Giant Cisco Didn't Pay Any Federal Income Tax

Henry C.K. Liu hliu at
Mon Oct 9 19:46:10 MDT 2000

Giant Cisco Didn't Pay Any Federal Income Tax
Businesses get break on employee stock options

                 Kathleen Pender, Chronicle Staff Writer

                     Monday, October 9, 2000

                 SAN JOSE -- Cisco Systems, the
                 second-most valuable company in
                 America, paid no federal income taxes for
                 its latest fiscal year thanks to a little-known
                 corporate tax break on employee stock

                 Microsoft, which ranks No. 4 in market
                 value, did not pay any federal taxes either,
                 it seems.

                 Like many high-tech firms, Cisco and
                 Microsoft are allowed to take a tax
                 deduction for money their employees earn
                 when they ``exercise'' options and buy
                 stock in the company at a preset price.

                 These options have become an increasingly
                 popular way for businesses to reward
                 employees, but they also have huge
                 benefits to the companies themselves.

                 The tax break was established decades ago,
                 when companies doled out stock options to
                 only a handful of top executives and the
                 tax benefit they generated was minimal.

                 But now that many companies -- including
                 Cisco, Microsoft and most other
                 new-economy firms -- give options to
                 everyone, the tax break is becoming

                 In Cisco's case, this benefit wiped out $1.8
                 billion in federal taxes, and probably more
                 than twice that for Microsoft.

                 Some people, even those who oppose
                 taxes, think it is unfair that wealthy
                 companies paid none to Uncle Sam.

                 For the fiscal year ended July 31, Cisco
                 had $23 billion in sales last year, $2.7
                 billion in net income, and its almost $400
                 billion market value is exceeded only by
                 General Electric's.

                 ``For a company that makes that kind of
                 money not to pay taxes raises serious
                 tax-equity questions,'' said Jon Coupal,
                 president of the Howard Jarvis Taxpayers

                 He also said he believes it is ``hypocritical''
                 for Cisco to take this ``massive tax break''
                 and at the same time support Proposition
                 39, which would make it easier to raise
                 property taxes on California homeowners.
                 Prop 39 would allow local school bonds to
                 be approved by a vote of 55 percent
                 instead of the current two-thirds.

                 ENTITLED TO DEDUCTION

                 Cisco is entitled to a deduction for stock
                 option income because ``in reality, that's
                 compensation,'' and tax law has always
                 treated employee compensation as a
                 deductible expense, said Dennis Powell,
                 Cisco's corporate controller.

                 When an employee exercises an option to
                 buy stock, the difference between the
                 strike price (what the employee pays) and
                 the market price (which is almost always
                 higher) becomes taxable income for the
                 employee and a tax deduction for the

                 Most Americans do not realize how
                 enormous this tax break has become,
                 because companies do not deduct
                 employee stock options from the earnings
                 they report to shareholders and the public.
                 In fact, American companies fought long
                 and hard to prevent employee stock
                 options from showing up as an expense on
                 their income statements, although they are
                 happy to consider them as an expense for
                 income tax purposes.

                 Cisco's and Microsoft's annual reports
                 make it appear as if they had paid billions
                 of dollars in income taxes.

                 Cisco's income statement for fiscal 2000,
                 which was published about a week ago,
                 shows net income before taxes of $4.34
                 billion, and a provision for income taxes of
                 $1.67 billion.

                 That number includes federal, state,
                 foreign and deferred taxes. The firm's
                 actual federal tax liability, buried deep in
                 the report, was $1.8 billion.

                 But in reality, the San Jose maker of
                 computer networking gear paid no federal
                 income taxes for fiscal 2000.

                 That is because its employees earned more
                 than $7 billion exercising stock options in
                 fiscal 2000. That $7-plus billion deduction
                 generated a $2.5 billion tax benefit for
                 Cisco, which wiped out its entire federal
                 tax liability. The benefit shows up on
                 Cisco's cash flow statement.


                 Cisco employees exercised ``an unusually
                 large number'' of stock options during
                 fiscal 2000, mainly because the company's
                 stock price more than doubled, said Cisco's

                 By comparison, Cisco's tax benefit from
                 employee stock options was only $837
                 million in 1999 and $422 million in 1998.

                 Unlike Cisco, which acknowledges that it
                 paid no federal income taxes, a Microsoft
                 spokeswoman would not say whether that
                 firm did or not.

                 But its annual report for fiscal 2000, which
                 ended June 30, shows stock option income
                 tax benefits of $5.5 billion, exceeding its
                 $4.85 billion provision for income taxes.
                 (Its actual federal and state tax liability for
                 2000 was $4.74 billion.)

                 ``I'd say their federal income tax was next
                 to nothing or probably nothing,'' said
                 Robert Willens, a tax and accounting
                 analyst with Lehman Brothers in New

                 Willens said another company that will be
                 wiping out its federal tax liability is Seagate,
                 which is undergoing a complicated
                 leveraged buyout.

                 SHAREHOLDERS GET

                 When the deal is completed, ``all of
                 Seagate's options have to be exercised. The
                 tax deduction they're going to get is so
                 large, it will wipe out their income for the
                 year of the merger,'' with some left over,
                 he said. The remainder will be passed on to
                 Seagate shareholders as a tax-refund right.

                 Companies do not pay anything for stock
                 options, at least not in the traditional sense.
                 The real cost is borne by shareholders.

                 That is because stock options increase a
                 company's shares outstanding, which
                 reduces earnings per share. All other things
                 being equal, that will lower the company's
                 stock price unless earnings rise enough to
                 compensate for the additional shares.

                 Theoretically, employees with stock
                 options will want to do everything they can
                 to increase earnings, since they are also
                 shareholders who will benefit if the stock
                 price rises.

                 ``Shareholders have decided they want to
                 share some money with employees to
                 provide an incentive'' to increase earnings,
                 said Powell.

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