<DOC>
[110th Congress House Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:35775.wais]
THE REVENUE-INCREASING MEASURES IN THE
``SMALL BUSINESS AND WORK OPPORTUNITY ACT
OF 2007''
=======================================================================
HEARING
before the
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
MARCH 14, 2007
__________
Serial No. 110-10
__________
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COMMITTEE ON WAYS AND MEANS
CHARLES B. RANGEL, New York, Chairman
FORTNEY PETE STARK, California JIM MCCRERY, Louisiana
SANDER M. LEVIN, Michigan WALLY HERGER, California
JIM MCDERMOTT, Washington DAVE CAMP, Michigan
JOHN LEWIS, Georgia JIM RAMSTAD, Minnesota
RICHARD E. NEAL, Massachusetts SAM JOHNSON, Texas
MICHAEL R. MCNULTY, New York PHIL ENGLISH, Pennsylvania
JOHN S. TANNER, Tennessee JERRY WELLER, Illinois
XAVIER BECERRA, California KENNY C. HULSHOF, Missouri
LLOYD DOGGETT, Texas RON LEWIS, Kentucky
EARL POMEROY, North Dakota KEVIN BRADY, Texas
STEPHANIE TUBBS JONES, Ohio THOMAS M. REYNOLDS, New York
MIKE THOMPSON, California PAUL RYAN, Wisconsin
JOHN B. LARSON, Connecticut ERIC CANTOR, Virginia
RAHM EMANUEL, Illinois JOHN LINDER, Georgia
EARL BLUMENAUER, Oregon DEVIN NUNES, California
RON KIND, Wisconsin PAT TIBERI, Ohio
BILL PASCRELL JR., New Jersey JON PORTER, Nevada
SHELLEY BERKLEY, Nevada
JOSEPH CROWLEY, New York
CHRIS VAN HOLLEN, Maryland
KENDRICK MEEK, Florida
ALLYSON Y. SCHWARTZ, Pennsylvania
ARTUR DAVIS, Alabama
Janice Mays, Chief Counsel and Staff Director
Brett Loper, Minority Staff Director
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C O N T E N T S
__________
Page
Advisory of March 7, announcing the hearing...................... 2
WITNESSES
The Honorable Kenneth E. Bentsen, Jr., President, Equipment
Leasing and Finance Association, Arlington, Virginia........... 4
Greg Heaslip, Vice President--Benefits, PepsiCo, Inc., Purchase,
New York....................................................... 10
Kenneth R. Petrini, Vice President--Taxes, Air Products and
Chemicals, Inc., Allentown, Pennsylvania, on behalf of the
National Association of Manufacturers.......................... 16
Edward D. Kleinbard, Partner, Cleary Gottlieb Steen & Hamilton
LLP, New York, New York, on behalf of the Securities Industry
and Financial Markets Association.............................. 27
SUBMISSIONS FOR THE RECORD
American Bankers Association, statement.......................... 54
American Bar Association Section of Taxation, statement.......... 56
American Benefits Council, statement............................. 60
Association for Advanced Life Underwriting, statement............ 64
ERISA Industry Committee, statement.............................. 68
Financial Services Roundtable, letter............................ 71
Hogan & Hartson LLP, statement................................... 73
HR Policy Association, statement................................. 75
Richard D. Ehrhart, statement.................................... 76
Statement of Air Products and Chemicals, Inc., Allentown, PA,
statement...................................................... 80
U.S. Chamber of Commerce, statement.............................. 89
Working Group for Certainty in Settlements, statement............ 90
THE REVENUE-INCREASING MEASURES IN THE
``SMALL BUSINESS AND WORK OPPORTUNITY
ACT OF 2007''
----------
WEDNESDAY, MARCH 14, 2007
U.S. House of Representatives,
Committee on Ways and Means,
Washington, DC.
The Committee met, pursuant to notice, at 10:15 a.m., in
room 1100, Longworth House Office Building, Hon. Charles B.
Rangel (Chairman of the Committee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
CONTACT: (202) 225-3625
FOR IMMEDIATE RELEASE
March 07, 2007
FC-11
Chairman Rangel Announces Hearing on the
Revenue-Increasing Measures in the ``Small
Business and Work Opportunity Act of 2007''
House Ways and Means Committee Chairman Charles B. Rangel (D-NY)
today announced that the Committee will hold a hearing on the revenue-
increasing measures that are included in the Senate-passed version of
H.R. 2, the ``Small Business and Work Opportunity Act of 2007.'' The
hearing will take place on Wednesday, March 14, 2007, in the main
Committee hearing room, 1100 Longworth House Office Building, beginning
at 10:00 a.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. However,
any individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committee and for
inclusion in the printed record of the hearing.
BACKGROUND:
On January 10, 2007, the House of Representatives passed H.R. 2,
the ``Fair Minimum Wage Act of 2007,'' which would increase the Federal
minimum wage for the first time in ten years. On February 1, 2007, the
Senate passed its own version of H.R. 2. The Senate-passed version
coupled an increase in the Federal minimum wage with a package of tax
benefits costing $8.3 billion over ten years. In order to offset the
cost of these tax benefits, the Senate bill includes over a dozen
separate provisions that, in the aggregate, would raise $8.3 billion
over ten years. These offsetting revenue increases would, among other
things, change the tax treatment of certain leases entered into before
March 12, 2004, deny deductions for certain government-required
payments and punitive damages in civil actions, enact new limitations
on deferred compensation plans, and change the tax treatment of certain
financial instruments. The Committee on Ways and Means has not held
prior hearings on these issues.
In announcing the hearing, Chairman Rangel said, ``The Senate tax
relief package includes a number of revenue-raising provisions that
would have a significant impact on the business community. Since the
Senate-passed bill was intended to help offset the costs associated
with an increase in the Federal minimum wage, it seems only fair that
the business community should be given an opportunity to explain the
effect these revenue increases would have on businesses.''
FOCUS OF THE HEARING:
This hearing will focus on the impact that the revenue increases
included in the ``Small Business and Work Opportunity Act of 2007''
would have on businesses.
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<F-dash>
Chairman RANGEL. Good morning. As you know, we are supposed
to be going to conference with the Senate on the minimum wage
bill. This Committee did provide a $1.3 billion tax relief bill
for small businesses.
However, even though there is no indication when we are
going to conference, they have begun an $8.6 billion tax bill,
and many of the Members of this Committee have been approached
by people who would be affected by the provisions in the Tax
Code they have suggested would pay for the $8.6 billion.
Since when we go to conference, these issues would be in
contention, the ranking Member and I thought that the Members
of the Committee should have a better understanding of what we
will be faced with in the conference. So, I look forward to
hearing from the witnesses, and it's with great pleasure that I
yield to the ranking Member, Mr. McCrery, for opening remarks.
Mr. MCCRERY. Thank you, Mr. Chairman. Thank you, in
particular, for calling this hearing today to explore several
tax increases recently passed by the Senate in conjunction with
an increase in the minimum wage.
My position on the small business tax relief bill is well-
documented. I have told virtually anyone who will listen that
Congress needs to provide more tax relief to small businesses,
in particular, to help offset the cost of the minimum wage
increase. These small businesses are crucial to the growth of
our economy.
As the Congressional Budget Office pointed out, a minimum
wage increase will impose, over the next five years, a burden
on employers of more than $16 billion. Thus, it would be my
preference to see an even larger tax package than the one
approved by the House last month. I would even like the total
amount of relief to be greater than the $8 billion in the
Senate-passed bill.
We cannot ignore the requirements imposed upon us by the
new pay-as-you-go (PAYGO) rules. Early experience with these
rules suggests to me that avoiding an ill-advised tax increase
can be just as important, and sometimes maybe even more so,
than an acting on desirable tax relief. Today's hearing will
give us an opportunity to hear directly from some of those who
would be most effected by the revenue-raising proposals in the
Senate-passed bill.
I look forward to gaining a better understanding of the
impact of these items, and I yield back the balance of my time.
Chairman RANGEL. Our first witness would be the Honorable
Kenneth Bentsen, president of Equipment Leasing and Finance
Association (ELFA), from Arlington, Virginia. Thank you.
STATEMENT OF THE HONORABLE KENNETH E. BENTSEN, JR., PRESIDENT,
EQUIPMENT LEASING AND FINANCE ASSOCIATION, ARLINGTON, VIRGINIA
Mr. BENTSEN. Thank you, Mr. Chairman, Ranking Member
McCrery, and Members of the Committee. Mr. Chairman, I would
ask that, if I could, summarize my statement to stay within the
5 minutes.
I appreciate the opportunity to present the views of ELFA
on the proposal contained in the Senate-passed version of H.R.
2, the Small Business and Work Opportunity Act of 2007, that we
believe would retroactively impose taxes on certain cross-
border leasing transactions.
The ELFA is a trade association representing 770 members,
including banks, financial services companies, and
manufacturers in the equipment finance industry. Our members
are engaged in a broad sector of commercial finance, including
business-to-business leasing and financing of capital equipment
and software. Our industry's members are the major financiers
of transportation, manufacturing, mining, medical, office,
construction, information, and technology equipment, and our
members' customers include Fortune 100 companies, small and
medium-sized enterprises, and State and local governments.
Nearly 3 years ago, Congress passed the American Jobs
Creation Act of 2004 (P.L. 108-357). As part of that
legislation, and in response to concerns regarding certain
domestic and cross-border leasing transactions, Congress
created a new section of the tax code, Internal Revenue Code
section 470, which applies a passive-loss type regime to
certain leasing transactions involving property used by
governments or other tax-exempt entities.
Importantly, in 2004, Congress recognized a sweeping change
in law as a policy change, and decided on a prospective
effective date which applies to the new rules to leases entered
into after March 12, 2004.
Moreover, the conferees specifically decided that no
inference is intended regarding the appropriate present law tax
treatment of transactions entered into prior to the effective
date, namely that no intent was given with respect to the
appropriateness of transactions entered into that prior
effective date.
To go back now and retroactively change the agreement is,
in effect, reopening the conference negotiations between the
House and the Senate 3 years later, and creating double
jeopardy for taxpayers. The proposal in the Senate version
would undermine the decisions made by the conferees of the Jobs
Act, and retroactively change the effective date for cross-
border leases entered into on or before March 12, 2004.
Specifically, the Senate proposal would reach back and
impose taxes that could never have been expected on
transactions that were completed years before the original jobs
act was ever contemplated. Indeed, under recently issued
Financial Accounting Standards Board (FASB) guidance, any
change of the timing of cashflows caused by changes in the tax
treatment of a lease will require recalculation of earnings
dating back to the inception of the lease.
As a consequence, the Senate provision would result in
significant new tax liabilities on U.S. taxpayers, as well as
significant adverse financial statement consequences caused by
such recomputations for those affected U.S. companies which are
publicly listed.
Additionally, as crafted, the provision would result in
consequences for transactions never targeted by the proponents
or the Government. As an example, one of our members states
that the proposed retroactive change in section 470 would
eliminate net deductions for tax years 2007 and beyond on a
number of lease transactions entered into years ago that the
Internal Revenue Service (IRS) does not consider abusive.
The Committee on Ways and Means appropriately rejected the
Senate proposal earlier this year in developing the House
version of the Small Business Tax Relief Act of 2007. In fact,
Mr. Chairman, you wisely stated that such retroactive tax
changes were ``bad policy.''
We also believe that this provision undermines taxpayer due
process. Proponents of the provision have asserted that the
provision would be beneficial to the IRS in litigation efforts
against certain U.S. taxpayers involved in such transactions.
Ultimately, any legal issues surrounding the transactions
completed prior to the Jobs Act effective date would be--should
and will be properly addressed by the IRS in the courts on the
basis of the laws that were in effect at the time of the
transactions.
On due process grounds alone, U.S. taxpayers deserve to
have their day in court, without interference from the
Congress, before any judgement has been rendered. To date,
there have been no judgements involving such cross-border
transactions.
Furthermore, nothing in the Senate provision would
preclude--nor could the taxpayer expect--that the Government
would discontinue to pursue a case against the taxpayer, as
such cases relate to tax treatment of prior years. If this is
allowed, there is no reason Congress could not simply
retroactively change the law and favor the IRS on any issue the
IRS is currently challenging in the courts, or otherwise. This
is not the way our U.S. rule of law works, and it's not a
change this Committee should endorse.
With all due respect to the proponents, I would submit to
the Committee that the issue before the congress is not the
merits of the underlying transactions in question, as many of
those are properly being reviewed by the IRS on independent
facts and circumstances, just as Congress intended.
The real issue is one of policy and process, the use of
retroactive tax law changes to raise revenue, as the Senate
version of H.R. 2 clearly does, and the due process rights of
taxpayers, which the Senate bill undermines. We believe such
actions are fundamentally unfair and unwise.
[The prepared statement of Mr. Bentsen follows:]
Statement of The Honorable Kenneth E. Bentsen, Jr., President,
Equipment Leasing and Finance Association, Arlington, Virginia
Mr. Chairman, Ranking Member McCrery, and members of the Committee,
thank you for the opportunity to present the views of the Equipment
Leasing and Finance Association (ELFA) on the proposal contained in the
Senate-passed version of H.R. 2 the ``Small Business and Work
Opportunity Act of 2007,'' that would retroactively impose taxes on
certain cross-border leasing transactions.
ELFA is a trade association representing 760 members, including
banks, financial services companies, and manufacturers, in the
equipment finance industry. ELFA's members are engaged in a broad
sector of commercial finance including business-to-business leasing and
financing of capital equipment and software. The industry size,
domestically, is estimated to comprise one-third of fixed business
investment annually and its members are the major financiers of the
transportation (aircraft, maritime, rail, and trucking), manufacturing,
mining, medical and office equipment, construction and information
technology fields. Our members' customers include Fortune 100
companies, small and medium sized enterprises, and state and local
governments. Our members also provide financing for equipment globally,
much of it domestically produced.
Nearly three years ago, Congress passed the American Jobs Creation
Act of 2004 (Pub. Law 108-357) (the ``JOBS Act''). As part of that
legislation, and in response to concerns regarding certain domestic and
cross-border leasing transactions, Congress created a new section of
the tax code, IRC section 470, which applies a ``passive-loss'' type
regime to certain leasing transactions involving property used by
governments or other tax-exempt entities. Generally, under the
provision tax losses incurred over the course of the lease are deferred
and offset against future income from the property. The provision
contains an exception if a taxpayer meets the requirements of all of
four specifically described rules involving certain types of property,
availability of funds, and where the lessor makes a substantial equity
investment, and the lessee does not bear more than a minimal risk of
loss.
Importantly, in 2004, Congress recognized this sweeping change in
law as a policy change and decided on a prospective effective date
which applies the new rules to leases entered into after March 12,
2004. Certain grandfather rules were also provided to avoid retroactive
application of the new regime.
Moreover, the conferees specifically decided that ``[N]o inference
is intended regarding the appropriate present-law tax treatment of
transactions entered into prior to the effective date,'' . . . namely
that no intent was given with respect to the appropriateness of
transactions entered into prior to the effective date. See, H. Rpt.
108-755, p. 647, 650. To now go back and retroactively change this
agreement is in effect reopening the conference negotiations between
the House and the Senate 3 years later and creating ``double jeopardy''
for taxpayers.
RETROACTIVE TAX INCREASE
The current proposal in the Senate version of H.R. 2 would
undermine the decisions made by the conferees of the JOBS Act and
retroactively change the effective date of IRC section 470 for cross-
border leases entered into on or before March 12, 2004. The Senate
proposal would reach back and impose taxes that could never have been
expected on transactions that were completed years before the original
JOBS Act was ever contemplated.
The Ways and Means Committee appropriately rejected the Senate
proposal earlier this year in developing the House version of the
``Small Business Tax Relief Act of 2007'' (H.R. 976) on February 12,
2007. And, in fact, Mr. Chairman you wisely stated that such
retroactive tax changes were ``bad policy.''
Proponents of the retroactive change to Section 470 as contained in
the Senate bill assert that the provision is: a) not retroactive
because it applies to future tax years albeit of transactions completed
prior to March 12, 2004; and b) necessary to relieve the Internal
Revenue Service of the burden of challenging certain transactions on
economic substance and other grounds. Proponents further argue that the
facts related to the transactions in question justify such actions.
In fact, as crafted: the provision is retroactive, the provision
will result in consequences for transactions never targeted by the
proponents or the government, and the provision will undermine
taxpayer's due process rights.
With all due respect to the proponents of the Senate provision, I
would submit to the Committee that the issue before the Congress is not
the merits of the underlying transactions in question, as many of those
are properly being reviewed by the IRS based on independent facts and
circumstances, just as the Congress intended. The real issue is one of
policy and process--the use of retroactive tax law changes to raise
revenue, as the Senate version of H.R. 2 clearly does; and the due
process of taxpayers, which the Senate bill undermines. We believe such
actions are fundamentally unfair and unwise.
If retroactive tax policy is pursued in this instance, there is no
reason retroactivity would not be pursued elsewhere thus undermining
all reliance on our U.S. tax laws. The imposition of this retroactive
provision would result in irreparable damage to investor confidence in
the leasing market going forward, and impede the Congress' ability to
utilize the tax code as a means to spur investment. For this reason,
the Congress historically has opposed such retroactive tax policy.
RECOMPUTATION OF U.S. TAXPAYER'S BOOKS
Proponents of the Senate provision have asserted that the proposal
is not retroactive because it applies to taxable years beginning after
December 31, 2006. Clearly this is incorrect as the proposal applies to
leases executed years ago. Indeed, under recently issued FASB guidance
(FSP FAS 13-2), any change in the timing of cash flows caused by
changes in the tax treatment of a lease will require a recalculation of
earnings dating back to the inception of the lease. As a consequence,
the Senate provision would result in significant new tax liabilities on
U.S. taxpayers and significant adverse financial statement consequences
caused by such recomputations for those affected U.S. companies which
are publicly listed.
The retroactive impact on a taxpayer's books under FASB rules is
described in more detail in an attachment, hereto.
The bottom line is that the provision would have the effect of
disrupting the economics of multiyear transactions entered into years
ago by U.S. financial institutions in reliance on existing law. This is
exacerbated since the Senate provision would be unlimited in its
application and would apply to transactions completed well into the
last century, long before any changes along the lines of Section 470
were contemplated by the Senate.
UNDERMINES TAXPAYER DUE PROCESS
Proponents of the Senate provision have asserted that the provision
contained in the Senate version of H.R. 2 would be beneficial to the
Internal Revenue Service in litigation efforts against certain U.S.
taxpayers involved in certain lease transactions. Ultimately any legal
issues surrounding transactions completed prior to the JOBS Act
effective date should properly be addressed by the IRS and in the
courts on the basis of the laws that were in effect at the time the
transactions were entered into. On due process grounds alone, U.S.
taxpayers deserve to have their day in court without interference from
the Congress before any judgment has been rendered. And to date, there
have been no judgments involving such cross border transactions.
Furthermore, nothing in the Senate provision would preclude, nor
could a taxpayer expect, that the government would not continue to
pursue a case against the taxpayer, as such cases relate to the tax
treatment of past tax years. To reopen such cases would mean that the
taxpayer would be subject to double jeopardy.
Adopting legislation that goes back and retroactively changes the
law in favor of the government on any provision of law is simply unfair
and potentially unconstitutional. The tax system is currently working
as intended, with the IRS reviewing facts and circumstances of
transactions and challenging taxpayer positions, as warranted. Changing
the law and economics midstream creates an unfair bias against
taxpayers in favor of the government. If this is allowed, there is no
reason Congress could not simply retroactively change the law in favor
of the IRS on any issue the IRS is currently challenging in courts or
otherwise. That is not the way our U.S. rule of law works, and it is
not a change this committee should endorse.
UNINTENDED CONSEQUENCES
We believe that imposing Section 470 retroactively would result in
unintended consequences, specifically by retroactively subjecting
otherwise common cross-border transactions to a regime designed to
address questioned transactions. That is, as drafted, the Senate
provision would impose Section 470 on existing transactions never
targeted by the proponents. Just as Section 470 has impacted such
things as the leasing of medical equipment to non-profit institutions
(an otherwise common and efficient practice) on a going forward basis,
imposing Section 470 retroactively would cause a number of such
previously executed cross border transactions to become uneconomic
without cause.
For instance, one of the members of our organization states that
the proposed retroactive change to Section 470 would eliminate net
deductions for tax years 2007 and beyond on a number of lease
transactions entered into years ago (with original equipment cost in
excess of $800 million) that the IRS does not consider abusive.
Examples include leases entered into during the mid to late 1990's such
as rail leases to various European entities and a large lease of
manufacturing equipment to a Canadian subsidiary of a U.S. company.
Another member highlights an existing problem with Section 470 that
will only be exacerbated by applying it retroactively. Current Section
470's complex loss-trapping rules have inadvertently put not-for-profit
hospitals at a competitive disadvantage, as the 9-year class life of
medical equipment causes a fixed price purchase option to trigger
adverse treatment to the lessor. Accordingly, a not-for-profit hospital
must either face a higher lease rate by choosing to have a fixed price
purchase option or lose significant flexibility by forgoing a fixed
price purchase option. Not only should this existing inequity under
Section 470 be fixed to recognize business realities in the area of
medical equipment leases, but it should not be imposed retroactively.
Indeed, the leadership of the House Ways and Means Committee and
Senate Finance Committee have recognized that as it exists today,
Section 470 results in unintended consequences. On December 15, 2005,
after the enactment of Section 470 in the JOBS Act, then Chairman
Grassley, Senator Baucus, then Chairman Thomas, and Congressman Rangel
wrote to then Treasury Secretary Snow and stated that ``it has come to
our attention that Section 470 may have . . . unintended
consequences.'' ``Specifically, Section 470 as currently drafted . . .
may apply to certain non-abusive transactions. . . .''
As part of their letter, Senators Grassley and Baucus, and
Congressmen Thomas and Rangel requested an extension of transition
relief and non-enforcement of Section 470 for certain transactions.
Because of these well-recognized unintended consequences, the
Treasury Department has provided relief and non-enforcement of Section
470 for certain transactions in each of the last three (3) years. See,
IRS Notice 2005-29 (2005-13 I.R.B. 796), IRS Notice 2006-2 (2006-2
I.R.B. 278), and IRS Notice 2007-4.
In addition, the tax-writing committee staffs and the staffs of the
Joint Committee on Taxation and the Treasury Department have been
trying to develop legislation that would correct the unintended
consequence problems that exist with current Section 470. Just last
year, on September 29, 2006, technical corrections legislation was
introduced in Congress to address, among other things, the problems of
Section 470 having unintended consequences. See, ``Tax Technical
Corrections Act of 2006.'' However, to date, those problems still
exist.
It seems illogical to now retroactively impose a provision of the
tax code that is well-recognized by the tax-writing committees as
already having unintended consequences, thereby creating additional
confusion and exacerbating IRS compliance and enforcement problems.
Moreover, it is irrational to impose it retroactively so as to capture
transactions that have never been in question.
CONCLUSION
Mr. Chairman, we believe taxpayers enter into transactions in full
reliance on current tax law. This reliance and confidence is the
bedrock of the Federal income tax system. Undermining the system by
imposing retroactive tax increases is simply unfair as a matter of
fundamental tax fairness. Further, it will serve to undermine the
confidence of investors to deploy capital, which would devalue any
attempt by Congress to use the Code as a means to incent investment.
Accordingly, I urge you and this committee to reject the Senate
leasing proposal as part of the minimum wage bill or any other tax
legislation. This does not let anyone ``off the hook'' or absolve any
questions of substance, as that process is well underway in the courts,
just at Congress intended when it gave the IRS the power to pursue such
cases, and just as the Constitution provides for taxpayers to have
their day in court.
Thank you for the opportunity to offer our views on this matter and
I would be happy to answer any questions you may have.
______
ATTACHMENT
Effects of Retroactive Application of Section 470 on Financial
Statement Earnings and Capital
Summary
The Senate proposal to make Section 470 retroactively applicable to
transactions entered into prior to March 12, 2004, coupled with a
current change in the GAAP treatment of leveraged leases, could have
potentially significant adverse financial statement consequences to
many U.S. corporations.
Financial Accounting Treatment of Leveraged Leases
The economic impact of a leveraged lease is determined by its cash
flows, including tax payments and refunds, and the associated GAAP
financial statement effect is computed under Statement of Financial
Accounting Standards No.13 (``SFAS 13''). SFAS 13 employs a two-step
methodology under which the internal rate of return (``IRR'') derived
from cash flows is first determined, followed by application of this
IRR to the unamortized investment in the lease. The result is the
amount of GAAP financial statement income that is recognized each
period. Because incoming cash flows resulting from tax refunds are
typically greatest in the early years of a leveraged lease, this
methodology has the effect of increasing the IRR, which in turn
increases the amount of GAAP financial statement earnings that are
recognized. In other words, financial statement earnings are usually
the greatest during the early portion of a lease when positive cash
flows are at their peak.
Until recently, SFAS 13 did not require a recomputation of GAAP
financial statement earnings in situations where the timing of cash
flows changed, but the total amount of income recognized over the life
of a lease did not change. In other words, a change in the stream of
financial statement earnings to be reported over the life of a lease
would not change even though the timing of the underlying cash flows
was altered.\1\
---------------------------------------------------------------------------
\1\ Such a change if known from inception would have changed the
IRR.
---------------------------------------------------------------------------
Subsequent to enactment of IRC Section 470 in 2004, the FASB issued
a FASB Staff Position (``FSP'') that became effective on January 1,
2007. See, FSP FAS 13-2. In a significant departure from the SFAS 13
approach described above, the FSP provides that changes in the timing
of cash flows caused by changes in tax treatment of a leveraged lease
will require a recalculation of earnings dating back to the inception
of the lease. When such changes in cash flows occur, the revised
approach will result in a cumulative adjustment equal to the difference
between the amount of GAAP income previously reported and the amount
that would have been reported if the change in tax treatment had been
known at lease inception. The entire amount of the cumulative
adjustment must be reported when a change in tax treatment occurs,
which will affect both current period earnings and retained earnings or
capital.
Financial Statement Impact of Retroactive Application of Section 470
When IRC Section 470 was enacted it was applicable only to
transactions entered into after March 12, 2004. Accordingly, neither
SFAS 13 nor the FSP would require any change in the GAAP financial
statement treatment with respect to transactions consummated before
that date. The Senate has now included a provision in H.R. 2 (the
``Small Business and Work Opportunity Act of 2007'') that would make
IRC Section 470 applicable to all transactions with a foreign entity or
person, regardless of when they were entered into. This retroactive
change to IRC Section 470 would virtually eliminate the benefit of
deductions over the remaining lives of the leases. As a result, future
cash flows would be dramatically reduced for a substantial period of
time, and the FSP would require recalculation of the IRR from inception
of the lease. Since the originally calculated IRR was heavily dependent
on all future cash flows, not just those already realized, the GAAP
financial statement impact on many affected lessors would be severe.
Apart from the negative tax policy considerations of retroactive
application of IRC Section 470, the effect on capital markets and the
economy, and on financial institutions in particular, would be
extremely undesirable. These charges could also reduce retained
earnings, and the regulatory capital of affected financial
institutions, with potentially severe consequences such as limiting the
ability to make loans, pay dividends, violation of debt covenants,
rating agency downgrades, and a decrease in share values. Taxpayers
clearly never anticipated that the tax law might be retroactively
changed in a manner that would lead to such dire consequences.
<F-dash>
Chairman RANGEL. I thank the former Member from Texas, and
welcome back to the House of Representatives.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman RANGEL. The Chair recognizes Greg Heaslip, from
the great State of New York, and the great firm of PepsiCo and
its very progressive way in which you are handling the
retirement problems of the employees.
We may be calling you back to assist us in giving aid to
other multi-nationals to see how we can best protect our
employees. Welcome to the Committee on Ways and Means.
STATEMENT OF GREG HEASLIP, VICE PRESIDENT, BENEFITS, PEPSICO,
INC., PURCHASE, NEW YORK
Mr. HEASLIP. Thank you, Chairman Rangel, Ranking Member
McCrery, and Members of the Committee, for the opportunity to
discuss executive compensation proposals contained in the
Senate's Small Business Work Opportunity Act of 2007.
PepsiCo is a leader in the food and beverage industry. We
employ over 155,000 people, worldwide, 60,000 in the United
States in over 400 locations. Our employees are in every
congressional district in America, and I hope you are familiar
with some of our brands, which include PepsiCola, Frito-Lay,
Quaker Oats, Gatoraid, and Tropicana.
At PepsiCo, we are proud of our overall approach to
employee compensation and benefits, including our practices in
the area of retirement plans and savings. We offer a variety of
broad-based programs to ensure that employees who spend a
career with our company and perform consistently well can
retire with secure lifetime income.
These programs include a traditional defined benefit plan,
which is well funded, and a 401(k) plan with a company match
that increases with tenure. In combination, these programs
achieve our goal of providing retirement security of 70 to 80
percent of pre-retirement income to career employees.
Now, as big as these programs are, a challenge facing many
of our employees is that as their earnings increase, qualified
plans and Social Security replace less and less of their pre-
retirement income. This is due to internal revenue code limits
on qualified plan benefits, and limits on Social Security
benefits.
Consequently, non-qualified plans and personal savings play
a more and more important role in achieving retirement
security, as earnings increase. In response to these
challenges, PepsiCo has instituted non-qualified savings and
retirement programs, which are subject to internal revenue code
section 409A. These plans restore benefits to employees
affected by qualified plan limits, and encourage employees to
save for retirement.
While it appears that the Senate bill is aimed at top
executives, its applicability goes far beyond. At PepsiCo, the
bill would impact over 1,000 employees, and the individual
impacts would be harsh and inequitable. At the same time, we
see little benefit to shareholders or to the Government, from a
revenue perspective. Allow me to provide three specific
examples of the problems the Senate provisions--proposals--
would create.
The first is with respect to a restoration plan for defined
benefits. PepsiCo sponsors a non-qualified restoration plan
that mirrors its qualified pension plan. It is designed to
treat employees equitably by restoring benefits that are lost
due to qualified plan limits. In our qualified pension plan, as
in many traditional defined benefit plans, the value of an
employee's pension increases significantly when they become
eligible for early retirement.
At PepsiCo, this step up in benefit value generally occurs
at age 55. The same feature is mirrored in our non-qualified
plan. The Senate's proposal would include the benefit accrual
and a non-qualified plan against a deferral cap equal to one
times pay--the lower of one times pay or $1 million.
To assess the impact of this on employees, we measured the
size of the age 55 accrual for 1,000 plan participants. We were
startled to learn that in almost every situation, over 90
percent of the time, the age 55 accrual exceeded the one times
pay cap.
As a result, under the Senate's approach, the employee
would be taxed on the value of all accruals in all non-
qualified plans, and pay a 20 percent penalty, even though he
or she is not retiring, or in constructive receipt of the
money.
This result would create the unfortunate effect of forcing
the company to limit, or eliminate, non-qualified restoration--
its non-qualified restoration plan. Clearly, this would cause a
significant loss of retirement security for a sizeable group of
middle and senior managers, and prevent them from receiving the
same level of benefits that other employees are entitled to.
An additional concern is the broader effect this could have
on the retirement security of all employees. In today's
environment, traditional defined benefit plans already face
many challenges. Disenfranchising middle and senior managers
from these plans would add another huge challenge to the
continuation of these plans. At a time when we're fighting
desperately to maintain the defined benefit pension system, it
is hard to imagine that this is what the Senate intended with
this provision.
PepsiCo offers the opportunity to elect to defer base
salary or bonus as a means of encouraging personal and
retirement savings. Under the Senate bill, investment earnings
on non-qualified deferrals would count against the cap, and
could trigger non-compliance, either in isolation or in
combination with other plans. The unpredictable and harsh
effect of this can be seen from a simple example.
Consider the example of a 45-year-old employee earning
about $200,000, who voluntarily defers 30 percent of salary
each year. Assume the account earns 7 percent interest, based
on market performance. The account generally increases in
value, due to the continued annual deferrals and steady
investment returns.
As the employee's account balance increases, however, it
becomes more likely that 1 year of unexpected high investment
returns, combined with accruals from other plans, would throw
the employee over the deferral cap. In our example, 1 year of
12 percent returns for a 61-year-old would throw them over the
cap, trigger taxes, and trigger penalties, again, even though
they're not in receipt of the money, and they haven't retired.
I have other examples that I would like to share with the
Committee, but let me suggest that before we issue any 409A
regulations, or expand upon it, we should finalize the current
regulations that are issued but don't have final guidance
available.
If further regulations are deemed necessary, I would
encourage that we focus on Chief Executive Officers (CEOs) or
National Exchange Officers (NEOs), which is where the perceived
abuses have been identified, implement a uniform cap of $1
million or more with annual indexation--in other words,
eliminate the ``lesser of'' test--exclude broad-based
restoration plans that don't provide extra benefits, exclude
elective deferral programs and the investment earnings on those
programs, and, if implemented, make any changes prospective,
without the need to modify or review current year deferral
elections.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Heaslip follows:]
Statement of Greg Heaslip, Vice President--Benefits, PespsiCo, Inc.,
Purchase, New York
Chairman Rangel, Ranking Member McCrery and members of the
Committee, thank you for the opportunity to discuss the executive
compensation provisions in the Senate ``Small Business Work Opportunity
Act of 2007.''
PepsiCo is a world leader in the food and beverage industry and is
headquartered in Chairman Rangel's great state of New York. PepsiCo
employees 155,000 people worldwide with 60,000 employees in the United
States at over 400 locations. In fact, we have employees in every
congressional district in America. I am sure you know and enjoy our
great company by its brands: Frito-Lay, Pepsi-Cola, Gatorade, Quaker
Oats and Tropicana.
As Vice President of Benefits for PepsiCo, let me begin by stating
that I share your belief that corporate America has a responsibility to
ensure executive compensation is consistent with company performance
and in line with shareholder interests. I applaud your efforts to call
attention to the vital issues raised by the Senate bill and for
providing an appropriate forum to discuss this important topic. At the
core, these issues have a direct impact on retirement security and
personal savings for millions of Americans, global competitiveness,
shareholder interests and tax policy. Any changes to the law in this
area should not be taken lightly and should be thoroughly vetted and
considered before moving forward. Your commitment to a deliberative
process should be commended and I look forward to working with you to
arrive at the right public policy outcome.
At PepsiCo we are proud of our overall approach to employee
compensation and benefits, including our practices in the area of
savings and retirement benefits. We offer a variety of broad-based
programs designed to provide retirement security to all employees who
spend their career with the company and consistently perform well.
These programs include a traditional defined benefit pension plan
(which is fully funded) and a 401(k) plan with a company match that
increases with tenure. We supplement these programs with an investment
in ongoing employee communications about the importance of savings,
pre-retirement planning seminars and personalized planning tools.
In combination, these programs achieve our goal of providing
retirement security to career employees by replacing 70 to 80 percent
of their pre-retirement income through a combination of company-
sponsored programs, Social Security and personal savings.
As good as these plans are, however, a challenge many of our
employees face is that, as earnings increase, qualified plans and
Social Security replace less of the employee's pre-retirement income.
This is due to Internal Revenue Code limits on qualified plan benefits
and limits on Social Security benefits. Consequently, non-qualified
plans and personal savings play a larger role in achieving retirement
security as earnings increase.
In response to these challenges and in order to enable all
employees to meet their retirement savings target, PepsiCo has
instituted non-qualified savings and retirement programs, which are
subject to Internal Revenue Code Section 409A. These programs apply to
a large group of middle and senior level managers. They restore
benefits to employees affected by qualified plan limits and encourage
employees to save for retirement.
The non-qualified ``pension restoration plan'' currently applies to
approximately 900 senior managers whose benefits are subject to
qualified plan limits. The restoration plan is mandatory and does not
provide executives with ``extra benefits.'' It merely seeks to ``keep
them whole'' with respect to the benefits other employees are entitled
to (and which they would receive were it not for the qualified plan
limits). Because the primary objective of the plan is to provide
retirement benefits, employees do not have any ability to take benefits
under the restoration plan in current cash.
In addition we provide an opportunity for approximately 1,000
middle and senior managers to save for retirement by voluntarily
deferring a portion of their pay into a non-qualified deferral plan.
These voluntary deferrals are not matched. Investment of the deferrals
is participant-directed. Investment options essentially match those
offered in the 401(k) plan; there are no ``above-market'' investment
options offered.
These programs are not just for the CEO and Named Executive
Officers. They are unfunded, meaning the benefits are at risk. In
addition, because they are non-qualified, no company deduction is taken
until the employee is taxed on their money. The plans are subject to
existing 409A requirements on the timing of elections and payouts, the
form of payout and the treatment of key employees. In fact, we are
still awaiting final regulations on the sweeping 409A reforms enacted
by Congress in 2005.
While it appears the Senate bill is aimed at the compensation
packages of top executives, its scope and applicability go far beyond
and have the potential for tremendous negative impact. At PepsiCo, the
bill would impact over a thousand employees who participate in the
programs outlined above, and the individual impacts would be harsh and
inequitable. At the same time we see little or no benefit to
shareholders or to government revenue from the proposal. Following are
some specific examples of how the Senate non-qualified deferred
compensation provision would turn employee-friendly programs into a
nightmare for over a thousand of PepsiCo's employees.
Traditional Defined Benefit Restoration Plan
PepsiCo's non-qualified restoration plan mirrors its qualified
plan. It is designed to treat employees equitably by restoring benefits
from the pension plan that are lost due to qualified plan limits. As
indicated above, the restoration plan does not provide extra or
supplemental benefits. It is designed to keep employees whole with
respect to the benefits obtainable within the company's broad-based
plan.
In PepsiCo's qualified pension plan, as in many traditional defined
benefit plans, the value of an employee's pension benefit increases
significantly when they become eligible for early retirement. At
PepsiCo this ``step up'' in benefit value generally occurs at age 55,
with 10 or more years of service. The same feature is mirrored in the
non-qualified plan.
The Senate's NQDC proposal would include the benefit accrual in a
non-qualified pension plan against the deferral cap of the lower of 1x
pay or $1,000,000. To assess the impact of this, we measured the size
of the age 55 accrual for nearly 1,000 employees who participate in
PepsiCo's non-qualified restoration plan. We were startled to learn
that in virtually all situations (90%+ of the time), the age 55 benefit
accrual exceeded the 1x pay cap. As a result, under the Senate's
approach the employee would be taxed on the value of all accruals in
all non-qualified plans and pay a 20 percent penalty even though he/she
is not retiring or in constructive receipt of the money.
This result would create the unfortunate effect of forcing the
Company to limit or eliminate the non-qualified restoration plan.
Clearly, this would cause a significant loss of retirement security for
a sizable group of middle and senior managers, and prevent them from
receiving the same level of benefits other employees are entitled to.
An additional concern is the broader effect this could have on the
retirement security of all employees. In today's environment,
traditional defined benefit plans already face many challenges.
Disenfranchising middle and senior managers from these plans would add
another huge challenge to the continuation of these plans. At a time
when we are fighting desperately to maintain the defined benefit
pension system, it is hard to imagine that this is what the Senate
intended with its provision.
Voluntary Deferral Plan
PepsiCo offers eligible employees the opportunity to elect to defer
base salary or bonus payments as a means of encouraging personal and
retirement savings. As mentioned above, the plan is subject to 409A,
the employee directs how the money is invested and there are no
``above-market'' investment options or company matching contributions.
Under the Senate bill, investment earnings on non-qualified
deferrals would count against the proposed annual cap and could trigger
non-compliance in isolation or in combination with accruals under other
plans. The unpredictable and harsh effect of this can be seen from a
simple example.
Consider the example of a 45-year-old employee at a salary of
$207,000 who voluntarily defers 30 percent of salary each year (typical
among our plan participants). Assume the account earns 7 percent
investment return each year based on market performance. The account
gradually increases in value due to continued annual deferrals and
steady investment returns. As the employee's account balance increases,
however, it becomes more likely that one year of higher-than-expected
investment returns, combined with accruals in other plans, will throw
the employee over the deferral cap. In our example, one year of 12%
market returns when the employee is age 61, combined with accruals from
other programs, would throw him over the 1x cap.
As a result, the employee would be taxed on the value of all
accruals in all non-qualified plans and pay a 20 percent penalty even
though he did not access the deferred funds and the funds are still at
risk. This draconian penalty is triggered by disciplined saving over
time coupled with one year of high market returns and is most likely to
happen to long service employees as they are nearing retirement. This
does not seem to be the type of behavior we should be punishing with
the tax code.
One potentially perverse outcome of this scenario is that
triggering taxes and severe penalties on an employee who has not
received the money could cause the employee to leave the company so
that he would receive the funds and have the cash to pay the taxes and
penalties. Public policy should help us retain our workers, not drive
them away.
In addition to the examples above, there are other situations in
which the Senate's proposal could produce broad, harsh and undesirable
outcomes.
Severed Employees
Unfortunately, the Senate non-qualified deferred compensation
proposal does not make a distinction between CEOs who are terminated
for poor performance and other employees who lose their jobs for
reasons beyond their control and receive economic consideration.
It is occasionally necessary through corporate restructuring and/or
reorganization to close plants or other facilities. When this occurs at
PepsiCo, the company often provides employees who are within five years
of retirement with a special retirement benefit that exceeds the value
of what they would otherwise be entitled to as a terminated employee.
The special retirement benefit equals what they would have received if
they had been eligible for retirement when the facility was closed.
As an example, take the case where Frito-Lay closes one of its
manufacturing plants. Consider a plant manager who is 53 years old (2
years from retirement eligibility), makes $100,000 and is losing his
job because of the plant closing. Because the employee is close to
retirement and his job is being eliminated, the Company provides a
special early retirement benefit as part of the employee's severance.
The benefit is paid from the non-qualified pension plan in order to
comply with qualified plan non-discrimination rules. In this case, the
employee could hit the cap in the year he was severed due to job
elimination as the value of the non-qualified severance benefit is
greater than 1x pay. The employee would be taxed on the value of his
special early retirement benefit and pay a 20 percent penalty at a time
when he has lost his job and is entering retirement or a financially
uncertain time.
This is a circumstance that reaches deep into the rank-and-file at
PepsiCo--it could affect any employee who makes $100,000 or more and is
close to retirement--that we would hope Congress would avoid.
Retention Bonus
In order to maintain an alignment of interests and retain
employees, particularly those at the executive level who have advanced
career experience, PepsiCo has a mandatory bonus deferral program.
Under the terms of the mandatory bonus deferral, a portion of an
executive's annual bonus is deferred for three years. The executive
must remain with the Company for the deferral period in order to
receive their deferred bonus. This is an essential tool for encouraging
and rewarding tenure. These bonuses are taxable when they are received
at the end of deferral period and the employee has no ability to
control the bonus amount or timing of this event.
If arrangements such as this were subject to the deferral cap,
companies would have to consider replacing employee retention features
with current year compensation. From a shareholder perspective the
Senate-passed legislation would be counterproductive in that it would
likely result in this type of change.
Grandfathering and Transition
In reviewing the Senate executive compensation provisions, it is
extremely troubling that the effect of the provisions is to apply new
rules retroactively. As someone who must confront the challenge of
helping employees plan for retirement in a way that complies with an
increasingly complex thicket of regulations, I would emphasize that
certainty is essential. Plan sponsors and individual employees are
already challenged with making significant financial decisions in the
face of incomplete guidance. In the case of non-qualified deferred
compensation, the recent changes to 409A impose strict new penalties
and require that binding elections be made well in advance of actual
deferrals. The Senate approach changes the rules after the fact and has
put employees and employers in a bind. There is no correction option
under 409A and, in fact, we still do not have final regulations on how
to interpret a law that was enacted two years ago. The Senate bill
creates many new headaches by ignoring the mechanics of how 409A is
being implemented.
Given the severity of penalties for non-compliance, it is likely we
will need to modify existing non-qualified deferred compensation plans
to meet the requirements of any change in law. To do so in the right
fashion, we must have an opportunity to transition to the new rules in
the least disruptive manner. In the absence of an actual change in law,
we also need to be able to move forward with the election and deferral
decisions that are locked in place and moving forward as we speak.
Grandfathering money that has already been deferred is a matter of
fairness and providing adequate transition relief will ensure that
employee attempts to save are not inappropriately and unfairly
undermined. I applaud and appreciate the Chairman and Ranking Member
for their unified opposition to retroactive changes in the law.
162(m)
The ``Small Business Work Opportunity Act of 2007'' also contains a
provision that would modify the definition of ``covered employee'' for
purposes of the deductibility of executive compensation. While PepsiCo
is not directly impacted by this provision, I think it is important to
make a few comments. First, the same principle of opposing
retroactivity applies here. To the extent employment agreements and
compensation decisions were based on current law and executed as such,
it is very troubling that Congress would even consider changing the law
and applying it retroactively. This sort of action undermines taxpayer
confidence and makes it exceedingly difficult to set compensation and
benefit policy at a company. The original 162(m) legislation contained
an explicit grandfather of binding contracts and arrangements. This
approach should be maintained. There is also an effort to extend the
``covered employee'' group beyond the current SEC definition. While
this does not seem to be problematic at face value, I would caution
that it adds complexity. To the extent we can unify the rules and speak
in consistent terms, it makes for a more coherent and easily
identifiable policy. It seems logical that the tax code and the SEC
should be able to agree on who constitutes the ``covered employee''
group.
Constructive Reforms
Based on a critical analysis, the nature and scope of the Senate
bill gives rise to myriad issues that should be resolved prior to
determining the need to act. Given the potential impact on retirement
security, personal savings, competitiveness and shareholder interests,
I would hope that Congress will proceed with great caution and
restraint. The issues are too important to not get this right.
Prior to any new legislation, we would like to see final guidance
on current 409A regulations. The impact of the recently enacted
sweeping new reforms of 409A is still being absorbed by most companies.
Enacting new changes before we know how the current rules work seems
premature. However, if expansion of the rules governing non-qualified
deferred compensation is necessary for political or substantive
reasons, we recommend a more focused approach:
<bullet> Issue final guidance on current 409A regulations before
expanding 409A's application to deferred compensation
<bullet> If further regulations are necessary:
<bullet> Focus on CEOs or NEOs, where perceived issues have been
identified, rather than a broad slice of employee population
<bullet> Implement a uniform cap ($1 million or more) with
annual indexation (i.e., eliminate the ``lesser of'' test)
<bullet> Exclude broad-based pension restoration plans that
offset limits in the qualified pension plan and do not provide
``extra'' benefits
<bullet> Exclude elective deferral programs and the earnings on
account balances so long as these earnings are market-based
<bullet> Exclude mandatory bonus deferrals
<bullet> If implemented, make any changes prospective, without
the need to review and modify current year deferral elections
<bullet> Provide for a ``correction'' mechanism to allow for
plan participants who run afoul of 409A to comply without triggering
penalties
PepsiCo is committed to being a world leader in corporate
governance. We take very seriously our responsibilities to our
employees, shareholders and customers. I appreciate the opportunity to
share our view of the Senate executive compensation proposals and your
willingness to consider them in an open venue with a healthy public
discourse. Most importantly, we look forward to working with you to
arrive at the appropriate public policy. I would be happy to discuss
any of these issues with you or answer any questions. Thank you.
<F-dash>
Chairman RANGEL. Thank you.
The Chair recognizes Kenneth Petrini, vice president of
taxes, Air Products and Chemicals, Inc.
STATEMENT OF KENNETH R. PETRINI, VICE PRESIDENT, TAXES, AIR
PRODUCTS AND CHEMICALS, INC., ALLENTOWN, PENNSYLVANIA, ON
BEHALF OF THE NATIONAL ASSOCIATION OF MANUFACTURERS
Mr. PETRINI. Mr. Chairman and Members of the Committee,
thank you for inviting me to testify on behalf of the National
Association of Manufacturers (NAM), on the revenue-raising
provisions included in the legislation currently pending in
Congress. My name is Ken Petrini, and I am vice president of
taxes at Air Products and Chemicals. I also serve as the Chair
of the tax and budget policy Committee of NAM.
The NAM is the Nation's largest industrial trade
association, representing small and large manufacturers in
every industrial sector, and in all 50 States. Many NAM members
believe that tax relief is critical to economic growth and job
creation. In contrast, revenue raisers, like those that we will
talk about in our testimony, will impose new taxes on those
businesses, making it more difficult for them to compete in the
global marketplace.
In particular, H.R. 2, as passed by the Senate, includes
several tax increases that are of particular concern to
American manufacturers. A common theme with these proposed
changes is that while they may be rooted in some valid policy
concerns, they are drafted in such a way to be overly broad,
and threaten to ensnare transactions and expenses well beyond
their intended scope.
Manufacturers currently face some of the highest legal
costs in the world. Based on a recent study by NAM's
Manufacturing Institute, court costs for U.S. businesses are at
historical highs, and are higher than similar legal costs in
other countries. Yet, two provisions in the Senate bill would
add to the current anti-competitive legal cost burden facing
U.S. manufacturers.
The proposals to eliminate tax deductions for punitive
damages and settlements of potential violations of law
represent significant changes to, and an unnecessary expansion
of, current law that will increase the cost of doing business
in the United States for manufacturers.
Under current law, taxpayers generally can deduct damages
paid or incurred, as a result of carrying out a trade or
business, regardless of whether those damages are compensatory
or punitive. The proposed change to make punitive damages--
damage payments in civil suits non-deductible, whether made in
satisfaction of a judgement or settlement of a claim, runs
counter to fundamental and well-established tax principles, and
represents unsound public policy.
In particular, the proposal violates the principle that
income should be taxed only once. Since punitive damages would
not be excluded from income, both the payor and the recipient
would be subject to tax on the punitive damages, thus imposing
a double tax on the same income.
The proposal also violates another principle of Federal tax
policy, and that is to provide similar tax treatment for
similar behavior. Different standards and guidelines apply in
different jurisdictions in this country, and that could result
in punitive damages in one jurisdiction that are not punitive
damages in another.
For a broader policy perspective, the proposal is based on
a false premise that punitive damages are the same as non-
deductible criminal or civil fines that are fixed in amount,
and are imposed for specific activities that are defined in
advance. In contrast, punitive damages are often awarded under
vague and unpredictable standards.
Clearly, too, the issue of settlement agreements with
governments, as in the proposal discussed earlier, this
provision runs counter to fundamental and well-established tax
principles, and represents unsound public policy. Currently, a
business cannot deduct from income any fine or similar penalty
paid to a government for violation of any law.
This proposal would extend this provision to the non-
penalty portion of settlement payments, thus eliminating the
deduction for most, if not all, settlement agreements with the
government on a wide range of issues, regardless of whether
there was any wrongdoing. We are concerned that, regardless of
the intended scope of the provision, that it could be greatly
expanded in subsequent administration by tax auditors to deny
deductions and to prevent resolutions of many issues that can
be beneficial to all.
Manufacturers operating in the United States today face a
significant regulatory burden. These regulations are often
ambiguous, and subject to interpretation, making it difficult,
if not impossible, to ensure 100 percent compliance at all
times. We have a strong policy reason to have a system that
allows businesses to voluntarily settle and pay Government
claims.
NAM, also in its testimony--and in the interest of time, I
will try to summarize very briefly--has expressed concern about
the non-qualified deferred compensation provisions, and also
section 162(M) of the proposals dealing with executive
compensation. We agree with the comments of the prior witness,
and we would only add that, with respect to deferred
compensation, that we ask the Committee to consider the policy
reasons behind the deferral of compensation, and the reasons
why businesses actually allow for deferred compensation, and
also to consider that in enacting section 409A in 2004, you
enacted provisions that would make it very difficult for senior
executives, key employees, to cash out of a business while it
was failing.
Those provisions are, in fact, consistent with the policy
behind deferred compensation, which seeks to align the
interests of the shareholders with those of the executive, and
we should be encouraging the deferral of compensation, in an
unfunded fashion, by executives, because it does, in fact,
align those interests with those of the shareholders. Thank you
again for this opportunity to testify.
[The prepared statement of Mr. Petrini follows:]
Statement of Kenneth R. Petrini, Vice President--Taxes, Air Products
and Chemicals, Inc., Allentown, Pennsylvania, on behalf of the National
Association of Manufacturers
Mr. Chairman and Members of the Committee,
I am pleased to have the opportunity to testify this morning on
behalf of the National Association of Manufacturers (NAM) on several
revenue raising provisions included in legislation currently pending in
Congress. We applaud the Committee's initiative in holding the hearing.
My name is Ken Petrini and I am Vice President, Taxes at Air
Products and Chemicals, Inc., in Allentown, Pennsylvania. I also serve
as the Chairman of the NAM's Tax and Budget Policy Committee. The NAM
is the nation's largest industrial trade association, representing
small and large manufacturers in every industrial sector and in all 50
states. NAM members believe strongly that tax relief is critical to
durable economic growth and job creation. In contrast, revenue
raisers--like those I will describe in my testimony--would impose new
taxes on many businesses, making it more difficult for them to compete
in the global marketplace.
In particular, the Small Business and Work Opportunity Act of 2007
(H.R. 2) as amended by the Senate on February 1, 2007,\1\ includes
several tax increases that are of particular concern to American
manufacturers. These include proposals to:
---------------------------------------------------------------------------
\1\ Fair Minimum Wage Act of 2007 [H.R. 2 EAS/17], as passed by the
Senate, 2/1/07
<bullet> Deny Deductions for Punitive Damage Payments; \2\
---------------------------------------------------------------------------
\2\ Ibid, Section 223
---------------------------------------------------------------------------
<bullet> Deny Deductions for Settlement Payments; \3\
---------------------------------------------------------------------------
\3\ Ibid, Section 224
---------------------------------------------------------------------------
<bullet> Limit Deferrals Under Nonqualified Deferred Compensation
Plans; \4\
---------------------------------------------------------------------------
\4\ Ibid, Section 226
---------------------------------------------------------------------------
<bullet> Expand the Definition of Employees Subject to Rules
Limiting the Deduction for Salary Payments; \5\ and
---------------------------------------------------------------------------
\5\ Ibid, Section 234
---------------------------------------------------------------------------
<bullet> Impose New Taxes on Expatriates.\6\
---------------------------------------------------------------------------
\6\ Ibid, Section 225
A common theme with these changes is that, while they may be rooted
in some valid policy concerns, they are drafted in such a way to be
overly broad and threaten to ensnare transactions and expenses well
beyond their intended scope.
Increasing Legal Costs for American Manufacturers
Manufacturers currently face some of the highest legal costs in the
world. Based on a recent study by NAM's research and education arm, the
Manufacturing Institute, tort costs for U.S. businesses are at
historical highs and are higher than similar legal costs in other
countries.\7\ Moreover, the tort burden on manufacturers (as a
percentage of manufacturing output) is roughly 2.2 times larger than
the burden of these costs on other sectors of the economy.\8\
---------------------------------------------------------------------------
\7\ ``The Escalating Cost Crisis,'' p. 11 The Manufacturing
Institute, 2006.
\8\ Ibid
---------------------------------------------------------------------------
Two provisions in the Senate-passed version of H.R. 2, if enacted,
would add to the current, anti-competitive legal cost burden facing
U.S. manufacturers. Specifically, the proposals to eliminate tax
deductions for punitive damages and settlements of potential violations
of law represent significant changes to, and unnecessary expansion of,
current law that will increase the cost of doing business in the United
States for manufacturers.
Punitive Damages
Under current law, taxpayers generally can deduct damages paid or
incurred as a result of carrying on a trade or business, regardless of
whether the damages are compensatory or punitive. The proposed change
to make punitive damage payments in civil suits non-deductible, whether
made in satisfaction of a judgment or in settlement of a claim, runs
counter to fundamental and well-established tax principles, and
represents unsound public policy.
From a tax policy perspective, the proposal represents a sharp
departure from the income tax principle that taxpayers should be taxed
on net income. To measure net income accurately, all expenses
associated with the production of income are properly deductible.
Similarly, the proposal violates the principle that income should
be taxed only once. Since punitive damage awards would not be excluded
from income, both the payor and the recipient would be subject to tax
on the punitive damages, thus imposing a ``double tax'' on the same
income. The United States Treasury would get a windfall, but businesses
would receive a ``tax penalty.''
The proposal also represents a departure from another objective of
federal tax policy--to provide similar tax treatment for similar
behavior. Because of different standards and guidelines in the current
civil justice system, conduct that results in punitive damages in one
state may not result in punitive damages in another. For example,
standards for awarding punitive damages vary widely among states--a
number of states have ``caps'' on punitive damages and some states do
not allow punitive damage awards at all.
NAM also is concerned about significant tax administration issues
under the proposal. Under current law, it is often difficult to
determine the character of awards (i.e., compensatory vs. punitive),
particularly in cases that are settled in a lump sum while on appeal.
The term ``punitive'' is not defined in the tax code or regulations nor
is the term defined in the proposal. The Tax Court has held that state
law determines whether awards are punitive or compensatory in nature,
which suggests that the proposal could result in dramatically different
treatment of otherwise similarly situated taxpayers in different
locales.
Moreover, one jury may award damages while another may decide there
is no liability even where the facts are very similar. A prime example
is BMW of North America v. Gore.\9\ In this case, a jury awarded the
plaintiff $4 million in punitive damages because BMW had sold as new a
car that had received touch up paint treatment. In contrast, a few
months earlier, another jury in the same county in a case with the same
defendant and nearly identical facts found no liability.
---------------------------------------------------------------------------
\9\ 517 U.S. 559
---------------------------------------------------------------------------
Another area of concern for NAM members is the effective date of
the proposal. Disallowing deductions for amounts paid or incurred on or
after the date of enactment would interfere with a taxpayer's decision
today whether to appeal an initial award of punitive damages. Because
the deduction would continue to be available only for amounts paid
before the enactment date, taxpayers recently hit with initial damages
awards would be discouraged from exercising their right to appeal.
Moreover, existing damage award amounts have been based on the
assumption that such amounts would be deductible. Disallowing
deductions for these existing awards would impose a far greater penalty
on taxpayers than was intended by judges and juries.
From a broader public policy perspective, the proposal is based on
the false premise that punitive damages are the same as non-deductible
criminal or civil fines. Criminal or civil fines are fixed in amount
and are imposed for specific activities that are defined in advance. In
addition, criminal liability must be proven ``beyond a reasonable
doubt,'' i.e., the jury must be virtually certain of its decision. In
contrast, punitive damages are awarded after the fact under vague and
unpredictable standards such as ``reckless'' or ``wanton'' or ``gross
negligence'' or all three.
Settlement Payments
NAM members also have significant concerns about the impact of the
proposal that would prevent companies from deducting the cost of
settlement agreements with the government. Like the proposal discussed
earlier, this provision runs counter to fundamental and well-
established tax principles, and represents unsound public policy.
Under current law, a business cannot deduct from income ``any fine
or similar penalty paid to a government for the violation of any law.''
The proposal would significantly extend this provision to the non-
penalty portion of settlement payments, thus eliminating deductions for
most, if not all, settlement agreements with the government on a wide
range of issues, regardless of whether there was any wrongdoing.
NAM members believe that the language as drafted would sweep in a
large number of unintended and legitimate expenses. In particular, the
``inquiry into the potential violation of any law'' clause included in
the proposal could be read to include almost all payments made by a
business in connection with daily, routine interaction with government
agencies. By eliminating a deduction for an ordinary and necessary
business expense, the proposal represents a dramatic change in long-
standing tax policy that would act as a disincentive for companies to
enter into these agreements.
Manufacturers operating today in the United States face a
significant regulatory burden. In many cases, these regulations are
ambiguous and subject to interpretation making it difficult, if not
impossible, to ensure 100 percent compliance at all times.
Consequently, there is a strong public policy reason to have a system
that allows businesses to voluntarily settle and pay government claims.
Moreover, current law establishes a distinction between punitive
and nonpunitive payments that has a long history in the courts and with
the Internal Revenue Service.\10\ According to IRS officials, the IRS
is committing ``significant resources'' to ensure the proper treatment
of settlement payments.\11\ In contrast, the proposed change would
replace this well-established and workable precedent with a new, all-
encompassing standard with which the courts and the IRS would have to
struggle. The approach taken by the proposal is to disallow a broad
category of deductions (legitimate and otherwise), and require
taxpayers to rely on limited exception language to claim clearly proper
deductions. Ironically, the need to fit oneself into the narrow scope
of the exception would limit some of the flexibility that exists today
in responding to real or perceived violations of laws and regulations
and would limit the ability of business and government to agree on
certain remedies that benefit society.
---------------------------------------------------------------------------
\10\ See Talley Inds., Inc. v. Commissioner, 116 F.3d 382 (9th Cir.
1997); Middle Atlantic Distributors, Inc. v. Commissioner, 72 T.C. 1136
(1979); see also Field Serv. Adv. 200210011 (Nov. 19, 2001).
\11\ Letter to Sen. Charles Grassley from B. John Williams, Jr.
Chief Counsel, Internal Revenue Service 4/1/03
---------------------------------------------------------------------------
Clearly, American consumers and businesses would lose if the
proposals on punitive damages and settlements were adopted. U.S.
manufacturers face significant government regulation and operate in a
world where no product is or can be absolutely perfect. These proposals
would hamper entrepreneurship, innovation, and product development by
further adding to the cost of doing business. This, in turn, would
increase the price of goods and services for consumers, chill
innovation, put jobs at risk and undermine U.S. competitiveness.
Unwarranted Attacks on Benefits and Compensation
Nonqualified Deferred Compensation
NAM members strongly oppose a provision in the Senate-passed
version of H.R. 2 that would impose significant limitations on
nonqualified deferred compensation plans. The proposal, which is not
targeted at any abuse of deferred compensation rules, is a solution in
search of a problem that would effectively eliminate the ability of
employers to use deferred compensation as a retention tool for valued
employees.
In 2004, Congress adopted significant changes to nonqualified
deferred compensation laws that were designed to address perceived
abuses. The legislation--the American Jobs Creation Act of 2004 \12\--
created a new tax code section (Section 409A) that significantly
reformed existing rules for the establishment and operation of
nonqualified deferral arrangements.
---------------------------------------------------------------------------
\12\ P.L. 108-357
---------------------------------------------------------------------------
In particular, Section 409A was designed to address perceived
abuses of nonqualified deferred compensation plans, principally whether
the individual making the deferral had control of the deferred assets.
Under 409A, amounts deferred under nonqualified arrangements must
remain at a substantial risk of forfeiture to the employee. Final
regulations to implement Section 409A (which are expected to run to
hundreds of pages) have yet to be finalized by the Treasury Department.
NAM members believe that Congress should allow the new law to work
before considering additional changes.
In contrast, the proposal included in the Senate bill would further
restrict the rules on nonqualified plans by limiting annual deferrals
to the lesser of the five-year average of an individual's taxable
compensation or $1 million. The legislative history of the provision
\13\ makes clear that earnings inside a deferred compensation plan
should be counted towards the annual cap on deferrals. As a result,
violations of the new rule could occur merely as the result of the
passage of time and not as a result of any action by the employee or
the company. The potential penalties are severe. An individual who
intentionally or unintentionally violates the provision would be
subject to immediate taxation on the entire deferred balance plus an
additional 20 percent excise tax.
---------------------------------------------------------------------------
\13\ Senate Report 110-1, p.52
---------------------------------------------------------------------------
Although tax avoidance on deferred amounts is cited as the primary
reason behind the proposal,\14\ there is no avoidance of taxation under
a nonqualified deferred compensation plan. Rather, tax is deferred
until a future period. There is no tax consequence to deferrals into
nonqualified plans because the matching principle applies, i.e., a
deduction is only taken by the employer when the deferred amounts are
actually received by the employee and taken into income. Furthermore,
though we believe the proposal is aimed at large deferrals (although as
explained later, it does not just pertain to large deferrals), it is
unlikely that there will be a significant benefit from lower tax
brackets when amounts are paid out. Since employment taxes will
typically be paid at deferral or when the amounts are no longer subject
to forfeiture, there simply is no tax avoidance in play.
---------------------------------------------------------------------------
\14\ Ibid
---------------------------------------------------------------------------
Nonqualified deferred compensation arrangements are used by many
manufacturers to motivate and reward their workforce and to align the
interests of employees with the interests of the company. Sometimes
these plans are non-elective restoration plans, effectively restoring
benefits to individuals that have been eliminated from tax qualified
plans because of income limits. In other cases, these plans are used as
supplemental retirement plans or incentive plans.\15\ Still, in other
cases, the decision to defer is a voluntary one, made by the employee
under the rules of Section 409A. The Senate proposal essentially takes
away an important human resources and management tool that businesses
both large and small utilize to retain and attract employee talent.
---------------------------------------------------------------------------
\15\ Examples of affected plans are included in Attachment A and
specific employee examples are included in Attachment B.
---------------------------------------------------------------------------
When a business chooses to pay its employees through deferred
rather than current compensation, it ties the employee to the business
in a meaningful way. By voluntarily deferring compensation into a
nonqualified plan, the employee gives up the right to receive that
compensation and puts its eventual payment at the risk of the future
performance of the company. If the plan offers the chance to invest the
deferred funds in company stock, the alignment is even stronger. These
arrangements should be encouraged, not restricted. The legislation
enacted in 2004 adds safeguards to prevent employees from taking the
deferred money and running when times are bad. As a result, employees
who defer compensation know that if the company fails, it is unlikely
they will ever receive those funds. This is a powerful corporate
governance tool that aligns the interests of executives and
shareholders.
The proposed limits on nonqualified deferred compensation also
would have unintended consequences when applied to a typical
supplemental pension plan that pays annual lifetime benefits in
retirement. In many cases, the vesting of these benefits in a single
year could push an employee's deferred compensation above the
provision's annual cap, leaving the employee liable for an immediate
tax and penalty on amounts they will receive over their lifetime. For
example, the present value of a modest lifetime annuity payable at
retirement could easily exceed the cap since the payment is assumed to
continue as long as the retired employee lives. To avoid this problem,
employers would have to pay the discounted value of the pension as a
lump sum. Forcing lump sum payments would be bad pension policy and
would remove a significant corporate governance benefit that is
achieved when an employee is tied to the company for life.
It also is important to note that because the proposal would apply
to amounts that exceed the lesser of the five-year average of an
individual's taxable compensation or $1 million, it would create an
arbitrary limit on deferred compensation that applies not just to top
corporate executives, but also to middle managers, sales people, and
other employees of both public and private employers. Furthermore, the
proposed limit on annual deferrals would act as a highly intrusive tax
penalty on a company's fundamental business decision to pay employees
through deferred rather than current compensation.
New Limits on Deducting Salary Payments
NAM members also have serious concerns about a provision in the
Senate bill that would expand the definition of a covered employee
under Section 162(m) of the tax code, which limits the deduction of
salary payments. In recent years, the Joint Committee on Taxation \16\
as well as a number of public and private sector witnesses before the
Senate Finance Committee \17\ has criticized this provision. In
contrast, the Senate proposal would add a far-reaching new compensation
limit to the tax code.
---------------------------------------------------------------------------
\16\ ``Present Law and Background Relating to Executive
Compensation, `` Joint Committee on Taxation, JCX-39-06, 9/5/06
\17\ Executive Compensation: Backdating to the Future, 9/6/06
---------------------------------------------------------------------------
Section 162(m) currently denies an employer a deduction for non-
performanced based compensation in excess of $1 million paid to an
individual who is a ``covered employee'' of the employer, i.e., the
taxpayer's chief executive officer (``CEO'') or one of the four highest
paid executive officers of the company at the end of the year (the
``Top 4'') whose compensation is required to be disclosed under the
Securities and Exchange Commission's (SEC) proxy rules.\18\
---------------------------------------------------------------------------
\18\ Note that, because the SEC recently amended the proxy
disclosure rules to no longer include ``the Top 4,'' Section 162(m) is
no longer congruent with the proxy rules. ``Executive Compensation and
Related Person Disclosure; Final Rule and Proposed Rule'' Federal
Register Vol. 71, No. 174 (8 September 2006): 33-8732A.
---------------------------------------------------------------------------
In addition, the deduction limit applies if the non-performance-
based compensation in excess of $1 million is paid to an individual who
is a covered employee on the last day of the year in which the payment
is made. Therefore, an employer might contractually commit to pay
compensation to an employee on separation from service, at which time
the employee would not be a ``covered employee'' under Section 162(m).
The Senate proposal would expand the definition of covered employee
under Section 162(m) to include (i) any person who was CEO during any
part of any year (not just the end of the year) and (ii) any person who
ever was a ``covered employee'' in any year after 2006 (even if that
person is not a covered employee in the year that the compensation
payments are received or the year the services are performed). In
effect, the proposal creates a new rule that if an employee is ever a
covered employee, he will always be a covered employee--even if current
compensation eliminated them from the ``high five'' of a corporation.
Under the proposal, compensation earned or payable in the future to
an employee who at any time in a taxable year beginning after December
31, 2006, was a covered employee would remain subject to Section 162(m)
in perpetuity. As drafted, this proposal represents a significant
expansion of the scope of Section 162(m), rather than an attempt to
close an inadvertent loophole.
The Senate proposal also modifies the definition of covered
employee by dropping a cross reference to the securities law from
existing Section 162(m). The SEC's new proxy rules (which apply to
proxies filed for fiscal years ending on or after December 15, 2006),
require detailed disclosure for any person who acts as CEO during the
fiscal year, any person who acts as CFO during the fiscal year, and the
three other most highly compensated executive officers other than the
CEO and CFO. In order to retain the previous group for tax purposes
(i.e., the CEO and the Top 4), the statutory change to Section 162(m)
removes from the definition of ``covered employee'' a requirement that
``the total compensation of such employee for the taxable year is
required to be reported to shareholders under the Securities Exchange
Act of 1934.'' This approach has serious unintended consequences and
may significantly and inadvertently expand the category of employees
who may be covered.
In addition, as drafted, the proposal would be retroactive, denying
corporations' deductions for compensation that was earned before 2007,
by any employee who becomes a covered employee after 2006. Many
employers today have outstanding compensation obligations that were
structured in reliance on current law, but that would become non-
deductible under the proposed amendment. Unfortunately, there is little
or nothing a corporation could do to protect the deduction it thought
it already had--existing contractual arrangements are legally binding
on the employer and cannot simply be rewritten by the employer to
reflect an unanticipated retroactive change in law.
By denying a deduction for pre-2007 compensation an employer is
obligated to pay, the proposal will raise taxes on corporate employers
without changing corporate compensation practices. While a retroactive
application of the new rule will not affect executives who will be paid
what they are owed, corporate shareholders stand to lose because of the
corporation's tax increase. Note that this was not the case when
Section 162(m) was originally enacted and Congress expressly
grandfathered all compensation payable under written binding contracts
that were already in effect.
While we oppose enactment of the changes to Section 162(m), if
these changes are made they should only apply prospectively since
employers cannot control past compensation arrangements. At a minimum,
the proposal should expressly provide that amended Section 162(m) will
only apply to tax years beginning after the date of enactment and will
not apply to any compensation to which an employee had a legally
binding right, whether or not contingent, on or before the last day of
the taxable year including [the date of enactment] or which relate to
services performed before such last day.\19\
---------------------------------------------------------------------------
\19\ The effective date of the proposal should permit public
companies time to obtain shareholder approval of performance-based
plans that may need to be modified.
---------------------------------------------------------------------------
The NAM also believes that delinking Section 162(m) from proxy
rules is not in the public interest. Current law defines a covered
employee by reference to the SEC's proxy rules. This makes sense for
two reasons. It is easier for taxpayers (and the IRS) to figure out who
is a covered employee in advance of paying compensation. In addition,
it targets the rule to ``executive officers'' of a company within the
meaning of the Securities Exchange Act, i.e., officers who have policy-
making functions and therefore arguably can influence their own
compensation.
Based on legislative history,\20\ the proposal is intended to
``delink'' the definition of a ``covered employee'' from the definition
used by the SEC as a result of changes in the SEC's proxy rules. The
SEC has recently revised the proxy rules to now cover the CEO, the CFO
and the next three most highly compensated employees. The policy reason
for ``delinking'' is not clear. As drafted, the proposal represents a
significant expansion of the scope of Section 162(m) to cover employees
with no policy-making authority who are not in a position to influence
their own compensation and ambiguity as to what compensation counts for
determining whether an employee is one of the ``Top 4''.
---------------------------------------------------------------------------
\20\ Senate Report 110-1, p.68
---------------------------------------------------------------------------
The proposal also deletes references in Section 162(m) to ``total
compensation . . . for the taxable year [that] is required to be
reported to shareholders under the Securities Exchange Act of 1934.''
Accordingly, proposed changes to Section 162(m) could be read to apply
to all ``officers'' of an employer, even those with no policy-making
authority. Neither Section 162(m) nor the Senate proposal defines the
word ``officer,'' thereby creating ambiguity where none exists today.
SEC proxy disclosure is limited to ``executive officers,'' which means
those officers who have significant policy-making authority for the
issuer. We do not believe that the proposal was intended to broaden the
scope of covered employees in this way and urge that, if enacted,
Congress clarifies the proposal to state that covered employees
continue to include only executive officers for whom proxy disclosure
could be required.
In addition, while the proposal provides that the four ``highest
compensated'' officers in the year would be covered, it does not
specify a definition of ``compensation.'' Under current law, that
answer is well understood by corporations because a ``covered
employee'' is determined by reference to the SEC's proxy rules. New SEC
rules capture executive officers' total compensation for each year,
including equity awards and deferred compensation, which may not be
taxable until several years in the future. By deleting the reference in
Section 162(m) to the SEC's proxy rules, the Senate proposal leaves no
definition of compensation whatsoever.
In sum, the NAM strongly believes that corporate governance
issues--like executive compensation--should be addressed through
corporate governance changes, not through the tax code.
New Tax on Ex-Pats
Among the revenue-raisers in the Senate proposal is a little
noticed but potentially devastating provision that would change the
rules for taxation of foreign persons who are long-term residents of
the United States and are leaving the country. The provisions would
levy a new ``mark-to-market'' tax on the unrealized appreciation in all
their property, on the day before expatriation. In effect, the
expatriate is treated as having ``sold'' all his or her property, for
its fair market value, on the day before expatriation. Property subject
to the provision includes personal property, interests in qualified
retirement plans, and interests in nonqualified trusts.
This provision could have a significant negative impact on resident
aliens employed by U.S. manufacturers. For example, a resident alien
who has worked for a U.S. company and decides to return to his or her
home country to retire or for other business or personal reasons could
find the value of their assets significantly eroded--especially if
there is an acceleration of tax payable on 401(K) or other retirement
accounts.
Finally, another general concern of NAM members is the inclusion of
retroactive tax provisions in the Senate bill as well as other tax
legislation. It has long been the position of the NAM that a
retroactive imposition of taxes is fundamentally unsound and unfair.
In sum, NAM members believe strongly that tax relief will go a long
way to ensuring that our economy keeps growing. Conversely, tax
increases, like those outlined above, will negate much of the positive
impact of tax relief and, in some cases, threaten continued economic
growth. We appreciate the opportunity to present our views on these
issues to the committee and we thank you in advance for rejecting these
revenue raisers.
Attachment A
Examples of Benefit Plans and Company Types Affected by Section 226
Restricted Stock Units: In recent years, many employers have
redesigned their equity programs to increasingly rely on the use of
restricted stock units (RSUs). Typically, employees are awarded a
specified number of RSUs, with a fixed percentage of the RSUs vesting
on a quarterly or annual basis or the entire block of RSUs vesting
after a specified performance period. Generally, upon vesting of an RSU
award, RSUs are converted into shares of the employer's common stock
and the employee is taxable on the fair market value of such stock.
Some RSU programs fit within the regulatory exception from 409A for
compensation that is paid upon vesting (or within 2\1/2\ months after
the year of vesting.) It is not uncommon, however, for employers to
find that their RSU program does not meet the short-term deferral
exception and that compensation paid under the program is subject to
409A. In some instances, an employee may vest in the RSUs in increments
over the performance period but is not paid until full vesting is
attained at the end of the performance period. In other instances, an
employee may vest fully upon reaching a specified retirement age during
the performance period. Under the legislation, such RSU grants would be
subject to the one-time pay limit and could cause employees to exceed
the limit.
For example, a newly hired employee of a Fortune 500 company
receives a grant of RSUs that is subject to 409A. The employee is
granted 6,000 RSUs at a time when the value of the company's stock is
$30 (i.e., value of the grant is $180,000). The employee is scheduled
to vest in \1/5\ of the RSUs each year over a 5-year performance
period. The employee receives a base salary of $140,000, which under
the Senate provision would be the employee's one-time pay limit for the
first year. Because the value of the RSU grant exceeds the one-times
pay limit, a 409A violation would occur and the employee would be
subject to a 20 percent additional tax on the value of the RSUs as they
vest (i.e., 20 percent of the RSUs per year) over the 5-year period.
Because ``earnings'' on the underlying shares of the company's
stock also are subject to the limit, employees could have a tax penalty
under 409A merely because the company was successful and the value of
the RSUs increased beyond the limit.
For example, an employee is granted 1,000 RSUs at the beginning of
employment with a technology company. The employee ``vests'' in these
units after 5 years of service and the RSUs are designed to pay out
after 10 years. The employer believes that this plan aligns the
employee's interest with growing the company value rather than
maximizing current salary. At the beginning of employment, the RSUs
were valued at $15 per share. The employee earns approximately $100,000
per year and receives modest increases (based on CPI of 3 percent). The
employee's 5-year average taxable compensation from the company is
$110,000 at the end of year 5. The company stock price stays relatively
flat, but in year 6 the company becomes highly successful and the
valuation of the stock takes off eventually to exceed 10 times the
original price. The one-times-pay limit would be exceeded because the
increase in the RSU value in year 6 will exceed $110,000.
Supplemental 401(k) Plans: Employees who cannot fully defer under a
401(k) plan because of the compensation limits under the Code may
participate in a supplemental or ``mirror'' 401(k) plan. Unlike
qualified plans, these programs are unfunded and the employer's
deduction is delayed until the time of payment. If the company becomes
insolvent, the employees are not paid. The legislation counts
``earnings'' that accrue under the supplemental plan as additional
deferrals that count against the one-time pay limit and could cause the
employee to exceed the limit.
For example, a Fortune 500 company offers a nonqualified
supplemental plan to certain employees, including mid-level management
employees receiving approximately $150,000 to $200,000 per year in
total wages from the company. Many of these mid-level management
employees are long-serving employees who typically defer 20 to 40
percent of their wages. Employees who participate in the plan receive a
small matching contribution (typically between $3,000 and $6,000) from
the company based on their deferrals. Investment earnings are credited
to an employee's bookkeeping account in the plan based upon deemed
investments chosen by the employee from among the same mutual funds as
those offered in the company's 401(k) plan. Using 2006 data, the
company has calculated that at least seven such employees would have
exceeded their 5-year average taxable compensation. The following chart
summarizes the relevant information:
----------------------------------------------------------------------------------------------------------------
Account
2006 5-year Balance 2006 2006 Deferrals
Emp. Years of Total Average As of Deferrals Investment Total Above 5-
Service Wages Taxable 12/29/ And Match Earnings Deferrals year Avg
Wages 06 Limit
----------------------------------------------------------------------------------------------------------------
1 27 $159,50 $ 90,180 $418,40 $ 66,700 $ 72,300 $139,000 $48,820
0 0
----------------------------------------------------------------------------------------------------------------
2 13 $175,40 $102,220 $508,30 $ 60,800 $ 52,500 $113,300 $11,080
0 0
----------------------------------------------------------------------------------------------------------------
3 28 $179,30 $ 62,380 $364,10 $116,400 $ 27,000 $143,400 $81,020
0 0
----------------------------------------------------------------------------------------------------------------
4 25 $178,30 $126,920 $614,70 $ 47,900 $109,100 $157,000 $30,080
0 0
----------------------------------------------------------------------------------------------------------------
5 30 $183,70 $126,040 $617,70 $ 38,000 $141,800 $179,800 $53,760
0 0
----------------------------------------------------------------------------------------------------------------
6 14 $194,40 $128,020 $486,50 $ 62,200 $ 73,200 $135,400 $ 7,380
0 0
----------------------------------------------------------------------------------------------------------------
7 6 $203,00 $ 92,020 $647,10 $ 76,300 $ 94,700 $171,000 $78,980
0 0
----------------------------------------------------------------------------------------------------------------
Since earnings that are tied to a publicly-traded investment are
often very unpredictable, employees would have to leave a large cushion
below the one-time pay limit to take into account potential earnings.
An employee who participates over a number of years could easily exceed
the one-time pay limit solely because of earnings.
For example, assume employee 5 in the above example stopped making
deferral elections after 2006, and that the employee receives modest
increases in wages each year (based on CPI of 3 percent). Also assume
that the employee elected to have all of his account balance as of
December 29, 2006 ($617,700) be deemed invested in the plan's S&P 500
index fund, and that for the 4-year period from 2007 to 2010 that
fund's annual return was 20 percent per year (which would be consistent
with the S&P 500's performance in the late 1990s). By 2010, there would
be a 409A violation solely because the ``earnings'' credited to the
employee's bookkeeping account ($213,477) exceeded the employee's 5-
year average taxable compensation from the company ($189,376).
Supplemental Pension Plans: Some companies maintain supplemental
pension programs to serve as retention tools and assist management
employees in saving for retirement. Unlike qualified plans, these
programs are unfunded and any employer deduction is delayed until the
time of payment. If the company becomes insolvent, the employees are
not paid. The nature of many of these plans is to provide the most
valuable accruals in the years right before retirement (e.g., age 65)
and, therefore, they incent employees to stay in their jobs. The
legislation would require employers to change or abandon these
arrangements because later-year accruals may exceed the one-time pay
limit under common plan designs for long-service employees. The problem
would be further exacerbated if the employer wanted to manage its
employee headcount by offering an early retirement incentive in the
qualified and supplemental pension plans (such as payment of the full
pension without a reduction for early commencement). The increased
value of the pension in the year that the early retirement incentive
was offered could cause the one-time pay limit to be exceeded.
For example, one Fortune 500 company sponsors a supplemental
pension plan that is available to middle managers making a little over
$100,000 per year, many of which work for the company's retail entity.
The company noted the difficulty in calculating annual accruals for
this type of plan and the fact that the value of annual accruals often
varies significantly from year to year due to interest rate changes and
eligibility for early retirement. To the extent an accrual under the
supplemental pension plan exceeded the limit, it is not clear how the
company could ``fix'' the pension plan formula to avoid an excess
accrual. The company also noted that the impact of the one-time pay
limit would be even more severe because other forms of compensation
provided to these managers, such as RSUs, performance units and
severance pay, would also be aggregated with accruals under the
supplemental pension plan in applying the limit. As a result, the
company advised us that they may discontinue the supplemental pension
plan if the annual limit is enacted.
Another Fortune 500 company provides a supplemental pension plan to
its key executives (about 4,000 U.S. employees). The covered employees
do not elect into the plan, it is provided automatically. The assets
are also at a substantial risk of forfeiture until the employee reaches
age 60. If an employee leaves the company before age 60, he or she
receives nothing from the plan. The plan benefit is unfunded before and
after an employee attains age 60. It is paid out on retirement as a
life contingent annuity (either single life or joint & survivor) with a
five year guarantee. The Senate proposal appears to apply to the
supplemental pension plans at the time the plan vests (i.e. at age 60).
Under the plan, until an employee reaches age 60, the benefit is
subject to a substantial risk of forfeiture. At age 60, the benefit is
vested and also deferred, since the employee has no choice but to defer
payment of the vested benefit as a life annuity when that employee
retires. The amount of the deferral at age 60 presumably would be the
then present value of the life annuity. A modest lifetime annuity
viewed that way would violate the $1 million cap and the employee would
be subject to a regular income tax and 20 percent penalty tax that
would significantly reduce their benefit.
For other employers whose supplemental pension plan may follow the
vesting schedule of their qualified plan, the situation is more acute.
In such a case, the vested annual accrual is likely to be subject to
the new limitations. The calculation of that amount (which can depend
upon salary levels and incentive compensation payouts) may be
impossible until after the fact, meaning that the employee will never
know, until it is too late, whether he has ``deferred'' too much.
Bonuses and Incentive Programs: Many employers structure their
bonus programs to fit within the regulatory exception from 409A for
compensation that is paid upon vesting (or 2\1/2\ months after the year
of vesting.) It is not uncommon, however, for employers to find that
they cannot meet this strict 2\1/2\ month rule. Employees may vest at
the end of the year or at the end of the performance period, but
business issues may necessitate a delay in payment that results in the
payment being subject to 409A. Some employers may need to wait longer
for performance criteria to be ascertained, financials certified, etc.,
resulting in the payment being subject to 409A and the one-time pay
limit. In other instances, an employee may vest in increments over the
performance period or upon reaching retirement age but is not paid
until the end of the period, which also would result in the payment
being subject to 409A and the one-times pay limit. Finally, employers
may, to align their interests with those of their managers, encourage
or allow that bonuses be deferred until retirement rather than being
paid currently. Section 409A specifically allows for voluntary deferral
of performance-based pay. The new limits would make such a voluntary
deferral difficult and often impossible.
Private Equity: Many private companies (including start-ups) cannot
readily conform to the specific administrative rules provided under the
409A regulatory exceptions for equity grants (e.g., stock options and
stock appreciation rights) because there is no public market to ensure
a true fair market value price for the grant. As a result, many private
companies' equity grants are subject to 409A. Under the Senate bill,
private companies could not provide this type of equity grant to
employees unless the grant does not exceed the one times pay limit.
Because ``earnings'' on the equity also are subject to the proposed
limit, employees could have a tax penalty under 409A merely because the
company was successful and the value of the equity increased beyond the
limit.
Cash Flow and Start Ups: Small and emerging businesses may pay
modest current compensation during the early stages of the business but
promise significant future compensation, including retirement payments,
in order to attract and retain talented employees. The Senate bill
limits the business from making any promise that exceeds one-time pay
for employees.
Attachment B
Real Examples of Employees Affected by Section 226
Asian male manager, age 57
Base Salary: $180,500
Average 5-year W-2: $142,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005):
$59,000
SERP earnings (not payable until after termination by irrevocable
distribution election): $80,000
Deferred Compensation earnings (irrevocable distribution election):
$6,500
Total 2006 ``deferrals'': $145,500
Amount above allowance: $3,500
Presumably, this would mean a 20% excise tax plus the income tax on
the entire amount.
Caucasian female manager, age 50
Base Salary: $197,000
Average 5-year W-2: $144,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005):
$72,000
SERP earnings (not payable until after termination by irrevocable
distribution election): $75,000
Deferred Compensation earnings (irrevocable distribution election):
$8,000
Total 2006 ``deferrals'': $155,000
Amount above allowance: $11,000
Presumably, this would mean a 20% excise tax plus the income tax on
the entire amount
<F-dash>
Chairman RANGEL. Thank you, Mr. Petrini. As an aside, are
you familiar with the International Labor Organziation (ILO)
suggestions, provisions in the trade laws, as relates to the
NAM?
Mr. PETRINI. No, Mr. Chairman, I am not.
Chairman RANGEL. It's not on today's schedule, I just
thought--thank you so much for your testimony.
Edward Kleinbard, partner, Cleary Gottlieb Steen &
Hamilton, New York, on behalf of the Securities Industry and
Financial Markets Association. Thank you so much for taking
time to share your views with us this morning.
STATEMENT OF EDWARD D. KLEINBARD, PARTNER, CLEARY, GOTTLIEB,
STEEN & HAMILTON, LLP, NEW YORK, NEW YORK, ON BEHALF OF THE
SECURITIES INDUSTRY AND FINANCIAL MARKETS ASSOCIATION
Mr. KLEINBARD. Thank you, Chairman Rangel, Ranking Member
McCrery, and Members of the Committee. Thank you all for
inviting me to testify today on behalf of the Securities
Industry and Financial Markets Association.
I am here to speak in opposition to a Senate proposal that
would reverse settled law by increasing the tax burden on
contingent payment convertible bonds. Contingent payment
convertible bonds are simply publicly issued debt instruments
with two additional features.
First, the holder of a contingent payment convertible bond
can convert that instrument into the issuer's stock at the
holder's option, just as is true of a traditional convertible
bond.
Second, issuers of contingent payment convertibles make an
economically meaningful promise to pay additional cash bonus
interest, if certain future conditions are met. In this
respect, contingent convertibles are similar to other
contingent payment bonds, such as one indexed to the price of
gold or to the S&P 500.
Contingent payment debt instruments may sound exotic, but
they in fact are a common and important financing tool that
many American corporations have used over the last few years to
raise over $90 billion in capital. The IRS and Treasury have
extensively reviewed the tax analysis of contingent payment
convertibles, and these experts confirmed the legal analysis
that the Senate bill now proposes to reverse.
The Senate bill would undo settled law by cutting back the
interest deduction available to an issuer of contingent payment
convertibles. Instead of deducting its true cost of borrowing,
an issuer would be limited to deducting no more interest than
it could have deducted if it had issued traditional convertible
bonds.
At the same time, investors would be taxed on much higher
amounts of income, as if they had purchased a pure contingent
payment bond linked, for example, to the price of gold.
Why is the Senate proposal wrong, as a matter of tax
policy? Why should simply adding a promise to pay bonus
interest to a traditional convertible bond change the tax
results for bond issuers and investors, alike? That, in
essence, is the Senate Finance Committee's argument.
Our response is that the Senate Finance Committee's
reasoning is problematic for four reasons. First, it claims to
treat contingent payment convertible bonds like other
convertibles, when, in fact, it does not do this.
The proposal creates a worst of all worlds result, in which
issuers' deductions are capped at an artificially low number,
just like traditional convertible bonds, but a holder's income
is not similarly capped. Instead, holders are required to
include, as taxable interest income, their entire economic
profit, including the value of any stock they obtain on
conversion.
Second, the Senate proposal denies issuers a full deduction
for the real economic cost of their borrowings. The Senate
proposal overlooks the economic reality that an issuer's true
cost of borrowing includes the value of the conversion option
that it conveys to investors, just as the issuance of
compensation options has real value to an employee, and a real
cost to the issuer.
Third, the Senate proposal will be difficult for the IRS to
administer, because it mistakenly assumes that there is a
single, typical convertible bond yield for every issuer.
Fourth, the Senate Finance Committee's underlying
assumption was that the extra contingent payment features in
contingent payment convertible bonds are economically
meaningless, and therefore, should not drive the tax results.
This assertion is incorrect. The IRS today audits exactly this
question, and requires an issuer to demonstrate that its
promise to pay bonus interest have substantial economic
substance.
The Senate Finance Committee acknowledged in its
legislative history that there was an irreducible logical
inconsistency in the current taxation of convertible
instruments. The Finance Committee argued that the resolution
of the question should be deferred until it can ``be addressed
legislatively through comprehensive reform of the tax treatment
of financial products.''
We agree with this sentiment, but we respectfully submit
that it is the Senate proposal that is introducing piecemeal
change, without regard to the larger context. The tax experts
at Treasury and the IRS exhaustively considered how contingent
payment convertible bonds should fit into the larger tax
system, and came to a carefully reasoned conclusion. That
conclusion should not now be overturned in this ad hoc fashion.
Thank you.
[The prepared statement of Mr. Kleinbard follows:]
Statement of Edward D. Kleinbard, Partner, Cleary Gottlieb Steen & Ham-
milton LLP, New York, New York, on behalf of the Securities
Industry
and Financial Markets Association
Chairman Rangel, Ranking Member McCrery, and members of the
Committee, thank you for inviting me to testify. I am a lawyer in
private practice with the firm of Cleary Gottlieb Steen & Hamilton LLP,
and I am testifying today on behalf of the Securities Industry and
Financial Markets Association (``SIFMA'').
I am here today to speak in opposition to Section 230 of the
Senate-passed version of H.R. 2, which would reverse settled law by
changing the taxation of ``contingent convertible'' debt instruments.
Before addressing this issue, I would like to note SIFMA's opposition
to other provisions in the Senate bill. Specifically, SIFMA has serious
concerns with the Senate bill's provisions that would deny the
deductibility of settlement payments, impose an arbitrary cap on
nonqualified deferred compensation arrangements and expand the Section
162(m) limit on the deduction of executive compensation. These
proposals have unintended consequences that would go beyond the stated
goal of closing loopholes and tax shelters.
Turning to the purpose of my testimony, contingent convertible
bonds are simply debt instruments that are publicly issued by U.S.
corporations, just like any other debt offering. These bonds have two
additional features. First, a holder of a contingent convertible bond
can convert it into the issuer's stock at the holder's option. (This
feature is common to both contingent convertible bonds and traditional
convertible bonds.) Second, contingent convertibles also contain an
economically meaningful promise to pay additional cash ``bonus''
interest if certain future conditions are met. (This feature is common
to other forms of contingent payment debt obligations as well.)
Contingent convertible debt instruments may sound exotic, but they
in fact are a common and important financing tool that many American
corporations have used over the last few years to raise over $90
billion in capital. These corporations often are growing companies with
lower credit quality ratings for which the markets for more traditional
capital markets instruments are foreclosed, or prohibitively expensive.
The Senate bill would undo settled law by cutting back the interest
deduction available to issuers of contingent convertible bonds. Instead
of deducting an amount of interest comparable to what they can deduct
on all of their straight debt or on other contingent debt obligations,
issuers would be limited to a smaller deduction equal to their cash
interest payments, as is also true for traditional convertible bonds.
This result in turn understates an issuer's true cost of borrowing.
The IRS and Treasury have extensively reviewed the tax analysis of
contingent convertible bonds, and these experts confirmed the legal
analysis that the Senate bill proposes to reverse. In doing so, these
experts also confirmed that the current law has a built-in bias that
favors the government because issuers' tax deductions for these
instruments are subject to a special cap, while investors' taxable
interest income inclusions are not. As a result, under current law, a
contingent convertible bond investor's ultimate taxable interest income
will often exceed the issuer's interest deductions.
For example, imagine a typical issuer that normally could borrow at
8 percent, but, in order to conserve its cash, decides to issue a
contingent convertible note. Because the right to convert the debt into
issuer stock is valuable, one might expect, in a typical issuance in
today's market, for the issuer to pay cash interest on the debt of,
say, 2 percent. Under current law, the issuer would be allowed a
deduction of 8 percent, which represents the expected total cost of the
issuer's debt. Under the Senate proposal, the issuer would deduct only
2 percent for its out-of-pocket cash costs. This is the same deduction
that would be allowed for a traditional convertible bond. If, at the
end of the day, the bond gets converted into stock, and it turns out
that the holder realized an effective yield on the bond of 20 percent,
that entire 20 percent is included in the investor's taxable income,
but the issuer's effective interest deduction will be subject to a cap
of 8 percent.
Why is the Senate proposal wrong as a matter of tax policy? After
all, it appears to conform the taxation of contingent convertibles to
the rules for traditional convertible bonds. That sounds superficially
sensible. Phrased differently, why should the addition of a contingent
interest feature give issuers a different tax treatment? That in
essence is the Senate Finance Committee's argument.
The Senate Finance Committee's reasoning is problematic for four
reasons:
First, it claims to treat contingent convertible bonds like other
convertible bonds. However, it does not do this. The proposal applies
the convertible bond rules for purposes of taxing the issuer, but does
not apply the convertible bond rules for purposes of taxing the
investor. This creates a ``worst of all worlds'' result in which
issuers' deductions are limited to their out-of-pocket cash expenses,
but holders' interest income is not similarly capped. Instead, holders
are required to include as taxable interest income their entire
economic profit--both the cash they receive and the value of any stock
they obtain on conversion.
Second, the Senate proposal denies issuers a full deduction for the
real economic cost of their borrowings. The Senate proposal overlooks
the economic reality that an issuer's true cost of borrowing includes
the value of the conversion option that it conveys to investors. A
conversion option has real value to investors, and a real cost to the
issuer, just as the issuance of compensation options has real value to
an employee, and a real cost to the issuer.
Third, the Senate proposal will be difficult for the IRS to
administer because it mistakenly assumes that there is a single typical
convertible bond yield for every issuer. In fact, convertible bonds are
complex instruments to construct, and the relative mix of cash interest
payments and conversion premium varies from deal to deal.
Fourth, the Senate Finance Committee's underlying assumption was
that the ``extra'' contingent payment features in contingent
convertible bonds are ``economically meaningless,'' and therefore
should not drive the tax results. This assertion is incorrect. The IRS
today audits exactly this question, and requires an issuer to
demonstrate that the additional contingent interest that it promises to
pay is economically meaningful--the contingency must be non-remote and
substantial.
Taking a step back, I believe that a persuasive case can be made
that it is the taxation of traditional convertible bonds, not the
taxation of contingent convertible bonds, that is the logical outlier
in the current system. Indeed, traditional convertible bonds are the
only debt instruments of which I am aware that are not taxed under the
``economic expectations '' model. This model, which is based on the
observation that rational issuers and investors expect that all debt
instruments, however constructed, will over time produce a yield
approximately the same as the issuer's normal cost of borrowing. The
treatment of traditional convertible bonds is an historical anomaly,
and its preservation in today's tax law can best be understood as a
``grandfathering'' of a preexisting market instrument.
In reality, the grandfathered tax rules for traditional convertible
bonds contain a hidden, and underappreciated, tax deduction for
investors. That is, in a traditional convertible bond, investors are
permitted to take what should be ordinary interest income and use that
to acquire a capital asset--an option to purchase issuer stock.
Effectively, then, the traditional convertible bond analysis permits
investors to make tax-deductible investments in capital assets.
The Senate Finance Committee describes the taxation of traditional
convertible bonds as consistent with ``the current operation of the
Code and general tax principles.'' But why do we want to elevate to a
general principle of law a tax result that gives investors the
equivalent of tax-deductible investments in capital assets, and that at
the same time takes away from issuers--often relatively young companies
trying to preserve their cash flows--a tax deduction for their true
economic cost of borrowing?
In its explanation of the Senate bill, the Senate Finance Committee
acknowledges that there is an irreducible logical inconsistency in the
current taxation of convertible instruments, and argues that the
resolution of the question be deferred until it can be ``addressed
legislatively through comprehensive reform of the tax treatment of
financial products.'' We agree with this sentiment, but we respectfully
submit that it is the Senate proposal that is introducing piecemeal
change, without regard to the larger context. The tax experts at the
Treasury Department and the Internal Revenue Service exhaustively
considered the issue of how contingent convertible bonds should fit
into the larger tax system, and came to a carefully-reasoned
conclusion. We submit that these experts' analysis of the ``the current
operation of the Code and general tax principles'' is correct, and
should not be overturned in this ad hoc fashion.
<F-dash>
Chairman RANGEL. I want to thank all of you for taking time
out. Could each of you very briefly illustrate an example of
the negative impact of the retroactivity of the deferral bill?
We will start with you, Mr. Kleinbard.
Mr. KLEINBARD. Yes. section 162(M)'s retroactive impact
means that if a company has a written contract with an employee
that is legally enforceable, legally binding against the
company, but which requires compensation to be paid this year
or next year, the consequence of the Senate bill would be to
subject that existing contractually binding agreement to the
limitations of revised section 162(M).
So, these are contracts which the company simply can't tear
up. They are enforceable today by the employee against the
employer. Yet, the consequences will be a punitive effect by
disallowing the interest expense, a punitive tax to the
employer, in the respect of a pre-existing arrangement with
respect to existing compensation.
Chairman RANGEL. Changing the tax law would not be a
defense to your contractual obligation?
Mr. KLEINBARD. No, sir. No. The contract does not typically
contain a change of law ``out'' that would permit the company
to tear up the contrast.
Chairman RANGEL. Mr. Petrini.
Mr. PETRINI. I think, sir, in that regard, it wasn't
unusual for companies to try to avoid violating the provisions
of 162(M). Many companies made it a policy and put it in their
policy statements that they would not pay compensation that
would exceed the 162(M) limits, and as a result, required
certain executives to defer compensation that would not
otherwise have been deferred, but would have been paid
currently, requiring those executives to put that compensation
at risk of the company, and the company's continued
performance, in unfunded deferred compensation, taking
advantage of the fact that under the 162(M) that's currently
drafted, that after an executive retired, he was no longer one
of those who was subject to 162(M).
To now retroactively change that, means that we have in
place many deferral arrangements which were specifically
designed, and which were done basically involuntarily, and
forced upon executives in order to comply with the 162(M),
which, as a result of the change in 162(M) now, would cause
those very payments to be non-deductible.
So, the entire rationale for requiring deferral of certain
amounts in excess of $1 million would have been defeated. It
doesn't change what executives can be paid, it doesn't do
anything to change their pay policies retroactively. Frankly,
we believe that if executive pay is the issue, then it should
be addressed through the work that Chairman Frank's Committee
is doing, not through the tax code.
Chairman RANGEL. Thank you. Mr. Heaslip.
Mr. HEASLIP. I generally agree with Mr. Petrini.
Individuals and corporations made deferral decisions based on
the rules as they existed at that time. It's troubling that
Congress would consider changing the law and applying it
retroactively. I think it under-
mines taxpayer confidence in the system, and makes it very,
very difficult to set compensation policy within a company.
The original 162(M) legislation had an explicit grandfather
of binding contracts and agreements. We think this approach
should be maintained. There is also an effort to extend the
covered employee group and the current Securities and Exchange
Commission definition. While this might not seem to be
problematic, I caution that it adds complexity. To the extent
that we can unify the rules, and speak in consistent terms, it
makes for a more coherent and identifiable policy.
So, retroactivity is something that we think is
problematic, and we applaud your efforts so far to make any
changes applied prospectively.
Chairman RANGEL. Mr. Bentsen.
Mr. BENTSEN. Enforcing the passive-loss retroactively would
trap a number of transactions with an original equipment cost
in excess of $800 million. There are transactions that the IRS
has already passed on, and not found--not challenged, and these
are transactions that go back to the mid-1990s, multi-year
transactions involving the financing of rail equipment,
manufacturing equipment, and the like.
In addition, Mr. Chairman, as you know, the existing
provision has already had unintended consequences as it relates
to the cross-reference rules that were included. In fact, the
final rules have not fully been promulgated because of concerns
about the unintended effects of the existing Act.
Mr. Chairman, you and the prior Chairman, Thomas, and the
respective Chairmen Bachus and Grassley had written to the
then-Treasury Secretary Snow, in 2005, raising concerns about
the cross-reference rules. We believe the Senate bill would
then impose that cross-reference provision retroactively, as
well, which would exacerbate the problem.
Chairman RANGEL. The Chair would like to recognize, for
questioning, the ranking Member, Mr. McCrery.
Mr. MCCRERY. Thank you, Mr. Chairman. Mr. Bentsen, would
this retroactive application of the Senate provision in any way
undermine the financial viability of some of those arrangements
that were entered into in the mid-1990s?
Mr. BENTSEN. Our understanding, from--is that under FASB
guidance, imposing 470 prospectively would cause members to
have to go back and recompute their books from the inception
date of the lease. That would cause them--because it would be a
changing in the cash flow stream, that would cause them to have
to restate--potentially, to restate their books. So, in
addition to a tax increase retroactively, it also could have
financial reporting consequences, as well.
I might add, Mr. McCrery, that my members tell me that they
view this as having--the retroactive nature of this--as having
a dramatic impact on the leasing market, from an investor
perspective, going forward, as well, well beyond the intent.
Mr. MCCRERY. Thank you. Mr. Heaslip, why do companies like
PepsiCo have these non-qualified deferred compensation plans,
in a nutshell?
Mr. HEASLIP. Let's take the case of an elective deferral
program. There are three primary reasons. The first is that
they incur savings for retirement, which we think is good
public policy.
Since the plans are unfunded, and the deferrals are at
risk, they provide an extra incentive for employees to ensure
the continuing health and success of the organization, so that
the obligations can be paid out at that point in the future,
when they retire.
Then, third, companies can use the deferred moneys to
invest in their businesses. Instead of paying them out in
current cash, we can take the funds and provide jobs, or buy
equipment, or build plants, or use them elsewhere.
Mr. MCCRERY. Well, you didn't mention, as one of the
reasons, that the employee who defers his income avoids
taxation. Does the employee, in fact, avoid taxation on that
income, should he receive it in the future?
Mr. HEASLIP. The employee defers taxation.
Mr. MCCRERY. That's different from avoiding it.
Mr. HEASLIP. They don't avoid taxation, they defer
taxation, and the matching principle still applies, so that the
company does not get a tax deduction for the payment until the
employee realizes the payment and pays taxes on it.
Mr. MCCRERY. Now, you mentioned, in the course of one of
those reasons, that the deferred compensation was ``unfunded
and at risk.'' What does that mean?
Mr. HEASLIP. What that means is that, unlike a traditional
pension plan, for example, assets are not set aside or secured,
in order to pay those obligations. The company pays those
obligations out of cash flow at that point in the future, when
they become due.
Mr. MCCRERY. Is that by choice of the corporation, or is
that by law?
Mr. HEASLIP. That is by law.
Mr. MCCRERY. In fact, the American Jobs Creation Act that
we passed recently tightened that criteria, didn't it?
Mr. HEASLIP. The American Jobs Creation Act imposed a
series of additional requirements around the timing of election
deferrals, the payout of election deferrals, the form of
election deferrals, and it put in special provisions for
executives that are considered key employees, in respect to
when they can take their deferrals.
We are still digesting those new regulations. Final
guidelines have not yet been issued. We would propose for final
clarification of existing law before we introduce new
complexities.
Mr. MCCRERY. So, since the deferred compensation is taxable
when it's finally given to the employee, and since that
deferred compensation is unfunded and at risk, as you say, it
really does make the employee very interested in the
performance of the company, because, as you said, the ultimate
payout of that deferred compensation is not dependent upon
tapping into some fund that is set aside. That would be
illegal. It is dependent on cash flow of the corporation.
Mr. HEASLIP. Exactly.
Mr. MCCRERY. It really does tie that employee's interest to
the interest of the shareholders, the interests of the
corporation, the interests of the officers of the corporation.
Mr. HEASLIP. That's correct.
Mr. MCCRERY. Which all goes into, we would hope, better
corporate governance.
Mr. HEASLIP. Better performance for shareholders.
Mr. MCCRERY. Right. Now, if the Senate provision were
enacted into law, would it impact only the bigwigs in the
corporation, the top executives?
Mr. HEASLIP. In our corporation, approximately 1,000
individuals are limited in the amount that they can receive
from the qualified pension plan, and receive a portion of their
pension benefits from the non-qualified restoration plan that I
mentioned. So, far beyond the scope of the CEO or the named
executive officers.
Mr. MCCRERY. Thank you. Thank you, Mr. Chairman.
Chairman RANGEL. Thank you. Mr. Levin.
Mr. LEVIN. Thank you, Mr. Chairman. Yes, I think you have
presented very articulately some problems. Have any of you
testified before the Senate on these issues?
Mr. HEASLIP. No.
Mr. LEVIN. No. Do you know, have there been hearings on
these issues before the Senate? Maybe you don't know that. Mr.
Bentsen, do you know of any hearings?
Mr. BENTSEN. Certainly not this year, I don't believe.
There were hearings back in 2003, during the initial--as the
Jobs Act, I guess, was initially being created. I might add,
during those hearings when the legislation was introduced, as
it relates to our concern, it was stated as prospective. So the
retroactive nature is a relatively new phenomenon.
Mr. LEVIN. I take it, Mr. Chairman, there is nobody here
from Treasury?
Chairman RANGEL. No, they declined to testify.
Mr. LEVIN. The punitive damages play a role, and there are
differing opinions as to how effective it might be. I think
your testimony should be taken not as an attack on the basic
structure, but whether we should change the taxation of
punitive damages. Isn't that correct?
Mr. PETRINI. That is absolutely correct. The issue really,
again, gets to be the matching principle, that if punitive
damages are income to the recipient, it makes sense that they
be deductible to the payor.
It is also the issue that the punitive damages is such a
vague concept, or it's a concept that isn't consistent from
jurisdiction to jurisdiction, and it is very difficult to have
a--what effectively would be a punitive tax treatment a payment
that is being made that is both taxable to the recipient and is
non-deductible to the payer.
Again, the question was asked about retroactivity. It would
have a chilling effect on cases that are currently pending, or
that may be an initial decision in, and a decision being made
as to whether they will appeal.
So, we are not at all questioning the validity of punitive
damages as a substantive matter of law. We are just saying that
the tax treatment shouldn't be singled out from the general
principles that we have of an item being taxable to one person
and deductible to another.
Mr. LEVIN. Mr. Heaslip, you said in your testimony that
there were about 1,000 employees who could be affected of your
company. Mr. McCrery questioned you, I think, very effectively
about that. Is there any reason to believe that the situation
in your company would be unique, or that this issue would apply
to a substantial number of employees, other than the CEOs and
the higher echelon personnel, in other companies? Do you have
any insight into that?
Mr. HEASLIP. The limits upon qualified plan benefits apply
to all plan sponsors. So, any company who sponsors a defined
benefit plan, like we do, is going to be subject to the same
qualified plan limits.
I would further kind of suggest that this is a growing
problem, because those qualified plan benefits are not moving
at the same rate as pay is. For example, the qualified plan
limit in 1989 was about $200,000. Today, 16 or 17 years later,
it is $225,000. So, we have a much, much larger group of
employees who receive benefits from the restoration plan today
than we did 15 years ago, and I would expect that trend to
continue.
Mr. PETRINI. Mr. Levin, if I could, because we can also
offer a perspective, being a much smaller employer than Pepsi--
we have roughly 10,000 employees in the United States, which
I'm sure is dwarfed by PepsiCo--and we would have about 300
employees who would be potentially impacted, because we allow
all employees who receive annual cash bonuses to voluntarily
defer bonuses, and they have other forms of deferred
compensation.
So, if Air Products is an example, on an employee base of
10,000, we have 300 that are affected. So, it's a very large
problem.
Mr. LEVIN. For those of us who have been very sensitive to
the future of defined benefit plans, it strikes me that this
testimony should be taken into account. Thank you very much.
Chairman RANGEL. Thank you. Mr. Johnson, from Texas.
Mr. JOHNSON. Thank you, Mr. Chairman. I appreciate your
testimony. I tell you, the--I used to be on the education
Committee, as you know, and Mr. Heaslip was a witness over
there a couple of times. You have always been clear and very
useful in your testimony.
This misguided revenue measure that we have been talking
about here that our friends in the Senate have passed, in your
testimony you said that the Senate provision would penalize
early retirement benefits that simply mirror those in
traditional defined benefit pension plans.
When we revised the pension plans here last year, we tried
to do it in a way to keep those plans in force, and it was
tough. As you know, it was marginal whether some companies kept
them. I guess yours did. What I would like to know is if this
retroactivity goes into force, would you all do away with your
defined benefit plans?
Mr. HEASLIP. It certainly would add another challenge to
the many that already face defined benefit plan sponsors. As I
said in my testimony, although I have a specific concern about
how the individuals in our restoration plan would be affected,
I have a broader concern about the implications of this for the
plan in general.
I think once we disenfranchise middle and senior managers
from a defined benefit plan, it just simply adds another
challenge or barrier in an already challenging environment.
Mr. JOHNSON. Well, it's a difficult position to be in. You
also said it might force managers to leave the company, so they
could just pay taxes on their deferred compensation. You talked
about deferral and various forms of compensation all lumped
together, a 20 percent penalty because of--the income is above
the annual base.
Isn't it possible that this might undermine long-term
corporate planning, and just further induce corporate raiders
to buy companies, or figure out how to get around the law, if
the law is not fair?
Mr. HEASLIP. That's true, sure.
Mr. JOHNSON. Do you want to comment?
Mr. HEASLIP. It certainly makes individual planning
challenging, and could have the effect that you hit on, which
is somebody who triggers taxes and penalties if they need to
leave the company in order to get the cash to pay those taxes
and penalties, and that's certainly not something that we want
the tax law to encourage.
Mr. JOHNSON. Thank you. Ken, it's good to have another
Texan with us today. Thanks for being here.
I think you hit it right on the head when you talk about
increased taxes retroactively. They're just not right. I do not
think we can travel back in time to undo transactions that were
legal at the time. The laws of physics and good tax policy
prevent, or prohibit, time travel, I would say.
One of the cries we used in 1994, when we won control of
this place, was opposition to retroactive taxes. I don't think
we can go back to that. I would like your comments on it.
Mr. BENTSEN. Well, Mr. Johnson, I agree with you from the
standpoint that I think retroactive tax policy is something
that this Committee and the congress, generally, has opposed,
because of the impact that it has on both investors and how
they will deploy capital for any length of time, and quite
frankly, on the ability of Congress to incent investment as
they see fit.
So, I think you are accurate. I would, if I might, very
briefly clarify in response to Mr. Levin regarding any
hearings, there had not been any hearings on the retroactive
nature of this. The Senate did, subsequent to the introduction
of the Jobs Act, take up amendments to this effect to go
retroactive. The House wisely and consistently rejected those
amendments, as it has as late as this year.
I just wanted to make sure I clarified that point. Yes, I
think you're right, Mr. Johnson, that this is something that is
quite out of character for how the congress has addressed tax
policy.
Mr. JOHNSON. Right on. Thank you, sir. Thank you, Mr.
Chairman.
Chairman RANGEL. Thank you, Mr. Johnson.
Dr. McDermott.
Mr. MCDERMOTT. Thank you, Mr. Chairman. This Committee has
changed in the years I have been here. Last week we had a
hearing on global warming, and we had a whole panel, and they
all agreed, both the Republican witnesses and the Democratic
witnesses, that there was global warming. The question was what
you ought to do about it.
Today we have a panel of four people, and I guess they
couldn't find anybody to come in and testify that there was
some good in what's been proposed by the Senate. How--explain
to me how the Senate could have looked at these provisions and
thought, some way, it was good for business. I assume this is
what it is, because if we raise the minimum wage, that's bad
for business. Now we've got to give business something that is
good for business to balance that out.
What in the world did they think they were giving to
business, or--out of this, that would somehow ameliorate the
problem of raising the minimum wage? Can you help me understand
what the thinking might have been over there? Somebody. Mr.
Petrini, you could start.
Mr. PETRINI. Thank you. I don't know whether there was any
intent to do something that was good for business. I think one
can look at the four provisions that I talked about, and see
how somebody could think that there was a policy behind them.
As we suggested, we think that the policy was misguided,
because the provisions themselves are not drafted tightly
enough.
The settlement provision, for example, one can look at that
and say, ``Yes, it makes sense that a company shouldn't be able
to deduct the cost of paying a settlement where they have a
violation of law, and they have reached a settlement with a
government agency.''
However, a lot of what we think would be the restitution
part of that settlement, it would be deductible. The parts that
become non-deductible are those parts that we often do that go
over and above the perceived violation. So, we think that the
way it was drafted is just too broad. You look at the deferred
compensation. Everybody agrees--and one can assume that the
deferred compensation changes had their genesis in this belief
that executives are overpaid.
As I suggested, I think that if you want to align
executives and shareholders alike, you should be encouraging
executives to take their compensation in a deferred manner,
rather than taking it currently, because that way, they have a
lot of skin in the game, as they like to say.
So, I don't think that there was necessarily any intent to
help big business, but I think there are some policy reasons
behind some of these changes that are proposed. We just don't
think that the policy was well thought-out, or that the
proposals get at the harm that was really being addressed.
Mr. KLEINBARD. Mr. McDermott, I think Mr. Petrini's remarks
are absolutely on point. What I would--to summarize our
thoughts on it, is that in several respects--perhaps not in the
contingent payment converts, but in some of the other cases--
there is a core of an issue that deserves to be thought about
and addressed, but that the Senate proposals, as they have been
enacted in the Senate bill, are just profoundly undercooked.
They are not yet fully developed proposals. They have lots
of collateral consequences, which we believe to be completely
unintended, or underappreciated. The ideas need to go back in
the oven for a proper set of--for the appropriate time, to
develop properly targeted, narrowly focused issue that does no
harm, as well as solving the very narrow problems that were the
original target.
Mr. MCDERMOTT. It's probably a good time, with St.
Patrick's Day, to enact Murphy's Law. That sounds like what
you're saying. Mr. Bentsen?
Mr. BENTSEN. Dr. McDermott, I think there is a sense that
perhaps imposing this provision retroactively, in the most
compassionate sense, is trying to go after certain transactions
that have been challenged by the Government.
However, in the way that it's done, first of all, serves to
undermine confidence in our tax system by doing it
retroactively, and I think has far reaching implications beyond
just those provisions that may be in question, and certainly
captures many more.
Second of all, I think undermines our whole system of due
process rights that we have in this country. Cases that should
be challenged will be challenged. The idea that this is somehow
relieving the Government from bringing suit is something
generally the congress doesn't do, just as it's something that
Congress generally doesn't do retroactive tax policy.
So, ironically, I think it has far-reaching unintended
consequences.
Mr. MCDERMOTT. Thank you. I still have my question as to
what did they think they were doing? Thank you, Mr. Chairman.
Chairman RANGEL. We may find out. Mr. Weller is recognized
for 5 minutes.
Mr. WELLER. Thank you, Mr. Chairman, and I commend you for
conducting this hearing today. As one who supports increasing
the minimum wage, I also want to commend you for the bipartisan
approach you have taken in putting together a package of tax
relief for small business, as part of the package which helps
both workers, as well as small business. The bipartisan
approach that you and Mr. McCrery have worked out I commend you
on. It sets a great precedent for this Committee and this
congress. I want to thank you for showing that kind of
leadership.
Mr. Chairman, I want to thank you and the panel for this
hearing. Clearly, decisions that investments by business make,
many of them are based on tax consequences. Many of us on this
Committee have raised concerns about what we call retroactive
tax increases.
I particularly want to ask about the decision by our
friends in the other body to expand transactions subject to the
2004 conversion rules. I was going to direct this question to
Mr. Petrini, if you would. If others want to respond--but I
will direct it to you, Mr. Petrini--is when the Senate voted to
expand transactions subject to 2004 inversion rules, would you
classify that as a retroactive tax increase?
Mr. PETRINI. Yes, I think you would have to.
Mr. WELLER. I guess I have always been told that
consistency and confidence in tax policy will remain the same
in the foreseeable future is a factor on businesses making
decisions on investing and job creation.
This precedent that would be set when it comes to a
retroactive tax increase, what will that do to the confidence
level, business decisionmakers, when it comes to making
business decisions when they consider tax policy with this
retroactive tax increase?
Mr. PETRINI. Well, I think it's very difficult. Considering
my role as a chief tax officer in a company, it's very
difficult if you have to give senior management answers to
their questions, whether it's inversions, deferred
compensation, or anything where you say, ``Well, that's the law
today, and the law may change.'' They accept the fact that the
law may change, and they will take the risk that it will change
in the future for things that they do in the future.
If there is an inability to tell people that what you do
today will be taxed under the rules that are applied today, and
exceptions for binding contracts and commitments made, and you
know, often billions of dollars--we're talking about
significant capital projects--if you can't give that kind of
certainty, it makes it much more difficult to operate in the
U.S. tax system. Perhaps places U.S. companies, or companies
wanting to do business in the United States, places the ability
to do business at a global competitive disadvantage.
Mr. KLEINBARD. Mr. Weller, if I could?
Mr. WELLER. Mr. Kleinbard.
Mr. KLEINBARD. Thank you. If I could give a parallel
answer, but from the perspective of the capital markets, as
opposed to the corporate employer itself, Congressman Bentsen
made a very important point, I thought, in his earlier
testimony, that the retroactive change in the law, one, changed
the perspective of participants in the leasing market.
The reason for that observation, I believe, is that if
participants in the leasing market or in the capital markets,
generally, believe that settled law is not, in fact, settled,
there is a risk of retroactive change in law, the consequence
of that is that they are going to have to charge more money.
They are going to have to charge a risk premium for the risk
that the law itself will change, as opposed to just credit risk
or market risks.
So, every time you introduce a new kind of risk, the
capital markets, which are very efficient, price that risk.
Now, what you're effectively doing, is asking the capital
markets to price not simply credit risk and market risks, and
those kinds of risks, but also the change of law risk that
settled, contractual expectations will not be honored by virtue
of change in the tax outcomes, so that the allocation of income
from a transaction will not be honored through the retroactive
changes in law. That raises the cost of capital for every
company.
Mr. WELLER. Of course, my classmate and former colleague is
with us--good to see you, Ken, thank you for joining us today.
Do you agree, have the same perspective on this retroactive----
Mr. BENTSEN. Absolutely, Mr. Weller, and I think that the
counselor is absolutely correct. You think of the situations--
say, United Airlines, for instance, in your State of Illinois,
that investors will underwrite the cost of their airplanes.
The airline industry, as we know, is already fairly tight
on margins in most cases--in many cases, negative margins from
time to time. Their ability to operate is to have aircraft that
they can put into the air on a regular basis. They have to pay
a cost for that. If the cost for capital rises in that, that
directly effects their ability to be an operating, or a going
concern.
So, yes. I think this is very serious, far beyond the
intended target.
Mr. WELLER. Thank you. Thank you, Mr. Chairman, you were
generous with my time. Thank you.
Chairman RANGEL. The Chair would like to recognize the
gentleman from Georgia, Mr. Lewis.
Mr. LEWIS OF GEORGIA. Thank you very much, Mr. Chairman.
Thank you very much for holding this hearing. I thank members
of the panel for being here today. Mr. Bentsen, it is good to
see you again.
Mr. Bentsen, you must have some friends in the Senate that
you could talk to and not just come before this Committee? I'm
sure you have some wonderful friends there.
Mr. BENTSEN. Well, I think I do, Mr. Lewis. We finally have
been talking to the Senate about this, as well. I think, as--
and let me say I appreciate the Chairman for calling this
hearing, and having not just us at this panel here, because it
does give us an ability to really air these issues out.
I believe that the intentions of the Senate are well
intentioned. I think that they have perhaps not taken the time
to look at the implications of what they are trying to do here,
as it relates----
Mr. LEWIS OF GEORGIA. One member of the panel said it's
like cooking a meal, and I think you suggested it's not
completely baked, and maybe they should put it back in the
oven? Can I hear a reaction to----
Mr. BENTSEN. Well, in our case, I would say as it relates
to retroactively tax policy, I don't know that retroactive tax
policy is ever going to be fully baked. I think that it's
something that is just a bad idea, which, if you go back and
look--at least from my recollection--at prior tax acts,
generally, consistently, the congress has tried to avoid
retroactive tax policy where it involves the long-term
deployment of capital, because of the impact.
So, I just don't think there is ever a situation where the
congress is going to say, ``Well, if we do something
retroactive, we can raise a lot of revenue doing it,'' that the
congress has just generally said, ``That's just not a good
idea.'' So I don't think there is every going to be a situation
where you would come back and say, ``Well, we looked at the
issue, we studied it more closely, and maybe this works
better.''
Perhaps when--certainly on more complex financial issues,
like the convertible bond issue, which I am not at all informed
to speak on, but there are certainly technical things that I do
think take time. Generally, the congress has always done that.
Mr. LEWIS OF GEORGIA. That's what he said. Mr. Heaslip, in
your testimony you describe a plan that covers an approximate
1,000 senior managers at PepsiCo. The program seemed to mimic
the company 401(k) plan. You described the program as a
voluntary savings plan.
How would the section 409A provision affect this plan and
its participants? What impact would it have?
Mr. HEASLIP. The plan that I am referring to is the
elective deferral program, where executives can voluntarily
defer a portion of their salary or bonus each year. It is
similar to the 401(k), in that it offers the same investment
options, but it's very different from the 401(k), in that the
money is at risk. There is no company match on this plan, as
well.
This is the plan where, because earnings are being included
in the deferral toward the one times cap, the amount of the
deferrals become very unpredictable. A year of good investment
performance could wind up triggering taxes and penalties on
money that the executive has not received.
So, in effect, somebody who has saved for their entire
career would wind up paying taxes and penalties because they're
a disciplined saver, they are putting money away for
retirement, and they weren't able to predict the stock market.
Mr. LEWIS OF GEORGIA. Do you have an estimate for
retirement savings for the rank and file employees of a
company, compared to the retirement savings for your high-
level, well-paid executives?
Mr. HEASLIP. I do. Again, we provide a defined benefit plan
that provides the primary vehicle for retirement security for
all of our employees, and that's completely funded by the
company. So, rank and file doesn't pay anything for that. Rank
and file, about 65 percent participate in our 401(k) plan. Of
our executives, about 30 percent participate in the elective
deferral program.
Mr. LEWIS OF GEORGIA. Would the benefits under the plan be
caught on the----
Mr. HEASLIP. Yes, the elective deferral plan would be.
Mr. LEWIS OF GEORGIA. So, you are telling Members of the
Committee that what the Senate is proposing would have a
negative impact?
Mr. HEASLIP. On savings?
Mr. LEWIS OF GEORGIA. Yes.
Mr. HEASLIP. For the individuals in that plan? Absolutely.
Mr. LEWIS OF GEORGIA. Thank you very much for being here.
Mr. HEASLIP. Thank you.
Mr. LEWIS OF GEORGIA. Thank you, Mr. Chairman.
Chairman RANGEL. Thank you. Mr. Brady.
Mr. BRADY. I am not aware of any taxpayers entering into
transactions after Congress enacted the legislation in 2004.
Are you?
Mr. BENTSEN. No, sir, not to our knowledge. From what our
members tell us, these transactions are effectively stopped
with the passage of the Jobs Act.
Mr. BRADY. Well, it seems to me that with both the
provisions, basically the Senate is trying to squeeze more
money out of a problem that Congress worked together to solve
already.
While I am not a big proponent of raising the minimum
wage--I am a Chamber of Commerce executive by profession,
worked a lot with small businesses, I think mandating a $5,000
pay raise will have a real impact on some of our small
businesses--nonetheless, Chairman Rangel worked hard with the
minority to craft a tax package in the House that actually
tried to ease some of the impact of that minimum wage. I am
very grateful for that.
I look at the Senate, and I think they're way off the mark,
both in their tax provisions and their revenue raisers. I look
at this provision as one of those issues.
To talk about the negative--or to reveal the negative
impact Mr. Lewis just talked about, the Senate is not just
changing rules in the middle of the stream, they are changing
the rules 5 years after you crossed the stream. I think it has
a real impact in the future, and can for you and Mr. Kleinbard.
Looking forward, what signal does this retroactivity send
to taxpayers who are thinking about making future capital
investments? Well, what does it say to them?
Mr. BENTSEN. Well, Mr. Brady, I would say, ironically, if
you look at the Senate package, for instance, it contains
certain provisions to create investment going forward, over a
multi-year basis. A taxpayer who would be looking--an investor
who might be looking at that would also be thinking, ``Well,
there is another provision within this bill that actually
steps--reaches back and imposes a tax on me.''
So, I would think twice about whether or not I would follow
the other provisions that are contained in this bill, where I
am going to be expensing benefits to make a long-term
investment, because who is to say that next year they're not
going to come back and reach back and take that back from me?
Whereas, I might go put my capital elsewhere, where I feel more
confident.
So, I just think it is quite problematic, the way it's
structured, and quite frankly, undermines some of the other
provisions that are in that bill.
Mr. BRADY. Encourage on one hand, and discourage and raise
uncertainty on the other hand?
Mr. BENTSEN. Yes, sir.
Mr. BRADY. Thank you.
Mr. KLEINBARD. I would agree with what Congressman Bentsen
said, and I would emphasize the theme that economics teaches us
that the success of our country's economy has always been based
on a notion of a rule of law, and the importance of having
clear property rights, having clear enforceability of those
property rights, and a clear relationship between--in
connection with this Committee--the taxpayers and the
Government, makes it possible to predict, with some certainty,
what the consequences of your actions will be.
Let me take an over-the-top example, just to illustrate the
point. If we had a world in which every homeowner was at risk,
that 1 out of every 1,000 homes would just be randomly seized
by virtue of a lottery by the Government, to be used to pay a
shortfall in the revenue bill, that would affect housing
prices.
Mr. BRADY. It's called eminent domain.
Mr. KLEINBARD. Eminent domain doesn't work by lottery, and
in eminent domain you could get paid. In my example, it's just
a lottery, the house gets taken away from you. It would affect
your willingness to own a house.
The same is true here. Any time you have rules where there
is a shadow of uncertainty, the capital markets will respond by
pricing in that risk. The consequence of pricing in risk is
that the cost of capital goes up.
Mr. BRADY. Well, thank you. You finished the point, I
think, that Chairman Rangel has made, which is while Congress
frequently changes rules in the middle of the stream, this
Committee has gone out of its way, historically, to not change
those rules retroactively, to try to provide some consistency
in Tax Code, in tax policy, especially in the areas of
investment. Thank you, Chairman Rangel.
Chairman RANGEL. Thank you, Mr. Brady. The Chair recognizes
Mr. Neal for 5 minutes.
Mr. NEAL. Thank you very much, Mr. Chairman. Mr. Heaslip,
you have testified about the problems you see in the non-
qualified deferred comp proposal. Many of us have also heard
from businesses in our districts that this provision could hit
middle or senior managers, not just necessarily CEOs.
Your testimony refers to one example of a manager earning
$100,000 annually, who was laid off because of downsizing. This
person's pay could be subject to the higher taxes because of
the proposed revision.
Could you explain how this would work, and might you make
some recommendations about how to better target this proposal,
including a $1 million uniform cap, and limiting the provision
to CEOs and certain other executive officers?
Finally, are these legislative changes--or, could they be
done in an administrative manner?
Mr. HEASLIP. The example that you referred to is the
example of where a manager is--loses his or her job because of
a restructuring or a plant closing. In our company, we have a
practice where, if an employee is within 5 years of retirement,
and they lose their job because of downsizing, we provide a
special early retirement benefit to them from the non-qualified
pension plan.
The goal for the non-qualified benefit is to treat them
more like an early retiree than a terminated employee, and to
avoid the substantial loss in pension benefits that they would
otherwise experience because of the plant closing.
We pay this benefit from the non-qualified plan, in order
to comply with discrimination rules on the qualified plan. If
this payment from the non-qualified plan were subject to the
Senate's proposals, it could easily trigger the one times
deferral cap, and invoke taxes and penalties at the same time
that somebody is losing their job and entering a more uncertain
financial future.
This scenario could be avoided through technical changes to
the law, but it would be much simpler, and I think fairer, if
it were resolved with something like the $1 million cap that
you suggested.
Mr. NEAL. Okay. Mr. Petrini.
Mr. PETRINI. If I may, because we have a slightly different
view, and that is that we continue to believe that it's a
misguided notion that somehow deferred compensation is CEO-
friendly and shareholder unfriendly. We believe that, one, you
should get input from shareholder groups, so they see the
alignment from deferred compensation.
We do believe, and our members believe, that when senior
executives defer compensation, and the more they defer, it
aligns their interests with the interests of the shareholders,
as far as the going concern of the company, because those
shareholders and the executives then have the same interests.
The executive essentially becomes an unsecured creditor, really
of the lowest rank, as far as security, in the company. That's
not a bad place to have your executives, where they have a
great amount invested in that company, and their ability to get
that payout depends upon the company's ability to perform.
So, we would suggest that trying to limit CEO deferred
compensation may, in itself, be one of those things that is
half-baked. Somebody should really look at whether deferred
compensation doesn't align CEO interests and shareholder
interests better, and should be something that we should
encourage, rather than discourage.
Mr. NEAL. Thank you. Thank you, Mr. Chairman.
Chairman RANGEL. The Chair recognizes Mr. Linder, from
Geogia, for 5 minutes.
Mr. LINDER. Thank you, Mr. Chairman. Mr. Heaslip, explain
again why you have this non-qualified plan. You said it was to
make up a shortfall in other provisions?
Mr. HEASLIP. Yes.
Mr. LINDER. Explain that again.
Mr. HEASLIP. We have a defined benefit plan that we offer
to all employees. The IRS code limits the benefits that can be
paid from such a plan. So, we sponsor a non-qualified
restoration plan to essentially mirror, or restore, the
benefits that would normally be available from the qualified
plan----
Mr. LINDER. How does that get around the IRS rule?
Mr. HEASLIP. Since the benefits are not funded, and they do
not receive the favorable tax treatment that qualified plan
benefits receive.
Mr. LINDER. Okay. It's just cash flow.
Mr. HEASLIP. It's just cash flow, unsecured.
Mr. LINDER. That is entirely elective?
Mr. HEASLIP. It is--no. There are no decisions.
Mr. LINDER. I see.
Mr. HEASLIP. The benefits are based on the same formula as
we have in the qualified pension plan. There is no discretion
or decisions or a choice between current cash and retirement
benefits, on the part of the executive. It's simply a
restoration adjunct to the----
Mr. LINDER [continuing]. The electability of it----
Mr. HEASLIP. That's correct.
Mr. LINDER. That's correct. Mr. Kleinbard, explain to me
what an exit tax is, for people who have spent a long time
living in the United States from Great Britain, and work for a
foreign company. I assume they don't pay taxes on the money
they make here.
Mr. KLEINBARD. An individual who is a citizen of Great
Britain, sir, is your example, and who lives in the United
States, and is a current resident of the United States?
Mr. LINDER. Yes.
Mr. KLEINBARD. Is taxed on his worldwide income by the
United States, just as a U.S. citizen is, if they are permanent
residents of the United States.
Mr. LINDER. What is the exit tax?
Mr. KLEINBARD. The exit tax--and this is an issue,
obviously, to which--in the nature of my practice, I always
like to do it with the books open in front of me, so I
apologize if I don't get it quite right.
The idea of current law is that if it's a U.S. citizen, for
example, who wishes to move to a foreign jurisdiction, we
impose a tax on the unrealized gain, in respect of his or her
assets and other contractual rights to income that they might
have, so there is no advantage, you can't make money by simply
tendering in your U.S. passport.
Mr. LINDER. What if it's a foreign citizen?
Mr. KLEINBARD. I don't know how the exit tax works for
foreign citizens.
Mr. PETRINI. This was actually part of our written
submission. If the individual is either a citizen or a green
card holder, and gives up the citizenship or the green card,
the exit tax applies. It has gone through various iterations.
It seems like there was always some form of a revenue-raiser
that is getting at expatriation.
It is revenue driven. Its original form was expatriation
that was designed to avoid income tax, and it made a lot of
sense, because it was getting at an abuse, where people were
giving up citizenship, or giving up green cards, to avoid tax.
The situation our members see is that we try to bring
foreign nationals in as--just as we send U.S. citizens abroad
as expatriates, we bring foreign nationals into this country to
work, sometimes for fairly long-term assignments. Someone, for
reasons--often personal reasons--will obtain their green card.
There is a natural flow of things. When they return to their
home country, they will give up that green card. They are not
expatriating to avoid tax, they're basically going home. It has
become a very difficult situation for companies that employ
both expatriates and inpatriates.
I suggest that it may actually be an issue that companies
have to take into account considering where they locate their
headquarters, because in this global economy, you want a
continued flow of people of all nationalities in and out of
your headquarters, so that you can really mirror the way your
customers look.
Mr. LINDER. Do other nations, to your knowledge, do other
nations have a tax like this?
Mr. PETRINI. I don't know of another nation that has this
kind of a mark to market tax, simply because you have given
up--especially as a permanent resident--non-citizen, and I
don't know of another country that has it.
Mr. LINDER. Thank you. Thank you, Mr. Chairman.
Chairman RANGEL. Thank you. The Chair would recognize Mr.
Tanner for 5 minutes.
Mr. TANNER. Thank you very much, Mr. Chairman. I will try
not to utilize all of the time. Thank all of you for being
here.
I came here this morning, primarily interested in hearing
the discussion regarding the compensation and retroactivity
issues, and I think you all have adequately covered them, and I
thank you. I also will welcome Ken back. I am always interested
in your observations of where we are here.
Now, one question. I was reading about part of the bill
that has to do with trying to help the IRS discern what's a
fine or a penalty, and there may be some problems with that, in
terms of some unintended consequences. Mr. Petrini, could you
address that, please?
Mr. PETRINI. Sure. The basic provision causes certain
payments that were made as a result of a settlement to be non-
deductible. I think the problem we see with it is that it--the
way it's drafted, and the reach of the bill may be a bit too
broad.
The example that I am going to use is it would deal with
any payment that is made in settlement of an inquiry into
violation of--possible violation--of law. So, take the example
that we have all seen of a spill of chemicals, or another item
somewhere, that has caused a problem in a stream. You deal with
the EPA, and you agree you're going to clean up the stream.
You have also had some bad press, so you decide you're
going to build a park--on the bank of a stream, maybe build
some areas for fish to spawn in the stream, and actually make
the stream better than it was before.
Well, under this provision, your expenses in cleaning up
your spill would probably be deductible, but the expenses that
you incur in building that park, and in building that spawning
area for fish, and in making the stream better than it was
before, those go beyond what's necessary, so therefore, they
would be non-deductible. To me, that's sort of counter to what
you would think public policy would be, to try to encourage
more of that kind of a civic spirit.
Mr. TANNER. That would represent a change in present law?
Mr. PETRINI. Yes. Under present law, these types of amounts
you would spend are deductible, and they are not treated the
same as a fine or a penalty would be.
Mr. TANNER. If a fish issue comes up again in conference,
maybe we could get you to help us with some language. It would
actually accomplish a good public policy in this area.
Mr. PETRINI. We would be very happy to do that.
Mr. TANNER. Thank you. I yield back the balance of my time,
Mr. Chairman.
Chairman RANGEL. Thank you. Mr. Porter is recognized for 5
minutes.
Mr. PORTER. Thank you, and I appreciate the panel being
here this morning. This may have been addressed, so bear with
me.
What I hear regularly from families and businesses is that
we are constantly changing the rules. Small investors and even
folks that are of modest incomes have tried to plan their
future. Some of these changes being retroactive and back to
2004, how does that impact the expansion of business, the
expansion of an individual that would like to reinvest, create
more jobs to help our economy? This changing the rules, how is
that impacting?
Mr. KLEINBARD. Mr. Porter, I would answer that question by
saying that I think that the point that we would like to make,
at least, is that a small investor is not directly affected by
the change in ILO rules. So, in that narrow sense, using that
as an example, there is no effect.
The same is true for some of the other retroactive
provisions of the bill. The question is if retroactivity is
viewed not as extraordinary, but as ordinary practice by the
congress, then the risk of retroactivity has to be priced into
everything that people do. That, in turn, has a direct impact
on the markets. It is another risk that needs to be priced, and
the consequence of that is that the cost of doing business in
the general sense, the cost of raising capital, goes up.
So, it's not the specific provision that necessarily
affects the economy as a whole, but it's the question of the
erosion of a principle, the principle being that tax laws are
a--are something that--to which people can predict with
certainty how they will apply.
Mr. PORTER. From the equipment leasing perspective, what
impact does it have on--long-term, for your industry?
Mr. BENTSEN. Well, I would agree with Mr. Kleinbard.
Investors, the people who are underwriting investments, and
whether it's commercial aircraft, or if it's construction
equipment, or rigs, or you name it, are going to--they will
price that risk in. They are going to look at actions by the
congress, and if they're making a 5, 7, 20, or 30-year
investment, and they see the congress coming back and changing
the rules retroactively, that will set a precedent that will
apply to other types of transactions.
The gentleman is correct, is doesn't--the specific
provision itself may only apply to some investors, but the
market, as a whole, will look at this, and look at the
precedent, and they will ultimately--markets are fairly
efficient, and they will ultimately price that in, because the
view will be, ``Well, if Congress feels that it can be
retroactive in this sense, in this instance, why can't they in
others?'' That's to say, ``Well, we did it before, what's to
stop us from doing it again?''
Mr. PORTER. Thank you.
Chairman RANGEL. The Chair recognizes Ms. Tubbs Jones for 5
minutes.
Ms. TUBBS JONES. Mr. Chairman, thank you very much, and
thank you for hosting this hearing. Like my colleagues, I heard
from my banking institutions and small businesses with regard
to these changes.
Let me also say hi to my colleague, Mr. Bentsen, it's nice
to see you. Welcome back to the House.
Let me start, if I can, with the gentleman from PepsiCo,
Mr. Heaslip. In your testimony--and I don't believe you spoke
specifically about this, but it is in your written testimony--
about the impact of these proposals with regard to deferred
comp would have laid-off workers or severed workers--maybe you
did talk about this, maybe I missed it--about coming and going.
If you would, just very briefly, reiterate the impact
this--these changes would have on laid-off workers, in terms of
diverted comp.
Mr. HEASLIP. Sure. It's not clear. We did touch on it
earlier, but there is a potential that severance benefits we
pay from the non-qualified plan to severed employees could be
swept up in this proposal.
While it's not clear if they are or not, it would seem to
be a harsh and unintended consequence if we further penalized
someone who had just recently lost their job as a result of
reorganization with taxes and penalties on a payment that was
supposed to represent some kind of retirement security for
them.
Ms. TUBBS JONES. If you had your opportunity to mark the
legislation, what would you propose that we would do? Leave it
as it is, or make some other change?
Mr. HEASLIP. Without trying to be facetious, I would
probably resort first to a shredder. Then I would--I actually--
--
Ms. TUBBS JONES. That specific provision, I apologize.
Mr. HEASLIP. That specific provision. I think if you stuck
with a $1 million cap, it would eliminate most of the
individual issues that I cited in my testimony.
Ms. TUBBS JONES. Great.
Mr. HEASLIP. Help to narrow this more--focuses more
narrowly on very senior executives, which I believe was its
intent.
Ms. TUBBS JONES. Mr. Bentsen, again, I have been coming and
going, so I apologize. This seems to be the day that every
constituent in my congressional district wanted to see me at
this hour.
Stick for a moment about the ILOs. Even though they are no
longer taking place, there are existing ones that still have
time to run their course. What would you propose that we would
do with regard to them?
Mr. BENTSEN. Good question, Congresswoman. There are such
transactions in place. Those that are--and there are some that
have been questioned by the IRS. The bottom line is that, as
Congress intended by establishing the tax courts and the whole
process of it, the transactions that the Service feels are
questionable or should be challenged, are in fact, being
challenged.
So, the process itself is working. If, in fact, the service
prevails in that challenge to record or direct negotiations,
then the Government and the taxpayers, as a whole, will get
their due.
What this provision would do--would do, really, two things.
One, it would impose this retroactive tax on every type of
transaction, whether they were challenged or not. So, it's a
very blunt instrument, in that regard.
Second, it really would tilt--it would undermine the due
process rights of taxpayers that is a basic standard and right
in this country, and would tilt the balance in the favor of the
Government.
The proponents have made the argument--perhaps well-
intentioned, but I think faulty--in saying, ``Well, this would
relieve the Service of having to bring suit. In fact, we
believe the Service is going to win all these cases.'' Well,
they haven't won any cases yet. There have been no judgements
rendered.
Again, I don't think it's appropriate to intervene at this
point on the assumption that something is going to happen that
has not yet happened, and to deny a taxpayer their day in
court. If, in fact, the Government proves their case, then, as
I said, the Government will get its due.
Ms. TUBBS JONES. I thank you for your answer. To the other
gentleman, I have run out of time. I had questions for you, but
the Chairman is running a close clock. Thank you, Mr. Chairman.
Chairman RANGEL. Mr. Pascrell.
Mr. PASCRELL. Thank you, Mr. Chairman. Sorry I had to duck
out for another meeting. I know some of these things have been
touched, but I would like to ask the panel your reaction to
what I have to say.
I have deep reservations about the Senate's version of
deferred compensation, I really do. It hurts too many people,
and we should be targeting those that are greedy, instead of
looking at the entire--I respect the attempt made by the Senate
to limit the levels of compensation of senior officials who can
electively defer, in an effort to avoid paying taxes. What that
number is, is quite interesting.
I have a couple of concerns. First, the Senate provision is
retroactive. I believe wholeheartedly that it is the duty of
Congress to remedy laws that are potentially being abused. I
believe it is often inherently unfair to go back in time and
penalize individuals for actions taken at a time when the law
was permissive of a particular activity.
I think this Committee needs to ensure that any
restrictions that may be adopted will be completely
prospective. I think that it should be a general rule that any
action we take, regardless of what specific section we're
talking about, will in no way, shape, or form, apply to any
prior actions, including prior deferrals. That's my opinion.
Or, decisions taken prior to the date of the enactment. I hope
you agree with that.
I am also concerned about the overly broad applications the
Senate provision would entail. There are many legitimate uses
for deferred compensations, including employee retention, the
alignment of shareholder/employee/employer interests. I would
hate to see these programs lose their effectiveness because the
congress was not precise, as well as incisiveness in shaping
and drafting the legislation.
I would like to work to ensure that if some form of the
Senate's provision is included in the final small business tax
package, that it be carefully crafted to affect only its
intended targets. I would like your quick responses to that,
please.
Mr. PETRINI. Mr. Pascrell, I have to respectfully disagree
with one premise that you started with--actually, two parts of
it.
One is the provision should only affect the greedy, because
I don't think that deferred compensation has anything to do
with greed, but let me explain. When we're talking deferred
compensation here, the issue of how much an executive should be
paid, I don't think that is an issue where the issue of greed
comes in.
Let's assume that it's been decided that the executive is
going to be paid $10 million a year, and we can agree whether
or not that is greedy. If that executive is going to be paid
$10 million a year in cash, versus being paid $1 million in
cash and $9 million deferred, there is no greed involved in
deferring that $9 million.
In fact, I think the shareholders are much better served by
the fact that instead of this person taking $10 million of cash
out of the company today, he has actually left $9 million at
risk. The other part of that----
Mr. PASCRELL. Just to respond to that----
Mr. PETRINI. Sure.
Mr. PASCRELL. I am talking about those folks who are at the
top of the ladder. I am not talking about middle management.
Those people have been caught up--or would be caught up--if
that legislation passed.
Mr. PETRINI. No, I'm talking about an executive who would
make $10 million, otherwise.
Mr. PASCRELL. All right.
Mr. PETRINI. I think we should encourage him to defer as
much of that $10 million as possible. I think it's a totally
different issue, how much he should be paid, but whatever he is
being paid, we should ask him to defer as much as possible.
Mr. PASCRELL. I agree, I agree, I agree.
Mr. PETRINI. The other issue is there is no tax avoidance
involved in deferred compensation, because non-qualified
deferred compensation perfectly follows the matching principle.
The executive is not taxed until he receives the money, the
company does not get the corporate tax deduction until it is
paid. It is perfect matching, there is no tax avoidance
involved. There is tax deferral.
In fact, the way the system works, the company has to give
up its deduction. It's the same as if the company had borrowed
money from the executive. So, there is really no tax avoidance
here.
That's the issue I have tried to make a few times today, is
that executive deferred compensation, whatever you believe
executives should be paid, having them defer compensation is
good. It's good for aligning their interests with those of the
shareholders, because if they run that company into the ground,
they get none of that. It's consistent with what you enacted in
section 409A, which basically requires key employees to leave
their money at risk of the company, and avoids cut and run type
of things on the pass.
So, I would actually urge a lot more thought on whether
deferred compensation is bad, even for those who make a real
lot of money.
Mr. PASCRELL. I did not say, nor did I imply, that deferred
compensation, in and of itself, is inherently bad. That I did
not say, did not infer. So, I listen to what you're telling me,
but I didn't say that.
I am concerned about fairness, and I am concerned about
what goes into the tax revenue, what goes into revenue, what
does not go into revenue. If you defer the tax, you are not--at
the time, we may need that in the revenue cycle.
Mr. PETRINI. Remember, if the executive defers his tax, the
company is also deferring its deduction. So, other than the
difference between the executive's rate and the corporate rate,
which currently is not all that great, there is no real loss of
revenue, just because the income has been deferred, since a
deduction is also being deferred.
Mr. PASCRELL. Thank you.
Chairman RANGEL. The gentleman from California is
recognized for questions, Mr. Becerra.
Mr. BECERRA. Thank you, Mr. Chairman, and thank you to the
four of you for your testimony. Mr. Heaslip, let me ask you a
couple of questions. Deferred compensation has become an issue
over the last few years, especially with regard to CEOs. You
make some good points. I think you are trying to say, ``Be
careful how you move on this, because it could have an impact
far beyond just a CEO.''
You also--very quickly, because you were running out of
time--had some potential recommendations, if we were to try to
consider acting on this. I'm wondering if you can give me a
sense of, not just with regard to the specific proposals that
were included in the Senate, but just generally, some
guideposts that you might want to offer us as we continue to
examine deferred compensation, because I think you made a very
good point about how the consequences of what we could do--and
if I could quote you directly, I think you mentioned that the
potential impact could affect things like retirement security,
personal savings, competitiveness, and shareholder interest. I
think you're right about that.
So, give me a more broad answer to the general question of
this issue of deferred compensation, obviously with a focus on
what the Senate did, but just, generally, some guideposts.
Mr. HEASLIP. Sure. We agree that executive compensation is
kind of one of the most important aspects of good corporate
governance. I think to the conversation that just took place, I
would like to make a distinction between how much we pay
executives and how we pay executives.
I think the broader issue is how much we pay executives
that is being addressed or swept up into this discussion about
deferred compensation, which is more about how we pay them and
when we pay them.
In my opinion, if you want to get at the issue of executive
compensation, we should be looking at governance, shareholder
advocacy, disclosure, and transparency in our compensation
practices. We shouldn't be focusing on tax legislation.
If, however, for political or substantive reasons, it is
felt necessary to take a look at the rules surrounding deferred
compensation, and further regulations are necessary, we think
we do need to narrow the focus to CEOs or named executive
officers. We think a uniform cap would be more appropriate than
the very broad-based one-time earnings test that is currently
proposed.
We would exclude broad-based restoration plans that simply
provide the benefits that other employees are entitled to. We
would exclude elective deferral programs for the kinds of
reasons that Mr. Petrini has outlined, in connection with the
revenue neutrality. Kind of the additional incentive to
perform, in the interest of shareholders.
Mr. BECERRA. I appreciate that. I wanted to say welcome to
former Member and colleague, Mr. Bentsen, for being here. We
thank you for your testimony. Hopefully, this will help us
shape something that may come out of conference that does
address the various concerns that you have all raised. So,
thank you very much.
Mr. LEWIS OF GEORGIA [presiding]. Well, thank you very
much. The gentleman from North Dakota, Mr. Pomeroy, is
recognized for questioning.
Mr. POMEROY. Thank the Chair. I will start with
acknowledging my friend and former colleague, Mr. Bentsen. We
still miss you. Bentsen is known as having made a significant
contribution in the Senate. Maybe less known, but still known
to many of us who worked with you. You served with great
distinction in the House, too. That's a good name, that
Bentsen.
Mr. Heaslip, I want to talk to you about pensions,
generally. I appreciated your testimony, in terms of the
deferred compensation issue, but in a broader context of
employee benefits.
You indicate that the PepsiCo pension is well funded. How,
in fact, has it been doing in recent years, in light of an
improving stock market, relatively strong interest rate
environment, what is the funding level?
Mr. HEASLIP. Yes, it's been a rough ride over the past 5
years. As you know, we had poor equity returns in the early
2000s, interest rates have been low, which have increased
liabilities, and we are fortunate to have a growing, thriving
company that has allowed us to fund the plan over this period
of time. Not all companies have been able to do that.
Over the past 5 years, we have contributed about $2.4
billion to our pension plan in order to retain its health and
funded status. As a result, we are currently at about 105
percent of liabilities, which obviously provides security to
our existing----
Mr. POMEROY. I think that that's excellent. I think that
there was a misperception, promoted by the Department of Labor,
that this rough ride you speak of was a bumpy road toward a
system-wide failure, in terms of private sector pensions.
Recently, the Wall Street Journal reported that the Fortune
100 are, on average, 102 percent funded, and that the recovery
of the stock market--because that's bouncing around a little
these days--but fundamentally looks strong, and the sustained
interest rate environment have substantially improved the long-
term outlook for pension plan funding, even before the Pension
Act passed by Congress last year takes effect. Is that your
read?
Mr. HEASLIP. All of those are beneficial to defined benefit
plans.
Mr. POMEROY. I am very concerned that the increase funding
requirements passed in the bill are going to lead toward a slew
of actions freezing pension programs.
Do you have an evaluation of that, and what are PepsiCo's
plans?
Mr. HEASLIP. We are going to continue to monitor our
industry and the marketplace. We did a very thorough pension
review last year. We concluded that the plan is appropriate for
our workforce. We are trying to encourage people to spend a
career with PepsiCo, have valuable industry and customer
knowledge that we want to retain in our workforce.
We are not interested in them working for us for 5 years or
10 years, and then going to a competitor. A plan is a very
effective means of encouraging people to spend their career at
PepsiCo. At the same time, we have to be competitive in the
marketplace, and we have to make sure we monitor what our
industry is doing, and what our peer companies are doing. We
have to maintain flexibility to make changes, if necessary, to
stay competitive.
I don't know that there is any one thing that are going to
drive these plans out of business. When I look at the
amalgamation of financial challenges, the types of challenges
that are presented by this legislation in combination, it does
generate concerns about the future health of the system.
Mr. POMEROY. I will get to this legislation. Just one
moment, one final question, first, and that would be the
importance of lifelong income, as provided by a pension. It's
70 to 80 percent, I believe you indicated, income replacement,
and guaranteed, then, over the lifetime the retired employee
will have in retirement, that, to me, is a very optimal benefit
for someone in the workforce, worrying about what they're going
to do in retirement years.
The--given your expertise, do you see anything--have you
been able to--have you perceived, either from Congress or the
Department of Labor, or anywhere else in the Administration,
support for your efforts to continue pensions?
Mr. HEASLIP. I think, from a policy standpoint, it's very
clear that Congress would like to see continuation of the
defined benefit system, but from time to time, we get
conflicting signals.
Mr. POMEROY. My own thought is that we are still--we are
protecting people right out of their pensions by putting
onerous funding requirements that are not necessarily
reflective of today's long-term solvency picture, and that
we're going to pressure companies.
One final issue--and this is the last question I would have
for you--if you take the deferred comp provision of the Senate,
and so that you would look at a provision where your upper
management, those making the decisions on whether to retain the
pension or not, would get a similar income replacement than the
rest of the workforce.
Wouldn't it further disincent PepsiCo and other companies
to continue pensions for employees?
Mr. HEASLIP. I think that is one highly likely outcome from
this legislation. If you disenfranchise middle and senior
managers, I believe it could throw these types of plans at risk
for all employees.
Mr. POMEROY. My own thought, Mr. Chairman, is that we need
to send a very clear and unequivocal signal that pensions for
the 20 million workers who have them are vitally important, and
we want to help companies keep them in place. I thank the
gentleman for his testimony. Thank you, Mr. Chairman.
Mr. LEWIS OF GEORGIA. Thank you, the gentleman from North
Dakota, for his comments. The Chair will recognize the
gentleman from New York, Mr. Crowley, for questioning.
Mr. CROWLEY. Thank you, Mr. Chairman. Thank you to the
gentlemen, for their testimony today. I know time is of the
essence, we have a number of votes before us, so I will just
state that I don't have a question for the panel, but I do want
to make a statement into the record, and direct that statement
to you, Mr. Chairman.
I have deep reservations about the Senate deferred
compensation provision. While I respect the attempt made by the
Senate to limit the levels of compensation, and a senior
official can electively defer in an intent or an effort to
avoid the payment of taxes, I have several fundamental
concerns, some of which have already been expressed already.
Second, the provision is retroactive. While I believe it is
the duty of Congress to remedy laws that are potentially being
abused, I believe it is inherently unfair to go back in time
and penalize individuals for actions taken at a time when the
law was permissive of a particular activity.
Mr. Chairman, I am also concerned about the overly broad
application the Senate provision would entail. There are many
legitimate uses for deferred compensation programs, including
employee retention, and the alignment of shareholder and
employee/employer interests. I would hate to see these programs
lose their effectiveness because the congress was not precise
in its drafting of its legislation.
Mr. Chairman, I would like to work with you to ensure that
if some form of the Senate provision is included in the final
small business tax package, that it be carefully drafted to
affect only its intended targets.
Mr. Chairman, I would like to work with you to ensure that
taxpayers are not subject to the retroactive provisions of the
bill in section 162(M), executive compensation that exceeds $1
million, or annual non-qualified compensation. Now, Mr.
Chairman, I hope to work and cooperate with you in those
efforts, and I hope to have your acknowledgment of that.
Mr. LEWIS OF GEORGIA. Let me thank the gentleman for the
comments, and thank each member of the panel for participating
and for being here today. I think your testimony has been quite
helpful, more than helpful.
Mr. CROWLEY. Thank you, Mr. Chairman. I would like to give
a special hello to a former colleague, as well as one of New
York State's greatest companies, PepsiCo, for testifying today.
Mr. LEWIS OF GEORGIA. I believe the record will stay open
for 14 days, for any Members who may have comments to issue.
Thank you for being here.
Chairman RANGEL. [presiding] Let me join in thanking this
panel for your knowledge and your patience. Thank you very
much.
[Whereupon, at 12:05 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of the American Bankers Association
Mr. Chairman and members of the Committee, this statement is being
submitted for the record by the American Bankers Association (``ABA'').
ABA, on behalf of the more than two million men and women who work in
the nation's banks, brings together all categories of banking
institutions to best represent the interests of this rapidly changing
industry. Its membership--which includes community, regional and money
center banks and holding companies, as well as savings associations,
trust companies and savings banks--makes ABA the largest banking trade
association in the country.
The ABA appreciates the opportunity to submit this statement for
the record regarding the Small Business and Work Opportunity Act of
2007, H.R. 2. We are troubled by three revenue raising provisions
(Sections 206, 214, and 201) that have been included in the bill by the
Senate, and are particularly concerned that they tax businesses
retroactively.
Retroactive tax policy is bad tax policy. America's business
community must be able to depend on the certainty of the law in order
to make informed business decisions. Enacting retroactive tax policy
completely changes the economics of those past decisions and could
result in excessive and arbitrary costs. Moreover, it adds to the risk
and uncertainty of any business decision and could force businesses to
delay or shun decisions for fear that later changes in the law will
render such decisions illegal or financially burdensome, or both.
Hence, retroactive changes to tax law should be avoided. The ABA,
therefore, urges this Committee to remove these sections from the bill.
In this statement, the ABA wishes to express our concerns regarding
the three revenue raising provisions embodied in H.R. 2:
<bullet> Congress should not impose an arbitrary limit on income
that can be deferred under non-qualified deferred compensation plans,
particularly since recent changes in law affecting these plans have yet
to be implemented and the consequences of those previous changes are
unknown. (Sec. 206)
<bullet> Expanding the definition of ``covered employees'' would
retroactively tax deferred compensation amounts even though decisions
about these amounts have been made under existing law for many years.
(Sec. 214)
<bullet> Changing the effective date for SILO transactions will
result in a retroactive tax increase on banks. (Sec. 201)
Each of these concerns will be addressed below.
I. Limitation of Deferrals for Non-Qualified Deferred Compensation is
Inappropriate
The bill seeks to limit the aggregate amount of executive
compensation that can be deferred under Internal Revenue Code Section
409A. Under that section, deductibility of deferred compensation is
limited to $1 million or the average annual compensation over five
years, whichever is lesser. Furthermore, this provision is made
applicable to deferred compensation plans for all employees, not simply
to deferred compensation for senior executives.
However, many employers offer deferred compensation plans to middle
management and other non-executive employees as a way to create
incentives, reward hard work, and retain valuable employees. If the
provision in question is enacted, it will create an arbitrary limit on
deferred compensation plans, which in turn would reduce the overall
compensation of the employee. Moreover, many employees find these plans
provide additional resources for retirement. Thus, arbitary
restrictions would put a greater strain on the ability to save for
retirement for these individuals. Additionally, deferred compensation
plans that are already in existence will become subject to this
provision. This has the potential of punishing employees and employers
for compensation agreements reached long before this provision was
considered.
It should also be noted that Congress recently changed the rules
for non-qualified deferred compensation arrangements when it enacted
the Pension Protection Act of 2006. The Department of the Treasury
(``Treasury'') was directed to promulgate regulations implementing
these changes, but it has not yet finalized its rules. We believe that
it is inappropriate for Congress to make further changes to the law
concerning deferred compensation arrangements, when the impact of
previous changes in this law are still unknown. Prior to any further
changes to the law governing non-qualified deferred compensation plans,
employers and Congress should be afforded time to study the rules
promulgated by Treasury (once finalized) in order to understand and
evaluate their impact.
II. Expanding the Definition of ``Covered Employees'' Will Result in
Retroactive Taxation
As passed by the Senate, H.R. 2 expands the definition of ``covered
employees'' in an effort to limit the amount of executive compensation
that publicly-held companies can deduct from their taxes. Under
existing law, both the CEO of a publicly-held company, and the four
officers with the highest compensation levels, are considered ``covered
employees.'' Any compensation that ``covered employees'' receive that
is in excess of $1 million is not tax deductible by the company.
H.R. 2 expands the definition of ``covered employee'' to include
any employee that was a ``covered employee'' for any preceding taxable
year beginning after December 31, 2006. The language of the provision
indicates that it is applicable only to executives that are subject to
reporting after 2006. However, this does not mean that the tax burden
is limited to compensation after 2006. In fact, the provision captures
the full amount of deferred compensation from all prior years for
``covered employees'' that the employer is contractually obligated to
fulfill. This represents a significant problem for deferred
compensation plans designed to accommodate executives that are
currently considered ``covered employees.''
As an example, consider the case of senior executives of a bank who
have been covered employees for several years and have received
deferred compensation in the form of company stock. Over time, the
price of the stock received has appreciated and the value of their
account has grown substantially. Under the deferred compensation plan
created many years earlier, the bank expected that it would be able to
pay the deferred amounts upon retirement or termination of the
executives. Since the executives would no longer be considered
``covered employees,'' the bank would then be able to deduct this
expense.
However, the provision in H.R. 2 will result in the bank losing its
ability to deduct those previously deferred amounts. This in turn will
increase the bank's tax liability by millions of dollars, resulting in
a retroactive tax increase.
A retroactive tax increase of this nature will punish businesses
for legitimate decisions that were based on the certainty of existing
tax law. It will also create great uncertainty and risk with respect to
future issues of compensation. Businesses should be able to continue to
rely on the certainty of the law and any restrictions imposed should
apply prospectively only.
III. Changing the Effective Date for SILO Transactions Results in
Retroactive Taxation
The proposed changes to the effective date for leasing provisions
under the American Jobs Creation Act (``AJCA'') of 2004 are also of
concern. With the passage of the AJCA, Congress enacted limitations on
the deductibility of losses from future sale-in/lease-out (``SILO'')
transactions. Effective March 14, 2004, deductions from property leased
to a tax-exempt entity were limited to the taxpayer's gross income
generated from the lease for that tax year. Significantly, Congress
made clear at the time that this change to the tax law would be applied
only on a prospective basis.
Prior to the passage of the AJCA, several issues impacting the
effective date of the new provisions were debated. These included: (1)
the fact that most transactions had been based on long-standing tax
law; (2) that several transactions were in mid-stream and a loss of tax
benefits would have negatively impacted them financially; and (3) that
the effective date for any such change in the law should be
prospective. As a result of these considerations, the final version of
AJCA included appropriate grandfathering for transactions entered into
before March 12, 2004.
Now, three years later, the Senate is attempting to change the
effective date. If enacted, the net effect will be a retroactive tax
increase on banks, punishing them for entering into transactions that
were, in some cases, crafted many years ago.
We would like to thank the committee for holding this hearing and
giving us the opportunity to comment. Additionally, we look forward to
working with you on these and other issues during the 110th Congress.
<F-dash>
Statement of the American Bar Association Section of Taxation
This statement is submitted on behalf of the Section of Taxation of
the American Bar Association. It has not been approved by the House of
Delegates or the Board of Governors of the American Bar Association.
Accordingly, it should not be construed as representing the policy of
the American Bar Association.
The Section of Taxation appreciates the opportunity to provide
input to the Committee on Ways and Means (the ``Committee'') on the
revenue increase measures in the ``Small Business and Work Opportunity
Act of 2007''--the Senate-passed version of H.R. 2 (the ``Bill''). Our
comments address the limit on the amount of annual deferrals under
nonqualified deferred compensation plans that would be added to section
409A \1\ by section 206 of the Bill.
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\1\ Unless otherwise indicated, all section references are to the
Internal Revenue Code of 1986, as amended (the ``Code'').
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We have followed these provisions with interest since they were
first proposed. On February 2, 2007, we wrote a letter to Chairman
Baucus and Senator Grassley of the Senate Finance Committee on behalf
of the American Bar Association expressing concern about the inclusion
of provisions in the Bill without the benefit of public hearings or
public comment. On February 7, 2007, we wrote a letter to Chairman
Rangel and Congressman McCrery of this Committee also urging that
proposed amendments to the tax laws, such as these, be exposed for
public comment, preferably through hearings, before Committee action.
We, therefore, commend the Committee for holding hearings on the
revenue increase measures in the Bill, and hope that our comments below
will be useful in the Committee's deliberations.
We believe that these provisions would impose enormous and
disproportionate (relative to the abuses they are designed to correct)
administrative burdens on taxpayers, their advisers, employers and
others. We previously urged the leadership of the tax-writing
committees ``to hold comprehensive hearings and otherwise gather
information about the potential impact of [section 409A], including the
estimated costs of compliance.'' \2\ At that time, we explained the
important policy reasons for conducting a thorough review of section
409A prior to the law becoming fully effective, which is now scheduled
for January 1, 2008. We continue to urge that the Committee hold such
hearings.
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\2\ Letter dated July 31, 2006, from the ABA Section of Taxation to
William M. Thomas, Chairman, House Committee on Ways and Means, Charles
B. Rangel, Ranking Member, House Committee on Ways and Means, Charles
E. Grassley, Chairman, Senate Committee on Finance, and Max S. Baucus,
Ranking Member, Senate Committee on Finance.
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Limit on amount of annual deferrals under nonqualified deferred
compensation plans
Section 206 of the Bill would amend section 409A to require
nonqualified deferred compensation plans subject to that section to
limit an individual employee's annual deferrals to the lesser of $1
million or the employee's average taxable compensation over the
previous five years. Earnings on previous deferrals would be treated as
additional deferrals for this purpose, and all nonqualified deferred
compensation plans of the same employer would be aggregated. Failure to
comply with the limit would trigger penalty taxes and interest under
section 409A. The $1 million limit would not be indexed for inflation.
Rationale for new limitations. We have a number of concerns about
the proposal. To begin with, we question several of the premises on
which it is based. The Finance Committee's report on the Bill states
that:
The Committee is concerned with the large amount of executive
compensation that is deferred in order to avoid the payment of income
taxes. Rank and file employees generally do not have the opportunity to
defer taxation on otherwise includible income in excess of the
qualified plan limits. However, it is common for nonqualified deferred
compensation arrangements to allow executives to choose the amount of
income inclusion they wish to defer. [footnote omitted] The Committee
is concerned that the ability to defer unlimited amounts of
compensation gives executives more control over the timing of income
inclusion than rank and file employees. S. REP. No. 110-__ at 58-59
(2007).
We respectfully disagree with the suggestion in the first sentence
that executive compensation is deferred primarily to avoid the payment
of income taxes. In our experience, executives defer compensation for
the same principal reason that rank-and-file employees do, namely to
save for retirement. This is a worthy goal regardless of an employee's
income level. We also disagree with the implicit assumption that
deferring compensation in a nonqualified deferred compensation plan
reduces tax revenues. Section 404 prohibits a taxable employer from
deducting nonqualified deferred compensation until it is included in
the employee's gross income.\3\ Income earned on the deferrals is
taxable to the employer. Thus, the net revenue effect of such deferrals
is close to zero.
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\3\ This creates a ``tax tension'' between a taxable employer and
an employee who want to defer compensation. There is no such tension in
the case of a nontaxable employer. That is the main reason that has
been given for imposing a dollar limit (currently $15,500) on annual
deferrals under nonqualified deferred compensation plans maintained by
governmental and tax-exempt employers. See Code 457(b). ``In
contrast,'' according to the Department of the Treasury, ``such
limitations are not necessary for private, taxable employers because
the tax tension between the employers' preference for a current
deduction and the employees' incentive for deferral will provide
inherent restraints on the amount of deferred compensation that is
provided.'' Department of the Treasury, Report to The Congress on The
Tax Treatment of Deferred Compensation Under Section 457, at 10 (Jan.
1992) (emphasis added).
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Furthermore, based on our experiences, the suggestion in the
remainder of the paragraph that rank-and-file employees have much more
limited deferral opportunities than executives because they only
participate in the employer's tax-qualified plans ignores several
important points:
<bullet> Differences in deferral opportunities are more likely to
reflect the structure of the Employee Retirement Income Security Act
(``ERISA'') than any kind of income-based discrimination. Any enhanced
deferral opportunities that executives have must be provided under a
nonqualified deferred compensation plan. Under ERISA, employees who are
not part of a ``select group of management or highly compensated
employees'' (often called a ``top-hat'' group) generally may not
participate in a deferred compensation plan which defers compensation
to termination of employment or later unless the plan is funded, and a
nonqualified deferred compensation plan that is funded is no longer
able to defer taxes. Thus, for the most part ERISA effectively
prohibits rank and file employees from participating in nonqualified
deferred compensation plans.
<bullet> Tax-qualified plans provide as much opportunity to save
for retirement as many rank-and-file employees are willing or able to
use. It is unusual for rank-and-file employees to make elective
contributions up to the current dollar limit ($15,500, or $20,500 if
the employee is 50 or over and the plan permits catch-up
contributions). Also, nonelective and matching contributions, and
accruals under pension plans, are subject to much higher limits.
Congress may want to examine ways to increase deferral opportunities--
and retirement savings generally--for rank-and-file employees who are
interested in saving more. We strongly support such consideration. We
do, however, question the purported constraints imposed by the existing
rules.
<bullet> A large percentage of nonqualified deferred compensation
is provided under supplemental retirement plans (``SERPs'') or benefit
equalization plans (``BEPs'')--plans designed to provide the benefits
that the executives would have received under the employer's tax-
qualified plans but for the Code-imposed limits on compensation,
contributions and benefits that apply to those plans. SERPs and BEPs,
by their nature, replicate the benefits and limitations (other than the
statutory limitations) that are imposed in the underlying tax-qualified
plans. For example, if the underlying tax-qualified plan provides for
an employer contribution of 6% of compensation up to the $225,000 limit
under section 401(a)(17), a SERP might provide a credit of 6% on
compensation over $225,000. Participants in such plans do not really
have more opportunities to defer compensation: they simply have more
compensation to defer and can only do so in a nonqualified plan,
because of the way that ERISA is structured.\4\ Congress may be
concerned when executives have much higher compensation than rank-and-
file employees, but that issue is a general economic matter, not a
structural problem with the existing tax system.
\4\ As noted above, amounts deferred under nonqualified plans do
not generate current tax deductions for the employer, and income
attributable to deferred amounts is taxed to the employer during the
deferral period. Also, participants in such plans have far fewer
protections than they would under a tax-qualified plan. For example,
amounts set aside to provide benefits are subject to the claims of the
company's creditors in bankruptcy.
The foregoing observations are based on our extensive experience
with employee benefit matters. There is, however, sparse data on
nonqualified deferred compensation.\5\ In part because of the absence
of data, we believe Congress should proceed carefully in this area,
after gathering as much information as possible through public hearings
and other means.
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\5\ At the same time that it enacted section 409A, Congress added a
requirement to report the amount deferred under a nonqualified deferred
compensation plan on Form W-2. However, that requirement is not yet in
effect, partly because the IRS has recognized how hard it is to value
those amounts.
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Scope of limit. We think the scope of the limit goes beyond even
what is required by the stated rationale. First, the passage quoted
above suggests that the Finance Committee was concerned primarily or
exclusively with elective deferrals, not retirement savings generally.
However, the limitation is not restricted to elective deferrals. To the
contrary, it appears to apply to any amounts that would be considered
deferred compensation under section 409A and the regulations under that
section. That section covers a wide range of nonelective arrangements,
including, for example, SERPs and BEPs that supplement benefits under
traditional defined benefit pension plans. Many companies also have
automatic deferrals of annual or long-term bonuses to which section
409A applies, as well.
Second, Senator Grassley's floor statements suggest that the Senate
thought the limit would apply mostly to ``the wealthiest
[individuals]--i.e., those individuals receiving more than $1 million
annually in nonqualified deferrals.''\6\ In practice, however, the new
limitation will apply to many other employees. The limit by its terms
is the lower of $1 million or the employee's average taxable
compensation over the past 5 years. Thus, it is certain to apply to
some middle-management employees deferring much less than $1 million.
It also treats earnings on previous deferrals as additional deferrals.
Thus, even without the 5-year look-back rule it could apply to middle-
management employees with substantial account balances and earnings who
defer relatively little from their current compensation.
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\6\ See 153 Cong. Rec. S1492 (daily ed. Feb. 1, 2006) (statement of
Sen. Grassley).
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In his floor statements, Senator Grassley did not dispute this.
Instead he said the Joint Committee on Taxation had estimated that
eliminating the five-year look-back rule would reduce the revenue score
by less than $100 million out of $806 million, and that this suggested
that only about 10% of the individuals affected by the limit were
deferring less than $1 million. However, since the revenue estimates
are based on deferrals, this actually suggests that middle management
will make up more--perhaps much more--than 10% of the affected group on
a headcount basis.\7\ Senator Grassley also said that including middle
management in nonqualified deferred compensation plans ``raises other
red flags''--suggesting, perhaps, that it does not or should not occur.
We agree that not all individuals in middle management are part of the
``top-hat'' group that can participate in nonqualified deferred
compensation plans. However, this group can be relatively large,\8\
there are no clear guidelines, and in our experience most employers try
to cover as many individuals as they are allowed to cover.
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\7\ For example, if three executives earned $200,000 each and
deferred half of that amount under a nonqualified deferred compensation
plan, and one executive earned $5.4 million and deferred half of that
amount under the same plan, the first three executives would defer 10%
of the total amount deferred under the plan, but make up 75% of the
plan participants.
\8\ See, e.g., Gallione v. Flaherty, 70 F.3d 724, 729 (2d Cir.
1995) (group consisting of all full-time officers of union was
sufficiently select even though it included over 25% of employees).
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Third, a violation will occur any time an individual's deferrals
(plus earnings on previous deferrals) exceed the limit in any given
year. For this purpose, all nonqualified plans (not just plans of the
same type) would need to be aggregated. Nonelective deferrals, and
earnings on previous deferrals, can be very uneven and difficult to
value or predict. If deferrals are not counted against the limit until
they vest, this problem is exacerbated and applies to elective
deferrals as well. Thus, even individuals whose regular deferrals (plus
earnings) are much less than the limit will, on occasion, have excess
deferrals which will have to be forfeited or corrected in some fashion.
Fourth, this type of limitation tends to favor new hires over long
term employees whose compensation is averaged over a longer period. It
tends to treat similarly situated employees differently based on quirks
on their compensation histories, such as option exercises which would
increase compensation in the particular year of exercise. It also tends
to disfavor employees at companies such as start-ups with relatively
low levels of cash compensation.
Practical difficulties implementing limit. We also think that the
limit, as currently drafted, will be difficult to implement--both by
employers and by the Internal Revenue Service (the ``IRS'')--and is
likely to have unexpected and unfair consequences. As noted above,
nonelective deferrals, and earnings on previous deferrals, can be
uneven and difficult to value or predict. For example, benefits under
non-account balance (defined benefit) plans, especially those that are
integrated with Social Security or that provide early-retirement
subsidies; equity-based plans that are treated as deferred compensation
under section 409A; and post-termination benefit continuations, are
particularly difficult to value as they accrue. In order to apply the
limit to such plans, the IRS will have to prepare elaborate valuation
guidance and train its auditors on how to apply it, which will require
substantial tax administrative resources. If it does not, it might
prove difficult for the IRS to challenge taxpayers' actuarial
valuations.\9\
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\9\ See, e.g., Wells Fargo & Company v. Commissioner, 120 T.C. 69
(2003); Vinson & Elkins v. Commissioner, 99 T.C. 9 (1992).
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One alternative would be to wait to value deferrals until they are
``reasonably ascertainable.''. That is what the regulations provide
under section 3121(v), which subjects deferred compensation to FICA
taxes when they accrue or vest, whichever is later. However, this would
tend to bunch up deferrals in a single year and substantially increase
the chances of violating the limit.
It might also be appealing to count deferrals against the limit
only when they vest, since it seems unfair to treat a plan as violating
the limit and trigger penalties taxes because of benefits that an
employee might never receive. That is the way the dollar limit in
section 457(b) is applied. However, this, too, would tend to bunch up
deferrals in a single year and substantially increase the chances of
violating the limit.
Finally, treating earnings on previous deferrals as additional
deferrals will punish employees whose deemed investments do well, and
will make it progressively harder for a long-service employee to avoid
the limit as his or her account--and the earnings on that account--grow
over time. This is likely to be perceived as unfair and even age-
discriminatory.
It has taken the IRS over two years to draft final regulations on
the major provisions of section 409A, and, according to an IRS
official, when those regulations are issued they will be
``voluminous.''\10\ To address concerns like those noted above, we
think that regulations implementing the proposed limit are likely to
take just as long to draft and be just as voluminous.
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\10\ Daily Report for Executives, No. 41, at G-4 (Friday March 2,
2007).
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Effective date issue. It is unclear whether the limit will apply to
amounts deferred on or before December 31, 2006, if they vest after
that date. For purposes of the effective date of the original section
409A, which used nearly identical language, amounts were not considered
deferred until they vested. Taking this approach under the proposed
limit would subject an even larger amount of deferred compensation to
the limit. Furthermore, it is unclear how the limit would apply to
existing deferrals. Applying it to existing deferrals when they vested
would create the bunching problem noted above. Applying it
retroactively to the years in which the deferrals occurred would, in
our view, be unfair to taxpayers who relied in good faith on prior law.
Effect on defined benefit plans. We think the limit, as currently
drafted, could indirectly discourage employers from maintaining tax-
qualified defined benefit plans. That is because, as noted above, in
our experience a large percentage of nonqualified deferred compensation
is provided under SERPs and BEPs that provide benefits that would have
been received under the employer's tax-qualified plans but for various
statutory limits, and benefits under SERPs and BEPs that supplement
defined benefit plans will be the most difficult to predict and value
under the proposed limit. This will impose one more burden on employers
that still maintain those plans, and add to the reasons they have for
freezing or terminating them.
Composition of deferred compensation. If the proposal is enacted,
it will inevitably reduce certain types of deferred compensation. Our
experience suggests, however, that total compensation will not be
significantly affected. This is borne out by experience after the
enactment of sections 280G and 162(m), and is likely to be the result
here as well. Instead, the new law may be expected to induce
distortions in executive pay, many of which will be undesirable for
non-tax reasons. For example, current cash compensation may increase,
thereby reducing the employee's interest in the long-term prospects of
the employer. Alternatively, greater emphasis may be placed on various
types of equity-based compensation that are not subject to the
proposal. This may cause over-utilization of stock options and
restricted stock. Any such changes may have significant ramifications
for executive compensation and corporate governance in general.
Conclusion
Fundamentally, we think that publicity and the activism of
shareholders and unions are more appropriate mechanisms for
counterbalancing excess executive compensation than one-size-fits-all
limits imposed by the Code. While certain CEO severance packages have
received a great deal of press recently, such arrangements have also
gotten the attention of shareholder activists.\11\ Furthermore, a
number of public companies have taken steps on their own following the
highly publicized--and criticized--large severance packages for the
Home Depot and Pfizer CEOs. For example, Waste Management, Inc.,
Marathon Oil Corporation and Wachovia Corporation have all published in
SEC filings that they have policies regarding when the Board must seek
shareholder approval of an executive officer's severance package when
it exceeds certain specified limits. These trends are likely to
continue as a result of the enhanced SEC disclosure requirements for
executive compensation which went into effect this year.
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\11\ See Joann S. Lublin and Phred Dvorak, How Five New Players Aid
Movement to Limit CEO Pay, Wall St. J., March 13, 2007, at A1.
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We would like to thank the Committee for the opportunity to express
our views on the executive compensation provisions in the Senate-passed
version of H.R. 2. We believe that, especially as currently drafted,
they are unlikely to achieve the purpose for which they are intended;
will unnecessarily complicate the Code and burden the IRS; may harm
many middle-management employees; and may well induce serious adverse
consequences outside of the tax system. By discouraging SERPs and BEPs
that supplement benefits under tax-qualified defined benefit plans, the
limit on annual deferrals could even end up hurting the rank-and-file
employees that it is intended to benefit.
<F-dash>
Statement of American Benefits Council
The American Benefits Council submits this statement in connection
with the hearing of the House Committee on Ways and Means on the Small
Business and Work Opportunity Act of 2007 (the ``Act''). We
respectfully request that this statement be included in the record of
the hearing.
Our comments address two revenue raising provisions included in the
Act: (i) Section 226, which expands Internal Revenue Code section 409A
to impose dollar caps on nonqualified deferred compensation plans,
including all earnings under those plans, equal to the lesser of ``one
times pay'' or $1 million; and (ii) Section 234, which expands Internal
Revenue Code section 162(m) to deny employer deductions for certain
compensation payments to both current and former top executives of
publicly-held companies, including payments that are already scheduled
to be made under legally binding contracts.
The American Benefits Council is a public policy organization
representing more than 250 members that are primarily major U.S.
businesses providing employee benefits to active and retired workers.
The Council's members do business in most, if not all, of the states.
The Council's membership also includes organizations that provide
employee benefit services to employers of all sizes. Collectively, the
Council's members either sponsor directly or provide services to
retirement and health plans that cover more than 100 million Americans.
The Council's members have raised significant concerns about both
the policy and practical effects of sections 226 and 234 in the Act. We
believe that both of these revenue raising provisions are significantly
flawed and we urge that they be rejected.
Section 226_Dollar Caps on Nonqualified Deferred Compensation
Section 226 would amend Code section 409A to impose a dollar cap on
nonqualified deferred compensation that is the lesser of $1 million or
``one times pay'' for an employee. The penalty for exceeding this
dollar cap is immediate income inclusion of the total nonqualified
deferred compensation earned by the employee plus a 20-percent addition
to tax and interest. The Council has serious concerns with this
provision because it would impose arbitrary limits on deferred
compensation plans and impose draconian tax penalties if those limits
are exceeded. The dollar cap is not limited to the pay packages of
senior executives. If enacted, the dollar cap in Section 226 would
apply to any arrangement that falls within the technical definition of
a ``nonqualified deferred compensation plan'' under Code section 409A.
These include non-elective plans, such as retirement-type and
supplemental pension plans, incentive compensation, and certain equity
arrangements, such as restricted stock units and stock appreciation
rights that do not squarely fit within the current regulatory
exceptions under section 409A.
Although section 226 of the Act may have been viewed as addressing
perceived problems with ``executive'' pay, the broad spectrum of plans
that would be subjected to the dollar cap lead us to conclude that
middle management employees likely would see the most drastic changes
in their benefit programs should section 226 be enacted. The
uncertainties and administrative burdens created by a dollar cap may
discourage some employers from providing such programs for middle-
management, many of which are designed to complement the employer's
tax-qualified retirement plans by allowing employees to save for
retirement on their total compensation. We have attached to our
statement a number of examples taken from companies, which illustrate
the scope of the dollar cap.
Moreover, the effect of the dollar cap included in section 226 of
the Act would be to subject nonqualified plan dollars to income
inclusion and a potential 20-percent addition to tax before funds are
actually paid or made available to an employee. This is a fundamental
and, in our view, unwise shift in basic tax principles. Contrary to
some erroneous news reports, nonqualified plans are not ``funded'' or
secured like qualified retirement plans. Employees are not guaranteed
to receive the money in the event of the employer's insolvency, for
example. If such were the case, these amounts would already be subject
to income tax under current law. Rather, section 226 of the Act would
tax employees before they are actually paid on funds that are ``at
risk'' and on amounts that might never be paid or that might end up
being lower in value when they are ultimately paid.
Our members also question why the U. S. income tax system would
favor current cash payments in lieu of deferred payments to employees.
Employers may have legitimate cash-flow and long term business goals
for designing compensation programs that defer payments into the future
rather than providing for current cash. Consider, for example, the
start-up company that instead of paying higher current salaries
promises bonuses or incentive compensation in the future based on the
growth and success of the business. At the time that the bonus is
promised, it may be worth a relatively small amount. But, if as hoped,
the business succeeds, the increased value of that bonus, (i.e., the
``earnings'') could easily exceed the one-times pay or the $1 million
limit in any future year. Section 226 of the Act would preclude such an
arrangement.
There are also troubling technical aspects of section 226 of the
Act that would make it difficult to administer and, therefore, easy to
inadvertently violate when applied in the real world. As the attached
examples illustrate, the ``one times pay'' prong of the dollar cap and
the inclusion of ``earnings'' in the annual deferrals subject to the
cap are both particularly pernicious. Section 223 of the Act would
impose the Code section 409A tax penalty on earnings in excess of the
applicable dollar limit--even if the earnings are based on the growth
of the business or another market rate of return--which cannot be
predicted with certainty.
Our members are also mindful that it was just a little over two
years ago that Congress enacted the current-law section 409A provisions
to regulate deferral elections and the timing of payouts for deferred
compensation. These new rules have required sweeping changes in the
design of deferred compensation plans and have generated literally
hundreds of pages in interim regulatory guidance. Employers have
already made significant changes to deferred compensation plans to
conform to these complicated new rules and are still awaiting final
regulations. Adding arbitrary dollar limits to the 409A rules on the
cusp of the publication of final regulations will create excessive
regulatory burdens. The massive employer effort required to conform to
409A and modify the design of nonqualified plans since 2005 will, in
many cases, have been futile if a dollar cap is now imposed. Design
decisions, administrative programs, and legal analyses for nonqualified
plans all would have to be revisited in light of the dollar caps.
Finally, experience shows that imposing dollar limits under the
Internal Revenue Code skews behavior. Sections 162(m) and 280G, two
provisions that impose tax penalties for exceeding compensation dollar
limits, have been uniformly criticized as causing greater harm than
benefit. Our members are concerned that imposing dollar limits under
409A will inevitably lead to the same result--excessive complexity and
arbitrary ``winners'' and ``losers.'' Employers should be designing
compensation systems to further their business goals rather than
avoiding disincentives created by the Internal Revenue Code.
Section 234_Expansion of Code section 162(m)
Section 234 of the Act would expand the definition of ``covered
employee'' as defined under section 162(m) to include anyone who was
ever a covered employee or anyone who served as CEO at any point during
the year. The expansion of section 162(m) would expand further a
provision that experts unequivocally agree is ``broken.'' The staff of
the Joint Committee on Taxation (JCT) recommended in 2003 that section
162(m) be repealed altogether. The recommendation was based on the JCT
staff's conclusion that the provision is ``ineffective at accomplishing
its purpose [and] overrides normal tax principles.'' The JCT staff also
noted that ``[t]he concerns reflected in the limitation can better be
addressed through laws other than the Federal tax laws.'' To that end,
the Securities and Exchange Commission has promulgated expansive new
proxy disclosure rules on executive compensation. Those provisions
should be given time to work rather than embark on an attempt to once
again use the tax laws to address perceived corporate governance
problems.
Our members are also concerned that the section 162(m) proposal
applies retroactively to amounts earned before 2007 and payments to
which the employer is already contractually obligated. The lack of a
binding contract exception is punitive. When Congress enacted the
section 162(m) deduction limit in 1993, an exception was included for
payments made under existing binding contracts that were not materially
modified. We urge that Congress not retroactively change the tax laws
with respect to binding compensation arrangements.
Examples
Restricted Stock Units. In recent years, many employers have
redesigned their equity programs to increasingly rely on the use of
restricted stock units (RSUs). Typically, employees are awarded a
specified number of RSUs, with a fixed percentage of the RSUs vesting
on a quarterly or annual basis or the entire block of RSUs vesting
after a specified performance period. Generally, upon vesting of an RSU
award, RSUs are converted into shares of the employer's common stock
and the employee is taxable on the fair market value of such stock.
Some RSU programs fit within the regulatory exception from 409A for
compensation that is paid upon vesting (or within 2\1/2\ months after
the year of vesting.) It is not uncommon, however, for employers to
find that their RSU program does not meet the short-term deferral
exception and that compensation paid under the program is subject to
409A. In some instances, an employee may vest in the RSUs in increments
over the performance period but is not paid until full vesting is
attained at the end of the performance period. In other instances, an
employee may vest fully upon reaching a specified retirement age during
the performance period. Under the legislation, such RSU grants would be
subject to the ``one times pay'' limit and could cause employees to
exceed the limit.
For example, a newly hired employee of a Fortune 500 company
receives a grant of RSUs that is subject to 409A. The employee is
granted 6,000 RSUs at a time when the value of the company's stock is
$30 (i.e., value of the grant is $180,000). The employee is scheduled
to vest in \1/5\ of the RSUs each year over a 5-year performance
period. The employee receives a base salary of $140,000, which under
the Senate provision would be the employee's ``one times pay'' limit
for the first year. Because the value of the RSU grant exceeds the
``one times pay'' limit, a 409A violation would occur and the employee
would be subject to a 20% additional tax on the value of the RSUs as
they vest (i.e., 20% of the RSUs per year) over the 5-year period.
Because ``earnings'' on the underlying shares of the company's
stock also are subject to the limit, employees could have a tax penalty
under 409A merely because the company was successful and the value of
the RSUs increased beyond the limit.
For example, an employee is granted 1,000 RSUs at the beginning of
employment with technology company. The employee ``vests'' in these
units after 5 years of service and the RSUs are designed to pay out
after 10 years. The employer believes that this plan aligns the
employee's interest with growing the company value rather than
maximizing current salary. At the beginning of employment, the RSUs
were valued at $15 per share. The employee earns approximately $100,000
per year and receives modest increases (based on CPI of 3 percent). The
employee's 5-year average taxable compensation from the company is
$110,000 at the end of year 5. The company stock price stays relatively
flat, but in year 6 the company becomes highly successful and the
valuation of the stock takes off eventually to exceed 10 times the
original price. The one-times-pay limit would be exceeded because the
increase in the RSU value in year 6 will exceed $110,000.
Supplemental 401(k) Plans. Employees who cannot fully defer under a
401(k) plan because of the compensation limits under the Code may
participate in a supplemental or ``mirror'' 401(k) plan. Unlike
qualified plans, these programs are unfunded and the employer's
deduction is delayed until the time of payment. If the company becomes
insolvent, the employees are not paid. The legislation counts
``earnings'' that accrue under the supplemental plan as additional
deferrals that count against the ``one times pay'' limit and could
cause the employee to exceed the limit.
For example, a Fortune 500 company offers a nonqualified
supplemental plan to certain employees, including mid-level management
employees receiving approximately $150,000 to $200,000 per year in
total wages from the company. Many of these mid-level management
employees are long-serving employees who typically defer 20 to 40
percent of their wages. Employees who participate in the plan receive a
small matching contribution (typically between $3,000 and $6,000) from
the company based on their deferrals. Investment earnings are credited
to an employee's bookkeeping account in the plan based upon deemed
investments chosen by the employee from among the same mutual funds as
those offered in the company's 401(k) plan. Using 2006 data, the
company has calculated that at least seven such employees would have
exceeded their 5-year average taxable compensation. Below is a chart
summarizing the relevant information.
----------------------------------------------------------------------------------------------------------------
Account
2006 5-year Balance 2006 2006 Deferrals
Emp. Years of Total Average As of Deferrals Investment Total Above 5-
Service Wages Taxable 12/29/ And Match Earnings Deferrals year Avg
Wages 06 Limit
----------------------------------------------------------------------------------------------------------------
1 27 $159,50 $ 90,180 $418,40 $ 66,700 $ 72,300 $139,000 $48,820
0 0
----------------------------------------------------------------------------------------------------------------
2 13 $175,40 $102,220 $508,30 $ 60,800 $ 52,500 $113,300 $11,080
0 0
----------------------------------------------------------------------------------------------------------------
3 28 $179,30 $ 62,380 $364,10 $116,400 $ 27,000 $143,400 $81,020
0 0
----------------------------------------------------------------------------------------------------------------
4 25 $178,30 $126,920 $614,70 $ 47,900 $109,100 $157,000 $30,080
0 0
----------------------------------------------------------------------------------------------------------------
5 30 $183,70 $126,040 $617,70 $ 38,000 $141,800 $179,800 $53,760
0 0
----------------------------------------------------------------------------------------------------------------
6 14 $194,40 $128,020 $486,50 $ 62,200 $ 73,200 $135,400 $ 7,380
0 0
----------------------------------------------------------------------------------------------------------------
7 6 $203,00 $ 92,020 $647,10 $ 76,300 $ 94,700 $171,000 $78,980
0 0
----------------------------------------------------------------------------------------------------------------
Two of these employees (5 and 7) would have exceeded their 5-year
average taxable compensation based solely upon their 2006 earnings.
Since earnings that are tied to a publicly-traded investment are often
very unpredictable, any employee participating in a supplemental 401(k)
plan would have to leave a large cushion below the ``one times pay''
limit to take into account potential earnings. Moreover, a long-serving
employee could exceed the annual deferral limit based upon earnings
even if the employee stopped making deferral elections.
For example, assume employee 5 in the above example stopped making
deferral elections after 2006, and that the employee receives modest
increases in wages each year (based on CPI of 3 percent). Also assume
that the employee elected to have all of his account balance as of
December 29, 2006 ($617,700) be deemed invested in the plan's S&P 500
index fund, and that for the 4-year period from 2007 to 2010 that
fund's annual return was 20% per year (which would be consistent with
the S&P 500's performance in the late 1990s). By 2010, there would be a
409A violation solely because the earnings credited to the employee's
bookkeeping account ($213,477) exceeded the employee's 5-year average
taxable compensation from the company ($189,376).
Non-elective, Supplemental Pension Plans. Some companies maintain
non-elective, supplemental pension programs to serve as retention tools
and assist management employees in saving for retirement. Unlike
qualified plans, these programs are unfunded and any employer deduction
is delayed until the time of payment. If the company becomes insolvent,
the employees are not paid. The nature of many of these plans is to
provide the most valuable accruals in the years right before retirement
(e.g., age 65) and, therefore, they incentivize employees to stay in
their jobs. The legislation would require employers to severely limit
or abandon these arrangements because later-year accruals may exceed
the ``one times pay'' limit under common plan designs for long-service
employees. The problem would be further exacerbated if the employer
wanted to manage its employee headcount by offering an early retirement
incentive in the qualified and supplemental pension plans (such as
payment of the full pension without a reduction for early
commencement). The increased value of the pension in the year that the
early retirement incentive was offered could cause the ``one times
pay'' limit to be exceeded.
For example, one Fortune 500 company sponsors a non-elective,
supplemental pension plan that is available to middle managers making a
little over $100,000 per year, many of which work for the company's
retail entity. The company noted the difficulty in calculating annual
accruals for this type of plan and the fact that the value of annual
accruals often varies significantly from year to year due to interest
rate changes and eligibility for early retirement. To the extent an
accrual under the supplemental pension plan exceeded the limit, it is
not clear how the company could ``fix'' the pension plan formula to
avoid an excess accrual. The company also noted that the impact of the
``one times pay'' limit would be even more severe because other forms
of compensation provided to these managers, such as RSUs, performance
units and severance pay, would also be aggregated with accruals under
the supplemental pension plan in applying the limit. As a result, the
company advised us that they may discontinue the supplemental pension
plan if the annual limit is enacted.
Bonuses and Incentive Programs. Many employers structure their
bonus programs to fit within the regulatory exception from 409A for
compensation that is paid upon vesting (or 2\1/2\ months after the year
of vesting.) It is not uncommon, however, for employers to find that
they cannot meet this strict 2\1/2\ month rule. Employees may vest at
the end of the year or at the end of the performance period, but
business issues may necessitate a delay in payment that results in the
payment being subject to 409A. Some employers may need to wait longer
for performance criteria to be ascertained, financials certified, etc.,
resulting in the payment being subject to 409A and the ``one times
pay'' limit. In other instances, an employee may vest in increments
over the performance period or upon reaching retirement age but is not
paid until the end of the period, which also would result in the
payment being subject to 409A and the ``one times pay'' limit.
Private Equity. Many private companies (including start-ups) cannot
readily conform to the specific administrative rules provided under the
409A regulatory exceptions for equity grants (e.g., stock options and
stock appreciation rights) because there is no public market to ensure
a true fair market value price for the grant. As a result, many private
companies' equity grants are subject to 409A. Under the Senate bill,
private companies could not provide this type of equity grant to
employees unless the grant does not exceed the one times pay limit.
Because ``earnings'' on the equity also are subject to the proposed
limit, employees could have a tax penalty under 409A merely because the
company was successful and the value of the equity increased beyond the
limit.
Cash Flow and Start Ups. Small and emerging businesses may pay
modest current compensation during the early stages of the business but
promise significant future compensation, including retirement payments,
in order to attract and retain talented employees. The Senate bill
limits the business from making any promise that exceeds ``one times
pay'' for employees.
<F-dash>
Statement of Association for Advanced Life Underwriting
I. INTRODUCTION
The Association for Advanced Life Underwriting (``AALU''), the
National Association of Insurance and Financial Advisors (``NAIFA''),
and the National Association of Independent Life Brokerage Agencies
(``NAILBA'') appreciate the opportunity to submit this statement to the
Committee on Ways and Means in connection with its review of the
revenue increasing measures approved by the Senate as part of the
``Small Business and Work Opportunity Act of 2007.'' These comments
focus on the Senate proposal to place an annual limit on the amount of
compensation that may be deferred under a nonqualified deferred
compensation plan.
AALU is a nationwide organization of life insurance agents, many of
whom are engaged in complex areas of life insurance such as business
continuation planning, estate planning, retirement planning, and
deferred compensation and employee benefit planning. AALU represents
approximately 2,000 life and health insurance agents and financial
advisors nationwide.
Founded in 1890 as the National Association of Life Underwriters,
the National Association of Insurance and Financial Advisors comprised
800 state and local associations representing the business interests of
225,000 members and their employees nationwide. Members focus their
practices on: life insurance and annuities, health insurance and
employee benefits, multiline, and financial advising and investments.
NAIFA's mission is to advocate for a positive legislative and
regulatory environment, enhance business and professional skills, and
promote the ethical conduct of its members.
The National Association of Independent Life Brokerage Agencies
(NAILBA) is a nonprofit trade association with over 350 member agencies
in the U.S., representing 100,000 producers who deliver more than one
billion dollars in first year life insurance premiums annually.
AALU, NAIFA, and NAILBA strongly oppose the nonqualified deferred
compensation proposal approved by the Senate. If enacted, the NQDC
proposal would severely limit (if not eliminate) a vehicle many mid-
level managers and employees now use to supplement their retirement
savings. These mid-level managers are at times caught in a vise between
limited social security benefits and a cap on 401(k) contributions that
can be further reduced when overall employee participation in such a
plan is lackluster. AALU, NAIFA, and NAILBA believe that concerns
relating to nonqualified deferred compensation plans have been
addressed by legislation enacted in 2004, which has been the subject of
extensive (but as yet incomplete) guidance from the Treasury Department
and the IRS.
Employers are struggling to implement the 2004 nonqualified
deferred compensation rules and should not be subjected to additional
burdens that may cause them to reconsider these important retirement
savings vehicles.
II. BACKGROUND ON NONQUALIFIED DEFERRED COMPENSATION
Nonqualified deferred compensation is sometimes mistakenly confused
with ``executive compensation.'' It goes far beyond the ranks of top
management and is integral to the ability of hundreds of thousands of
mid-level managers and employees to save for retirement and for
employers to recruit and retain high-quality employees.
A typical nonqualified deferred compensation plan is an arrangement
under which a portion of an employee's salary is deferred until a
future date. Generally, the employee is at risk for the deferred
portion of their salary. Individuals typically enter into these
arrangements as a means of saving for retirement, in many cases
augmenting amounts saved through 401(k) and other qualified plans.
Limits on such qualified plans--for example, a maximum annual
contribution limit of $15,500 for 401 (k) plans--and a lengthening life
expectancy make nonqualified deferred compensation plans particularly
important savings tools for employees. Such plans are increasingly
important in light of concerns regarding the future availability of
social security benefits to retirees at middle to upper income levels.
Both large and small employers view these plans as valuable tools for
retaining and attracting talent.
In setting up a nonqualified deferred compensation agreement, the
employer and employee typically will specify the percentage of current
salary to be deferred and how earnings on the deferred amounts will be
computed. In some cases, the agreement will specify a rate of return on
the deferred amounts. In other cases, employees maintain an account in
which they may make hypothetical investments that will govern the
amount ultimately received by the employee. Some nonqualified deferred
compensation arrangements--referred to as ``non-elective''
arrangements--do not involve voluntary deferrals by employees.
A nonqualified deferred compensation plan is not eligible for the
tax benefits granted to qualified plans. Under a qualified plan, the
employer may deduct the deferred compensation currently, as amounts are
contributed to the plan, while the employee is able to defer paying
taxes until receiving distributions from the plan. By contrast, in a
nonqualified plan, the employer's deduction is postponed until the
employee recognizes the compensation for income tax purposes. This
matching of deductions and income inclusion effectively eliminates any
revenue concerns on the part of the federal government and provides a
cost-effective way for the government to encourage additional
retirement savings beyond those for which qualified plan tax benefits
are allowed.
Another key difference between nonqualified and qualified plans is
that amounts deferred in a nonqualified plan are not protected in the
event of the employer's bankruptcy. Assets intended to fund
nonqualified deferred compensation must remain subject to the claims of
the employer's general creditors. Thus, if the employer becomes
insolvent, there are no assurances that the deferred amounts will ever
be paid to the employee. In this case, the employee simply becomes
another unsecured creditor of a bankrupt company. Thus, employees with
nonqualified deferred compensation balances have a greater interest in
building a financially strong enterprise for the very reason that their
retirement income is dependent on the long-term financial stability of
the company.
EXHAUSTIVE RULES ALREADY ENSURE RESPONSIBLE USE
In 2004, Congress enacted sweeping additional requirements
(Internal Revenue Code section 409A) on deferred compensation. The
legislation imposed strict rules affecting deferral elections, funding,
and distributions and imposed tax and penalties for violations of these
rules. These rules were designed to ensure that employees do not have
control over the receipt of income that is deferred. Regulations to
implement the 2004 changes, which still have not been finalized, will
run to hundreds of pages. Employers have already incurred, and will
continue to incur significant legal and administrative expenses trying
to navigate through the quagmire of these new rules. Code Section 409A
and subsequent regulations surely address adequately any concerns about
nonqualified deferred compensation.
BROAD BENEFITS OF DEFERRED COMPENSATION PLANS
With longer life expectancies, the need for substantial retirement
savings, and restrictive limits on qualified retirement plans, deferred
compensation plans have become important to a wide-range of employees
and businesses. According to a recent survey by Clark Consulting, 91%
of Fortune 1000 respondent companies have nonqualified deferred
compensation plans.
Smaller businesses also commonly offer nonqualified deferred
compensation programs. For large and small businesses alike, deferred
compensation can be used as a tool to increase productivity and to
retain employees who make important contributions to the businesses'
bottom lines.
Of survey respondents with nonqualified deferred compensation
plans, 28% allow employees with compensation below $100,000 to
participate, and 63% allow employees with compensation below $150,000
to participate.
The following are some examples of plans now in operation:
1. A nationwide retailer based in the Midwest offers its
nonqualified deferred compensation plan to 1,120 employees. Of the 962
participants, 68% have annual salaries between $66,000 and $120,000.
2. A nationwide specialty retailer based in the Southwest offers it
nonqualified deferred compensation plan to 335 participants, 73% of
whom have annual salaries below $120,000.
3. One of the nation's leading homebuilders offers its plan to
almost 500 employees. 60% of those employees have annual salaries below
$140,000, and 40% have annual salaries below $120,000.
These numbers counter any perception that individuals making less
than $100,000 have little ability to save after they have ``maxed out''
contributions to 401(k) plans and IRAs. In reality, there are many
reasons mid-level managers and employees need to utilize nonqualified
plans. A common scenario is a ``two-earner'' couple whose combined
income affords significant additional savings capacity. There also are
situations where a worker making less than $100,000 is prevented--by
operation of the tax law's nondiscrimination rules--from making his or
her full contribution to a qualified plan. At the same time,
particularly for small businesses, business leaders might see less
merit instituting or maintaining a deferred compensation plan if they
themselves were unable to benefit from a deferred compensation plan.
In summary, nonqualified deferred compensation represents a major
source of personal savings for many employees. In light of the
dramatically low rate of U.S. individual savings--the personal savings
rate has dropped from 9% to a negative 1% since 1985--policymakers
should consider ways to make it easier, not more difficult, for
employees at all levels to save for retirement.
III. SENATE PROPOSAL
The nonqualified deferred compensation proposal approved by the
Senate would limit an individual's annual deferral under a nonqualified
deferred compensation plan to the lesser of (1) $1 million or (2) the
individual's average taxable compensation from the employer during the
preceding five years. The proposal would be effective for taxable years
beginning after December 31, 2006. Earnings (whether actual or
notional) attributable to post-December 31, 2006, nonqualified deferred
compensation would be treated as additional deferred compensation
subject to the proposal.
The Senate proposal applies to all amounts deferred under
nonqualified deferred compensation plans (as defined under section
409A), including plans of both private and publicly-held corporations.
The proposal applies to non-elective deferrals as well as those that
are elective.
Any deferrals in excess of those permitted by the Senate proposal
would trigger severe tax sanctions. As a result of an excess deferral,
all amounts deferred under the nonqualified deferred compensation plan
for all taxable years (after 2006) would become immediately taxable (to
the extent not subject to a substantial risk of forfeiture and not
previously included in gross income).
In addition to current income inclusion, interest would be imposed
as if the compensation had been taxable when first deferred (or, if
later, when first vested). Finally, the amount required to be included
in income would be subject to a 20-percent additional tax.
SENATE PROPOSAL DOES NOT MATCH STATED GOALS OF SPONSORS
Senator Charles Grassley has stated that the Senate's nonqualified
deferred compensation proposal was intended to backstop the rules of
Internal Revenue Code section 162(m),\1\ which generally limits to $1
million a public company's deduction for compensation paid to the top
five executives.
---------------------------------------------------------------------------
\1\ Section 162(m) is separately the subject of another one of the
Senate's revenue increasing proposals.
---------------------------------------------------------------------------
However, the Senate nonqualified deferred compensation proposal is
not limited to public companies or to the top five employees of a
company. It applies to all companies, public or private, and it applies
to all employees participating in a nonqualified deferred compensation
arrangement. Moreover, the Senate's nonqualified deferred compensation
proposal is not limited to those deferring more than $1 million per
year; the Senate's proposed annual deferral limit is the lesser of $1
million or the employee's average taxable compensation from the
employer during the prior five years. As a result, the Senate proposal
would limit deferred compensation for many mid-level managers and
employees who would otherwise be making deferrals of far less than $1
million.
Senator Grassley has acknowledged problems with the proposal he and
Senate Finance Committee Chairman Baucus placed before the Senate
Finance Committee. During a January 31, 2007, interview with CNBC,
Senator Grassley stated that the nonqualified deferred compensation
proposal had ``overreached.''
COUNTING EARNINGS TOWARDS ANNUAL DEFERRAL LIMIT WILL CAUSE SIGNIFICANT
PROBLEMS
The feature of the Senate proposal that would count earnings on
previously deferred compensation towards the annual deferral limit is
not administratively feasible and will cause significant problems.
These include the possible triggering of tax, interest, and penalties
on prior deferrals without any action on the part of the employee.
Because earnings on nonqualified deferred compensation are often
variable, depending on the performance of underlying investment
benchmarks (e.g., S&P 500), an employee cannot know with any certainty
the amount of earnings that will be generated with respect to prior
compensation deferrals. As a result, the employee cannot calculate with
any certainty the maximum amount of salary that would be eligible to be
deferred under the Senate proposal. For example, if an employee's
average taxable compensation (after 401(k) contributions, health
insurance withholdings, and dependent care withholdings) for the prior
five is $50,000, the maximum amount the employee can defer, through a
combination of salary reductions and earnings on prior deferrals, is
$50,000. Because even inadvertent and de minimis deferrals exceeding
the Senate limits would have significant adverse consequences,
employees will be forced to seek only predictable, but relatively low
earnings on their previously deferred compensation.
The longer the employee has participated in the nonqualified
deferred compensation plan, the more significant the earnings component
will be. At some point, just the earnings themselves on previously
deferred compensation could cause an employee to exceed the permissible
annual deferral. For example, if the employee above had previously
deferred $550,000 and earned $55,000 on those prior deferrals during
the current year, the earnings alone, without any additional salary
deferrals, would cause the employee to violate the new deferral limit
and trigger taxation of all prior deferrals plus a 20-percent penalty
tax and retrospective interest.
For employees with nonqualified plan distributions occurring in
years after the termination of employment, any earnings (even $1) on
past deferrals could trigger the adverse tax consequences. For example,
in the case of an employee who terminates employment in 2008, the
average taxable compensation from the employer during a rolling five-
year period will decline until it reaches zero after 2013. Thus, any
earnings in 2014 or later on undistributed prior deferrals will exceed
the five-year average taxable compensation (i.e., zero) and trigger
draconian tax results.
PROBLEMS WITH APPLICATION TO NON-ELECTIVE PLANS
Many employers provide deferred compensation to groups of employees
on a non-elective basis; the employee groups covered by these
arrangements can be quite broad. These arrangements (e.g. defined
benefit arrangements), under which employers unilaterally defer the
payment of a portion of current compensation, serve valuable employer
goals such as employee retention. From a policy perspective, it makes
no sense to limit an employee's deferred compensation under these non-
elective deferred compensation plans where the employee has no choice
as to whether the deferral is made.
In addition, the Senate proposal gives absolutely no guidance on
how to apply the rules to such non-elective arrangements. The proposal
does not provide any indication of how to compute the amount that is
being deferred under a defined benefit arrangement and, instead, leaves
this task to the Treasury Department and the IRS in regulations.
IV. CONCLUSION
AALU, NAIFA, and NAILBA believe that the Senate's proposed
limitation on annual deferrals under nonqualified deferred compensation
arrangements should not be adopted. Employers are still struggling to
comply with restrictions on deferred compensation enacted in 2004, and
guidance on many key issues involved in that earlier legislation has
not even been proposed. The Senate's new proposed limits, with their
operational complexity and potential for significant adverse tax
consequences for even de minimis violations, may prompt employers to
simply abandon nonqualified deferred compensation arrangements. Such a
result would clearly run counter to the goal of encouraging Americans
to save as much as possible towards retirement.
<F-dash>
Statement of ERISA Industry Committee
Chairman Rangel, Ranking Member McCrery, and Members of the
Committee, thank you for the opportunity to present the views of The
ERISA Industry Committee (``ERIC'') on the Senate revenue increasing
provisions in H.R. 2 related to deferred and executive compensation.
ERIC is a nonprofit association committed to the advancement of
America's major employer's retirement, health, incentive, and
compensation plans. ERIC's members' plans are the benchmarks against
which industry, third-party providers, consultants, and policy makers
measure the design and effectiveness of other plans. These plans affect
millions of Americans and the American economy. ERIC has a strong
interest in protecting its members' ability to provide the best
employee benefit, incentive, and compensation plans in the most cost
effective manor.
PERCEPTION IS NOT REALITY
Recent media reports have highlighted the size of the compensation
packages of some highly compensated senior corporate executives. These
reports have created the erroneous perception that deferred
compensation plans are abusive and available to only the most senior
executives. They are not. Hundreds of thousands of dedicated,
hardworking middle managers participate in deferred compensation
programs. Far from being abusive, these programs serve legitimate
purposes that benefit both employers and employees. They provide
recruitment and retention tools for employers and needed retirement
security for employees.
The ill-conceived deferred compensation provisions in the Senate-
passed version of H.R. 2, the Fair Minimum Wage Act of 2007, are based
on these erroneous perceptions. They represent bad employment policy
and bad tax policy. In particular, the broad sweep of the provisions is
unsuitable for legislation that purports to be aimed solely at the
highest-paid executives. These provisions will cause many thousands of
the nation's most talented and productive people--scientists,
engineers, and researchers on whom the nation and its enterprises
depend for economic vitality--to be blindsided by an egregious and
retroactive tax increase.
ERIC strongly urges the House Ways and Means Committee to reject
the Senate-passed deferred and executive compensation provisions and to
exclude them from any legislation that the Committee approves.
THE CAP ON DEFERRED COMPENSATION EXCEEDS THE SCOPE OF ANY PERCEIVED
PROBLEM
The limit on deferred compensation in the Senate bill goes far
beyond its stated objective. The Senate Finance Committee's report
indicates that the limit on deferred compensation is intended to target
``the large amount of executive compensation'' provided by arrangements
that ``allow executives to choose the amount of income . . . they wish
to defer . . . in order to avoid the payment of income taxes.'' The
limit imposed by the Senate bill, however, would curtail the
compensation and benefits of many more employees than the executives
referred to in the Senate Finance Committee report. Specifically, the
deferred compensation limit would--
1) Apply to all employees, not just to executives;
2) Apply to nonelective plans--plans that provide deferred
compensation automatically, without allowing the employees covered by
the plan to elect how much they will defer--not just to elective plans;
3) Restrict the deferred compensation that an employee may earn in
a year to an amount equal to the lesser of (a) $ 1 million or (b) the
employee's average annual pay over a five-year base period--a limit
that is much less than $ 1 million for the vast majority of employees;
4) Treat as additional deferred compensation any earnings that are
credited in a given year on an employee's post-2006 deferred
compensation, so that such earnings (a) are subject to the bill's limit
on the amount of deferred compensation for that year and (b) reduce--
possibly to zero--the limit on any other deferred compensation that the
employee may earn in the same year;
5) Impose an annual limit on the aggregate of all of the benefits
that an employee may earn under all of the employer's deferred
compensation plans; and
6) Apply to every employee who participates in a plan that is
treated as a deferred compensation plan by the Tax Code--regardless of
whether the employee elected to participate in the plan, regardless of
whether the employee had any influence over the amount of the deferred
compensation that he or she is credited with under the plan, and
regardless of the employee's motive or intent.
Contrary to the impression that the Senate Finance Committee report
creates, many of the deferred compensation plans that would be affected
by the deferred compensation limit, if it is enacted, do not give
employees the option to defer part of their current pay. For example, a
great many of the deferred compensation plans sponsored by employers
are benefit restoration plans that are designed to provide pension
benefits that the employer considers appropriate and would have
provided through its tax-advantaged pension plan were it not for the
limits that the Tax Code imposes on tax-advantaged plans. Benefit
restoration plans are not optional plans that employees use for tax
avoidance purposes. Eligible employees earn benefits under these plans
automatically and pay income tax on the benefits they receive when they
receive them.
Congress has limited the benefits that tax-advantaged plans may
provide because of the tax benefits that those plans receive. In
general, a tax-advantaged plan's investment income is exempt from
income tax; the employees who participate in the plan are not taxed on
their benefits until they actually receive them (and even then,
participants can further defer the tax on some distributions by rolling
them over into an IRA or into another tax-advantaged plan); and within
limits, the employer can currently deduct its contributions to the
plan--even though plan participants are not taxed on the employer's
contributions to the plan, and are not taxed until the plan distributes
benefits to them--often many years after the employer funded those
benefits. Deferred compensation plans do not receive any of these
benefits and, as a result, are not subject to the restrictions that
apply to tax-advantaged plans.
The limits that the Tax Code imposes on tax-advantaged plans apply
to such aspects of the plan as benefits, contributions, and the
employee compensation on which plan benefits and plan contributions are
based. These limits are designed to restrict the tax benefits that tax-
advantaged plans receive and to assure that tax-advantaged plans
provide benefits that do not favor highly compensated employees.
In many cases, however, the Tax Code limits have been imposed, or
have been frozen or reduced, in order to achieve federal budgetary
objectives, rather than retirement-income objectives. As a result, the
Tax Code limits have not kept up with inflation and have prevented tax-
advantaged plans from providing an increasing percentage of the
benefits that they would otherwise provide to a growing number of mid-
level employees. Employers have established benefit restoration plans
and other nonelective deferred compensation plans to provide affected
employees with the benefits that the Tax Code prevents a tax-advantaged
plan from providing.
One example of the Senate's deferred compensation limit
demonstrates the extreme penalty that an employee would be subjected to
without any action on her part. A Caucasian female manager, age 50,
whose average five-year W-2 earnings is $144,000, would have been
subjected to a $31,000 excise tax plus income tax on her deferred
earnings if the provision had been in place for 2006. Her deferrals
included irrevocable elections under a supplemental employee retirement
plan, a bonus deferral plan, and earnings on previous deferrals. The
egregious penalty on this hardworking middle manager's deferrals are
the result of total deferral exceeding her five-year average W-2
earnings by a mere $11,000. As a result, the Senate's limit on deferred
compensation triggers a 20 percent excise tax penalty plus income tax
on the amount deferred even though the employee cannot receive any
income from the deferrals until after retirement.
This example illustrates that the Senate bill's limit on deferred
compensation will needlessly harm mid-level employees and raise a host
of practical problems, including the following:
<bullet> If the value of an employee's deferred compensation
benefit takes into account the value of an early retirement subsidy,
the annual limit could harm many mid-level employees in the year when
the value of their benefit restoration plan benefits ``spike'' as a
result of the employee's entitlement to subsidized early retirement
benefits. (The bill does not make clear whether the value of the
subsidy can be ignored in a year if the employee does not actually
retire in that year.)
<bullet> The annual limit would likely cause mid-level employees
who participate in an early retirement window program to exceed the
annual limit where a benefit restoration plan provides some or all of
the window benefits.
<bullet> The annual limit also could cause mid-level employees to
exceed the annual limit when they are laid off and become entitled to
severance benefits that the Tax Code treats as deferred compensation.
<bullet> The compensation-based prong of the annual limit on
deferred compensation would have a disproportionately severe effect on
the benefits of mid-level employees whose annual compensation declines
(and for whom the annual limit therefore declines) as a result of
shifting to a part-time or seasonal position or participating in a
phased retirement program.
<bullet> The annual limit would have a disproportionately severe
effect on loyal, long-service employees who, by reason of their long
service with their employer, have accumulated significant deferred
compensation benefits that could be credited with substantial
investment earnings in a single year.
<bullet> The treatment of investment earnings as additional
deferred compensation could cause a mid-level employee to exhaust the
annual limit on deferrals solely as a result of investment performance
equaling or exceeding the annual limit for the year, and could thereby
prevent the employee from accruing any other deferred compensation in
that year.
<bullet> The treatment of investment earnings as additional
deferred compensation also would make it impossible for an employee to
engage in reliable advance planning designed to avoid exceeding the
annual limit. For example, where the earnings that are credited on
deferred compensation are tied to the performance of an equity security
or an equity index, the earnings (and therefore the employee's
deferrals) for the year could not be known until the last day of the
year.
<bullet> The treatment of investment earnings as additional
deferred compensation would perversely penalize employees for making
successful investment decisions.
<bullet> Because the annual limit on deferrals appears to apply to
foreign, as well to U.S., deferred compensation plans, a U.S. citizen
who participates in both U.S. and foreign deferred compensation plans
could be taxed on the deferred compensation under the U.S. plan as a
result of being pushed over the limit on deferrals by the benefits that
he or she accrues under the foreign plan.
<bullet> The compensation prong of the annual limit could stop
outside directors from engaging in the benign practice of accepting
deferred stock units instead of current directors' fees.
<bullet> Retirees who are credited with additional deferred
compensation in years in which they receive no current pay would appear
to exceed the annual limit for those years (zero).
EXPANDING THE 162(m) LIMIT WOULD PENALIZE COMPANIES FOR COMPLYING WITH
CURRENT LAW
The Senate-passed version of H.R. 2 would also expand the limit
that Section 162(m) of the Tax Code imposes on the deductibility of the
compensation that a public company pays to certain current officers.
The provision would make the Section 162(m) limit applicable to
compensation that the company pays to individuals who were covered by
the deduction limit in any prior taxable year beginning after December
31, 2006.
Under current law, the Section 162(m) limit does not apply to
compensation paid to former employees. If Section 162(m) is amended, in
accordance with the Senate-passed bill, to apply to payments made after
2006 to former employees who were covered by Section 162(m) at any time
after 2006, the limit would apply to payments that employers and
employees deliberately deferred in the past in order to assure that, in
accordance with the law then in effect, the deductibility of those
payments would not be disallowed by Section 162(m).
It is bad tax policy to penalize employers for having done
precisely what the tax law encouraged them to do. The Committee should
reject the Senate provision.
EXORBITANT ``TOLL CHARGE'' FOR LEAVING THE U.S.
The Senate bill also contains a provision that would impose a
``mark-to-market'' regime on certain U.S. citizens who relinquish their
U.S. citizenship and certain long-term U.S. residents who terminate
their U.S. residency. In general terms, the bill would tax these
individuals on the net unrealized gain in their property as if the
property had been sold for its current fair market value. Subject to
certain exceptions, the bill treats an interest in a Section 401(a)
plan, a deferred compensation plan, or an IRA as property for purposes
of this ``deemed sale'' rule.
The provision also includes a special rule for certain retirement
plans, including Section 401(a) plans and certain foreign retirement
plans. Under the special rule, instead of being subject to the ``deemed
sale'' rule, the individual would be treated as having received an
amount equal to the present value of the individual's vested accrued
benefit on the day before he or she relinquishes U.S. citizenship or
terminates residency in the U.S. If the plan later makes a distribution
to the individual, the amount otherwise includible in the individual's
gross income as a result of that distribution would be reduced to
reflect the amount previously included in the individual's gross
income.
A covered expatriate also would be allowed to make an irrevocable
election to continue to be taxed as a U.S. citizen with respect to all
property otherwise covered by the expatriation tax. If he or she makes
this election, the individual would be required to continue to pay U.S.
income tax on the income produced by the property, the individual would
be required to post collateral to ensure payment of the tax, and the
amount of the ``mark-to-market'' tax that otherwise would have been due
(but for this election) would become a lien in favor the U.S. on all of
the individual's U.S. property.
If enacted, these provisions would impose an exorbitant ``toll
charge'' on individuals who leave the United States. Because the toll
charge requires a departing long-term U.S. resident to pay tax on
income that he has not received and may have no right to receive, this
provision would, if enacted, discourage talented foreign employees from
accepting assignments in the United States. It is bad policy to create
such barriers to becoming a U.S. resident.
CONCLUSION
ERIC strongly urges the House Committee on Ways and Means to reject
the Senate-passed deferred and executive compensation provisions and to
exclude them from any legislation that the Committee approves. They are
ill-conceived solutions to a problem that do not exist. If enacted, the
provisions' principal effect will be to harm hundreds of thousands of
mid-level employees who earn far less than the Senate Finance
Committee's report and recent media coverage would suggest.
<F-dash>
Financial Services Roundtable
March 13, 2007
The Honorable Charlie Rangel, Chairman
Committee on Ways and Means
United States House of Representatives
Washington, DC 20515
Dear Chairman Rangel,
The Financial Services Roundtable supports your efforts to examine
the consequences of revenue raisers contained in the ``Small Business
and Work Opportunity Act of 2007'' (the Act).
We oppose the revenue raisers in the Act which retroactively change
the tax treatment of certain leasing transactions, which limit the
opportunity and incentive for employees to contribute to certain
retirement plans, and which retroactively deny the deductibility of
accrued compensation.
(1) Retroactive Tax Changes
The Roundtable opposes all retroactive tax changes because they
undermine the entire foundation of the tax code. Retroactive changes
create uncertainty and the inability to rely on the tax code. It makes
it almost impossible for Americans businesses to price deals and to be
competitive in a global economy.
The Roundtable opposes the Senate's retroactive revenue raiser on
sale-in lease-out transactions. Removing the grandfather protection for
these leasing transactions is simply wrong. It is particularly harmful
to the companies which entered into these transactions legally and
under the guidance of the federal government. For the government to now
reach back and punitively tax these transactions is unfair and will
have negative economic consequences. This change would adversely impact
the stock market, the regulatory capital of the affected banks and
further produce a weakening on investor confidence in corporate
earnings.
During the 108th Congress, as part of the American Jobs Creation
Act of 2004 (P.L. 108-357), a provision was included to make a
prospective change to the tax treatment of certain leasing
transactions, applying new rules to leases entered into after March 12,
2004. In the last Congress, a provision was proposed that would have
changed the effective date for leases entered into on or before March
12, 2004. This provision was wisely rejected and should be rejected
again.
(2) Limitations on Savings
The Roundtable is opposed to the provisions in the Act that would
limit deferrals into nonqualified deferred compensation plans. These
revenue raisers are overbroad and include many benefit programs outside
of the intended scope.
The Act and would impose a dramatic shift in tax policy relating to
the receipt of income. The proposals will force some employers to
significantly reduce or abandon retirement and savings programs that
benefit middle management employees in favor of current cash
compensation. Further, the Act reduces the opportunity and incentive
for employees and employers to plan for the retirement of their
employees, and will make it harder to attract and retain employees. The
flawed tax policy contained in the Act would result in a cash drain for
many employers, resulting in less flexibility and needlessly add
complexity in the administration of compensation arrangements.
Additionally, the Senate bill makes changes to Sec. 162(m) relating
to the deductibility of executive compensation. These changes are
intended to target large compensation payments to executives when they
are no longer ``covered'' executives and thus no longer subject to the
$1 million cap on the deduction for non-performance-based pay.
Unfortunately, the Senate bill as currently drafted applies
retroactively because a company would be denied a deduction for pre-
2007 accrued compensation paid to an employee after 2006, if that
employee is a CEO or one of the top four at any point in time after
2006. This section should be amended so it doesn't apply to any
compensation to which an employee had a legally binding right, whether
or not contingent, on January 17, 2007 or which relates to services
performed before January 17, 2007.
The Financial Services Roundtable represents 100 of the largest
integrated financial services companies providing banking, insurance,
and investment products and services to the American consumer. Member
companies participate through the Chief Executive Officer and other
senior executives nominated by the CEO
Roundtable member companies provide fuel for America's economic
engine, accounting directly for $65 trillion in managed assets, $1
trillion in revenue, and 2.4 million jobs.
Best regards,
Steve Bartlett
President and CEO
<F-dash>
Statement of Hogan & Hartson LLP
Transition Relief under Proposed Change to Section 162(m) Definition of
Covered Employee--Necessary to Avoid Retroactively Denying the
Employer's Deduction for Its Current Binding Obligation to Pay
Compensation Already Earned for Services Already Performed
Background
Under current law, compensation in excess of $1 million paid by a
public company to its ``covered employees'' is not deductible unless it
is performance-based and has been approved by shareholders. (I.R.C.
162(m)). ``Covered employees'' for this purpose are defined as the
chief executive officer as of the close of the taxable year and the
four other most highly compensated officers of the company whose
compensation is required under the federal securities laws to be
reported in the company's proxy statement for the year. The limitation
applies in the year in which the compensation is paid out and the
company takes the deduction.
It has been the longstanding rule since the enactment of section
162(m) in the Omnibus Reconciliation Act of 1993 that once an employee
terminates employment with the company, he or she is no longer a
``covered employee''. As the House-Senate Conference Report adopting
section 162(m) stated: ``Of course, if the executive is no longer a
covered employee at the time the options are exercised, then the
deduction limitation would not apply.'' (House Rept. No. 103-213, at p.
585 n. 45 (Conference Report); House Rept. No. 103-111, at p. 647, n.
21 (Identical statement)). This rule has been repeatedly re-affirmed in
longstanding IRS guidance. (See, e.g., IRS Private Letter Rulings
200547006, 200042016, 200039028, 200019010, 199928014, and 199910011).
Proposed Change
Citing recent changes by the Securities and Exchange Commission to
the group of company executives for whom compensation is required to be
disclosed, the Senate's tax component of the minimum wage legislation
proposes to adopt a new definition of ``covered employee'' and in so
doing to reverse this longstanding current law rule under section
162(m) that once a person has terminated employment, he or she is no
longer a ``covered employee''. (H.R. 2, sec. 234). Under the Senate
provision, once having been a ``covered employee'', the person would
remain so in perpetuity, even years after leaving the company. (Sen.
Rept. No. 110-1). This proposed change would apply to taxable years
beginning after December 31, 2006.
Transition Relief Is Necessary for Existing Binding Contracts
Entered into in Reliance on Longstanding Current Law Rules
The proposed change would have a retroactive effect of denying the
company's deduction for its binding contractual obligation to pay
compensation already earnedfor services already performed_all
undertaken in reliance on the current law rules
Because the proposal would apply to taxable years beginning after
December 31, 2006 and the section 162(m) limitation applies in the year
in which the compensation is paid out, the proposed reversal of the
longstanding definition of covered employee will apply retroactively to
compensation that already has been earned for services that were
rendered years ago. Since the section 162(m) limitation is a
disallowance of the employer's deduction, the proposal has the effect
of disallowing a deduction for compensation that an employer is
contractually obligated to pay under binding contracts entered into
years, even a decade or more ago, in reliance on the longstanding
current law rule on covered employees as reflected in the legislative
history of section 162(m) and repeatedly re-affirmed in IRS guidance.
Taxpayers enter into business agreements relying on the laws in
effect at the time. Accordingly, Congressional tax-writers historically
have been reluctant to adopt retroactive tax changes to avoid upsetting
such reliance on the governing law at the time and imposing unexpected
penalties or windfalls after-the fact
Congress has provided transition relief in similar situations for pre-
Act deferrals and subsequent earnings
Original enactment of section 162(m)
In originally enacting section 162(m), Congress adopted broad
transition relief for existing binding contracts, providing that the
limitation did not apply to ``any remuneration payable under a written
binding contract which was in effect on February 17, 1993, and which
was not modified thereafter in any material respect before such
remuneration is paid.'' (Section 162(m)(4)(D)). This broad transition
relief extended to services to be performed in the future under the
contract.
Section 409A rules for nonqualified deferred compensation arrangements
In enacting new section 409A which adopted broad changes to the
rules governing nonqualified deferred compensation arrangements,
Congress grandfathered not only pre-Act deferrals of compensation but
also to post-Act earnings on such deferrals. Congress provided that
``[t]he amendments made by this section apply to amounts deferred after
December 31, 2004'' and that such amendments ``shall apply to earnings
on deferred compensation only to the extent that such amendments apply
to such compensation.'' (American Jobs Creation Act of 2004, P.L. 108-
357, Sec. 885(d)).
Proposed cap on annual deferrals of nonqualified deferred compensation
Indeed, elsewhere in the same Senate minimum wage tax package,
under the proposed new cap on annual deferrals of nonqualified deferred
compensation, a grandfather is provided for both pre-Act deferrals of
compensation and post-Act earnings on such deferrals. Under the Senate
bill, the new cap applies ``only to amounts deferred after December 31,
2006 (and to earnings on such amounts).'' (Sec. 226(b) of H.R. 2).
Proposed Transition Rule
Consistent with the approach taken by Congress in these similar
contexts, the proposed transition rule would provide a binding contract
exception. Indeed, the transition rule would be even tighter, being
limited to compensation that has been earned for services that already
have been performed. More specifically, the proposed change to the
section 162(m) definition of covered employee would not apply to
remuneration (as defined under section 162(m)(4)(E), including amounts
deferred and earnings on such deferrals) for services that were
rendered in a taxable year beginning before January 1, 2007 and payable
under a written binding agreement which was in effect on December 31,
2006 and which was not modified thereafter in any material respect
before such remuneration is paid.
Possible Amendment to Section 162(m) Proposal to Provide Transition
Relief to Protect
Existing Binding Contracts Entered Into in Reliance on Longstanding
Current Law Rules
Section 234 (regarding modifications of definition of employee
covered by denial of deduction for excessive employee remuneration) of
Title II (the ``Small Business and Work Opportunity Act of 2007'') of
H.R. 2 is amended to read as follows:
SEC. 234. MODIFICATIONS OF DEFINITION OF EMPLOYEE COVERED BY DENIAL OF
DEDUCTION FOR EXCESSIVE EMPLOYEE REMUNERATION
``(a) IN GENERAL.--Paragraph (3) of section 162(m) is amended to
read as follows:
``(3) COVERED EMPLOYEE.--For purposes of this subsection, the term
`covered employee' means, with respect to any taxpayer for any taxable
year, an individual who--
``(A) was the chief executive officer of the taxpayer, or an
individual acting in such a capacity, at any time during the taxable
year,
``(B) is 1 of the 4 highest compensated officers of the taxpayer
for the taxable year (other than the individual described in
subparagraph (A)), or
``(C) was a covered employee of the taxpayer (or any predecessor)
for any preceding taxable year beginning after December 31, 2006.
In the case of an individual who was a covered employee for any
taxable year beginning after December 31, 2006, the term ?covered
employee' shall include a beneficiary of such employee with respect to
any remuneration for services performed by such employee as a covered
employee (whether or not such services are performed during the taxable
year in which the remuneration is paid).'.
``(b) EFFECTIVE DATE.--
``(1) IN GENERAL.--The amendment made by this section shall apply
to taxable years beginning after December 31, 2006.
``(2) EXCEPTION FOR EXISTING BINDING CONTRACTS.--The amendment made
by this section shall not apply to remuneration (within the meaning of
section 162(m)(4)(E) of the Internal Revenue Code of 1986, as amended,
including amounts deferred and earnings thereon) for services that were
rendered in a taxable year beginning before January 1, 2007 and payable
under a written binding agreement which was in effect on December 31,
2006 and which was not modified thereafter in any material respect
before such remuneration is paid.''
<F-dash>
Statement of HR Policy Association
Thank you for holding this hearing and for this opportunity to
present the views of the HR Policy Association regarding the impact of
Sections 206 and 214 of H.R. 2, the Small Business Work and Opportunity
Act. We believe that these sections, which would impose substantial
limits on annual deferrals of nonqualified deferred compensation and
significantly change the treatment of nonqualified deferred
compensation for former ``top five'' executive officers, would create
significant unintended consequences and should be eliminated from any
final bill that is sent to the President.
HR Policy Association is a public policy advocacy organization
representing the chief human resource officers of over 250 leading
employers doing business in the United States. Representing nearly
every major industry sector, HR Policy members have a combined U.S.
market capitalization of more than $7.5 trillion and employ more than
18 million employees world wide. Our members are particularly
interested in sound executive compensation practices because they are
responsible for assisting boards of directors and board compensation
committees in developing compensation programs for executives. Our
members are very concerned that Congress consider the full effects of
tax law changes intended to limit executive compensation. In the past,
such changes have had the opposite effect from that intended, and may
have accelerated increases in executive compensation.
Section 206 of the Small Business Work and Opportunity Act would
amend section 409A of the tax code to cap the amount an individual
could defer into a nonqualified deferred compensation arrangement
annually. The cap would be the lesser of (a) $1 million or (b) the
average of the individual's gross income over the five years preceding
the year in which the deferral election is made. As described below,
the cap would have a significant impact on middle managers and would
make even more complex an extremely arcane tax law provision.
Nonqualified Deferred Compensation Plans Used to Provide Benefits
Restoration to Managers and Executives
Nonqualified deferred compensation plans generally are used as
retirement savings vehicles. Their underlying purpose is to permit
managers, sales employees, and executives to defer until retirement a
percentage of their regular pay that is more comparable to the
percentage of regular pay deferred in qualified retirement plans by
lower-level employees. Like qualified retirement plans, nonqualified
plans permit the deferral of compensation, which in this case means
that compensation is credited to the plan for later withdrawal, usually
at retirement. The plans are nonqualified, meaning that they do not
receive the special tax advantages of ``qualified'' retirement plans,
including that employers are not allowed to deduct plan contributions
in the year they are made. Instead, the company must wait to deduct the
compensation as an expense until the year the employee receives the
income. The mechanics of this are strictly regulated by tax code
section 409A, which Congress passed in 2004 and for which the IRS and
Treasury Department have not yet finalized regulations.
The deferral of compensation in nonqualified arrangements comes
with a risk that the individual will never receive the money, because
the arrangements generally are unsecured. Unlike qualified plans, no
money is set aside for participating employees, and there is no
guaranty that the funds will be paid. The arrangements normally do not
provide participating employees protection from creditors in bankruptcy
or insolvency. This lack of security acts as an incentive to all
employees, and particularly senior executives, to manage the company
prudently. It also enables companies to preserve resources for
operating the company, rather than paying it directly to the employees.
Restrictions on Deferred Compensation Will Affect Many More Employees
Than Senior Executives
The expansion of section 409A in Section 206 will affect far more
employees than just senior executives, because a broad array of
employees--from middle managers, to junior executives, to CEOs--often
participate in their employer's nonqualified deferred compensation
programs. There is no one-size-fits-all program. In fact, among HR
Policy member companies, the type of arrangements and number of
participants varies with the size of the company and their overall
compensation structure. Most large companies have several hundred
employees participating, and in some companies, several thousand
participate. Especially at the lower levels, those who participate most
often do so because of the opportunity for benefits restoration.
Cap on Nonqualified Deferred Compensation Would Have Unintended
Effects, Limit Severance Programs
The cap on nonqualified deferred compensation would limit the
opportunity for benefits restoration, especially for the lower tier of
employees who participate in these arrangements. The proposal's
deferral limitation, which is an average of the five years of gross
income before the year in which a deferral election is made, will
significantly limit the percentage of compensation middle and senior
managers can defer. This would be an issue for those employees who have
risen rapidly into or beyond the middle management ranks and whose
income has increased proportionately during that time.
In addition, the proposal will affect arrangements that fall within
the scope of 409A, but that have traditionally not been considered
deferred compensation. For example, the limit on deferred compensation
would impose a 20 percent excise tax penalty on individuals who may
automatically be eligible for broad-based severance programs that
provide more than one year's salary. Severance benefits often include
two years' salary for senior managers, for example, to protect trade
secrets or to provide a transition in the event of a merger or
acquisition.
Proposal Would Limit Further Complicate Arcane Deferral Rules Under
Section 409A
The $1 million cap on nonqualified deferred compensation also will
further complicate the extremely complex area of tax law under section
409A of the tax code. Congress passed 409A in 2004, and because of the
complexities involved in applying the law to uniquely tailored
programs, the Treasury Department has not yet finalized implementing
regulations. Thus, it is difficult to determine the effects this change
will have on nonqualified deferred compensation programs, especially
those that are already in effect or that may be arranged through
employment contracts.
Retroactive Changes to Section 162(m) Would Perpetuate Unintended
Consequences
Section 214 of the proposal also would extend the application of
162(m) by expanding the definition of ``covered employee'' to include
any individual who had previously served as CEO or one of the other
four most highly compensated executive officers. The change would apply
retroactively to amounts employers are already contractually obligated
to pay and would provide for no transition to enable employers to alter
their compensation strategy prospectively.
More importantly, this change expands a tax code section that, as
Securities and Exchange Commission Chairman Christopher Cox recently
described, was intended ``to control the rate of growth in CEO pay.''
He added: ``With complete hindsight, we can now all agree that this
purpose was not achieved. Indeed, this tax law change deserves pride of
place in the Museum of Unintended Consequences.'' This lack of
effectiveness led the Joint Committee on Taxation staff to recommend
repealing Section 162(m) altogether in its 2003 report on Enron. HR
Policy opposes this provision because rather than heed the lessons of
history, the bill expands and complicates section 162(m) further.
In sum, we oppose the restriction on nonqualified deferred
compensation imposed by Sections 206 and 214 of the tax code. We
believe the restrictions in Section 206 would encourage companies to
eliminate the benefit for lower-level executives while keeping senior
executives whole in other ways. Moreover, the change would remove an
important incentive for many senior executives to manage the company
prudently. Likewise, the restrictions in Section 214 would undermine
assumptions companies had made when originally entering into
compensation arrangements with senior executives and would further
complicate a section of the Code that has failed to accomplish its
intended purposes.
Thank you for the opportunity to express our views on this
important legislation. Please do not hesitate to contact us if you have
any questions.
<F-dash>
Statement of Richard D. Ehrhart
My Background. I am a deferred compensation expert with a unique
combination of perspectives developed over 26 years of work in the
deferred compensation industry. For 18 years I was a tax and benefits
attorney specializing in deferred compensation. For the past 8 years, I
have been a small business owner and executive running Optcapital.
Optcapital helps employers design and administer deferred compensation
plans. We work with public and private companies from large Fortune
1000 firms to small businesses. I have written extensively about
deferred compensation. Most recently, I published ``Section 409A:
Treasury Newspeak Lost in the Briar Patch,'' 38 The John Marshall Law
Review 743 (Spring 2005). For more than 20 years, I have been a member
of the Employee Benefits Committee of the Tax Section of the American
Bar Association.
The Bill's Background. On January 10, 2007, the House of
Representatives passed H.R. 2, the ``Fair Minimum Wage Act of 2007,''
which would increase the Federal minimum wage for the first time in ten
years. On February 1, 2007, the Senate passed its own version of H.R.
2. The Senate-passed version coupled an increase in the Federal minimum
wage with a package of tax benefits costing $8.3 billion over ten
years. In order to offset the cost of these tax benefits, the Senate
bill includes over a dozen separate provisions that, in the aggregate,
would raise $8.3 billion over ten years. These offsetting revenue
increases would, among other things, change the tax treatment of
certain leases entered into before March 12, 2004, deny deductions for
certain government-required payments and punitive damages in civil
actions, enact new limitations on nonqualified deferred compensation
(``NQDC'') plans, and change the tax treatment of certain financial
instruments.
The bill includes two separate NQDC limitations. The first would
limit annual deferrals under NQDC plans to an employee's average
taxable compensation from the employer during the preceding five years
or, if less, $1 million (the ``409A CAP''). Additionally, the proposal
contains an expansion of the class of individuals who are subject to
the $1 million cap on deductible compensation under Code Section 162(m)
to include all individuals who qualify as ``covered employees'' at any
time on or after January 1, 2007 (the ``162(m) EXPANSION'').
The Joint Committee on Taxation (``JCT'') has projected the 409A
CAP to generate $800 million of tax revenues over 10 years. It has
projected the 162(m) EXPANSION to raise $100 million over 10 years.
My Recommendation. As explained below, the 409A CAP is ill
conceived and would damage the economy, the competitiveness of American
businesses and U.S. financial markets. It would not raise tax revenues,
but reduce them. It would not reduce executive pay, but greatly expand
the use of stock options. It would also expand the use capital gains
for services.
The 409A CAP is a ``mega-ton nuclear bomb'' sort of legislation
that would kill all NQDC for all companies, public and private, large
and small. Private companies (which can't use stock options) would be
disadvantaged versus public companies. More important, U.S. companies
would be handicapped in competing with foreign companies, inasmuch as
no other industrialized nation limits NQDC.
The 162(m) EXPANSION, by contrast, is a ``smart missile'' approach
that can be effective in reducing executive pay, without hurting the
competitiveness of U.S. companies in global markets for talent. Instead
of killing NQDC, and the long-term wealth that NQDC helps to generate,
it simply raises the cost of ``excessive'' pay for the top 5 executives
of public companies.
In its September 5, 2006 Report entitled ``Present Law and
Background Relating to Executive Compensation, the JCT identified two
major loopholes in Section 162(m) and recommended that they be closed.
The Senate Finance Committee's proposal would only partially close just
one of the two loopholes. By closing all the loopholes in Section
162(m), the revenue tag of the 162(m) EXPANSION would probably be in
the billions.
In sum, if NQDC must be restricted, then we strongly urge Ways and
Means to abandon the 409A CAP and fashion a 162(m) EXPANSION amendment
that plugs the loopholes the JCT has identified.
NQDC Is Essential to the Competitiveness of U.S. Business. Most
employers use NQDC. They use NQDC to reward key employees. NQDC
consists of promises to pay specified benefits in the future. For many
businesses, NQDC is essential for sustainable growth. The market for
top talent is highly competitive. U.S. companies compete globally for
management, sales and marketing labor. The ability to provide long-term
incentives is vital to attracting and retaining key employees. It is
also absolutely critical to ensure that motivations and contributions
of key employees are aligned with shareholders' interests.
For example, we started Optcapital in 1998. NQDC enabled us to
attract some of the best minds available. Most of them came from the
big companies like Wachovia, Bank of America, U.S. Trust and Deutsche
Bank. We could not compete with these firms on the basis of current
compensation. Without the ability to promise substantial NQDC, we could
not have acquired the talent we needed.
NQDC Is Tax Revenue Neutral. NQDC is ``nonqualified'' because it is
for a select group of higher-paid employees over and above the limits
of qualified retirement plans. Because it is nonqualified, the employer
does not receive a tax deduction for NQDC until the employee realizes
the NQDC as gross income. See Section 404 of the Internal Revenue Code
(the so-called ``matching rule'').
When a U.S. business provides NQDC to a U.S. service provider, the
U.S. business does not receive a federal income tax deduction until the
NQDC is includible in the service provider's gross income. Because
federal tax rates on ordinary income are about the same for
corporations and individuals, NQDC should be tax revenue neutral. For
example, if an employee defers a $10,000 bonus, the employee would
avoid $3,500 of income taxes currently. The corporation's taxable
income would increase by $10,000, causing a $3,500 increase in its
federal income taxes.
The JCT estimates that the 409A CAP would generate $800 million
over 10 years. The projection is badly flawed. It attempts to take into
account tax effects from activities that are related to NQDC, but are
not NQDC. Many taxable corporations informally fund their NQDC using
corporate-owned life insurance (``COLI''). If a bank uses it, it is
commonly called ``BOLI.'' COLI and BOLI are tax-exempt investments. The
JCT assumes that if NQDC is capped or killed, then the use of COLI or
BOLI will decrease, and tax revenues will increase.
Keep in mind that NQDC is nothing more than the employer's
unfunded, unsecured promise to pay a specified benefit in the future.
An employer may or may not choose to informally fund its NQDC
obligations. Informal funding is not a necessary consequence of NQDC.
Many employers do not informally fund their NQDC. And many that do
choose to informally fund use taxable investments rather than COLI or
BOLI.
It should also be noted that the use of COLI and BOLI as informal
funding has expanded far beyond NQDC. Banks are probably the biggest
user, and they use it to informally fund post-retirement medical and
other employee and executive benefits.
Each year, COLI and BOLI cause billions of direct tax revenue
losses.
The JCT's tax revenue analysis is incomplete because it fails to
take into account all the effects the 409A CAP would have on tax
revenues. It does not account for the damage to competitiveness, nor
how the 409A CAP would drive public companies to a much heavier use of
stock options, and private companies to a much heavier use of capital
gains-type income.
The estimate of the amount of tax revenue that the 162(m) EXPANSION
would raise is far more defensible. The effects of limiting NQDC
deductibility are directly measurable. Although the 162(m) EXPANSION
that closed all the loopholes could be expected to have a moderating
effect on executive pay, its potential negative effects to tax revenues
would be minimal. Moreover, if all the 162(m) loopholes were closed,
the 162(m) EXPANSION would raise billions over 10 years.
The Problems with the 409A CAP. The proponents of the 409A CAP
contend that it merely limits an employee's deferred comp to $1 million
each year. Do not be fooled. Its practical effect would be to kill the
use of deferred comp. First, the 409A CAP is virtually impossible to
administer. It applies across all plans, including account balance
plans (defined contribution plans), nonaccount balance plans (e.g.,
defined benefit plans), severance plans and stock plans. It ostensibly
includes earnings on principal credits. The limit is not $1 million,
but the lesser of (A) $1 million or (B) the employee's 5-year average
pay.
Bear in mind that the 409A CAP would be an added requirement of
Section 409A. The existing 409A rules, now in proposed regulation form,
run 240 pages. They are highly technical and complex. Most important,
however, is that a failure to comply with all the 409A requirements
subjects all plan participants to immediate taxes, interest and a 20%
penalty. Thus, the 409A CAP is not simply a ceiling on the amount that
can be tax-deferred. The consequence of providing more than the limit
is not simply current taxation on the excess, but taxes, interest and
penalties on all the deferred compensation of all participants.
The proposed CAP is like a speed limit that is based on your weekly
average speed where the penalty for speeding is loss of your car. The
CAP carries such drastic consequences, our prediction is that employers
would decide that the ``game is not worth the candle.''
The 162(m) EXPANSION. The 162(m) EXPANSION is an amendment to Code
Section 162(m). Congress enacted 162(m) in 1993. It provides that a
public corporation may not deduct amounts paid to a ``covered
employee'' during a taxable year to the extent such amounts exceed $1
million. A ``covered employee'' includes the CEO as of the close of the
taxable year and the four highest compensated officers as of the close
of the taxable year (other than the CEO) whose compensation is required
by the SEC to be reported under the Securities Exchange Act of 1934.
Unless specifically excluded, the deduction limitation applies to
all remuneration for services, including cash and the cash value of all
remuneration paid in a medium other than cash. The following types of
compensation are specifically excluded:
(1) commissions;
(2) performance-based compensation;
(3) contributions to tax-qualified retirement plans;
(4) amounts excluded from gross income such as health benefits and
Section 132 fringe benefits; and
(5) remuneration payable under a binding contract that was in
effect on February 17, 1993.
In its September 5, 2006 Report entitled ``Present Law and
Background Relating to Executive Compensation, the JCT notes as
follows:
The legislative history states that section 162(m) was motivated by
then-current concerns regarding the amount of executive compensation in
public companies, and that the purpose of the provision was to reduce
``excessive'' compensation. While not specifically mentioned in the
legislative history, the exception to the limitation for performance-
based compensation reflects the view that such compensation, by its
nature, is not ``excessive''. A provision similar to section 162(m) was
also proposed by the Clinton Administration. The rationale behind this
provision was stated a bit differently, and focused on the ``unlimited
tax benefit'' provided to executive compensation. This tax benefit was
described as particularly inappropriate in cases in which executive
compensation increased while company performance suffered. The
Administration proposal also had as a stated objective the intent to
provide an incentive to link compensation to business performance.
Since the enactment of section 162(m) the appropriateness of executive
compensation has remained a topic in the public eye.
The Report also notes that ``According to a number of studies,
Section 162(m) has not reduced the growth in executive compensation.''
The Report cites studies that conclude that 162(m) contains various
``loopholes'' that should be closed to effect the desired reduction of
executive compensation. First, the performance-based compensation
exception is overly broad. Second, the limitation does not apply once a
covered employee terminates employment. Thus, it has been easy for
employers to evade the limit simply by shifting pay to performance-
based compensation and by deferring pay to after termination of
employment. The Report suggests the following ways of plugging the gaps
in 162(m):
(1) eliminate the performance-based compensation exemption and
apply a limit to all remuneration;
(2) instead of exempting all performance-based compensation, exempt
only a specified dollar amount;
(3) restrict the performance-based compensation exemption to
compensation that is truly performance-based (such as indexed options
or options that are granted at a specified premium strike price above
the current market price); and
(4) expand the definition of covered employee to include any
employee or former employee who was a covered employee at any time in
the past.
The proposed 162(m) EXPANSION takes approach No. 4. It contains an
expansion of the class of individuals who are subject to the $1 million
cap on deductible compensation under Code Section 162(m) to include all
individuals who qualify as ``covered employees'' at any time on or
after January 1, 2007.
162(m) is a Better Mousetrap. The 162(m) EXPANSION approach--
disallowing the deductibility of compensation deemed excessive--is far
superior to the 409A CAP as a means of curbing executive compensation.
It makes deferred comp for the top 5 executives of public companies
substantially more expensive. If a compensation committee were to
provide compensation in excess of the 162(m) limits, it would have to
answer to shareholders. Such nondeductible compensation would come
under intense scrutiny and would need to be justified. Moreover, the
162(m) approach would not kill deferred comp, but merely ration it by
increasing its cost at the upper levels.
A simple way to change would be to delete the phrase ``at any time
on or after January 1, 2007.'' This would pick up all former ``covered
employees.'' We suspect this change alone would produce close to $1
billion of revenue.
Any of approaches Nos. 1 through 3 would also generate many
billions of revenues. My personal preference would be to eliminate the
performance-based compensation exemption altogether, and simply apply a
higher limit to all compensation. For example, why not simply apply a
$5 million deductibility limit to all compensation. Such a law would be
relatively easy to administer, and avoid the definitional and
interpretation problems that comes with carving out exceptions.
<F-dash>
Statement of Air Products and Chemicals, Inc., Allentown, PA
I am pleased to have the opportunity to testify this morning on
behalf of the National Association of Manufacturers (NAM) on several
revenue raising provisions included in legislation currently pending in
Congress. We applaud the committee's initiative in holding the hearing.
My name is Ken Petrini and I am Vice President, Taxes at Air
Products and Chemicals, Inc., in Allentown, Pennsylvania. I also serve
as the Chairman of the NAM's Tax and Budget Policy Committee. The NAM
is the nation's largest industrial trade association, representing
small and large manufacturers in every industrial sector and in all 50
states. NAM members believe strongly that tax relief is critical to
durable economic growth and job creation. In contrast, revenue
raisers--like those I will describe in my testimony--would impose new
taxes on many businesses, making it more difficult for them to compete
in the global marketplace.
In particular, the Small Business and Work Opportunity Act of 2007
(H.R. 2) as amended by the Senate on February 1, 2007,\1\ includes
several tax increases that are of particular concern to American
manufacturers. These include proposals to:
\1\ Fair Minimum Wage Act of 2007 [H.R. 2 EAS], as passed by the
Senate, 2/1/07
<bullet> Deny Deductions for Punitive Damage Payments; \2\
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\2\ Ibid, Section 223
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<bullet> Deny Deductions for Settlement Payments; \3\
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\3\ Ibid, Section 224
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<bullet> Limit Deferrals Under Nonqualified Deferred Compensation
Plans; \4\
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\4\ Ibid, Section 226
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<bullet> Expand the Definition of Employees Subject to Rules
Limiting the Deduction for Salary Payments, and \5\
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\5\ Ibid, Section 234
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<bullet> Impose New Taxes on Expatriates.\6\
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\6\ Ibid, Section 225
A common theme with these changes is that, while they may be rooted
in some valid policy concerns, they are drafted in such a way to be
overly broad and threaten to ensnare transactions and expenses well
beyond their intended scope.
Increasing Legal Costs for American Manufacturers
Manufacturers currently face some of the highest legal costs in the
world. Based on a recent study by NAM's research and education arm, the
Manufacturing Institute, tort costs for U.S. businesses are at
historical highs and are higher than similar legal costs in other
countries.\7\ Moreover, the tort burden on manufacturers (as a
percentage of manufacturing output) is roughly 2.2 times larger than
the burden of these costs on other sectors of the economy.\8\
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\7\ ``The Escalating Cost Crisis,'' p. 11 The Manufacturing
Institute, 2006.
\8\ Ibid
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Two provisions in the Senate-passed version of H.R. 2, if enacted,
would add to the current, anti-competitive legal cost burden facing
U.S. manufacturers. Specifically, the proposals to eliminate tax
deductions for punitive damages and settlements of potential violations
of law represent significant changes to, and unnecessary expansion of,
current law that will increase the cost of doing business in the United
States for manufacturers.
Punitive Damages
Under current law, taxpayers generally can deduct damages paid or
incurred as a result of carrying on a trade or business, regardless of
whether the damages are compensatory or punitive. The proposed change
to make punitive damage payments in civil suits non-deductible, whether
made in satisfaction of a judgment or in settlement of a claim, runs
counter to fundamental and well-established tax principles, and
represents unsound public policy.
From a tax policy perspective, the proposal represents a sharp
departure from the income tax principle that taxpayers should be taxed
on net income. To measure net income accurately, all expenses
associated with the production of income are properly deductible.
Similarly, the proposal violates the principle that income should
be taxed only once. Since punitive damage awards would not be excluded
from income, both the payor and the recipient would be subject to tax
on the punitive damages, thus imposing a ``double tax'' on the same
income. The United States Treasury would get a windfall, but businesses
would receive a ``tax penalty.''
The proposal also represents a departure from another objective of
federal tax policy--to provide similar tax treatment for similar
behavior. Because of different standards and guidelines in the current
civil justice system, conduct that results in punitive damages in one
state may not result in punitive damages in another. For example,
standards for awarding punitive damages vary widely among states--a
number of states have ``caps'' on punitive damages and some states do
not allow punitive damage awards at all.
NAM also is concerned about significant tax administration issues
under the proposal. Under current law, it is often difficult to
determine the character of awards (i.e., compensatory vs. punitive),
particularly in cases that are settled in a lump sum while on appeal.
The term ``punitive'' is not defined in the tax code or regulations nor
is the term defined in the proposal. The Tax Court has held that state
law determines whether awards are punitive or compensatory in nature,
which suggests that the proposal could result in dramatically different
treatment of otherwise similarly situated taxpayers in different
locales.
Moreover, one jury may award damages while another may decide there
is no liability even where the facts are very similar. A prime example
is BMW of North America v. Gore.\9\ In this case, a jury awarded the
plaintiff $4 million in punitive damages because BMW had sold as new a
car that had received touch up paint treatment. In contrast, a few
months earlier, another jury in the same county in a case with the same
defendant and nearly identical facts found no liability.
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\9\ 517 U.S. 559
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Another area of concern for NAM members is the effective date of
the proposal. Disallowing deductions for amounts paid or incurred on or
after the date of enactment would interfere with a taxpayer's decision
today whether to appeal an initial award of punitive damages. Because
the deduction would continue to be available only for amounts paid
before the enactment date, taxpayers recently hit with initial damages
awards would be discouraged from exercising their right to appeal.
Moreover, existing damage award amounts have been based on the
assumption that such amounts would be deductible. Disallowing
deductions for these existing awards would impose a far greater penalty
on taxpayers than was intended by judges and juries.
From a broader public policy perspective, the proposal is based on
the false premise that punitive damages are the same as non-deductible
criminal or civil fines. Criminal or civil fines are fixed in amount
and are imposed for specific activities that are defined in advance. In
addition, criminal liability must be proven ``beyond a reasonable
doubt,'' i.e., the jury must be virtually certain of its decision. In
contrast, punitive damages are awarded after the fact under vague and
unpredictable standards such as ``reckless'' or ``wanton'' or ``gross
negligence'' or all three.
Settlement Payments
NAM members also have significant concerns about the impact of the
proposal that would prevent companies from deducting the cost of
settlement agreements with the government. Like the proposal discussed
earlier, this provision runs counter to fundamental and well-
established tax principles, and represents unsound public policy.
Under current law, a business cannot deduct from income ``any fine
or similar penalty paid to a government for the violation of any law.''
The proposal would significantly extend this provision to the non-
penalty portion of settlement payments, thus eliminating deductions for
most, if not all, settlement agreements with the government on a wide
range of issues, regardless of whether there was any wrongdoing.
NAM members believe that the language as drafted would sweep in a
large number of unintended and legitimate expenses. In particular, the
``inquiry into the potential violation of any law'' clause included in
the proposal could be read to include almost all payments made by a
business in connection with daily, routine interaction with government
agencies. By eliminating a deduction for an ordinary and necessary
business expense, the proposal represents a dramatic change in long-
standing tax policy that would act as a disincentive for companies to
enter into these agreements.
Manufacturers operating today in the United States face a
significant regulatory burden. In many cases, these regulations are
ambiguous and subject to interpretation making it difficult, if not
impossible, to ensure 100 percent compliance at all times.
Consequently, there is a strong public policy reason to have a system
that allows businesses to voluntarily settle and pay government claims.
Moreover, current law establishes a distinction between punitive
and nonpunitive payments that has a long history in the courts and with
the Internal Revenue Service.\10\ According to IRS officials, the IRS
is committing ``significant resources'' to ensure the proper treatment
of settlement payments.\11\ In contrast, the proposed change would
replace this well-established and workable precedent with a new, all-
encompassing standard with which the courts and the IRS would have to
struggle. The approach taken by the proposal is to disallow a broad
category of deductions (legitimate and otherwise), and require
taxpayers to rely on limited exception language to claim clearly proper
deductions. Ironically, the need to fit oneself into the narrow scope
of the exception would limit some of the flexibility that exists today
in responding to real or perceived violations of laws and regulations
and would limit the ability of business and government to agree on
certain remedies that benefit society.
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\10\ See Talley Inds., Inc. v. Commissioner, 116 F.3d 382 (9th Cir.
1997); Middle Atlantic Distributors, Inc. v. Commissioner, 72 T.C. 1136
(1979); see also Field Serv. Adv. 200210011 (Nov. 19, 2001).
\11\ Letter to Sen. Charles Grassley from B. John Williams, Jr.
Chief Counsel, Internal Revenue Service 4/1/03
---------------------------------------------------------------------------
Clearly, American consumers and businesses would lose if the
proposals on punitive damages and settlements were adopted. U.S.
manufacturers face significant government regulation and operate in a
world where no product is or can be absolutely perfect. These proposals
would hamper entrepreneurship, innovation, and product development by
further adding to the cost of doing business. This, in turn, would
increase the price of goods and services for consumers, chill
innovation, put jobs at risk and undermine U.S. competitiveness.
Unwarranted Attacks on Benefits and Compensation
Nonqualified Deferred Compensation
NAM member s strongly oppose a provision in the Senate-passed
version of H.R. 2 that would impose significant limitations on
nonqualified deferred compensation plans. The proposal, which is not
targeted at any abuse of deferred compensation rules, is a solution in
search of a problem that would effectively eliminate the ability of
employers to use deferred compensation as a retention tool for valued
employees.
In 2004, Congress adopted significant changes to nonqualified
deferred compensation laws that were designed to address perceived
abuses. The legislation--the American Jobs Creation Act of 2004 \12\--
created a new tax code section (Section 409A) that significantly
reformed existing rules for the establishment and operation of
nonqualified deferral arrangements.
---------------------------------------------------------------------------
\12\ P.L. 108-357
---------------------------------------------------------------------------
In particular, Section 409A was designed to address perceived
abuses of nonqualified deferred compensation plans, principally whether
the individual making the deferral had control of the deferred assets.
Under 409A, amounts deferred under nonqualified arrangements must
remain at a substantial risk of forfeiture to the employee. Final
regulations to implement Section 409A (which are expected to run to
hundreds of pages) have yet to be finalized by the Treasury Department.
NAM members believe that Congress should allow the new law to work
before considering additional changes.
In contrast, the proposal included in the Senate bill would further
restrict the rules on nonqualified plans by limiting annual deferrals
to the lesser of the five-year average of an individual's taxable
compensation or $1 million. The legislative history of the provision
\13\ makes clear that earnings inside a deferred compensation plan
should be counted towards the annual cap on deferrals. As a result,
violations of the new rule could occur merely as the result of the
passage of time and not as a result of any action by the employee or
the company. The potential penalties are severe. An individual who
intentionally or unintentionally violates the provision would be
subject to immediate taxation on the entire deferred balance plus an
additional 20 percent excise tax.
---------------------------------------------------------------------------
\13\ Senate Report 110-1, p.52
---------------------------------------------------------------------------
Although tax avoidance on deferred amounts is cited as the primary
reason behind the proposal,\14\ there is no avoidance of taxation under
a nonqualified deferred compensation plan. Rather, tax is deferred
until a future period. There is no tax consequence to deferrals into
nonqualified plans because the matching principle applies, i.e., a
deduction is only taken by the employer when the deferred amounts are
actually received by the employee and taken into income. Furthermore,
though we believe the proposal is aimed at large deferrals (although as
explained later, it does not just pertain to large deferrals), it is
unlikely that there will be a significant benefit from lower tax
brackets when amounts are paid out. Since employment taxes will
typically be paid at deferral or when the amounts are no longer subject
to forfeiture, there simply is no tax avoidance in play.
---------------------------------------------------------------------------
\14\ Ibid
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Nonqualified deferred compensation arrangements are used by many
manufacturers to motivate and reward their workforce and to align the
interests of employees with the interests of the company. Sometimes
these plans are non-elective restoration plans, effectively restoring
benefits to individuals that have been eliminated from tax qualified
plans because of income limits. In other cases, these plans are used as
supplemental retirement plans or incentive plans.\15\ Still, in other
cases, the decision to defer is a voluntary one, made by the employee
under the rules of Section 409A. The Senate proposal essentially takes
away an important human resources and management tool that businesses
both large and small utilize to retain and attract employee talent.
---------------------------------------------------------------------------
\15\ Examples of affected plans are included in Attachment A and
specific employee examples are included in Attachment B.
---------------------------------------------------------------------------
When a business chooses to pay its employees through deferred
rather than current compensation, it ties the employee to the business
in a meaningful way. By voluntarily deferring compensation into a
nonqualified plan, the employee gives up the right to receive that
compensation and puts its eventual payment at the risk of the future
performance of the company. If the plan offers the chance to invest the
deferred funds in company stock, the alignment is even stronger. These
arrangements should be encouraged, not restricted. The legislation
enacted in 2004 adds safeguards to prevent employees from taking the
deferred money and running when times are bad. As a result, employees
who defer compensation know that if the company fails, it is unlikely
they will ever receive those funds. This is a powerful corporate
governance tool that aligns the interests of executives and
shareholders.
The proposed limits on nonqualified deferred compensation also
would have unintended consequences when applied to a typical
supplemental pension plan that pays annual lifetime benefits in
retirement. In many cases, the vesting of these benefits in a single
year could push an employee's deferred compensation above the
provision's annual cap, leaving the employee liable for an immediate
tax and penalty on amounts they will receive over their lifetime. For
example, the present value of a modest lifetime annuity payable at
retirement could easily exceed the cap since the payment is assumed to
continue as long as the retired employee lives. To avoid this problem,
employers would have to pay the discounted value of the pension as a
lump sum. Forcing lump sum payments would be bad pension policy and
would remove a significant corporate governance benefit that is
achieved when an employee is tied to the company for life.
It also is important to note that because the proposal would apply
to amounts that exceed the lesser of the five-year average of an
individual's taxable compensation or $1 million, it would create an
arbitrary limit on deferred compensation that applies not just to top
corporate executives, but also to middle managers, sales people, and
other employees of both public and private employers. Furthermore, the
proposed limit on annual deferrals would act as a highly intrusive tax
penalty on a company's fundamental business decision to pay employees
through deferred rather than current compensation.
New Limits on Deducting Salary Payments
NAM members also have serious concerns about a provision in the
Senate bill that would expand the definition of a covered employee
under Section 162(m) of the tax code, which limits the deduction of
salary payments. In recent years, the Joint Committee on Taxation \16\
as well as a number of public and private sector witnesses before the
Senate Finance Committee \17\ has criticized this provision. In
contrast, the Senate proposal would add a far-reaching new compensation
limit to the tax code.
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\16\ ``Present Law and Background Relating to Executive
Compensation,'' Joint Committee on Taxation, JCX-39-06, 9/5/06
\17\ Executive Compensation: Backdating to the Future, 9/6/06
---------------------------------------------------------------------------
Section 162(m) currently denies an employer a deduction for non-
performanced based compensation in excess of $1 million paid to an
individual who is a ``covered employee'' of the employer, i.e., the
taxpayer's chief executive officer (``CEO'') or one of the four highest
paid executive officers of the company at the end of the year (the
``Top 4'') whose compensation is required to be disclosed under the
Securities and Exchange Commission's (SEC) proxy rules.\18\
---------------------------------------------------------------------------
\18\ Note that, because the SEC recently amended the proxy
disclosure rules to no longer include ``the Top 4,'' Section 162(m) is
no longer congruent with the proxy rules. ``Executive Compensation and
Related Person Disclosure; Final Rule and Proposed Rule'' Federal
Register Vol. 71, No. 174 (8 September 2006): 33-8732A.
---------------------------------------------------------------------------
In addition, the deduction limit applies if the non-performance-
based compensation in excess of $1 million is paid to an individual who
is a covered employee on the last day of the year in which the payment
is made. Therefore, an employer might contractually commit to pay
compensation to an employee on separation from service, at which time
the employee would not be a ``covered employee'' under Section 162(m).
The Senate proposal would expand the definition of covered employee
under Section 162(m) to include (i) any person who was CEO during any
part of any year (not just the end of the year) and (ii) any person who
ever was a ``covered employee'' in any year after 2006 (even if that
person is not a covered employee in the year that the compensation
payments are received or the year the services are performed). In
effect, the proposal creates a new rule that if an employee is ever a
covered employee, he will always be a covered employee--even if current
compensation eliminated them from the ``high five'' of a corporation.
Under the proposal, compensation earned or payable in the future to
an employee who at any time in a taxable year beginning after December
31, 2006, was a covered employee would remain subject to Section 162(m)
in perpetuity. As drafted, this proposal represents a significant
expansion of the scope of Section 162(m), rather than an attempt to
close an inadvertent loophole.
The Senate proposal also modifies the definition of covered
employee by dropping a cross reference to the securities law from
existing Section 162(m). The SEC's new proxy rules (which apply to
proxies filed for fiscal years ending on or after December 15, 2006),
require detailed disclosure for any person who acts as CEO during the
fiscal year, any person who acts as CFO during the fiscal year, and the
three other most highly compensated executive officers other than the
CEO and CFO. In order to retain the previous group for tax purposes
(i.e., the CEO and the Top 4), the statutory change to Section 162(m)
removes from the definition of ``covered employee'' a requirement that
``the total compensation of such employee for the taxable year is
required to be reported to shareholders under the Securities Exchange
Act of 1934.'' This approach has serious unintended consequences and
may significantly and inadvertently expand the category of employees
who may be covered.
In addition, as drafted, the proposal would be retroactive, denying
corporations' deductions for compensation that was earned before 2007,
by any employee who becomes a covered employee after 2006. Many
employers today have outstanding compensation obligations that were
structured in reliance on current law, but that would become non-
deductible under the proposed amendment. Unfortunately, there is little
or nothing a corporation could do to protect the deduction it thought
it already had--existing contractual arrangements are legally binding
on the employer and cannot simply be rewritten by the employer to
reflect an unanticipated retroactive change in law.
By denying a deduction for pre-2007 compensation an employer is
obligated to pay, the proposal will raise taxes on corporate employers
without changing corporate compensation practices. While a retroactive
application of the new rule will not affect executives who will be paid
what they are owed, corporate shareholders stand to lose because of the
corporation's tax increase. Note that this was not the case when
Section 162(m) was originally enacted and Congress expressly
grandfathered all compensation payable under written binding contracts
that were already in effect.
While we oppose enactment of the changes to Section 162(m), if
these changes are made they should only apply prospectively since
employers cannot control past compensation arrangements. At a minimum,
the proposal should expressly provide that amended Section 162(m) will
only apply to tax years beginning after the date of enactment and will
not apply to any compensation to which an employee had a legally
binding right, whether or not contingent, on or before the last day of
the taxable year including [the date of enactment] or which relate to
services performed before such last day.\19\
---------------------------------------------------------------------------
\19\ The effective date of the proposal should permit public
companies time to obtain shareholder approval of performance-based
plans that may need to be modified.
---------------------------------------------------------------------------
The NAM also believes that delinking Section 162(m) from proxy
rules is not in the public interest. Current law defines a covered
employee by reference to the SEC's proxy rules. This makes sense for
two reasons. It is easier for taxpayers (and the IRS) to figure out who
is a covered employee in advance of paying compensation. In addition,
it targets the rule to ``executive officers'' of a company within the
meaning of the Securities Exchange Act, i.e., officers who have policy-
making functions and therefore arguably can influence their own
compensation.
Based on legislative history,\20\ the proposal is intended to
``delink'' the definition of a ``covered employee'' from the definition
used by the SEC as a result of changes in the SEC's proxy rules. The
SEC has recently revised the proxy rules to now cover the CEO, the CFO
and the next three most highly compensated employees. The policy reason
for ``delinking'' is not clear. As drafted, the proposal represents a
significant expansion of the scope of Section 162(m) to cover employees
with no policy-making authority who are not in a position to influence
their own compensation and ambiguity as to what compensation counts for
determining whether an employee is one of the ``Top 4''.
---------------------------------------------------------------------------
\20\ Senate Report 110-1, p.68
---------------------------------------------------------------------------
The proposal also deletes references in Section 162(m) to ``total
compensation . . . for the taxable year [that] is required to be
reported to shareholders under the Securities Exchange Act of 1934.''
Accordingly, proposed changes to Section 162(m) could be read to apply
to all ``officers'' of an employer, even those with no policy-making
authority. Neither Section 162(m) nor the Senate proposal defines the
word ``officer,'' thereby creating ambiguity where none exists today.
SEC proxy disclosure is limited to ``executive officers,'' which means
those officers who have significant policy-making authority for the
issuer. We do not believe that the proposal was intended to broaden the
scope of covered employees in this way and urge that, if enacted,
Congress clarifies the proposal to state that covered employees
continue to include only executive officers for whom proxy disclosure
could be required.
In addition, while the proposal provides that the four ``highest
compensated'' officers in the year would be covered, it does not
specify a definition of ``compensation.'' Under current law, that
answer is well understood by corporations because a ``covered
employee'' is determined by reference to the SEC's proxy rules. New SEC
rules capture executive officers' total compensation for each year,
including equity awards and deferred compensation, which may not be
taxable until several years in the future. By deleting the reference in
Section 162(m) to the SEC's proxy rules, the Senate proposal leaves no
definition of compensation whatsoever.
In sum, the NAM strongly believes that corporate governance
issues--like executive compensation--should be addressed through
corporate governance changes, not through the tax code.
New Tax on Ex-Pats
Among the revenue-raisers in the Senate proposal is a little
noticed but potentially devastating provision that would change the
rules for taxation of foreign persons who are long-term residents of
the United States and are leaving the country. The provisions would
levy a new ``mark-to-market'' tax on the unrealized appreciation in all
their property, on the day before expatriation. In effect, the
expatriate is treated as having ``sold'' all his or her property, for
its fair market value, on the day before expatriation. Property subject
to the provision includes personal property, interests in qualified
retirement plans, and interests in nonqualified trusts.
This provision could have a significant negative impact on resident
aliens employed by U.S. manufacturers. For example, a resident alien
who has worked for a U.S. company and decides to return to his or her
home country to retire or for other business or personal reasons could
find the value of their assets significantly eroded--especially if
there is an acceleration of tax payable on 401(K) or other retirement
accounts.
Finally, another general concern of NAM members is the inclusion of
retroactive tax provisions in the Senate bill as well as other tax
legislation. It has long been the position of the NAM that a
retroactive imposition of taxes is fundamentally unsound and unfair.
In sum, NAM members believe strongly that tax relief will go a long
way to ensuring that our economy keeps growing. Conversely, tax
increases, like those outlined above, will negate much of the positive
impact of tax relief and, in some cases, threaten continued economic
growth. We appreciate the opportunity to present our views on these
issues to the committee and we thank you in advance for rejecting these
revenue raisers.
Attachment A
Examples of Benefit Plans and Company Types Affected by Section 226
Restricted Stock Units: In recent years, many employers have
redesigned their equity programs to increasingly rely on the use of
restricted stock units (RSUs). Typically, employees are awarded a
specified number of RSUs, with a fixed percentage of the RSUs vesting
on a quarterly or annual basis or the entire block of RSUs vesting
after a specified performance period. Generally, upon vesting of an RSU
award, RSUs are converted into shares of the employer's common stock
and the employee is taxable on the fair market value of such stock.
Some RSU programs fit within the regulatory exception from 409A for
compensation that is paid upon vesting (or within 2\1/2\ months after
the year of vesting.) It is not uncommon, however, for employers to
find that their RSU program does not meet the short-term deferral
exception and that compensation paid under the program is subject to
409A. In some instances, an employee may vest in the RSUs in increments
over the performance period but is not paid until full vesting is
attained at the end of the performance period. In other instances, an
employee may vest fully upon reaching a specified retirement age during
the performance period. Under the legislation, such RSU grants would be
subject to the one-time pay limit and could cause employees to exceed
the limit.
For example, a newly hired employee of a Fortune 500 company
receives a grant of RSUs that is subject to 409A. The employee is
granted 6,000 RSUs at a time when the value of the company's stock is
$30 (i.e., value of the grant is $180,000). The employee is scheduled
to vest in \1/5\ of the RSUs each year over a 5-year performance
period. The employee receives a base salary of $140,000, which under
the Senate provision would be the employee's one-time pay limit for the
first year. Because the value of the RSU grant exceeds the one-times
pay limit, a 409A violation would occur and the employee would be
subject to a 20 percent additional tax on the value of the RSUs as they
vest (i.e., 20 percent of the RSUs per year) over the 5-year period.
Because ``earnings'' on the underlying shares of the company's
stock also are subject to the limit, employees could have a tax penalty
under 409A merely because the company was successful and the value of
the RSUs increased beyond the limit.
For example, an employee is granted 1,000 RSUs at the beginning of
employment with a technology company. The employee ``vests'' in these
units after 5 years of service and the RSUs are designed to pay out
after 10 years. The employer believes that this plan aligns the
employee's interest with growing the company value rather than
maximizing current salary. At the beginning of employment, the RSUs
were valued at $15 per share. The employee earns approximately $100,000
per year and receives modest increases (based on CPI of 3 percent). The
employee's 5-year average taxable compensation from the company is
$110,000 at the end of year 5. The company stock price stays relatively
flat, but in year 6 the company becomes highly successful and the
valuation of the stock takes off eventually to exceed 10 times the
original price. The one-times-pay limit would be exceeded because the
increase in the RSU value in year 6 will exceed $110,000.
Supplemental 401(k) Plans: Employees who cannot fully defer under a
401(k) plan because of the compensation limits under the Code may
participate in a supplemental or ``mirror'' 401(k) plan. Unlike
qualified plans, these programs are unfunded and the employer's
deduction is delayed until the time of payment. If the company becomes
insolvent, the employees are not paid. The legislation counts
``earnings'' that accrue under the supplemental plan as additional
deferrals that count against the one-time pay limit and could cause the
employee to exceed the limit.
For example, a Fortune 500 company offers a nonqualified
supplemental plan to certain employees, including mid-level management
employees receiving approximately $150,000 to $200,000 per year in
total wages from the company. Many of these mid-level management
employees are long-serving employees who typically defer 20 to 40
percent of their wages. Employees who participate in the plan receive a
small matching contribution (typically between $3,000 and $6,000) from
the company based on their deferrals. Investment earnings are credited
to an employee's bookkeeping account in the plan based upon deemed
investments chosen by the employee from among the same mutual funds as
those offered in the company's 401(k) plan. Using 2006 data, the
company has calculated that at least seven such employees would have
exceeded their 5-year average taxable compensation. The following chart
summarizes the relevant information:
----------------------------------------------------------------------------------------------------------------
Account
2006 5-year Balance 2006 2006 Deferrals
Emp. Years of Total Average As of Deferrals Investment Total Above 5-
Service Wages Taxable 12/29/ And Match Earnings Deferrals year Avg
Wages 06 Limit
----------------------------------------------------------------------------------------------------------------
1 27 $159,50 $ 90,180 $418,40 $ 66,700 $ 72,300 $139,000 $48,820
0 0
----------------------------------------------------------------------------------------------------------------
2 13 $175,40 $102,220 $508,30 $ 60,800 $ 52,500 $113,300 $11,080
0 0
----------------------------------------------------------------------------------------------------------------
3 28 $179,30 $ 62,380 $364,10 $116,400 $ 27,000 $143,400 $81,020
0 0
----------------------------------------------------------------------------------------------------------------
4 25 $178,30 $126,920 $614,70 $ 47,900 $109,100 $157,000 $30,080
0 0
----------------------------------------------------------------------------------------------------------------
5 30 $183,70 $126,040 $617,70 $ 38,000 $141,800 $179,800 $53,760
0 0
----------------------------------------------------------------------------------------------------------------
6 14 $194,40 $128,020 $486,50 $ 62,200 $ 73,200 $135,400 $ 7,380
0 0
----------------------------------------------------------------------------------------------------------------
7 6 $203,00 $ 92,020 $647,10 $ 76,300 $ 94,700 $171,000 $78,980
0 0
----------------------------------------------------------------------------------------------------------------
Since earnings that are tied to a publicly-traded investment are
often very unpredictable, employees would have to leave a large cushion
below the one-time pay limit to take into account potential earnings.
An employee who participates over a number of years could easily exceed
the one-time pay limit solely because of earnings.
For example, assume employee 5 in the above example stopped making
deferral elections after 2006, and that the employee receives modest
increases in wages each year (based on CPI of 3 percent). Also assume
that the employee elected to have all of his account balance as of
December 29, 2006 ($617,700) be deemed invested in the plan's S&P 500
index fund, and that for the 4-year period from 2007 to 2010 that
fund's annual return was 20 percent per year (which would be consistent
with the S&P 500's performance in the late 1990s). By 2010, there would
be a 409A violation solely because the ``earnings'' credited to the
employee's bookkeeping account ($213,477) exceeded the employee's 5-
year average taxable compensation from the company ($189,376).
Supplemental Pension Plans: Some companies maintain supplemental
pension programs to serve as retention tools and assist management
employees in saving for retirement. Unlike qualified plans, these
programs are unfunded and any employer deduction is delayed until the
time of payment. If the company becomes insolvent, the employees are
not paid. The nature of many of these plans is to provide the most
valuable accruals in the years right before retirement (e.g., age 65)
and, therefore, they incent employees to stay in their jobs. The
legislation would require employers to change or abandon these
arrangements because later-year accruals may exceed the one-time pay
limit under common plan designs for long-service employees. The problem
would be further exacerbated if the employer wanted to manage its
employee headcount by offering an early retirement incentive in the
qualified and supplemental pension plans (such as payment of the full
pension without a reduction for early commencement). The increased
value of the pension in the year that the early retirement incentive
was offered could cause the one-time pay limit to be exceeded.
For example, one Fortune 500 company sponsors a supplemental
pension plan that is available to middle managers making a little over
$100,000 per year, many of which work for the company's retail entity.
The company noted the difficulty in calculating annual accruals for
this type of plan and the fact that the value of annual accruals often
varies significantly from year to year due to interest rate changes and
eligibility for early retirement. To the extent an accrual under the
supplemental pension plan exceeded the limit, it is not clear how the
company could ``fix'' the pension plan formula to avoid an excess
accrual. The company also noted that the impact of the one-time pay
limit would be even more severe because other forms of compensation
provided to these managers, such as RSUs, performance units and
severance pay, would also be aggregated with accruals under the
supplemental pension plan in applying the limit. As a result, the
company advised us that they may discontinue the supplemental pension
plan if the annual limit is enacted.
Another Fortune 500 company provides a supplemental pension plan to
its key executives (about 4,000 U.S. employees). The covered employees
do not elect into the plan, it is provided automatically. The assets
are also at a substantial risk of forfeiture until the employee reaches
age 60. If an employee leaves the company before age 60, he or she
receives nothing from the plan. The plan benefit is unfunded before and
after an employee attains age 60. It is paid out on retirement as a
life contingent annuity (either single life or joint & survivor) with a
five year guarantee. The Senate proposal appears to apply to the
supplemental pension plans at the time the plan vests (i.e. at age 60).
Under the plan, until an employee reaches age 60, the benefit is
subject to a substantial risk of forfeiture. At age 60, the benefit is
vested and also deferred, since the employee has no choice but to defer
payment of the vested benefit as a life annuity when that employee
retires. The amount of the deferral at age 60 presumably would be the
then present value of the life annuity. A modest lifetime annuity
viewed that way would violate the $1 million cap and the employee would
be subject to a regular income tax and 20 percent penalty tax that
would significantly reduce their benefit.
For other employers whose supplemental pension plan may follow the
vesting schedule of their qualified plan, the situation is more acute.
In such a case, the vested annual accrual is likely to be subject to
the new limitations. The calculation of that amount (which can depend
upon salary levels and incentive compensation payouts) may be
impossible until after the fact, meaning that the employee will never
know, until it is too late, whether he has ``deferred'' too much.
Bonuses and Incentive Programs: Many employers structure their
bonus programs to fit within the regulatory exception from 409A for
compensation that is paid upon vesting (or 2\1/2\ months after the year
of vesting.) It is not uncommon, however, for employers to find that
they cannot meet this strict 2\1/2\ month rule. Employees may vest at
the end of the year or at the end of the performance period, but
business issues may necessitate a delay in payment that results in the
payment being subject to 409A. Some employers may need to wait longer
for performance criteria to be ascertained, financials certified, etc.,
resulting in the payment being subject to 409A and the one-time pay
limit. In other instances, an employee may vest in increments over the
performance period or upon reaching retirement age but is not paid
until the end of the period, which also would result in the payment
being subject to 409A and the one-times pay limit. Finally, employers
may, to align their interests with those of their managers, encourage
or allow that bonuses be deferred until retirement rather than being
paid currently. Section 409A specifically allows for voluntary deferral
of performance-based pay. The new limits would make such a voluntary
deferral difficult and often impossible.
Private Equity: Many private companies (including start-ups) cannot
readily conform to the specific administrative rules provided under the
409A regulatory exceptions for equity grants (e.g., stock options and
stock appreciation rights) because there is no public market to ensure
a true fair market value price for the grant. As a result, many private
companies' equity grants are subject to 409A. Under the Senate bill,
private companies could not provide this type of equity grant to
employees unless the grant does not exceed the one times pay limit.
Because ``earnings'' on the equity also are subject to the proposed
limit, employees could have a tax penalty under 409A merely because the
company was successful and the value of the equity increased beyond the
limit.
Cash Flow and Start Ups: Small and emerging businesses may pay
modest current compensation during the early stages of the business but
promise significant future compensation, including retirement payments,
in order to attract and retain talented employees. The Senate bill
limits the business from making any promise that exceeds one-time pay
for employees.
Attachment B
Real Examples of Employees Affected by Section 226
Asian male manager, age 57
Base Salary: $180,500
Average 5-year W-2: $142,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005):
$59,000
SERP earnings (not payable until after termination by irrevocable
distribution election): $80,000
Deferred Compensation earnings (irrevocable distribution election):
$6,500
Total 2006 ``deferrals'': $145,500
Amount above allowance: $3,500
Presumably, this would mean a 20% excise tax plus the income tax on
the entire amount.
Caucasian Female manager, age 50
Base Salary: $197,000
Average 5-year W-2: $144,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005):
$72,000
SERP earnings (not payable until after termination by irrevocable
distribution election): $75,000
Deferred Compensation earnings (irrevocable distribution election):
$8,000
Total 2006 ``deferrals'': $155,000
Amount above allowance: $11,000
Presumably, this would mean a 20% excise tax plus the income tax on
the entire amount
Supplemental Sheet
Witness:
Kenneth R. Petrini
Vice President, Taxes
Air Products and Chemicals, Inc.
7201 Hamilton Boulevard
Allentown, PA 18195
On Behalf of:
National Association of Manufacturers
1331 Pennsylvania Avenue, NW
Suite 600
Washington, DC 20004
NAM contact: Dorothy Coleman
<F-dash>
Statement of U.S. Chamber of Commerce
The U.S. Chamber of Commerce, the world's largest business
federation representing more than three million businesses and
organizations of every size, sector, and region, is pleased to have the
opportunity to express our views on the revenue-raising provisions
contained in the Senate-passed version of H.R. 2, the ``Small Business
and Work Opportunity Act of 2007.''
The Chamber strongly opposes the permanent tax increases used to
offset the cost of the Senate legislation. The denial of deductions for
settlements and punitive damages would discourage the out-of-court
settlement of legal cases and will increase the burden on the judicial
system. Imposing limitations on non-qualified deferred compensation
interferes unnecessarily in the management labor market and retroactive
changes to the Tax Code unfairly penalize companies for engaging in
legal behavior. Together, these provisions run counter to the goal of
promoting economic growth and job creation.
Disallowance of Tax Deductions for Government Settlements
Increased Burden on Judicial System. This proposal runs counter to
the goal of settling disputes without litigation and will increase the
volume of cases in our court system. It would impose a chilling effect
on the ability and willingness of parties to settle cases that would
not ultimately merit prosecution to a conclusion. The blanket denial of
otherwise allowable tax deductions for settlement of potential
violations of laws, or mere investigations of such, is overly broad and
unfair.
Reduction in Settlement Amounts. The proposal likely will have the
perverse impact of lowering settlement recoveries if such settlements
are nondeductible or if there is uncertainty regarding what portion of
settlements may be deductible.
Overturns 30 years of Precedent. The proposal turns 30 years of
well-established policy as to what are deductible settlement payments
and what are fines and penalties on its head. Under this provision, the
regulatory agency always is right and the payment always is non-
deductible unless a company can prove it is making payments directly to
the specific persons harmed. This narrow definition of restitution is
not in sync with long-established current law allowing restitution to
cover a class of similarly situated persons.
Limitations on Non-qualified Deferred Compensation
Deferred Compensation is not Executive Compensation. Deferred
compensation is a contractual agreement under which the employee elects
to defer current payment. These arrangements apply to multiple
management levels--not just the top executives--who, for various
reasons, may be limited in the amounts that they can save in qualified
plan arrangements.
Additional Changes to Deferred Compensation are Premature. The
Treasury Department has yet to release final regulations interpreting
the 2004 statute due to the complexity of these issues. Including new
provisions at this time will only add to the uncertainty about the
application of Section 409A. In addition, the Securities and Exchange
Commission recently issued regulations requiring enhanced disclosure of
executive compensation generally. The impact of these changes has not
yet been realized and additional changes at this time are premature at
best.
Arbitrary Compensation Limits are Bad Tax Policy. In a 2003 report,
the Joint Committee on Taxation concluded that Code section 162(m),
which limits cash compensation, is ``ineffective at accomplishing its
purpose [and] overrides normal tax principles.'' Accordingly, the
imposition of similar restrictions on nonqualified deferred
compensation does not address the perceived abuses and would similarly
be bad policy.
Retroactive Tax Increases
Unfairly Penalizes Legal Behavior. The companies that would be
affected by the retroactive Sale-In Lease-Out and corporate inversion
proposals were engaged in perfectly legal behavior at the time.
Congress had previously passed legislation to limit these transactions.
Adopting the Senate position would unfairly change the tax rules after
the fact.
Increase Uncertainty for Business Planning. The business community
requires predictability in order to plan appropriately. The proposed
retroactive changes require companies to second-guess congressional
intent and create unnecessary uncertainty, which run counter to the
goal of producing a stable economic environment.
Erodes Faith in the Tax System. Changes to the tax code should not
be made lightly absent strong policy considerations. The Senate bill
would further modify changes to the tax code that were passed by
Congress in 2004. Repeated changes to the same provisions of our tax
laws erode their reliability and stability.
<F-dash>
Statement of Working Group for Certainty in Settlements
On behalf of the thousands of businesses we represent, we
appreciate the opportunity to express our strong opposition to Sections
223 and 224 of the Senate-passed version of H.R. 2, the ``Small
Business and Work Opportunity Act of 2007.'' As Chairman Rangel stated,
``the Senate tax relief package includes a number of revenue-raising
provisions that would have a significant impact on the business
community.'' Because of significant negative impacts, the Working Group
for Certainty in Settlements strongly opposes Sections 223 and 224.
The denial of deductions for punitive damages by Section 223 runs
counter to 30 years of strong public policies and applies principles of
tort law to the tax code. Section 223 will have not only a significant
negative impact on the business community by forcing them to spend more
resources litigating claims, but will also adversely affect victims by
reducing the likelihood of prompt settlement and forcing more cases to
lumber through trial. This will also increase litigation costs for
states. Finally, disallowing a deduction for payment of punitive
damages, and requiring insurance proceeds to be taxed as income, will
add unnecessary and unmitigated strains on United States taxpayers. As
such, Section 223 should be removed from H.R. 2.
Similarly, the Working Group for Certainty in Settlements strongly
opposes Section 224 of H.R. 2. As passed by the Senate, Section 224
would deny a deduction for all types of settlements that currently are
entered into in the normal course of business. Consequently, ordinary
and necessary business expenses that, under the well-established
principles of taxation, are not considered fines or penalties would now
be non-deductible under this provision. Worse, Section 224 would deny a
deduction for any such payments, including those where there is no
admission of guilt or liability. Accordingly, Section 224 should also
be removed from H.R. 2.
I. Section 223, Denial of Deduction for Punitive Damages
Section 223 would have a significant impact on business by denying
any deduction for punitive damages that are paid or incurred by the
taxpayer as a result of a judgment or in settlement of a claim. If the
liability for punitive damages is covered by insurance, any such
punitive damages paid by the insurer would be included in gross income
of the insured person and the insurer would be required to report such
amounts to both the insured person and the Internal Revenue Service
(``IRS''). Section 223 runs counter to 30 years of legislative history
and strong public policies. If enacted, the provision will have
significant negative effects on the business community and injured
victims. Finally, disallowing a deduction for payment of punitive
damages and requiring insurance proceeds to be taxed as income, will
implement a harmful ``double-tax'' on United States taxpayers.
A. Background on Deductible Business Expenses
The Internal Revenue Code allows the taxpayer a deduction for all
ordinary and necessary expenses that are paid or incurred by the
taxpayer during the taxable year in carrying on any trade or
business.\1\ness expenses are the cost of carrying on a trade or
business. Current law allows amounts paid by a taxpayer as punitive
damages that arose as a result of the ordinary conduct of its business
activities to be deductible as an ordinary and necessary business
expense. This provision is a result of Congressional action and IRS
guidance.
---------------------------------------------------------------------------
\1\ 26 U.S.C. 162(a).
---------------------------------------------------------------------------
In 1969, Congress, through codification of Tank Truck Rentals, Inc.
v. Commissioner,\2\ recognized that public policy restricts deductions
for certain business expenses.\3\ However, Congress expressly limited
the denial of deductions on public-policy grounds to a limited group of
expenditures. Section 162(f) denied deductions of fines and
penalties.\4\ Section 162(g) denied deduction for a portion of treble
damage payments resulting from a criminal conviction under the
antitrust laws. Section 162(c)(1) denied deductions for bribes paid to
public officials.\5\ Finally, Sections 162(c)(2) and (3) denied
deduction for other unlawful bribes or kickbacks.\6\ In the
accompanying Senate Finance Committee report, the Committee stated
``the provision for the denial of the deduction for payments in these
situations which are deemed to violate public policy is intended to be
all inclusive. Public policy, in other circumstances, generally is not
sufficiently clearly defined to justify the disallowance of
deductions.'' \7\
---------------------------------------------------------------------------
\2\ Tank Trunk Rentals, Inc. v. Commissioner, 356 U.S. 30 (1958).
\3\ The Tax Reform Act of 1969, Pub. L. No. 91-172, 902, 83 Stat.
487, 710-711.
\4\ 26 U.S.C. 162(g).
\5\ Id at 162(c)(1).
\6\ Id at 162(c)(2) and (3)
\7\ S. Rept. 91-522 at 274, 91st Cong., 1st Sess. (1969).
---------------------------------------------------------------------------
Later, in 1980, the IRS issued a revenue ruling clarifying whether
the amounts paid as punitive damages that are incurred in the ordinary
conduct of the taxpayer's business operations are deductible as an
ordinary and necessary business expense.\8\ A revenue ruling is a
``written statement issued to a taxpayer or his authorized
representative by the National Office which interprets and applies the
tax laws to a specific set of facts.'' \9\ There, a company was sued by
another corporation for acts and contractual violations perpetuated in
the ordinary conduct of its business activities. The IRS wrote that if
the issues were not based on any prohibited activities outlined in
162, then the judgment, including amounts identified as punitive
damages, were an ordinary and necessary cost of doing business.
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\8\ Rev. Rul. 80-211; 1980-2 C.B. 57.
\9\ 26 C.F.R. 601.201(a)(2).
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B. Impact of Section 223 on the Business Community and Public Policy
The deductibility of punitive damages is also rooted in strong
public policies. It is a reflection that no product can be absolutely
safe. The worst effects of Section 223, however, may be felt by the
injured. The ability of taxpayers to deduct punitive damages encourages
settlement which makes the victim quickly whole. Additionally,
requiring insurance proceeds to be taxed as income to the extent such
proceeds are used to pay for punitive damages further increases the
actual costs of any settlement thereby reducing the likelihood that
cases will settle short of trial. Discouraging settlement in our
already overheated and strained court systems makes little sense for at
least three reasons.
First, Section 223 would apply principles of strict product
liability to the tax code. This legal theory provides that an injured
plaintiff need only show that a company, regardless of its level of
care, sold a defective product and that the product proximately caused
the plaintiff's injuries. This principle, having grown since the 1960s,
has made it substantially easier for plaintiffs to recover damages.
Under this theory, United States companies must operate in a world
where no product is or can be absolutely perfect. Examining the issue,
the Congressional Budget Office reported that ``such high costs
sometimes have perverse negative effects on safety, they argue--for
example, by discouraging firms from conducting safety research that
could create a legal `paper trail' or by raising the prices of risk-
reducing goods and services, such as medical care. Critics also contend
that plaintiffs frequently bring frivolous lawsuits when they know that
the defendant is inclined to settle out of court to avoid the costs of
litigation.'' \10\ Applying these principles of strict liability to the
tax code will only further hamper entrepreneurship, innovation, and
product development. As such, Section 223 should be removed from H.R.
2.
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\10\ ``The Economics of U.S. Tort Liability: A Primer,'' chapter 1
(Congressional Budget Office October 2003), available at http: //
www.cbo.gov / showdoc.cfm?index =4641&sequence=2.
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Second, Section 223 will discourage settlements in an already
overburdened judicial system and negatively affect the injured. Under
current law, companies may settle their cases without admitting guilt.
In many cases involving products regulated by the Food and Drug
Administration or the United States Department of Agriculture, for
example, having to admit guilt would have extremely harsh business
ramifications. Having the costs be non-deductible may be deemed to many
businesses as tantamount to an admission of guilt and may discourage
many of these settlements. Because of this, Section 223 will discourage
efforts to make victims whole. Current law allows a company to deduct
settlement payments, thereby encouraging companies to spend fewer
resources litigating claims and to make victims whole as quickly as
possible. Allowing companies to deduct all settlement payments as an
ordinary business expense resulting from events undertaken in the
ordinary course of business (outside of punitive damages for
wrongdoing) encourages a rapid and cost-efficient response to genuine
claims. As enactment of Section 223 will effectively drive up
settlement costs, thereby prolonging litigation and discouraging
settlement, it should be removed from H.R. 2.
Third, removing the deduction for payment of punitive damages, and
requiring insurance proceeds to be taxed as income to the extent such
proceeds are used to pay for punitive damages, will unnecessarily
strain the corporation, its shareholders, and the economy by taxing the
corporation on unearned income. Also, Section 223 will force the
corporation to pay such taxes out of its cash reserves, thereby
reducing the shareholders' value in the corporation. This policy
basically penalizes the company thrice for the same act. First the
court slaps punitive damages on the company. Second, the corporation is
also forced to pay tax out of pocket on any insurance payments. Third,
the payment to the plaintiff will not be deductible to the company.
This will significantly increase how much a company has to pay for any
punitive damage award. As Section 223 will tax insurance proceeds as
income, it will increase the penalty to the corporation, without
benefiting the injured party. It will also increase the costs to the
States by forcing more cases to go to trial. Indeed, the only
beneficiary would be the federal government, and we believe that the
added increase in tax revenues will be far less than the added costs
incurred by the states in trying the additional cases. As such, Section
223 should be struck from H.R. 2.
II. Section 224, Denial of Deduction for Certain Fines, Penalties and
Other Amounts
Section 224 would have a significant negative impact on businesses
by radically modifying the rules regarding the deductibility of fines
and penalties. This significant extension would deny a deduction for
all types of positive settlements that are currently entered into in
the normal course of business. As such, the Working Group for Certainty
in Settlements strongly opposes Section 224 of H.R. 2.
A. Background on Deductions for Fines and Penalties
In 1969, Congress specifically limited the deductibility of payment
for certain fines or penalties to a government for the violation of
law.\11\ Specifically, implementing regulations provide that the
following fines and penalties are not deductible as legitimate business
expenses: (1) amounts paid pursuant to a conviction or a plea of guilty
or nolo contendere for a crime (felony or misdemeanor) in a criminal
proceeding; (2) amounts paid as a civil penalty imposed by Federal,
State, or local law, including additions to tax and additional amounts
and assessable penalties; (3) amounts paid in settlement of the
taxpayer's actual or potential liability for a fine or penalty (civil
or criminal); or (4) amounts forfeited as collateral posted in
connection with a proceeding which could result in imposition of such a
fine or penalty.\12\
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\11\ 26 U.S.C. 162(f).
\12\ 26 C.F.R. 1.162-21 (emphasis added).
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B. Impact of Section 224 on the Business Community and Public Policy
Congress correctly denied the deduction as a business expense for
the payment of certain fines or penalties to a government for the
violation of law. However, Section 224 of H.R. 2 would radically modify
these rules by providing that amounts paid or incurred (whether by
suit, agreement, or otherwise) to a government for the violation of any
law or the investigation or inquiry into the potential violation of any
law are nondeductible, even if these payments are not fines or
penalties. While we strongly support measures to combat corporate
wrongdoing, this provision will have significant unintended and
negative impacts on the business community, government agencies, and
nongovernmental regulatory entities by reducing the likelihood of
prompt settlements and forcing more litigation.
Beyond the extension of listed fines and penalties to nearly all
``fines, penalties, and other amounts,'' the Working Group for
Certainty in Settlements is extremely concerned with the ``guilty until
proven innocent'' nature of Section 224. As passed by the Senate, the
provision denies a deduction for any such payments, including those
where there is no admission of guilt or liability and those made for
the purpose of avoiding further litigation. Rather than providing
clarity and certainty, Section 224 would deny a deduction for all types
of settlements that are positively entered into in the normal course of
business and are more properly and logically viewed as remediation
rather than punishment. For example, the following types of settlements
are illustrative of the types of costs companies incur in the ordinary
course of business that might no longer be deductible if this provision
were to become law: rate refunds made by regulated utilities; rate case
settlements for alleged violations of tariff; royalty settlements;
automobile manufacturer costs associated with safety recalls; bank
examination fees that banking institutions, as a regulated industry,
are required to pay; and, EPA information requests which are routinely
sent to companies. It appears Section 224, if enacted, would deny the
deductibility of all these expenses.
The Working Group for Certainty in Settlements strongly opposes the
non-deductibility of nearly all ``fines, penalties, and other amounts''
paid by taxpayers regardless of whether the actions were the result of
actual wrongdoing or not. Because of this, Section 224 will
significantly interfere with the regulatory system by increasing the
incentive for companies to force regulatory agencies to prove up their
cases at formal hearings, as now required in many instances by the
Administration Procedure Act.\13\
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\13\ 5 U.S.C. 554 et seq.
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III. Conclusion
The Working Group for Certainty in Settlements urges elimination of
Sections 223 and 224 of the Senate-passed version of H.R. 2, the
``Small Business and Work Opportunity Act of 2007.'' Both Sections
would remove certainty from the tax code, run counter to strong public
policies, and further strain already overtaxed United States
corporations.
We appreciate your consideration of our views on Sections 223 and
224. We look forward to continuing to work with you and your staff to
develop tax policy that encourages economic growth and helps us better
compete in the global marketplace.
The Working Group for Certainty in Settlements
American Chemistry Council
American Petroleum Institute
American Tort Reform Association
Associated Builders and Contractors
Association of American Railroads
Business Roundtable
Edison Electric Institute
The Financial Services Roundtable
National Association of Manufacturers
National Association of Mutual Insurance Companies
National Foreign Trade Council
Securities Industry and Financial Markets Association
Small Business and Entrepreneurship Council
U.S. Chamber of Commerce
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