We’ve recently read articles that discuss the question of whether the repeal of the performance-based exception under Code section 162(m) would require companies to adopt a new approach to proxy disclosure given that losing the tax deduction could have a material impact on the company’s financial statement for some companies. We do think there will be changes made to the Securities and Exchange Commission (SEC) Item 402 pertaining to executive compensation disclosure, but we don’t see that the current rules actually mandate a separate disclosure that focuses specifically on non-deductible compensation paid to named executive officers.

Forgive us for the following forensic analysis of the current SEC disclosure regime, but having a solid understanding of what the rules require, and what they don’t, is essential to this discussion.

First of all, there is nothing in the new tax law that says anything about the SEC disclosure rules regarding executive compensation. So the starting point is to revisit what the existing Item 402 rules say on the issue of tax deductibility:

 - § 229.402 (Item 402) Executive compensation. (b) Compensation discussion and analysis (CD&A).  (2) While the material information to be disclosed under CD&A will vary depending upon the facts and circumstances, examples of such information may include, in a given case, among other things, the following:

(xii) The impact of the accounting and tax treatments of the particular form of compensation

 - Instructions to Item 402(b). 1. The purpose of the CD&A is to provide to investors material information that is necessary to an understanding of the registrant’s compensation policies and decisions regarding the named executive officers.

Read on its own, the language in Item 402(b)(2)(xi) might lead to a conclusion that there is a requirement to discuss the tax and accounting impact of any grant of compensation, as a matter of course.  But to do so ignores the language in the Instruction to Item 402(b), which focuses on the question of whether a potential item to be disclosed in the CD&A would meet the test of being “material information.”

We read this instruction to require a two-prong test to be met before a company determines it will provide a CD&A disclosure regarding the accounting or tax treatment of a particular form of compensation:

  1. First, was the compensation policy or decision regarding any particular item of compensation influenced by the accounting or tax treatment of that item of compensation?
  2. Second, if yes, is that policy or decision material information that is necessary for shareholders to have an understanding of the policy or decisions made?

To date, most companies have addressed this guidance by taking a rather general approach to their disclosures regarding 162(m), although almost every company has some form of disclosure regarding its impact. Those disclosures follow a formula whereby the CD&A describes that the company intends to comply with the performance-based exception under 162(m) for payments to executive officers, as a policy matter, but caveats that disclosure to state that shareholders cannot be assured that any particular payment will be tax deductible. There are many variations on this theme, although we have rarely seen disclosures that provide any degree of assurance that any particular payment will be tax deductible.

With the pending change in 162(m), we don’t see that companies will need to modify their disclosures under existing guidance. We are not persuaded by arguments that suggest companies will need to depict a specific table that states which elements of compensation are and are not tax deductible because the lost tax deduction will now potentially have a material impact on a company’s financial statement. While that may be the case for some companies, that simply is not the standard for disclosure in the CD&A.

Let’s consider the pending 2018 proxy disclosure. Companies are wrestling with how the repeal of the performance-based exception will impact their ability to deduct amounts earned during 2017 that might be paid during 2018, as detailed in “Making sense of the tax reform bill’s confounding 162(m) transition rule – is action by year-end necessary to preserve deductions?”, Executive Pay Matters, December 20, 2017. But let’s assume that the 2017 fiscal year cash bonus will not be deductible under the repeal when paid in early 2018. Grants made by the compensation committee during 2017 often were intended to be deductible, and it turns out that due to a change in tax law the payments will not be deductible. We don’t see under those circumstances how this really changes the disclosure from what it has been in past years. The intention was to try and get the deduction, and the deduction has now been repealed.

For future years, we do see that disclosures will change because no actions can meet the performance-based exception, so language that talks about compliance with that rule will no longer be relevant. Instead, companies will likely note the existence of the 162(m) $1 million pay cap, and that payments to executive officers who are “covered employees” will no longer be deductible for amounts are over $1 million. 

So does that mean we have to depict precisely which amounts are and are not deductible?  Let’s go back to our two-prong test:

  1. Under the first prong, we would say that unless the company makes wholesale changes to its pay programs to respond to the change in tax deductibility, we would not think that the policy or decision regarding any particular item of compensation was influenced by its  tax deductibility. For most companies, we think this will be the case, and that the loss of the deduction for payments to be made will not influence the pay decisions.
  2. As for the second prong, while it is true that the loss of deductibility may be material to financial statements, if the pay setting actions are not influenced by this change, we don’t see anything other than a statement noting that a deduction will be lost due to the tax law change as being material to their understanding of the policy or decisions made.

Changes in disclosure rules we anticipate from the SEC

Without the need to meet the performance-based pay exception, companies would no longer need to get shareholder approval of their plans for 162(m) purposes, and compensation committees need not set performance goals within the first 90 days of the performance period. They also would no longer be limited to using negative discretion only in making their bonus and long-term incentive plan payout determinations. This could free up the process quite a bit, and might also remove the need for companies to use umbrella plans to help them cope with the negative discretion rule.

Companies need to examine their existing shareholder approved plan to make sure they are not restricted by the old 162(m) requirements for the 2018 grant cycle, as some plans do hard-code compliance with 162(m) into the plan document. This could mean that a company would have to continue to follow the more restrictive terms of its plan, limiting the use of positive discretion until it could be amended and approved by shareholders.

For companies that have plan documents that are not so restrictive, getting out of the 162(m) performance-based exception business for 2018 may sound appealing, but there may be disclosure issues that would suggest some caution.

First, if a company stops using an umbrella plan structure, this might change its current approach to disclosing its plan in the Grants of Plan Based Awards (GOPBA) table. These disclosures vary a lot. Some companies disclose only the performance goals under their umbrella plans while remaining a bit coy about the actual goals under the “plan within a plan,” while others disclose the actual sub-plan goals. For companies that eliminate their umbrella plan, we would expect to see them disclose the actual goals of the “plan within a plan” in the Threshold, Target and Maximum columns of the GOPBA, which may not be in line with what has been done to date.

Second, consider the current versus future regime of disclosure under the Summary Compensation Table (SCT).  Under current rules, 162(m) compliant plan payouts can be disclosed in the Non-Equity Plan Compensation (NEPC) column so that exercises of negative discretion under an umbrella plan do not appear to be upward adjustments of bonuses under the “plan within a plan.”  This is the SEC’s instruction in its Compensation and Disclosure Interpretations 119.02. With the demise of the 162(m) performance-based pay exception, we anticipate the new disclosure regime would eliminate this exception. 

But how would that rule be applied if a company kept in place its umbrella plan even after the 162(m) rules change? Would the use of the umbrella plan with negative discretion still permit the disclosure to remain in the NEPC column, or would the SEC rules explicitly prohibit use of an umbrella plan to avoid disclosing upward discretionary adjustments in the Bonus column? A reasonable approach may be to continue to use an umbrella plan, and be optimistic that the SEC will follow its existing guidance. If, instead, negative discretion under that plan is really considered upward discretion by the SEC rules, then the disclosure would need to be in the Bonus column. 


Steve Seelig 

Steve Seelig

Willis Towers Watson

Puneet Arora 

Puneet Arora

Willis Towers Watson

Bill Kalten 

William Kalten

Willis Towers Watson

Steve Seelig, Puneet Arora and William Kalten are regulatory advisors specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center. Email steve.seelig@willistowerswatson.com, puneet.arora@willistowerswatson.com, William.kalten@willistowerswatson.com or executive.pay.matters@willistowerswatson.com.