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Accounting

Executive Compensation Performance Metrics Will Change Under Tax Reform


by FEI Daily Staff

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law, introducing the most sweeping changes to the tax code seen in decades. How will tax reform immediately affect financial statements? And how will the new tax code affect outstanding incentive plans?

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On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act into law, introducing the most sweeping changes to the tax code seen in decades. One of the most notable changes is a reduction in the corporate tax rate from 35 percent to 21 percent.

The obvious impact? Going forward, companies generally will pay less tax while making a larger share of profit available to shareholders. Less obvious is how tax reform will immediately affect financial statements. The change in the tax rate has some complicated ramifications on companies with deferred tax assets (DTAs), deferred tax liabilities (DTL), and significant profits outside the U.S. that are subject to repatriation taxes. The tax reform also changes section 162(m) of the tax code, which affects the deductibility of taxes for senior executives.

Here’s what each of these changes means to outstanding annual incentive and long-term incentive awards.

Outstanding Annual Incentive and LTI Awards

When companies set their performance goals—for the 2017 annual incentive plan as well as for recent long-term incentive plan grants (which for most, include the 2015-2017, 2016-2018, and 2017-2019 cycles), they most likely did so assuming there would be no material changes to the corporate tax rate. Since any ensuing reward or burden from the new tax rate is unintentional, many firms will want to eliminate any effect it has on performance metrics that reference after-tax earnings (such as EPS, earnings growth rates, or ratios that include net income).

A basic principle in executive compensation is “line of sight,” which describes an effort to set and maintain goals that are reasonably controllable by the executive. When line of sight is low, goals move in response to factors outside executives’ control, thereby causing the award to feel less like an incentive and more like a lottery ticket. In this context, line of sight is worsened if executives miss their targets or only achieve their targets due to tax reform. As a result, most companies anticipate adjusting their targets.

2017 Performance Year: 

Although the new corporate tax rate starts in 2018, it can still affect 2017 financial performance. The reason is that many companies have deferred tax assets or deferred tax liabilities on their balance sheets. Accounting rules require adjusting those assets or liabilities for the period when a tax code change takes effect.

As a result, companies will write down the value of their deferred tax assets in financial statements that include December 2017, causing a hit to earnings. A DTA represents a future deductible amount that will produce tax savings at a later date. Since tax reform deflates that future savings, the expected benefit projected in the financials is too high, and the process of truing it down to the right level reduces earnings.

In contrast, some companies have more deferred tax liabilities than deferred tax assets. This means they captured a tax deduction on their tax return ahead of incurring the expense in their financial statements. Conceptually, the DTL represents the extent to which the financials understate a future tax amount. Adjusting the DTL for the lower tax rate therefore increases earnings. On top of this, profits outside the U.S. are now subject to a repatriation tax.

All of these are either one-time costs or benefits associated with changes in the tax code. As a result, we expect most companies to exclude them from any 2017 performance measures used in incentive plans—as if the tax change had never happened.

To sum up, companies need to consider the tax change’s impact on any incentive plans that include the 2017 performance year. They’ll also need to examine how the new rate affects use of an after-tax performance measure (like EPS) or a financial ratio that is influenced by changes in the deferred tax balance.

2018 Performance Year and Beyond:

Beginning in 2018, the lower tax rate will boost after-tax earnings for most companies. The new rate should be straightforward enough to establish for the 2018 annual incentive plan. The same applies to setting financial performance goals for any new long-term plan that incorporates after-tax metrics.

But it’s more complicated for outstanding long-term performance periods that predate 2018 and include the enactment date of tax reform. For example, the deferred tax asset or liability write-down could artificially hurt or boost 2017 earnings, whereas 2018 earnings performance will likely be positively influenced by the lower tax rate. These offsetting forces will play out differently depending on the organization.

As a first step, carefully model the multi-year effect on earnings, especially when earnings in one year are depressed by tax reform and then artificially lifted in the year after. When contemplating adjustments to as-reported financial results, best practice is to set a principle and follow the principle consistently regardless of whether it helps or hurts incentive payouts in any given year. We expect that most companies using after-tax performance measures will back out the earnings effect of the tax cut on after-tax measures.

Additional Considerations

To shareholders and compensation committees, it makes sense to shield financial performance measures from the tax change. However, the tax deductibility of executive compensation—and/or the accounting for executive compensation—could negatively affect the company.

Tax Deductibility

Compensation greater than $1 million used to be tax-deductible for named executive officers (other than the CFO) as long as it counted as “performance-based” compensation under 162(m). The new tax rule eliminates this “performance-based” pay exception and aligns the definition of covered employees with SEC rules (encompassing the CEO, CFO, and next three highest paid executive officers).  However, “remuneration provided pursuant to a written binding contract in effect on November 2, 2017, and not modified in any material respect on or after such date” is effectively grandfathered. It remains tax-deductible as long as it complies with the performance-based compensation exception.

Under most incentive plans, the compensation committee can apply negative discretion to the payout. Under 162(m), negative discretion is allowed under the performance-based exception. Right now, there’s some ambiguity over whether the presence of negative discretion undercuts the notion of there being a “written binding contract.” Most companies will argue that NEO compensation under existing 162(m) compliant arrangements should be grandfathered.

But if companies make adjustments that raise after-tax performance and the payout, they’ll likely violate the performance-based exception under 162(m) by exercising upward discretion. The only exception is if, upon granting the award, the company had specified that changes to the tax code would adjust the performance measure. Before adjusting after-tax measures that might increase payouts, firms should review the performance measure definition in their grant agreements to validate that adjusting goals in response to changes in the tax code are contemplating and would not constitute an exercise of positive discretion.

Accounting

As with the tax treatment, adjusting performance measures to reflect changes in the tax code could have adverse accounting implications. Unless the award agreement states that the performance measure will be adjusted to back out the impact of changes in the tax code on the measure, the company probably will have to treat the award as a modified award upon making the adjustment. Given the setup of modification accounting rules, an incremental charge triggered by a modification could be quite large—especially if the stock price has grown over time.

 

From an executive compensation perspective, the most immediate concern is understanding how the new tax code affects outstanding incentive plans. The impact may be minimal for companies that don’t use after-tax measures.

But if you do make use of after-tax performance measures, start by assessing how much tax reform affects financial performance in 2017 and 2018. Carefully review what your incentive plan documentation and award agreements say about making adjustments to performance results in response to changes in the tax code. When considering adjustments, finance, legal, and human resources need to work together to understand any unintended tax deductibility and accounting ramifications of modifying the performance measures.

In the future, we expect myriad changes to incentive program design. Now that performance-based compensation is no longer deductible (above the $1 million threshold), any number of design changes may arise. Some companies may revert back to strict time-based equity, whereas others may move in the other extreme by establishing Subjective targets that require discretion. In any case, financial statements will likely become more volatile as companies find their own paths to long-term goal-setting under a tax code that’s altogether different from before.

Finance, legal and HR professionals will need to work through these issues to support informed decision-making by Compensation Committees and senior management.

 

Eric Hosken is a partner with Compensation Advisory Partners, LLC. Takis Makridis is the president and CEO of Equity Methods, LLC.