Priceline's Big Tax Advantage Over Expedia Could Vanish in an Instant

Source: Priceline's Booking.com(Booking.com)

The past few years have been very good for The Priceline Group (BKNG -0.45%). In spite of sluggish economic growth at home and abroad, revenue and earnings for the company have skyrocketed even as rivals like Expedia (EXPE 0.55%) have fallen even further behind. While all of these developments are, without a doubt, good, is it possible that Mr. Market is overlooking a little detail that could have big consequences for the travel site?

Talk about growth... but not everywhere
Between 2011 and 2013, Priceline's revenue soared 56% from $4.36 billion to $6.79 billion. No matter how you stack it, these results are impressive, especially compared to Expedia, whose top line rose a more modest 38% from $3.45 billion to $4.77 billion. There is, however, one caveat to all this; Priceline's growth has been far more one-sided than Expedia's.

Over this three-year period, sales in Priceline's U.S. operations barely budged, rising just 0.6% from $1.76 billion to $1.77 billion. In this same region, Expedia's sales shot up 30% from $1.96 billion to a hefty $2.55 billion. In the international arena, on the other hand, the picture's a little more challenging to decipher.

Source: Priceline

In what Expedia classifies as its "All other countries" category, sales jumped 49% from $1.49 billion in 2011 to $2.22 billion in 2013. Unlike Expedia though, Priceline's international operations are divided up between the two following categories: The Netherlands and Other. Over the past three years, Other saw revenue climb 84% from $955.7 million to $1.76 billion, while The Netherlands skyrocketed 150% from $1.64 billion to $4.10 billion, making the latter the main source of the company's sales growth.

It's all about taxes, baby!
After Priceline acquired Booking.com, an online travel site located in Amsterdam, the company began experiencing a great deal of growth. Today, revenue from this part of the company's overall business makes up over 60% of Priceline's revenue, up from just 38% two years earlier. While this in and of itself is noteworthy, what's even more interesting is that the significant source of revenue brings with it some interesting tax advantages.

Source: Expedia

Under current Dutch law, any revenue attributable to the region brings with it a 25% statutory tax rate, a nice haircut from the 35% statutory tax rate applied to U.S. based companies like Expedia. However, because Priceline has been able to convince the government in The Netherlands that its activities are "innovative" in nature, any profits from the business are taxed at just 5% under what the company refers to as the Innovation Box Tax treatment. In the case of Priceline, this classification is good until Jan. 1 2018.

There is one big catch to this designation though. Every six months, Booking.com is required to apply for and obtain a government-provided research and development certificate that verifies that what the business plans to do over the next six months is truly innovative. In the event that management is unable to receive one of these certificates, the business will lose its tax treatment and its tax rate in The Netherlands will shoot up to 25%.

Source: Priceline

Because Priceline derives some of its revenue from the U.S., as well as other countries, the business does have to pay tax on sales from those regions, but because of the nice buffer from The Netherlands, the company's effective tax rate in 2013 was just 17.6%. Expedia's, in contrast, stood at 28% for the year. To put into perspective what losing its special tax treatment in The Netherlands would result in, let's do the following exercise.

According to Priceline's most recent annual report, the company paid $403.7 million in taxes on pre-tax income of $2.3 billion during 2013. Losing the tax benefit the company received from The Netherlands, would increase Priceline's income tax expense by $177.2 million to $580.9 million. Keeping all else the same, this change in its effective tax rate from 17.6% to 25.3% would have caused Priceline's earnings per share to fall 9% from $36.11 to $32.73. This, in turn, would result in the company's already high P/E ratio of 34 to climb to nearly 38.

Foolish takeaway
Priceline has been a great growth story in recent years, and it doesn't appear that the business's run is over yet. Moving forward, management will likely be able to increase the company's revenue and profits, but this doesn't mean that the Foolish investor should turn a blind eye to the issues that could arise.

As Warren Buffett has quipped before, it's not important to know what can go right but, rather, to keep in mind what can go wrong. In the case of Priceline, one potentially dangerous scenario is that the company may not be able to prove its ability to be innovative forever. Should this situation arise, the results wouldn't prove disastrous for the company, but they could be enough to impair shareholder value in the long run.