Tax Breaks for Stock Pay Curbed, Handing Tech `Huge' Liabilities

(Bloomberg) -- Silicon Valley's favorite compensation strategy -- paying top employees in stock rather than cash -- just got more expensive.

A recent U.S. federal court ruling means companies such as Facebook Inc. and Alphabet Inc.'s Google won't be able to deduct the full cost of the stock payments they make to employees when calculating their corporate tax bills, which they've done for years.

Instead, they'll have to allocate some of the expense to their foreign subsidiaries, usually in tax havens such as the Cayman Islands, where the deduction is nearly worthless because they don't have much of a tax liability there.

For Facebook, the change means the struggling social media giant could face a tax rate as high as 30 percent in the third quarter, compared to the new corporate rate of 21 percent. That's because the company has to make up for previous quarters and pay additional taxes for when it deducted more of the stock-based compensation than the court decision allows, according to a regulatory filing. In the third quarter of 2017, it paid a rate of just 10 percent.

Facebook hasn't yet disclosed what it will actually owe in the third quarter as a result of the court ruling.

‘Huge Number'

“It's going to be a huge number,” Robert Willens, an independent tax consultant in New York, said referring to Facebook's liability. “This also means the loss of certainly several hundred millions of deductions each quarter going forward. It could even be $1 billion."

A spokeswoman for Facebook declined to comment.

Technology firms rely on stock-based compensation because it gives employees and executives an opportunity to share in the growth of the company without burning through the cash the company has on hand. Investors also like it because it can encourage employees to think about market value in addition to product development.

“This is a big Silicon Valley issue and there is a lot of money at stake,” said David Fischer, a tax litigator at Crowell & Moring.

How much the stock compensation deduction is limited by will vary based on companies' agreements about sharing costs between U.S. and foreign entities, but tax lawyers say it's likely that at least half their deductions going forward will be capped.

Companies aren't likely to stop paying employees with stock, so it's a tax hit they'll probably just be forced to absorb, according to Clinton Wallace, a law professor at the University of South Carolina.

‘Material' Impact

The court ruling that affects deductions for stock-based compensation involved an Intel Corp. subsidiary, Altera Corp., and its cost-sharing agreement with a subsidiary in the Cayman Islands. The Ninth Circuit Court of Appeals ruled against Intel by overturning a Tax Court decision that had been favorable to the company.

The tax benefits tied to stock-based compensation can figure prominently in a company's tax bill. Facebook's deduction decreased its tax liability by $1.25 billion and the company's effective tax rate by 6 percentage points, according to an annual regulatory filing last year.

Alphabet paid $7.7 billion in stock-based compensation, yielding a $1.7 billion deduction in 2017, according to a regulatory filing. Apple Inc. valued the tax benefit for equity compensation at $1.6 billion last year. Apple said in a filing Thursday that it would allocate some of its stock compensation deduction to its foreign entities as a result of the Altera ruling.

Semiconductor developer Silicon Laboratories Inc. said in a recent filing that it's reviewing the court decision and the outcome “could be material” to financial statements.

Controversial Case

It's possible the case could get a rehearing in the Ninth Circuit with a new panel of judges. One of the three judges, Stephen Roy Reinhardt -- known as the "liberal lion"-- died between the hearing and the release of the court's opinion.

Tech firms could get a reprieve if the case is elevated to the Supreme Court, where a conservative bench of judges could be interested in overturning a Ninth Circuit decision, according to Patrick J. Smith, a partner at law firm Ivins, Phillips & Barker.

“The conventional wisdom is that any controversial case that Judge Reinhardt heard is something that they're going to look at closely,” Smith said. “Any judge that President Trump is going to nominate is going to have the mindset to look carefully at the Ninth Circuit.”

To contact the reporter on this story: Laura Davison in Washington at ldavison4@bloomberg.net

To contact the editors responsible for this story: Alexis Leondis at aleondis@bloomberg.net, Andrew Pollack

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