tax expense.

Regardless of the tax implications, cleaning up filings to properly account for options grants is expensive. At the high end, Mercury said it had spent about $70 million on its investigation and restatement. Others have it a bit easier. Altera had racked up a $10 million bill as of late October, while Asyst estimates the cost at $4 million to $5 million. The costs vary widely depending on how many years of data and how many options are involved, says Tony Lopez, senior managing director, forensic and litigation consulting, at FTI Consulting, which is currently working on some 40 backdating investigations. And some may never be known. "Companies would rather not disclose the cost, because they know plaintiff's attorneys will be looking for damages," and these may be among the few cash charges involved, he says.

Whatever the outcome, companies should not expect the IRS to let them off lightly. "I think they'll be aggressive," says Langdon, a prediction shored up by IRS Commissioner Mark Everson's recent speeches promising to crack down on greedy executives. The IRS could even seek to extend its statutes of limitation beyond the standard three-year time frame in order to allow more investigations, says the AICPA's Ochsenschlager. "Companies really do have to bare their souls on this one," he says.

Alix Nyberg Stuart is senior writer at CFO.

Early Returns
New tax bills for six companies that backdated stock options.
Company Tax effect of backdated options
Altera $12.4 million tax benefit
Asyst Technologies Net $3.3 million in additional noncash tax liabilities, given tax benefit of $1.6 million in FY 2002 and an income tax expense of $4.9 million in FY 2003.
Brocade Communications Systems Cash payments to true up amended shares totaled $3.3 million; additional noncash expense associated with the tender offer was $2.1 million.
Brooks Automation $1.8 million tax benefit
Mercury Interactive $44 million in additional tax liabilities, plus $57.1 million reduction in NOLs
Nvidia $72.2 million income tax benefit; $9.4 million payroll tax charge
Source: The companies