By Roger O. Crockett There's no way to sugarcoat the fact that the Internal Revenue Service is seeking $500 million or more in back taxes from communications giant Motorola (MOT). In dispute is the way the company calculated earnings from 1996 to 2000. Motorola revealed Aug. 11 in a federal filing that the IRS has concluded the outfit should have reported an additional $1.4 billion dollars in income during that period. And the underreported income could make Motorola liable for an additional $500 million in income tax, the IRS says.
Yet the situation isn't nearly as alarming as it might seem at first glance. For starters, Motorola says it disagrees with the IRS's assessment. And so far, this dispute doesn't smack of corporate indiscretion or even adverse impact to Motorola's financials.
PREFERRED PRICES. The IRS completed a routine field examination of the company's 1996 through 2000 tax returns in June -- the sort of examination the agency does each year with several companies. It notified Motorola of certain proposed adjustments, primarily related to transfer pricing, according to the company.
Transfer pricing isn't what it seems. Investors and analysts at first assumed that the phrase refers to prices individual business units pay for goods or services sold to one another. Over the years, Motorola's semiconductor unit (spun off in July, 2004, and now named Freescale (FSL)) had a preferential relationship when it came to selling chips to the company's cellular-phone division.
Such transactions, however, are not at the center of the IRS dispute. In tax vernacular, transfer pricing refers to profits reported by regional tax entities. Multinational corporations have tax entities in each of the countries they do business in. For Motorola, that's 67 countries.
LOST IN TRANSLATION? The IRS claims that during the late '90s, too much profit was left in Motorola's tax entities in other countries and not enough was allocated to the U.S. Motorola disagrees. "They say we didn't recognize enough profit in the U.S., and we're saying that we did," says Motorola spokeswoman Jennifer Weyrauch.
Motorola is appealing the claim. Its lawyers hope they can work out the issue via discussions with IRS officials and point to their success at resolving a similar tax dispute with the IRS in the second quarter. The negotiation process is likely to take months. And if the IRS can't be convinced of Motorola's view, the company most likely will resort to tax court or an appellate court, if necessary. In that case, this issue could take several years to resolve.
Weyrauch admits that an unfavorable resolution could have a material adverse effect on Motorola's operating results in the period in which the matter is resolved. It would likely mean a one-time charge. But consider this: Motorola has built a very tight balance sheet with $1.8 billion in net debt to cash -- its best cash position in years. Even if it had to fork over $500 million today, doing so would reduce its cash position to $1.3 billion, still a healthy level.
UNWANTED HEADACHE. In the post-Enron era, getting the information out to investors quickly was paramount. Motorola shares slipped 5.3%, to $14.33, on Aug. 11 as Wall Street struggled to make sense of the news. After all, in recent months, Motorola had been showing signs of recovery momentum -- second-quarter earnings reported July 20 were up fivefold, to $845 million.
"Every time you think they can get their problems resolved," says Ren Zamora, telecom analyst at Loop Capital Markets, "something else pops up." The IRS has indicated that future Motorola audits might bring similar tax claims for years beyond 2000.
No doubt, the tax issue is a headache and a distraction for Motorola. Amid the race to catch rivals like cell-phone leader Nokia (NOK) and wireless infrastructure giant Ericsson (ERICY), Motorola and new CEO Ed Zander don't need the specter of accounting woes hanging over them. In this competitive field, continuing to execute should remain Motorola's key focus. Crockett is deputy bureau chief in Chicago for BusinessWeek