Stock-based Compensation and Tax Implications under ASC 740-718 (f/k/a FAS 123R)

Stock-based Compensation and Tax Implications under ASC 740-718 (f/k/a FAS 123R)

Page 2 San Jose State University

Overview of tax treatment

► Statutory stock options, e.g., incentive stock options, generally do not yield a tax deduction► Deduction in the case of a disqualifying disposition if employee

sells stock within one year of the date of exercise and two years of the date of grant ► Tax deduction is equal to the stock price on the date of exercise less

the exercise price (i.e., the intrinsic spread)

► Nonqualified stock options will generally result in a tax deduction equal to the stock price on the date of exercise less the exercise price (W-2 comp)

► Restricted stock option will generally result in a tax deduction equal to the stock price on the vesting date


Recording of tax effects

Under either ASC 740-718 [FAS 123R] or the intrinsic value method (APB 25), deferred tax assets (DTA) for stock-based awards are recognized for book purposes only for awards that normally result in a tax deduction Nonqualified stock options

Tax deduction equal to intrinsic value on the date of exercise Nonvested stock (e.g., restricted stock)

Tax deduction equal to the stock price on the date of vesting

Consider tax rules in foreign jurisdictions Statutory Foreign Deduction Stock option recharge agreements


ASC 740-718 [FAS 123R] income tax considerations

► No change in US income tax treatment ► Tax deduction is generally realized when the option is exercised,

stock is received and the employee recognizes income

► Book-tax difference:► Amount of compensation:

► Book – fair value of option measured at grant date, vs.► Tax – intrinsic value measured at exercise date or vest date

► Timing of compensation: ► Book – amortized over service period (vesting period), vs. ► Tax - upon exercise (Non Qualified stock), Disqualified Disposition

(ISO/ESPP), or vesting of option (Restricted Stock)


ASC 740-718 [FAS 123R] – Calculating deferred taxes

► Calculating deferred taxes for deductible awards► Recognized compensation cost for awards that will result in a tax

deduction multiplied by entity’s statutory tax rate► Deductible temporary difference, set up deferred tax asset for the

types of equity awards where the presumption is they will result in a future tax deduction (such as NQ and RS, See SC 740-718-25-2)

► The presumption is ISO and ESPP grants WILL NOT result in a tax deduction. (See ASC 740-718-25-3)


Example 1

► Assume:► 10,000 nonqualified options with 4-year cliff vesting► Estimate that 8,000 options will ultimately vest► Strike price of options – $3► Fair value of options – $6► Statutory tax rate – 35%


Example 1 (cont.)

► Annual compensation cost:► $12,000 = ($6 x 8,000) ÷ 4 years

Annual deferred tax benefit:► $4,200 = $12,000 x 35%

► Annual journal entries► Dr. Compensation cost (P&L) $12,000

Cr. Additional paid-in capital $12,000

(To record FV book stock based compensation)► Dr. Current income tax expense (P&L) $4,200

Cr. Income tax payable$4,200

(To record current tax expense)► Dr. Deferred tax asset $4,200

Cr. Deferred income tax benefit (P&L)$4,200

(To record DTA at the end of Year 1)


Example 1 (cont.)

► 2,000 options are exercised in Year 2 ► Market price of stock on the date of exercise is $20 per share► Strike price is $3 per share – intrinsic value is $17 per share

► Journal Entries► Dr. Deferred Income Tax Expense $4,200

Cr. DTA (FV$6 x 2,000 shrs x 35%) $4,200

(To reverse the previously set up DTA)► Dr. Tax Payable $11,900

Cr. Current Tax Expense $4,200

Cr. APIC $7,700

(To record the tax effect of the option exercise)


Valuation allowance on DTA

► Valuation allowance on DTAs (740-718-30-1,2)► Record a valuation allowance if it is more likely than not that some

portion of the DTA will not be realized► Consider whether future taxable income will be sufficient to realize

the DTA► Changes in the intrinsic value of the award are not considered

when determining if a valuation allowance is required


In a Full Valuation Allowance Case

► Paragraph 35-5 [63] of ASC 740-718 [FAS123R] provides that the write-off of a deferred tax asset is net of any related valuation allowance.

► Thus, when an award is settled and the award’s related deferred tax asset has a full valuation allowance recorded against it, a shortfall does not occur because there is no deferred tax asset to write off.


Realization of excess tax benefits

► Tax deduction when options are exercised► If tax deduction is greater than recognized compensation cost:

► Excess tax benefit recorded as increase to APIC► Only record excess tax benefit if it is realized (ASC 740-718-25-10 and

ASC 718-20-55-20 (f/k/a FAS123R Footnote 82)► When the benefit reduces current taxes payable (i.e., cash tax savings)► If company has an NOL that is increased by the deduction, the benefit is

not realized and the excess tax benefit is not recorded in APIC (but must be tracked offline for later potential realization/recognition)

► Excess stock option deduction that can potentially be used to offset (reduce) uncertain tax positions[FIN 48 liabilities] is not considered “realized” (but, can be used for purpose of calculating the related[FIN 48] interest liabilities)

► Under APB 25, an excess tax benefit that increased an NOL was also recorded as increase to APIC (i.e., DTA was recorded)


Realization of excess tax benefits (cont.)

► Resource Group meeting believes that there are two approaches to determine the timing and the amount of the “excess stock option deduction” realized.► With and without approach► Follow the Tax Law approach

► (See Class exercise)


Realization of excess tax benefits (example) – Follow the tax law approachFollow the Tax Law Approach - (assume no valuation allowance)

Payable Current Provision Excess ded used Total APIC TaintTaxable Income before option deduction 1,000 Stock option deduction 400 (matching book of $50, excess option deduction of $350) (400) (350) Taxable income b/f NOL 600 NOL carried into the year of 1000 (800 operating loss and 200 of APIC tainted) =200/1000*600 (600) (120)

APIC taint recorded - (470) (470)

Off B/SDTA NOL per TR APIC taint B/S presented

DTA NOL - Gross Beg 1,000 (200) 800 Utilization - Gross (600) 120 (480) DTA NOL - Gross End 400 (80) 320

APIC taint unrecorded (off B/S) (80)

Total APIC Taint (recorded + unrecorded) (550)

J/EDr. Current Provision (P/L) 1000x40% 400 Cr. Payable (400)

Dr. Payable 400 Cr. DTA-123R 50x40% (20) Cr. DTA - NOL (600-120=480)x 40% (192) Cr. APIC (350+120=470)x40% (188)


Realization of excess tax benefits (example) –with and without option approach

With and Without Approach - (assume no valuation allowance)

Payable Without Options with Options Total APIC TaintTaxable Income before option deduction 1,000 1,000 Stock option deduction 400 (matching book of $50, excess option deduction of $350) (50) (400) Taxable income b/f NOL 950 600 NOL carried into the year of 1000 (800 operating loss and 200 of APIC tainted) (800) (600)

APIC taint utilized/Recorded 150 - (150) - - -

DTA NOL per TR APIC taint B/S

DTA NOL - gross Beg 1,000 (200) 800 Additional APIC Taint generated (350) Utilization (600) 150 (800) DTA NOL - Gross End 400 (400) -

APIC taint unrecorded (350+200-150)=400 (400) Total APIC Taint (recorded + unrecorded) (550)

J/EDr. Current provision (P/L) 1000x40% 400 Cr. Payable (400)

Dr. Payable 400 Cr. DTA - 123R 50x40% (20) Cr. DTA - NOL 800x40% (320) Cr. APIC 150x40% (60)


R&D Cost Share and Management fee charge (§1.482-7A and §1.482-9)

► 1.482-7A R&D cost share: U.S. tax regulations specify the expenses that must be included in a pool of shared costs; such expenses include costs related to stock-based-compensation awards granted in tax years beginning after August 26, 2003.► The tax regulations provide two methods for determining the amount and timing of

stock-based compensation that is to be included in the pool of shared costs► the “exercise method”: Under the exercise method, the timing and amount of the allocated

expense is based on the intrinsic value of the award on the exercise date. ► the “grant method”: Companies that elect to follow the grant method use grant-date fair

values that are determined based on the amount of U.S. GAAP compensation costs. Companies must include such costs in U.S. taxable income regardless of whether the options are ultimately exercised by the holder and result in an actual U.S. tax deduction. (Full tax deduction will be taken later on the U.S. tax return if the options result in tax deduction)

► 1.482-9(k)(2) Management fee charge: Reference to the GAAP or federal income tax rules (i.e. Book FV or Tax deduction) as the starting point to determine the cost to be allocated. (Years beginning after December 31st, 2006)


Cost sharing (Example)

Facts:► Company A, which is located in the U.S., enters into a cost-sharing

arrangement with its subsidiary, Company B, which is located in Singapore

► Under the arrangement, the two Companies share costs associated with the R&D of certain technology

► Company B reimburses Company A for 30% of the R&D costs incurred by Company A

► In 2006 A Company recorded share based compensation book charges of $100

► In 2007, the awards are exercised with an intrinsic value of $150► U.S. cost share 70%, Singapore cost share 30%► U.S. Tax rate: 40% and Singapore tax rate: 0%


Cost Sharing (Example) continued

Tax Accounting under Exercise Method:

In 2006 Dr. DTA (100x70%x40%+100x30%x0%) 28 Cr. Deferred Provision Benefit 28

In 2007Dr. Tax Payable (150x70%x40%+150x30%x0%) 42

Cr. DTA (100x70%x40%) 28Cr. APIC ((150-100)x70%x40%) 14

Tax Accounting under Grant Method:

In 2006 Dr. Current Provision 12Dr. DTA (100x40%) 40

Cr. Payable (100x30%x40%) 12 <- paying current U.S. taxesCr. Deferred Provision Benefit 40

In 2007Dr. Payable (150x40%) 60

Cr. DTA (100 x 40%) 40Cr. APIC (150-100)x40%) 20


Discrete Items for Tax Provisions

► Disqualifying dispositions of statutory options (ISO and ESPP)► Tax benefits to extent of prior book charge (was a Perm add back)

► Deficiencies not covered by APIC pool► Debit to income tax expense on DTA reversal

► Recovery of deficiency due to subsequent excess benefits generated within the same fiscal year► Reversal of income tax expense

► Revaluation of DTA due to change in tax rate (changes in the cost share arrangement)► In period of enactment change


Cash Flow Statement

In a significant change in practice, cash retained by the company as a result of excess tax benefitsrelating to share-based payments to employees, as well as nonemployees, would be presented in thestatement of cash flows as a financing cash inflow (and a corresponding reduction in operating cashflows). Previously, the cash retained from excess tax benefits was presented in operating cash flowsalong with other tax cash flows pursuant to Issue 00-15.

It should also be noted that the calculation of excess tax benefits that must be presented as afinancing cash flow must be performed on an option-by-option basis. That is, while the creditsrecognized in additional paid-in capital during a reporting period (see Section S10.3.1) may bereduced by write-offs of deferred tax assets to additional paid-in capital (i.e., presented net, asdiscussed in Section S10.3.2), the amount presented in the statement of cash flows as a financingactivity is based on a gross calculation without offset from any deferred tax asset write-offs to additional paid-in capital.

See ASC718-20-55-24 and ASC 718-20-55-23


Cashflow statement Example (stock option impact)

Cashflow Statement - Presentation of Stock option impact

Tax Accounting Rollforward B/S Dr/(Cr) P/L DTA Payable APIC Cash

Beginning Balance - -

Provision 80 120 (200) Option exercises with short falls (write off DTA thru APIC) (25) 15 10 Option exercises with excess windfall tax benefits (10) 50 (40) Cash tax payment 100 (100)

Balance at YE 80 85 (35) (30) (100)

Cashflow Statement Beg End Windfall Reclass

Cashflow stmt

Net loss (80) (80) (80) Assumed use of cash

Payable movement - (35) = 35 35 35 Source of cashDTA movement - 85 = (85) (85) (85) Use of cashTax Benefit from exercise of stock option (the net APIC J/E) 30 30 30 Source of cashExcess tax benefit from stock-based compensation (windfalls only) (40) (40) Total Operating Activities (140)

Total Financing Activities 40 40 Net Cash position per B/S (100) (100)


EPS

► ASC 260 [FAS 128] provides guidance on the computation and disclosure of EPS and defines EPS as “the amount of earnings attributable to each share of common stock.”

► Assumed proceeds under the treasury stock method► Because stock based compensation expense will be recognized in the income

statement under ASC 718 [FAS 123(R)], the numerator (net income) for both the basic EPS and diluted EPS computations will be reduced.

► Basic EPS is computed by dividing income that is available to common shareholders by the weighted average number of common shares that are outstanding during the period, while diluted EPS gives effect to all dilutive potential common shares that are outstanding during a period.


EPS

► The assumed proceeds under the treasury stock method of ASC 260-10-45-29 include:► The purchase price that the grantee will pay in the future, if any (e.g., the

exercise price of a stock option);► Compensation cost for future service that the company has not yet

recognized; and► Any windfall tax benefits (tax effected amount) that would be credited to

APIC when the award generates a tax deduction. If there would be a charge to APIC (i.e., shortfall), such an amount would be a reduction of proceeds. Shortfalls that would be charged to income tax expense (i.e., because there is no pool of windfall tax benefits) should not be included as a reduction of proceeds.

► Companies should not include potential windfall tax benefits if the award does not ordinarily result in a tax deduction (ASC 740-718-25-3, ASC 740-718-25-10 (f/k/a FAS 123(R) Footnote 82).


EPS

► Applying the treasury stock method to in-the-money options could be anti-dilutive if the sum of the proceeds, including the unrecognized compensation, exceeds the average stock price. In this case, those options would be excluded from the calculation of diluted EPS.


EPS – Treasury method example

► 1,000 nonqualified stock options granted on January 1, 2007 with an exercise price of $10

► Each share has $5 FV determined at the grant date► Options vest straight line over 5 years► Market price as of 1/1/07 is $20 and as of 12/31/07 is $26. Average market

price of 2007 is $23.► Tax rate is 40%► The Company has sufficient taxable income to realize any windfalls generated

from the exercise of the award► How many shares of stock options (if dilutive) should be included in diluted

EPS for the year ended December 31, 2007.


EPS – Treasury method example (Solution)

► Hypothetical average “unrecognized compensation for 2007 is (1,000 x $5)/5 = $1,000 per year. So unrecognized as of 1/1/2007 is $5,000 and as of 12/31/07 is $4,000. The average is $4,500

► Hypothetical proceeds from exercise price = $10 x 1000=10,000► Hypothetical tax benefit at 12/31/07 = (average market price $23 –

exercise price $10) x 1,000 shares x 40% = $5,200► Hypothetical windfall = the tax benefit of $5,200 less hypothetical DTA

($5 x 1000 x 40% = $2,000) = $3,200► Total Assumed proceeds = $4,500 + $10,000 + $3,200 = $17,700► Buy back $17,700 / $23 = 769.56 shares► Incremental shares to be included in the dilutive EPS =

1,000 (issued upon exercise, dilutive) – 769.56 (buy back shares, anti-dilutive)= 230.43 (overall dilutive)


Summary

► ASC 740-718 [FAS123R] imposed significant impact on financial reporting and income tax accounting (for both U.S. and Foreign jurisdictions)

► Deficiencies around financial reporting and disclosures around this area► Planning around stock options and income tax accounting implications► Focus on proof of ending SBC-related deferred tax asset


Questions?

Documents

Stock-based Compensation and Tax Implications under ASC 740-718 (f/k/a FAS 123R)