The Decline and Fall of the 280G Excise Tax Gross-Up: Managing Equity (and Other) Compensation After the Gross-Up Is Gone

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1 The Decline and Fall of the 280G Excise Tax Gross-Up: Managing Equity (and Other) Compensation After the Gross-Up Is Gone Marshall Scott, Towers Watson Laura Thatcher, Alston & Bird LLP Mike Cyran, Microsoft Corporation 2010 NASPP Annual Conference September 23, 2010 Terry Adamson, Radford Valuation Services

2 30,000 Foot Overview of Golden Parachutes Internal Revenue Code 4999 imposes a 20% excise tax on excess parachute payments Parachute payments are change-in-control payments that equal or exceed 3 times a person s base amount (average taxable compensation over the 5 years ending prior to the year in which the change in control occurs) An excess parachute payment is the amount by which a parachute payment exceeds the portion of the base amount allocated to that payment Internal Revenue Code 280G prohibits the company s corporate tax deduction for excess parachute payments under IRC 4999 As the two Code sections go hand in hand, these are often referred to collectively (although inaccurately) as 280G consequences 1

3 Gross-Up Protection Historically, it has been common for public companies to provide a tax gross-up payment to executives to cover both (i) the golden parachute excise tax, and (ii) the resulting income and excise taxes on the grossup payment Due to the tax-on-tax compounding effect of the gross-up obligation, as a general rule of thumb, the gross-up payment is approximately 2.5 times the amount of the excise tax In addition, the company loses its income tax deduction for the excess parachute payment, which compounds the overall expense to the company of providing gross-up protection Because of this, excise tax gross-ups are becoming increasingly unpopular with investors 2

4 Tax Gross-Up Provisions 2009 Recent data (generally 2009) for the largest 500 U.S. corporations reveal that 48% of CEOs and 38% of other named officers are provided full excise tax gross-ups Some companies provide adjustments or address the excise tax in other ways 1% 1% 3% 10% CEO 1% 7% 2% 4% Other NEOs 12% 38% 48% 37% Full Conditional Capped Partial Conditional & Capped Range 36% Full Conditional Best of Net Capped Partial Conditional & Capped Range * Tax gross-up definitions in the key can be found in the next slide. 3

5 Tax Gross-up Definitions Full Tax Gross-up Conditional Tax Gross-up Partial Tax Gross-up Capped Conditional & Capped Best of Net Tax gross-up that completely offsets the impact of excise taxes imposed on the parachute recipient by IRC 4999 With these provisions, the full gross-up is provided only if total parachute payments exceed the statutory limit imposed by IRC 280G by an arbitrary amount (e.g., 10%, $100,000); otherwise, the parachute payments are capped at the IRC 280G limit The excise tax gross-up only indemnifies for a portion (e.g., 50%) of the excise tax incurred, and the executive is liable for the balance The parachute payments are limited or capped so that no excise tax is incurred An excise tax gross-up is paid only if the parachute payment exceeds a certain threshold, and the amount payable will be capped at a certain amount (e.g., parachute payments must exceed the safe harbor by at least ten percent, but no excise tax gross-up will be more than $1 million) No excise tax gross-up, and parachute payments may be limited or reduced if the amount as adjusted or reduced is greater than the amount of parachute payments determined net of all taxes 4

6 Tax Gross-Ups Provision 2010 Most recent data (generally 2009) for the largest 200 U.S. corporations reveal that approximately fifty percent (50%) of those corporations (i.e., 101) provide or have historically provided some sort of contractual change-in-control protection, including excise tax gross-ups or other adjustments Prevalence of Types of Gross-ups; Reflective of Grandfathered Arrangements Full Conditional Partial Best of Net Total # % 41% 42% 3% 15% 100% At the present, eighty-five percent (85%) of those companies report that they have not adjusted their traditional approach to excise tax protection (other than for seven companies who moved to a best-of-net practice) Prevalence of Types of Gross-ups; Reflective of On-going Practices # % Full 29 34% Conditional 31 36% Partial 3 4% Best of Net Total % 100% 5

7 Tax Gross-Up Provisions 2010 On-going largest 200 U.S. corporations reflect recent changes Sixteen (16) companies have eliminated the use of excise tax gross-ups going forward (although most of the companies have grandfathered the use for executives who had such protection at the time of the change). Seven (7) companies now offer a best-of-net replacement Looking behind the data, most companies are electing to grandfather existing designs for current executives, but are not providing CIC protection to new or promoted executives As a result of the grandfathering, market statistics may understate the rate at which company policy is changing Also, many companies are trying to manage the expense associated with the excise tax, which reflects the move away from full gross-ups to alternatives designed to eliminate or minimize excess parachute payments 6

8 Business Reasons for 280G Tax Protection The business case for Change in Control (CIC) benefits, including excise tax protection, has not changed Boards claim not incorrectly that a CIC is distracting to executives, and that, by providing severance and tax protection, the executive can be assured that compensation is sure. This allows the executive to focus on leading the company through the CIC, without worrying about personal consequences However, many factors are now dissuading companies from continued parachute tax protection. Negative pressure from shareholder advisory groups like ISS, significant expense to the company, and pressure from shareholders have induced many companies to eliminate parachute tax gross-ups The following companies have elected no longer to provide gross-ups of parachute tax payments for some or all of their current or future executives: Advanced Micro Devices Ameren Corp American Electric Power Borg Warner Freeport-McMoRan Copper & Gold Goodyear Honeywell J. C. Penney Medco Health Solutions Newell Rubbermaid Sherwin-Williams Textron Verizon Communications 7

9 Reasons to eliminate CIC Tax Protection A company s failure to eliminate CIC tax protection can result in negative votes for directors on select committees, or in some cases, all directors standing for re-election Institutional shareholders have expressed strong disfavor of CIC tax protection Institutional Shareholder Services ( ISS, a division of RiskMetrics Group) has taken a specific stand on excise tax gross-up protection ISS will render a negative vote recommendation on a say-on-pay proposal, or a withhold vote recommendation for directors, when a CIC excise tax gross-up is included in a new CIC agreement or plan, or maintained in an amended agreement or plan New developments in corporate governance (majority voting standards for directors and limitation on discretionary voting by brokers) increase the likelihood that negative vote recommendations will be successful 8

10 Reasons to Eliminate CIC Tax Protection Majority voting standard Majority voting requires a director to tender resignation if majority votes in favor of re-election are not received (if majority is against or withhold ) A large majority of S&P 500 firms have already adopted majority voting; most midand small-cap companies have not done so Senate version of the 2010 Financial Reform legislation contained a majority voting standard in uncontested director elections at public companies (but as of June 17, Senate conferees reportedly had agreed to drop this provision) Broker non-votes In 2009, broker non-votes were eliminated from the vote count for director nominations, making any election more dependent upon the votes of institutional shareholders As of June 24 while still in conference, the 2010 Financial Reform legislation would also eliminate broker discretionary voting on say-on pay proposals 9

11 Courting Institutional Investor Votes: ISS Poor Pay Practices Any of the following poor pay practices substantially increase the likelihood of a withhold vote recommendation from Institutional Shareholder Services: ISS Poor Pay Practices in CIC Severance payments exceeding three times base salary and target bonus CIC payments without job loss or substantial diminution of duties ( single triggers ) New or materially amended agreements that provide for modified single triggers, in which an executive may voluntarily leave for any reason and still receive the CIC severance package New or materially amended agreements that provide for an excise tax gross-up (including modified / conditional grossups) Commentary Emerging practice is to align the CIC severance multiple with the period of the non-compete. This will typically bring CIC severance into the safe harbor (typically to a to a 1 to 2 times multiplier, depending on the executive s level). CIC severance multiple may remain higher than for other involuntary terminations. Single triggers that allow for a CIC severance payment even though the executive remains employed in a job at a comparable level and with comparable pay have become atypical. Single trigger severance is generally inconsistent with the income protection goal of severance pay. In the 2010 ISS guidelines, singletriggers account for more than 20% of the overall GRId index score. This refers primarily to walk away provisions. An executive may leave voluntarily during a window period, usually the 13 month period following the CIC, without loss of severance pay. The original intent was to allow the acquiring company time following the CIC to negotiate to retain an executive, but not bind the executive longer-term to the new company. ISS will, however, support provisions that provide for a sunset of the existing excise tax gross-up protection over time, typically 12 to 24 months, if the Company also commits not to add excise tax gross-ups in any subsequent agreements 10

12 Courting Institutional Investor Votes: Institutional Perspective Three large institutional investors, Fidelity, Vanguard and CalPERS, have expressed the following opinions on CIC protection: Investor Fidelity Vanguard CalPERS Major Views Expressed on CIC Provisions Fidelity will generally withhold authority for the election of all directors, or directors on responsible committees, if a golden parachute was introduced, extended, or adopted upon the expiration of an existing contract or plan without shareholder approval. Fidelity defines a golden parachute as employment contracts, agreements, or policies that include an excise tax gross-up provision or may result in a lump sum payment of cash and acceleration of equity that may total more than 3X annual compensation in the event of a termination following a change in control. Any new or amended change in control arrangement under which the beneficiary receives more than three times salary and bonus or where severance is guaranteed absent a change in control should be submitted for shareholder approval Companies should not compensate executives for any excise or other additional taxes payable as a result of any employment, severance, or other agreement 11

13 Effect of Public Disclosure of CIC Severance The required proxy disclosure of the dollar value of excise tax protection and the total severance payment for CICs highlights the issue and fuels shareholder concern. Below is an actual example from a 2010 proxy statement, which illustrates this disclosure. Chief Executive Officer Executive Benefits & Payments Involuntary Change in Upon Termination Termination Control Compensation Severance $3,300,000 $3,300,000 Short-Term Incentive Plan Long-Term Incentive Plan $500,000 $500,000 Stock Options (Unvested & Accelerated) Restricted Stock (Unvested & Accelerated) $29,466 $139,966 Restricted Stock Units (Unvested & Accelerated) $4,000,014 Benefits Benefits Continuation $108,471 $91, G Tax Gross-Up $3,783,409 Other Benefits $44,290 $44,290 TOTAL $3,982,227 $11,858,758 12

14 Company Advantages for Removing CIC Tax Gross-Ups Positive public proxy disclosure now, both in tabular and narrative form In some cases, may receive positive benefits of disclosure even when potential tax liability is small or non-existent (and when the risk is small that elimination of the gross-up will actually lead to talent loss) Limited disclosure value if change were to occur later, after likely required Increased director retention minimizes potential embarrassment of low shareholder support of re-election Reduced change-in-control costs, and potential for increased shareholder value This may also increase the tax deductibility of compensation paid as a result of a change in control 13

15 Considering a Decision to Change Each of the elements below should be part of any decision to change or remove parachute excise tax protection Market conditions: Companies rarely want to be first in adopting a new practice or going against the broader prevalent practice Business/strategic rationale: Boards will always be concerned with whether limiting benefits will affect the ability to attract and retain talent Benefit to executives: Change is easiest before excise tax liability exists; by altering provisions early, there is no actual immediate financial take-away from executives Performance Trend: Boards will face easier choices in an environment of strong historical performance and pay trending up (historical weak performance tends to yield lower base amounts and increase chance of excise taxes) Cost of parachute provisions: Usually not a stand alone reason for change, but can add to the strength of a recommendation when incorporated with other factors 14

16 Considering a Decision to Change Market context can be ascertained through researching peer group CIC severance practices and published survey sources Example Summary of CIC Provisions Provision Peer Group Prevalent Practice General Industry Prevalent Practice Cash severance payments Treatment of outstanding long-term incentive awards CIC excise taxes Severance multiple ranging from 2x to 3x base salary plus annual incentive, with a trend toward 2x Provide a pro-rata payout of current performance plan cycles Accelerated vesting of stock options and restricted stock Excise tax gross-ups are provided, with a trend toward only providing gross-ups if payments exceed 110% of the excise tax threshold; otherwise, payments are reduced to avoid excise taxes Severance multiple ranging from 2x to 3x base salary plus annual incentive, with CEOs typically receiving 3x and direct reports receiving 2x Accelerated vesting of all outstanding long-term incentives Full tax gross-up prevalent practice for the CEO and direct reports to the CEO Trend toward only providing gross-ups if payments exceed 110% of the excise tax threshold; otherwise, payments are reduced to avoid excise taxes Business / strategic rationale for certain CIC provisions require input from an organization s management team and board More detailed analysis is required for surfacing issues regarding the benefit to executives, the implications of historical performance and the cost of CIC provisions; examples are on the pages that follow 15

17 Considering a Decision to Change Limited tenure, which provides a shorter W-2 history and less opportunity to have realized gains from equity awards, bonus payouts, etc., can result in small 280G safe harbors relative to the severance otherwise provided In this respect, excise tax protection can be validated for purposes of retaining executives that are newly hired and have limited tenure Exhibit A: Tenure plays a major role in the size of the 280G limit cash severance alone (i.e., without consideration for vesting of equity awards and other CIC related payments) in this example is sufficient to exceed the 280G limit and generate excise taxes Exhibit A CEO with 3.0x CIC severance multiple and limited tenure Year W-2 Value 2009 $1,127, $307, Base Amount $698, G Limit $2,096,684 1 Adjusted for one-time payment in year of hire of $350,000 Base Salary $750,000 Average Bonus $175, x (Base + Average Bonus) $2,775,000 16

18 Considering a Decision to Change Similar to limited tenure, a history of poor company performance (in terms of financial and shareholder returns) can over time lead to lower 280G safe harbors for executives, as smaller incentive payouts are captured in W-2 histories; if excise tax protection is provided, this creates a double bogey of an increased likelihood of excise taxes in the face of poor returns to shareholders This challenges the rationale for providing any sort of excise tax protection Exhibit B: A decline in W-2 earnings (corresponding to a protracted decline in stock price over the same period) drives down the 280G limit; as with the prior example, cash severance alone would be sufficient to exceed the 280G limit and generate excise taxes (particularly since the use of target bonus in the severance formula avoids aligning severance with actual bonus history) Exhibit B Executive with 2.0x CIC severance multiple and declining W-2 Earnings from poor performance Year W-2 Value 2009 $227, $249, $343, $342, $361,963 Base Amount $304, G Limit $914,975 Stock Price History 12/31/2005: $ /31/2009: $2.21 Base Salary $300,000 Target Bonus $180, x (Base + Target Bonus) $960,000 17

19 Considering a Decision to Change While limited tenure and sustained poor performance increase the potential for parachute payments exceeding the 280G threshold, strong historical performance has the opposite effect; above-target bonus and equity award payouts from healthy financial results and shareholder returns can increase W-2 histories and 280G limits, reducing the likelihood that CIC severance payments will generate excise taxes Consequently, even if excise tax protection is provided, it may be unnecessary (apart from perceived value to executives) Exhibit C: While performance has declined following the market downturn, longer-term historical performance provided substantial W-2 earnings to the CEO, raising the 280G limit and insulating the substantial severance package (including accelerated equity) from approaching the 280G limit Exhibit C CEO with 3.0x CIC severance multiple and high W-2 Earnings and performance Year W-2 Value 2009 $16,351, $56,563, $39,183, $10,831, $11,033,044 Base Amount $26,792, G Limit $80,377,958 Stock Price History 12/31/2005: $ /31/2007: $ /31/2009: $81.75 Base Salary $1,403,780 Average Bonus $2,060, x (Base + Average Bonus) Stock-Based Awards $10,394,100 $10,265,704 Total $20,659,804 18

20 Techniques for Change Organizations that are making change rarely eliminate the CIC tax protection from existing participants immediately. Instead, organizations typically adopt one of the following methods A prospective change, meaning CIC tax protection is not included in any new or amended agreement or plans; or A sunset provision, eliminating CIC tax protection after a specified period of time. Example: The employment agreement provides that if Mr. XXX receives any payments that are subject to the excise tax imposed on parachute payments under the Code on account of a transaction occurring within 18 months following the effective date of the employment agreement, we will pay him a gross-up payment so that he retains an amount of the gross-up payment equal to the excise tax, after payment of all taxes on that gross-up payment. This provision modifies the right Mr. XXX had in his original offer letter to receive this form of grossup payment throughout his employment with us. Mr. XXX is not entitled to any such gross-up payment for transactions occurring after such 18 month period. This sunset provision was supported by ISS (though the company was required to make a public statement that no further CIC excise tax benefits would be added in the future) 19

21 Techniques for Change The following additional techniques are being used to minimize the potential and size of excise tax liability: Cut-back to safe harbor limit (or variations thereof) Increased allocation of payment to restrictive covenants Providing damages for breach of contract, rather than severance Identifying CIC payments as reasonable compensation for prior services Double-trigger vesting (probability analysis of termination actually occurring) Cancellation of unvested equity with little or no intrinsic value Accelerated exercise of vested options in year prior to CIC 20

22 Techniques for Change: Cut-Back to Safe Harbor This technique involves cutting back the parachute payment until it falls within the 2.999x safe harbor. Consider the following parachute payment: Total parachute payments $300,000 Base amount $100,000 Safe harbor $299,999 Excess parachute payment ($300,000 - $100,000) $200,000 Excise tax liability ($300,000 - $100,000) x 20% $40,000 Note, by cutting back the parachute payment by to the safe harbor amount, the tax is avoided. Here, a $1 cutback eliminates the excise tax liability entirely. Cutbacks benefit both the executive and the company without an expensive gross-up: The executive nets $299,999 of payments before tax withholding (rather than $260,000, with the excise tax) and the company can deduct the entire amount, rather than just the $100,000 base amount. 21

23 Techniques for Change: Restrictive Covenants Compensation paid for a restrictive covenant, such as a covenant not to compete is not a parachute payment (to the extent it is reasonable compensation for future services) Companies have typically only assigned a limited value to the restrictive covenant Companies can provide extra severance by allocating more of the payment as consideration for the restrictive covenant For example, the executive may be entitled to one or two years of severance without regard to the restrictive covenant, and if he or she agrees to a restrictive covenant, one additional year of severance Following ISS s new policy, companies must approach restrictive covenants with more rigor Generally must get an expert valuation of the restrictive covenant, which is based on the facts and circumstances 22

24 Techniques for Change: Restrictive Covenants Valuation experts typically meet with the executive to understand: the scope of the executive s position the executive s ability to influence or set company strategy the executive s ability to affect revenue or cost and his or her skills and background Unique for each executive at each company Based on the set of circumstances, valuation experts estimate cash flow and net present value to the company as a result of the continued employment of that executive 23

25 Techniques for Change: Restrictive Covenants Challenges to the covenant valuation process Managing the process: HR typically has to manage the valuation process, including discussing the valuation with the executive before the interview managing communication among executives communicating the results to the Compensation Committee or Board Buy in: executives typically want to understand the methodology and assumptions behind the valuations before the interviews many will want to discuss with their own legal and/or tax counsel some will be uncomfortable discussing their value to the company, especially during a CIC Timing: given the complexity of the issue, the valuation process can take time if the valuation is taking place during a potential CIC, it can be even more difficult to carve out time for interviews and valuations 24

26 Techniques for Change: Damages for Breach This technique involves characterizing CIC payments as damages for breach of contract, rather than as severance* The following factors are generally considered clear and convincing evidence that the payment constitutes damages for breach of contract (i.e., reasonable compensation for personal services to be rendered after the CIC): The contract was not entered into, amended or renewed in contemplation of the CIC The compensation the executive would have received under the contract absent a CIC would have qualified as reasonable compensation under IRC 162 The damages do not exceed the present value (as of the date of receipt) of the compensation the person would have received under the contract if he or she had continued to perform services for the company until the end of the contract term The damages are received because executive s offer to continue providing personal services was rejected by the employer (including involuntary termination or constructive discharge) The damages are reduced by compensation earned during the original contract term (mitigation) * Treas. Regs G-1, Q&A-42(c) 25

27 Techniques for Change: Damages for Breach, continued Illustration Damages for Breach Severance Damages for Breach Accelerated Vesting of Equity $300,000 $200,000 Severance Accelerated Vesting of Equity $300,000 $200,000 Total $500,000 Total $500,000 Base $100,000 Base $100,000 Total Parachute $200,000 Total Parachute $500,000 Payment in Excess of Base $100,000 Payment in Excess of Base $400,000 Safe Harbor $299,000 Safe Harbor $299,999 No excise tax Parachute Payment $500, ,000 $400,000 Excise Tax ($400,000 x 20%) $80,000 26

28 Techniques for Change: Reasonable Compensation for Prior Services If there is clear and convincing evidence that a payment is reasonable compensation for services rendered prior to a CIC, they may be excluded from the excise tax and loss of deduction consequences* Factors relevant to such determination include, without limitation, the following:** The nature of the services rendered The individual s historic compensation for performing such services The compensation of individuals performing comparable services in situations in which the compensation is not contingent on a CIC If an individual s actual total direct compensation has consistently been below the market competitive pay level (e.g., 50 th percentile), may some of the CIC pay be characterized as compensation for past services? * Treas. Regs G-1, Q&A-39 **Treas. Regs G-1, Q&A-40 27

29 Techniques for Change: Double-Trigger Vesting; Probability of Employment Termination Double-trigger vesting and payment provisions allow individuals to disregard unlikely future payments in calculating present taxes If a payment (including the value of accelerating vesting of such payment) is based on an event that has less than a 50% probability of occurring, it may be excluded from the parachute payment calculation unless or until the event (typically termination of employment) actually occurs* This approach may help reduce the excise tax if the individual is not likely (i.e., less than 50% probability) to be terminated as a result of the CIC A person who does not experience a termination of employment, and thus does not receive a payment pursuant to the double trigger may not have excise taxable compensation However, if the person later terminates and receives the payment, the parachute tax will need to be recalculated and adjusted * Treas. Regs G-1, Q&A-33 28

30 Techniques for Change: Cancellation of Unvested Stock Options That Have Little or No Intrinsic Value Treasury regulations provide that the accelerated vesting of a stock option or restricted stock upon a CIC is treated as a payment in the nature of compensation The parachute value of the CIC vesting of a time-based option or restricted stock award depends on the intrinsic value of the award at the time of the CIC and number of months the vesting was accelerated by virtue of the CIC The acceleration of vesting of even underwater options can have parachute value (although usually minimal) One way to marginally reduce the total parachute payment is to cancel (rather than accelerate) unvested underwater options; but this could be an inefficient choice to eliminate a small amount of parachute value especially if the options have a long remaining time to recover value 29

31 Techniques for Change: Exercise Vested Options in Year Before CIC In cases where a CIC is expected to occur early in a calendar year, executives may consider exercising vested nonqualified options before the beginning of that year The option gain will be taxable compensation in the year before the year in which the CIC occurs and, therefore, will increase the person s base amount and provide a higher 280G limit before the excise tax applies 30

32 Tips for Consideration Plan ahead to address the elimination of gross-ups Agreements with CIC tax protection usually have notice periods of 6 months or more Monitor / check competitor (peer) company actions relative to excise tax protection; if you don t want to be the leader, at least avoid being the laggard Easiest to consider when excise liability is not expected to arise in the foreseeable future Focus on opportunities for the Company This is a chance to make a very positive change that may not be a direct financial take away Demonstrate the quantitative impact of a change over a range of stock prices and incentive plan performance levels Critical to demonstrate the potential tax risk, or lack thereof, for the current covered group Discuss an implementation strategy Use provisions, such as sunset clauses, to establish the principle of CIC tax treatment while controlling the timing of its effective date Company may get credit for the making the change now, even though implementation could be delayed until all others are required to eliminate gross-ups 31

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