By Therese Poletti, MarketWatch
MarketWatch photo illustration/iStockphoto
With every company expected to talk about the impact of the COVID-19 pandemic on earnings in coming weeks, look out for a completely unrelated issue that could cost technology companies billions of dollars in cash or write-offs.
The U.S. Supreme Court in late June declined to hear a case filed by chip maker Altera Corp ., now owned by Intel Corp. /zigman2/quotes/203649727/composite INTC +1.59% , that sought to challenge a ruling upholding U.S. tax regulations that define how companies can split costs with foreign units.
The result is likely to be a big tax bill or a charge for some tech companies: Facebook /zigman2/quotes/205064656/composite FB +2.12% and Alphabet Inc. /zigman2/quotes/205453964/composite GOOG +1.17% /zigman2/quotes/202490156/composite GOOGL +1.14% have already paid and taken charges amounting, respectively, to just more than $2 billion. An additional 20 companies have recorded material charges totaling about $623 million in the past year as a result of the unfavorable Ninth Circuit appellate court ruling, and at least one tech company has already disclosed a charge coming off its second-quarter results.
Many more are expected. A MarketWatch review of SEC quarterly and annual filings with the Securities and Exchange Commission found that more than 50 companies — mostly in the technology sector, but with a few exceptions — mentioned the Altera case as potentially material to their finances and all noted that they were following the case closely. Several companies mentioned the case in their 2019 filings as well.
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Even with the years-long case seemingly decided and concrete examples of costs from tech companies, mysteries and confusion about the impact of the Altera ruling remain. Some companies believe the effects will not be material to their returns, but some are claiming geography will save them, while some tech companies with large stock-based-compensation totals have oddly not mentioned the case at all.
Tech companies, like the rest of corporate America, have many ways to try to avoid income taxes, and one of them has been having their cake and eating it too with offshore entities. Companies typically have an offshore entity in a low-income tax location that acts as the main center on paper for all sales outside the U.S. That revenue was typically taxed at a far lower tax rate than the U.S. entity before tax regulations were changed in 2017.
The offshore subsidiaries have related party agreements with the main U.S.-based company, and these agreements determine how costs and expenses are split between them. The U.S. entity typically tries to account for as many costs and expenses as it can, including salaries and stock-based-compensation costs, in the higher tax arena of the U.S., to lower its overall tax bill.
“They want the best of both worlds,” said Daniel Shaviro, Wayne Perry Professor of Taxation at New York University School of Law. “It’s completely lawful and legitimate,” he said, adding that personally he thinks it is a scam.
Shaviro was one of 19 law professors who signed onto an amicus brief in support of the Internal Revenue Service and the tax code in 2016, when the Altera case landed in front of the U.S. Ninth Circuit Court of Appeals.
The appellate court upheld the validity of a 2003 tax regulation that “seeks to prevent avoidance of U.S. taxes”. The regulation requires that “certain cost-sharing agreements between related entities, such as a U.S. corporate parent and its offshore subsidiary, include stock-based compensation as part of the shared ‘costs,’ or else be subject to adjustment by the IRS,” the tax lawyers wrote.
With the Supreme Court declining to review the Ninth Circuit ruling, tech companies are now going back to look at their books, including how they have been expensing stock-based-compensation. Some companies have already taken charges or, in some cases, actually written big checks to the IRS based on the appellate ruling.
“This is about real dollars paid to the IRS, not just a paper issue. This is why Altera cared enough to appeal,” said Paul Zarowin, professor of accounting at the Stern School of Business at New York University, in an email. But he also noted that the issue is going to matter much less now, because the federal corporate tax rate in the U.S. dropped to 21% from 35% in 2017. For most companies, charges will involve the years before that tax code change in 2017.
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Facebook said in its annual report filed with the Securities and Exchange Commission in January that the company paid $5.18 billion in cash for income taxes for the year 2019, of which $1.64 billion was related to the Altera case. The company also said that its tax rate in 2019 increased to 25.5%, doubling from the rate of 12.8% in 2018, primarily due to the increase in taxes from the Altera case. A Facebook spokesman declined to comment beyond its statements in regulatory filings.