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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.

Assuming that the tax legislation working its way through Congress is enacted, it is likely to include the elimination of the qualified performance-based compensation exception under Section 162(m). 

Under current law, Section 162(m) generally disallows a publicly traded company’s federal income tax deduction for compensation in excess of $1 million paid in a year to each of the company’s chief executive officer and its three other most highly-compensated executive officers (other than the chief financial officer) in respect of that year (“covered employees”).  The limit on deductible compensation does not apply to “qualified performance-based compensation”, which is compensation that meets certain technical criteria specified in the regulations under Section 162(m). 

In its current form, the proposed legislation would repeal the qualified performance-based compensation exception under Section 162(m), subject to transition rules.  While the elimination of the qualified performance-based compensation exception raises a number of issues, such as the effect, if any, on compensation plan design and the financial impact to each company subject to the rule of the expansion of the rule’s coverage to include its chief financial officer and former covered employees, this post focuses solely on a related disclosure question.

Many companies rely on the qualified performance-based compensation exception and therefore comply with the relevant technical criteria under Section 162(m), including the requirement that the material terms under which the compensation is to be paid, including the performance goals, are disclosed to and approved by shareholders.  If the exception is no longer available, companies may be considering whether to modify their existing performance-based compensation programs to permit practices previously prohibited, such as the use of upward discretion in formulaic bonus plans.  Additionally, certain provisions in compensation plans are often limited by their terms to awards intended to comply with the qualified performance-based compensation exception under Section 162(m).  Companies should review their existing plan documentation to determine the extent to which any such provisions should continue to be applicable if the exception is eliminated.    

Companies that obtained shareholder approval of performance-based plans in the past should consider whether to notify shareholders in the compensation discussion and analysis section of their proxies that there is no longer a tax reason to comply with the requirements of the old exception, and, accordingly, compensation plan design and practices may reflect that change in the future, for example, by permitting the use of upward discretion, notwithstanding prior disclosures.  Without such a notice, shareholders might infer that the limitations that were intended to permit compliance with the qualified performance-based compensation exception will continue to apply even though the reason for such limitations was eliminated.  The extent of the concern may be affected by a company’s historical disclosure related to Section 162(m).  For example, companies might consider including the following disclosure in their 2018 proxy statement:

“Our compensation programs were designed to permit the Company to deduct compensation expense under Section 162(m) of the Internal Revenue Code, which historically limited the tax deductibility of annual compensation paid to executives to $1 million, unless the compensation qualified as ‘performance-based’, although the Company reserved the right to pay compensation that did not qualify as ‘performance-based’ from time to time.  The ability to rely on this ‘performance-based’ exception was eliminated in 2017 and the limitation on deductibility generally was expanded to include all named executive officers.  As a result, the Company may no longer take a deduction for any compensation paid to its named executive officers in excess of $1 million.  In [applicable year], in order to permit the Company to take deductions for performance-based compensation, we asked shareholders to approve our [name of bonus/equity plan].  That plan contained [certain]/[the following] limitations that were required by the tax regulations which were approved by shareholders for the purpose of qualifying for a deduction[: insert list].  Now that the deduction is no longer available, those limitations are no longer applicable.”

In the event that companies wish to provide additional disclosure to shareholders, they may also consider supplementing the suggested disclosure above with language to the effect that the Compensation Committee will continue to take into account all applicable facts and circumstances in exercising its business judgment with respect to appropriate compensation plan design.  Of course, if a company decides to continue to comply with certain of the shareholder-approved Section 162(m) criteria – such as, for example, the individual limit on the amount of compensation that may be paid to a covered person – for investor relations, governance or other reasons, that should be carved out from the disclosure.  Prior to amending any plan to reflect the foregoing, companies should consider whether the amendment would require shareholder approval pursuant to applicable listing requirements or the terms of the relevant plan or by reason of prior shareholder communications.  Companies should consult with their counsel to analyze their particular circumstances.

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: Arthur H. Kohn

    Arthur H. Kohn

    Arthur H. Kohn is a partner based in the New York office of Cleary Gottlieb Steen & Hamilton LLP. His practice focuses on compensation and benefit matters, including executive compensation, pensio…

    Full Bio | More from Arthur H. Kohn

     

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