Last week, the IRS issued Notice 2018-68 containing initial guidance on the amendments to section 162(m) made by the Tax Cuts and Jobs Act (“TCJA”), including the transitional relief for written binding contracts. On balance, the guidance is not particularly favorable to taxpayers, as it takes a narrow view of the grandfathering relief for arrangements in effect under prior law, particularly for arrangements with negative discretion, and a broad view of the new group of section 162(m) covered employees.
As a reminder, the TCJA made the following changes to section 162(m), as outlined in our December 20, 2017, client alert “US Tax Reform: Tax Cuts and Jobs Act Expected to Come Into Effect in 2018”:
- The CEO, CFO, and top three other highest paid executive officers at any time in a year are now treated as covered employees subject to section 162(m) deduction disallowance, and the section 162(m) covered employee designation extends to all future years, including years following termination of employment.
- There is no longer an exception from section 162(m) for performance-based and commission compensation.
- The section 162(m) deduction disallowance has been expanded to all companies that file SEC reports, including companies issuing public debt or equity, non-U.S. issuers publicly traded through ADRs, and certain large private C and S corporations.
The expanded section 162(m) provisions are generally applicable for taxable years beginning after December 31, 2017. Importantly, however, the expanded provisions do not apply to remuneration provided pursuant to a written binding contract in effect on November 2, 2017 which is not modified in any material respect after that date.
Notice 2018-68 provides limited guidance on the substantive changes made to section 162(m), as well as the written binding contract transition rule. It states that the IRS anticipates the guidance in the Notice will be incorporated into regulations, which will apply to any tax year ending on or after September 10, 2018.
New Section 162(m) Covered Employee Rules. Notice 2018-68 provides as follows with regard to the new definition of covered employee:
- As the starting point for the covered employee list going into the new regime (i.e., the first group of “permanently covered employees”), a company uses its calendar year 2017 list under the rules that were in effect prior to the TCJA changes (the “Pre-TCJA Section 162(m)”) (e.g., CFO is not included) or, for fiscal year companies, the Pre-TCJA Section 162(m) rules list for the fiscal year that begins in 2017.
- The term “covered employee” now includes individuals who serve as the CEO or CFO at any time during a year, which is now consistent with SEC executive compensation disclosure rules applicable to companies other than emerging growth companies or smaller reporting companies. If in a single year, a company has a former, interim, and/or current CEO or CFO, each of those individuals will be treated as a covered employee (as well as disclosed in the proxy statement).
- The term “covered employee” also includes the top three highest compensated officers (i.e., in addition to the CEO and CFO), whether or not they were officers at the end of the year, which results in a potential variation with the SEC’s rules. If the company reports in its proxy the three highest compensated officers in place as of year end, plus another former employee who would have been reportable had he or she been at that role at the company as of year end, the covered employees will be the top three of those four listed individuals.
- A person can be a covered employee under the new rules even if that person’s compensation is not required to be disclosed because, for example, the company has delisted for the stub year ending with its merger into or acquisition by another entity or if the company is an emerging growth company or smaller reporting company.
Written Binding Contract Transition Rule/Grandfathering Relief.
The Notice contains a number of examples to illustrate the application of the transition rule. The following are some of the main points regarding the application of the transition rule:
- The transition rule applies to all of the TCJA changes to section 162(m), including the changes to the definition of “covered employee,” and basically preserves the Pre-TCJA Section 162(m) rules. Accordingly, if the transition rule applies, then remuneration paid to the CFO, including salary and other items of non-performance-based compensation, may be excluded from the deduction disallowance because the CFO is not a covered employee under Pre-TCJA Section 162(m).
- Remuneration is considered to be payable under a written binding contract that was in effect on November 2, 2017, only to the extent that the company is obligated under applicable law (e.g., state contract or employment law) to pay the remuneration if the employee performs services or satisfies the vesting conditions. Although the Notice clarifies that state contract law (or other applicable law such as employment law) is generally controlling, it does not provide guidance regarding what state law to apply. Presumably, if the contract does not have a governing law clause, the law of the state in which the contract was formed, which generally would be the law of the state where the employee resides, would apply. Moreover, some courts may ignore choice of law provisions and apply the law of the state in which the employee resides.
- The amount of remuneration that is grandfathered is only the amount that the company is obligated to pay under applicable law and the terms of the written binding contract. If the compensation committee has reserved the right to reduce the compensation (so-called “negative discretion”), or if the contract expressly provides that the company may reduce or stop certain accruals (e.g., the Notice has several examples where the company can stop or reduce future earnings credits under an account balance plan), then the employee may not have a binding right to all (or any) of the remuneration because under applicable state law the company may not be obligated to pay those amounts. Accordingly, the transition rule would not apply and those amounts, when paid, may be subject to deduction disallowance.
- If a written binding contract is renewed after November 2, 2017, then the transition rule ceases to be available as of the date of renewal, and amounts paid after the date of renewal will be subject to the new section 162(m) rules and may no longer be deductible. The Notice provides guidance on when a contract is renewed. If the written binding contract is terminable or cancelable by the company without the employee’s consent after November 2, 2017, it is treated as renewed as of the earliest date that any cancellation or termination, if made, would be effective. However, if the company will remain legally obligated by the terms of the contract beyond a certain date at the sole discretion of the employee, the contract is not treated as renewed as of that date if the employee exercises the discretion to keep the company bound to the contract. A contract is not treated as terminable or cancelable if it can be terminated or canceled only by terminating the employment relationship of the employee.
- If a written compensation plan or arrangement is binding, the amount that is required to be paid as of November 2, 2017, to an employee pursuant to the plan or arrangement will not be subject to deduction disallowance even though the employee was not eligible to participate in the plan or arrangement as of November 2, 2017 so long as either (i) the employee was employed on November 2, 2017 by the company that maintained the plan or arrangement or (ii) the employee had a right to participate in the plan or arrangement under a written binding contract as of that date.
- The transition rule is not available for compensation paid under a contract that is materially modified after November 2, 2017. The Notice clarifies that failure to exercise a negative discretion provision is not a material modification; however, as noted above, the mere existence of a negative discretion provision may lead to the conclusion that the company has no binding obligation under state contract law to pay any amount under the written contract.
- A material modification occurs when the contract is amended to increase the amount of compensation payable to the employee. Acceleration is not a material modification if the payment amount reasonably reflects the time value of money. Similarly, deferral is not a material modification if any additional amount in excess of the amount originally payable is based on either a reasonable rate of interest or a predetermined actual investment (without regard to whether the assets are actually invested in such investment). The adoption of a supplemental contract or agreement that provides for increased compensation, or the payment of additional compensation, is a material modification if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the written binding contract, unless the supplemental payment does not exceed a reasonable cost-of-living increase over the payment made in the preceding year under that written binding contract.
- To the extent that issues remain unresolved regarding the meaning of “written binding contract” and “material modification,” taxpayers are directed to the guidance under Pre-TCJA Section 162(m) regarding the transition rule that was available when section 162(m) was first added to the Code.
Request for Comments.
The Notice specifically requests comments, by November 9, 2018, on the following topics, for the purpose of providing additional IRS and Treasury Department guidance:
- The application of the definition of “publicly held corporation” to foreign private issuers;
- The application of the definition of “covered employee” to an employee who was a covered employee of a predecessor of the publicly held corporation;
- The application of new section 162(m) to corporations immediately after they become publicly held either through an initial public offering or a similar business transaction;
- The application of the SEC executive compensation disclosure rules for determining the three most highly compensated executive officers for a taxable year that does not end on the same date as the last completed fiscal year; and
- Other issues that should be addressed in the proposed regulations.
Taxpayers are always welcome to comment on any additional issues under section 162(m), including, for example, concerns raised by Notice 2018-68. It is important for companies to consider commenting to the extent that the above topics are important to them, and we are ready to assist clients wishing to do so. However, the narrow interpretation of the transition/grandfathering rule means that many companies will prioritize revisiting the deductibility of Pre-TCJA Section 162(m) compensation arrangements and determining whether any adjustments are required to their deferred tax asset reporting in their financial statements.