Insult to Injury

Already bruised by backdating scandals, companies may face an unexpected tax hit as well.

Two years ago, Mercury Interactive Corp. was in rapid ascent. Having boosted revenue by more than 30 percent and signed an agreement with SAP that would create hundreds of new sales opportunities, the business-technology-optimization software company nearly tripled its year-over-year earnings for the fourth quarter of 2004. In response, analysts raised their price targets for Mercury, then trading at $44, to as high as $54.

One year later, Mercury crashed to earth. The Securities and Exchange Commission opened a probe into the company’s practices for granting stock options, and Mercury subsequently admitted it had backdated options for the CEO, CFO, and general counsel. Those executives resigned in November 2005. Two months later, Mercury was delisted from Nasdaq, unable to file amended financial statements on time. The company finally restated its earnings for 12 years in July 2006, downward by $566.7 million (later amended to $575 million), and was trading below $30 on the pink sheets before being acquired by Hewlett-Packard last November.

But Mercury’s headaches haven’t ended. Aside from a possible SEC lawsuit against its directors, the company also faces $44 million in additional tax liabilities. While the cash expense is still being negotiated with the Internal Revenue Service, Mercury estimates it will have to withhold an additional $9.1 million to cover employee stock options that lost their tax-favored status as incentive stock options. To add more complications, Mercury reported that some of its executives had fudged option-exercise dates on several occasions to lower their personal tax bills, which could have resulted in the company underreporting its tax liability, exposing it to more penalties. Meanwhile, executive grants that could no longer be considered performance-based (and therefore tax-deductible) by virtue of being backdated have forced Mercury to give up $57.1 million of future tax breaks in the form of net operating loss (NOL) carryforwards.

Backdated stock options have caused
potential earnings woes for more than
100 firms, but the possible tax hit has only
begun to be quantified. “The focus right
now is on looking at measurement dates
and deciding whether to change them. As
companies get that figured out and move
through the [accounting] restatement,
many of them are turning to the tax
effects,” says Lawrence L. Hoenig, a tax
partner in the Palo Alto, California, office
of Pillsbury Winthrop Shaw Pittman LLP.

Many more companies may share
Mercury’s dilemma. Altera, Asyst Technologies,
Brocade Communications Systems,
and Brooks Automation have all announced
multi-million-dollar tax adjustments
due to stock options that turned out
to be backdated. Other companies, including
American Tower, Broadcom, F5 Networks,
and McAfee, are still hard at work
calculating their liabilities. Recent statistical
evidence also suggests that Mercury
executives were not alone in misreporting
exercise dates, upping the tax exposure for
an untold number of companies.

No doubt those efforts will be hastened
by the IRS, which has announced it
will piggyback on the investigative efforts
of the SEC and the Department of Justice
through the stock options accounting task
force set up by Northern District of California
U.S. Attorney Kevin Ryan. While
no one knows exactly how much the IRS
stands to recoup, “I’ve got to think you’re
talking hundreds of millions of dollars,”
says Tom Ochsenschlager, vice president
of taxation for the American Institute of
Certified Public Accountants.

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