(The news featured
below is a selection from Jim Hamilton's World of Securities Regulation blog,
located at http://jimhamiltonblog.blogspot.com/.
)
IRS Revenue Ruling Impacts
Executive Compensation Plans and Disclosure
In response to a letter from 90
global securities law firms, the Internal Revenue Service issued a revenue
ruling essentially backing up an earlier private letter made public by the IRS (LTR
200804004) that cast doubt on the exclusion of some performance-based executive
compensation from the $1 million pay cap mandated by IRC §162(m) if a company
wants to deduct an executive’s pay from its income tax. The firms who signed
the letter included Skadden Arps, Wachtell Lipton, Cleary Gottlieb, Baker Botts,
and Clifford Chance.
Under IRC 162(m),
compensation in excess of $1 million paid by a public company to its covered
employees generally is not deductible. Notice 2007-49 states that the term
"covered employee," for purposes of §162(m), will apply to the
principal executive officer and the three highest compensated officers (other
than the principal executive officer and principal financial officer).
Performance-based
compensation is not subject to the deduction limitation and is not taken into
account in determining whether other compensation exceeds $1 million. In
general, performance-based compensation is compensation payable solely on
account of the attainment of performance goals.
In the letter
ruling, the IRS said that provisions in a company’s compensation scheme
allowing for payment of performance-based compensation even if the performance
goals are not met upon an executive's involuntary termination without cause or
voluntarily termination with good reason do not meet the exception in section
1.162-27(e)(2)(v) of IRS regulations allowing compensation to be payable upon
death, disability or change of ownership or control. Thus, the compensation
cannot be excluded from the $1 million calculation
In Revenue Ruling
2008-13, the IRS backed up the letter ruling by essentially saying that the
performance goals must be met before the payment of performance-based awards can
be excluded from calculating the $1 million cap. In the revenue ruling, the IRS
set forth two separate scenarios that would not qualify as performance-based
compensation under Code Section 162(m). In the first scenario, the executive did
not meet the performance but received the performance-based compensation anyway
after being terminated involuntarily without cause or voluntarily ending his/her
employment for good reason. In such a situation, said the IRS, the compensation
would not be considered payable solely on account of the attainment of a
performance goal under the 162(m) exclusion. In the second scenario, the
employee voluntary retired and the performance-based compensation was paid even
though the performance goal was not attained. Similarly, this award is not
qualified performance-based compensation under Code Section 162(m).
The law firms’
letter to the IRS comes against the backdrop of pressing deadlines for
SEC-mandated financial and proxy disclosure. The letter cites the IRS regulation
allowing performance-based compensation to be considered qualified for the
exclusion if paid upon death, disability, or change of control even if the
performance goal remains unsatisfied.
According to the
law firms, consistent with prior IRS rulings, many public companies entered into
compensation arrangements patterning the treatment of involuntary and good
reason terminations after what the regulation authorized for death and
disability. In the firms’ view, these prior rulings, now apparently reversed,
represent a reasonable interpretation of the regulations and taxpayers who
conformed their compensation plans to them acted in good faith.
The
publication of this new position has significant repercussions for many public
companies, said the firms, with an accounting impact that will affect financial
reporting. In addition, the ruling presents considerable difficulty for
companies that are currently making decisions regarding 2008 awards and proxy
reporting regarding award deductibility. The situation is further complicated by
the fact that many of the affected arrangements are bilateral contracts that
will require negotiation with the affected employees.
Thus,
the firms urge the IRS to apply the new ruling prospectively and also allow
grandfathered tax treatment, consistent with the prior rulings, for compensation
awards that are made prior to the publication of the new ruling, with special
transition relief for binding, written agreements that obligate an employer to
provide future grants that conform to these prior rulings; with such transition
relief to continue, absent a material modification, for a period that provides
an adequate opportunity to negotiate and implement revised agreements.
It should also be noted that, when it adopted the
new executive disclosure regime, the SEC emphasized that any tax or accounting
treatment, including a company’s section 162(m) policy, that is material to
the company’s compensation policy or decisions with respect to a named
executive officer is covered by Compensation Discussion and Analysis and should
be discussed. Tax consequences to the named executive officers, as well as tax
consequences to the company, may fall within this example. |