Proposed Section 162(m) regulations on deductions for executive compensation.

On March 11, 1994, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under section 162(m) of the Internal Revenue Code. The proposed regulations provide guidance concerning the $1 million limitation on deductions for compensation paid to certain corporate executives. The Institute's comments were prepared under the auspices of the Employee Benefits Subcommittee of TEI's Federal Tax Committee. The chair of the subcommittee is David L. Klausman of Westinghouse Electric Corporation, and the chair of the full committee is Michael A. DeLuca of Household International, Inc. In addition, the following individuals materially contributed to the Institute's comments: George B. Bauernfeind of Humana Inc., Louis DeMattei of lntel Corporation, Edmond J. Downing of Philip Morris Management Corporation, Richard N. Kappler of MCI Communications Corporation, Robert Levy of ACCO World Corp., and Paul J. Schaffhausen of McDonald's Corporation.

On December 15, 1993, the Internal Revenue Service issued proposed regulations under section 162(m) of the Internal Revenue Code. The proposed regulations provide guidance concerning the $1 million limitation on deductions for compensation paid to certain corporate executives. The proposed regulations were published in 'the Federal Register on December 20, 1993 (58 Fed. Reg. 66310), and in the Internal Revenue Bulletin (19944 I.R.B. 24) on January 24, 1994.(1) A public hearing on the proposed regulations is not yet scheduled.

I. Background

Tax Executives Institute is the principal association of business tax executives in North America. The Institute's approximately 4,700 members represent more than 2,400 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the temporary and proposed regulations relating to the $1 million limitation on deductions for compensation paid to individual corporate executives.

II. Overview and

General Comments

The Omnibus Budget Reconciliation Act of 1993 added new section 162(m) to the Internal Revenue Code to deny deductions to any publicly held corporation for compensation in excess of $1 million paid to a "covered employee" in a taxable year. A publicly held corporation means any corporation issuing a class of common equity securities required to be registered under section 12 of the Securities Exchange Act. A "covered employee" under new section 162(m)(3) is the chief executive officer (or acting CEO) on the last day of the taxable year or any other individual whose compensation is required to be reported to shareholders under disclosure rules issued by the Securities Exchange Commission (SEC) by reason of being among the four highest compensated officers.

The deduction limit applies to any compensation that would otherwise be deducted in a taxable year, except for certain enumerated payments set forth in section 162(m)(4), including amounts (i) payable under compensation agreements in effect on February 17, 1993, (ii) excludible from gross income, (iii) paid from qualified plans, or (iv) payable as commissions or that otherwise meet specified requirements for performance-based compensation.

On an on-going basis, the most important of the exceptions to the deduction limitation is that for performance-based compensation. Under section 162(m)(4)(C), compensation will not be subject to the $1 million limitation where (i) it is payable on account of attainment of one or more performance goals; (ii) the performance goals are established by a compensation committee of the board of directors that is comprised solely of two or more "outside" directors; (iii) the material terms of the compensation and the performance goals are disclosed to and approved by shareholders before payment; and (iv) the compensation committee certifies that the performance goals have been satisfied before payment.

Given the short period for taxpayer reaction between the release of the preliminary guidance on December 15, 1993, and the January 1, 1994, effective date, the Treasury and IRS are to be commended for recognizing that complying with certain proposed rules--in particular, obtaining the requisite board of director compensation committee approvals for the objective, pre-established performancebased goals--would be extremely difficult. Consequently, the transition rule relief set forth in Notice 94-22 for approval of performance-based compensation payable by calendar-year companies was welcomed.

The proposed rules generally represent a reasonable attempt to administer the highly questionable tax policy underlying the limitation on corporate officer compensation? We believe, however, that final rules should not become effective until all publicly held corporations--regardless of yearend--have been afforded a reasonable opportunity to analyze their existing compensation programs, to seek and obtain proper guidance under these rules (or any material modifications to these rules that may be made as a result of taxpayer comments), and to revise their compensation programs. Furthermore, because the announced comment period on the proposed regulations will have ended before many companies have completed their 1993 annual shareholder reports, SEC Form 10-K reports, and associated shareholder proxy statements, we recommend the IRS consider both reopening the comment period and delaying a hearing on the proposed rules until late June or early July. By postponing the hearing until after the relatively heavy "proxy-filing" and shareholder-meeting season for calendar-year publicly held corporations, the IRS will provide taxpayers an opportunity to detect latent administrative and interpretative problems within the proposed rules.(4)

III. Covered Employees

Under Prop. Reg, [sections] 1.16227(c)(2)(i), an employee's compensation is subject to the $1 million deduction limitation if, as of the last day of the employer's taxable year, the employee is either (i) the corporation's chief executive officer (CEO) or acting CEO or (ii) is among the four highest compensated officers of the corporation other than the CEO. Under the proposed regulations, an individual is a covered employee if the individual's compensation is reported on the "summary compensation table" under the SEC's executive compensation disclosure rules as set forth in Item 402 of Regulation S-K under the Securities Exchange Act of 1934.(5)

The application of the proposed rules to corporations whose fiscal year for shareholder and SEC reporting purposes differs from its taxable year is unclear. One practical means of administering the interaction of section 162(m) with the SEC-reporting rules is for the compensation of the officers disclosed for the SEC year that ends with or within the taxable year of the corporation to be subject to the deduction limitation and its attendant exceptions. For example, assume a corporation reports to shareholders on a calendar-year basis but files its tax returns on the basis of a June 30 yearend. Based on our suggested approach, the compensation paid to executives listed in the proxy statement for the December 31, 1994, SEC year would be subject to the limitation (and its exceptions) for the corporation's taxable year ending June 30, 1995.6 TEI recommends that the regulations provide additional guidance concerning covered employees where the SEC reporting and taxable years differ.

IV. Objective Compensation

Formula

A. Time for Establishing

Objective Performance Based Goal

Prop. Reg. [sections] 1.162-27(e) sets forth rules concerning the principal exception to the $1 million limitation on deductions for corporate officer compensation, viz., the performancebased exception of section 162(m)(4)(C). Prop. Reg. [sections] 1.16227(e)(i) states that qualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals? A performance goal is considered pre-established if it is established in writing by the compensation committee before the commencement of the services to which the performance goal relates and while the outcome is substantially uncertain? The preamble explains that these requirements are intended to preclude post hoc performance goals?

Many corporations establish garden-variety incentive bonus plans depending in whole or in part upon the company's meeting or exceeding an earnings-per-share (EPS) or other financial performance target. In practice,. companies offering such incentive plans nearly always establish their goals after the actual results for the preceding fiscal year are known because the prior-year EPS results serve as a benchmark in establishing the goal for the subsequent year's incentive goals. For example, if a calendar-year corporation establishes' an EPS-based target for a bonus pool, the actual results for the year will not be known until the January or February following the close of the year for which the bonus accrues. Typically, the company's board of director's compensation committee will meet in late January or early February of the succeeding year to review the actual financial results of the prior year, to approve the bonus pool payable (and the participants' shares) for the prior year, and to establish the EPS-based bonus goals for the current year. Such meetings are productive only when, and as soon as, the prior year's results are available. Under the proposed regulations, however, such an incentive bonus arrangement will not meet the criteria for a pre-established goal because the employees will have already performed services for the corporation in January and February.(10)

TEI believes that the transition rule enunciated in Notice 94-2(11) sets forth the proper standard for adopting pre-established goals and recommends that the rule announced there be permanently incorporated in the regulations. Thus, where the compensation committee of the board of directors meets within the first three months of a corporation's taxable year (the "incentive year") to establish a written, performance-based incentive goal for the entire incentive year, compensation payable as a result of attaining those goals should not be subject to the deduction limitation of section 162(m)--irrespective of whether the employees may have already performed services for a small portion of the incentive year. An anti-abuse rule could be crafted to prevent compensation from qualifying for the exception as a result of goals already attained by the end of the three-month grace period.(12)

B. Business Criteria for

Performance-Based

Goals

Under Prop. Reg. [sections] 1.16227(e)(2)(i), a performance goal is objective if a third party having knowledge of the relevant facts could determine whether the goal is met. Performance goals may be based on one or more business criteria that apply to the individual, a business unit, or the corporation as a whole. Such business criteria can include stock price, market share, sales, earnings per share, return on equity, or costs.

All the enumerated examples of acceptable "business criteria" for which an objective performance goal may be established are measures of financial performance. Some goals, however, may not be measurable in financial or even numerical terms. For example, a CEO or Vice President for Human Resources may be given a goal of increasing the diversity of its management ranks to include greater representation of women and minorities. Such an objective, while not measurable in financial terms, is nonetheless an objective standard for which an individual performancebased goal may be established. We recommend that the regulations be revised to include examples of nonfinancial and non-numerical objectives as performance-based goals.(13)

C. Identification of Class

of Employees

Under Prop. Reg. [sections] 1.16227(e)(2)(ii), the pre-established performance goal must state, in terms of an objective formula or standard, the method for computing the amount of compensation payable to an employee if the goal is attained. In addition, the formula must specify the individual employees or class of employees to whom it applies.(14)

Employees that benefit from corporate incentive bonus plans are variously described in company plan documents as "key management employees," "officers," or "persons holding substantially similar positions in subsidiary corporations." Occasionally, the incentive plan may refer to employee grades or titles (e.g., directorlevel and above). TEI believes that the regulations would be improved by adding examples of "approved" descriptions of generic classes of employees benefitting from performancebased compensation plans. Alternatively, the regulations should include a cross-reference to the definition of "eligible employee" in Prop. Reg. [sections] 1.162-27(e)(4)(ii) for additional guid&nee.

D. Outcome of Performance

Goal Must Be "Substantially Uncertain"

In order to meet the standard for an objective, performance-based goal, Prop. Reg. 1.162-27(e)(2) provides that the goal must be pro-established "... while the outcome is substantially uncertain." The standard of a "substantially uncertain" outcome is illustrated in Example 2 of Prop. Reg. [sections] 1.162-27(e)(2)(vii), but is otherwise undefined.

Although the purpose of the rule seems clear, i.e., to prevent the establishment of post hoc goals, the "substantially uncertain" standard may be erroneously applied by revenue agents through the lens of hindsight. For example, a corporation's earnings history may show that it consistently achieves a year-on-year return on equity of 10 percent. In our view, a performance-based goal based on this standard clearly satisfies the proposed regulations. Yet, a revenue agent may argue that the corporation's successful track record establishes that the goal was not "substantially uncertain" when established. To avoid such a possibility without imperiling the statutory purpose, the substantial uncertainty requirement should be eliminated from the regulations. Alternatively, we recommend the addition of an example illustrating that a successful corporate sales or earnings (or any other criteria) record will not cause a performancegoal based on that criterion to fail to meet the requirement of being "substantially uncertain."

E. Grants Contingent on 

Attainment of Performance Goals--

Aggregation Rule

Under Prop. Reg. [sections] 1.16227(e)(2)(i), compensation paid under a qualified performance-based compensation plan must be payable solely on account of attainment of one or more performance goals. Prop. Reg. [sections] 1.162-27(e)(2)(iv) elaborates on the requirement that the grant be contingent solely on the attainment of performance goals by stating that no part of the compensation paid under a grant or award will qualify for the performance-based exception "if the facts and circumstances indicate that the employee would receive all or part of the compensation, regardless of whether the performance goal is attained. Thus, if the payment of compensation . . . is only nominally or partially contingent on attaining a performance goal, none of the compensation payable . . . satisfies the requirements of this [exception]." Prop. Reg. [sections] 1.162-27(e)(2)(iv) concludes with the requirement that "[a]ll plans, arrangements, or agreements that provide for compensation to the employee will be taken into account for purposes of this paragraph (e)(2)(iv)."

An aggregation rule that sweeps discretionary and nondiscretionary performance-based compensation into a single plan is unworkable. If the purpose of the rule is to prevent abuse of the performance-based exception through the use of post hoc determinations whether a performance-based goal is met, then the rule should be limited to situations involving demonstrable bad faith. As crafted, the proposed rule is excessively broad and will result in the disallowance of deductions for compensation that is truly performance-based. We believe that regulations should provide a clear rule that, in the absence of a bad faith attempt to reformulate a performance-based compensation payout after the facts are known, all amounts paid out under a plan or arrangement that meets the requirements for performance-based compensation will be deductible. This should be the result regardless of whether the compensation arrangement contains other elements (with separate, but not necessarily qualified criteria including, for example, a base salary or a base salary with discretionary cash awards) that do not meet the requirements for performance-based compensation. Any amount that qualifies as performance-based compensation should remain deductible, notwithstanding the existence of any other compensation that may not qualify.(15)

V. Exercise of Discretion by

Compensation Committee

Under Prop. Reg. [sections] 1.16227(e)(2)(iii), the compensation committee of the board of directors is precluded from increasing the amount of compensation subject to the performance-based exception upon attainment of the goal. The compensation committee, however, may retain discretion to reduce or eliminate the compensation or other economic benefit that was due upon attainment of the goal. The preamble explains that the "retention of 'negative' discretion does not undercut the policies underlying the exception for performancebased compensation under section 162(m)" and that, to preserve the flexibility of the board to act in the best interests of the company and its shareholders, it is desirable for the committee to retain this discretion.(16)

A. Change in Business

Requiring Alteration 

of Goals

TEl agrees that the policy underlying enactment of section 162(m) (as wrong-headed as it may be) is not undercut by the retention of "negative" discretion by the compensation committee. We similarly believe that the policy underlying the statute is not undermined where the compensation committee has discretion to modify goals underlying performancebased compensation where the performance-based goals become unattainable as a result of unanticipated changes in the corporation's business structure or other extraordinary events.(17) As a result, the proposed regulations should be revised to permit compensation committees to modify the goals underlying performancebased compensation where the previously set performance goals are affected by business restructuring, significant legislative(18) or regulatory changes, or events not within the control of the business (e.g., an earthquake or fire that destroys a manufacturing facility that is the sole source of a critical product component).

Corporations are constantly evaluating and assessing the performance of their various business units. After a period of sub-par performance, corporate officers will often recommend to the board of directors (or, indeed, the board may direct) that units be divested or that the business be restructured to improve its profitability. Typically, when a business unit is identified as discontinued operations held for sale, the unit's assets, liabilities, and operating results are segregated from the financial statements of the company's continuing operations and reported separately on a single line of the statements. When managers of publicly held companies announce such decisions, the price of the company's stock often increases as investors respond to the company's decision. In such circumstances, the compensation committee should be able to "act in the best interest of the company and shareholders" to revise the performance goals of the executives whose incentive compensation will be affected by the restructuring without a requirement to submit the revised goals for shareho]der approval. Our proposal is analogous to the special rule of Prop. Reg. [sections] 1.16227(e)(2)(vi)(C), permitting a change to an award or grant of stock appreciation rights (SARs) and stock options to reflect changes in corporate capitalization. To circumscribe the proffered rule and to enhance the underlying purpose of section 162(m), our proposed exception could be limited to corporate events that are disclosed to shareholders and potential investors under SEC reporting rules?

B. Acceleration or Deferral 

of Performance-Based

Compensation

Under Prop. Reg. [sections] 1.16227(e)(2)(iii)(B), the taxpayer may accelerate of the date of payment of performance-based compensation after a performance goal is attained, provided the amount of the award is discounted "to reasonably reflect the time value of money." Likewise, if a change is made after attainment of the goal to defer payment of the award to a later date, any amount in excess of the original amount qualifies for the performancebased exception if the additional amount is based on a "reasonable" rate of interest.

In order to provide guidance to taxpayers and revenue agents concerning a "reasonable" rate of interest for deferred and accelerated payments, we recommend that the IRS propound a safe-harbor interest rate, say, the applicable interest rate under section 6621(a) for refunds of overpaid taxes. Alternatively, a safeharbor rate of interest could be the rate that reasonably reflects the corporation's actual weighted average cost of borrowing. We also recommend that the regulations state expressly the additional amount paid as a result of deferred payment of the award constitutes interest to the employee and corporation and, as a result, the additional payment is not itself subject to section 162(m).

VI. Outside Directors

To qualify for a deduction for compensation in excess of the $1 million limitation under the performancebased exception, Prop. Reg. [sections] 1.16227(e)(3)(i) provides that the compensation committee of the board of directors that sets the performance-based goal must be composed solely of outside directors. An "outside director" is a director who (A) is not a current employee of the corporation; (B) is not a former employee of the corporation receiving compensation for prior services (other than benefits from tax-qualified plans); (C) has not been an officer of the corporation; and (D) does not receive remuneration, either directly or indirectly, from the corporation in any capacity other than as a director. Remuneration "includes any payment in exchange for goods or services,"(20) except for deemed de minimis amounts. Under the de minirnis exception, an individual employed by another entity may serve as an outside director for a publicly held corporation as long as the publicly held corporation's payments for goods or services to the outside director's entity does not exceed the lesser of $60,000 or five percent of the entity's gross income.

TEI believes that the proposed de minimis remuneration exception is inadequate and should be significantly revised. As drafted, the rule will substantially limit the pool of individuals eligible to serve as outside directors, since officers of many industrial companies or banks and partners in law and accounting firms with which the company has dealings--all of whom are traditional sources of business experience and expertise and who are knowledgeable concerning industry compensation practices and performance standards--will be ineligible to serve as outside directors. For example, any corporation that buys or leases more than four average-priced automobiles in a year will be unable to avail itself of the advice of executives at the automobile company as "outside directors" because payments to the automobile company will exceed the $60,000 threshold. Similarly, executives at companies producing or distributing copiers, computers, airplanes, or any other costly capital equipment will be ineligible to serve as outside directors, regardless of how immaterial the sales volume may be to the entity employing the prospective outside director (or to the company to which section 162(m) is being applied). Likewise, executives of utility companies supplying more than $60,000 in electric, gas, or water services to a publicly held corporation will be ineligible to serve on a customer's board as an outside director.

To satisfy the statutory requirement of "outside director" without adversely affecting the pool of eligible directors, we believe that the SEC rules regarding "disinterested directors" provide the proper benchmark of independence. Indeed, the transition rules of Prop. Reg. [sections]227(h)(2) and (3) invoke the SEC rules for "disinterested directors." Under the SEC rules, a disinterested director is permitted to receive directly up to $60,000 in remuneration for personal services without disqualification as a "disinterested director"; in addition, if the director is employed (or self-employed) by an entity that derives no more than five percent of its gross income from the public corporation, the director will still be considered disinterested. In its discussion of the outside director requirement, the Conference Report on OBRA refers only to payments for personal services (e.g., as a consultant) as denying an individual from the status of an outside director.(21) There is no mention of either payments for goods or payments to the individual's employer. Thus, we believe the dollar limitation should be withdrawn or limited to payments for direct personal services of the individual.

As an alternative to incorporating the SEC rules for disinterested directors, the definition of de minimis remuneration could be restated as the greater of $60,000 or five percent of total revenue reported in the consolidated financial statements of the corporate group by which the director is employed (or self-employed) for the group's year with or within the publicly held corporation's financial reporting year.

VII. Shareholder Approval

Prop. Reg. [sections] 1.162-27(e)(4) requires that the material terms of the performance goal be disclosed to and subsequently approved by shareholders of the publicly held corporation. The material terms to be disclosed include the identity of the individuals eligible to receive compensation, a description of the business criteria on which the goal is based, and either the maximum amount of the compensation to be paid or the formula used to calculate the compensation upon attainment of the goal. Under Prop. Reg. [sections] 1.162-27(e)(4)(iii)(B), disclosure of confidential business information that would adversely affect the corporation is not required. A factsand-circumstances test is to be employed to determine whether disclosure of information would adversely affect the corporation.

A. Mechanics of

Shareholder Approval

The proposed regulations provide precious little guidance on the mechanics of obtaining shareholder approval for the performance-based goals. Two principal issues arise from the lack of guidance. The first is whether a publicly held corporation should employ SEC procedures for shareholder approvals and proxy disclosures or whether the corporation should follow state law requirements for shareholder votes. In particular, which set of rules is to be employed to determine whether a performance goal has been approved? We believe that either one is sufficient for purposes of section 162(m) and recommend that the regulations explicitly permit a corporation to employ either of the two procedures. The second issue is whether various components of performance-based plans must be approved separately or as part of a single vote on an entire package of proposed changes. To minimize administrative costs and maximize flexibility to corporate taxpayers, TEl again recommends that corporations be permitted to employ either method.

B. Exception for Disclosure

of Confidential

Information

The exception enabling publicly held corporations to withhold disclosure of confidential business information is proper and welcome. A considerable amount of business information is proprietary and disclosure may, in the view of management and the board, be damaging to a publicly held company. For example, an officer may be given a performance goal of negotiating an acquisition or joint venture arrangement. Premature disclosure of such an objective may jeopardize its attainment because the target of an acquisition, for example, may seek out a different acquiror or alternative coventurers, or another acquiror may be prompted to pursue the target.(22) Consequently, TEI recommends that the regulations be expanded to provide additional examples of the types of confidential information that may be withheld without losing the benefit of the performance-based compensation exception.

C. Disclosure of Maximum

Award Payable

Some corporations establish multiple performance-based compensation programs for their executives. The objective goals under the separate programs may differ. Alternatively, corporations may establish a single incentive compensation program, but establish multiple incentive goals. To meet the requirements of Prop. Reg. [sections] 1.162-27(e)(4)(i), either the maximum amount of compensation to be paid or the formula used to calculate the amount of compensation must be disclosed. The application of this disclosure rule to incentive programs with multiple performance-based goals, however, is unclear.

TEI believes that corporations should not be required to disclose the maximum amount payable with respect to each separate performance goal under either multiple incentive programs or a multi-goal program: Rather, section 162(m) should be deemed satisfied where the disclosure permits calculation of the maximum award payable assuming all performance-based goals (or the combination of goals that results in the maximum dollar award payable) are attained. TEI recommends that the regulations permit the disclosure of the maximum award payable under the assumption that the goals yielding the aggregate maximum payout under a multiple-goal incentive program are met. The calculation and disclosure of all the possible intermediate maximums assuming attainment of different combinations of a series of separate goals are both burdensome and unnecessary. In addition, many performance plans limit the maximum payout to a set percentage of the executive's base salary. Disclosure of a maximum payout limitation as a percentage of base salary should be deemed sufficient for purposes of section 162(m).

VIII. Grandfather and

Transition Rules

Prop. Reg [sections] 1.162-27(h) provides transition and grandfather rules for compensation payable under binding contracts in existence on February 17, 1993, and for plans or agreements approved by shareholders before December 21, 1993. Under Prop. Reg. [sections] 1.16227(h)(1)(i), the deduction limit of section 162(m) does not apply to any compensation payable under a written binding contract in effect on February 17, 1993. This grandfather rule will not apply, however, to agreements that are renewed after such date. Furthermore, under Prop. Reg. [sections] 1.16227(h)(1)(iii), the exclusion accorded to binding contracts does not apply where the binding contract is materially modified after February 17, 1993. Under that subparagraph, a material modification occurs when the contract is amended to increase the compensation payable to the employee. The proposed regulations treat a material modification as establishing an entirely new contract with respect to all amounts payable under the agreement, thereby eliminating the relief accorded by the grandfather rule. As a result, all compensation payable after the date of the material modification is subject to the limitation.

A. Material Modifications

TEl believes the interplay between the binding contract and the performance-based exceptions to the $1 million limitation requires further clarification. Under the material modification rule, the entire amount of any compensation payable under a "modified" binding contract is subject to the $1 million limitation. In essence, the benefit of the grandfather exception is forfeited upon a material modification to a binding contract. Nonetheless, if the contract contains performance-based goals, the amount of such compensation should still qualify for an unlimited deduction under that exception. It is unclear, however, how the compensation payable under the modified contract would qualify. For example, assume a stock-option compensation plan with certain performance-based goals isin existence on February 17, 1993. Assume further that the plan is modified in 1994 and additional option grants are made under different performance-based goals (i.e., the "old" options remain subject to the "old" performance goals, while the "new" options are subject to the new performance-based goals). Must the exercise price of the previously granted options (the "old" options) be reset to a new fair market value price to qualify for the performance-based exception? We believe not. Rather, the "old" options should be grandfathered and deemed not subject to section 162(m), while the "new" options should be subject to the section 162(m) limitation and related exceptions. TEI's suggested approach is consistent with the approach of Prop. Reg. [sections] 1.16227(e)(2)(v), permitting grant-by-grant determinations.

B. Previously Approved

Plans

Assuming certain conditions are met, Prop. Reg. [sections] 1.162-27(h)(3) provides a transition period during which compensation arising from the exercise of certain stock-option plans will not be subject to the section 162(m) limitation. Specifically, any compensation paid under a plan or agreement approved by shareholders before December 20, 1993, and established and administered by "disinterested directors" is deemed to meet the requirements of Prop. Reg. [sections]227(e)(3) and (4), involving the board and shareholder approval requirements for the performance-based exception. The transition period relief (the "reliance period") continues until the earliest of (i) the expiration or material modification of the plan; (ii) the issuance of all the employer stock allocated under the plan; or (iii) the first meeting of shareholders at which directors are to be elected that occurs after December 31, 1996.23

1. Treatment of Transition Period Option Grants. The preamble states that "if options are granted under the plan [that is accorded the transition relief period] with an exercise price at fair market value, the options typically would satisfy the exception for qualified performancebased compensation." (24) Thus, any options granted during the reliance period would seem beyond the scope of the section 162(m) limitation. By contrast, the example set forth in the proposed regulations to illustrate the operation of the transition rule and the reliance period states that "[c]ompensation attributable to the exercise of those options will be treated as satisfying the requirements... for qualified performance-based compensation .... "(25) To eliminate confusion and uncertainty, the example illustrating the application of the transition rule should be amended to conform to the statement in the preamble. Thus, any income arising upon the exercise of a stock option granted before the earliest of the three events in Prop. Reg. [sections] 1.162-27(h)(3)(ii) should be beyond the section 162(m) limitation, regardless of when a covered employee exercises an option.

2. Automatic, Additional Grants Under Formula Plans. Some plans contain formulas whereby an additional amount of stock options or stock appreciation rights (SARs) available under a shareholder-approved incentive plan automatically increase in every year by a percentage of total stock outstanding at the beginning of the year where there is an increase in the number of outstanding shares of the corporation over a predetermined base-year amount of outstanding stock. Typically under such plans, the compensation committee of the board retains discretion to identify the participants and the additional amount of shares to be granted to each individual. TEI believes that the final regulations should clarify that options and SARs automatically available under such a previously approved formula plan and that are subsequently granted by the compensation committee qualify for the grandfather transitional relief without regard to the time when the option is exercised.

IX. Conclusion

TEI is pleased to have the opportunity to submit its views on the subject of the proposed regulations relating to the limitation on deductions for corporate executive compensation. These comments were prepared under the aegis of the Employee Benefits Subcommittee of TEI's Federal Tax Committee. The chair of the Employee Benefits Subcommittee is David L. Klausman of Westinghouse Electric Corporation. The chair of the Federal Tax Committee is Michael A. DeLuca of Household International, Inc. If you have any questions concerning these comments, please call either Mr. DeLuca at [phone], Mr. Klansmart at [phone], or Jeffcry P. Rasmussen of the Institute's professional tax staff at (202) 6385601.

Notes

1 For convenience's sake, the proposed regulations under section 162(m) are referred to as "the proposed regulations." Specific provisions are cited as "Prop. Reg. [sections]" as appropriate. References to page numbers are to the proposed regulations (and the preamble) as published in the Internal Revenue Bulletin.

2 1994-1 I.R.B. 25. The Notice permits companies to establish performance-based compensation goals in respect of a calendaryear 1994 tax year that comply with the proposed regulations as long as the requisite approvals are obtained by April 1, 1994.

3 In our mind's eye, the policy is odious because it violates a fundamental tenet of the income tax system: the income tax is a tax on the net income of the taxpayer and all legitimate business expenses attributable to the production of taxable income should be deductible. In addition, it invidiously applies solely to officers of publicly held corporations, while other well-compensated individuals are unaffected. If there have been abuses of shareholder rights or a failure of public company boards of directors to exercise proper oversight in setting corporate officer compensation, the legislative response should have been to provide a remedy through amendment of the federal securities laws or state corporate laws to mandate, for example, better disclosure of compensation information.

4 In the interim, the IRS should announce that, until the tax year following the year final regulations are promulgated, reasonable, good-faith interpretations of the statute, especially the performance-based exception, will be sufficient to preclude the disallowance of deductions.

5 17 C.F.R. [sections] 229.402.

6 Other approaches exist, but their use would require the allocation of compensation between the overlapping SEC-reporting and taxable years. Given the disparate types of executive compensation programs that exist in a typical larger corporation, allocation calculations may be quite complex, especially where the composition of the class of covered employees changes from year to year.

7 1994-4 I.R.B. at 29.

8 Id.

9 1994-4 I.R.B. at 26.

10 To comply with the literal requirements of the proposed regulations, the compensation committee will be obliged to meet before the results of the base-measuring year are known and likely would be compelled to set performance goals based on estimated data for the base-measuring year. Section 162(m) should not be construed to dictate this impractical result.

11 1994-1 I.R.B. 25. The Notice permits companies to establish performance-based compensation goals in respect of a calendaryear 1994 tax year that comply with the proposed regulations as long as the requisite approvals are obtained by April 1, 1994.

12 Under many, if not most, company incentive plans, an employee must be employed by the company on the last day of the "incentive year" to be eligible for a bonus. An officer leaving the company prior to the end of the incentive year may or may not receive a pro-rated share of the bonus depending upon the terms of a severance agreement. In any event, the amount of such a bonus will still depend upon the EPS results of the company for the entire year and will not be paid until the time generally set for payout of bonuses.

13 A non-numerical goal might be, e.g., the identification of candidates to serve as members of the company board of directors.

14 1994-4 I.R.B. at 30.

15 An employee's base salary is, in most cases, a discretionary amount of compensation. Under the proposed regulations, any increase in that discretionary base salary beyond a cost-of-living increase apparently taints the entire compensation paid to an officer as noncontingent where the maximum performance-based compensation is expressed as percentage of base salary. This represents a trap for the unwary and is not the proper result under the statute. Performance-based compensation should always qualify for deduction. In addition, the regulations should not inhibit the ability of the compensation committee to grant salary increases attributable to promotions.

16 1994-4 I.R.B. at 26.

17 In a similar fashion, the adoption of a new accounting rule affecting reported financial results should constitute an event permitting the compensation committee to adjust the performance-based goals.

18 For example, a corporation that establishes a five-year nondiscretionary incentive plan that is approved by the shareholders may find in year 3 of the plan that, as a result of cutbacks in defense spending, the likely poor performance of the business unit devoted to defense contracting will, unless the unit is divested and the plan altered, prevent the officers from ever achieving an award under the plan. We do not believe that the corporation should be required to incur the expense of seeking shareholder approval to revise the longterm incentive compensation plan to take account of the business restructuring. Instead, the compensation committee should retain discretion to alter the performance goals of a compensation program that is adversely affected by unforeseen changes, especially governmental actions such as legislative or regulatory changes.

19 See, e.g., Accounting Principles Board Statement 30, to which public companies are generally subject under SEC rules.

20 Prop, Reg. [sections] 1.162-27(e)(3)(ii)(emphasis added).

21 H.R. Rep. No. 103-213,103rd Cong., 1st Sess. 96 (1993).

22 Other examples of confidential business information that should not be required to be disclosed include goals based on development of proprietary technologies, rollouts of new products or product enhancements, product or service pricing and discount information, and the identification of targeted customer accounts or market segments.

23 Prop. Reg. [sections] 1.162-27(h)(3)(ii).

24 1994-4 I.R.B. at 28 (emphasis added).

25 See Prop. Reg. [sections] 1.162-27(h)(3)(iii).