Stock-based compensation can have a significant impact on the effective tax rate. For US companies the effect is driven to a large extent by changes in the stock price. In 2021 this reduced the effective tax rate for many companies; however, in 2022 you could well see the reverse.
We use Netflix to explain the effect of stock-based compensation on cash taxes and deferred tax adjustments. The accounting is complex and made even more challenging for investors by differences between IFRS and US GAAP. Unfortunately, neither US GAAP nor IFRS financial statements may fully reflect the underlying economics.
The effective tax rate is simply the reported tax expense divided by pre-tax profit. This rate, and the differences observed between companies, matters in equity analysis.
Tax affects post-tax profitability and values derived from applying multiples of post-tax profit such as EV/NOPAT and a P/E ratio. In DCF analysis effective tax is a component of free cash flow, usually incorporated by starting the derivation of FCF with post-tax operating profit (NOPAT). Even if your approach to valuation uses pre-tax metrics, such as in EV/EBITDA, effective tax rates still matter. Differences in tax rates affect the observed multiples and should be considered when comparing multiples in a relative valuation analysis.
Different versions of the effective tax rate may be calculated. Sometimes the impact of deferred taxes is excluded on the basis that these adjustments are non-cash items. The resulting rate may be referred to as the effective cash tax rate.1There is no standardisation of terminology. Effective cash tax rate may refer to either the current tax charge in profit and loss divided by pre-tax profit or, alternatively, the actual cash tax payment in the cash flow statement divided by pre-tax profit. In our view, the tax expense better reflects the economic cost of taxation when deferred tax is included. This is because the total tax charge more closely reflects the tax consequences of those gains and losses recognised in profit and loss.2To understand the mechanics of deferred tax, and how deferred tax adjustments produce a more useful effective tax rate, see ’Deferred tax and temporary differences – A Footnotes Analyst guide for investors’.
Companies must disclose an effective tax rate reconciliation
Under both IFRS and US GAAP companies provide a reconciliation between the effective tax rate and the statutory corporate tax rate of the jurisdiction of the parent company. The disclosure may be done in absolute or percentage terms. The absolute approach starts with what corporate tax would have been paid had the statutory rate been applied to pre-tax profits, with the difference between this and the actual tax charge attributed to the various factors. Alternatively, the same reconciliation may start with the statutory rate, with the same factors expressed in percentage terms and the reconciliation ending with the effective tax rate.
Netflix effective tax rate reconciliation
Netflix 2021 financial statements
In the example above, US GAAP reporter Netflix uses the absolute approach for the reconciliation, but with the percentage effective tax rate noted. The expected tax expense at the US Federal rate of 21% is $1,226m. To convert the reconciliation into percentages simply divide each figure by the reported pre-tax profit of $5,840m.
The individual components of the effective tax reconciliation will vary by company and by jurisdiction. However, there are some items that you will often see:
- Other taxes: In some jurisdictions there may be other corporate taxes payable, such as State income taxes for the USA.
- Foreign taxes paid at different rates: Companies with foreign operations will be affected by higher or lower foreign tax rates. If, for example, these are lower than the parent company rate, and the effect is not offset by additional tax payable on remitted profit, the effective tax rate is reduced.
- Rate adjustments: In some jurisdictions the headline tax rate is not what is actually paid. Fiscal incentives such as credits for investment in R&D or for export earnings may reduce tax paid.
- Non-taxable and non-deductible amounts: Some components of profit may be taxed differently and at different rates. For example, certain income might be tax-free or an expense not tax deductible.3Netflix separately identifies one such item – Non-deductible Officers Compensation. This probably relates to the grant of so-called incentive stock options to management, the tax rules for which preclude a deduction, which results in a small (0.5%) increase in the effective tax rate.
- Deferred tax adjustments: Most deferred tax adjustments do not contribute to differences in the effective tax rate reconciliation. Indeed, the point of deferred tax is essentially to produce an effective tax rate that more closely aligns with the statutory rate, even if the cash tax rate temporarily differs4For an explanation about how deferred tax adjustments result in a more realistic periodic effective tax rate see ‘Deferred tax and temporary differences – A Footnotes Analyst guide for investors’.. However, some aspects of deferred tax do produce adjustments, particularly those related to the recovery of deferred tax assets.
Stock-based compensation reduces Netflix effective tax rate by 5%
You can identify some of these in the Netflix effective tax rate reconciliation above. However, it is the effect of stock-based compensation which we focus on in this article.
For Netflix “excess tax benefits on stock-based compensation” reduced the effective tax rate by 5% ($291m / $5,840m) in 2021, with the impact varying in prior years. We explain below why this reduction occurs, what it means and why the amount would likely have been very different if measured under IFRS.
Tax impact of stock-based compensation
The impact of stock-based compensation on the tax expense and the effective tax rate reconciliation depends on how it affects (1) the amount and timing of current tax payments; (2) deferred tax adjustments; and (3) where in financial statements the tax expense is recognised.
1. Current tax
In most jurisdictions, companies receive a tax deduction for the stock-based compensation expense. There are exceptions to this, such as the incentive stock options in the USA, but most compensation is tax deductible and results in a reduced tax payment in the period the deduction is obtained.
However, the timing and amount of the tax deduction will probably not be the same as the expense recognised in profit and loss. The corporate tax deduction is commonly obtained when the employee pays income tax on the stock that they receive. Generally, this takes place when the employee receives and can sell their shares; for stock grants this is at the point of vesting and for options it is delayed until the option is exercised. Given that the SBC expense is recognised over the vesting period, the tax deduction is generally obtained in a later period. This difference in the timing of the recognition of the expense and the tax deduction results in the deferred tax adjustments we explain below.
SBC tax deduction is often not the same as the SBC expense
To complicate matters the amount of the deduction may also differ from the profit and loss expense. Generally, the tax deduction equals the value of the shares received by the employee at the date of vesting or exercise, less any amount paid for those shares by the employee. Because the profit and loss expense is based on the grant date value of the stock or options, the tax deduction may be higher or lower depending on the movements in the share price. This is the primary driver of the adjustment seen in the US GAAP effective tax reconciliation.
The negative effect of SBC on the Netflix effective tax rate is due to the value of options exercised in 2021 being higher than the previously recognised expense. The extract below shows that the average exercise price of options exercised in 2021 of $65.67 is significantly below the Netflix stock price in this period, as evidenced by the average exercise price of options granted in 2021 of $554.11. The actual intrinsic value of options exercised in the year, and hence the tax deduction, is given in the text below the table – $1,363m in 2021.
Netflix stock options granted and exercised
Netflix 2021 financial statements
We can estimate the previously recognised expense by multiplying the number of options exercised in 2021 by the original grant date value. Considering these options would have been issued on different dates we don’t know exactly what this is. However, Netflix does disclose the fair value of options granted each period, which in the last 3 years were relatively stable at between 47% and 50% of the average stock price. In the table below we have assumed that the prior grant date value, and hence amount expensed, of options exercised in 2021 is 48% of the average exercise price.
Using this information, we can demonstrate how the excess tax deduction in the effective tax reconciliation was calculated:
Netflix excess tax benefits on stock-based compensation in 2021
It may seem odd that the tax saving reported by Netflix in 2021 ($291m) is greater than the profit and loss expense previously recognised in respect of these same options (estimated at $83m). The result is a net gain from granting options which seems to contradict the notion that option grants to employees are an expense. Of course, this is a result of the significant increase in Netflix stock price since the options exercised in 2021 were originally granted. Had the stock price fallen below and remained below the exercise price then no exercise would have taken place and no tax saving obtained.
The disconnect between the expense and tax does seem to support a view that stock-based compensation expense should be measured at the vesting or exercise date value to reflect the ultimate gain made by the employees. The change in value of stock and options granted to employees after the grant date can be regarded as either an adjustment to the employment compensation amount or as a gain or loss made by the employees in their capacity as shareholders. Both views are valid
We think that the best approach from an analytical perspective is the grant date accounting adopted by IFRS and US GAAP. However, the consequence of this is that investors need to be careful when analysing taxation.
2. Deferred tax
Stock-based compensation has a deferred tax effect due to the difference in timing of when the deduction is received and when the expense is recognised.
While the current tax effects of stock-based compensation are simply a function of the amount and timing of the tax deduction, the deferred tax impact depends on the accounting methodology applied. US GAAP and IFRS adopt very different approaches.
US GAAP
Under US GAAP, when SBC is expensed, a deferred tax asset is recognised in the balance sheet and a tax credit recognised in profit and loss which equal the tax rate multiplied by the expense. This is to recognise the future tax saving and the related expense in profit and loss in the same period.
When the tax deduction is obtained, the deferred tax entry is reversed. This results in a charge to profit and loss that offsets part of the actual current tax saving. It is this deferred tax adjustment that results in the excess tax benefits in the year of exercise being included in the effective tax reconciliation.
In the Netflix extract below the SBC expense for 2021 is $403.2m. The “total income tax impact” of $89.6m is the deferred tax entry we describe – a credit in profit and loss and an increase in the deferred tax asset.
Netflix stock option expense and tax credit
Netflix 2021 financial statements
A key feature of the US GAAP approach (but not IFRS) is that once deferred tax is recognised it is not updated, even though we know that, due to the stock price changing, the actual tax saving on the vesting or exercise date will differ from the deferred tax asset. As a result, for companies where the stock price has increased (such as Netflix) the future tax savings that are likely to materialise are not fully recognised, and the deferred tax asset reported in the balance sheet is understated.
Netflix has an unrecognised deferred tax asset of $1,149m
We can estimate the extent of this for Netflix. In the text below the table about options granted and exercised, Netflix says that the aggregate intrinsic value of options outstanding at the end of 2021 was $6,744m. This will produce a future tax saving of about $1,500m. The deferred tax balance in respect of stock-based compensation is $351m5See note 10 of the 2021 financial statements., which means that the excess tax saving expected in future periods, and that will appear in future effective tax rate reconciliations, is $1,149m (assuming the stock price does not change – see below).
If the price declines such that the gains realised by employees are less than the grant date value of the options, then the effect will be reversed – the deferred tax asset in the balance sheet will be greater than the likely future tax saving. In his case the entry in the effective tax reconciliation will be an increase not reduction in tax.
IFRS
Under IFRS, deferred tax assets are also reported for the future tax effects of stock-based compensation. However, unlike US GAAP, the amount is based on the intrinsic value of the recognised compensation measured at the reporting date and is updated each period. Had Netflix reported under IFRS it would have had a deferred tax asset in its 2021 balance sheet of about $1,500m instead of the reported $351m, although, as we explain below, not all of that would have been reported as a gain in profit and loss.
Deferred tax is updated under IFRS but based on intrinsic value not fair value
Tax benefits under IFRS are gradually recognised and adjusted over the period to vesting or exercise, instead of an initial amount plus a later catch up, as under US GAAP. The effective tax rate reconciliation of an IFRS reporter may still feature an entry for stock-based compensation but in a different period and probably not as large as under US GAAP.
3. Location of the tax effect
Income or expense items and the related tax effect are usually both reported in the same location. For example, if preferred stock is classified as equity for accounting purposes but as debt for taxation purposes (a common goal of financial engineering) the dividends are an appropriation of profit, not an expense, but still create a tax deduction and saving. In that case the tax will be reported as a movement in equity along with the dividends.
While the stock-based compensation expense is fully reported in profit and loss, part of the related tax saving arises from a change in the stock price which, arguably, should be reported directly in shareholders’ equity and not profit and loss. However, IFRS and US GAAP take different views:
- US GAAP: The full tax saving is reported in profit and loss irrespective of whether the tax deduction is affected by stock price changes and differs from the stock-based compensation expense. This was not always the case. Prior to 2017 any excess tax savings were mostly reported directly in equity. Those rules were very complex – one of the reasons for the change was to simplify GAAP.
- IFRS: If the tax deduction exceeds the stock-based compensation expense, the additional excess tax saving is reported directly in equity and never impacts profit and loss. Had Netflix reported under IFRS, its tax charge would have been higher and earnings lower by the $291m we identified in the effective tax reconciliation.
The logic of the IFRS approach is that the increase in value of shares or stock options since their date of grant is an exchange between different shareholders. Therefore, the related taxation should be recognised in shareholders’ equity. In effect, the cost of capital related to unvested stock or unexercised options granted to employees is tax deductible.
An illustration
In our simple illustration below we show how the IFRS and US GAAP accounting for the tax effects of stock-based compensation produce very different results.
The inputs for the stock price at the end of year 1 and 2 can be changed. For US GAAP this only affects the final adjustment at the point of vesting because the deferred tax entries are not updated. For IFRS the stock price affects both the tax expense and tax recognised directly in equity during the vesting period; however, because the deferred tax asset is updated there is no later catch up.
Stock-based compensation deferred tax under US GAAP and IFRS
Note: This is a simplified model. We show the grant of options in just one period (at the start of year 1) and the resulting profit and loss and tax effects over the following 3 years. It is for this reason that the excess tax benefits only arise in the third year. In practice stock-based compensation will be granted each period with the tax impacts overlapping.
Our view
There is no perfect answer to the method of accounting for the tax effects of stock-based compensation.
The problem with the US GAAP approach is that deferred tax assets recognised when the stock-based compensation is expensed are not updated. This can result in tax assets in the balance sheet that are under or overstated. They may even have no value if there is no expectation of any future tax saving. These worthless assets may persist for many years. IFRS is better in that deferred tax assets are adjusted – if the options are underwater then no deferred tax asset will be reported.
IFRS tax asset is updated but some tax savings are missing from profit and loss
However, the problem with the IFRS approach is that deferred tax is based only on the option intrinsic value and not the fair value used under US GAAP (there is no problem for stock grants). When stock options are expensed under IFRS, the related tax saving is likely to be understated, only for an expected catch up to come later.
Which of IFRS and US GAAP has the right approach to excess tax savings is difficult to say. The US GAAP approach of recognising this in profit and loss makes the effect more transparent than the IFRS approach of reporting the effect directly in equity. The US GAAP approach also ensures that all cash taxes flow through profit and loss. However, it also seems to introduce a mismatch between how the stock-based compensation expense and the related tax saving is reported.
What matters is that the accounting applied is understood and the full effect on tax, including on future cash tax payments, is included in your analysis.
Implications of the recent fall in Netflix stock price
Our above analysis of the effect of stock-based compensation on the effective tax rate of Netflix is based on the company’s stock price during and at the end of 2021. The average price in 2021 was around $550 and at 31 December 2021 it was $602. However, by the time we wrote this article in May 2022 the price had fallen to $199.
The consequences of this fall are that future cash tax savings and the related reduction in the tax expense will be much lower than previously expected, although the actual tax saving will depend on the Netflix stock price if and when options are exercised.
Stock price fall in 2022 likely to result in a higher effective tax rate in the future
The options granted in the last 3 years are now all underwater and will not be exercised unless the stock price recovers. If they are never exercised, then in some future period there would be an increase in the effective tax rate when the related deferred tax asset is reversed and not offset by an actual cash tax saving. However, this effect will be offset by the exercise of options granted in earlier periods, where the intrinsic value remains positive and higher than the original fair value when granted, for which there would still be excess tax benefits.
Unfortunately, it is not possible to accurately estimate how the future tax effect of stock-based compensation is affected by changes to the stock price. However, by examining past grants you should be able to get a reasonable idea.
Implications for equity analysis and valuation
For companies with a significant stock-based compensation programme, and especially those reporting under US GAAP, it is important that investors realise that the effective tax rate can be affected by stock price changes. When stock prices rise, such that the gains made by employees are greater than the prior reported SBC expense, the effect is to reduce the US GAAP effective tax rate. But this effect is variable and can change significantly from one period to another.
For equity valuation it is important that you fully incorporate the tax savings arising from stock-based compensation. Where taxation reflects vesting or exercise date values, the equity finance arising from SBC is, in effect, tax deductible. This benefits equity investors and must be included in any valuation of common stock.
There are two approaches:
- Include all tax effects in the effective tax rate: If the effective tax rate used within performance measures and to derive free cash flow for DCF purposes includes the full forecast tax consequences of stock-based compensation, no other adjustments are required. However, for IFRS this means including tax savings that would be reported in equity. And for both US GAAP and IFRS it means including in long-term forecasts ‘normalised’ tax savings arising from the expected return for employees from their unvested or unexercised stock or stock options.
- Separately include the future excess tax savings: In this case use an effective tax rate that excludes any adjustments in respect of stock-based compensation and instead include the excess absolute tax savings as separate components of a valuation. Tax savings that have accrued in respect of stock and options that have been granted, but not yet vested or exercised, should be included in enterprise value and the enterprise to equity bridge. Future tax savings related to the expected return on current and future grants may be included either by adjusting the cost of capital for SBC to be post tax or by a further absolute adjustment. In effect there is a ‘tax shield’ arising from unvested or unexercised stock-based compensation that is not available from other equity capital. This ‘tax shield’ needs be either be included in WACC or separately valued in much the same way that the debt interest tax shield is dealt with in an APV approach to valuation.
The first approach treats all SBC related tax as operating in nature. The second approach regards the tax savings related to the stock-based compensation expense as operating, and additional excess savings that have already accrued, and that are expected in future periods, regarded as financing.
Insights for investors
- The effective tax rate reconciliation provides important information about why tax varies, which may impact your assessment of forecast taxes.
- Many US companies will report a reduction in effective tax rates in 2021 due to excess stock-based compensation deductions. But this gain may not be sustainable if stock prices fall.
- It is common to find that the tax deduction in respect of stock-based compensation differs in both amount and timing from the expense recognised in profit and loss.
- Any excess tax saving is reported in profit and loss and will reduce the effective tax rate under US GAAP. For IFRS the same effect is reported directly in equity.
- The deferred tax asset measured under US GAAP initially correctly reflects the expected future tax saving, but it is not updated for changes in the stock price and may quickly become out of date.
- Under IFRS the deferred tax asset will be initially understated in the case of option grants but is remeasured each period and converges on the actual tax saving.
- Do not omit the expected future tax savings from your analysis just because they may be omitted or understated (and for US GAAP sometimes overstated) in financial statements.
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