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What Every Corporate Director Should Know About the New Tax Law-Part 1

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George M. Gerachis and David C. Cole

The Tax Cuts and Jobs Act of 2017 (“Tax Act”) has sweeping ramifications. These range from mechanical compliance issues (e.g., revised withholding rates for employees) to strategic concerns that must ultimately be decided in the boardroom. For domestic corporations and foreign corporations with U.S. operations, one strategic imperative is a wholesale re-evaluation of the structure of a company’s operations. In this first of two articles, we identify four significant aspects of the Tax Act with which corporate directors should become familiar.

1. Mandatory “Transition Tax” on Deemed Repatriations of Deferred Foreign Earnings. Many corporations have deferred foreign earnings under Accounting Principles Board Opinion No. 23, recording no associated financial statement U.S. income tax liability based on the position that such earnings are indefinitely reinvested in foreign operations. The Tax Act terminates the deferral and imposes a tax liability on deferred earnings regardless of whether they are actually repatriated. The Transition Tax on this “deemed repatriation” is 15.5 percent on the portion of the earnings represented by cash and cash equivalents and 8 percent on the portion invested in non-cash assets. Although most of the provisions of the Tax Act take effect in 2018, the Transition Tax is due on a corporation’s 2017 tax return and will likely cause a charge to 2017 earnings. There is an election to pay the tax in installments over an eight-year period.

What Directors Should Do. Computing the Transition Tax can be extremely complex and requires data the corporation may not have collected in the ordinary course of its business. This is particularly the case where the corporation has acquired companies that earned foreign profits after 1986. The U.S. Securities and Exchange Commission (SEC) has issued guidance, including Staff Accounting Bulletin 118, to assist corporations in applying generally accepted accounting principles (GAAP) to reflect the impact of the Tax Act where necessary information is not yet available. Directors, and in particular audit committee members, should ensure that the corporation devotes adequate resources to preparing a reasonably accurate computation of the Transition Tax in time to make their disclosures for the fiscal quarter or year ended December 31, 2017. Given the many open issues regarding the Transition Tax that may not be clarified by the filing date of the corporation’s tax return, corporations should enlist expert assistance to interpret the law and refine the company’s computation of the Transition Tax.

The deemed repatriation affords many corporations greater flexibility to utilize previously “trapped” cash (i.e., cash that was held by non-U.S. entities that could not be repatriated without being subject to U.S. tax). This cash might be used to fund acquisitions, capital expenditures, debt repayments, stock buybacks or dividends. Directors should ask management to focus on the corporation’s optimal capital allocation and to report to the board concerning available options.

2. Reduction in Corporate Tax Rate from 35 Percent to 21 Percent. The default rate on corporate taxable income drops from 35 to 21 percent, although there are special lower rates for certain types of foreign earnings discussed below. This 40-percent reduction in the corporate tax rate will affect the value of a corporation’s deferred tax assets and liabilities. For example, all things being equal the value of a net operating loss carry-forward may drop by 40 percent. At the same time, however, the lower tax rate may increase after-tax earnings going forward for many corporations. There are many less obvious implications of the rate reduction, particularly in conjunction with other changes in the Tax Act.

What Directors Should Do. Directors should commission a study by the corporation’s tax department of potential changes in the corporation’s legal entity and operational structures to take full advantage of the rate reductions in combination with other relevant provisions of the Tax Act. Such a study will also be useful in completing the corporation’s tax accounting analysis of the impact of the Tax Act under GAAP and related disclosures in the corporation’s SEC filings.

3. Reform of Taxation of International Operations. The Tax Act radically changes the taxation of profits earned outside the United States.

  • First, it eliminates the deferral of U.S. tax on foreign earnings. Thus, U.S. income tax now will be imposed on most current earnings of foreign subsidiaries rather than being postponed until earnings are repatriated.
  • Second, as a limited exception, foreign profits amounting to a 10 percent return on certain investments in tangible assets are permanently exempt from U.S. tax.
  • Third, profits from intangible assets earned outside the U.S. can be taxed at a special rate of 10.5 percent to the extent those profits result from certain types of revenues. Profits earned by domestic corporations from certain foreign sales of property or services are eligible for a special tax rate of 13.125 percent. Both of these special rates are scheduled to increase after 2025, but to levels well below the general 21 percent corporate rate.

What Directors Should Do. Directors should request a thorough review of the corporation’s international footprint as part of the study described above. This review should consider the optimal location not only of the corporation’s operations, but its personnel, tangible assets and intangible assets. Unlike GAAP consolidation, tax reporting must generally be made on an entity-by-entity basis (although consolidation of affiliates within a single country is often allowed). As a result, the corporation’s legal entity structure and inter-company contracts must be carefully aligned with its commercial arrangements. Given evolving changes in the tax laws of other member countries in the Organization for Economic Co-operation and Development (OECD), and particularly under the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, structuring operations to accommodate both foreign tax laws and the new U.S. tax regime may be challenging. Finally, in evaluating any structure, directors should consider the prospects for future tax changes in reaction to the Tax Act in jurisdictions where the corporation operates.

4. Changes to Interest and Depreciation Deductions. The Tax Act gives with one proverbial hand—allowing immediate deduction of 100 percent of the acquisition cost for certain depreciable assets—and takes away with the other by limiting deductibility of net interest expense for many corporations. The “immediate expensing” provision applies only to tangible assets like plant and equipment and is phased down beginning in 2023. This new provision is more generous than prior “bonus depreciation” rules because it also applies to used assets, as well as new assets.
The interest expense rule limits certain corporations’ ability to currently deduct net business interest expense amounts exceeding 30 percent of certain thresholds. These thresholds are based on Earnings Before Income and Tax (EBIT) in years through 2021 and—less favorably—on Earnings Before Income, Tax, and Depreciation (EBITDA) after 2021. Disallowed interest deductions generally may be carried forward indefinitely. Interest expense on existing indebtedness is not grandfathered. Regulated public utilities are automatically exempt from these rules. Corporations in a broad spectrum of real property related businesses, farming businesses, and certain other agricultural businesses may elect to have these rules not apply.

What Directors Should Do. Directors should evaluate the impact of these two provisions on their corporation’s capital structure and its investment decisions. They should understand the implications of immediate deductibility of depreciable assets on acquisition structures. For example, acquiring stock may result in a lower internal rate of return than acquiring assets. Regarding the business interest limitations, directors should encourage management to determine whether the corporation is eligible to elect out of these rules and, if not, to explore alternatives to debt repayment, such as preferred equity instruments or other structures, that might mitigate the impact of these limitations.

Visit the NACD Board Leaders’ Blog again for the second installment in this series. 

George M. Gerachis serves as head of Vinson & Elkins’ Tax and Executive Compensation and Benefits department. He represents corporate and individual clients in a wide range of tax planning and tax controversy matters. David C. Cole is a tax partner at Vinson & Elkins and represents corporations, partnerships, and high net worth individuals in a wide range of domestic and international tax matters. Thoughts expressed here are their own. 

Overseeing Executive Pay in a Tumultuous Time

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Executive pay has long been a key focus for shareholders, activists, directors, and the media—and there are no signs of that changing. Increased attention on income inequality, corporate social responsibility, and incentive plans that encourage risky behavior has further increased scrutiny of executive pay, making it a critical oversight area for boards of directors.

Compensation committee members should address the following questions to assist in exercising sufficient oversight:

  1. What is the board’s required level of oversight on executive pay? Emerging best practices are pushing compensation committees to go beyond the technical requirements for approving and disclosing CEO pay set by the U.S. Securities and Exchange Committee and stock exchanges. It is now becoming a best practice also to include a broader view of human resources-related issues, including how a company allocates resources toward compensation and benefits, how incentive plan metrics interact with desired behaviors, and the board’s involvement in proactive succession planning.
  2. How can compensation committees operate with the greatest efficiency? Compensation committee agendas tend to follow a similar pattern from year to year across companies, but certain practices can ensure meetings run more efficiently. For example, following an established cadence of pre-calls in advance of meetings between management and the committee chair, the committee chair and the advisors, and among other committee members can help them run smoothly. Many committees also reference the agenda at the end of each meeting to ensure that all parties’ expectations are aligned. Selecting and working effectively with outside advisors can further enhance efficiency and keep the committee as a whole up to speed on potential pitfalls and implications of pay and governance decisions.
  3. How do compensation committees evaluate incentive plan designs and set performance goals? Incentive compensation is an important lever to encourage behavior and align management with shareholders. Recently, goal setting has received increased scrutiny from shareholders and proxy advisors who have raised concerns about significant payouts to management when performance did not yield a sufficient return for investors. Whether goals are set on an absolute basis or relative to peers, compensation committees often review models that stress-test payouts under various growth and return scenarios to avoid windfalls to executives. In defining acceptable target performance levels, compensation committees may consider multiple perspectives of the company’s expected future performance, such as past performance, peer performance, analyst expectations, internal budgeting and planning, financial modeling, and correlation between the company’s share price and the general market.
  4. What are shareholders really looking for in compensation plans? Institutional investors and proxy advisory firms have views on compensation levels and design that are generally well documented. Committees should consider how compensation design features and pay decisions will be perceived by the company’s major shareholders and the proxy advisory firms. Typically their voting guidelines stem from the principal of pay for performance, but subtle changes to a compensation plan design can make it more acceptable to particular stakeholders. For example, investors have different views on acceptable levels of dilution from stock-based compensation. Knowing those levels may steer a company toward cash-based phantom shares for certain levels of employees to avoid triggering a dilution concern from a major shareholder. In addition, directors should be aware of trends in shareholder proposals, litigation risks, and how and when to engage directly with shareholders on issues related to compensation.
  5. What keeps compensation committee members up at night? Succession planning, risk mitigation, environmental and social goals, gender pay equity, board diversity, director pay, and executive employment agreements are just some of the areas that have bubbled up to the compensation committee agenda recently.  US tax reform is also affecting compensation plans and processes. Most notably, the elimination of the performance-based exception to Internal Revenue Code Section 162(m) means that compensation above $1 million paid to certain executives cannot be deducted by a public company, even if it met the former Internal Revenue Service definition of “performance-based.”  The elimination of the performance-based pay exception gives companies more flexibility in how plans are designed (e.g., goals can be set later in the year and subjective judgement can be used to set and evaluate performance against goals). However, companies may not want to abandon the best practices dictated by the performance-based exception since shareholders and proxy advisors may object.

To help directors with their oversight responsibility, Mercer has partnered with NACD to publish the Director Essentials Guide to Board Oversight of Executive Pay. The goal of the publication is to provide directors with a clear and concise reference guide to basic principles that affect design and governance of executive compensation programs. Mercer and NACD are committed to helping directors stay ahead of the curve and aware of evolving trends. We hope you find the guide a useful reference and welcome your feedback in the comments section below.

Teresa Bayewitz is a principal in Mercer’s rewards consulting practice based out of New York City.

Six Concepts for Oversight of Performance Management

Published by
Jim DeLoach

Jim DeLoach

Performance management relates virtually to everything that is important to a company’s progress—execution of its strategy, the customer experience, investor expectations, executive compensation, and the board’s oversight itself. In spite of the importance of performance to a company’s success, there is very little literature on board oversight of performance management. Given the complexity of the global marketplace, the accelerating pace of disruptive change, and ever-increasing stakeholder expectations, how should the board oversee the performance management process so that it is effective in driving execution of the strategy and in its efforts to incent the desired behaviors across the organization?

In August 2017, Protiviti met with 18 active directors during a dinner roundtable at a National Association of Corporate Directors (NACD) event to discuss this topic. As the ultimate champion for effective corporate governance, the board engages management with an emphasis on four broad themes: strategy, policy, execution, and transparency. With effective performance management touching each of these themes, many organizations use some variation of a balanced scorecard that integrates financial and nonfinancial measures to communicate what’s important, focus and align processes and people with strategic objectives, and monitor progress in executing the strategy.

Our discussions with the directors identified six important concepts to consider when overseeing performance management.

Return on Expectation

Performance management must embrace the appropriate metrics, given the strategy management seeks to implement and the entity’s expected investments. Alignment with strategic priorities is a challenge. As one director noted, most organizations have yet to bridge the gap between efforts to attract and retain employees and efforts to engage and align them.

The directors agreed that managing the balance between short-term and long-term performance presents particular challenges when determining executive compensation. Executives must be rewarded for performance, and long-term shareholder interests must be preserved. The prevailing view was that performance management should be linked to the storyline articulated in investor communications. However, directors should not allow stock price performance to dominate the spotlight so much that it detracts management from focusing on business fundamentals and strategic drivers.

Structure

Performance management must focus on operational excellence in the structure, or business model, in place to execute the strategy. Alignment starts with defining performance expectations, as set forth by the strategy, and communicating those expectations across the organization. Performance measures should be used to track the execution of the strategy at the organizational, process, and employee levels so that accountability for results cascades down into the organization. Tracking for these measures allows for necessary midcourse adjustments to be made on a timely basis to achieve performance targets. Metrics must be linked the reward system in a manner that ensures people are incented in the right way, consistent with the strategy. The impact of incentive compensation on behavior and risk taking should be a board priority.

Culture

With this topic sparking considerable discussion, several directors noted that while most boards assess and understand the tone at the top, they neither assess nor understand the tone in the middle. One director suggested the use of organizational health and effectiveness surveys to gauge how employees perceive the current leadership culture and compare that perception to the culture they desire. Gaps in perception revealed by such surveys almost always provide informative insights into what’s really happening in the business and what people below senior management really think. They also reveal opportunities for leadership development and improving the tone at the top and in the middle. The consensus of the group was that boards should encourage and, if necessary, push management to consider culture-related measures that make sense for the company. As one director noted, “What gets measured matters.”

Customer Experience

The customer base should be segmented, and metrics should focus on the needs of each targeted segment. Customer experience metrics should address the distinctive attributes of the value proposition underlying why customers choose the company’s product or service over other alternatives and provide insight into what a company needs to do once issues are identified. To that end, these metrics should reach beyond nonfinancial areas and address quality, responsiveness, and other critical aspects of the brand promise, both expressed and implied. Less than half of the directors in the roundtable indicated that their top executives reported on one or more customer experience metrics. Several directors noted that when it comes to the customer experience, and even culture across the company, it is incumbent upon board members to “do some homework.” As one director put it, “Try to do your own research and be a ‘secret shopper.’”

Innovation and Resilience
Metrics should inform the organization’s focus on innovation, changes in technology and the business environment, emerging disruption, and market opportunities. The directors at the discussion dedicated a portion of the evening to innovation as a source of new revenue-generating opportunities and a driver of a positive, thriving culture. Among the key points made, the directors agreed the board should encourage consideration of innovation in the performance management process with emphasis on establishing an “innovation pipeline” with reporting on progress through the pipeline.

Monitoring for “Perfect Narratives”

When it comes to performance management, there is a risk of gaming the system. It is human nature for management to instinctively want measurements to reflect positive results. As one director noted, “Flawed stories are better than perfect ones.” It’s a positive when the performance management process identifies one or more areas requiring attention and improvement. So-called perfect narratives, a term used by the director referenced above, tend to raise questions about the rigor under which performance is measured and monitored, as well as the authenticity of the results.

These points get to the bottom of an essential question: do the CEO and executive team really want to know the unvarnished truth about the culture? The customer experience? Innovation? The effectiveness of the business model?

When executive management commits to managing by fact and earnestly seeks genuine results, the board can stand behind them with confidence when results are communicated to shareholders.

 

Dig into deeper insights from Protiviti by visiting their Board Perspectives piece on board oversight of performance management.