19 Dec. 2017 | Comments (0)

On Governance is a new series of guest blog posts from corporate governance thought leaders. The series, which is curated by the Governance Center research team, is meant to serve as a way to spark discussion on some of the most important corporate governance issues.

Last Friday, the House and Senate Conference Committee on H.R. 1 (the “Tax Cuts and Jobs Act”) released its reconciliation (the Bill) of the versions previously passed by the House and Senate.  The House is scheduled to vote on the Bill today and the Senate is scheduled to vote on it tomorrow, with the stated goal of sending the Bill to the President for his signature before Christmas.  The Bill largely conforms to the version passed by the Senate, especially with respect to the provisions affecting executive compensation. 

 

Most importantly for executive compensation, if enacted, the Bill would substantially impact the deductibility of “qualified performance-based compensation” paid by public companies for taxable years beginning after 2017 by amending Section 162(m) of the Internal Revenue Code (Section 162(m)), which generally imposes a $1 million annual limit on deductions for compensation paid to any “covered employee” (generally a company’s CEO and its three most highly compensated officers other than the CFO).  Here the Bill would (i) eliminate the exception for commissions and “qualified performance-based compensation” (thereby subjecting them to non-deductibility under the general deduction limitation), (ii) amend the definition of “covered employee” to include a company’s principal financial officer, (iii) provide that any person who is a “covered employee” for any taxable year after 2016 will forever be a “covered employee” (thereby subjecting compensation paid to such person in any year after 2017 to the Section 162(m) limit) and (iv) expand the scope of corporations subject to Section 162(m) to include corporations with publicly-traded debt and certain foreign corporations. 

 

The Bill, like the Senate version, contains a grandfather provision, which would allow companies to continue to deduct “qualified performance-based compensation” paid after 2017 to any “covered employee” if it is provided pursuant to a written binding contract that was in effect on November 2, 2017, and which was not materially modified on or after that date. 

 

By way of an explanation for the amendments to Section 162(m), the House Ways and Means Committee report on the same provisions (except without the grandfather provision) briefly states that the current exceptions in Section 162(m) have resulted in a shift in public company executive compensation to stock options and other forms of performance pay which has led to perverse consequences as some executives focus on, and could in rare cases manipulate, quarterly results, rather than on the long-term success of a company.  This explanation does not address the decline in stock option usage in recent years or the growing importance of performance-based compensation to companies and their shareholders.  But like so many other provisions in the Bill without strong policy foundations, these amendments more plausibly can be explained as needed revenue raisers (a modest $9.3 billion over a 10-year period in this case) in order to bring the cost of the Bill’s tax cuts to a rosily estimated $1.5 trillion over the same period. 

 

In addition to amending Section 162(m), the Bill would substantially reduce corporate income tax rates (from a current maximum rate of 35 percent to 21 percent), modify individual income tax rates and eliminate certain tax deductions. 

 

Taken together, these changes would impact public company deductions for performance-based compensation, the design of public company compensation plans and arrangements and the proxy disclosure of such plans and arrangements. 

 

Deductions and Timing

 

While it is disappointing to see the elimination of the deduction for performance-based compensation paid to covered employees given the importance of such compensation to public companies and investors, most public companies will see this as a small price to pay for the Bill’s massive cut in the corporate tax rate and will happily take the trade-off. 

 

Nevertheless, given the prospect of the Section 162(m) amendments and lower corporate income tax rates beginning in 2018, some companies are now engaged in 2017 year-end planning to accelerate deductions for compensation paid to covered employees where the deduction would otherwise be lost, as well as for compensation paid to other executives and employees where the deductions would be taken at reduced corporate tax rates.  Among the acceleration techniques being considered are (i) paying cash bonuses in 2017 rather than in early 2018, (ii) accruing liabilities under the Internal Revenue Code’s “all-events” test for incentive compensation that would be paid within 2½ months after the end of the 2017 taxable year and (iii) accelerating the vesting and/or payment of equity awards. 

 

Given the changes in the definition of “covered employee” and potential deduction losses, special attention is being paid to compensation payable to a company’s chief financial officer or to persons who cease to be covered employees prior to the last day of the 2017 taxable year by reason of termination of employment or a change in position. 

 

Whether such year-end maneuvers are worth the time and effort depend on the particular facts of each company’s situation.  However, in general, it would seem advisable for public companies to take advantage of any low-hanging tax deductions but not take acceleration actions that would be fundamentally inconsistent with the objectives of the compensation awards or the reasonable expectations of investors or executives. 

 

Design of Performance-Based Compensation Plans

 

While the enactment of Section 162(m) in 1993, with its performance-based compensation exemption, was ahead of its time in recognizing the importance of performance-based compensation, since then much has happened to make performance-based compensation much more important in incentivizing executives and aligning their interests with those of shareholders, as demanded by institutional investors and the proxy advisory firms.  In the current environment, it is clear that performance-based compensation is here to stay for at least the foreseeable future, whether or not the Bill is enacted.  Therefore, an important silver lining in the Bill’s repeal of deductions for performance-based compensation is that companies will no longer need to deal with the highly technical and prescriptive requirements of Section 162(m) in designing and administering their performance-based executive compensation plans and arrangements. 

 

Accordingly, as companies and Compensation Committees work on their year-end 2017 compensation decisions and plan designs for 2018 and beyond, they should be thinking of ways in which they can enhance the effectiveness of their performance-based annual bonuses, long-term incentive and equity awards without regard to the surly bonds of Section 162(m).  Among the salutary possibilities worth considering are (i) the use of more finely tuned and timely-initiated performance goals and metrics, (ii) not using umbrella plans which permit negative discretion (now permitted by Section 162(m)) but setting more focused and readily communicated and understood performance goals and targets, with discretion to increase payments for substantial outperformance, (iii) the ability to adjust performance goals during a performance period to meet extraordinary situations and (iv) the reduced tax appeal of stock options and stock appreciation rights which should encourage more innovation in performance share or unit incentive designs.  All of this new-found flexibility would likely make compensation committees more comfortable in granting awards with substantially longer performance and vesting periods, which would foster long-term incentive focuses and benefit shareholders.  In approaching all of these and other performance-based compensation matters, compensation committees and the advisors would have more freedom to apply their judgments in the best interest of companies and their shareholders, without regard to what the Congress enacted in 1993, which is a good thing.

 

Disclosure of Tax Impacts

 

Item 402(b)(2)(a) of Regulation S-K, as amended by the SEC in 2006, requires most public companies to disclose and discuss the “material elements” relating to seven features of their compensation plans for named executive officers in the then newly-required Compensation Discussion and Analysis (CD&A) section of their annual proxy statements. Subsection (b) of Item 402(b)(2) states that the material information “may include” 15 categories of information, including the impacts of the accounting and tax treatment of the compensation.  Since 2006, the conventional and well-established practice has developed for most public companies to briefly describe the rules of Section 162(m) and Section 409A of the Internal Revenue Code (relating to the taxation of deferred compensation) and the relevant accounting rules in their CD&As and to state that while these matters are taken into consideration by the compensation committee in setting pay, they are only factors and not dispositive.  In addition, companies often state that certain of their bonus, long-term incentive and equity plans have been drafted to permit the company to pay “qualified performance-based compensation” which is exempt from Section 162(m), but that their Compensation Committees reserve the discretion to pay compensation that is not deductible.

 

Last week,  a widely-read article in the November/December issue of The Corporate Executive(Registration required) expressed the concern that public companies have not been appropriately disclosing whether their compensation has not been deductible under Section 162(m) and that public companies should assume that the tax consequences of the deductibility of executive compensation are material to shareholders, whether or not the Bill is enacted. The article contends that CD&As should disclose not only whether a company seeks to comply with Section 162(m) but also the amounts that are intended to be deductible or non-deductible, on an item by item basis, and posts model disclosure on its CompensationStandards.com website.  The posted disclosure follows the required Summary Compensation Table (SCT) format and in the same tabular form states the percentage of each item of SCT compensation which is intended not to be deductible, with two models, one if the Bill is enacted and the other if it is not. 

 

While the article and model tables are worth consideration, I for one do not think that the disclosure approach that it strongly recommends should be used by most public companies, whether or not the Bill is enacted (and even more so if it is), for the following reasons:

 

  • ·         First, I do not believe that the actual deductibility of each of the SCT items of compensation is material to investors as an item of expense, or even that it is generally taken into account by compensation committees in designing executive compensation; on the contrary, for most companies the tax dollars are immaterial. Further, while most compensation committees are aware of Section 162(m) and company lawyers have drafted appropriate plan language and shareholder approval disclosure to allow the payment of exempt compensation, in my experience Compensation Committees generally are not presented with and do not evaluate the deductibility of specific items of compensation when they award compensation, and view taxes  as an unstable cost of doing business, which is incidental to achieving their policy objectives.

 

  • ·         Second, the SEC staff has not been shy about noting deficiencies in compensation proxy disclosures (as it did in 2007 in commenting on numerous CD&A deficiencies and calling out more than 150 companies on their disclosure of performance targets and results, and in the years since on pay risk and other matters), but I have never seen an SEC or SEC staff statement, or even a comment on any company proxy, suggesting that companies are required to disclose the actual deductibility of specific compensation payments.  Moreover, there is no reason to expect that this SEC is likely to impose further disclosure burdens on companies or push for longer CD&As.  In his first published speech as SEC Chairman, Jay Clayton decried the sometimes limited benefits to investors of discrete new disclosure items and the associated added costs to companies in preparing this information. Requiring companies to create a table like that suggested would clearly run afoul of Clayton’s principle to maintain materiality as the core concept underlying the SEC’s disclosure scheme.

 

  • ·         Third, I have not heard institutional investors, or even proxy advisory firms like ISS or Glass Lewis, assert that such disclosure is material or required by the proxy rules, and even if some investors may have a political or other interest in compelling such disclosure does not mean that it is material to investors generally and required by Item 402.

 

  • ·         Fourth, I have heard of no lawsuits being filed against companies claiming that such disclosure is required, but know that there are more than a few lawsuits against companies that stated or implied that certain items would be deductible when the companies turned out to be wrong because of one Section 162(m) foot-fault or another, making it risky for companies to promise tax results given the complexity of Section 162(m). 

 

  • ·         Fifth, even if a company were to conclude that the actual deductibility of items of executive compensation was material to investors and required proxy disclosure, disclosing the potential non-deductibility percentage of an SCT table item would be of little value to, and might potentially mislead, investors, given that the SCT is an antiquated fruit salad of valuation methods  (For example, stating the deductibility percentage of the Black-Scholes value of a stock option award provides little information regarding the potential non-deduction cost to the company when the option is exercised years later, raises the issue of whether the company  should also be required  to report the actual lost deduction cost when it ultimately became known and could subject the company to attack by the shareholder plaintiffs’ lawyers for not providing more informative and less misleading disclosure anywhere along the way.)

 

  • ·         Sixth, if a company believed that actual tax deductibility was material and required disclosure, in order not to make the disclosure misleading and to protect the company, it likely would be required to provide pages of additional proxy CD&A disclosure stating the amounts of the potential lost deductions as and when the compensation would otherwise be deductible and the tax costs to the company of the lost deductions, with full disclosure of all of the vagaries of the tax laws, applicable deduction timing rules and assumptions about tax rates, along with carefully lawyered disclaimers regarding all of the things that could possibly go wrong with the company’s projections. Once a company starts down the rabbit hole of disclosing  predicted tax consequences of specific compensation payments, it would not be easy for it to know when to stop, and risky to do so.    

 

  • ·         Seventh, if the Bill is enacted, the deductibility of executive compensation for Section 162(m) covered employees becomes far simpler and the tax treatment of various items even less material than under current law, and would make it easy to draft simple disclosure to the effect that any amounts paid to a named executive officer in any year in excess of $1 million will not be deductible, no matter when or how paid. 

 

The Bottom Line

 

Companies should consult with their lawyers, accountants and compensation consultants with respect to the Bill’s impact on their compensation deductions, the design of their performance-based plans and arrangements, and their proxy disclosure requirements regarding tax consequences. In particular, companies should book extra time with experienced lawyers to discuss the requirements of Item 402(b)(2), what constitutes material information and the company’s particular facts and circumstances in order to decide how, if it all, they should change their proxy disclosure on the impact of taxes on their pay plans in their 2018 proxies.  

 

In the meantime, here is link to Latham & Watkins’ client alert, “The Impact of Pending Tax Reform on Executive Compensation,” which discusses many of these issues in more detail.  The alert was published on December 11, after the House and Senate passed their versions of the Bill, but before The Corporate Executive published its provocative article on proxy disclosure requirements.

 

The views presented on the Governance Center Blog are not the official views of The Conference Board or the Governance Center and are not necessarily endorsed by all members, sponsors, advisors, contributors, staff members, or others associated with The Conference Board or the Governance Center.

  • About the Author: James D. C. Barrall

    James D. C.  Barrall

    Jim Barrall is a senior fellow at The Conference Board Governance Center and a visiting scholar and senior fellow in residence at the Lowell Milken Institute for Business Law and Policy at the UCLA Sc…

    Full Bio | More from James D. C. Barrall

     

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