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Trends in Executive Compensation Strategies and Design
In the aftermath of the economic meltdown there continues to be strong public resentment of excessive bonuses for executives of banks and public companies. The failure to take risk management principles into account in setting up executive compensation packages has been identified as a contributing factor to the financial crisis. Government regulators are imposing strict disclosure requirements and there is an international trend toward greater regulation of executive compensation practices.
Shareholder advisors are establishing governance guidelines and "say on pay" requirements and there is generally increased shareholder engagement in the process. All of this has heightened accountability for directors and compensation committees in setting the compensation strategies for their companies. Taxand Canada investigates examples of design strategies for executive compensation packages that satisfy the shareholder governance standards and regulatory requirements, as well as mitigate the disincentives and costs of adverse tax treatment.
While executive compensation practices are evolving under the new guidelines, the first principles of executive compensation continue to be the same: to attract, motivate and retain the best talent. An executive compensation design that satisfies the regulators and minimises business risk must also meet those first principles. An inefficient tax structure that results in adverse tax treatment for executives will not satisfy those principles and will generally result in substantial additional costs to the company that compensates those executives for their tax burdens.
In Canada, the tax laws have not kept pace with the evolution in governance standards. For example, stock options still receive the most favourable Canadian tax treatment for executives. Evolving executive compensation practice is moving away from stock options toward immediate restricted stock ownership subject to risks of forfeiture and hold periods. Under Canada's current tax regime, there is immediate tax and potential adverse tax results for Canadian employees who are awarded restricted stock.
The international guidelines based on risk alignment principles favour long-term incentives matched to the time horizon needed to ensure the relevant performance criteria have been met. In Canada, long-term cash incentives that have a deferral period that extends more than three years from the end of the calendar year which gave rise to the bonus, have immediate and harsh tax consequences for Canadian executives.
The following are some examples of design strategies for Canadian executive compensation packages that satisfy the shareholder governance standards and regulatory requirements, and mitigate the disincentives and costs of adverse tax treatment.
Stock Options with Performance Criteria for Vesting
For Canadian resident executives, a package that includes some stock options will allow them to benefit from beneficial tax treatment. 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 the executive's employment income. From a governance perspective, linking compensation to share performance may not be considered adequate protection against risk-taking activities. Stock prices may reflect market trends rather than management performance. 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. A possible solution is to incorporate specific performance measures into the vesting criteria. Provided this performance criteria is established at the outset, the favourable stock option tax treatment at the time of exercise of the vested options should not be jeopardised.
Avoiding the Harsh Consequences of Restricted Stock
Awards of restricted stock are becoming more common in Canada. Unlike the US, Canada has no special rules governing the tax treatment of restricted stock and there is potential for extremely harsh Canadian tax consequences. For Canadian resident executives, an alternative to restricted stock is the awarding of shares to be 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, the executive will be entitled to a deduction against employment income if shares are forfeited as a result of the conditions not being met.
Medium- and Long-Term Incentive Plans
Incentive plans with returns that vary with the quality of performance are considered 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, under Canada's salary deferral arrangement rules, the executive is taxed in the year in which he or she has a right to receive the deferred amount, even if there is a risk of forfeiture on termination of employment and conditions must be met before receipt.
There is a limited exemption from these rules, if the plan provides for payout within three years after the year in which the services were performed and the award was made. This exemption is relied upon for phantom share plans and performance unit plans established for Canadian residents. It is possible to defer payout beyond three years in very limited circumstances, for example, under an appreciation rights plan that rewards only increases in value that relate to future performance of services after the time the rights are granted.
A Word about Claw Backs
In the current economic climate, there has been a lot of discussion regarding claw backs for poor performance. Beyond issues of legal enforceability, a claw back 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.
The international trend appears to be moving toward rules and regulations governing executive compensation and increased power of institutional shareholders. Countries like Canada, whose approach to governance principles for executive compensation has until now, been based on best practices and guidelines, will likely follow suit. However, at the same time, governments need to consider whether their current tax regimes penalise rather than motivate compliance with the new guidelines and principles (or rules and regulations) and whether changes need to be made to those tax regimes. In the meantime, companies and their advisors need to keep these tax implications in mind when designing and implementing executive compensation packages.
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