U.S. Tax Reform: Changes to 162(m) and Implications for Investors

The Tax Cuts and Jobs Act of 2017 introduces significant changes to Section 162(m) of the Internal Revenue Code, which regulates several compensation-related practices in the United States. The changes raise many questions about how companies will adapt with respect to disclosure practices, general meeting agendas, and—more importantly—pay structures. To help make sense of it all, we turned to David Kokell, Head of U.S. Compensation Research at ISS, who provided insight into how ISS will assess potential changes in compensation practices as a result of the new legislation. Before we delve into the discussion, it is worth reviewing the changes to 162(m) in order to understand their potential impact.

What changed?

Section 162(m) of the Internal Revenue Code of 1986 (“the Code”) limits public company tax deductibility for compensation paid to each covered executive to no more than $1 million. However, commission-based compensation and qualified performance-based compensation (including stock options granted at the money) were previously excluded from the $1 million deduction limit; until now. The new law struck the paragraphs describing these exceptions along with the definitions and requirements of what constituted qualified performance-based compensation.

Companies may lose a significant portion of their tax deduction attributable to executive pay, and also the revision removes many provisions that, at least until now, have served as common standards concerning how companies defined and disclosed performance-based compensation. The deleted provisions include:

• Performance Goals. To qualify as performance-based under the Code, awards needed to be appreciation based (e.g. stock options or stock appreciation rights) or come with objective goals attached. The goals had to be based on business criteria and on an objective formula. Furthermore, the goals had to be established and disclosed before or soon after the performance period started.
• Compensation Committee. The Code required that the performance goals be set and certified by a compensation committee comprising at least two outside directors. Exchange listing rules later established full-independence requirements for the compensation committee. As such, the committee independence rules are not in question at the moment (at least for companies listed on the major U.S. exchanges).
• Shareholder Approval Requirements. Paragraph 4(C) of 162(m), which was struck, included a requirement that “the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before the payment of such remuneration.” This was the reason why shareholders were so often asked to vote on cash bonus plans and amendments to equity compensation plans to qualify under 162(m).
• Maximum Pay and Business Criteria. The provisions for maximum pay and business criteria were among the “material terms” associated with the shareholder approval requirement. Under the maximum compensation disclosure requirement, companies had to disclose maximum pay upon the achievement of performance goals based on a dollar amount, a formula, or the number of stock-based awards to be granted. The business criteria rules required disclosure of the types of the goals the company used.
• Stock option and SAR granting terms. Stock options and stock appreciation rights (SARs)—treated as performance-based under 162(m)—had to be issued with the exercise price at least equal to fair market value to qualify as performance-based. Discounted options became almost extinct in the U.S. market partially due to this provision.

In our interview with David Kokell, his responses offer a perspective on what ISS is hearing on shareholder expectations concerning best practices in executive compensation. It is too early to predict how company practice will change, as interpretation of the new law’s impact on 162(m) is not final. Therefore, this discussion does not constitute ISS’ official policy in response to the revised tax code. Instead, Mr. Kokell’s expert opinion helps position ISS’ existing policy framework in the changing landscape.

David, broadly speaking, how do investors view the changes to 162(m)?

David Kokell: 162(m) helped paint the lines on the executive compensation field, defining what was in-bounds and out-of-bounds for executive compensation programs, and providing some transparency and investor control. Some investors fear that the removal of certain 162(m) features may serve to blur those lines, and encourage companies to be less transparent, less objective, less performance-based, and less well-governed around executive compensation than they are today—potentially rolling back significant advances in executive compensation practices gained since the inception of broad say-on-pay in 2011. Many investors will be watching companies closely over the next several years to see how compensation programs evolve under the new regime.

How do you expect the changes to 162(m) to affect proxy season in 2018?

DK: The most immediate change is that we expect to see a decrease in equity plan proposals filed in 2018. Last calendar year, ISS evaluated 740 equity compensation plan proposals at companies in the Russell 3000; 76 of these were placed on the ballot solely (or bundled with minor administrative amendments) to renew the five-year 162(m) deductibility benefit. We expect to see very few similar proposals in 2018. Annual incentive bonus plans may see an even larger impact. In calendar 2017, ISS evaluated 105 amended executive incentive bonus plan proposals, many of which were placed on the ballot to preserve 162(m) benefits. We expect to see a decline in those proposals, as well.

From a pay-for-performance perspective, we don’t expect to see changes to materialize frequently in 2018 proxies, perhaps with the exception of certain forward-looking and subsequent-event disclosures.

The new tax law strikes certain sections of 162(m) that defined how the company established performance-based compensation as well as provided requirements around disclosure and shareholder approval of such awards. With these provisions gone, will ISS change the framework of analyzing pay for performance?

DK: In short: no. Investors will continue to expect that executive pay programs emphasize performance-based incentives; that is, awards that are conditioned on the achievement of rigorous and transparent performance goals. The purpose of these awards is both to retain and incentivize management to drive performance that aligns with long-term corporate strategy which, in turn, creates value for shareholders. While the tax deduction for performance pay afforded under 162(m) provided an added benefit, it was seldom a primary reason behind investors’ expectation for performance-based programs, or a driving factor in ISS’ analysis of pay for performance.

As in previous years, changes that generally reduce the transparent and objective pay-and-performance alignment between shareholders and executives will be viewed negatively when we evaluate compensation pay-for-performance. Negative changes could include material shifts away from performance-based compensation, less transparent disclosure of performance metrics and goals, selecting metrics and setting performance goals later in the performance cycle, and issuing in-the-money stock options.

Speaking of compensation mix, now that the tax deduction exceptions for performance-based pay are eliminated, do you anticipate a shift towards fixed salary or more discretionary pay? How would ISS respond to this type of development?

DK: We’ve seen at least one high profile company, citing the new tax regime, replace variable bonus opportunities with large guaranteed base salaries. Such a decision effectively eliminates the at-risk nature of pay and severs the linkage between pay and performance. I have no doubt that any board that eliminates or reduces performance-conditioned incentives in favor of guaranteed or highly discretionary pay is going to face investor backlash. ISS will continue to closely scrutinize any decision that diminishes performance pay, and wholesale shifts to fixed pay components will likely result in adverse vote recommendations.

Will ISS change the framework for analyzing equity compensation plan proposals?

DK: Again, in short: no. We will continue to analyze equity plan proposals under the ISS Equity Plan Scorecard, and we will continue to qualitatively evaluate plan amendments as we have for some time. We recognize that with the removal of 162(m) comes the potential for companies to remove shareholder risk-reducing plan features. I would caution companies that may be considering removing these shareholder-friendly features (such as limits on discretion or award caps) from their incentive programs simply because they are no longer required under 162(m). ISS, and many investors, will view such actions as detrimental to shareholders’ interests. In fact, some investors would prefer to see a move to adopt overall individual award limits (covering all award types in a plan).

Newly-IPO’d companies also may present new shareholder challenges. In the past, to maintain 162(m) benefits, those newly-IPO’d companies were required to take equity plans to investors for approval (approximately) three years after their IPO. In many cases, companies used this occasion to update their pre-IPO plans, often installing features more beneficial to shareholders and removing features that tend to be problematic (such as evergreen share pools). In the new regime, these pre-IPO plans may survive for many years—up to close to ten years in some cases—after the IPO. We are carefully considering how to handle these situations in the future.

In the absence of a code of best practice in the United States, the recently eliminated provisions of 162(m) for performance-based awards helped set some minimum standards. Which of these standards would you consider best practices in performance-based pay?

DK: While incentive plan designs can vary dramatically company to company, there are a number of features and practices that are routinely recognized by investors as good or best practices. Many of these practices were already embedded in Section 162(m)’s requirements for qualifying performance-based compensation. The requirement that awards be contingent on the attainment of pre-established performance goals remains paramount. Investors also tend to prefer an objective payout formula with performance goals established early in the performance measurement period. I would also stress that setting individual award caps and limiting the ability for upwards discretion on payouts will also be viewed as important safeguards. That said, we’ve heard from some investors that they have comfort with some level of discretion embedded in programs, as long as that discretion is applied judiciously and is well-explained.

The new law took effect on January 1, 2018. In anticipation of the new rules, companies had an incentive to accelerate the accrual of deductions for cash bonuses or restricted stock awards into 2017. Will such actions raise concerns?

DK: In general, the acceleration of awards absent a qualifying termination is considered a poor practice, since it effectively removes the retention and incentive components inherent in vesting criteria. Boards must weigh this risk against the benefit of taking final advantage of the more favorable tax treatment.

That being said, we are aware that some companies have accelerated the payout of awards to the end of 2017 that were originally due to be paid in early 2018. I don’t foresee acceleration of payouts by only a few weeks as being viewed as problematic by most investors. However, many investors will undoubtedly object to the acceleration of awards otherwise due to be paid later in 2018 or, even worse, in subsequent years.

Do you have any final thoughts for investors and companies as they formulate their strategy in the absence of certain 162(m) provisions?

DK: For companies, think carefully about significant departures from your existing compensation framework and, to the extent possible, test those changes with your shareholder base to get early feedback whether they view the changes as beneficial. And for investors, given that the proactive portion of shareholder engagement season for most issuers is drawing to a close, consider making your views known publicly and communicate them to other shareholders. Now is when those compensation program and award decisions are being made, and now is when the opportunity to influence outcomes is high.