Precedent Shown for Using Technical Corrections to Make Significant Changes to Final Regs

Dear Jessica and Alexa:

I'm writing first to convey my sincere thanks to both of you both for spending time with me and other A4A members on November 27, and for your thoughtful comments about our suggestions.

One point we discussed in our meeting was whether a clarification of the type we are proposing could appropriately be added as a "technical correction" to the final regulations, particularly in light of the fact that most technical corrections simply correct mistakes in spelling or punctuation, or change words from plural to singular. I'd said that I've seen numerous examples of substantive corrections which definitely go beyond mere corrections of typographical errors, and instead make significant changes, either to modify specific instructions in the final regulations, or to add rules which may have been overlooked by the original drafters. All these changes are made under the guise of "technical corrections," and are submitted to the Federal Register with introductory language explaining that "the final regulations contain errors that may prove to be misleading and are in need of clarification." Some of these changes have been adopted with effective dates as of the dates that the "corrections" were published (giving further indication that Treasury understood that the changes were substantive in nature).

In follow-up to my comments at our meeting, I've listed below examples of substantive changes to three separate sets of final regulations, all affecting my particular practice area. I'm sure if I'd broadened my search to cover more areas than compensation and benefits, I could produce more examples.

A. Section 162(m) Final Regulations: Two Corrections Narrowing Rules of Final Regulations.

1. Change to Include Costs of Taxable Life Insurance and Disability Insurance. The final regulations published on December 20, 1995 had excluded from the types of "compensation" subject to the deduction limitation rules of Code section 162(m) any "[r]emuneration covered in section 3121(a)(1) through section 3121(a)(5)(D)" (all provisions describing amounts that are not treated as compensation for purposes of FICA taxes).¹ Treasury reconsidered this exclusion, and corrected it on February 6, 1996 to refer only to "[r]emuneration covered in section 3121(a)(5)(A) through section 3121(a)(5)(D). . . ."² This change eliminated any exclusion from Code section 162(m) for the costs of both taxable life insurance and taxable disability insurance.

2. Change to Require Shareholder Approval of Maximum Dollar Amount of Performance Compensation in More Situations. The final regulations under Code section 162(m) had not required shareholders to approve the maximum dollar amount of compensation payable under any particular performance plan, so long as: (a) the formula used to calculate the performance compensation was disclosed to and approved by shareholders, and (b) if the performance formula was linked to salary or base pay, each time the compensation committee meets to approve such a performance formula, the dollar amount of salary or base pay is fixed as of the time the performance formula and underlying performance targets are established.³ Treasury reconsidered this shareholder approval requirement, and corrected it on February 6, 1996 to require shareholders to approve the maximum dollar amount of compensation to be paid to company executives in any cases where the performance formula is "based, in whole or in part, on a percentage of salary or base pay."⁴ Thus, shareholders of public companies subject to Code section 162(m) would have to approve a maximum compensation limit payable to any executive as a performance award, if the performance formula is tied to salary and/or base pay, even if the plan requires the compensation committee always to tie any performance award to salary and/or base pay amounts that are in place as of the start of each performance period.

B. Incentive Stock Option Final Regulations: Three Substantive Corrections.

1. Addition of Guidance on Capital Gains Holding Period. The final regulations on incentive stock options ("ISOs") published on August 3, 2004 provided guidance on the ordinary income tax treatment of any disqualifying disposition ("DD") of ISO stock, and also had indicated that the time period used for purposes of determining whether a DD had occurred would start on the date of exercise. However, the final regulations had failed to provide any guidance as to when the capital gains holding period would start in the event of any disposition of stock.⁵ In response to questions from taxpayers uncertain about the capital gains treatment of the DD income (assuming that the ISO-holder had waited long enough to sell the stock), the Treasury issued clarifying regulations on October 18, 2004, which explain that the capital gains holding period would not start until the stock vests (which would make it more likely that an optionee would have short term gains upon the ultimate sale of the stock).⁶

2. Alternative Types of Grants after a Spinoff. The final ISO regulations published on August 3, 2004 indicated that after a corporate spinoff, employees of the spun-off company should receive new options only on the spun-off company's stock.⁷ These regulations were modified by two technical corrections, both helpful to taxpayers, which allowed alternative types of grants to be made after a spinoff, including a grant split between the old and new companies' stocks, so long as the same spread ratio was maintained.⁸

3. Change to Shareholder Approval Requirements. The final ISO regulations published on August 3, 2004 contained specific instructions about re-approval of ISO plans after corporate acquisitions, which indicated that in the case of any corporate acquisition, even if the ISOs were modified to be options on the acquiring company's stock, the options considered to be ISOs, so long as the shareholders of the target company had approved the plan within 12 months before the acquisition.⁹ This rule was modified by a technical correction published October 16, 2004, indicating that in the case of such a modification of the options, the shareholders of the acquiring company may approve the ISO either as part of the acquisition, or within 12 months after the acquisition, in order for options granted after the acquisition to qualify as ISOs.¹⁰

C. Section 409A Final Regulations; Numerous Substantive Corrections.

1. Exemption for Deferred Compensation Addressed in Non-Treaty Agreements. The final regulations governing nonqualified deferred compensation agreements published on April 17, 2004 had exempted payments under certain foreign plans whose tax treatment was governed by any "bilateral income tax convention."¹¹ That exemption was expanded to cover foreign plans whose tax treatment was governed by any "other bilateral or multilateral agreement."¹²

2. Change in General Definition of Deferred Compensation. In response to questions from taxpayers confused about the amended definition of deferred compensation contained in the final section 409A regulations, Treasury amended the exemption applicable to short-term deferral plans, without notice and comment (although the change was made effective as of the date of the correction, instead of being retroactively applicable to the date the final regulations were published).¹³

D. Conclusion.

I believe that all these changes outlined above were significant in nature, and (to the best of my knowledge) responded to comments and suggestions made by taxpayers after the final regulations were published. In each instance, by describing the changes as "technical corrections," the Treasury Department was able to make these helpful changes very quickly, without the need for opening "guidance projects," and also succeeding in making the necessary changes to the regulations themselves, instead of in notices, revenue rulings, or announcements.

I would hope that, following this historic practice, you would be able to make the changes to the final regulations which we discussed in our recent meeting by technical corrections.

Please don't hesitate to call me if you have any further questions. We very much appreciate your help.

²See Treas. Reg. § 1.162-27(c)(3)(ii)(A), as published at 60 Fed. Reg. 4349, 4350 (February 6, 1996).

³See Treas. Reg. § 1.162-27(c)(3)(ii)(A), as published at 60 Fed. Reg. 65534, 65543 (December 20, 1995).

⁴See Treas. Reg. § 1.162-27(c)(3)(ii)(A), as published at 60 Fed. Reg. 4349, 4350 (February 6, 1996).

⁵See Treas. Reg. § 1.422-1(b)(3), Example (2), at 69 Fed. Reg. 46401, 46412 (August 3, 2004).

⁶See Treas. Reg. § 1.422-1(b)(3), Example (2), as corrected at 69 Fed. Reg. 61309, 61310 (October 18, 2004). See also the discussion of this correction at 102 J. Taxation at 91 and 104 (February 2005).

⁷See Treas. Reg. § 1.424-1(a)(10), Example (8), at 69 Fed. Reg. 46401, 46423 (August 3, 2004).

⁸See Treas. Reg. § 1.424-1(a)(10), Example (8), as corrected at 69 Fed. Reg. 61309, 61310 (October 18, 2004) and at 69 Fed. Reg. (December 7, 2004). See also the discussion of this correction contained in an article that I wrote for the Journal of Taxation, at 102 J. Taxation at 109 (February 2005).

⁹See Treas. Reg. § 1.424-1(a)(10, Example (9), paragraph (iii), at 69 Fed. Reg. 46401, 46423 (August 3, 2004).

¹⁰See Treas. Reg. § 1.422-1(b)(3), Example (2), as corrected at 69 Fed. Reg. 61309, 61310 (October 18, 2004). See also the discussion of this correction at 102 J. Taxation at 96 (February 2005).

¹¹See Treas. Reg. § 1.409A-1(a)(3)(i), at 72 Fed. Reg. 19234, 19278 (April 17, 2007).

¹²See Treas. Reg. § 1.409A-1(a)(3)(i), as corrected at 72 Fed. Reg. 41620 (July 31, 2007).

¹³See Treas. Reg. § 1.409A-1(b)(4)(i) and (D), as corrected at 72 Fed. Reg. 41620 (July 31, 2007).