The filing revealed an effective tax rate in 2011 of 41%. This was up from 39.9% at the end of 2010 and only 10% the year before that. The statutory corporate tax rate in the US was 35% during each of these years.
If you include deferred tax expenses or benefits, Facebook provided for $25 million in tax in 2009. This has increased dramatically in each of the last two years: $402 million in 2010 and $695 million in 2011. But then the company’s income has also shot up in those years. Pre-tax profit was $254 million in 2009, $1.008 billion the year after and $1.695 billion in 2011.
The tax and transfer pricing risks mentioned in the prospectus include having lower profits in jurisdictions where tax rates are low and more than expected income in places where tax rates high. Tax authorities could also challenge the company’s methodologies for valuing developed technology and intercompany arrangements.
The company also raised the threat posed to its business by changes to how deferral works in the US’s international tax rules. It pointed out that the Obama Administration has made international tax reform a priority and that Congressional committees have held hearings on the topic.
“Certain changes to U.S. tax laws, including limitations on the ability to defer US taxation on earnings outside of the United States until those earnings are repatriated to the United States, could affect the tax treatment of our foreign earnings, as well as cash and cash equivalent balances we currently maintain outside of the United States,” the prospectus states. “Due to the large and expanding scale of our international business activities, any changes in the U.S. taxation of such activities may increase our worldwide effective tax rate and harm our financial position and results of operations.”
The company stated that excess tax benefits associated with stock option exercises and other equity awards are credited to stockholders’ equity. The income tax benefits that were accounted for in this way were $50 million, $107 million and $433 million for the years ended 2009, 2010, and 2011. Its fiscal year corresponds to the calendar year.
Tony Nitti, a tax partner of WithumSmith & Brown, an accounting and consulting firm, pointed out, in a blog post, that Facebook anticipates it will generate a net operating loss (NOL) in 2012 even though it recognised $1.7 billion in pre-tax book income in 2011. He explained this was because of employees’ exercise of nonqualified stock options.
These hundreds of millions of shares of non-qualified options previously granted to employees, which Facebook expects to be exercised after the IPO, are generally not taxable under the Internal Revenue Code until exercise if the stock is freely transferable and not subject to a substantial risk of not being able to be utilised at that time.
“If these requirements are met, upon exercise the employee must recognize income equal to the excess of the FMV (fair market value) of the stock over the exercise price, with the employer getting a corresponding deduction,” Nitti wrote. “Assuming Facebook stock reaches a price of $40 per share on the open market, the corporate deduction related to the exercise of employee options will be in the billions; large enough not only to wipe out the company’s 2012 taxable income, but also –according to the prospectus — to generate an NOL that will be carried back to generate $500 million in tax refunds.”
Nitti added that because the income recognised by employees upon the exercise of non-qualified options is taxed as compensation, the prospectus indicates that Facebook is anticipating using a large amount of the $5 billion raised from the IPO to pay its required tax withholding obligations.
“We anticipate that we will expend substantial funds in connection with tax withholding and remittance obligations related to the initial settlement of our restricted stock units (RSUs) approximately six months following our initial public offering,” the document states.
Net deferred tax assets (DTA) were $39 million for the year ended December 31 2010, consisting of deferred tax assets, excluding a valuation allowance, which was zero, of $68 million and deferred tax liabilities of $29 million. At the end of December last year, net deferred tax assets were $60 million, which were made up $140 million of deferred tax assets excluding a valuation allowance of about $9 million, and deferred tax liabilities of $80 million.
The prospectus states that the valuation allowance was lower by about $76 million for the year ended December 31 2009.
“In all likelihood, the bulk of this DTA related to a large NOL carryforward that the company determined in 2009 would be fully utilized in the future against taxable income, so a valuation allowance was no longer necessary,” wrote Nitti.
A valuation allowance refers to the requirement, under GAAP tax accounting, that companies assess the likelihood, of more than 50%, that deferred tax assets will be realised. When the likelihood falls below this threshold, a valuation allowance, or the amount of DTAs the company believes it will not be able to use, is necessary. The company said the valuation allowance of about $9 million at the end of last year related to state tax credits.
Facebook has $24 million in US net operating loss carryforwards: $7 million are federal, which will expire in 2027 if the company does not use them, and $17 million are from the state of California. These will be lost in 2021 if not used before then. State tax credit carryforwards of $9 million can be used for an indefinite period. Nitti speculates that for a company with Facebook’s earnings to have a federal NOL carryforward could be because it is limited by Section 382, which relates to a change in ownership of a company, from using all of the losses. In fact, the prospectus mentions the possibility that its use of losses could be curbed by changes to rules on the annual limitation because of ownership changes.
Gross unrecognised tax benefits amounted to $9 million, $18 million and $63 million respectively, at the end of the 2009, 2010 and 2011 fiscal years.
The IRS began a review of Facebook’s 2008 and 2009 tax years in 2011. The company believes it has reserved enough in its accounts to pay for any adjustments that arise from these examinations, and the company does not anticipate any significant impact to its unrecognised benefits. It stated that the US tax authorities still have to examine its 2010 and 2011 tax years and that the tax administration in Ireland, the only other material taxing jurisdiction it mentions and where it set up its international headquarters four years ago, could look at all of its tax years there, starting from 2008.
This is the first glimpse for many of the tax details behind the growth of Facebook. It paints a conventional picture of a company’s tax expense increasing at the same time as its revenue. What will surprise in a climate of criticism of multinational companies for not contributing enough tax is an effective tax rate that has been above the statutory figure for each of the last two years.
Fenwick & West, the law firm located in Mountain View, close to Facebook in Menlo Park in Northern California, advised the company on the tax aspects of the IPO.
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