The Trouble with Tax Accounting: A Primer on Tax Accounting for Stock Plans and DTA Balances

Transcription

1 The Trouble with Tax Accounting: A Primer on Tax Accounting for Stock Plans and DTA Balances Elizabeth Dodge, CEP, Stock & Option Solutions Lori Ellingboe, Pivotal Software, Inc Ellie Kehmeier, Steele Consulting, LLP

2 The Trouble with Tax Accounting: Today s Topics What Trouble? General Concepts & Tax Terminology Common Complications How to Be a Star What the Tax Department Needs From You DTA Balance Proof Appendix ASC 718 Tax Accounting Cites -2-

3 What Trouble? Hugely complicated calculations And this is just one of many tax accounting issues that Tax deals with Systems don t meet many of Tax Department s needs A lot of information needs to be cobbled together Special circumstances cause more complications, and there are lots of special circumstances! Need collaboration across specialized knowledge areas Generally speaking, Tax doesn t understand stock admin and vice versa -3-

4 General Concepts Deferred Tax Asset Why Bother? Expense recorded in P&L over vesting or service period Tax deduction is expected in the future, if at all Non-Qualified Option = Tax Deduction at Exercise Restricted Stock & RSUs = Tax Deduction at Release Deferred Tax Asset ( DTA ) Accounting way of anticipating future tax deduction (matching concept) Booked as expense is recognized (i.e. over vesting or service period) instead of being booked all at once when event actually occurs DTA = Expense x statutory corporate tax rate DTA not booked for ISO/ESPP, other awards (more later) -4-

5 General Concepts Tax Deduction almost never matches GAAP expense ASC 718 Requires that: DTA be reconciled at time of tax settlement (exercise, release, expiration) Excess tax benefit or windfall if tax deduction > expense Tax deficiency or shortfall if tax deduction < expense Windfalls be recognized as an addition to paid-in capital, NOT as a reduction in income tax expense Shortfalls be recognized as income tax expense Unless there are excess tax benefits from prior awards in paid-in capital to which it can be offset (run it through the FAS 123 APIC pool) -5-

6 General Concepts Translation Deferred Tax Asset (that you booked as expense was recognized) does not equal Actual Tax Deduction If windfall/excess = increase APIC Pool If shortfall/deficiency = Reduction to APIC pool (if sufficient) or Potential tax expense (if APIC pool not available to offset) Actual Tax Benefit DTA = Positive = Excess = Negative = Deficiency -6-

7 Other Tax Terminology Book Expense What was actually booked /recognized in the financials Aka book cost, GAAP expense, fair value Tax-effected i.e. tax-affected if you re the grammar police With corporate tax rate applied Effective Tax Rate (ETR) Total tax expense divided by company s net income before taxes NOT the rate you use when running Diluted EPS report or other tax reports Use combined statutory tax rate for these (typically US + state average) Suggest using 100% when running APIC / Tax Accounting Reports -7-

8 Non-Qualified Option - Excess Example NQ granted for 1,000 shares, exercise price = $30 Expense = $10 per share (total = $10,000) Deferred tax asset = 40% tax rate x $10,000 = $4,000 Shares exercised when market value = $42 Tax Deduction = 1,000 shares x $12 gain per share = $12,000 Actual Tax Benefit = $12,000 x 40% tax rate = $4,800 Actual Tax Benefit Deferred Tax Asset Result $4,800 $4,000 Excess (Windfall) = $800 (Increase APIC pool) -8-

9 Non-Qualified Option - Shortfall Example NQ granted for 1,000 shares, exercise price = $30 Expense = $10 per share (total = $10,000) Deferred tax asset = 40% tax rate x $10,000 = $4,000 Shares exercised when market value = $36 Tax Deduction = 1,000 shares x $6 gain per share = $6,000 Actual Tax Benefit = $6,000 x 40% tax rate = $2,400 Actual Tax Benefit Deferred Tax Asset Result $2,400 $4,000 Shortfall (Deficiency) = $1,600 (Reduction to APIC pool or increase to Income Tax Expense) -9-

10 Non-Qualified Option Cancel/Expiration Example Same facts as shortfall example Larger shortfall (deficiency) because NO tax benefit Vested shares expire unexercised Tax Deduction = $0 Actual Tax Benefit = $0 Actual Tax Benefit Deferred Tax Asset Result $0 $4,000 Shortfall = $4,000 (Reduction to APIC pool or increase to Income Tax Expense) -10-

11 Journal Entry Oversimplification Very generally speaking, when the tax deduction occurs, you will make three entries to your General Ledger: Decrease taxes payable Company receives a tax deduction Reverse previously booked DTA (if any) No longer anticipated DTA should be reversed Post the difference (the plug ) to APIC or to Income Tax Expense Increase APIC for windfalls (credit to APIC) Decrease APIC for shortfalls (debit to APIC) -11-

12 Common Complications Tracking your APIC Pool Options that straddle the adoption date Companies that were private at adoption ISO/ESPP treatment Net Operating Loss (NOL) Situations International and Mobile Employees -12-

13 Tracking the APIC Pool From Initial Adoption Historic FAS 123R APIC pools Long-form (aka Regular ) vs. Shortcut (aka Simplified ) method elected at adoption Still has continuing impact until all pre-adoption grants expire Under Shortcut method, windfall is greater for options fully vested at adoption Similar impact for diluted EPS calculation Hopefully your system will recognize different methods Beware if non-public company at adoption (more later) -13-

14 Tracking the APIC Pool Two ways to track Can be tracked offline (spreadsheet, etc.) Journal entry to APIC general ledger account will be entire offsetting entry or plug Can be tracked as sub-account to General APIC in your general ledger Journal entry to General APIC will be just the difference between FAS 123 APIC (calculated with total expense) and APIC (calculated with recognized expense only) You will have entries to APIC that are not related to windfalls/shortfalls, so need to track General APIC separately from APIC Pool -14-

15 Companies that were Private at Adoption Vast majority of private companies adopted using the prospective method (aka prospective-only ) Under this method, options granted prior to adoption continue to be accounted for under pre-123r guidance (i.e. Opinion 25) Typically no expense recorded even after adoption, unless granted at a discount or modified post-adoption No impact on FAS 123R APIC Pool These companies had a zero APIC Pool at adoption, by definition So concept of Short-cut vs. Long-form method for APIC Pool is inapplicable Only grants made on or after adoption impact the APIC Pool -15-

16 Straddle Option Issue ASC 718 Adoption Date Grant Date Vest Date Recognized Expense Used for DTA Journal entry to reverse DTA Full (Fair Value) Expense (Hypothetical DTA) Used for APIC Pool Calculation -16-

17 ISOs/ESPPs ISOs and ESPPs are so-called statutory options, because they are governed by special rules in the tax law Employers only get a tax deduction if there is a disqualifying disposition i.e. a sale or disposition of the shares within one year of exercise or two years of grant Companies are not allowed to anticipate a tax deduction - and not allowed to set up a DTA Book expense for ISOs/ESPPs is added back when calculating Taxable Income Increases ETR bad! When there is a disqualifying disposition, the lesser of the book expense or the tax deduction is recorded as a tax benefit in the P&L Decreases ETR good! Any windfall is recorded in APIC, similar to NSOs No real shortfalls, since no DTA -17-

18 ISOs/ESPPs - Excess Example If the actual tax benefit is greater than the estimated tax benefit, excess treated as additional paid-in capital and estimated tax benefit reduces tax expense, but only in year of disqualifying disposition If actual > estimated Windfall (Excess tax benefit) = APIC Estimated tax benefit = reduces tax expense Example Actual $4,800 > estimated $4,000 $800 = APIC AND $4,000 reduction to tax expense Actual Tax Benefit Estimated Tax Benefit Result $4,800 $4,000 Windfall = $800 (Increase APIC pool AND $4,000 reduction to Tax Expense) -18-

19 ISOs/ESPPs Deficiency Example No DTA booked, so no real deficiency If actual tax benefit <= estimated tax benefit, no additional paid-in capital and the actual tax benefit reduces tax expense If actual < estimated APIC = $0 Actual tax benefit = reduces tax expense Example Actual $3,000 < estimated $4,000 $0 = APIC AND $3,000 reduction to tax expense Actual Tax Benefit Estimated Tax Benefit Result $3,000 $4,000 Shortfall = $1,000 ($0 APIC AND $3,000 Reduction to Tax Expense) -19-

20 Net Operating Losses ( NOLs ) Companies with NOLs or NOL carryovers face additional challenges Company may have a Valuation Allowance ( VA ) offsetting DTAs If so, shortfalls disappear i.e. they are netted with the VA and don t reduce APIC And windfalls may not get recorded because they haven t yet been realized (i.e. haven t reduced taxes payable) For diluted EPS calculations, VA generally means that windfalls and shortfalls won t be considered, so reports may need to be changed to use tax rate of zero Realization concept adds enormous complexity to tax accounting, but that s mostly for the Tax folks to worry about Tax will need to track the amount of gross excess benefits that make up the NOL carryover -20-

21 International Options Many complications to keep tax folks busy Record expected benefits (i.e. DTA) and actual tax benefits only for countries in which you anticipate a local deduction Using local country corporate tax rate Only US & UK allow deductions without company bearing cost of equity comp Recharge agreements used to allow deductions in many other countries careful analysis required Globally mobile employees Allocate income, tax deduction and DTA based on where income is deemed earned -21-

22 How to be a (Tax) Star Stock Administrator Tax has a goal in mind, but doesn t know how to get there not sure what the system can provide Star stock admin will work with Tax to help them reach their goals most efficiently Understand basic tax accounting concepts so you can work collaboratively to run the reports Tax needs Congratulations on attending this session you re on your way to being a star! Be able to ask questions such as: Do you want ISOs isolated? Do you want to subtotal by country or by type of award, both or... Do you want separate reports by country or by type of award? Do you need a report for ISO / ESPP disqualifying dispositions and fair values to determine tax benefit? -22-

23 What Tax Dept Needs from You: Current Period Expense for DTA set-up Typically expense is net of forfeiture estimates and actual forfeiture adjustments (this is appropriate) By type of award and jurisdiction typically don t need grant by grant Amount of expense for ISOs, ESPP, 162(m) limited awards Won t be used to set up DTA, but necessary for tax expense calculation ( bad perm ) Any out-of-system expense for modifications, accelerations, etc. -23-

24 What Tax Dept Needs from You: Current period settlements for DTA reversals Need both actual tax deduction and related book expense to calculate windfall or shortfall Hopefully your system will perform this calculation Need amounts grant by grant Group by type and jurisdiction or run separate reports Include ISOs & ESPP disqualifying dispositions Many ESPP reports don t include expense needed for calculations, so need to add fair value for each grant date/purchase date combination Typical reports APIC report, tax benefit report Exercise report, release report, etc. -24-

25 What Tax Dept Needs from You: Actual Tax Deduction for Corporate Tax Returns Typically same amount as income reported on W-2 or MISC for non-employees APIC Report, Exercise Report, Release Report ESPP/ISO Disqualifying dispositions Work with Tax Dept to make sure data is relevant Eg. Foreign branches, check-the-box subs Individuals with awards limited under 162(m) -25-

26 What Tax Dept Needs from You: Gross Windfalls for Cash Flow Statement Reclass Windfalls must be reclassified from Operating Cash Flows to Financing Cash Flows Filter APIC Pool calculations just for excess benefits I.e. Amount should not be netted with shortfalls Amount should be calculated under ASC 718 provisions i.e. take into account straddle options, method of calculating opening APIC Pool Actually, this may be SEC Reporting, not Tax asking for this Frequently see this not getting calculated correctly If same amount as the APIC line in the Rollforward of Shareholder s Equity, it s usually wrong -26-

27 DTA BALANCE PROOF (AKA TROUBLE IN PARADISE ) -27-

28 Proving Out Your ASC 718 DTA Balance Most companies track ASC 718 DTA balance using rollforward approach Beginning balance plus current year book expense, minus current year Concern is that small yearly mistakes can build up in DTA balance Increasingly, attest firms are asking companies to prove out their DTA on a balance-sheet or snap-shot basis Even for companies with full valuation allowance covering their DTA balance Conceptually easy, practically difficult -28-

29 DTA Balance Sheet Proof in 3 Easy Steps 1. Obtain inventory of outstanding awards at report date Exclude awards where no deduction is anticipated ISOs, ESPPs, Overseas grants where no deduction is allowed 162(m) limited awards 2. Determine cumulative book expense for outstanding shares as of balance sheet date 3. Apply appropriate tax rate to cumulative book expense Statutory US or overseas rate; plus statutory state rate -29-

30 DTA Balance Proof Not So Fast! Conceptually easy, practically difficult Most stock plan systems do not have a report that shows cumulative book expense just for outstanding awards You can generally get cumulative book expense, but reports usually include: Entire grant, not taking into account portions already settled So you take your cumulative expense from date of adoption, and then back out terminated, cancelled, released and exercised awards More complicated than it would seem, especially with different vesting schedules, multiple tranche valuation, partial exercises, estimated forfeitures, etc Another approach is to use a report for just outstanding awards and then try to recreate the book expense to date Similar difficulties with this approach Difficulties: expected forfeiture rate, straddle options, partial vesting, which population to include -30-

31 DTA Balance Proof Other Complications Straddle options granted prior to adoption of ASC 718 Forfeiture estimate for as-yet unvested grants 162(m) limited awards Expense booked outside of system - common for modified, accelerated awards; usually for executives Assumed/substituted awards and option exchanges R&D cost-sharing on exercise method Mobile employees which company in which country will claim the tax deduction, if any Changing tax rates overseas and for state apportionment Changing organizational structures: sub vs. branch, check-the-box status, CA world-wide filers -31-

32 DTA Balance Proof Practical Considerations Delay for another year or two, until pre-adoption options have all expired, to eliminate straddle options Lean on your system vendor to provide a solution Run all calculations using 100% tax rate apply appropriate tax rates to end result Ignore immaterial factors, like impact of CA world-wide filings Check for hanging DTAs; i.e. outstanding awards = zero You should have some if you use True Up at Vest (Static) Consider oddball vesting, like front-loaded or back-loaded vesting schedules Get to know your tax professionals! Outsource the calculation to a third-party! -32-

33 DTA Balance Proof Practical Considerations Work upfront with stock admin and finance group to understand how grants are input for acquisitions and/or modifications like option exchanges Have a process to link DTA booked in purchase accounting to awards upon tax settlement Have special identifier for assumed/substituted options by acquired company system may only track DTA for expense recorded post-acquisition Need to pull in DTA recorded in purchase accounting for pre-combination service Similar concepts for option exchange or other modifications need to track DTA associated with cancelled options Be very careful if company changes system providers make sure Tax personnel have input -33-

34 DTA Balance Approaches Outstanding by Tranche Begins with shares outstanding report with one row per vesting tranche Vested Tranches All expense recognized, however some shares may have been exercised/released DTA balance = grant date fair value per share * shares outstanding Unvested Tranches Expense amortization in progress or not yet begun Net to date from expense report for tranche Booked less Reversed (duplicates annual Rollforward Approach ) Approach begins with expense report Provides net to date expense for grant = Total DTA Booked Tax accounting / APIC report Provides Total DTA reversed for exercises, releases, expirations, etc. DTA Booked minus DTA Reversed = DTA Balance Compare to shares outstanding for each grant -34-

35 Contact Info Elizabeth Dodge (408) Lori Ellingboe (650) Ellie Kehmeier (408)

36 APPENDIX -36-

37 ASC Income tax regulations specify allowable tax deductions for instruments issued under share-based payment arrangements in determining an entity s income tax liability. For example, under U.S. tax law allowable tax deductions may be measured as the intrinsic value of an instrument on a specified date. The time value component, if any, of the fair value of an instrument generally is not tax deductible. Therefore, tax deductions generally will arise in different amounts and in different periods from compensation cost recognized in financial statements. Similarly, the amount of expense reported for an employee stock ownership plan during a period may differ from the amount of the related income tax deduction prescribed by income tax rules and regulations. -37-

38 ASC & 3 The cumulative amount of compensation cost recognized for instruments classified as equity that ordinarily would result in a future tax deduction under existing tax law shall be considered to be a deductible temporary difference in applying the requirements of subtopic ASC The deductible temporary difference shall be based on the compensation cost recognized for financial reporting purposes. Recognition of compensation cost for instruments that ordinarily do not result in tax deductions under existing tax law shall not be considered to result in a deductible temporary difference. A future event can give rise to a tax deduction for instruments that ordinarily do not result in a tax deduction. The tax effects of such an event shall be recognized only when it occurs. -38-

39 ASC & 2 The deferred tax benefit (or expense) that results from increases (or decreases) in that temporary difference, for example, an increase that results as additional service is rendered and the related cost is recognized or a decrease that results from forfeiture of an award, shall be recognized in the income statement. Subtopic requires a deferred tax asset to be evaluated for future realization and to be reduced by a valuation allowance if, based on the weight of the available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. Differences between the deductible temporary difference computed pursuant to paragraphs through 25-3 and the tax deduction that would result based on the current fair value of the entity s shares shall not be considered in measuring the gross deferred tax asset or determining the need for a valuation allowance for a deferred tax asset recognized under these requirements. -39-

40 ASC If a deduction reported on a tax return for an award of equity instruments exceeds the cumulative compensation cost for those instruments recognized for financial reporting, any resulting realized tax benefit that exceeds the previously recognized deferred tax asset for those instruments (the excess tax benefit) shall be recognized as additional paid-in capital. -40-

41 ASC & The amount deductible on the employer s tax return may be less than the cumulative compensation cost recognized for financial reporting purposes. The write-off of a deferred tax asset related to that deficiency, net of the related valuation allowance, if any, shall first be offset to the extent of any remaining additional paid-in capital from excess tax benefits from previous awards granted, modified, or settled in cash in fiscal years beginning after December 15, 1994 and measured in accordance with a fair value method of accounting. The remaining balance, if any, of the write-off of a deferred tax asset related to a tax deficiency shall be recognized in the income statement. -41-