Summary of key provisions of the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act of 2017 (the Act) requires public companies to assess the impact of the law on compensation-related matters for their current fiscal reporting period and their future tax returns.
- To what extent, if any, does the inability to deduct performance-based and post-employment compensation paid to covered employees impact a company’s compensation philosophy?
Section 162(m)The Act significantly rewrites and expands the application of Internal Revenue Code Section 162(m). Amended Section 162(m) repeals the exceptions allowing the deductibility of performance-based and post-employment compensation to covered employees. In addition, the Act significantly amends Section 162(m) by:
- Expanding the definition of “publicly held corporation” to include new classes of public companies
- Expanding the term “covered employees” to include the CFO and provide that “covered employee” status, once attained, is permanent
The Act is effective for taxable years beginning after December 31, 2017, and has a grandfather provision for written binding contracts in effect on November 2, 2017, as explained below.
Prior to the Act, Section 162(m) limited compensation deductions for publicly held corporations to $1 million for covered employees, with the key exception that performance-based compensation and post-employment payments to covered employees were not subject to the $1 million deduction limitation, provided companies complied with certain conditions, including:
- Designing compensation plans to provide for performance-based compensation, including the articulation of specific performance measures that could be used in setting and paying performance-based compensation to covered employees
- Having shareholders specifically approve, generally every five years, the performance measures established for purposes of Section 162(m)
- Having compensation committees comprised of members who were “outside” directors for purposes of Section 162(m)
- Having their compensation committees certify the attainment of performance measures used for covered employee compensation
The amendments to Section 162(m) generally make these actions unnecessary going forward for any new grants.
Elimination of the performance-based compensation and commission payment exemptions
The Act disallows the deduction of performance-based compensation and commissions paid to any covered employee for any tax year starting after December 31, 2017. A grandfathering provision for written binding contracts in effect on November 2, 2017, explained below, provides a key exception to the disallowance. As a result, in many cases, stock options and appreciation rights that were issued as of November 2, 2017 are likely to be grandfathered and still deductible when exercised or paid in future years; however, any grants after November 2, 2017 will not be exempted.
Expanded definition of “publicly held corporation”
The Act expands the definition to include new classes of public companies, as explained below.
Section 12 and Section 15(d) companies: Prior to the Act, Section 162(m) defined a “publicly held corporation” as any corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act). Amended Section 162(m) is expanded to include any company that is required to register under Section 12 of the Exchange Act or that is required to file periodic reports with the SEC under Section 15(d) of the Exchange Act.
As a result, the following companies are newly captured by amended Section 162(m):
- Domestic and foreign companies that issue debt listed for public trading on a US securities exchange
- Domestic or foreign companies that issue securities under the Exchange Act but are not required to register under Section 12 (such issuers are often portfolio companies of private equity firms), for so long as they are subject to Section 15(d) (one year after the effectiveness of the Exchange Act registration statement, unless a reporting obligation is retriggered)
Amended Section 162(m) now also covers foreign private issuers, including those who sponsor American Depositary Receipts facilities.
Foreign private issuers:
- Foreign private issuers do not file proxy statements and are not required to provide a summary compensation table disclosing the compensation of its named executive officers. For these reasons, the IRS had taken the position in private letter rulings that foreign private issuers were not subject to prior Section 162(m).
- The section of the Conference Report for the Act that discusses the definition of “covered employee” states that “officers of a corporation not required to file a proxy statement but which otherwise falls within the revised definition of a publicly held corporation” are deemed covered employees under Section 162(m). Thus, the basis for the prior IRS regulatory exemption is eliminated. Foreign private issuers should consider whether and how amended Section 162(m) may apply to them.
American Depositary Receipts:
- The Conference Report states that amended Section 162(m) applies to “all foreign companies publicly traded through ADRs [American Depositary Receipts].” Despite the language in the Conference Report, amended Section 162(m) itself does not capture unsponsored ADR facilities for foreign private issuers exempt from SEC registration and reporting.
Expanded definition of “covered employee”
The Act expands the definition of “covered employee” to include the CFO, which had previously been a position carved out of the covered employee definition via an IRS administrative interpretation. Significantly, amended Section 162(m) provides that once a person is defined as a “covered employee,” the person retains that status permanently – even after death. Thus, even if a covered employee ceases to be included in the summary compensation table, whether due to position or compensation changes or due to departure from the company, including by death, the company is required to comply with Section 162(m) in respect of any compensation payments to the now permanently defined covered employee (including his or her estate). Amended Section 162(m) captures individuals who are covered employees in tax years beginning after December 31, 2016. Thus, any individual who is a covered employee on the last day of a company’s 2017 taxable year is permanently treated as a covered employee.
Written binding contract grandfathering provision
Amended Section 162(m) does not apply to compensation paid pursuant to a “written binding contract which was in effect on November 2, 2017, and which was not modified in any material respect on or after such date.” For this purpose, a “written contract” can be a document that is in the form of a plan, a grant, an employment contract or other writing. The document label is not of significance. The written contract refers to the material terms that delineate the legal obligations of the employer to pay compensation in whatever form those terms are memorialized; however, securities law disclosure, board minutes and communications to the executives all may form part of the “writing” for this purpose.
The material modification question is likely to arise in connection with ongoing plans, given that amended Section 162(m) eliminates the performance-based compensation exemption altogether. Further, guidance is likely needed on the scope of the material modification rule. At this time, it is reasonable to view compensation that would have been payable on the basis of November 2, 2017 factors (such as current compensation levels) as grandfathered if the other binding contract rules are satisfied. Further, since vesting contingencies do not preclude an amount from being payable under a binding contract, the acceleration of a vesting requirement after November 2, 2017 may not itself be a material modification.
Compensation committee considerations
Compensation committees will want to inventory, assess and reconsider their performance-based compensation programs, plans and arrangements, as well as all their compensation elements and options; however, before taking any actions to simplify, or otherwise revise, compensation committees will want to carefully consider how amended Section 162(m) will be interpreted and applied by the IRS. Guidance is anticipated, but the timing and scope is uncertain at this time.
Elimination of the performance-based compensation exemption and other changes to Section 162(m) mean that salary and post-employment compensation to covered employees is treated the same as performance-based compensation. Companies should take care before significantly revising performance-based compensation structures, however, as institutional investors, other stakeholders and proxy advisors will continue to press for and insist on seeing close ties between company performance and executive compensation. Of course, companies themselves may want to maintain if not enhance clear ties between pay and performance.
Proxy statements, compensation committee charters, and compensation plans and arrangements should be revised to eliminate unnecessary references to Section 162(m). Proxy statements should also include appropriate disclosures about how the Act impacts executive compensation programs and other company practices.
Questions for the compensation committee to consider
- To what extent, if any, does the inability to deduct performance-based and post-employment compensation paid to covered employees impact the company’s compensation philosophy?
- What changes in compensation practices can be anticipated among the company’s peers and industry group? Has the compensation committee consulted with outside compensation professionals?
- What changes to the company’s executive compensation program, including as it relates to covered employee recruitment, retention and succession planning, should be considered as a result of amended 162(m)?
- Who are the company’s covered employees now? How will the company keep track of the company’s covered employees — not only the ones that can be identified now, but those that may become (and remain) covered employees over time? How should a company track covered employees?
- What executive compensation arrangements can be deemed written binding contracts and grandfathered under amended Section 162(m)?
- What compensation committee or other actions, if taken, could result in the future inability to claim the grandfather provision for currently grandfathered written binding contracts?
- Do any grandfathered compensation arrangements have performance-based requirements that would call for the company to continue any practices relevant under prior Section 162(m)? For example, should Section 162(m) “outside” directors certify the attainment of any performance conditions relevant to unpaid covered employee compensation?