Amazon Minimizes Profits Because CEO Jeff Bezos Hates Paying Taxes

Amazon CEO Jeff Bezos claims the company eschews profits so “free cash flow” can drive growth. Investors can’t see what cash is spent on, but do see a volatile stock price and no dividends. Bezos’ actual strategy is much more mundane: skim the cream and leave nothing for the tax man.

Technology companies often say profits aren’t the only thing. Focus on growth, especially of a company’s “free cash flow”, and earnings will eventually follow.

Recently Benedict Evans, of VC firm Andreessen Horowitz, suggested that it’s not as important whether consistently profit-poor Amazon and its CEO Jeff Bezos can “capture the future” but instead, “How long are you willing to wait?”

Evans says Amazon, the granddaddy of growth and market share over short-term profits, is brilliant for putting every last bit of earnings back into its business. Evans thinks “someone at Amazon has the job of making sure that each quarter, this nets out to as close to zero as possible, at least as far as net income goes.” And Evans doesn’t seem to see any problem with someone doing that.

I agree with Evans’ conclusion. There are few other ways to achieve consistently equal revenue and expense lines than by hands-on management of the results. CEO Jeff Bezos wants Amazon to be the biggest and best retail organization in the world. But I believe Bezos and his team massage the numbers each quarter to minimize profit for a bigger reason.

Amazon reports little or no profit because Jeff Bezos hates paying taxes, on his own income and Amazon’s.

Bezos’ recent individual purchase of the assets, not the shares, of the Washington Post allows him to use its prolonged losses to offset his own income — if he plays an active role in its management. Bezos was widely quoted saying he wanted to start Amazon on an American Indian reservation to avoid taxes. Amazon fought hard to avoid collecting sales taxes from its online customers until a late 2013 Supreme Court rejection of its appeal of a New York ruling on the subject forced a capitulation. In 2010 Bezos personally donated $100,000 to an anti-income tax increase initiative in his home state of Washington that succeeded.

Amazon employs two of the largest accounting firms in the world to meet its goal — maximize revenue but minimize taxes. EY has been Amazon’s independent auditor since its 1997 IPO and prior, preparing the audited opinions for the company’s IPO filing with the SEC. EY is the third-largest accounting firm ­globally, behind PricewaterhouseCoopers and Deloitte, but leads in market share for auditing technology and social media/social gaming companies. EY’s Strategic Growth Markets consulting unit helps companies develop financial systems, controls and accounting policies before they go public. EY helps companies understand tedious accounting rules to ensure legal recognition of complex revenue streams and gives its opinion as an independent auditor to the same companies.

Amazon will need EY’s help to implement new revenue recognition rules issued jointly by the US Financial Accounting Standards Board and the International Accounting Standards Board. These new standards cover contracts that combine software, hardware and maintenance or other services. Sales of the Amazon Kindle device are “arrangements with multiple deliverables” and so are sales of Amazon Prime memberships.

Accounting for complex contracts requires extensive use of estimates and judgments to determine a selling price and, therefore, the amount and timing of revenue recognition for each item. Accounting for intangible revenue streams common in new media and gaming companies also requires estimates and lots of judgment. EY, also the auditor of intangible revenue super users such as Facebook, Zynga and Groupon, writes the books, literally, on how to defend creative revenue recognition policies for “innovative” new business models.

Benedict Evans’ boss at Andreessen Horowitz, Ben Horowitz, has a funny strange — not funny ha ha — anecdote about auditor EY in his book, “The Hard Thing About Hard Things”. Horowitz tells the story of two EY audit clients, software makers BMC and HP, bidding in 2007 to acquire another EY audit client, software maker Opsware, then run by Horowitz. Opsware’s CFO was also an EY alum. BMC’s EY audit partner questioned some aggressive revenue recognition by Opsware for software upgrade contracts.

Horowitz says in his book that the aggressive revenue recognition approach had been approved by Opsware’s EY audit partner. EY’s national standards office was called in and insisted that revisions to the contracts must be made or else EY would insist that Opsware reverse its early recognition of the revenue. A reversal of the revenue would have forced an ugly formal earnings restatement by Opsware that could have jeopardized its share price and the deal. Even though Horowitz was able to get his clients to revise the contracts as EY insisted— he said the clients were large banks — BMC backed out of the deal and HP bought Opsware and Horowitz instead.

Funny… Horowitz doesn’t say that HP’s EY audit partners questioned Opsware’s EY partner and the aggressive revenue recognition approach the way BMC did. It’s possible HP and its EY auditor, also aggressively recognized revenue for similar contracts.

If Amazon doesn’t start showing a profit, at home and abroad, the company risks losing the ability to utilize some benefits accrued by virtue of having been such a loser. Almost $2.5 billion in operating loss carryforwards will expire in 2014. I suspect we’ll see enough profits by the end of 2014, a “just right” like Goldilocks pudding amount, to take advantage of this one tangible benefit of being a money-losing company.

Amazon’s tax advisor is not EY. Its sophisticated tax avoidance strategy using low-tax Luxembourg cost tens of millions to design and implement, more than the minuscule amount EY collects for tax services each year. For example, Caterpillar paid $55 million to advisors including PricewaterhouseCoopers for a scheme, criticized in public hearings by Sen. Carl Levin last April, that reroutes U.S. profits to low-tax Switzerland.

Based on media reports and PwC Luxembourg’s own horn-tooting, I believe PwC structured the Amazon Luxembourg 2005 restructuring deal that’s now under scrutiny by the IRS and continues to be its primary tax minimization strategy advisor. (Amazon did not respond to my request for comment or confirmation of its relationship with PwC.)

Amazon tells us in 3Q 2014 that capital expenditures — where Evans thinks Amazon spends its profits — were $1.3 billion and $855 million during Q2 2014 and Q2 2013, and $2.4 billion and $1.5 billion for the six months ended June 30, 2014 and 2013. The company says the cash was used to make investments in technology infrastructure, including Amazon Web Services (AWS), and more warehouses to support business growth.

Cash and cash equivalents, specifically money market funds, however, decreased by $3.5 billion in the first six months of 2014. There’s no report of overseas cash being repatriated and taxed so, I suspect, Amazon likely still holds $4.6 billion of cash in foreign subsidiaries out of close to $8 billion on the books at June 30, 2014. That $4.6 billion includes $2.5 billion of undistributed earnings indefinitely “invested” in foreign subsidiaries. Those earnings will not be taxed unless brought back to the U.S..

Amazon is not the worst example of a U.S. company with “unpatriotic” cash and earnings parked overseas. But that tied-up overseas cash might also explain why Amazon is fighting so hard to avoid paying $1.5 billion plus interest and penalties to the IRS for what the agency claims is a tax avoidance scheme. A potential multi-billion assessment for the Luxembourg restructuring would make a big dent in Amazon’s U.S.-based cash.

This past July Amazon and Bezos lost a bid in U.S. Tax Court to avoid paying that bill. The case is scheduled to go to trial this November.