Executive pay policies re-evaluated

Compensation should reflect long-term goals of organizations

Economic conditions and public and shareholder resentment of excessive executive bonuses are causing many companies to re-evaluate executive pay policies.

In general, a company’s executive compensation framework should provide incentives consistent with the firm’s long-term goals and the variable components should reward executives according to performance.

Stock options and other equity-based incentives

Most corporations grant stock options as an incentive to senior management. From the executive’s perspective, stock options have a number of benefits.

Tax is deferred until stock options are exercised and shares are acquired. In some circumstances, there may be a further deferral of tax until the shares are sold. If certain conditions are satisfied, only one-half of the benefit (the difference between the exercise price and the value of the shares at the time they are acquired) is included in income.

From the company’s standpoint, there is no tax deduction in respect of the benefit, but there is no actual cash outlay when shares are issued from treasury.

Another advantage is that option plans are well understood and generally straightforward.

For a public company, stock options should be considered as a means of providing a deferred bonus rather than an investment in the company. A good tax advisor will recommend the immediate sale of the shares acquired on the exercise of the option to avoid potential adverse tax consequences if the shares drop in value after they are acquired.

This reduction in value would be treated as a capital loss that could only be applied against capital gains and would not reduce the taxable benefit included in income when the options were exercised.

In a worst-case scenario, the proceeds on a sale of shares after the stock price dropped could be less than the tax liability triggered on the exercise of the options.

The downside of stock options for investors is dilution and the impact on earnings-per-share when new shares are issued at a low price to optionees.

Also, a significant, short-term run up in the stock price could result in an undeserved windfall for executives with relatively little or no impact on company performance.

Share awards may be more closely aligned with shareholder interests than options considering the potential reduction in share value on poor company performance.

Awards of restricted stock, popular in the United States, are becoming more common in Canada. Such shares are issued with restrictions on sale and the risk of forfeiture until certain conditions are satisfied. Unlike the U.S., Canada has no special rules governing the tax treatment of restricted stock and there is potential for extremely harsh Canadian tax consequences.

The executive is taxed on the value of the restricted stock at the time the shares are awarded and must find other funds to pay the tax. Or, if the shares are forfeited, the executive will realize a capital loss that cannot be applied to offset the employment income assessed at the time the restricted stock was awarded.

An alternative to restricted stock is the awarding of shares that are held in trust until certain conditions are satisfied. While the executive will still be taxed at the time the shares are issued to the trust, there will be a deduction from employment income if shares are forfeited as a result of the executive not meeting the conditions.

Medium- and long-term incentive plans

Incentive plans with returns that vary with the quality of performance are most effective when they track performance and risks over a multi-year horizon and when payment is deferred until the results of the executive’s actions for the defined period can be fully assessed.

However, Canada’s tax rules penalize the executive if receipt of the cash award is deferred to a time after the year the award is made, except in very limited circumstances.

Tax is imposed under the “salary deferral arrangement” rules in the year in which the employee has a right to receive the deferred amount, even if conditions must be met before receipt.

Immediate taxation under salary deferral arrangement rules can be avoided by providing for payout within three years after the year the award is made. This structure is used for most phantom share plans and restricted share unit plans.

Notional units represent a proxy for common shares and tie the executive’s interests to shareholder returns without additional shares being issued. Payment may be in cash or in the form of shares.

Performance unit plans may be similarly structured with future payments based on the corporation achieving specified goals that contribute to shareholder value, such as earnings growth rate, return on capital and cash generated by the underlying business.

A company choosing to defer payment beyond three years can design a plan similar to appreciation rights plans, which tend to be very complex.

They are structured to avoid the salary deferral arrangement rules by ensuring the rights to receive amounts under the plan are based only on increases in value that relate to future services rendered.

A word about clawbacks

In the current economic climate, there has been a lot of discussion regarding clawbacks for poor performance.

Beyond issues of legal enforceability, a clawback will have particularly harsh tax consequences for an executive. The amount received will have been taxed and there is no offsetting deduction for the amount that the executive is required to pay back to the company.

Gloria Geddes is national leader of the Gowling, Lafleur, Henderson Executive Compensation Group. She can be reached at (416) 369-4583).

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