Last week, on December 20, 2019, the U.S. Department of the Treasury and Internal Revenue Service (the “IRS”) published a proposed regulation (the “Proposed Regulation”) under Section 162(m) of the Internal Revenue Code of 1986, which was amended in significant ways by 2017’s Tax Cuts and Jobs Act (the “TCJA”).
Section 162(m) generally limits the amount of a deduction by a “publicly held corporation” for compensation paid to a “covered employee” for the applicable taxable year to US$1 million. Before the enactment of the TCJA, there was a critical Section 162(m) exception for qualified performance-based compensation. The TCJA eliminated that exception, expanded the reach of Section 162(m) and made various other changes to Section 162(m).1
The elimination of the Section 162(m) exception for performance-based compensation is a significant development in the world of public-company compensation, dramatically affecting the manner in which a wide range of compensation programs will be structured, and may have important ramifications for certain private companies, such as a foreign private issuer.2 Now that compensation over the US$1 million limit will be nondeductible regardless of whether it is qualified performance-based compensation, Section 162(m) will no longer drive the structure of compensation programs to meet the special and detailed performance-based compensation exception. An exception for commissions was also eliminated. In addition, among other things, the TCJA (i) restored the reach of Section 162(m) to the chief financial officer (the “CFO”), which had been previously eliminated in prior guidance under Section 162(m),3 and (ii) extended the applicability of Section 162(m) by expanding the definition of “publicly held corporation” to include any company that has reporting obligations under Section 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), which would include, for example, issuers of public debt.
The TCJA generally provides that any amendments to Section 162(m) would apply to taxable years after December 31, 2017, but offers a transition rule for any “written binding contract” in effect as of November 2, 2017 that was not materially modified on or after such date. This transition rule is particularly relevant for those companies historically relying on the exception for performance-based compensation with respect to their existing plans and programs.
On August 21, 2018, the IRS issued Notice 2018-68 (the “Notice”), which provided guidance regarding certain of the changes to Section 162(m).4 The Notice clarified how the transition rule applies (or does not apply) in a variety of circumstances and that a written binding contract that is renewed after November 2, 2017 is not eligible for relief under the transition rule and described a number of arrangements that would be treated as being renewed. The Notice also confirmed, among other things, that an employee who is an executive officer can be a covered employee even if the employee is not serving as an executive officer at the end of the corporation’s taxable year, and that any covered employee for taxable years beginning after December 31, 2016 will continue to be a covered employee for all subsequent taxable years.
The Proposed Regulation
The Proposed Regulation would generally implement the TCJA changes to Section 162(m). Except as otherwise noted below, the Proposed Regulation will apply to compensation that is otherwise deductible for taxable years beginning on or after final regulations are published. However, taxpayers may rely on the Proposed Regulation until final regulations are issued, if they apply the Proposed Regulation consistently and in its entirety. As a result of this ability to rely on the Proposed Regulation, the Notice is no longer of any force or effect for taxable years ending on or after December 20, 2019. Certain aspects of the Proposed Regulation are noted below.
- The Proposed Regulation adopts the definitions of “written binding contract” and “material modification” in the Notice, which derived from Section 1.162-27(h) of the Treasury Regulations and were used for purposes of applying the original Section 162(m) grandfather rule in 1993. These definitions apply to taxable years ending on or after September 10, 2018 (when the Notice was published).
- The Proposed Regulation takes a very broad approach in interpreting the terms “written binding contract” and “material modification.” For example, where a plan provides for so-called “negative discretion” to reduce the amount of an award, as was commonly the case under Section 162(m) plans, the Proposed Regulation takes the position that there is no written binding contract to the extent of the negative discretion, thereby rendering transition relief unavailable to the portion over which there is discretion. In addition, where there is the possibility of later compensation increases that may affect other compensation affected by Section 162(m) (e.g., as might occur in the case of severance arrangements), such increase may result in a material modification, thereby rendering transition relief unavailable to any amounts paid after such material modification.
- There are also rules and examples addressing clawbacks, the treatment of earnings under account and nonaccount balance plans and subsequent contractual modifications.
- In light of the elimination of the exception for performance-based compensation, the Proposed Regulation would eliminate existing regulatory relief under Section 1.162-27(f)(1) of the Treasury Regulations for corporations that become publicly held corporations. Thus, Section 162(m) would apply to the deduction for any compensation that is otherwise deductible for the taxable year ending on or after the date that the corporation becomes a publicly held corporation. The elimination of the private-to-public relief would apply to corporations that become publicly held corporations after December 20, 2019. A corporation that became a publicly held corporation on or before December 20, 2019 may rely on Section 1.162-27(f)(1) of the Treasury Regulations in accordance with its terms.
- The Proposed Regulation implements the restoration of the reach of Section 162(m) to the CFO and certain other changes relating to the identification of covered employees. The definition of covered employee applies to taxable years ending on or after September 10, 2018 (when the Notice was published). For a corporation whose fiscal and taxable years do not end on the same date, the rule requiring the determination of the three most highly compensated executive officers to be made pursuant to the rules under the Exchange Act applies to taxable years beginning on or after December 20, 2019.
- Former employees are now covered by Section 162(m). Therefore, if an individual is a covered employee for a taxable year, the individual remains a covered employee for all subsequent taxable years, even after the individual has separated from service.
- The Proposed Regulation adds rules for what constitutes a predecessor corporation of a publicly held corporation for purposes of determining whether an individual who was a covered employee of such predecessor corporation remains a covered employee for subsequent taxable years. These rules would apply to corporate transactions for which all events necessary for the transaction occur on or after final regulations are issued.
Applicable Employee Remuneration
- Since a covered employee remains a covered employee after separation from service, the Proposed Regulation would clarify that, if after the separation from service as an employee a covered employee returns to provide services to the publicly held corporation in any capacity (including as an independent contractor), then any deduction for compensation paid to the covered employee is potentially subject to Section 162(m).
- The Proposed Regulation would make various other changes to the rules governing the identification of covered compensation.
Definition of “Publicly Held Corporation”
- The Proposed Regulation would define a publicly held corporation as any corporation that issues securities required to be registered under Section 12 of the Exchange Act or any corporation that is required to file reports under Section 15(d) thereof, and use the last day of a corporation’s taxable year to determine whether it is publicly held. Accordingly, a corporation is publicly held if, as of the last day of its taxable year, it is required to be so registered or it is required to file such reports.
- The Proposed Regulation would clarify that a publicly held corporation potentially may include, among other things, a publicly held subsidiary, a foreign private issuer, a publicly traded partnership, an affiliated group of corporations and a privately held corporation.
The Proposed Regulation takes a distinctly rigid view of the TCJA's transition provisions surrounding the changes to Section 162(m), rendering (if the Proposed Regulation is finalized as proposed) transitional relief unavailable to a wide range of plans and arrangements. Likewise, the approach in the Proposed Regulation to material modifications and to earnings would greatly expand Section 162(m)’s reach. In a variety of situations, issuers (and their shareholders) may have to come to terms with the fact that Section 162(m) will deny deductions when they had been previously expected. When these rules are taken together with other TCJA changes that expand the reach of Section 162(m), it seems likely that Section 162(m) will result in significantly greater nondeductibility of executive compensation than had previously been the case. The ultimate effect of the TCJA's changes to Section 162(m) on the design and implementation of compensation plans and programs is yet to be seen.