Changes to Executive Compensation: The Tax Cuts and Jobs Act’s Impact on Section 162(m)
On December 22, 2017, President Trump signed the bill popularly referred to as the “Tax Cuts and Jobs Act” (the “Act”) into law. The Act contains significant changes to Section 162(m) of the Internal Revenue Code that are effective for taxable years beginning after December 31, 2017. In this article, we provide a summary of the changes to Section 162(m) and suggest planning considerations for publicly held corporations.
Summary of Changes to Section 162(m)
Among other changes to Section 162(m), the Act eliminated the performance-based compensation exception to the $1 million deduction limitation under Section 162(m). The Act amended the scope of the covered employees, corporations, and compensation for purposes of the $1 million limitation on the deduction for compensation paid to certain employees under Section 162(m). The changes to Section 162(m) include the following:
- Eliminating the performance-based compensation and commission exceptions from compensation subject to Section 162(m) (other than as permitted by the transition rule, discussed below). Under the prior rules of Section 162(m), performance- and commission-based compensation were excluded from the $1 million deduction limitation. This change means that a corporation’s compensation committee no longer will be required to establish objective performance goals within 90 days of the start of an applicable performance period and that shareholder approval of the compensation terms and maximum amounts payable no longer is required for Section 162(m) purposes.
- Expanding the definition of publicly held corporations to include corporations that file reports under Section 15(d) of the Securities Exchange Act of 1934, as amended, which will subject certain corporations with publicly traded debt and certain foreign private issuers to the deduction limitation of Section 162(m). Under the prior rules, only corporations with publicly traded equity were subject to Section 162(m).
- Expanding the definition of covered employee to include any individual who served as the CFO during the taxable year. In addition to the CEO and CFO, the definition continues to include the three other highest compensated officers required to be reported to shareholders under the Securities and Exchange Commission rules. The prior rules did not include the CFO.
- Expanding the definition of covered employee to include any individual who was a covered employee in any taxable year beginning after December 31, 2016, so that once an employee is covered under Section 162(m) for any year, that individual will continue to be covered for all future years. Under the prior definition, covered employees were determined each year without regard to whether an individual was a covered employee in a prior year. With this change, payments to former employees (such as severance payments and stock option exercises) will be subject to the $1 million deduction limitation.
- Expanding the scope of compensation subject to Section 162(m) to include amounts paid to an individual other than the covered employee, including a covered employee’s beneficiary following the employee’s death.
Transition Rule for Contracts in effect on November 2, 2017
The Act includes a transition rule under which the changes to Section 162(m) will not apply to compensation paid pursuant to a written binding contract that was in effect on November 2, 2017, provided that no material modification is made after that date. The Act’s conference agreement between the House and Senate makes clear that a contract that was in place prior to November 2, 2017 but that is renewed after that date will be treated as a new contract that will no longer qualify for the transition rule. The requirement of a written binding contract under the transition rule raises issues such as whether a contract or plan subject to the compensation committee’s discretion to adjust a performance award downward will result in the contract being ineligible for the transition rule. We expect that future guidance from the Internal Revenue Service will address these issues and will provide additional guidance as to what constitutes a written binding contract and a material modification.
Considerations in Planning for the New Section 162(m)
Corporations covered by Section 162(m) should review their current compensation arrangements now to identify the contracts and plans that may take advantage of the transition rule. We recommend the following:
- In order to determine what constitutes a written binding contract, it may be helpful to look to applicable state law or analogous federal laws until we have further guidance from the IRS.
- Once identified, any change to a contract should be carefully reviewed to determine whether it will cause the arrangement to lose the benefit of the transition rule. In the absence of guidance from the Internal Revenue Service, guidance and interpretations under other tax laws that included transition relief for agreements that had not been subject to a material modification, such as Section 409A of the Internal Revenue Code, may be helpful in determining whether such a modification has been made.
- In addition, because contracts eligible to take advantage of the transition rule are subject to the prior Section 162(m) rules, they must be administered in compliance with the prior requirements related to performance-based compensation, including the requirement to certify the attainment of the performance goals.
For new performance-based compensation arrangements, the repeal of the performance-based pay exception allows corporations increased flexibility in the establishment and operation of performance-based pay programs.
- Performance goals no longer need to be pre-established or objectively determinable. This change will permit compensation committees greater flexibility in taking into account events that occur during the performance period when determining whether the performance goals have been satisfied.
- Performance goals no longer need to be approved by the compensation committee within 90 days of the beginning of the performance period.
- The compensation committee may reserve the discretion to adjust performance-based awards up or down based on actual performance.
- To limit the impact of the repeal of the performance-based pay and commission exceptions, a corporation may consider permitting or requiring covered employees to defer receipt of all or a portion of the individual’s compensation or extending the payment schedule over a period of years in a manner such that the payments would fit within the $1 million deduction limit for the year. These strategies may implicate additional legal requirements applicable to deferred compensation which should be taken into account, including under Section 409A.
In addition, the changes to Section 162(m) may present state tax deduction issues in states which conform sections of their tax code to the federal tax code. In states that permit deductions for performance-based pay under state tax laws mirroring the prior version of Section 162(m), the performance-based pay deduction may continue to be available for performance-based plans that comply with the prior rules of Section 162(m) until the state brings its tax law into conformity with the new federal Section 162(m). Amended or newly established performance-based plans designed under the new federal Section 162(m) may lose a state tax deduction for performance-based pay in states that have not conformed to the new federal Section 162(m) because these plans will not comply with the prior Section 162(m) performance-based pay exception rules.
Finally, in addition to planning for compliance with the transition rule and the repeal of the performance- and commission-based compensation exceptions, corporations should consult with their outside advisers to determine whether and how to describe the changes relating to Section 162(m) in their proxy statements.
The changes to Section 162(m) and the repeal of the performance- and commission-based pay exceptions pose a significant change in the tax rules governing executive compensation and, likely, a major shift in how corporations will compensate their executives as a result. We expect future guidance from the Internal Revenue Service will be issued to assist with compliance. With this in mind, corporations subject to Section 162(m) should consult with their legal counsel, compensation consultants, and other outside advisers to implement any changes to their compensation programs and comply with the new rules.
An Update on the Impact of the Tax Cuts and Jobs Act on a Company’s Financial Statements
By Frank Crisafi and Phil Wright
Congress passed and the President signed sweeping tax legislation that not only reduced the rate of income tax on corporations to a flat 21%, but also has a widespread impact on businesses and across industries. The Tax Cuts and Jobs Act (the “Act”) was signed into law on December 22, 2017, which is the U.S. GAAP enactment date for purposes of reflecting the financial impact of the Act in a company’s financial statements.
The changes made by the Act will affect the disclosure obligations of reporting companies both with respect to financial statement presentation of balance sheet items as well as the impact on reported earnings. In addition, the changes may require an assessment of the impact on the operations of the company, and any attendant tax risk or required restructuring will need to be reflected in the risk disclosure section.
The Act’s impact will vary among industries and as a result the effect on disclosure will be both company and industry specific.
The SEC staff has issued Staff Accounting Bulletin (SAB) No. 118, providing the Staff’s views regarding application of U.S. GAAP in accounting for the income tax effects of the Act. The FASB Staff also has posted guidance in the form of Frequently Asked Questions (the FASB FAQs) on accounting for changes resulting from specific provisions included in the Act as well as items or attributes with respect to a company or industry.
Virtually all companies will be required to revalue their deferred tax assets (DTAs) and deferred tax liabilities (DTLs). Those amounts must be remeasured as of the date of enactment (December 22, 2017) using the new lower tax rate and taking into account other changes applicable to the particular company based on the characteristics and tax items giving rise to the DTA or DTL. The change in DTAs and DTLs should be reflected in tax expense on the financial statements as of the date of enactment. For companies with a reporting year-end of December 31, 2017 (and thereafter) that cannot complete the accounting for changes made by the Act prior to the time a company is required to issue its financial statements, SAB 118 provides for the use of “provisional amounts” with an appropriate “limited” measuring period in which the change in amounts are reflected in the financial statements. If a company’s year-end was before the date of enactment, then subsequent event disclosure may be appropriate. However, any reduction in value of a DTA as a result of remeasurement is not an impairment triggering an obligation to file under Item 2.06 of Form 8-K.
Other changes included in the Act -- beyond the reduction in tax rate -- that may have a significant impact on a reporting company’s disclosure obligations include those affecting (i) companies with special tax attributes, such as net operating losses (NOL) or alternative minimum tax (AMT) credit carryforwards, (ii) companies with international operations, and (iii) companies in specialized industries.
The Act limits the use of NOL carryforwards to an amount equal to 80% of taxable income in tax periods ending after December 31, 2017, but NOLs may now be carried forward indefinitely. In addition, other provisions of the Act could impact both the timing and the amount of NOL carryforwards to be utilized in future tax periods for purposes of determining the value and reserve against a DTA that is established for an NOL carryforward (e.g., the provisions allowing expensing 100% of eligible property and the limitation on the deduction for certain interest expense).
The Act also repealed the alternative minimum tax (AMT) and allows AMT credit carryforwards to both offset regular tax liability and to be refunded over a period beginning after 2017 and before 2022. Thus, a company’s entire AMT credit carryforward amount should be fully refundable no later than 2022.
The Act contains extensive changes impacting the U.S. income taxation of companies with international operations, including (i) the “deemed repatriation” provisions that impose a one-time tax on previously deferred foreign earnings, (ii) a territorial taxing regime that allows the repatriation of future foreign earnings without the imposition of U.S. income tax, (iii) provisions intended to limit base erosion of U.S. income subject to taxation, and (iv) new provisions subjecting global intangible low-taxed income to current U.S. income taxation.
The deemed repatriation provisions impose a mandatory tax on post-1986 accumulated foreign earnings on certain U.S. shareholders (shareholders owning 10% or more of a foreign corporation). A portion of the tax on deemed repatriated foreign earnings can be deferred and paid over eight years. The tax due on deemed repatriated foreign earnings must be recorded as a liability (and a component of income tax expense) on the financial statements as of the date of enactment. If a company elects to defer payment of a portion of the tax as permitted by the Act, the amount of the liability should not be discounted (see the FASB FAQs).
As a result of the more territorial tax regime, a company’s position with respect to foreign earnings being permanently reinvested may no longer have a significant impact on its accrual of U.S. income tax liability associated with such earnings. However, there may still be other impacts on a company’s financial statements arising out of its policy with respect to foreign earnings, such as accruals for foreign withholding taxes.
A number of other provisions in the Act impact multinational companies and their tax accounting. The base erosion anti-abuse tax (BEAT) provisions limit the deduction for certain payments made to foreign affiliates. The provisions impose a separate 10% base erosion minimum tax (12.5% after 2025), raising questions of whether the tax is separately accounted for or is a component of regular income tax expense. The anti-deferral provisions requiring inclusion of global low-taxed income in U.S. taxable income (similar to a subpart F inclusion) raise similar tax accounting issues.
The Act also includes provisions limiting or disallowing in full the amount a company may claim as a deduction for certain payments or expenses, the most important of which is likely to be the disallowance of performance-based incentive compensation and non-qualified deferred compensation paid to a public company’s current and former “covered employees.” The loss of these tax deductions will increase the permanent U.S. rate at which a public company is taxed. As discussed in the article Changes to Executive Compensation: The Tax Cuts and Jobs Act’s Impact on Section 162(m) above, the Act eliminates the exemption for performance-based compensation (subject to certain performance-based compensation paid under a grandfathered plan, i.e., a pre-existing and unmodified plan), thus, increasing the amount of compensation paid to covered employees subject to the limitation. Other changes in the Act limit the deduction for certain items going forward, which will increase a company’s permanent U.S. income tax expense; these include the loss of deductions for domestic production activities, non-deductibility of certain local “lobbying” expenses, and further limitation on deductions for entertainment expenses and fringe benefits.
The discussion presented above only covers a limited number of changes made by the Act and their impact on the proper accounting and reporting by a company on its income tax expense, including any footnote thereto. There likely will be further technical corrections to the Act as well as additional accounting pronouncements and updates by the FASB and the SEC as companies work through implementation of the changes in tax law.
Recent Attention by SEC Underscores Need for Companies to Look Deeply into Executive Perquisites
By Paul William and Tiffany Jones
The SEC has demonstrated a renewed focus on improper disclosure of executive perquisites. For example, Provectus Biopharmaceuticals Inc. was recently charged with committing a series of accounting control and disclosure violations by failing to disclose millions in perquisites provided to its then-CEO and then-CFO. The former CEO received $3.2 million in perquisites and cash advances by submitting false cash requests and expense reports that included few details of certain business trips and included little, no or false supporting documentation. Rather than paying for business expenses, funds went to paying the CEO’s personal expenses, including cosmetic surgery for female friends, restaurant tips and personal travel.
Public companies must disclose perquisites or other personal benefits paid to certain named executive officers unless the aggregate value paid is less than $10,000 (see Regulation S-K, Item 402(c)(2)(ix)). When determining whether an item is a “perquisite,” companies should use a two-step analysis endorsed by the SEC (see Securities and Exchange Commission, “Executive Compensation and Related Person Disclosure,” Release Nos. 33-8732A, 34-54302A, File No. S7-03-06 (Aug. 29, 2006), at 74).
The first step requires examination of whether the benefit conferred is “integrally and directly related to the performance of the executive’s duties.” If the payment or benefit is found to be integral and directly related to the performance of duties, then such payment or benefit is not a perquisite. For example, a car used for business travel, regardless of the type of car, would not generally be a perquisite because the car is both integral and directly related to the performance of the executive’s duties.
If the payment or benefit is not integral and directly related to the performance of the executive’s duties, then the second step requires a determination of whether the potential perquisite has a “direct or indirect benefit that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company.” If it is determined that there is a benefit with a personal aspect, then the item is a “perquisite.” It should be noted that no payment or benefit qualifies as a perquisite if it is generally available on a non-discriminatory basis to all employees.
For purposes of illustration, the following is a list of items that the SEC generally views as perquisites:
- Club memberships not used exclusively for business entertainment purposes;
- Personal advice on financial or tax matters;
- Personal travel using vehicles owned, leased or financed by the company;
- Personal use of property owned or leased by the company;
- Housing and other living expenses (including relocation assistance);
- Security provided at a personal residence; and
- Discounts on the company’s products or services.
Companies should consider implementing robust controls to protect the company and ensure full transparency of compensation and perquisites. Not only do strong controls reduce the probability of undisclosed perquisites but it may also help reduce the severity of penalty for a disclosure failure. Implementation of control measures following discovery of problematic practices was cited by the SEC as a factor in its decision to not impose a fine on Provectus Biopharmaceuticals. Consider implementing or enhancing the following controls:
- Improve internal controls, compliance policies and procedures, and executive training programs, for example:
- Develop procedures that track personal use of company assets (such as tickets for entertainment events); and
- Develop a methodology for calculating the aggregate incremental cost of perquisites. If a perquisite needs to be quantified in a footnote of the proxy statement, then the corresponding methodology will need to be explained (for example: determining the cost of the personal use of an airplane, which includes the cost of fuel and landing fees).
- Ensure that the compensation committee approves all aspects of compensation and the relevant rationale.
- Implement a requirement to pre-approve perquisites to executives and maintain a cost limit. A cost limit facilitates the collection of information and estimation of the perquisite’s cost (a necessary step in the disclosure process). A cost limit also increases the committee’s awareness of the overall costs of the company’s compensation program.
- Ensure that an internal or external audit team reviews the company’s proxy disclosures and underlying support documentation; and
- Companies can also work with directors and officers to ensure compliance, for example:
- Elicit information about perquisites in the standard director & officer questionnaires. Consider including examples as a way to spark one’s recollection of infrequently provided benefit (for example: reimbursement of a spouse’s travel expense to company sponsored events). Remind respondents that providing inaccurate information could have adverse consequences for the individual and the company; and
- Provide a text of company policies regarding travel, entertainment, and other expenses, when distributing director & officer questionnaires.
A company will be better prepared to meet its SEC reporting obligations by implementing some of the strategies above and conducting a thorough analysis of the benefits provided to executives.
By Jay Warren
The recently enacted Tax Cuts and Jobs Act eliminated a business expense deduction for settlements of sexual harassment and sexual abuse claims that are subject to confidentiality restrictions. Specifically, a “settlement or payment related to sexual harassment or sexual abuse,” and the “attorney’s fees related to such a settlement or payment,” are no longer a deductible business expense “if such settlement or payment is subject to a nondisclosure agreement.” IRC §162(q) (added to the IRC by §13307 of the TCJA). Section 13307 became effective on December 22, 2017.
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Federal Circuit Court Split Creates Uncertainty as to MD&A Omissions
By Rob Endicott and Mark Stern
A recent Second Circuit decision allows shareholder plaintiffs to establish securities fraud claims based on omissions of “known trends or uncertainties” from the Management’s Discussion and Analysis of Financial Condition and Results of Operation (“MD&A”) section of Forms 10-K and 10-Q. As noted below, the Supreme Court had agreed to hear argument on this the Second Circuit decision to resolve a conflict with the Ninth and Third Ninth Circuits, which had held to the contrary in earlier decisions, but the parties subsequently reached an agreement in principle to settle the matter.
The Supreme Court has long held that a company’s nondisclosure is not actionable under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder unless such company has an affirmative duty to disclose and that such duty to disclose arises only where nondisclosure would cause statements made by the company to be misleading. Basic Inc. v. Levinson, 485 U.S. 224 (1988); Chiarella v. U.S., 445 U.S. 222 (1980). Moreover, with respect to the MD&A section of Forms 10-K and 10-Q, which is required by Item 303 of Regulation S-K (“Item 303”), the Ninth Circuit held in 2014 that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5” and that such a duty to disclose must be separately shown in order to establish liability. In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014). The Third Circuit had reached the same conclusion in a 2000 case. Oran v. Stafford, 226 F.3d 275 (3d Cir. 2000). Therefore, historically, a company’s decision to remain completely silent, whether in the MD&A section or otherwise, would generally not lead to liability for securities fraud.
More recently, the Second Circuit split from the Ninth and Third Circuits in Indiana Public Retirement System v. SAIC, Inc., 818 F.3d 85 (2d Cir. 2016), holding that Item 303 does in fact establish an affirmative duty to disclose. Item 303 requires a reporting company to include in the MD&A section of Forms 10-K and 10-Q a discussion of “known trends or uncertainties that have had or . . . will have a material . . . unfavorable impact on net sales or revenues or income from continuing operations.” 17 C.F.R. § 229.303(a)(3)(ii). In SAIC, shareholder plaintiffs alleged that SAIC (now known as Leidos) committed securities fraud in violation of Section 10(b) by failing to disclose potentially significant liability in a criminal investigation of an alleged kickback scheme perpetuated by certain SAIC employees in the MD&A section of its Form 10-K filed on March 25, 2011. SAIC allegedly was aware of the potential liability in advance of the Form 10-K filing because, prior to the filing, SAIC placed one of the employees involved in the scheme on administrative leave and received an audit report evidencing the employee’s improper billing practices.
Despite SAIC’s complete silence as to the potential liability, the Second Circuit held that the shareholder plaintiffs adequately pleaded their claim for securities fraud in violation of Section 10(b) because SAIC had an affirmative duty to disclose the potential liability under Item 303. In reaching its decision, the Second Circuit relied on an interpretive release by the SEC, which states that a duty to disclose under Item 303 “exists where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial condition or results of operation.” Management’s Discussion and Analysis of Financial Condition and Results of Operations, Securities Act Release No. 33-6835 (May 18, 1989). The Second Circuit reasoned that because (i) the plaintiffs’ allegations supported a strong inference that SAIC knew of the potential liability and (ii) the liability, if realized, was reasonably likely to have a material impact on SAIC’s financial condition, SAIC had a duty to disclose such potential liability under Item 303.
The Supreme Court granted certiorari in SAIC on March 27, 2017, which would likely have resolved the split between the Second, on the one hand and the Ninth and Third Circuits, on the other. However, such resolution has been delayed for the foreseeable future as the parties reached a settlement agreement in principle in October 2017, causing the Supreme Court to remove scheduled oral arguments from its calendar.
The circuit split, until resolved by the Supreme Court, has significant implications for companies subject to public reporting requirements. For example, opportunistic plaintiffs seeking to take advantage of the decision reached in SAIC may be increasingly likely to bring securities fraud claims under Section 10(b) and Rule 10b-5 in the Second Circuit. However, plaintiffs still must establish the remaining elements of Rule 10b-5 in order to succeed on a securities fraud claim under Section 10(b). Additionally, the Second Circuit held that a company may face exposure to securities fraud liability under Section 10(b) only if it actually knows of potential material liabilities and fails to disclose such potential material liabilities in the MD&A section. A company that should have known, but did not actually know, of such potential material liabilities may not face exposure to securities fraud liability under Section 10(b), under the SAIC reasoning.