by Lisa Croley, Donald Kalfen, Meridian Compensation Partners, LLC
Just as adverse climate changes have felled once mighty beasts, profound changes in the corporate governance environment may spell the end for a once ubiquitous feature of golden parachute arrangements, the excise tax gross-up.
Nearly 30 years ago Congress approved a 20% excise tax on certain golden parachute benefits. Due to the unusual way the excise tax is calculated, the tax could potentially be assessed on benefits paid to one executive but not imposed on exactly the same benefits paid to another executive. Companies implemented tax gross-ups to neutralize this disparate tax treatment of otherwise similarly situated executives. This economic justification resulted in the widespread inclusion of excise tax gross-up provisions in golden parachute arrangements.
For over 20 years, except for occasional grumblings, excise tax gross-ups drew little fuss. That all changed with the 2007 proxy season. For the first time, corporate proxy statements disclosed in extensive detail the potential cost of each executive officer’s golden parachute benefits including the potential cost of excise tax gross-up provisions. Shareholders and their advisors took notice.
Proxy advisors have roundly criticized excise tax gross-up provisions. These criticisms are reflected in their proxy voting policies which have become progressively more restrictive with regard to tax gross-ups. For example, under its most recently issued proxy voting policy, Institutional Shareholder Services (ISS) will likely recommend against a company’s say on pay proposal if the company includes a tax gross-up provision in any new or extended golden parachute arrangement. If a company fails to heed ISS’s negative vote recommendation by eliminating excise tax gross-ups, ISS will likely recommend that shareholders vote against incumbent members of a company’s compensation committee. Further, ISS will likely recommend against a proposal to approve a company’s golden parachute arrangement (in the context of a corporate transaction subject to shareholder approval) that includes an excise tax gross-up provision if the golden parachute arrangement was adopted or materially modified since the last shareholder meeting.
Congress, in fact, banned financial institutions that received TARP funds from making tax gross-up payments to their executives.
Greater transparency of pay practices, proxy advisor voting policies and Congressional action have all fueled growing popular discontent with tax gross-up provisions. In turn, this discontent has impacted the corporate governance environment. So, despite the economic justification for excise tax gross-ups, many corporate boards are responding to the populist view by removing excise tax gross-ups at an accelerating rate.
We project that within the next few years less than a third of large public companies’ golden parachute arrangements will include an excise tax gross-up provision based on our study of 160 large public companies’ 2011 proxy disclosures. Ultimately, we believe that the prevalence of excise tax gross-ups will become small minority practice.
Our study found that when a golden parachute arrangement did not include a tax gross-up provision, companies addressed the potential imposition of the 20% golden parachute excise tax in one of the following ways:
■ Capped Benefits. Golden parachute benefits are reduced so that the excise tax is avoided. We found that only a small minority of companies capped benefits in this manner.
■ Best Net After-Tax Benefit. Golden parachute benefits are cut back only if doing so would result in greater after-tax proceeds to the executive officer. When this provision is used, the executive officer is responsible for paying the excise tax. Approximately 20% of companies utilize the “best net” approach. We believe this approach will become the majority practice over the next several years.
■ No Provision. Nearly 20% of companies did not disclose any provision relating to the potential imposition of the golden parachute excise tax. In the absence of any such provision, an executive would be required to pay the excise tax. At the time of a change in control, companies could negotiate with an executive to alter this outcome. However, to avoid last minute negotiations, companies and their executives would often be better served if a “best net” provision is included their golden parachute arrangements.
Donald Kalfen is a partner and senior consultant with Meridian Compensation Partners, LLC with over 25 years experience advising clients on design and technical issues relating to executive compensation programs. Don’s contact information is firstname.lastname@example.org.
Lisa Croley is a senior consultant with Meridian Compensation Partners, LLC with over 15 years experience advising clients on design and technical issues relating to executive compensation programs. Lisa’s contact information is email@example.com. To receive a copy of Meridian’s 2011-2012 Study of Executive Change-in-Control Arrangements, please contact the author at firstname.lastname@example.org.
Topic tags: board of directors, corporate governance, executive change-in-control arrangement, executive compensation, tax gross-up