Back in December I reported on a shareholder who was sending demand letters to companies alleging that share withholding transactions aren’t exempt from Section 16(b) unless the transaction is automatic, i.e., insiders have no choice in how to pay their taxes (“Shareholder Challenging 16(b) Status of Share Withholding“). I have a few updates on this development.
The Bad News
Back in December, it was just one shareholder but now there at least two more shareholders that are issuing demand letters like this. Also, we’ve now progressed beyond demand letters, with several companies now in litigation over this.
Both Good and Bad News
As noted in the March 2017 issue of Section 16 Updates, the shareholders have submitted demand letters to around 70 companies. One bit of good news is that in most cases, the amount of the alleged short-swing profits has been small, so payments to the shareholders have also been small.
But this is also bad news because it means that most companies would prefer to settle rather than pursuing costly litigation, which is necessary to get clarification on this matter from the courts. As noted in Section 16 Updates:
A clear ruling on the issue is much needed, given the chilling effect that the shareholders’ demand letters have had on the grant and exercise of elective stock withholding rights and the burden that re-approvals have imposed on compensation committees.
The court dismissed the complaint for failure to state a claim, holding in a one-page order that “the transactions in question are compensation related and are designed to be exempt under” Rule 16b-3(e). While a lengthier discussion of the issue might have been more helpful in resolving other pending cases, the court’s holding is nevertheless important because it clearly rejects the plaintiff’s argument that Rule 16b-3 exempts withholding transactions only if they are “automatic.” Moreover, the court allowed reliance on the exemption even where the decision to withhold shares was made by the issuer (i.e., employees) rather than the insider or the compensation committee. The case therefore provides reason to believe that courts will reach a similar result regarding all forms of stock withholding so long as withholding was authorized by the compensation committee as part of the initial equity award.
I’m sure this is a topic that Alan will be discussing in his session “Section 16 & Insider Considerations in Today’s Market” at the 25th Annual NASPP Conference—don’t miss it!
For today’s blog, I feature five trends in tax withholding practices for restricted stock and units, from the 2016 Domestic Stock Plan Design Survey (co-sponsored by the NASPP and Deloitte Consulting):
Share Withholding Dominates; Sell-to-Cover Is a Distant Second. The majority (79% of respondents for executive transactions, 77% for non-executive transactions) report that share withholding is used to fund the tax payments the majority (greater than 75%) of award transactions. Most of the remaining respondents (17% of respondents for executive transactions, 18% for non-executive transactions) report that sell-to-cover is used to pay the taxes due on the majority of award transactions.
Rounding Up Is the Way to Go. Where shares are withheld to cover taxes, 75% of respondents report that the shares withheld are rounded up to the nearest whole share. Most respondents (62% overall) include the excess with employees’ tax payments; only 13% refund the excess to employees.
FMV Is Usually the Close or Average. The overwhelming majority (87%) of respondents use the close or average stock price on the vesting date to determine taxable income. Only 12% look to the prior day’s value to determine taxable income, despite the fact that this approach provides an additional 24 hours to determine, collect, and deposit the tax withholding due as a result of the vesting event (see “Need More Time? Consider Using Prior Day Close“).
Form 1099-B Is Rare for Share Withholding. Although share withholding can be considered the equivalent of a sale of stock to the company, only 21% of respondents issue a Form 1099-B to employees for the shares withheld.
Companies Are Split on Collecting FICA from Retirement Eligible Employees. Where awards provide for accelerated or continued vesting upon retirement, practices with respect to the collection of FICA taxes are largely split between share withholding and collecting the tax from employees’ other compensation (41% of respondents in each case).
Last week, I blogged about the FASB’s recent update to ASC 718, which clarifies when modification accounting is required for amendments to outstanding awards. The genesis for this update is the amendments companies are making to their share withholding provisions in light of ASU 2016-09. So the question is: will the update be final in time for companies to rely on it for their share withholding amendments?
Timing of Share Withholding Amendments
Calendar-year public companies have to adopt ASU 2016-09 by this quarter and presumably will want to amend the share withholding provisions in their plan at the same time or shortly thereafter. Unfortunately, the update on modification accounting (which doesn’t have an official number yet) won’t be issued until April, at the earliest.
Consider Waiting
One obvious alternative is to wait until the update is issued to amend plans and award agreements. But companies with major vesting events happening before then may want to amend their plans and awards sooner.
Hope for the Best
Once the update is issued, companies can adopt it early. The update clearly won’t be issued in time for it to be adopted in calendar Q1, but companies should be able to adopt it in calendar Q2. When companies adopted ASU 2016-09 in an interim period, they were required to apply it to prior interim periods in the same year. We don’t know for sure that this requirement will apply to the update on modification accounting, but it seems reasonable to assume that it will (it applies to many, if not all, ASUs issued lately by the FASB).
Thus, if calendar-year companies amend their awards in Q1 and account for the amendments as modifications, it’s possible that early adopting the modification accounting update would allow them to reverse that treatment.
Maybe Auditors Won’t Make Companies Wait for the Update
Lastly, my understanding is that—even without the FASB’s update—some auditors don’t think amending a share withholding provision requires modification treatment. The few comment letters that opposed the update did so on the basis that it is unnecessary because this conclusion can already be reached under the current standard.
The FASB’s recent vote on the update (which was unanimous with respect to the question of when modification accounting should be required) provides a clear indication of the board’s attitude. Given that, perhaps the actual issuance of the final update is a mere formality and most (maybe all) auditors will come to the conclusion that modification accounting isn’t required for share withholding amendments even without the final update. But I wouldn’t assume this without discussing it with your auditors.
As most of my readers know, the FASB has amended ASC 718 to expand the exception to liability treatment that applies to shares withheld to cover taxes to include withholding up to the maximum individual tax rate. This has led many companies to consider changing their tax withholding practices for stock compensation.
Plan Amendment Likely Necessary
As noted in my blog entry “Getting Ready for the New Share Withholding” (May 5, 2016), companies that are interested in taking advantage of the expanded exception face an obstacle in that virtually all stock plans include a prohibition on using shares to cover taxes in excess of the minimally required statutory withholding. Where companies want to allow shares to be withheld for tax payments in excess of this amount, the plan must first be amended to allow this.
Shareholder Approval Not Necessary
In the aforementioned blog entry, I had noted that it wasn’t clear if shareholder approval would be required for the plan amendment, particularly if the shares withheld will be recycled back into the plan. I have good news on this question: both the NYSE and Nasdaq have amended their shareholder approval FAQs to clarify that this amendment does not require shareholder approval, even if the shares will be recycled.
Nasdaq (ID number 1269, it should be the last question on the second page. Or do a keyword search for the word “withholding” and the relevant FAQ should come right up.)
For a while, there was still a question as to whether the NYSE required shareholder approval when shares withheld from restricted stock awards would be recycled. In late December, John Roe of ISS arranged for the two of us to meet with John Carey, the Senior Director at NYSE Regulation, to get clarification on this. Just prior to our meeting, the NYSE updated their FAQs to clarify that shareholder approval is not required even in the case of share withholding for restricted stock awards, even when the shares will be recycled.
ISS Still Not a Fan of Share Recycling
It should come as no surprise that, where the withheld shares will be recycled, ISS isn’t a fan of amendments to allow shares to be withheld for excess tax payments. Now that it’s clear shareholder approval isn’t required for the amendment, this likely isn’t a significant concern for most companies, unless they are submitting their plan for shareholder approval for some other reason. It isn’t a deal-breaker, but it could enter into ISS’s qualitative assessment of the plan. This would particularly be an issue if ISS’s recommendation is tied to more than the plan’s EPSC score.
Not a Modification for Accounting Purposes
There also has been some question as to whether the amendment would be considered a modification for accounting purposes if applied to outstanding awards. Based on the FASB’s recent exposure draft to amend the definition of a modification under ASC 718 (see “ASC 718 Gets Even Simpler,” November 22, 2016), the FASB doesn’t seem to think modification accounting is necessary. The comment period on the exposure draft ended on January 6. There was little opposition to the FASB’s position: only 14 comment letters were received, one letter clearly opposed the change, 12 supported the change, and one was “not opposed” but not enthusiastic. Given that response, hopefully the FASB will finalize the proposed update quickly so that this question is settled.
Just when you thought it was safe to withhold shares to cover taxes, a shareholder has started issuing demand letters to companies claiming that share withholding is a nonexempt sale for purposes of Section 16b.
Shareholder?
Yep, I say “shareholder” because apparently it’s just one guy and he’s representing himself, he’s not even engaging the services of the plaintiffs’ bar.
What the Heck?
But wait, you say, that’s ridiculous. Share withholding is exempt from Section 16(b) pursuant to Rule 16b-3(e), which covers dispositions back to the issuer that are approved in advance by the board or compensation committee (and approval of the grant agreement allowing said disposition counts as approval of the disposition).
You are correct, but the shareholder is claiming that Rule 16b-3(e) applies only if shares are withheld automatically. His claim is that if the insider could pay the taxes in some other way (e.g., cash), the transaction isn’t exempt.
Is My Company Going to Hear from this Guy?
Only if the share withholding transaction can be matched against a nonexempt purchase that occurs within six months before or after it. A nonexempt sale by itself is nothing to be alarmed about; the sale has to be matched against a nonexempt purchase to trigger profits recovery.
Also, since the shareholder’s argument hinges on the share withholding transaction being at the election of the insider, if you don’t allow insiders a choice in how to pay their taxes (and the shareholder can figure this out), you may not hear from him.
“For what it’s worth, Peter Romeo and I disagree strongly with the shareholder’s position, as do the attorneys I’ve spoken with who are responding to similar demand letters.”
Alan also notes that the shareholder has just issued demand letters, he hasn’t filed any complaints yet. But Alan says that he has been litigious in other Section 16(b) contexts.
What Should We Do?
If you allow insiders to use share withholding to cover their taxes on either awards or stock options, you should make sure your in-house legal team is aware of this, so they can decide how to proceed.
In addition, at the time shares are withheld to cover taxes, it is a good idea to check (or have whoever is responsible for Section 16 filings check) for nonexempt purchases by insiders in the past six months. Even though you might still allow the insiders to go ahead with the share withholding, it will be helpful to know ahead of time that the transaction might attract a demand letter, so your legal team can be prepared for it.
It will come as no surprise to any of you that accounting for modifications under ASC 718 is complicated. In the aftermath of the issuance of ASU 2016-09, the FASB has received a number of questions about whether amending a stock plan or award to allow shares to be withheld for more than the minimum statutorily required tax payment would trigger modification accounting under ASC 718. It probably seems crazy to you that we even have to consider this question and I guess it also seemed that way to the FASB, because they’ve issued an exposure draft to amend ASC 718 to clarify that this sort of change isn’t a modification.
ASC 718 currently says that any change whatsoever to an award is considered an modification and goes on to define four types of modifications: probable-to-probable, probable-to-improbable, improbable-to-probable, and improbable-to-improbable. The accounting treatment varies based on which type of modification you are dealing with and for some types of modifications, a new valuation of the award is required even if the value of the award isn’t changed as a result of the modification. Hence, the concern about the amendments relating to share withholding, even though these amendments arguably don’t materially increase the value of an award to the award holder.
So the FASB has proposed an amendment to ASC 718 that would clarify that not every change to the terms and conditions of an award requires modification treatment. Instead, a change to the terms and conditions of an award would require modification treatment only if at least one of the following conditions is met:
The fair value of the award is changed as a result of the amendment. For purposes of determining if there is a change in fair value, the fair value of the award immediately following the amendment would be compared to the fair value immediately beforehand (rather than to the grant date fair value). Generally, there would be no change in fair value if the amendment does not impact any of the inputs necessary to determine the award fair value.
The amendment modifies the vesting conditions of the award.
The amendment causes the classification of the award to change (from equity to liability or vice versa).
Amending a plan or award to allow additional shares to be withhold for taxes would not meet any of the about conditions (provided the share withholding is still limited to the maximum individual tax rate in the applicable jurisdiction) and, thus, under the proposed amendment, there would be no question that this is a modification. Even without the proposed amendment to ASC 718, I believe that many practitioners would not treat this as a modification.
Comments may be submitted on the exposure draft until January 6, 2017. The update would be applied prospectively only, thus the accounting treatment for any prior modifications of awards would not change. The exposure draft does not specify an effective date.
The IASB recently finalized amendments to IFRS 2 relating to the accounting treatment of share withholding and cash-settled awards.
FASB in the Lead
The IASB issued the exposure draft of the amendments in November 2014—so long ago that I was beginning to think that maybe they had forgotten about the project and would never get around to it. By way of reference, the FASB issued the exposure draft of their amendments to ASC 718 seven months later and still managed to issue their final amendments three months ahead of the IASB.
Share Withholding
The most exciting amendment permits shares to be used to cover tax withholding without triggering liability treatment. Under the original IFRS 2, share withholding triggered liability treatment for the shares that were applied to the tax payment—no exceptions. This resulted in a bifurcated accounting treatment for the award: the portion that would be settled in cash to cover the tax payment was subject to liability treatment while the rest of the award was subject to equity treatment. It was also an area where IFRS 2 diverged from ASC 718, which has always included an exception to liability treatment for share withholding.
Unfortunately, the two standards still don’t converge. The IASB’s amendment only permits share withholding up to the statutorily required payment, and, as my readers know, the FASB recently expanded the exception in ASC 718 to apply to share withholding up to the maximum individual tax rate in the applicable jurisdiction. It’s ironic: the primary reason the FASB expanded the exception in ASC 718 was to facilitate share withholding for non-US employees but, unfortunately, for companies that have to report under IFRS, the international standard will still pose an obstacle to doing this.
Cash-Settled Awards
The IASB also amended IFRS 2 to clarify the vesting conditions that apply to cash-settled awards should be accounted for in the same manner as for stock-settled awards. The upshot is that for non-market conditions, the company records expense based on an estimated forfeiture rate and trues up to outcome. Market conditions (and non-vesting conditions) are incorporated into the fair value of the award. I’m surprised that anyone thought anything different. I guess that’s the problem with a “principles-based standard.” If you don’t spell everything out with a nice clear set of rules, someone is bound to interpret the principle in a way you don’t want them to.
The amendments also clarify how to account for modifications that change the classification of awards from cash-settled to stock-settled. I’m not going to bother to explain this because 1) it’s a total snore (as compared to the rest of the action-packed amendments) and 2) it happens so rarely that hardly anyone cares about it. And, as with any modification of stock awards, it’s crazy complicated—if this is something your company is doing, you should really be talking to your accounting advisors and not relying on an English major to tell you how to account for the modification.
Thanks to Ken Stoler of PwC for bringing the amendments to my attention and for providing a handy summary of them.
I’ve been getting a lot of questions about what tax withholding rate can be used for federal income tax purposes, now that the FASB’s update to ASC 718 is final and companies are free to adopt it. So I thought I’d take a blog entry to clarify what’s changed and what hasn’t.
Who’s the Decider on Tax Withholding Procedures
One thing that a lot of folks seem to have forgotten is that the FASB doesn’t determine tax withholding procedures; they just determine how you account for situations in which tax is withheld. The ultimate authority on how much tax you should (and can) withhold in the United States is the IRS, not the FASB.
Tax Withholding for Supplemental Payments
I’ve blogged about the rules for withholding on supplemental payments, which include stock plan transactions, quite a bit (search on the term “Excess Withholding” in the NASPP Blog). There are two choices when it comes to withholding taxes on stock plan transactions for employees who have received less than $1 million in supplemental payments for the year:
Withhold at the flat rate (currently 25%). No other rate is permissible.
Withhold at the employee’s W-4 rate. Here again, no other rate is permissible.
If employees want you to withhold additional FIT, they have to submit a new W-4 requesting the withholding (as a flat dollar amount, not a percentage) and you have to agree to withhold at the W-4 rate. This is stated in IRS Publication 15 and even more emphatically in IRS Information Letter 2012-0063. Whether you are using method 1 or 2, you can’t arbitrarily select a withholding rate.
Where Does the FASB Come Into This?
The FASB has no authority over these requirements and they didn’t amend ASC 718 to make is easier for you to ignore the IRS requirements. They amended ASC 718 to make it easier for companies that grant awards to non-US employees to allow those employees to use share withholding. Other countries don’t have a flat rate, making it challenging for the US stock plan administration group to figure out the correct withholding rate for non-US employees. This would allow companies to withhold at the maximum rate in other countries and refund the excess to employees through local payroll (who is more easily able to figure out the correct withholding rate).
The only change for US tax withholding procedures is that if you want to use the W-4 rate to withhold excess FIT, withholding shares for the excess payment will no longer trigger liability treatment once you adopt the update to ASC 718. But if you want to withhold excess FIT, you still have to follow the IRS procedures to do so. Previously, even if you had followed the IRS W-4 procedures, withholding shares for an excess tax payment would have triggered liability treatment.
Why Not Use the W-4 Rate?
No one wants to use the W-4 rate because it is impossible to figure out. You have to aggregate the income from the stock plan transaction with the employee’s other income for the payroll period, which the stock plan administration group doesn’t have any visibility to. The rate varies depending on the number of exemptions the employee claims on Form W-4. And the rate is complicated to figure out. I count at least seven official methods of figuring out this rate and companies can make up their own method (but if they make up a method, they have to apply it consistently, the stock plan administration group can’t make up a method that is different than the method the payroll group uses).
The upshot is that you literally can’t figure it out. You would have to run the income through your payroll system to figure out what the tax withholding should be. And that’s a problem because your stock plan administration system is designed to figure out the withholding and tell payroll what it is, not the other way around.
What’s the Penalty?
Members often ask me what the penalty is for withholding extra FIT without following the IRS procedures. Generally there isn’t a penalty to the company for overwithholding, provided there’s no intent to defraud the IRS (if you don’t understand how overwithholding could involve tax fraud, see “Excess Withholding, Part 2“) and the withholding is at the request of the employee. Doing this on a one-off basis, at the occasional request of an employee, probably won’t result in substantial penalties to the company, especially if the employee has appropriately completed Form W-4 for his/her tax situation. (Note, however, that I’m not a tax advisor. You should consult your own advisors to assess the risk of penalty to your company.)
But I’ve encountered a number of companies that want to create a system to automate electing a higher withholding rate without following the W-4 procedures (in some cases, for all of their award holders). I think that it could be problematic to create an automated system that circumvents the W-4 process, especially in light of Information Letter 2012-0063. That system is likely to be noticed if the company is audited, and I think it could have negative ramifications.
For today’s blog entry, I have the results of the NASPP’s Quick Survey on ASC 718, presented in a nifty interactive infographic (place your cursor over a section of each chart to see its label). (Click here if you don’t see the graphic below.)
BTW—if you are one of the 83% of respondents that haven’t yet figured out the impact of the tax accounting changes to your earnings per share, see my blog entry “Run Your Own Numbers,” for easy-peasy instructions on how most companies can figure this out in just 5 minutes. It’s a great opportunity to demonstrate your knowledge and value to your accounting/finance team.
In late March, ISS issued an updated Equity Compensation Plans FAQ. This development was largely eclipsed by the FASB’s issuance of ASU 2016-09, so I haven’t had a chance to get around to it until now. Here is a quick summary of the most significant updates:
Plan Amendments
FAQ 2 has been updated and a new FAQ 28 has been added to clarify that plan amendments may be evaluated under the Equity Plan Scorecard (EPSC), if the amendment could increase the potential cost of the plan. (By “cost,” ISS means dilution or shareholder value transfer; ISS is less concerned with the actual P&L expense.)
In other cases, i.e., amendments that don’t increase cost to shareholders, ISS evaluates the amendment based on whether it is favorable to shareholder interests, but without going through the whole EPSC.
Plans submitted for shareholder approval solely for Section 162(m) purposes fall into a separate category and ISS hasn’t changed or clarified anything with respect to these proposals.
Share Withholding
ISS suggests requesting new shares or extending the term of a plan as examples of the types of amendments that would trigger a new EPSC evaluation, but my guess is that this would also include amendments to allow share withholding for taxes up to the maximum tax rate when the shares withheld will be returned to the plan (my blog from last week explains why these amendments are necessary).
It’s possible that the timing of the release of these updated FAQs is not coincidental. It’s also possible I’m paranoid; hard to say. But then again, just because I’m paranoid, doesn’t mean ISS won’t apply the EPSC to your share withholding amendment. This issue is definitely a hot button for ISS. If your plan allows shares withheld for taxes to be returned to your plan, it’s a good idea to discuss this with whoever advises you on ISS concerns before you amend your plan.
Performance Awards
Previously, the FAQ provided that ISS would consider performance awards as being subject to accelerated vesting upon a CIC, unless the amount paid was tied to the performance achieved as of the CIC and was pro rated based on the amount of the performance period that was completed.
The new FAQ states that:
If a plan would permit accelerated vesting of performance awards upon a change in control (either automatically, at the board’s discretion, or only if they are not assumed), ISS will consider whether the amount of the performance award that would be payable/vested is (a) at target level, (b) above target level, (c) based on actual performance as of the CIC date and/or pro rated based on the time elapsed in the performance period as of the CIC date, or (d) based on board discretion.
I’m not sure this changes much, but it does seem to be a more nuanced position.