The Indian budget proposal that includes the abolition of fringe benefit tax (FBT) and the institution of income tax on employee equity compensation has been approved. Although we can now be sure that the FBT tax will no longer be due by employers, and that employees will now be taxed on income from option exercises, RSU vests, and ESPP purchases, there are still several issues that companies will need to sort through.
The Impact of the 2009-2010 Budget
First, a quick summary of what we can be sure of based on the new budget:
Employers must remit taxes on income from stock transactions on or after April 1, 2009 for both current and former employees.
Employers are responsible for remitting the tax regardless of whether or not it was actually withheld from employees.
The income amount will be based on the spread at the transaction date (exercise, vest, purchase).
Late payment is subject to penalties of 1% per month.
Employers who already paid the first installment of FBT for the financial year 2009-10 will need to apply for a refund.
Further Guidance Needed
The key element of the new taxation that is pending further guidance is how the fair market value of stock is to be determined. Under FBT, companies were required to enlist the services of a Merchant Bank to determine the fair value of stock. At this point, it looks like it is possible that the Indian government will accept the use of the actual market price of the shares. The most recent alert from Baker & McKenzie suggests that, until guidance is available, companies should be able to use the market value of shares to determine the appropriate tax amount.
Outstanding Issues
There are still a number of issues that companies will need to address.
Grant Agreements
First, companies will want to review their grant agreements. If companies intend to collect taxes from employees on equity compensation, hopefully they implemented sufficiently broad language in the grant documents to accommodate the new tax withholding requirement. Additionally, it will need to be made clear to employees what tax payment methods will be permitted.
Interim Tax Payments
Then there is the issue of the taxes that are due retroactively on transactions that have already taken place after April 1, 2009. Companies that did not remit their first FBT installment may use those funds to cover the taxes that are now due. However, if the company already submitted the first FBT installment, the funds can’t be “transferred over” to pay employees’ income taxes.
Companies can opt to go ahead and eat the cost of the taxes for the interim transactions (grossed-up to compensate for the additional income). If this isn’t a viable option, then companies may choose to withhold the tax amounts from future paychecks. This is possible for current employees, but poses a problem when it comes to employees who have had transactions after April 1, but are no longer with the company. Companies are required to remit this tax to the government, even though there is no viable way to collect it from former employees. Paying the taxes on behalf of former employees while forcing current employees to foot would, at the very least, be a difficult PR strategy.
Terminated Employees
If your company grants stock options to employees in India that have a post-termination exercise period, the issue of terminated employees is likely to haunt you down the road as well. In situations where terminated employees are exercising their options, companies will have no way to confirm the appropriate tax rate and no way to true-up the tax withholding through local payroll.
Employee Concerns?
I’ve already seen blog posts and articles from sources in India with employees concerned about the impact of the change. I found this interesting comparison from iTrust Financial Advisors that proposes the new tax on perquisites will negatively impact employees even if their employers were already passing the FBT through to them.
However, I suspect that companies who did pass the FBT tax through to employees will likely not encounter much resistance to the new tax on equity compensation going forward (even if employees are unhappy about the taxes on other benefits). Employers who were covering the FBT, on the other hand, may find that employees are unhappy about having to suddenly pay taxes on their equity compensation. This will be especially true for grants that were either granted under a tax-favorable plan prior to FBT or for grants that were awarded at a reduced size to account for the cost of the FBT. Companies will need to determine how best to address employees’ concerns and then roll out a well-orchestrated education campaign to get everyone on board.
The Million Dollar Question
So, what are companies doing about it, now? An informal poll taken by Elizabeth Dodge of Stock & Option Solutions showed a wide range of responses including: withholding taxes as soon as the proposed budget was announced, covering the taxes for employees on current grants with plans to increase the size of future grants, and the “wait and see” approach pending further guidance from the government.
These days you can’t talk to a compensation consultant without having a discussion around the increased usage in performance-based equity plans, especially around the growing trend of total shareholder return (TSR) as a relative long-term performance measure. Relative TSR plans are ones where a company measures the return of its own stock against the performance of other companies (typically a group of 15 to 20 pre-defined industry peers) over a period of time. How the company’s stock performs as compared to its peers is then used as the metric to determine whether vesting in the award is achieved and at what payout level.
Relative TSR plans have been used in Europe for several years, and have recently grown in popularity in the United States. In this current market, relative TSR is likely to become a predominant long-term performance measure when setting performance goals since, in a volatile market like the one we are experiencing now, it can be difficult for companies to identify absolute performance goals e.g., where vesting is dependent on the company achieving specified targets, such as a threshold stock price. And, with relative TSR as a performance metric, the award holder can often realize some value from the underlying award regardless of market/economic conditions, provided that the company outperforms its peer group.
The length of the performance period, the number of peer companies to be included in the plan and which peer companies should be included in the plan are among some of the criteria to decide when designing a relative TSR plan. It’s probably not critical to understand all aspects of the design of a relative TSR plan, however, what you should plan for is the likelihood that you will have to administer one of these plans in the near future and as a result will want to have some familiarity with how they operate. There are a number of companies who have already adopted TSR type plans–for example, see Intel, Yahoo, or Bank of New York Mellon–the details around these plans are available in their respective proxy statements. This is a good place to start your education around this topic. In addition, we have several articles that discuss TSR as a perforamnce measure and relative TSR plans in our Performance Plans portal, including Octane-Driven Performance – Pearl Myers & Partners, Correlating Performance Metrics and Business Value in Growth – Workspan, Plan Design Considerations with Performance Shares – Radford, and Relative TSR — A U.K. Perspective – Towers Perrin. And, finally, be sure to check out www.RelativeTSR.com for further information on this topic.
As companies look for new ways to set performance goals in this current marketplace, it’s likely they will look to relative TSR as a performance measure; make sure you are prepared to support these plans!
Although incentive stock options (ISOs) were created under the Economic Recovery Tax Act of 1981, many of the ISO characteristics and limitations as we know them now were a part of the Tax Reform Act of 1986. This includes the $100,000 limitation. However, we do still see questions about the application of the $100,000 limit come up periodically in our Discussion Forum. So, I’d like to take this opportunity to elaborate a bit on the ISO $100,000 limitation.
The $100,000 Limitation
Under Section 422(d) of the Internal Revenue Code, the total aggregate fair value of ISOs that become exercisable for an individual employee for the first time within a calendar year under all plans may not exceed $100,000. The fair value of the shares for the purposes of determining the aggregate value of shares within a calendar year is the value as of the grant date. Any shares that become exercisable within a calendar year that cause the value of the aggregate number of shares vesting to exceed $100,000 will no longer qualify for preferential tax treatment as ISO shares.
The $100,000 limitation applies to the shares as the first become exercisable. This distinction in the language makes the most sense when considering an ISO grant with an early exercise provision. You calculate the value of the shares as they first become exercisable, regardless of when they vest or are actually exercised. If the entire grant is eligible for early exercise, then the full value of the grant is applied against the $100,000 limitation for the year in which it was granted.
However, it is not a common practice for companies to include early exercise in an ISO grant. So, in most cases, the shares “become exercisable for the first time” per the vesting schedule. For these grants, only the shares that are vesting (becoming exercisable) in any given year are included in the calculation. The full value of the grant, or the number of shares in the grant, is not directly relevant.
For example, an ISO grant of 40,000 shares granted on a day when the FMV is $10 would have a total value of $400,000, regardless of whether or not the shares are exercised or how much income is realized from any transaction(s). Although the full value of this grant exceeds $100,000, this entire grant could be an ISO if only 10,000 shares vest and become exercisable each year and the employee holds no other ISOs that become exercisable in the same years.
Keep in mind that the ISO grants under all plans of your company, parent company, and subsidiaries should be aggregated together to determine the value of the shares that become exercisable. If you are using a stock plan administration software that does not aggregate between plans, or if you track grants from a plan or subsidiary outside of your stock plan administration software, then you will need to pay special attention to the $100,000 limitation.
When the ISO Grant Exceeds $100,000
Portions of ISOs that exceed the $100,000 limitation are taxed as if they are non-qualified stock options. You will need to withhold taxes and report the gain on any exercise of shares that exceeds the limit. This includes your company’s matching FICA and FUTA payments (if applicable). Penalties for not withholding the appropriate taxes can be up to 100% of the amounts that should have been withheld, can include interest and other administrative fees, and, in extreme cases, can involve criminal penalties. Additionally, by not properly reporting the income realized by employees upon exercise, your company won’t be able to claim the tax deduction on that income.
This does not mean that you need to have two separate grants approved and awarded to your employee. Even if you know that an ISO will exceed the $100,000 limitation, it should be approved as one ISO grant. Most stock plan administration softwares will bifurcate the grant for you, but this should be for tracking purposes only.
What to Include in Grant Agreements
All ISO grant agreements should include language indicating that an exercise of any portion of the grant exceeding the $100,000 limitation will be subject to income reporting and withholding. This allows employees to make informed decisions about their exercise strategies for their ISOs and avoids unpleasant surprises when they do engage in option exercises. Additionally, including this language even if you don’t believe any portion of the grant exceeds the limitation will help to protect the company if the initial calculation turns out to be incorrect.
Cancellations
The Final ISO Regulations address the cancellation of incentive stock options. If an ISO grant is cancelled prior to the calendar year in which it first becomes exercisable, then the value of the shares no longer needs to be counted against the $100,000 limitation.
This means that if there is a more recent ISO grant held by the employee that exceeded the $100,000 limitation prior to the cancelation, then a larger portion of that grant may now be treated as an ISO. Or, if a new ISO is granted to the employee, then the cancelled grant should not impact the $100,000 limitation as it is applied to that new grant. You may not, however, go back in time and change a non-qualified stock option to an ISO because of the cancellation.
The trickiest part of this rule is the case of a grant that is cancelled prior to vesting, but within the calendar year of the vest date. The value of the shares that would have vested still counts toward the $100,000 limitation for that calendar year. For example, if a grant should vest in October, but is cancelled in the preceding June, the value of that vest must still be included in the calculation for that year. This is especially important if your company is executing an options exchange program that includes unvested incentive stock options.
Accelerations
If the vesting/exercisability of an ISO is accelerated, then the application of the $100,000 limit must be reviewed for the new vesting schedule. Grants should be considered in the order in which they were granted. Therefore, if multiple grants are accelerated simultaneously (in the case of an acquisition, for example), you should review the new vesting schedules beginning with the oldest grant first.
I got nothin’. No new legislation, no IRS pronouncements, no SEC proposals…the world of stock compensation was eerily quiet last week. So I have a hodge podge of non-news this week.
Section 6039 Returns I have been pestering folks that I know at the IRS and Treasury for a status update on the Section 6039 and Section 423 regulations. I don’t have any news on when either of these regs will be issued, but I have heard that it is likely that the effective date for filing the Section 6039 returns will be delayed. No word on how long the delay will be or when we’ll know for sure, but I suspect that the delay means that the final regulations are going to differ from the regulations that were proposed last year. Of course, the delayed effective date would only apply to the returns filed with the IRS; companies will continue to be required to provide the information statements to employees, just as they are now.
Did Stock Options Cause the Recession? This headline showed up in my Google alert on stock options last week. Apparently, a research paper titled “Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts” has been published positing that this is case. The general idea is that stock options encouraged executives to take more risks than they would have otherwise, ultimately leading to the demise of their firms, which, in turn, led to the recession. This isn’t really a new idea–it’s the reason the SEC has proposed to require companies to discuss the impact of their compensation programs on risk-taking behavior in the CD&A and Treasury requires similar analysis from TARP companies.
I had hoped to read the paper and provide a summary of it for you. But I didn’t make it very far. The paper includes sentences like: “Sunspot equilibria have previously been studied in one-sector dynamic equilibrium models with external effects or monopolistic competition coupled with some degree of increasing returns.” And that’s just in the third paragraph of the introduction; the rest of the paper is much worse. Ten points to anyone who can decipher that sentence. Ten more points for anyone who can use the words “sunspots” and “stock options” in the same sentence.
If anyone wants to read the paper and provide a summary of it, I’d be happy to let you guest author the blog for a day.
Quick Survey on Equity Award Modifications Take the NASPP’s Quick Survey on Equity Award Modifications to find out what types of modifications are most common and practices related to modifications. The survey is just seven short questions–you can complete it in just a few minutes. And don’t forget to email your questions on award modifications for our August 27 webcast, “Ask the Experts: Modifications of Equity Awards.”
NASPP Conference Workshop of the Week This week’s workshop is “IFRS–A Lesson in Implementation.” The migration to IFRS will involve many challenges–and stock compensation is an area that imposes some of the greatest burdens. More than just a technical transition, IFRS will require companies to re-engineer their data flows, linking diverse organizational aspects such as stock plan administration, payroll, finance, tax and human resources. This panel–which includes a company that has already fully transitioned to IFRS–will provide practical hands-on guidance on overcoming the obstacles and smoothly transitioning to this complex new accounting standard.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
In April I wrote about how the current environment is renewing an interest in shareholder votes on executive compensation. The Obama administration has made it clear that “say on pay” is an integral part of efforts to reform corporate governance. On June 10th of this year, the Administration released a “Say on Pay” Fact Sheet outlining President Obama’s perspective on the need for non-binding shareholder votes on executive compensation and golden parachute payments.
The Treasury has already proposed legislation, the Investor Protection Act of 2009 that I wrote about in July, which would require a non-binding shareholder vote on executive compensation, golden parachute payments, and improve compensation committee independence.
If enacted, this bill will impose the following Say-on-Pay standards:
Annual non-binding shareholder approval of executive compensation
Disclosure (in simple tabular format) of compensation to principal executives relating to corporate transactions as well as the aggregate total for such compensation
Separate non-binding shareholder approval of disclosed compensation to principal executives related to corporate transactions
Compensation Committee Independence
In addition, it includes the following requirements to facilitate compensation committee independence:
In order to be considered independent, members of the compensation committee may not receive any compensatory fees from the company and cannot be affiliated with the company in any other way.
Companies must allow compensation committees to engage independent compensation consultants and legal counsel as well as provide funding to do so.
In their proxies, companies must disclose whether or not their compensation committees engaged the services of a compensation consultant and if not, then provide an explanation.
Further Restrictions for Financial Institutions
Additionally, the House bill would give regulators the authority to prohibit any compensation arrangement that encourages “inappropriate risks” by financial institutions which could have “serious adverse effects on economic conditions or financial stability”. Since the bill only instructs Federal regulators to come up with appropriate legislation to prohibit this type of compensation, it is not yet clear how it will be defined or what penalties may be imposed. It does reinforce that the Administration clearly feels that the compensation structures within financial institutions were at least partially to blame for the economic crisis. Although this is a small part of the bill, I think it’s worth keeping an eye on. If financial institutions are ultimately subject to this type of scrutiny, then all public companies should take note and consider keeping their own compensation policies within the guidelines set for financial institutions and banks.
IRS Legal Memorandum on §162(m) Treatment of Backdated Stock Options
Just when you thought you’d heard the last on option backdating, last month the IRS issued a legal memorandum on the treatment of backdated stock options for Section 162(m) purposes.
A Little Background–Skip Ahead if You Already Understand §162(m)
Under Section 162(m), companies cannot claim a tax deduction for any compensation paid to “covered employees” in excess of $1 million per year. “Covered employees” are generally the same as the “named executive officers” included in the company’s proxy disclosures, except for terminated officers and the chief financial officer (see the NASPP alert “IRS Issues Guidance on ‘Covered Employees’ Under Section 162(m)“).
Performance-based compensation, however, is exempt from this limit. But, of course, that means there’s a whole bunch of rules you have to follow for compensation to be considered performance-based, and, there’s even a special set of rules that apply to stock options. One of the rules for stock options is that they can’t be discounted.
No Do-Overs
You don’t get to rewrite history with the IRS. According to the memo, the determination of whether an option is considered performance-based is made at the time of grant, based on the terms and conditions in effect at that time. If the option doesn’t qualify for the performance-based compensation exemption then, nothing you do to the option later can make it qualify.
Thus, if an option is discounted when it is granted, it doesn’t qualify as performance-based compensation under §162(m). Even if the option is later repriced upwards, so that it isn’t discounted anymore, this doesn’t change the fact that it was discounted when it was granted. It might help for other purposes (accounting, securities law, even other tax purposes), but it won’t make the option performance-based for §162(m) purposes.
More Financial Statement Restatements?
Many companies that have found option pricing errors related to backdating have already had to restate their financials for the additional expense attributable to the discounted options under APB 25, FAS 123, and FAS 123(R). The lost tax deductions under §162(m) will impact cash flow and tax expense, possibly resulting in more restatements.
No Do-Over for ISOs Either
The memo also points out that this same standard has been applied to ISOs that were subject to backdating. As I’m sure all my readers know, ISOs cannot be discounted. According to the memo, just as under §162(m), the determination of whether an option meets all the requirements of Section 422 (including the exercise price requirements), is made at the time of grant. Where an option doesn’t meet the ISO requirements when it is granted, there’s nothing that can be done later to bring it into compliance. Thus, if an option is discounted at grant, it can’t receive ISO treatment, even if the exercise price is later increased.
Keynotes and New Sessions Announced for the NASPP Conference I’m thrilled to announce that the keynote sessions at the NASPP Conference will include an address from J. Mark Iwry, Senior Advisor to U.S. Treasury Secretary and Deputy Assistant Secretary. In this newly created role, Mr. Iwry is responsible for executive compensation, pensions, retirement savings and health care. His remarks are sure to be illuminating and of critical importance to companies as they begin to plan next year’s compensation packages.
The NASPP Conference will also feature a keynote presentation from John Olson of Gibson, Dunn & Crutcher and Jesse Brill of the NASPP and CompensationStandards.com on “Overcoming the Compensation Crisis: Sage Guidance,” and another keynote from Joe Nocera of the NY Times, Fred Cook of Frederic W. Cook & Co., and Ira Kay of Watson Wyatt on “The Basics Have Changed: How to Proceed in this New Environment.”
In light of recent regulatory developments, including Say-On-Pay, proposed restrictions on executive compensation and requirements for comp committee independence, and the SEC’s proposed new disclosures for executive compensation, we’ve announced several new sessions for the NASPP Conference:
Quick Survey on Equity Award Modifications Take the NASPP’s Quick Survey on Equity Award Modifications to find out what types of modifications are most common and practices related to modifications. The survey is just seven short questions–you can complete it in just a few minutes. And don’t forget to email your questions on award modifications for our August 27 webcast, “Ask the Experts: Modifications of Equity Awards.”
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
In June, I wrote about two important 16(b)short-swing profit recovery cases. Last week, Alan Dye’s Section16.net blog pointed me to another noteworthy case, Segen v. OptionsXpress Holdings, Inc., 2009 WL 1868611 (D. Del. 2009). This case offers a view into the process of determining the attorney fees provided for bringing short-swing transactions to the attention of the company. The original short-swing recovery was settled without litigation, which means that the attorney fees, if negotiated privately, would remain undisclosed.
The Decision on Attorney Fees
In this particular situation, however, OptionsXpress and the attorneys could not come to an agreement. Apparently, OptionsXpress offered an amount that the attorneys considered to be less than the value of the billable hours the firm had already dedicated to the case. What is particularly intriguing about this argument is that attorney fees in 16(b) short-swing profit recovery cases are based on a percentage of the funds recovered, not on billable hours. The percentage of the fee can vary greatly. As Alan Dye pointed out in an earlier blog entry, fees from the cases that must be approved by the court have ranged from 2% to 51%.
In deciding on this case, the court confirmed that the number of hours dedicated to the case should not be a direct factor in the fee that may be recovered. What the court did say, however, is that the billable hours may be used to check the reasonableness of the amount of the fee. In the end, the attorneys received significantly less than they’d asked for (they received 8% vs. the 25% they requested), but more than OptionsXpress had originally offered, and more than they felt had been accrued in billable hours.
Romeo & Dye Handbook – Seventh Edition
Have questions about how recent changes have impacted Section 16 filings? Well, you’re in luck–the 2009 Romeo & Dye Section 16 Forms and Filings Handbook is out! Since the last edition, a dozen new Model Forms have been added, numerous Forms have been updated, and obsolete Forms have been removed. If you currently subscribe to the Section 16 Annual Service, you should have already received your Handbook. If you are not subscribed, don’t miss out–Subscribe now!
More on Senator Levin’s Bill, Starting with ISOs Right now, ISOs are a potential boon in terms of federal tax revenue–if employees hold their ISO shares long enough to meet the statutory holding periods, the company forgoes its tax deduction but employees still pay tax on the gain. On top of that, some employees are forced to “pre-pay” the tax due upon sale in the form of AMT. But if Levin’s bill is passed, companies would receive a tax deduction for ISOs whether or not employees meet the statutory holding period or even exercise the options. There would be little reason for companies to grant NQSOs until forced to by the $100,000 limitation, potentially reducing tax revenue even further.
Why Not Restricted Stock?
Another significant weakness in Levin’s bill is that it ignores restricted stock. I’ve never understood the media and regulator bias for restricted stock. It seems to me that stock options, which contribute capital to the company and which require the stock price to increase before producing any gains for executives, are a better form of compensation than just handing out stock for free. Yet, Levin’s bill would do nothing to address the inequities between book expense and corporate tax deductions for restricted stock.
This would bifurcate the tax accounting required for options versus other types of stock compensation (restricted stock, performance awards, ESPPs), ultimately making the financial reporting for stock compensation more confusing than it already is today.
No Performance-Based Compensation Exception Under 162(m)
Levin’s bill would also exclude “stock option compensation” from qualifying for the performance-based compensation exemption on Section 162(m). This would generate additional tax revenue by including stock option gains in the compensation in excess of $1 million that companies can’t take a deduction for, but, of course, this limit only applies to the company’s named executive officers. It’s hard to say whether this would make up for the lost revenue from tax deductions realized on underwater stock options.
Crunching the Numbers
I looked at a few companies to see which method (Levin’s or the current tax code) produced a bigger tax deduction. Of course, the first company I looked at–Exxon Mobil (why not start with #1 on the Fortune 500 list)–doesn’t grant stock options, further proving my point about restricted stock. So I looked at #3, which is Chevron. In 2008, they recognized $154 million in expense for stock options (excluding options granted to NEOs) and their aggregate intrinsic value for exercises that year was $433 million, so Chevron did better last year with the current tax code. Then I looked at Time Warner (yes, jumping down to #48 on the Fortune 500–it’s not like I have time to analyze all 500 companies and it’s a challenge to find companies that grant stock options and disclose the expense for their options separately from the rest of their stock plan expense). Time Warner recognized option expense of $132 million (exclusive of options granted to NEOs) with an aggregate intrinsic value for exercises last year of only $53 million. So Time Warner would have realized a greater tax savings under Levin’s bill than under the current system. You win some; you lose some.
I looked at several companies that implemented option exchange programs this year (Nvidia, Google, a few others) and all would have come out ahead under Levin’s method, but I admit that looking at these companies was stacking the deck.
It would be fascinating to see an analysis of more than just a few random companies. Got some free time on your hands?
NASPP Conference Workshop of the Week This week’s workshop is “Night of the Living Dead: Equity Compensation Horror Stories.” From IRS auditors, to natural disasters, to misfired communications, we all love to hear about–and learn from stock plan misfortunes. This panel has lined up some doozies for you! Thrill to tales of stock plan disasters with “The Equity Plan Massacre,” lay awake at night dreading the stock exchange and transfer agent horrors in “Nightmare on Wall Street,” and try not to scream during the blood chilling compliance thrills of “Invasion of the IRS Auditors.” This panel will frighten you with nightmares and set you on the path to safety with recommendations on how to avoid similar misfortunes.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.