|
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
2008, after a series of progressive steps, the
FASB had substantially achieved its goal of banning
merger accounting, with its Statement No. 141(R),
Business Combinations, 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 by 2006 the
FASB had successfully installed a rule requiring
the expensing of stock options.
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, US hotel chain Marriott International,
Inc. announced that it had paid $220 million
to the Treasury and a number of unnamed states
to settle a tax dispute relating to its leveraged
employee stock ownership plan (ESOP). The payment
stems from an Internal Revenue Service audit
of Marriott's 2000-2002 tax returns, which uncovered
$1 billion in deductions that the company took
from the employee stock ownership portion of
a program called 'Employees' Profit Sharing,
Retirement and Savings Plan and Trust'. As a
result of the settlement, the company revealed
that it would make cash payments to the Treasury
and state tax jurisdictions of approximately
$220 million. The payments reflect income taxes,
excise taxes and interest charges. No penalties
were assessed.
-
In April 2008 The US Securities and Exchange
Commission (SEC) charged Broadcom Corporation
with falsifying its reported income by backdating
stock option grants over a five-year period.
As a result of the fraud, Broadcom restated
its financial results in January 2007 and reported
more than USD2bn in additional compensation
expenses. The Irvine, Calif.-based semiconductor
maker agreed to settle the charges, and consented
to pay a USD12m penalty. "The backdating
scheme at Broadcom went on for five years, involved
dozens of option grants, and resulted in the
largest accounting restatement to date arising
from stock option backdating," explained
Linda Chatman Thomsen, Director of the SEC's
Division of Enforcement, continuing: "The
scope and magnitude of the fraud warrants the
significant penalty imposed on the company."
Rosalind R. Tyson, Acting Regional Director
of the SEC's Los Angeles Regional Office, added
that: "Today's action highlights the ways
in which certain companies have abused option
grants. Broadcom used lucrative in-the-money
grants to recruit and retain talented employees
without paying them higher cash salaries, but
avoided the requirement to report the billions
of dollars in compensation expenses by secretly
backdating the options." In a complaint
filed in the US District Court for the Central
District of California, the SEC alleges that
from June 1998 to May 2003, Broadcom, acting
through its top officers, misrepresented the
dates on which stock options were granted to
executives and employees. The SEC further alleged
that, as a result of the backdating scheme,
Broadcom avoided reporting USD2.22bn in compensation
expenses during the relevant period. Without
admitting or denying the SEC's allegations,
Broadcom agreed to settle the charges by consenting
to a permanent injunction against further violations
of the antifraud, record-keeping, financial
reporting, internal controls, and proxy provisions
of the federal securities laws, and payment
of the USD12m penalty.
-
Combating accounting fraud, including illegal
stock option backdating, was a priority for
the SEC in fiscal year 2008. During the year,
the SEC charged eight public companies and 27
executives with providing false information
to investors based on improper accounting for
backdated stock option grants.
-
In August 2008, a report claimed that US taxpayers
are effectively subsidizing excessive executive
compensation to the tune of billions of dollars
every year as a result of loopholes in the tax
code. The 15th annual 'Executive Excess' report
from the Institute for Policy Studies and United
for a Fair Economy calculates that the annual
cost to taxpayers of five commonly-used tax
and accounting loopholes that encourage excessive
executive pay is USD20 billion annually. The
most expensive of these loophole as far as the
US Treasury and the average taxpayer are concerned
is the stock option accounting double standard.
Under Section 83 of the tax code, first enacted
in 1969, the stock option tax deduction does
not reflect the expense shown on a company’s
books. Instead, the stock option deduction is
calculated on the date that a stock option is
exercised, which is often years after it is
granted. The deduction is equal to the difference
between what the employee paid to exercise the
option and the market value of the shares on
the exercise date.
-
In October 2008 the Treasury Department announced
that firms participating in its rescue programs
under the Emergency Economic Stabilization Act
would have to follow tougher tax rules governing
executive compensation and adhere to stricter
corporate governance standards surrounding executive
pay in general. Under the Stabilization Act,
any financial institution that sells more than
USD300 million of troubled assets to the Treasury
via an auction would be prohibited from entering
into new executive employment contracts that
include golden parachutes for the term of the
program. In addition to this, financial institutions
are prohibited from deducting executive compensation
in excess of USD500,000 for each senior executive
and certain golden parachute payments for tax
purposes. Also, a 20% excise tax will be imposed
on the senior executive for these golden parachute
payments. The Treasury released IRS Notice 2008-94
regarding these new tax rules. These rules also
apply to financial institutions participating
in the Capital Purchase Program, which requires
these firms to ensure that incentive compensation
for senior executives does not encourage "unnecessary
and excessive risks" that threaten the
value of the financial institution.
-
In March 2009 the US House of Representatives
gave bipartisan support legislation written
by Ways and Means Committee Chairman Charles
Rangel to tax the bonuses of highly paid individuals
employed at companies in receipt of bail-out
funds at a rate of 90%. Meanwhile, over in the
Senate, four members introduced legislation
to discourage excessive compensation by companies
that have taken taxpayer dollars by proposing
a 35% excise tax on both employers and employees,
on retention bonuses and other bonuses, and
by imposing a limit on non-qualified deferred
compensation. Small banks as defined by the
tax code and entities that received less than
USD100m in TARP funds would be exempt from this
legislation. Senate Finance Committee Chairman
Max Baucus said: “We must act quickly
on this proposal – for the sake of the
American taxpayer, for the sake of what’s
right to do. I will work with my colleagues
in both the House and Senate to make sure that’s
what happens," Baucus added. The Senate
bill directs the Treasury to issue guidance
allowing an institution to cancel or modify
an outstanding deferral election or an individual
to terminate participation in the non-qualified
deferred compensation plan without being subject
to the legislation or the penalties that would
otherwise apply under the tax code.
The
'Carried Interest' Debate
Over the past few years there has been constant
pressure from Democrats in and out of Congress
to change the basis of taxation of fund managers
(including venture capitalists). 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. The profit
element is known as 'carried interest' and is
normally taxed as a long-term capital gain at
15%, rather than as income at 35%.
In
April, 2009, Democratic lawmaker Sander Levin
reintroduced legislation into the US House of
Representatives that would tax fund managers'
carried interest compensation at the same rates
as ordinary income.
“This
is a basic issue of fairness,” said Levin.
“Fund managers are receiving compensation
for managing their investors’ money. They
should not pay the 15% capital gains rate on their
compensation when millions of other hard-working
Americans, many of whose income is performance-based,
pay ordinary rates of up to 35%."
The
move is of course supported by President Obama
who had inserted a similar proposal into his 2010
budget. "The budget proposes to tax the compensation
paid to hedge fund managers, private equity partners
and others in the same way that we tax the wages
paid to ordinary American workers," Treasury
Secretary Tim Geithner told the House Ways and
Means Committee in March. "By closing this
carried interest provision, the tax code will
provide equal tax treatment for wages regardless
of whether an individual works as a teacher or
a hedge fund manager."
As
long ago as June 2007, former United States Treasury
Secretary Robert E Rubin had suggested that fund
managers receiving pay through performance fees
were not paying their fair share of tax, adding
fuel to the debate as to whether curbs should
be placed on the escalating sums earned by the
top fund managers.
“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.
Senate
Finance Committee Chairman Max Baucus (D - Mon)
had also expressed concern that hedge fund and
private equity fund managers are manipulating
the US tax code to reduce their tax bills.
"The
different rate between capital gains and ordinary
income puts a lot of strain on the code,"
Baucus explained.
Adding
to the debate, 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.
BACK
TO TOP
|
USA-INVESTMENT-TAX.COM 
