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

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 If local deduction then can set up DTA at the local statutory rate Need to consider transfer pricing implications Recharge agreements are a way to repatriate cash tax free – Section 1032

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) For more details on the information covered by this slide, refer to FRD Section: S10.1.1

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: Annual journal entries $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) Year 1 year 2 1100 1000 1000 (100) X 40% (100) 1000 400 900 X 40% x 40% 400 360 cur exp 400 pay 400 Current Exp 440 Pay 440 def exp 40 dta 40 DTA 40 def exp 40 pay 40 cur exp 40

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 For more details on the information covered by this slide, refer to FRD Section: S10.1.2

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) For more details on the information covered by this slide, refer to FRD Section: S10.1.3 S10.1.3.1 S10.1.3.3

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) For more details on the information covered by this slide, refer to FRD Section: S10.1.3.2

Realization of excess tax benefits (example) – Follow the tax law approach

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

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) Under Treas Reg. section 1.482-7(d)(2)(iii)(A), the general rules for inclusion of SBC for R&D Costs is the amount allowable to the controlled participant as a deduction for federal income tax purposes under section 83(h) for the taxable year for which the deduction is allowable. In the case of ISOs and ESPPs, the spread/discount at exercise/purchase is not taxed currently (disregarding AMT) by virtue of section 421, and the employer receives no deduction under section 83(h) unless there is a “disqualifying disposition” by the employee.  As such, under the general rule it may appear that if there is no disqualifying disposition, then there is no deduction and no inclusion in the cost sharing pool. However, Treas. Reg. section 1.482-7(d)(2)(iii)(A)(1) Transfers to which section 421 applies., states that “solely for purposes of this paragraph (d)(2)(iii)(A), section 421 does not apply to the transfer of stock pursuant to the exercise of an option that meets the requirements of section 422(a) or 423(a)”. IRC section 421 provides the general rules for a “qualifying transfer” or “disqualifying disposition” for ISOs, section 422(a), and ESPPs, section 423(a). As such, by ignoring the non-inclusion in income and non-deduction provisions of section 421 applicable to ISOs and ESPPs, the Regulations provide that the spread on exercise  of the ISO or discount under the ESPP be included in the cost sharing pool, regardless of whether there is a disqualifying disposition. For further insight, the preamble to the proposed regulation provides: "The proposed regulations prescribe a general rule of measurement based primarily on the amount and timing of the income tax deduction associated with stock-based compensation, while in certain cases permitting controlled participants in a qualified cost sharing arrangement to elect a rule of measurement with respect to stock options based on the amount and timing of the fair value of the option that is required to be computed for purposes of financial accounting in accordance with United States generally accepted accounting principles (U.S. GAAP). To provide for uniform measurement of the cost associated with both statutory and nonstatutory stock options, the general deduction-based measurement rule is applied as if section 421 did not apply upon the exercise of a statutory stock option. Thus, although section 421 generally disallows compensation deductions with respect to the exercise of statutory stock options except in the case of certain disqualifying dispositions, the proposed regulations treat the exercise of a statutory stock option as giving rise to a deduction for purposes of the deduction-based measurement rule. Consequently, the operating expense with respect to all stock options, whether statutory or nonstatutory, generally will be measured by the “spread” and taken into account as of the date the stock option is exercised. "

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% Read the resource meeting note discussion and examples Change Singapore to 10%

Cost Sharing (Example) continued Decision on grant vs. spread If you think the stock price will rise over time then grant makes more sense because you will get the full benefit of the deductions on the future. Downside is cash cost upfront.

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 benefits relating to share-based payments to employees, as well as nonemployees, would be presented in the statement of cash flows as a financing cash inflow (and a corresponding reduction in operating cash flows). Previously, the cash retained from excess tax benefits was presented in operating cash flows along 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 a financing cash flow must be performed on an option-by-option basis. That is, while the credits recognized in additional paid-in capital during a reporting period (see Section S10.3.1) may be reduced by write-offs of deferred tax assets to additional paid-in capital (i.e., presented net, as discussed in Section S10.3.2), the amount presented in the statement of cash flows as a financing activity 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)

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

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