A recent IRS Chief Counsel Memorandum indicates that smaller reporting companies must treat their CFO as a covered employee under Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.
Wait a Minute! The CFO Isn’t Subject to 162(m)?
Yep, that’s right. For larger reporting companies, it may seem crazy, but the CFO isn’t ever a covered employee under Section 162(m). This is because the definition of a named executive officer under Item 402 of Reg S-K for purposes of the executive compensation disclosures in the proxy has evolved and the definition of a covered employee under Section 162(m) hasn’t kept pace.
Section 162(m) applies to the following executives:
The CEO
The top four highest paid executives other than the CEO, as determined for proxy disclosure purposes.
Back when 162(m) was adopted, this was the same group of people that were considered NEOs for purposes of the proxy disclosures. But in 2006, the SEC changed Item 402 to carve out a separate requirement for CFOs. So now, the NEOs in the proxy are:
Anyone serving as CEO during the year
Anyone serving as CFO during the year
The top three highest paid executives other than the CEO and the CFO.
Up to two additional executives that would have been in the top three except that they terminated before the end of the year.
Unfortunately, only Congress can change the statutory language under Section 162(m), so the IRS can’t modify the definition of a covered employee to match the SEC’s new definition of an NEO. (When Congress drafted Section 162(m), they probably should have just said that it applies to all NEOs as determined under Item 402 of Reg S-K.)
All the IRS can do is interpret the requirement under 162(m) in light of the SEC’s definition. Their interpretation is that the SEC’s change exempts CFOs from Section 162(m) (see the NASPP alert “IRS Issues Guidance on ‘Covered Employees’ Under Section 162(m),” June 9, 2007). (If you are wondering, former employees are also not subject to Section 162(m); this is another evolution in the SEC definition that hasn’t been implemented in the tax code.)
What Gives With Smaller Reporting Companies?
Smaller reporting companies are subject to abbreviated reporting requirements, including fewer NEOs for proxy reporting purposes. Thus, the SEC’s new definition in 2006 never applied to smaller reporting companies. Instead, NEOs in smaller reporting companies are defined as:
The CEO
The top two highest paid executives other than the CEO.
Per Chief Counsel Memorandum 201543003, because the CFO isn’t separately required to be included in the proxy disclosures for smaller reporting companies, he/she is still a covered employee for Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.
It’s no April Fool’s joke—on March 31, the IRS and Treasury issued final regulations under Section 162(m). The final regs are largely the same as the proposed regs that were issued back in 2011 (don’t believe me—check out the redline I created); so much so that I considered just copying my blog entry on the proposed regs and changing the word “proposed” to “final” throughout. But I’m not the sort of person that takes short-cuts like that, so I’ve written a whole new blog for you.
For more information on the final regs, check on the NASPP alert, which includes several law-firm memos.
The IRS Says “We Told You So”
The final regulations implement the clarification in the proposed regs that, for options and SARs to be exempt from the deduction limit under Section 162(m), the plan must specify a limit on the maximum number of shares that can be granted to an individual employee over a specified time period. It is not sufficient for the plan to merely limit the aggregate number of shares that can be granted, even though this creates a de facto per-person limit; the plan must separately state a per person limit (although the separately stated per-person limit could be equal to the aggregate number of shares that can be issued under the plan). One small change in the final regs was to clarify that the limit doesn’t have to be specific to options/SARs; a limit on all types of awards to individual employees is sufficient.
When the proposed regs came out, I was surprised that the IRS felt the need to issue regs clarifying this. This had always been my understanding of Section 162(m) and, as far as I know, the understanding of most, if not all, tax practitioners. In his sessions over the years at the NASPP Conference, IRS representative Stephen Tackney has said that everyone always agrees on the rules until some company gets dinged on audit for not complying with them—then all of a sudden the rules aren’t so clear. I expect that a situation like this drove the need for the clarification.
In the preamble to the final regs, the IRS is very clear that this is merely a “clarification” and that companies should have been doing this all along, even going so far as to quote from the preamble to the 1993 regs. Given that the IRS feels like this was clear all the way back in 1993, the effective date for this portion of the final regs is retroactive to June 24, 2011, when the proposed regs were issued (and I guess maybe we are lucky they didn’t make it effective as of 1993). Hopefully, you took the proposed regs to heart and made sure all your option/SAR plans include a per-person limit. If you didn’t, it looks like any options/SARs you’ve granted since then may not be fully deductible under Section 162(m).
Why Doesn’t the IRS Like RSUs?
Newly public companies enjoy the benefit of a transitional period before they have to fully comply with Section 162(m). The definition of this period is one of the most ridiculously complex things I’ve ever read and it’s not the point of the new regs, so I’m not going to try to explain it here. Suffice it to say that it works out to be more or less three years for most companies.
During the transitional period, awards granted under plans that were implemented prior to the IPO are not subject to the deduction limit. Even better, the deduction limit doesn’t apply to options, SARs, and restricted stock granted under those plans during this period, even if the awards are settled after the period has elapsed. It’s essentially a free pass for options, SARs, and restricted stock granted during the transition period. The proposed regs and the final regs clarify that this free pass doesn’t apply to RSUs. For RSUs to be exempt from the deduction limit, they must be settled during the transition period. This provides a fairly strong incentive for newly public companies to grant restricted stock, rather than RSUs, to executives that are likely to be covered by Section 162(m).
I am surprised by this. I thought that some very reasonable arguments had been made for treating RSUs the same as options, SARs, and restricted stock and that the IRS might be willing to reverse the position taken in the proposed regs. (In fact, private letter rulings had sometimes taken the reverse position). I think the IRS felt that because RSUs are essentially a form of non-qualified deferred comp, providing a broad exemption for them might lead to abuse and practices that are beyond the intent of the exemption.
This portion of the regs is effective for RSUs granted after April 1, 2015.
As I write this blog, the buzz is escalating around the imminent IPO of social media site Twitter. I don’t think there’s been this much anticipation for an IPO since Facebook joined the ranks of public companies last year. It’s like the perfect storm of variables – stock compensation, hot IPO, and the prospect of significant wealth. Yet, with every party there are “party poopers”, and the Twitter party is no different. That’s why I wasn’t entirely surprised when Senators Levin and McCain tried to crash the party yesterday with a joint statement pushing once again to eliminate the corporate tax deductions on stock compensation.
What is it this time?
It’s likely the Senators are following the lead of Citizens for Tax Justice (a left-leaning tax activist and research group), who earlier this week released results of an analysis of 11 public companies and Twitter, suggesting that the cumulative corporate tax deductions in the coming years for these 12 companies would be in the billions of dollars. So what is new and different in the latest argument that companies are somehow avoiding paying taxes on stock compensation and that this “loophole” should be avoided? Well, not much. There have been many NASPP Blogs on this topic in the past, so I’ll let you catch up on the nuances of the corporate tax deduction through those. The latest justification the Senators offer for ending this perfectly reasonable deduction appears to be that “…given the deficit and damaging sequester cuts facing this country, this corporate stock option tax deduction is the kind of tax loophole that ought to be closed.” Huh? Now this is the solution to a slew of other fiscal issues?
Another Battle in a Long War…
Senator Levin has been waging this battle for years, so it seems every time there is a new opportunity, he’ll raise the issue again, with a new twist. The reality is, and this is often overlooked in media analysis of the Senators’ calls to action, for every dollar of corporate tax deduction taken for stock compensation transactions, there is a dollar that is taxable income to an employee. Companies are not “avoiding” paying tax – the tax is being paid by the employee. Another tidbit I’ll point out is that starting January 1, 2013, the maximum individual tax rate was increased to 39.6% – higher than the highest corporate rate of 35%. So by taxing the individual rather than corporations on significant stock compensation gains, the IRS actually is likely to fare better. For example, if Mark Zuckerberg of Facebook makes $1 billion in stock compensation gains he would theoretically be taxed at 39.6% on the vast majority of his gains. Facebook would get a corresponding $1 billion tax deduction, reducing the company’s taxable income (which, let’s hypothetically say is taxed at 35%). I’m simplifying this – but you get the gist.
How Does Financial Reporting Factor In?
Another argument the Senators are raising (and not for the first time) is that stock compensation tax deductions should not exceed the amount of accounting expense recorded by the company in its financial statements. To that I say “who cares?”. Accounting and tax are two completely different animals, with completely different intents. It’s reasonable and common for the two to be misaligned.
Moving On…
I’m guessing that this latest effort by the two Senators will be short lived, just as in prior instances. Let’s hope so, or I’ll have to invest in a larger bandwagon and bigger megaphone, because I vehemently disagree with Senators Levin and McCain on this issue. I’m also getting kind of tired of the party crashing. Can’t we just bask in the enjoyment of another successful stock compensation IPO without the grumbling about corporate tax deductions? It’s time to move on.
Back in August, I blogged about Senator Levin’s most recent efforts attacking the tax deduction companies claim for stock options (“Senator Levin, Still Trying,” August 9, 2011), then in September, I blogged about a study on CEOs that made more than their companies paid in taxes, which was clearly aimed at supporting Senator Levin’s position (“Corp Taxes and CEO Compensation,” September 16, 2011). Now, with the news that Facebook may be entitled to a significant tax deduction as a result of stock options awarded to founder, Mark Zuckerberg, Senator Levin gave a speech in Congress about the evils of tax deductions for stock options and again introduced legislation to limit the company tax deduction (“Senator Levin Calls for Congress to Close ‘Facebook’ Tax Loophole,” by Carl Franzen, TPN, March 1, 2012).
The Rebuttal to Senator Levin When I read this stuff, I get so frustrated I lose the ability to speak coherently and just sputter out half-sentences of outrage. Luckily, however, the folks that write the Executive Pay Matters blog at Towers Perrin are much more articulate than I am. On January 23, James Scannella pointed out a number of weaknesses in Senator Levin’s arguments (“Is It Time for a Change in the Tax Treatment of Stock Options“). A few highlights from the blog:
The company is only getting a tax deduction because the executive is paying tax on the same income–making the transaction, at worst, tax neutral for the U.S. government. It’s even possible that the executive is paying tax at a higher rate than the company would.
It isn’t necessary for compensation to be paid in cash for it to result in a tax deduction; there are other instances where non-cash compensation results in a tax deduction that no one seems outraged about.
It also isn’t uncommon for the accounting expense for compensation to be misaligned with the tax expense. The two sets of rules serve very different purposes. This, in and of itself, isn’t a argument that the tax deduction is wrong or a loophole.
Scannella also points out that, in Towers Watson’s experience, decisions regarding how and how much to pay executives are rarely driven by the timing or amount of the company’s tax deduction. Just as ASC 718 wasn’t the end of stock compensation, this legislation probably wouldn’t be either. And it could have the effect of steering more companies towards service-based restricted stock, a result that shareholders probably wouldn’t be too keen on.
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A new study reporting that some CEOs make more than their companies pay in taxes has been making a splash in the media lately. Today I offer some comments on the study.
Executive Excess 2011: The Massive CEO Rewards for Tax Dodging The study looked at the 100 highest paid CEOs in the US and found that 25 of them earned more than their companies paid in taxes. The study also found that the average pay of the 25 CEOs exceeded the average pay of CEOs at all Fortune 500 companies, but, as one criticism of the study points out: “any subset of the 100 highest-paid CEOs in the country is going to have higher average pay than S&P 500 CEOs in general,” so this isn’t exactly groundbreaking.
The study also emphasizes that most of the 25 companies received tax refunds. Maybe I’m missing something here, but I thought getting a tax refund means you paid too much in tax, the IRS earned interest on your money all year, and then gave your excess payment back without interest at the end of the year. The companies that didn’t get a tax refund were the clever ones because they earned interest on their money all year, rather than the IRS–they aren’t necessarily paying their CEOs any less.
Compensation Apples to Tax Oranges
One problem I have with this study is that CEO pay isn’t directly related to the company’s tax bill. The two amounts really have nothing to do with each other. In fact, amounts paid to the CEO are an expense to the company; expenses reduce the company’s profitability which in turn reduces the amount the company pays in taxes.
Companies that aren’t profitable don’t pay any taxes. If CEO pay shouldn’t exceed the company’s tax bill, does this mean that CEOs at companies that aren’t realizing a profit shouldn’t be paid anything? That’s really going to put a damper on the start-up market.
Don’t get me wrong, I agree with the principle that many CEOs of public companies are paid excessively–I’m just not sure that the company’s tax bill is the appropriate yardstick by which we should determine what is excessive.
Is Senator Levin Behind This?
The study includes a special side bar (on pg 7) that explains how stock options contribute to this problem by producing a tax deduction for the corporation that differs from the expense recognized for the option–something Senator Carl Levin has been trying to change for years (see my August 9 blog, “Senator Levin, Still Trying“).
The study says that “The amount of compensation the executive receives on the exercise date is often substantially more than the book expense of the options…” I take issue with this statement. I’ve never seen any data to back it up, I don’t see any data backing it up in this study, and I know that many options end up underwater or result in a spread at exercise that is less than the grant date fair value. In fact, I’d love to see an analysis comparing grant date fair value to spread at exercise for a wide range of stock options at a wide range of companies, if anyone out there wants to take the project on.
CEOs Pay Taxes Too
One reason why compensation results in a tax deduction for the company is that the individual receiving the compensation pays taxes on it. So, while the company might be getting a tax break, the CEOs are still paying tax, probably a lot of tax.
NQSO exercises are certainly subject to tax. The US corporate tax rate for large public companies is around 34% to 35% (at least according to Wikipedia–I know nothing about corporate tax rates). The highest federal marginal income tax rate in the US is 35% and I have to believe that the CEOs in the study are paying tax at this rate (plus they are paying FICA taxes and the company is paying matching FICA taxes on the income). So whether the company pays tax on the income or the CEO does, it seems like the tax revenue is about the same (maybe slightly higher when the CEO is paying the tax because of FICA).
For example, let’s say that a company earns a profit $100 million and the CEO of the company holds an NQSO with a spread of $1 million. If the CEO doesn’t exercise the option, the company pays tax on $1 billion. If the CEO does exercise the option, the company pays tax on $99 million, but the CEO pays tax on the $1 million spread–at possibly a slightly higher rate than company would have paid. Tax revenue for the US federal government is about the same either way.
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.
Earlier this summer, Senator Carl Levin (D-MI), introduced another bill that would limit corporate tax deductions for stock options to the expense recognized for them, the “Ending Excessive Corporate Deductions for Stock Options Act.” His cohort on this year’s bill is Senator Sherrod Brown (D-Ohio) (Senator Claire McCaskill, D-OH, has also signed on since the bill was introduced).
A Bi-Annual Event I say “this year’s bill” because this is becoming a bi-annual event. Levin has been introducing bills like this for at least the past 20 years. He didn’t even bother to change the name of the bill this year. In fact, just for kicks, I did a redline comparison of this bill to his 2009 bill; the two bills are almost exactly the same. His co-sponsors have varied over the years but often include Senator John McCain (R-AZ).
The bill would limit the tax deduction corporations could take for stock options to the amount of expense recognized for them (i.e., the grant date fair value). According to Levin’s press release, this would raise $24.6 billion in tax revenue over the next ten years (assuming, apparently, that the market doesn’t have too many more days like yesterday). The press release states that Levin has released IRS data showing that, from 2005 to 2009, corporations took tax deductions that were “billions of dollars” greater than the expenses shown on their financial statements.
This is surprising to me because I’m not sure how the IRS would even have this data. The tax deductions companies took in those years would relate to options that were granted in prior years–many may have been granted before FAS 123(R) (now ASC 718) even went into effect. Comparing the tax deduction the company claimed to the option expense for that year is not a valid comparison.
You can usually get an idea of whether a company’s tax deductions for stock compensation exceed the expense recorded for it from their financial statements, but most of the financial statements I’ve seen only provide this information in aggregate for all types of arrangements the company offers–stock options, restricted stock, RSUs, performance awards, ESPP, etc. Levin’s bill only applies to stock options.
Section 162(m)–No More Free Pass
The bill would also make stock options subject to the limitation on corporate tax deductions under Section 162(m). Currently, stock options are exempt from the limit by virtue of being considered inherently performance-based (because the stock price must appreciate for the option to deliver a benefit). This clearly would raise revenue–maybe that’s where a good chunk of the $25 billion comes from. What was the tax deduction your company claimed for the options exercised by your NEOs last year?
Given that, after twenty years, Levin still hasn’t had any success with this agenda, I think chances are nothing will happen with this bill either, so I don’t expect it to be a hot topic at this year’s NASPP Conference. But you can catch up on all hottest tax topics–straight from the IRS–with the session “The IRS Speaks” at the 19th Annual NASPP Conference.
It’s Not Too Late to Enroll in the NASPP’s Financial Reporting Course The NASPP’s newest online program, “Financial Reporting for Equity Compensation” started on Thursday, July 14, but it’s not too late to get into the course. All webcasts have been archived for you to listen to at your convenience.
Designed for non-accounting professionals, this course will help you become literate in all aspects of stock plan accounting, from expense measurement and recognition, to EPS and tax accounting. Register today so you don’t miss any more webcasts.
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.
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On June 23, the IRS and Treasury proposed new regulations under Section 162(m) relating to the requirements for options and SARs to be considered performance-based compensation and the transition period for newly public companies.
Not-So-Surprising Proposed Regs for Section 162(m) (Well, Maybe a Little Surprise for IPO Companies)
Section 162(m) limits the tax deduction public companies can take for compensation paid to specified executive officers to $1 million per year. As I’m sure you all know, however, performance-based compensation is exempt from this limitation.
The recently issued proposed regs are not nearly as controversial as the IRS’s 2008 surprise ruling on 162(m), but are still worth taking note of–especially since, as the Morgan Lewis memo we posted on the proposal points out, some of these clarifications are the direct result of compliance failures the IRS has encountered during audits.
Stock Options and SARs
Normally, for compensation to be considered performance-based, it must meet a number of rigorous requirements. At the time that Section 162(m) was implemented, however, at-the-money stock options and SARs were considered inherently performance-based, so the requirements applicable to them are significantly more relaxed (a decision I can only imagine regulators regret today, given current public sentiment towards stock options). The primary requirements are that the options/SARs be granted from a shareholder approved plan, individual grants are approved by a committee of non-employee directors, the exercise price is no less than the FMV at grant, and the plan states the maximum number of shares that can be granted to an employee during a specified period.
The proposed regs clarify that, for this last requirement, the plan must state a per-person limit; the aggregate limit on the number of shares that can be granted under the plan is insufficient (although, the stated per-person limit could be equal to the aggregate limit).
Disclosure
For all performance-based compensation, including stock options and SARs, the regs already require that the maximum amount of compensation that may be paid under the plan/awards to an individual employee during a specified period must be disclosed to shareholders. For stock options and SARs, it’s pretty hard to determine what the maximum compensation is, since this depends on the company’s stock price over the ten years or so that the grant might be outstanding. The proposed regs clarify that it is sufficient to disclose the maximum number of shares for which options/SARs can be granted during a specified period and that the exercise of the grants is the FMV at grant.
Newly Public Companies
For a limited “transition” period, Section 162(m) doesn’t apply to arrangements that were in effect while a company was privately held (provided that the arrangements are disclosed in the IPO prospectus, if applicable). This transition period ends with the first shareholders’ meeting at which directors are elected after the end of the third calendar year (first calendar year, for companies that didn’t complete an IPO) following the year the company first became public (unless the plan expires, is materially modified, or runs out of shares or the arrangement is materially modified before then).
For stock options, SARs, and restricted stock, the current regs are even more generous–any awards granted during this transition period are not subject to 162(m), even if settled after the transition period ends. The proposed regs don’t change this, but they do make it clear that RSUs and phantom stock are not covered by this exemption. My understanding from some of the memos we’ve posted in our alert on this is that this reverses a couple of private letter rulings on this issue (see the Morrison & Foerster, Morgan Lewis, and Edwards Angell Palmer & Dodge memos). The current regs specifically state that the exemption applies to stock options, SARs, and restricted stock, but are silent as to the treatment of RSUs and phantom stock–providing the IRS/Treasury with the leeway to exclude them now.
Subtle Changes
Several of the changes are pretty subtle–so subtle that when comparing the proposed regs to the current regs, I couldn’t figure out what had changed. So I used the handy-dandy document compare feature in Word to create a redline version of the new regs, which I’ve posted for the convenience of NASPP members.
Chickens, Stock Plan Administrators, and Whiskey The author of the joke that appeared in last week’s blog entry is John Hammond of AST Equity Plan Solutions (and poet laureate of the NASPP blog). Ten points to Erin Madison of Broadcom, who was the only person to email me the correct the answer. I can’t believe no one else figured it out!
A recharge agreement is a written agreement between a parent corporation and its subsidiary under which the subsidiary reimburses the parent corporation for the cost of equity compensation. Companies enter into this type of agreement in order to secure a corporate tax deduction at the subsidiary for equity compensation to its employees. In many countries, if a tax deduction is allowed, the subsidiary must bear the costs of the equity compensation either directly or indirectly via a written agreement. Additionally, a recharge agreement may be a tax-free way for the company to repatriate funds to the U.S. (so that the transfer of funds is not considered a dividend). For many companies, recharge agreements may be a sound corporate strategy; however, there are some pitfalls that you should be aware of if your company is considering implementing or has already entered into recharge agreements.
First, you will need to know the timing of when a recharge agreement must be in place in order for the company to take a corporate tax deduction. In some countries, the agreement must be in place at the time of grant. It is possible that the recharge agreement may even need to be a part of the grant language. This may mean that even with a recharge agreement in place, it is possible that not all grants will be part of the corporate tax deduction.
Second, there may be special requirements for tax deductibility beyond the recharge agreement. For example, deductibility may not apply to officers and/or directors of the subsidiary, the parent company may be required to use treasury shares, or the shares may need to be purchased by the subsidiary on the open market. Additionally, the requirements may differ between types of grants.
Third, the recharge agreement may cause exchange control or labor law issues in some countries. For example, the agreement may require exchange control approval, which may not be easy or likely to achieve. On the labor law side, the recharge agreement may cause the income from equity to be considered a part of compensation, which may open the company to entitlement issues.
Finally, the recharge agreement may trigger tax withholding on the gain in countries where a tax withholding on equity compensation income may not otherwise be required. This is important for two reasons. First, it means that with the recharge agreement in place, you will need to coordinate tax withholding with your payroll team in that country. Second, it may mean that the employer social insurance payment is required for employee equity income. This may even be high enough to negate the benefit of the corporate tax deduction.
Another consideration for recharge agreements: Don’t assume your company isn’t using them. Check with your tax team to make sure that your company hasn’t entered into an agreement that will impact your day-to-day operations (like tax withholding) or create unforeseen exposure for your company.
Want a quick review of tax deductibility for the countries your company does business in? We have several great resources on our Global Stock Plans portal. You can find information in the Country Guides as well as many of the matrices posted to the left portion of the portal.