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IT giants who don't pay tax part 2: how Microsoft does it

And how the Weimar republic may beckon...

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Analysis Microsoft makes much more money from dealing in stock options than from Windows, and as a result paid no tax in fiscal 2000. It's not the picture you'd expect, and it's not exactly easy to get the real picture either - but it's all perfectly legal, really.

In effect, Microsoft has three sets of accounts: the ones its auditors see; the ones it gives to the IRS tax man, with some further breakdowns; and the ones it uses to figure out how to optimise its financial position. Since it discloses only the first set, it requires quite a bit of work to figure out the hidden lines available to Microsoft and which are hard to reconstruct from the data available. We used Microsoft's recent 10-K filing with the SEC, analysis from Bill Parish's web site - Parish is the best-known critic of Microsoft's financial practices - and insightful comment from fool.com and elsewhere in an attempt to dissect how Microsoft manages its finances.

Put warrants

In 1994, the then-Microsoft treasurer Greg Maffei convinced Bill Gates that Microsoft should sell put warrants to offset the costs and risks associated with buying back its own shares. Puts are essentially a bet by Microsoft that the share price will go up, and the warrants are sold to investment managers at a specific, higher price for redemption on a specific date. This worked well until recently and made Microsoft hundreds of million of dollars that it used to repurchase its shares. But with the downturn in the share price, Microsoft is forced pay the difference between the strike price and the expiry price. The puts are now "in the money", and Microsoft is in effect having to shell out the difference.

Fund managers buy the warrants as an insurance, so that they can always be sure of getting at least the strike price back from Microsoft, however much the share price might fall.

Microsoft received nearly $500 million for selling its puts in fiscal 2000, down 40 per cent from the previous year. As of 30 June, warrants for 157 million shares were outstanding, with strike prices ranging from $70 to $78 per share and expiring between September 2000 and December 2002. The average price is $74 and the total value more than $11 billion, so that if they had all expired when the share price was $54, there would be a loss of $3.14 billion, dwarfing the $2.1 billion Microsoft has made from hedging premiums and giving a net loss of around $1 billion. Microsoft analyst Rick Sherlund of Goldman Sachs suggested recently that the puts could cost Microsoft around $1 billion a quarter if the share price stays at present levels. Curiously, this liability does not have to be shown on the balance sheet.

Stock options

Microsoft's game plan for making money from stock options is quite simple. First, print some share certificates. Second, give out handfuls of stock options from time to time to keep the employees slaving away for at least 4.5 years until the shares vest. Third, Microsoft claims a tax rebate from the IRS when the employee takes up the shares and pays tax on them.

Microsoft gained $5.5 billion in "stock option income tax benefits" in fiscal 2000, meaning that it had a tax benefit against share options that had been exercised (up nearly 80 per cent over the previous year). With corporate tax levels around 35 per cent, Microsoft effectively received an untaxed benefit of $16 billion. In practice, Microsoft has no choice but to pay employees substantially in shares if it is to keep its present level of staffing, since if it had used cash in fiscal 2000 instead of shares, this would have increased the salary bill by $16 billion - more than Microsoft's net income, and thus resulted in Microsoft making a loss of $7 billion.

The beauty of this system for Microsoft is that it did not have to spend anything to grant the options, but gained $2.25 billion (shown as "common stock issued" in the cash flow) from what the employees have to pay to exercise the options. A line that should appear in Microsoft's accounts - but doesn't - is how much it saves as a result of stock option dealing. The total can be worked out by adding three things together: $0.5 billion from put warrants; $5.5 billion from the income tax that employees had to pay to acquire the stock; and $2.25 billion that employees had to pay Microsoft for the stock, making a total of $8.25 billion or 88 per cent of Microsoft's net income of $9.5 billion in fiscal 2000.

Microsoft only made $5.8 billion on Windows, $4.9 billion on applications, and lost $1.5 billion on its consumer and other activities. Of course, Microsoft does not have to account for stock option dealing in this way under the present accounting rules, but the benefit that Microsoft gets is clearly of very great importance - and more than that received by any competitor. The provision for income tax in Microsoft's accounts was $4.9 billion, implying it would carry forward a tax credit of $680 million. There appears to be no direct way of identifying the rebate (in effect a subsidy on non-US sales) that Microsoft gets from the now-illegal foreign sales corporation scheme, but it must be considerable.

Repurchasing shares

There are no effective rules about the number of shares a company can print for its employees, and the only real problem comes when these dilute the shares owned by other investors, which is why Microsoft has a share buy-back programme. The employees have tended to hang on to their shares, but the crunch will come if they start having to sell them on a significant scale to repay loans against them - and with the share price in the low 50s, that time could well be near. This would increase the number of shares in circulation and could result in a further fall in the share price. Not even Microsoft's reserves would be enough to stop such an avalanche of selling, since its $24 billion cash and short-term investments would be insufficient for any large-scale support operation.

Microsoft spent $5 billion repurchasing its shares in fiscal 2000. At 30 June 2000, Microsoft had options for 341 million shares vested and 734 billion shares available for future grants. The weighted average price per share was $41.23. The dilutive effect of employee stock options was $338 million. Since fiscal 1990, Microsoft has repurchased 765 million of its common shares and issued 1,990 million shares. The market value of all outstanding stock options at 30 June was $67 billion, and there were 5.26 billion shares outstanding.

There are four main problems for Microsoft if the share price remains depressed: because of poor morale, Microsoft had to agree in April to give employees an additional $1.9 billion of new options because the depressed share price had made the previous year's options worthless. Another similar handout may be needed soon. Furthermore, while the share price is down, employees will not exercise so many options so Microsoft could find itself paying some tax this year. Then there's the amounts that Microsoft will have to pay up on expiring put warrants.

Finally, major fund managers have been reducing their Microsoft holdings for several months: Fidelity Investments reduced its holdings by 36 per cent to 119 million shares, Janus Capital by 47 per cent to 18.1 million shares and Putnam Investments by 14 per cent to 48.4 million shares, according to their latest SEC filings. Socially responsible investment funds have also been dropping Microsoft holdings as a result of the trial verdict. And let's not forget that the Dominican Sisters Vision of Hope in Fremont, California clearly saw no upside for the shares they were given, so have sold them.

MS financial practices questioned

Parish believes that if Deloitte and Touche, Microsoft's external auditors, followed the Statement of Auditing Standards (SAS), it should qualify Microsoft's accounts. He also accuses Microsoft of having constructed a "financial pyramid" that has the key weakness that Microsoft has liability for some $67 billion of stock options but is not required to account for these in the balance sheet. In a Senate hearing in 1993 when this issue was discussed, it was claimed in evidence produced by an auditor that Silicon Valley profits would decline by 35 per cent if options had to be shown on the balance sheet. Parish also says that the accounts that Microsoft presents publicly, and files with the SEC each quarter, have been managed to ensure that analysts' expectations are met.

We know that the SEC became interested after Microsoft settled with a whistleblower former employee, who funnily enough then shut up, and because Microsoft admitted that the SEC has started a "non-public investigation into the company's accounting reserve practices". This investigation was spurred following disclosures related to a wrongful dismissal claim brought by Microsoft's former (internal) general auditor, Charles Pancerzewski, who had been offered a "resign or be fired" choice in 1996 after he claimed accounting practice irregularities. Pancerzewski complained that Microsoft used its reserves to pad its earnings in lean quarters, with the result that Microsoft misreported its earnings.

Microsoft's "unearned revenue from prior periods" in its cash flow statement shows that Microsoft recognised $5.6 billion in fiscal 2000, up from $4.526 billion in fiscal 1999 and $1.798 billion in fiscal 1998. Pancerzewski filed suit under the Whistleblowers Protection Act, resulting in Microsoft's records being subpoenaed. The judge decided there was enough evidence to go to trial on the whistleblower charges, but Microsoft quietly settled out of court, with Pancerzewski apparently accepting $4 million in compensation, a gagging agreement, and the sealing of the court record.

It is interesting to recall that pundit Robert Cringely noted a conversation he had with former Microsoft CFO Frank Gaudette. When asked what signs there would be as to when Microsoft stock should be sold, Gaudette said: "Watch for any changes in our accounting. If I need, I can start depreciating the software and maintain earnings growth for years on flat revenue." Although Microsoft hasn't yet reached the point of doing this, it is highly significant that a major change in the accounting system was introduced recently, especially as lacklustre results are expected for the current Q1.

The worst scenario for Microsoft would be if the share price stayed depressed during the appeals. A long-term financial decline at Microsoft is beginning to look more likely than a defeat in the appeal courts. ®

Related Stories:
Accounting masterclass: how Cisco and MS avoid tax
IT giants who don't pay tax part 1: how Cisco does it

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