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Policy
Issues Affecting Venture Capital
There
are a number of ongoing issues which are relevant
for venture capitalists in the US.
Accounting Standards
The Financial Accounting Standards Board (FASB),
an independent regulatory body overseen by the
Securities and Exchange Commission (SEC), has
wanted for some years to eliminate pooling accounting
for business combinations. In Europe, the equivalent
technique, known as merger accounting, has been
banned, and the International Accounting Standards
Committee (IASC), an advisory body made up of
representatives from FASB and other foreign accounting
standards boards, is against it.
Under
pooling, the balance sheets of the two companies
are combined, and no change in asset value is
recognized. Under purchase accounting, a business
combination is treated as the purchase of one
company by another. The value of the purchased
company is then treated as an asset and the value
is restated to reflect the price paid to its shareholders.
Purchase accounting poses serious difficulties
for tech sector growth companies because of the
costs involved. This is mainly because under established
purchase accounting rules, goodwill (the difference
between the purchase price and the value of all
identifiable assets of the purchased company)
must be allocated to intangible assets amortized
over a period of time. These amortization expenses
often can cause a company that would otherwise
report profits to instead report losses.
By
2004, after a series of progressive steps, the
FASB was close to its goal of banning merger accounting,
having been able to agree compromise standards
on a range of issues including the amortisation
of goodwill.
Stock
Options
The IASC issued a paper in 2000 calling for rules
to require companies to expense the stock options
they offer to directors and employees. The FASB
had made a similar proposal some years before
but ultimately dropped it in the face of fierce
industry and congressional opposition. Business
has long maintained that stock options are not
to be viewed as compensation and thus should not
be expensed. This proved to be only a temporary
setback for the IASC and FASB, and the expensing
of share options has been moving ineluctably closer
ever since.
On
March 31, 2004, the FASB issued a proposed Statement,
Share-Based Payment, that addresses the accounting
for share-based payment transactions in which
an enterprise receives employee services in exchange
for (a) equity instruments of the enterprise or
(b) liabilities that are based on the fair value
of the enterprise’s equity instruments or
that may be settled by the issuance of such equity
instruments. The proposed Statement would eliminate
the ability to account for share-based compensation
transactions using APB Opinion No. 25, Accounting
for Stock Issued to Employees, and generally would
require instead that such transactions be accounted
for using a fair-value-based method.
In
October, 2004, the FASB announced that it had
decided to delay for six months the implementation
of the new rule which will oblige companies to
expense the value of stock options granted to
their employees.
The
FASB revealed that the decision had been made
following feedback to the exposure draft of the
planned standard for the expensing of employee
stock options from accountants and tax preparers,
who requested more time, arguing that they also
need to meet the demands of the Sarbanes-Oxley
corporate governance legislation.
FASB spokesman Steven Getz explained that: "What
the board had to weigh up was the consideration
of how the investor community was eager to have
the effective date as soon as possible, whereas
preparers felt they needed more time in order
to implement any new standard."
"What
ended up influencing the decision, in part, was
that the board felt that companies are feeling
a lot of pressure to implement Sarbanes-Oxley
404 for the first quarter, combined with the fact
that the board wanted to be sure to give companies
sufficient time to absorb the new standard and
to apply it appropriately. The board felt that
delaying the effective date by six months is the
best position to take."
Then
in April, 2005, it appeared that SEC commissioners
were considering granting US firms a further six
month reprieve over stock option expensing rules.
Following complaints from the US business community
over the timing of the measure, which coincides
with the introduction of increasingly stringent
corporate governance measures, the Securities
and Exchange Commission is mulling delaying the
implementation of the new regime.
Finally,
in April, 2005, the SEC voted to delay the implementation
of rules created by the Financial accounting Standards
Board which will require listed firms to expense
stock options given to employees. The SEC voted
to approve a measure making the rule effective
for fiscal years, not quarters, beginning after
June 15. This will effectively give most US firms
an additional six months to comply.
In
a statement issued following the vote, the SEC's
chief accountant at the time, Donald Nicolaisen
confirmed that concerns had been raised with the
regulator "that the accounting staffs at companies
and accounting firms already have been stretched
thin by other compliance responsibilities".
He
went on to add that: "In addition, implementing
the new standard at the beginning of a fiscal
year allows companies to change their accounting
systems in a more orderly fashion."
Critics
of the move, however, have argued that the SEC's
decision to delay implementation of the FASB rules
will merely serve as an extended opportunity for
the business community to lobby Congress and prevent
the measures from being imposed at all.
Expensed
or otherwise, stock options have been a fruitful
source of controversy over the years, and the
Treasury has made numerous moves to clamp down
on what it sees as abusive aspects of option issuance:
- In
February, 2004, the US Treasury Department and
the IRS issued a revenue ruling that would shut
down an aggressive transaction involving the
exercise of stock options by corporate insiders
using debt financing provided by the corporation.
In these transactions, typically the corporate
insider will exercise options he or she holds
by giving the company a promissory note. If
the value of the stock later falls below the
face amount of the note, the company may agree
to reduce the insider’s debt. Certain individuals
have claimed that this debt reduction does not
result in taxable income.
- In
January, the Treasury issued a ruling to shut
down abusive transactions involving ‘S corporation
ESOPs’ (employee stock ownership plans) in a
ruling that will classify such investments as
listed transactions for the purposes of tax
shelter disclosure. According to a Treasury
statement: “The ruling shuts down transactions
that move business profits of the S corporation
away from the ESOP, so that rank-and-file employees
do not benefit from the arrangement. For example,
the ruling prohibits using stock options on
a subsidiary to drain value out of the ESOP
for the benefit of the S corporation’s former
owners or key employees.” Treasury Assistant
Secretary for Tax Policy Pam Olson observed:
"Congress recognized the potential for attempts
to circumvent the rules and specifically authorized
Treasury and IRS to prevent it. This notice
does just that, imposing a 50% excise tax on
the option holders in cases where rank-and-file
ESOP participants are deprived of the business
profits."
- In
July, 2003 the Treasury announced the closure
of a tax loophole promoted to executives enabling
them to defer income tax on stock option gains
beyond the exercise of the option. The method
employed to execute this scheme involves the
transfer of stock options to a family member
or family-owned limited partnership in which
the executive has a significant interest. The
executive then receives a long term unsecured
note in exchange whilst the relative exercises
the option, stating that they will not recognize
any gains until it is subsequently sold and
then only if the proceeds are more than the
price paid for the option and the exercise price.
The scheme's promoters claim that no tax needs
to be paid on the option until payments are
made on the long term note. The Treasury Department
says: "The IRS will challenge the executive’s
claim that income from the exercise of the stock
options can be deferred. The regulations, which
are effective immediately, prevent an executive
or any other person from claiming tax deferral
from the transfer of options to a related party."
- In
October, 2004, tax experts voiced fears that
when the Treasury Department comes to draft
regulations for the expensing of stock options,
the benefits of stock appreciation rights (SARs),
a form of stock-based pay that has been steadily
growing in popularity, may be nullified. SARS
give employees the right to any increase in
a stock’s value between the granting of
the rights and the time it is exercised, and
a change in accounting rules that will require
firms to recognize the cost of stock options
as an expense on their income statements was
expected to boost the popularity of this form
of compensation further. However, tax and pay
experts fear that provisions in the draft regulations
will take the shine off SARs by requiring beneficiaries
to disclose ahead of time when they intend to
exercise their grants. If a date is not set,
then executives could be compelled to pay tax
when the award vests, as opposed to paying tax
when the income is realized. Employees typically
have ten years from the date of the grant to
cash in SARs. Unless SARs are exempted from
the deferred compensation rules, it is feared
by many observers that the schemes will be unable
to function, and most companies will withdraw
them in favour of other forms of incentive.
- In
December of that year, the Treasury announced
new guidance concerning changes to certain executive
compensation rules brought about by recently
passed tax legislation. The legislation surrounding
deferred compensation plans was tightened as
one of the revenue-saving measures contained
in the corporate tax bill passed by Congress
in October. By placing access restrictions on
monies contained in deferred compensation plans,
lawmakers are hoping to prevent a repeat of
some of the abuses witnessed in the Enron affair,
when several executives siphoned off assets
from deferred accounts shortly before the firm
went bust. The new rules will make it more difficult
for a beneficiary to take out money from such
a plan without incurring a 20% penalty. To avoid
this penalty, it is likely that the rules will
stipulate that deferred payments must be made
only at specified times, such as the end of
employment or death, whilst executives classed
as ‘key employees’ may not be able to receive
deferred compensation for six months after ending
their job with a company. The new rules are
expected to prompt a wholesale review of executive
compensation schemes to determine what forms
of pay will be caught by the revised legislation.
- In
June 2007, meanwhile, a Senate subcommittee
hearing concluded that new tax and accounting
rules are needed to bring more transparency
for investors regarding CEO pay, and to rein
in huge and undeserved salaries enjoyed by some
bosses at non-performing companies.The hearing,
held by the Senate’s Permanent Subcommittee
on Investigations examined corporate accounting
and tax rules that require corporations to report
one set of stock option compensation figures
to investors on their financial statements and
completely different figures to the Internal
Revenue Service on their tax returns.
“Stock
options are a major factor in the growing
gap – now chasm – between executive
pay and average worker pay,” said Sen.
Carl Levin (D - Mich), subcommittee chairman.
“Companies pay their executives with
stock options in part because, right now,
those stock options often generate huge tax
deductions that are 2, 3, even 10 times larger
than the stock option expense shown on the
company books."
New
IRS data, examining tax returns for periods
ending between December 2004 to June 2005,
shows a stock option book-tax gap of $43 billion,
"which means US companies legally reduced
their taxes by billions of dollars for that
period by claiming $43 billion more in stock
option tax deductions than the stock option
compensation amount shown on their books,"
Levin stated.
"Those
companies did not break the law," he
continued. "They are benefiting from
an outdated and overly generous stock option
tax rule that produces tax deductions that
often far exceed the companies’ reported
expenses.”
“It
is time to take a serious look at whether
it makes sense to have two completely different
sets of stock option rules for financial accounting
and tax purposes,” concluded Levin,
“especially when the result is a revenue
loss of billions of dollars.”
Venture
Capital Taxation
In
June 2007, former United States Treasury Secretary
suggested that fund managers receiving pay through
performance fees are not paying their fair share
of tax, adding fuel to the debate as to whether
curbs should be placed the escalating sums earned
by the top fund managers.
Sitting
as a panelist at a tax reform conference organised
by the Hamilton Project, part of the Brookings
Institution, Robert E. Rubin, a Treasury Secretary
during the Clinton administration, was asked whether
it would be more appropriate for fund managers
earning profits from managing others' money, known
as carried interest, to pay income tax at rates
of up to 35%, instead of capital gains tax, which
can be taxed at 15%.
“It
seems to me what is happening is people are performing
a service, managing peoples’ money in a
private equity form, and fees for that service
would ordinarily be thought of as ordinary income,”
Rubin said. He went on to state that the issue
should be examined “with great seriousness”
by the Congressional tax committees.
Currently,
the standard basic fee structure for managers
of hedge and private equity funds is 20% of gains
made by the fund, plus a 2% management fee. This
has helped to fuel some massive pay increases
for the heads of the most successful funds. According
to Alpha magazine, the average pay of the 25 top
performing fund managers was $570 million last
year. The highest paid of these fund managers
was James Simons, chairman of Renaissance Technologies,
who earned $1.7 billion.
Senate
Finance Committee Chairman Max Baucus (D - Mon)
has expressed concern that hedge fund and private
equity fund managers are manipulating the US tax
code to reduce their tax bills.
Senate
Finance Committee staff are currently examining
this area of taxation after a closed-door hearing
heard from a number of experts on the subject,
including University of Colorado law professor
Victor Fleischer, who has written a study of the
tax implications of hedge-fund managers' pay,
and Internal Revenue Service officials.
"The
different rate between capital gains and ordinary
income puts a lot of strain on the code,"
Baucus explained.
Later
that month, the industry's main lobby group suggested
that new legislative proposals that would tax
as corporations all publicly traded partnerships
that directly or indirectly derive income from
investment adviser or asset management services
would leave the majority of US venture capital
firms unaffected.
Responding
to the introduction of a bill that aims to tax
such funds at 35% instead of 15%, Mark Heesen,
president of the National Venture Capital Association
(NVCA), said in a statement that "almost
no" venture capital firms would be affected
by the proposals since they are aimed at funds
which are publicly traded.
"The
Bill proposed by Senators Baucus (D-MT) and Grassley
(R-IA) is directed at publicly-traded partnerships,"
Heesen stated. "As almost no venture capital
firms are publicly held, this proposed legislation
does not impact our business."
Heesen
added that the NVCA has met with staff members
of the Senate Finance Committee, Joint Tax, and
the House of Representatives Ways and Means Committee
over the past several months to explain how the
venture capital model is "taxed correctly".
"We
remain hopeful that lawmakers will continue to
demonstrate an understanding that the existing
venture capital tax structure is appropriate and
critical to economic growth in the US," Heesen
stated.
The
National Venture Capital Association (NVCA) represents
approximately 480 venture capital and private
equity firms. According to a 2006 Global Insight
study, venture-backed companies accounted for
10.4 million jobs and $2.3 trillion in revenue
in the United States in 2006.
Baucus
and ranking committee Republican Chuck Grassley
explained that they had introduced the bill because,
in the words of Grassley, some firms are "pretending
to be something they’re not to avoid most,
if not all, corporate taxes".
"It’s
unfair to allow a publicly traded company to act
like a corporation but not pay corporate tax,
contrary to the intent of the tax code,"
he said upon the bill's introduction, adding:
"If left unaddressed, the tax concerns presented
by the public offerings of investment managers,
like private equity and hedge fund management
firms, could fundamentally erode the corporate
tax base."
Similar
sentiments are being echoed across the Atlantic
in the United Kingdom, where incoming Prime Minister
Gordon Brown is under increasing pressure from
unions and the left of the ruling Labour Party
to change tax rules allowing private equity firms
to treat income as capital gains, and qualify
for a special tax regime that can reduce tax on
carried interest to 10%.
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