Exec Comp Regs Need More or Different Guidance, Firms Say

February 18, 2020

CC:PA:LPD:PR (REG-122180-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Proposed Regulations — Certain Employee Remuneration in Excess of $1,000,000 Under Internal Revenue Code Section 162(m)

Ladies and Gentlemen:

McGuireWoods LLP and Brownstein Hyatt Farber Schreck, LLP hereby submit this letter in response to the request for public comments in REG-122180-18 (the “Proposed Regulations”), which provides guidance on amendments that were made to section 162(m) of the Internal Revenue Code¹ (the “Code”) by section 13601 of “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, Public Law 115-97 (2017)” (the “Act”).

I. Introduction

On December 22, 2017, section 13601 of the Act amended Code section 162(m) to (1) expand the definition of covered employee, (2) eliminate the performance-based compensation exception (other than for grandfathered arrangements), and (3) broaden the limitation's application to corporations required to report under the Securities Exchange Act of 1934 (the “Exchange Act”).² On August 21, 2018, the Internal Revenue Service (the “IRS”) released its initial guidance in Notice 2018-68 (the “Notice”) regarding the amendments made by section 13601 to Code section 162(m). In general, the Notice addressed issues concerning the application of the amended definition of “covered employee,” remuneration paid pursuant to a “written binding contract,” and what constitutes a material modification thereto. On December 20, 2020, the Department of Treasury (“Treasury”) and the IRS released the Proposed Regulations, addressing the Notice and comments received in response to it, as well as the other provisions of amended section 162(m).

II. Executive Summary

As Treasury and the IRS develop additional guidance on the amendments to section 162(m), we would like to take this opportunity to provide feedback on a variety of items discussed in the Proposed Regulations. In doing so, we have highlighted areas where we believe different or additional rule-making would be helpful. In general, our letter is organized by topic and covers (i) written binding contracts; (ii) investment options; (iii) severance and benefits formulas; (iv) negative discretion and claw backs; (v) transitional rules; and (vi) foreign private issuers (“FPIs”).

Before discussing areas where we suggest differing and/or additional guidance, we would like to express our approval for certain provisions in the Proposed Regulations. We would welcome the opportunity to discuss any of these matters further should Treasury and the IRS decide to alter these provisions in Final Regulations.

• Support the provision that a principal executive officer (“PEO”), principal financial officer (“PFO”), or other executive officer of a disregarded entity wholly-owned by a publicly held corporation is not treated as a PEO, PFO, or executive officer of the publicly held corporation unless such person performs policy making functions for the corporate owner during the year, consistent with 17 CFR 240.3b-7.

• Similarly, we support the Proposed Regulations' provision that when a publicly held S corporation owns a qualified subchapter S subsidiary (“QSub”), the QSub's PEO, PFO and other executive officers are not treated as covered employees of the S corporation, unless such individuals perform policy making functions for the S corporation.

• Commend Treasury and the IRS for providing that, for all forms of compensation, a modification to a written binding contract that accelerates vesting will not be considered a material modification.

• Approve the Proposed Regulations' provision that a corporation will not be considered publicly held if its obligation to file reports under section 15(d) of the Exchange Act is suspended and it qualifies for an exemption from registration under section 12 of the Exchange Act.

Below is an overview of the provisions where we suggest differing and/or additional guidance, each of which is discussed in greater detail herein. We welcome the opportunity to discuss any or all of these matters further.

• Written Binding Contract:

  • Recommend utilizing the Generally Accepted Accounting Principles (“GAAP”) safe harbor, or an alternative safe harbor described herein.

  • Provide guidance that equity awards promised pursuant to written binding contracts that are conditioned upon Board/Compensation Committee approval qualify for transition relief.

  • Negative discretion renewal provisions should not prevent a contract from being eligible for transition relief.

  • If an amount is grandfathered but not yet paid, and the contract is materially modified before such grandfathered amount is paid, the grandfathered amounts should remain grandfathered when actually paid.

  • Provide guidance that modifications to a contract in effect on November 2, 2017, that are required by changes in applicable law or due to accounting standards after November 2, 2017, do not constitute material modifications.

• Investment Options: Clarify that choices between multiple investments are permitted and companies are able to change investment lineups.

• Severance and Benefits Formulas:

  • As long as a severance formula is not changed, all amounts paid as severance should be grandfathered.

  • Benefits and earnings accruing on nonqualified defined benefit plans should qualify for transition relief as long as the formula is not materially modified.

• Negative Discretion and Clawbacks: Treasury and the IRS should provide guidance that the reduction of an amount payable under a contract in effect prior to November 2, 2017, by operation of company policies outside the contract (e.g., corporate best practices, malus, detrimental conduct, clawback), does not constitute a material modification.

• Transitional Rules:

  • A transition period should be provided for actions taken from November 2, 2017, to the issuance of Final Regulations.

  • The section 409A regulations should permit a transition period so that existing contracts can be modified to permit a one-time payment election with respect to deferred amounts.

• Foreign Private Issuers: Approve the adoption of a safe harbor for FPIs that are not required to disclose compensation of their officers on an individual basis in their home countries.

III. Written Binding Contract: The Proposed Regulations' guidance regarding written binding contracts should be revised and supplemented.

A. Overview of written binding contract standard.

The amendments to section 162(m) made by the Act do not apply to remuneration payable under a written binding contract which was in effect on November 2, 2017, and which is not modified in any material respect on or after such date.³ Remuneration is payable under a written binding contract that was in effect on November 2, 2017, only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under such contract if the employee performs services or satisfies the applicable vesting conditions.⁴ Accordingly, the amendments to section 162(m) made by the Act apply to any amount of remuneration that exceeds the amount of remuneration that applicable law obligates the corporation to pay under a written binding contract that was in effect on November 2, 2017, if the employee performs services or satisfies the applicable vesting conditions.⁵

Section 1.162-27(h) of the regulations defines a written binding contract as a contract that “under applicable state law, the corporation is obligated to pay the compensation if the employee performs services.”⁶ A contract can include any plan or agreement by which an employee is entitled to compensation.⁷

B. A safe harbor standard is needed regarding the determination of what constitutes a written binding contract.

The Proposed Regulations provide limited guidance as to what constitutes a binding written contract, leaving uncertainty among companies subject to section 162(m). While using an “applicable law” standard provides some guidance, it will prove unworkable in practice.

In this fact pattern, the following questions arise when considering which state law should be considered when determining whether the arrangements constitute a written binding contract for purposes of section 162(m), as amended by the Act:

• Would the choice of law provision automatically control?

• Should the company's state of incorporation law be determinative?

• Should the state in which the employee performs the services govern?

• Does the company need to review pertinent case law in each possible jurisdiction to determine if one would override a choice of law provision?

• Which law should govern if there is no choice of law recited in a contract?

To reduce this uncertainty, we recommend utilizing the GAAP safe harbor discussed in the Proposed Regulations for determining whether an arrangement qualifies as a written binding contract.⁸ Under the GAAP safe harbor, any arrangement in effect on or before November 2, 2017, would be treated as a written binding contract if an amount related to the compensation payable under the contract was accrued (or could have been accrued) as a cost under GAAP.⁹

As an alternative safe harbor to the GAAP safe harbor, arrangements with the following characteristics should be considered binding written contracts if in effect on or before November 2, 2017:

These three factors address the core aspects of compensation arrangements that should be considered written binding contracts for purposes of section 162(m). This standard is flexible enough to accommodate many different styles of compiling and disseminating the terms of compensation programs, and relies on the “reasonable expectation of payment” requirement to ensure that only truly compensatory arrangements meet the standard.

In this instance there is a written binding contract pursuant to the safe harbor that is grandfathered because the arrangement was put in writing, communicated to its participants, and the participants in the arrangement had a reasonable expectation that they are eligible to receive compensation pursuant to the arrangement.

C. Treasury and the IRS should provide guidance that equity awards promised pursuant to written binding contracts that are conditioned upon Board/Compensation Committee approval qualify for transition relief.

In the Notice, a comparison of Examples 7 and 8 of Section III.B indicates that equity grants pursuant to written binding contracts, that are not subject to Board/Compensation Committee approval, can qualify for transition relief, but any such grants that are subject to Board/Compensation Committee approval cannot qualify for such relief.¹⁰ These examples were removed from the Proposed Regulations, creating uncertainty as to whether written binding contracts, subject only to Board/Compensation Committee approval, can qualify as written binding contracts under section 162(m).

In general, new hires are not made coincident with a Board or Compensation Committee meeting, and the authority to grant equity awards under most equity plan documents is reserved for the Board or Compensation Committee. Therefore, many employment agreements/offer letters reflect the reality that promised equity awards will be made at the upcoming Board/Compensation Committee meeting, as required under the terms of the equity plan document. These promises of future equity awards are regarded as binding promises and the individual hired has a reasonable expectation of receiving the promised award.¹¹ Therefore, provided that an employment agreement/offer letter is in effect on or before November 2, 2017, and the employee had a reasonable expectation of receiving the promised award, the ministerial act of final Board/Compensation Committee approval should not remove such awards from being part of a written binding contract in effect on or before November 2, 2017.

D. Treasury and the IRS should provide guidance that “negative discretion” renewal provisions will not prevent a contract from being a “written binding contract” that is eligible for transition relief.

The Proposed Regulations provide that if a written binding contract is renewed after November 2, 2017, amended section 162(m) applies to any payments made after the renewal.¹² The Proposed Regulations further provide that a written binding contract that is terminable or cancelable by a corporation without an employee's consent after November 2, 2017, is treated as renewed as of the earliest date that any such termination or cancellation, if made, would be effective.¹³ However, if the corporation will remain legally obligated by the terms of a contract beyond a certain date, at the sole discretion of the employee, the contract will not be treated as renewed as of that date if the employee exercises the discretion to keep the corporation bound to the contract.¹⁴ While we agree and appreciate that a contract only renewable or terminable by an employee will not be considered a renewed contract as of the date of such renewal, this distinction is arbitrary and should be applied both ways, i.e., a contract renewable or terminable only by a corporation should not be treated as renewed or terminated as of such date unless the contract is actually cancelled or the terms are materially modified upon renewal.

The Proposed Regulations state “the failure, in whole or in part, to exercise negative discretion under a contract does not result in the material modification of that contract.”¹⁵ By that logic, a corporation's unilateral right to decide to renew or terminate a contract amounts to nothing more than negative discretion, and the failure to exercise such discretion should not result in a material modification or renewed contract, unless the terms of such contract are materially modified (e.g., increased benefits). We request that Treasury and the IRS apply this provision uniformly and clarify that a corporation's unilateral right to renew or terminate a contract does not remove such contract from grandfathering relief unless the terms are materially modified. Alternatively, we request that Treasury and the IRS provide a transition period so that corporations can alter their contracts with covered employees to avoid the application of this provision.

E. Treasury and the IRS should provide specific guidance that a material modification, prior to payment of a grandfathered amount, only affects the increased compensation.

The Proposed Regulations provide that if a contract is materially modified after November 2, 2017, but before the payment of a grandfathered amount of compensation, then the compensation is treated as paid pursuant to a new contract and is no longer grandfathered.¹⁶ We believe that Treasury and the IRS should make clear that only the increased amount of compensation in the modified contract is not grandfathered.

Amounts are grandfathered under a binding written contract in effect on or before November 2, 2017, to the extent that the corporation is obligated under applicable law to pay the remuneration under such contract if the employee performs services or satisfies applicable vesting conditions.

F. Treasury and the IRS should provide guidance that modifications to a contract in effect on November 2, 2017, that are required by changes in applicable law or due to accounting standards after November 2, 2017, do not constitute material modifications.

Treasury and the IRS should specify that changes to grandfathered arrangements that are required by changes in applicable law or due to changes in accounting standards do not constitute material modifications. Matters of executive compensation have become increasingly subject to Congressional lawmaking and regulatory oversight. As new laws are passed and new or modified regulations are promulgated, it stands to reason that compensation arrangements may require modifications to ensure compliance. Likewise, accounting standards are likely to evolve over time and companies may be required to adjust executive compensation programs to reflect new standards.

For example, it is not a material modification to comply with a domestic relations order, or to amend a plan to require compliance with a domestic relations order, with respect to payments to an individual other than the service provider.¹⁷ Treasury and the IRS should make similar provisions in the Final Regulations, i.e., that court orders, changes in law, and other areas where a company must comply, will not result in material modifications.

Treasury and the IRS should recognize that the legal and regulatory landscape concerning executive compensation will continue to develop over time and that, unless legislation is purposefully promulgated to remove such compensation programs from grandfathering, that changes to compensation programs as a result of changes in law or accounting standards will not cause such grandfathered arrangements to lose their grandfathered status.

IV. Investment Options: Treasury and IRS should clarify and expand upon the guidance regarding predetermined actual investments (whether or not actually invested) of nonqualified deferred compensation.

The Proposed Regulations provide that earnings on compensation paid under a contract in effect on November 2, 2017 will not cause the contract to be materially modified if those earnings are based on a reasonable rate of interest or the rate of return on a predetermined actual investment (whether or not assets associated with the amount originally owed are actually invested therein).¹⁸ The Proposed Regulations clarify that while the earnings will not result in a material modification, that does not mean that such earnings are grandfathered.¹⁹

Many nonqualified defined contribution deferred compensation plans provide plan participants the opportunity to hypothetically invest their deferred amounts based on a menu of investment options. Typically, these plans mirror a company's tax-qualified defined contribution plan investment line-up, though not always so. Likewise, plan sponsors often update the menu of potential investment options over time to replace underperforming funds with better investment options.

The examples provided in the Proposed Regulations suggest that choices between multiple investments are permitted and will not result in a material modification. We recommend that Final Regulations make clear that companies are able to provide a range of (hypothetical or actual) investment options, and also be permitted to modify such investment options, and that such options or modifications thereto will not result in material modifications.

We note that Treasury and the IRS appear to have recently contemplated changes to investment measures under account balance plans and determined that “it is not a material modification to change a notional investment measure to, or add to an existing investment, an investment measure that qualifies as a predetermined actual investment within the meaning of section 31.3121(v)(2)-1(d)(2) of this chapter or, for any given taxable year, reflects a reasonable rate of interest (determined in accordance with section 31.3121(v)(2)-1(d)(2)(i)(C) of this chapter).²⁰

V. Severance and Benefits Formulas: Treasury and the IRS should provide guidance that severance and accruing benefits qualify for transition relief so long as the applicable formula is not modified.

A. Treasury and the IRS should provide guidance that unless a formula-based severance package is modified, all amounts paid as severance will be grandfathered.

The Proposed Regulations provide that severance payable under a written binding contract in effect on November 2, 2017 is grandfathered only if the amount of severance is based on compensation elements the employer is obligated to pay under the contract.²¹ For example, if the amount of severance is based on final base salary, the severance is grandfathered only if the corporation is obligated to pay both the base salary and the severance under applicable law pursuant to a written binding contract in effect on November 2, 2017.²²

Treasury and the IRS should clarify that this does not mean that severance is only grandfathered to the extent of locked in compensation amounts from 2017. So long as the severance formula is not changed after November 2, 2017, all amounts paid as severance should qualify for transition relief and be grandfathered. While the amount of severance payable to a covered employee may increase over time based on increases in the covered employee's base salary, bonus or other wages (as applicable per the severance formula), such increases are akin to earnings determined according to a predetermined formula.

B. Treasury and the IRS should provide guidance that benefits and earnings accruing on nonqualified defined benefit plans may qualify for transition relief as long as the formula is not materially modified.

The Proposed Regulations provide that benefits and earnings accruing under a nonaccount balance plan after November 2, 2017, are not automatically grandfathered.²³ The amount of compensation that is grandfathered under a nonaccount balance plan is the amount that the corporation is obligated to pay under applicable law on November 2, 2017.²⁴

Treasury and the IRS should clarify that the benefits payable to a participant in a nonqualified defined benefit program (“NQDB program”) that was in effect on November 2, 2017 (and not materially modified thereafter) should be grandfathered if the benefits formula is not modified.

NQDB programs generally provide benefits based on a specified formula (often a derivation of final average compensation, years of service and other adjustment factors). Unlike their defined contribution brethren, NQDB programs do not specify a particular rate of earnings. Instead a participant's benefit increases or decreases based on the predetermined formula.

Therefore, Treasury and the IRS should provide guidance to company's sponsoring these arrangements that benefits payable thereunder may qualify for grandfathering for those individuals who were NQDB participants. Consistent with the Proposed Regulations' guidance, benefits payable under these circumstances should be viewed as paid pursuant to a written binding contract (the plan document and/or participation agreement) and the benefit calculation formula should be viewed as analogous to a “predetermined actual investment.”

VI. Negative Discretion and Clawbacks: Treasury and the IRS should provide guidance that the reduction of an amount payable under a contract in effect on November 2, 2017 by operation of company policies outside the contract, does not constitute a material modification (e.g., malus/detrimental conduct/clawback).

As corporate governance standards have continued to evolve following the financial crisis and Great Recession of 2008, many companies have implemented policies that provide employers with negative discretion to reduce or clawback compensation otherwise payable due to an employee's malus or detrimental conduct. While these policies take many shapes and forms, at their core, they generally operate as an overlay on top of a company's executive compensation program and are designed to prevent unjust enrichment should an employer learn that an employee has engaged in inappropriate behavior.

The development and implementation of policies providing for negative discretion is generally regarded as a modern best practice when evaluating executive pay programs. Treasury and the IRS should recognize the value in these programs and provide guidance that affirms the utilization of such a policy or arrangement to reduce or eliminate pay that otherwise could have qualified as grandfathered under the section 162(m), as amended by the Act, should not render such pay as materially modified. Likewise, Treasury and the IRS should specify that the existence of policies providing for negative discretion also does not jeopardize grandfathered status.

With respect to discretion to recover compensation, the Proposed Regulations provide that a corporation is not treated as currently having discretion merely because it will have discretion to recover an amount if a condition occurs subsequent to the vesting and payment of the compensation and the occurrence of the condition is objectively outside of the corporation's control.²⁵ For example, pursuant to a written binding contract in effect on November 2, 2017, a corporation may be obligated under applicable law to pay $500,000 of compensation if the employee satisfies a vesting condition, but the corporation may be permitted to recover $300,000 from the employee if the employee is convicted of a felony within three calendar years from the date of payment. If the employee is not convicted of a felony within three calendar years from the date of payment, then the $500,000 is grandfathered.²⁶ If, however, the employee is convicted of a felony within three years after the payment of the $500,000, then the corporation has discretion whether to recover the $300,000 from the employee. Accordingly, if the employee is convicted of a felony within three calendar years after the payment, $300,000 of the $500,000 is not grandfathered.²⁷ This is true regardless of whether the corporation exercises its discretion to recover the $300,000.²⁸ Because the corporation may not recover $200,000 of the $500,000 payment in any event, the $200,000 remains grandfathered regardless of whether the employee is convicted of a felony.²⁹

This clawback guidance is unworkable. Consider the application of this proposed clawback guidance in practice — who is to say if the actual behavior has occurred? Surely some items are clear such as the conviction of a felony or absence thereof, but what if there is a dispute? What if the behavior is not discovered until later tax years or when the employee no longer works for the firm — how would the employer realistically even know it occurred?

To avoid these problems, we recommend that Treasury and the IRS provide guidance that the reduction of an amount payable under a contract in effect prior to November 2, 2017, by operation of negative discretion or corporate best practices outside the contract (e.g., malus, detrimental conduct, clawback), not constitute a material modification, or prevent the grandfathering of amounts that may be subject to negative discretion. In applying this proposed recommendation to the example above, the mere existence of negative discretion should not prevent grandfathering of the full $500,000 (less any portions not actually paid or recovered).

VII. Transitional Rules:

A. Treasury and the IRS should provide for a transition period for actions taken from November 2, 2017 to the issuance of Final Regulations.

Section 13601 of the Act became effective for all taxable years beginning after December 31, 2017, but the amendments made do not apply to remuneration provided pursuant to a written binding contract which was in effect on November 2, 2017 and which was not modified in any material respect on or after such date.³⁰ The Notice, which was released on August 21, 2018, was the first guidance available regarding what actions may constitute a material modification of a written binding contract. Thus, there was an approximate 10-month period in which companies subject to section 162(m) were left with no guidance as to actions that they could take with respect to their compensation programs to avoid losing grandfathered status. While the Proposed Regulations provide that the definition of “material modification” will apply to taxable years ending on or after September 10, 2018, (which would allow time to revise contracts based on the Notice), the Notice did not provide sufficient guidance for actions companies could take to avoid losing grandfathered status.

The 10-month period after the release of the Notice, however, was a critical time for many companies as many fiscal years correspond to the calendar year and Compensation Committees frequently meet early in the year to determine incentive compensation payments under short-term and long-term programs.³¹ Thus, Compensation Committees were forced to make determinations regarding payments under these programs without having the benefit of guidance as to what actions may be permissible without jeopardizing grandfathering of their arrangements.

Therefore, we recommend that Treasury and the IRS provide a transition period beginning November 2, 2017 and continuing through the date of the issuance of Final Regulations to offer companies relief from a potential loss of grandfathering that might occur due to actions taken before additional guidance was available.

Moreover, providing transition relief would also avoid companies having to potentially restate tax returns and/or publicly-reported financials due to good faith actions taken prior to Treasury's and IRS's release of the Final Regulations.

B. The Section 409A regulations should permit a transition period so that existing contracts can be modified to permit a one-time payment election with respect to amounts deferred until not subject to section 162(m).

Treasury and the IRS recognize that Act's amendments to the definition of covered employee fundamentally alter the premise of certain section 409A regulations, and comments were received asking whether a service recipient may delay the scheduled payment of grandfathered amounts in accordance with section 409A regulations, without delaying the payment of non-grandfathered amounts, in circumstances in which the service recipient has the discretion to delay the payment.³² In response, the Proposed Regulations provide that in circumstances in which the service recipient has discretion to delay the payment, a service recipient may delay the scheduled payment of grandfathered amounts in accordance with §§1.409A-1(b)(4)(ii) and 1.409A-2(b)(7)(i), without delaying the payment of non-grandfathered amounts, and the delay of the grandfathered amounts will not be treated as a subsequent deferral election.³³ The Proposed Regulations further provide that if an NQDC arrangement is amended to remove the provision requiring the corporation to delay a payment if the corporation reasonably anticipates at the time of the scheduled payment that the deduction would not be permitted under 162(m), then the amendment will not result in an impermissible acceleration of payment under §1.409A-3(j), and will not be considered a material modification for purposes of the grandfather rule under 162(m).³⁴ The plan amendment must be made no later than December 31, 2020. If pursuant to the amended plan, the corporation would have been required to make a payment prior to December 31, 2020, then the payment must be made no later than December 31, 2020.³⁵

We commend Treasury and the IRS for the recognition of these issues and proposed solutions, and also request that if the rule remains that “once a covered employee, always a covered employee,” that the section 409A regulations be revised to permit a transition period in which existing contracts can be modified to permit a one-time payment election with respect to deferred amounts. To avoid uncertainty, we recommend this one-time payment election period be provided for the year following the year in which final section 162(m) regulations are promulgated so companies and executives will have full information available regarding the application of section 162(m) when amending arrangements covered by section 409A.

VIII. Foreign Private Issuers: Treasury and IRS should provide a safe harbor for FPIs that are not required to disclose compensation of their officers on an individual basis in their home countries.

The Proposed Regulations specifically requested comments on whether a safe harbor for the determination of the three highest compensated executive officers was appropriate for FPIs that are not required to disclose compensation of their officers on an individual basis in their home countries.³⁶ We recommend that Treasury and the IRS provide a safe harbor or exempt such FPIs from this requirement altogether.

IX. Conclusion

As noted at the outset of our letter, we greatly appreciate Treasury and the IRS issuing the Proposed Regulations. We hope that the suggestions outlined above are helpful when considering Final Regulations.

We welcome the opportunity to further discuss the concerns and recommendations set forth in this letter and hope that we can be a resource to Treasury and the IRS as you review and consider all of the comments. If you have any questions, please do not hesitate to contact Taylor W. French at (704) 373-8037 or Rosemary Becchi at (202) 359-4270.

Sincerely,

Taylor W. French
Partner, McGuireWoods

Rosemary Becchi
Of Counsel, Brownstein Hyatt Farber Schreck

cc:
David Kautter
Assistant Secretary
Office of Tax Policy, Department of Treasury

William M. Paul
Acting Chief Counsel
Office of Chief Counsel, Internal Revenue Service

Ilya Enkishev
Associate Chief Counsel's Office
Tax Exempt and Government Entities
Office of Chief Counsel, Internal Revenue Service