Saturday, December 14, 2019

ITEP and J. P. Morgan's employee stock options

Two days ago I commented on ITEP’s article How Congress Can Stop Corporations from Using Stock Options to Dodge Taxes. Table 1 in the article shows amounts of tax breaks in 2018 for 25 corporations, including J.P.Morgan Chase & Co., second highest with an amount of $1.1 billion. The article says, “Table 1 lists the 25 corporations disclosing the largest tax breaks from stock options in 2018. The tax break listed for each company is the tax decrease resulting from tax deductions it claimed for stock options in excess of the stock option expenses reported on its books.”

So ITEP describes the numbers as reductions in taxes, not the reduction in taxable income. The former is the latter times a tax rate. I looked for the $1.1 billion in J.P.Morgan Chase’s 2018 10-K. It’s on page 210. "Income tax benefits related to share-based incentive arrangements recognized in the Firm’s Consolidated statements of income for the years ended December 31, 2018, 2017 and 2016, were $1.1 billion, $1.0 billion and $916 million, respectively. The following table sets forth [ ] the actual income tax benefit related to tax deductions from the exercise of the stock options." The table shows $75 million for 2018. So it’s clear that $1.1 billion was the reduction in taxable income and $75 million was the reduction in tax. Why did ITEP claim a reduction in taxable income as a reduction in tax? $75 million would have put J.P.Morgan #25 or off the list. By the way, $75 million is only 6.8% of $1.1 billion, whereas the main corporate tax rate is 21%. I can’t reconcile the difference. Perhaps the $1.1 billion includes some incentive compensation other than nonqualified stock options. The 10-K refers to such plans (RSU and PSU).

Also relevant to my recent posts about employee stock options is the following on page 209 of the 10-K: “The Firm’s policy for issuing shares upon settlement of employee share-based incentive awards is to issue either new shares of common stock or treasury shares. During 2018, 2017 and 2016, the Firm settled all of its employee share-based awards by issuing treasury shares.” In other words, J.P.Morgan Chase used what I labeled Method 2 here, a method none of ITEP’s articles mention.

The tax break amount ITEP shows for Amazon (#1) matches its 10-K and is a reduction in tax. Ditto for Facebook (#5). I didn't find ITEP's number for Google (#4) in its 10-K. So there doesn't appear to be a systematic error.

Thursday, December 12, 2019

ITEP and employee stock options

Two days ago ITEP published another article about employee stock options: How Congress Can Stop Corporations from Using Stock Options to Dodge TaxesOne of its authors did a separate blogpost the same day, New Report from ITEP Explores the Stock Options Tax Dodge. It only echoes a part of the article.
  
My December 8 post commented on ITEP’s previous articles about employee stock options. I stated three methods a corporation could use to supply the stock the employee receives upon exercise of the option. This latest ITEPS article was again written as if there is only one method, which I labeled Method 3, in which the corporation issues new stock. The employee pays the exercise price.

In some cases, perhaps most for the 25 companies the ITEP article shows in Table 1, the company used Method 3. If so, I think ITEP has a legitimate complaint – the tax deduction the corporation gets upon exercise is excessive. However, it is not so for Method 1 and partly not so for Method 2, which I explained on December 8.

The authors support the Levin-McCain proposal, or something like it, to reform the amount of tax deduction a corporation gets. They propose this: “If the Levin-McCain proposal had been in effect in the hypothetical described above, the corporation at issue would have reported a $10 million stock option compensation expense for book purposes and deducted the exact same amount from its taxable income in the year when the options were granted. The book expense and tax deduction would have matched. The book expense and the tax deduction would have been taken in the same year. No more valuation gaps, no more timing differences, no more excessive tax deductions” (my bold).

It shifts the taxable event from the exercise date – when the value of the option is known – to the grant date – when the future value of the option is very uncertain. That's radical and nutty. First, they propose eliminating a non-cash expense, but invoke a different non-cash expense. Second, for GAAP accounting companies start accruing an expense for employee stock options when the grant is made. Upon exercise more accounting is required to recognize what the option turns out to be actually worth and the corporation’s actual cost. In contrast, the authors propose to ignore entirely what happens upon exercise for the employer’s taxes. They ignore or are unaware of what happens with GAAP accounting upon exercise. “It is time to require the same type of symmetry for stock options: the book expense and tax deduction should match. After all, in our example, the $50 million in income to the employee is irrelevant to the compensation cost of the employer, which was reported at $10 million at the time the compensation was awarded [the option was granted] to the employee years earlier.”

This is nutty for the following reasons as well.
1. Suppose an option expires worthless (market price of stock less than exercise price). The corporation gets a tax deduction when the option is granted, but the corporation never incurs an actual expense. 
2. Suppose an employee gets a grant and later quits when all or part of the option is not vested. The corporation gets a tax deduction when the option is granted, but the corporation never incurs an actual expense for the non-vested part.
3. Suppose the share price skyrockets, the option is exercised, and the employer uses Method 1 or Method 2. The employer buys the stock when the price is much more than the exercise price. The employer pays a lot to meet its obligation – share price at purchase minus exercise price. It’s an actual and significant expense, but ITEP proposes no tax deduction for it.



Tuesday, December 10, 2019

ITEP and depreciation

One week ago I gave an example to show how accelerated depreciation can lower a corporation’s “effective” tax rate (link). I assumed X Corp makes a capital expenditure, which it depreciates over 5 years for GAAP accounting, but is all deducted immediately for income tax purposes. For the 5 years combined, the total depreciation for GAAP and tax purposes are equal. The difference between the two series is a matter of timing. To keep it simple I said nothing about what X Corp would do with its initial tax savings.

ITEP published two articles critical of accelerated depreciation on November 19:

The first article gives a link to the second one. The second article shows two tables labeled Table 1a and Table 1b. Table 1a shows the GAAP depreciation and Table 1b tax deductions for accelerated depreciation. Over 20 years the sum of depreciation and tax deductions are equal. The authors follow with: “The final line in both Tables 1a and 1b illustrates the present value of the after-tax profits in each year. ... Taking into account the “time value of money” in this way, we see that the investment generates an after-tax profit of $1,020 if economic depreciation applies and $1,888 if full expensing is allowed.”

The last sentence suggests the company benefits from accelerated depreciation. On the other hand, the federal government collects the same sum of taxes either way, so the federal government gets no extra benefit from allowing accelerated depreciation.

The first ITEP article calls accelerated depreciation a giveaway and an interest-free loan. A giveaway and a loan are not the same, so which is it?

Their analysis, backed up with the math, appears persuasive. However, there is something missing. What will the company do with its initial tax savings? Table 1b assumes nothing, which fits with the authors’ saying that the federal government in effect makes an interest-free loan. That is a weak assumption. Assume instead the company invests its initial saving of $1995 to earn 5% taxable interest yearly, drawing down the savings in years 2-20 to pay the difference in taxes, $128 - $23. Per my calculation the amount of interest each year averages – it varies slightly – $95.27. The federal government will collect an average of $95.27 * 21% = $20.28 more in taxes annually. For 19 years that is $385 more than the $462 taxes shown in each table! The federal government in effect makes a loan at 5%*21% = 1.05%. That’s not interest-free, but it is low.

Assume instead the company invests the initial savings to earn 6.1% taxable interest yearly (the same as the $10,000 machine). Then for 19 years the federal government will collect $539 more than the $462 taxes shown in each table! The federal government in effect makes a loan at 6.1%*21% = 1.28%. That’s still low, but not zero.

I am neither much in favor nor much against accelerated depreciation. If, unlike the authors assume, the accelerated depreciation is used by a company that eventually loses money rather than making a profit, the federal government’s overall tax revenue is less than zero. It’s a money loser. The accelerated depreciation is not quite like a tax credit, which is more a giveaway than a loan. However, in money losing cases, it has a similar de facto effect as a tax credit.

Sunday, December 8, 2019

ITEP and three tax topics

The Institute on Taxation and Economic Policys (ITEP) report The 35 Percent Corporate Tax Myth said the following:

- Most big corporations give their executives (and sometimes other employees) options to buy the company’s stock at a favorable price in the future. When those options are exercised, companies can take a tax deduction for the difference between what the employees pay for the stock and what it’s worth.
- Such stock options reduce their taxes by generating phantom “costs” these corporations never incur.
- This non-cash “expense” should not be deductible for either tax or book (GAAP reporting to shareholders) purposes.
- Tax breaks such as stock options lower the corporations “effective” tax rate well below the main corporate rate on taxable income. Such rate was 35% before the Tax Cuts and Jobs Act reduced it to 21%.

ITEP has said this in a few other reports and articles, such as this one, which includes: “One tax loophole that Facebook has led the pack in exploiting is the “stock option loophole.” Facebook and other big corporations often compensate their executives with stock options (options to purchase shares of company stock at a discounted rate). When those options are exercised, the company is allowed to deduct from its taxable income the difference between the value of the shares and what the employee pays for the stock, even though the company doesn’t have to spend anything to provide the stock option to its executives.”

The tax deduction part is true. But the quote gives the impression there is only one method a corporation can use to fulfill its part. That is, the corporation creates new shares and incurs no expense. However, there are three methods.

Method 1. Like I said here, the corporation can buy the shares on the market. The employee pays the exercise price. The corporation pay the rest – market price minus exercise price. That’s a current cash expense to the corporation.

Method 2. The corporation can transfer to the employee shares that it already purchased on the market in anticipation of employees exercising options or by a stock repurchase/buyback. This is not a current cash expense, but it was a cash expense. Such purchased stock is often called treasury stock. It’s carried at historical cost. It seems the appropriate tax deduction should be the lesser of (a) historical cost and (b) market price minus exercise price. The phrase “not a current cash expense” downplays this method.

Method 3. The corporation can issue new shares. Suppose the employee’s exercise price is $40 and the share price is $100. The corporation in effect sells each share discounted $60. Cash and capital each increase $40. There is no expense akin to $60 paying the employee a cash bonus. So it raises the question, what justifies a $60 tax deduction as compensation akin to paying the employee a $60 salary bonus?

Current tax law treats all three alike. Which method a company uses may not be fully revealed in a 10-K. It seems to me that ITEP’s view is correct about Method 3, and it is likely the method companies such as Facebook, Google, and Apple have most often used. (Facebook had large share repurchases in 2018, but not in the years addressed by ITEP.) But they might also have used Method 2. Given the tax treatment, why wouldn't a company always use Method 3? Because it dilutes the stock, reducing earnings per share (EPS is widely tracked by investors).

Onto the second topic, I did not find anywhere ITEP criticizing the double taxation of stock dividends. The dividends are taxable to the receiving shareholder, and corporations are not allowed to deduct them -- unlike interest paid -- when calculating taxable income. Assume $100 of pre-tax earnings the corporation wants to use for a dividend, the corporate tax rate is 21%, and the shareholder’s tax rate is 23.8%. Since $21 + $79*23.8% = $39.80, the combined tax rate is 39.8%. The Bush tax cuts of 2003 partly reduced the degree of double taxation when it made qualified dividends taxable at the lower capital gains tax rates.

Onto the third topic, I found one ITEP blog about the taxation of “carried interest” here. I agree with the author’s view of it being a loophole that should be closed.

ITEP is politically liberal. It and its sister organization Citizens for Tax Justice often favor tax breaks for middle and lower income individuals and families.

Tuesday, December 3, 2019

ITEP makes a myth

The Institute on Taxation and Economic Policy (ITEP) instigated the articles about Amazon’s and Netflix’s income taxes, which I recently wrote about. I wasn’t aware of ITEP before then. So I decided to search for other things published by ITEP. One that I found was this, The 35 Percent Corporate Tax Myth.

It was written when the main corporate income tax rate was 35% and before The Tax Cuts and Jobs Act reduced said rate to 21%. The following are quotes from the executive Summary of the report:

Profitable corporations are subject to a 35 percent federal income tax rate on their U.S. profits. But many corporations pay far less, or nothing at all, because of the many tax loopholes and special breaks they enjoy. This report documents just how successful many Fortune 500 corporations have been at using loopholes and special breaks over the past eight years.”

Two hundred and fifty-eight Fortune 500 companies were consistently profitable in each of the eight years between 2008 and 2015.”

As a group, the 258 corporations paid an effective federal income tax rate of 21.2 percent over the eight-year period, slightly over half the statutory 35 percent tax rate.”

The 21.2% is the amount of federal income tax as a percent of “profit,” which is partly explained in Appendix 1 of the report. “Our report is based on corporate annual reports to shareholders and the similar 10-K forms that corporations are required to file with the Securities and Exchange Commission.” U.S. companies are required to prepare these documents according to a set of accounting standards, conventions and rules known as Generally Accepted Accounting Principles, or GAAP. What the report calls “profit” is GAAP net income before tax (not mentioned in the report). The authors determined the U.S. part of it when it was not separately shown.

However, the amount of federal income tax is the 35% statutory rate times taxable income in accordance with the Internal Revenue Code and regulations. Income taxes are not based on “profit” as used by ITEP, and the report shows no taxable income amounts. The two italicized things are often very different. I will illustrate with an example.

X Corp has $110 operating income ignoring depreciation. It also makes a capital expenditure of $50 which is depreciated over 5 years, since what is purchased is considered useful for 5 years for GAAP accounting. So X’s GAAP net income before tax is $100 (= $110 - $50/5). For income taxes X takes advantage of one of ITEP’s favorite targets for criticism, accelerated depreciation. The prevailing tax law allows the $50 capital expenditure to be deducted immediately. Therefore, its taxable income is $110 - $50 = $60. Tax is 35% * $60 = $21. From one perspective the $21 is 21% of GAAP net income before tax or profit. From a different perspective the $21 is 35% of taxable income. Is the 35% a myth? ITEP’s answer is obvious, but I don’t think so.

To make the example a little more complete, suppose X also has $110 operating income ignoring depreciation the next year. Absent another capital expenditure X’s GAAP net income before tax is again $100, while its taxable income is $110, since the prior year’s $50 capital expense has already been fully deducted. (If the next three years were like year 2, GAAP net income and taxable income would both sum to $500. The difference between the two series is a matter of timing.)  

If instead in the second year X makes another $50 capital expenditure depreciable over 5 years, its GAAP net income before tax is $90. Taxable income will again be $60. This scenario is more likely for a growing business. That’s one reason how the corporations in ITEP’s report consistently showed an average 21.2% “effective” tax rate (as a percent of profit, not of taxable income).

Sunday, December 1, 2019

AOC's "free stuff"

Alexandria Ocasio-Ortez has strongly objected to others calling her proposals “giving away free stuff.” She says the goods aren’t “free stuff”; they are “public goods.” She added, "I never want to hear the word, or the term, 'free stuff,' ever again." The Washington Examiner, Washington Timesand Fox News tell the story. AOC is from New York, but I didn't find a story in the NY Times, whose motto is “All the News That’s Fit to Print.” I guess they judged it "not fit to print."

The meaning of public good in economics is something like what AOC says. However, the good being something that can be used or enjoyed "without paying for it" is part of the definition. So what she proposes is both a public good and "free stuff" to the users. What she proposes isn't "free stuff" to those who pay for it, taxpayers. Wikipedia says AOC majored in economics (and international relations) at Boston University. Maybe she forgot about or was sleeping when that phrase "without paying for it" was used. 😊

Friday, November 29, 2019

Netflix income taxes 2018

This ITEP blog, written by Matthew Gardner, asserted that “Netflix posted its largest-ever U.S. profit in 2018—$845 million—on which it didn’t pay a dime in federal or state income taxes. In fact, the company reported a $22 million federal tax rebate.” Netflix’s 2018 10-K does show a “current provision” for federal income tax of -$22 million on page 58. The same page shows U.S. net income before taxes of $845 million. Both match what ITEP says.

However, provisions for income taxes in accordance with GAAP accounting are often very different from cash paid for taxes. The -$22 million provision is not a cash rebate or refund like Gardner says. He also conveniently omitted that page 42 of the 10-K shows Netflix paid income taxes of $131 million. The 10-K does not say how much of this was U.S. federal and state income tax.

A few days later a Snopes article asked “Did Netflix Make $845M In Profit and Pay $0 in Taxes Under New Tax Law?” No true or false judgment was given. To Snopes' credit, the article recognizes Netflix's taxes paid, $131 million. The article quoted Gardner of ITEP: “The popular video streaming service Netflix posted its largest-ever U.S. profit in 2018 — $845 million — on which it didn’t pay a dime in federal or state income taxes. In fact, the company reported a $22 million federal tax rebate.” …. "In all likelihood, every last dime of that $131 million has to do with foreign income and foreign taxes. We don’t know for sure but it sure looks that way based on current and cash income taxes.”

The way something looks is not proof. Gardner expresses no similar uncertainty and says nothing about Netflix paying foreign income taxes in his ITEP blog article. The only way to really know how much Netflix paid in U.S. federal income taxes is knowing what is on Netflix's U.S. Form 1120, which is a private matter between Netflix and the IRS. State income tax filings are likewise private.

Regarding Netflix's foreign operations, page 58 shows a provision of -$133 million for foreign taxes. So Gardner might be correct about the $131 million taxes paid being to foreign countries. This likely helped reduce Netflix's U.S. income tax provision, being that Form 1120 allows a credit for foreign taxes. The main U.S. corporate income tax rate of 21% suggests a crude tax estimate of 0.21 * $845 million = $177 million. The $131 million foreign taxes paid is large relative to that. Also significant are the deferred tax provisions of  -$37 million federal and -$52 million state. This suggests larger deductions (faster depreciation) of capital spending for federal and state income taxes purposes than per GAAP accounting. (The difference will be reversed in future years.)

Lastly, neither Gardner nor Snopes said anything about Netflix employees paying federal or state income taxes. It seems Gardner's overwhelming purpose is to promote the idea that corporations per se should be taxed more. "When hugely profitable corporations avoid tax, that means smaller businesses and working families must make up the difference." That is clearly a non sequitur.