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Compensation Clawback Provisions: Why you Need to be Prepared

10 Jul 2011

With the global economic crisis still on everyone's minds, jurisdictions all over the world have begun to address what caused the economic meltdown. Governments are exploring what went wrong and are attempting to fix the perceived problems in order to avert another crippling crisis. In the United States, the Government responded by signing into law the Dodd-Frank Wall Street Reform and the Consumer Protection Act (the "Act"), which was aimed at restoring public confidence in the financial services industry. The Act ushered in the most sweeping changes to the US financial services industry since the US Great Depression in the 1920's and 1930's, and introduced enhanced corporate governance and compensation provisions generally applicable to all US exchange listed companies.

The Act, sure to have far-reaching implications even abroad, prohibits the listing of any issuer of a security that fails to adopt a mandatory recoupment policy of previously received compensation, ie a "clawback" provision. The effective date for this new requirement is contingent on additional guidance that is yet to be released, so it is unclear at this time when US exchange listed companies must include these new provisions in their compensation arrangements. Similarly, jurisdictions across the globe are implementing their own version of clawback legislation to curb "excessive risk taking," which has been blamed as one of the main contributing factors to the recent global economic crisis. With all of the new regulatory requirements across the world, clawback provisions are an international issue that must match today's international business environment.

Tax issues pervade the repayment of compensation, which is a factor to be carefully considered as clawbacks find favour across global jurisdictions. It is in this context that Taxand US conducted a survey of US public and private companies across a wide spectrum of industries to gauge current practices and preparations for compliance with this part of the Act. Taxand US discusses the findings of the survey and examines some of the current complexities around implementing compensation clawbacks.

Under the Act, US exchange listed companies must implement a policy to clawback certain incentive-based compensation in the event of an accounting restatement due to material noncompliance with any financial reporting requirement. These new requirements apply to covered incentive compensation, including bonuses and equity awards, received by current and former executive officers within a 3 year period preceding the date of the restatement.

Tax Considerations
As in many jurisdictions, US employees are subject to income tax and various payroll taxes on compensation received, and employers are generally entitled to a deduction for compensation paid. As a result, clawback provisions that require repayment of income, particularly income received in prior tax years, create certain tax complexities in most countries. From the employee's perspective, if income is recaptured by a clawback provision, the individual may have paid taxes on such income that he or she no longer has. Similarly, employers who had taken a deduction for compensation paid in prior years may have to recognise income upon repayment or adjust their prior years' tax returns to reflect the return of such compensation. Various jurisdictions may have procedures to unwind compensation transactions; however, as companies are required to implement clawback provisions, these tax issues should be fully explored in creating a coherent clawback policy.

Clawback Design Survey Results
Notwithstanding the tax considerations, traditional design features of a clawback policy include which employees and what compensation should be subject to the clawback, the triggering event, the time period that such clawback may apply and whether the company retains any discretion to enforce the clawback once triggered. Due to the new law in the US, many US public companies will be required to amend one or more of those elements, and US private companies may wish to make certain adjustments to their clawback policies as best practices shift. Our recent survey provides some insight as to how the new clawback rules under the Act will affect market practices.

While compensation clawback policies have been gradually working their way into US companies (particularly large corporations) even prior to the Act, the survey found that nearly 3 in 4 companies have not yet adopted a policy on executive compensation clawbacks. Further, most companies that have not yet adopted a policy reported that they will wait until final rules under the Act are issued before adopting one.

Among the surveyed companies that have implemented an executive compensation clawback policy, approximately 80% were either written and/or disclosed in public filings, while the balance had some informal policy in place. Most often, clawback policies covered a broader group of employees than just executive officers. However, a sizable portion of current policies (approximately 35%) limit coverage to only executive officers. Clawbacks under the Act are required to cover all current and former executive officers.

Approximately 65% of the existing policies cover annual incentive plans, but other compensation arrangements were commonly subject to recoupment as well. Stock options, stock appreciation rights, restricted stock, restricted stock units, and performance plans were covered by clawback policies at a slightly lower rate.

Slightly less than half of existing clawback policies require recoupment of incentive-based compensation only in the event of an accounting restatement, which is the standard required under the Act. Other clawback policies require fraud or misconduct, artificially inflated performance, breach of contract, or some other triggering mechanism. Accordingly, it appears that a substantial portion of existing policies in the US will need to be amended to comply with this provision of the Act. Since recoupment of compensation is required even in the absence of fraud or misconduct upon a restatement due to material non-compliance, the Act has greatly lowered for most companies the standard that trips the repayment of compensation.

Finally, 3 in 4 of the current clawback policies, if triggered, allow for some element of Board discretion in operation. The clawback provisions of the Act do not permit Board discretion in enforcing compensation clawbacks and as a result, formula-based clawbacks will need to be developed by a large number of corporations.

Taxand's Take

Either in order to comply with new laws or as a best practice for corporate governance, clawbacks are gaining ground quickly. Accordingly, companies should review the laws of all the jurisdictions in which it operates to determine the impact of this new prevalent practice. For US exchange listed companies, current clawback policies should be reviewed for compliance with the Act and any complications with international executives. Not only will companies need to think about the US tax implications for these international executives, but also the tax rules of any foreign jurisdictions involved. Considering today's mobile workforce, this is no easy task. Even US exchange listed companies that do not have a clawback policy currently in place should begin to think about how the organisation will be impacted by these new requirements. Now is the time for all companies to prepare and think about the tax timing issues that these policies will create for both the employee and the company.

Finally, as the clawback rules are more fully developed across the globe, companies may wish to examine the types of compensation awarded to its employees to mitigate the havoc created by the clawback provisions.

Read the full survey report from Taxand US here: Clawback Survey Results

Your Taxand contacts for further queries are:
Brian Cumberland
T. +1 214 438 1013

J.D. Ivy
T. +1 214 438 1028

Allison Hearne
T. +1 214 438 1037

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