Human Capital & Careers

Insult to Injury

Already bruised by backdating scandals, companies may face an unexpected tax hit as well.
Alix StuartJanuary 4, 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

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