Why US tax reform may cause executive pay shake-up

Under the Tax Cuts and Jobs Act, rules governing executive pay have dramatically changed, prompting a possible need to review compensation.

The US tax reform law, known as the Tax Cuts and Jobs Act (TCJA), is changing the tax treatment of top executive pay for public companies, including expanding the pool of business taxpayers and types of compensation arrangements subject to limits on tax deductibility.

While business decisions generally drive retention and reward programs, now might be a good time for organizations to re-examine executive compensation policies and structures to comply with the new law and to make certain that their executive compensation packages remain competitive.

They should also prepare for a potentially higher tax bill: the Joint Committee on Taxation (JCT) has estimated the changes could bring in US$9b more in tax revenue between 2018 and 2027.

“The changes are really monumental,” Helen Morrison, a member of the Compensation and Benefits services of Ernst & Young LLP’s National Tax Department, said in an EY Policy Perspectives webcast. The rules that drove the design of many common performance-based compensation programs no longer apply, she explained. While that deduction may be gone, the new tax treatment may encourage greater flexibility, she said.

What’s new?

Changes to the tax treatment of executive compensation are aimed at addressing what the US House of Representatives’ Ways and Means Committee labeled “excessive employee remuneration” in a 2017 summary of its tax proposal. The prior system and exceptions resulted in publicly traded companies shifting away from cash compensation to performance-based pay such as stock options, according to the committee.

“This shift has led to perverse consequences as some executives focus on … quarterly results (off of which their compensation is determined), rather than on the long-term success of the company,” the Committee wrote.

One of the more wide-reaching changes is the new law’s expanded application of tax code Section 162(m). This section limits the deduction public companies can take for compensation of more than US$1m paid annually to a “covered employee,” which now includes the CEO, CFO and three most highly compensated officers. Under prior law, the CFO was explicitly exempted from “covered employee” status.

Additionally, foreign private issuers and public debt issuers that were not formerly subject to Section 162(m) may now be pulled in, as Section 162(m) now applies to any corporation that is an “issuer” under the Securities and Exchange Act of 1934 and is required to file certain reports with the U.S. Securities and Exchange Commission (SEC).

As a result, companies that previously were exempt from the Section 162(m) deduction limits are covered, which means that to the extent a deduction is being claimed for a named executive officer on the US tax return, any compensation of more than US$1m annually to a covered employee is no longer deductible.

The new law also makes clear that issuers are subject to the Section 162(m) deduction limit even if they have not been required to report the compensation of their named executive officers under SEC rules; in such cases, Section 162(m) applies to the individuals who would be named executive officers if such reporting were to apply.

The new law also eliminated the exemption for performance-based compensation, including stock options, and for post-employment pay, such as supplemental pensions, deferred compensation and severance. Before the new tax law, performance-based compensation plans had to meet a variety of requirements to qualify for a deduction, but with this exemption gone, some companies may rethink how they structure such programs.

The goal of performance-based programs should be attracting, motivating and retaining employees, says EY Americas Reward Leader Michael Schoonmaker. “Now that we’re unshackled from [Section] 162(m), is there a new design that works better for us from a business or commercial perspective?”

The ties that bind

Under the new law, once people are identified as covered employees, they (or their beneficiaries) remain covered employees, even if they leave the company — for example, a retired executive who continues to receive compensation.

“It is the gift that keeps on giving,” Schoonmaker said in our webcast, “even post death, believe it or not.” As such, a company’s group of covered employees is likely to expand over time and must be managed. “As the years go by, you could end up with 20, 30, 40 covered employees,” he says. “You’re going to have to have the ability to track them and the payments made to them.”

The new law does include some transition relief: an exception allowing companies to rely on prior law for compensation arrangements governed by “binding contracts” in effect as of 2 November 2017 — the date the House Ways and Means Committee Chairman Kevin Brady released the tax reform bill. To the extent compensation falls within this exception and would have been deductible under prior law, companies can still deduct it.

For example, compensation payable in the future to CFOs under an existing binding contract would continue to be deductible unless and until the contract expires or is materially modified. The challenge for companies is in determining whether they have a “binding contract.”

For the purposes of identifying a binding contract, “we need to ask ourselves: do we have a written arrangement to provide compensation that would be enforceable by the employee if they performed the requisite services or if the performance targets were met?” Catherine Creech, leader of the Compensation and Benefits group within Ernst & Young LLP’s US National Tax Department, said in the webcast. “It doesn’t have to be an employment contract; it could be in a plan, it could be in a grant, it could be in some other writing that would be enforceable by the employee.”

One example of a clause that might render a contract not enforceable by the employee is a so-called negative discretion clause, commonly included in performance-based compensation arrangements. These allow compensation committees to reduce compensation as they deem appropriate. While these clauses may be considered good governance, they also might disqualify an arrangement from binding-contract status because they give the sole enforcement discretion to the compensation committee.

Not all negative discretion provisions operate in the same way; provisions that are limited in their scope and application may not void an otherwise binding contract. Nonetheless, some stakeholders are pushing for clarification in this area.

Interpreting the legislation to disqualify all plans with any type of negative discretion clauses from the exception “would render many — even most — of the plans Congress intended to grandfather not eligible for the grandfather provision,” Lynn D. Dudley, Senior Vice President, Global Retirement and Compensation Policy, for the American Benefits Council, wrote in a letter in February 2018 to the Joint Committee on Taxation, the Senate Finance Committee and the House Ways and Means Committee.

Next steps

Key actions employers can take now to better align their executive compensation policies with the new law include:

• Evaluating the tax and financial statement impacts of changes to the Section 162(m) deduction
  
• Beginning to track the potentially expanding group of covered employees and adding the CFO to the covered employee group beginning in tax year 2018, if needed
  
• For companies operating outside the United States, assessing the extent to which the deduction limit affects any US tax returns
  
• With the performance-based compensation exception gone, considering whether provisions formerly in place to preserve the deduction are still needed
  
• Considering compensation structures that might preserve more of the compensation deduction, such as smaller payments made over time in lieu of lump-sum payments upon employment termination