Principal Shaun Bisman discusses the renewed investor and public interest of clawbacks and that companies are beginning to broaden their policies beyond a financial restatement.

On August 21, 2018, the IRS issued long-awaited guidance on the amendment of Section 162(m) made in the Tax Cuts and Jobs Act (TCJA).

This initial guidance is limited in scope and intended to respond to comments requesting clarification on the amended rules for identifying covered employees and the operation of the grandfather rule applicable to written binding contracts in effect before November 2, 2017. The initial guidance contains commentary, as well as numerous examples, on:

  • The definition of publicly held corporations covered by Section 162(m);

  • The definition of covered employees;

  • The definition of applicable employee remuneration;

  • The grandfather rule for compensation arrangements made under a written binding contract; and

  • Material modification of written binding contracts.

Highlights

The most important highlights include:

  1. The definition of publicly held corporations covered by Section 162(m) is broadened.
  2. The definition of covered employees is modified to better align with current proxy disclosure rules, although differences continue to exist primarily because the “end-of-year” requirement is eliminated for purposes of Section 162(m).
  3. The definition of covered employees is expanded to include chief financial officers, former covered employees and payments to a covered employee’s heirs and estate.
  4. The tax deductibility of compensation is preserved if the compensation is paid under a written binding contract in effect on November 2, 2017 and not materially modified after that date.
  5. The ability to use negative discretion to reduce compensation under such an arrangement is likely sufficient to limit tax deductibility, since the contract is not binding. We expect companies to test this concept in the courts over time.
  6. A material modification increases compensation, or provides additional compensation, on substantially the same elements or conditions.
  7. Additional payments equal to or less than reasonable cost of living adjustments do not result in a material modification.

Amendments to the Definition of Publicly Held Corporation

The TCJA amendment broadened the definition of publicly held corporations covered by Section 162(m). Rather than limiting the scope to companies issuing common equity securities, the new definition includes “any corporation:

  1. Which is an issuer the Securities of which are required to be registered under section 12 of the Securities Exchange Act of 1934 (the 1934 Act), or
  2. That is required to file reports under section 15(d) of the 1934 Act.”

The new definition expands coverage to companies issuing various equity securities and publicly traded debt, as well as companies that may be otherwise exempt from filing a proxy statement. For example, the executive officers of a public company that delists its securities, thus eliminating the requirement to file a proxy statement and disclose executive compensation, would be covered employees for tax purposes and subject to the amendment’s limits on tax deductibility.

Amendments to the Definition of Covered Employee

Under the TCJA, the definition of covered employees is modified to better align with current proxy disclosure rules. Under the new definition, a covered employee means “any employee if:

  1. Such employee is the principal executive officer (PEO) or principal financial officer (PFO) of the taxpayer at any time during the taxable year, or was an individual acting in such a capacity,
  2. The total compensation of such employee for the taxable year is required to be reported to shareholders under the 1934 Act by reason of such employee being among the three highest compensated officers for the taxable year other than any individual described in (a), or
  3. Such employee was a covered employee of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016.”

Importantly, the initial guidance clarifies that a covered employee is not limited to only those serving in their role at the end of the year. By eliminating the end-of-year requirement, disconnects between the individuals reported in the proxy statement and actual covered employees may occur. The IRS notes that SEC rules do not constitute the sole basis for interpreting Section 162(m).

By including covered employees for any preceding taxable year beginning after December 31, 2016, the initial guidance clarifies that the pre-amendment rules for identifying covered employees will apply for taxable years beginning during 2017. These employees will be wrapped in under the amendment, with tax deductibility strictly limited beginning in taxable years beginning in 2018 and beyond.

Amendment to the Definition of Applicable Employee Remuneration

Applicable employee remuneration was defined, under Section 162(m), as the total amount allowed to be deducted for the tax year. Prior to the amendment to Section 162(m), applicable employee remuneration excluded commission-based and qualified performance-based compensation. The amendments to Section 162(m) removed these exclusions from the definition. The Act also added a rule that limits the deductibility of applicable employee remuneration even if the compensation is paid to a beneficiary in the event of the death of a covered employee.

Application of the Grandfather Rule

The amendment to Section 162(m) allows for the tax deductibility of compensation to be preserved (in other words “grandfathered”) if the compensation is paid under a written binding contract in effect on November 2, 2017 and not materially modified after that date. The initial guidance preserves the pre-amendment definitions of “written binding contract” and “material modification” as first detailed in the original 1993 grandfather rules included when Section 162(m) was added to the Internal Revenue Code.

Written Binding Contract

The initial guidance defines a written binding contract as a contract that requires the company under applicable law (for example, under state law) to pay compensation if the employee performs services or satisfies the vesting conditions attached to the compensation. If a contract contains elements that are binding and other elements that are discretionary, the amounts that are binding will continue to be deductible under the grandfather rule, absent a material modification, and the discretionary amounts will be subject to the amendment's limits on tax deductibility and not grandfathered.

Grandfathering is not available to contracts that are renewed after November 2, 2017. Instead, these are treated as new contracts. If a company has the right to cancel or terminate a contract without the executive’s consent after November 2, 2017, the loss of grandfathering occurs as of that date and the amendment’s limits on tax deductibility apply at that point and going forward. One common scenario plays out when a contract contains a notice period. For example, if a company can give notice of non-renewal after a defined initial term ends, or annually thereafter, the contract is treated as a new contract when the notice period ends or upon renewal, if earlier.

There are important caveats to this rule to keep in mind. If a contract can only be cancelled or terminated by ending the employment of the executive, the contract does not lose grandfathered status. Similarly, if the executive has the unilateral right to cancel the contract after a certain date but chooses not to do so, the contract does not lose grandfathered status after this date.

Consensus has developed that the ability of the board or compensation committee to exercise negative discretion and adjust payments down to zero makes a compensation plan or arrangement non-binding. This results in a loss of grandfathering and limits on tax deductibility under the amendment to Section 162(m).

We expect this position to be tested by issuers in tax court and/or state court. For example, if performance metrics and targets are clearly articulated in a contract or award agreement and the company has no history of actually applying negative discretion, a case could be made that the executive has a valid claim to receive that compensation. We will monitor developments on this point, since negative discretion is built into the majority of executive incentive plans.

Finally, if a compensation plan or arrangement is binding, the amount that is required to be paid as of November 2, 2017, will be grandfathered with no loss of tax deductibility, provided the executive was employed on that date by the corporate sponsor or the employee had a written binding contract as of that date. Supplemental executive retirement plan (SERP) benefits are a good example of this. If an executive has a binding right to receive SERP benefits, the accrued benefit as of November 2, 2017 will continue to be deductible when paid in the future, while amounts accrued for service after that date will be subject to the amendment’s limits on tax deductibility.

Material Modification

The IRS defines a material modification as an amendment that increases the amount of compensation payable to the executive, or provides additional compensation, on substantially the same elements or conditions. If a material modification occurs, amounts received prior to the date of the modification are grandfathered and amounts received after that are not grandfathered, but rather subject to the amendment’s limits on tax deductibility.

Another aspect identified by the IRS as a material modification to a written binding contract includes the acceleration of the timing of a payment unless the payment is discounted to reasonably account for receiving the compensation early. The IRS notes that modifying a contract to defer a payment does not constitute a material modification as long as the excess amount payable is based on a reasonable rate of interest or the rate of return of a predetermined investment.

The adoption of a supplemental contract that increases compensation or provides for an additional payment is a material modification, when the facts and circumstances demonstrate that the “compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the written binding contract.”

On the other hand, companies may increase compensation to offset the impact of cost-of-living without loss of grandfathering. The guidance clarifies that an additional payment that is less than or equal to a reasonable cost- of-living increase (for example, a modest salary increase) would not be a material modification.

Effective Date

According to the guidance, the amendment to Section 162(m) applies to taxable years beginning on or after January 1, 2018. The regulators anticipate that the guidance will be incorporated in future regulations and will apply to taxable years ending on or after September 10, 2018. The IRS also notes that any future guidance or regulations that address issues covered in the guidance that would broaden the definition of covered employee or limit the definition of written binding contract would apply prospectively only.

IRS Request for Comments

Treasury and the IRS expect to issue additional guidance on Section 162(m) and is requesting comments on other aspects of the amendments to Section 162(m) that should be addressed. These include a number of highly technical points, such as:

  • The definition of “publicly held corporation” applicable to foreign private issuers,
  • The definition of “covered employee” to an employee who was a covered employee of a predecessor of the publicly held corporation,
  • The application of Section 162(m) to corporations immediately after an initial public offering or a similar business transaction, and
  • The application of the SEC executive compensation disclosure rules for determining the three most highly compensated executive officers for a taxable year that does not end on the same date as the last completed fiscal year.

Written comments are being requested through November 9, 2018.

Conclusion

The IRS has provided initial guidance on key questions from practitioner after the TCJA passed. Plenty of examples as to how the new rules would be applied going forward are provided. However, the guidance is complex. Companies should evaluate how the rules apply by consulting internal and external subject matter expert that understand compensation, as well as the tax and legal perspectives. We will keep clients informed as consensus develops on various aspects of the guidance and as the IRS issues further guidance on Section 162(m).

Beginning with fiscal years ending on or after December 31, 2017, companies are required to disclose the ratio that compares the compensation of the CEO to the compensation of the median employee (pay ratio). This disclosure was part of the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law in 2010.

Compensation Advisory Partners LLC (CAP) researched early pay ratio disclosures. As of March 9, 2018, we obtained pay ratios from 150 companies with a median revenue of $2.1B from a cross-section of industries.

Pay Ratio

The median pay ratio disclosed by these companies is 87x. The lowest ratio is 1x (Apollo Global Management, Dorchester Minerals and The Carlyle Group) and the highest ratio is 1465x (Fresh Del Monte Produce Inc.).

Summary Statistics Median Employee Pay Median CEO Pay Pay Ratio
75th percentile $88,612 $10.5M 172x
Median $58,256 $5.6M 87x
25th percentile $43,966 $2.5M 36x

As expected, the pay ratio correlates with company size, with larger companies disclosing higher ratios. CEO pay varies greatly depending on the size and complexity of the organization. Employee pay has less variability since it reflects the job function and does not vary significantly based on the size of the organization. The median ratio in our sample of 150 companies ranges from 20x for companies with revenue less than $500M to 218x for companies with revenue greater than $15B.

Artboard 1 20x 54x 84x 157x 183x 218x <$500M $500M-$1B $1B-$5B $5B-$10B $10B-$15B >$15B Median Pay Ratio by Revenue Size

Few companies, 15, disclose a supplemental pay ratio with only a handful of companies (three) disclosing more than one additional ratio. These companies with supplemental ratios are typically adjusting the CEO’s pay which may exclude anomalies such as a one-time special bonus or equity award. Interestingly, three companies disclosed a higher supplemental pay ratio likely to provide context for a large year over year increase in the 2019 proxy statement.

Location of Disclosure

Nearly 70% of companies disclose the pay ratio after the Potential Payments upon Termination or Change in Control section of the proxy statement. Approximately 25% of companies disclose the pay ratio just before or after the Summary Compensation Table and a small minority, 5%, disclose it in the Compensation Discussion and Analysis (CD&A).

Pay ratio is typically not disclosed in the CD&A, signaling to shareholders that the pay ratio is not used to determine CEO pay levels. Additionally, around 25% of companies include language in the disclosure that the ratio should not be used to compare pay levels to other companies within the industry, region of the country or revenue size.

Measurement Date

The SEC’s final rules give companies the flexibility to use any date within the last quarter of the fiscal year to identify the median employee. Companies most commonly used the last day of the fiscal year or a date within the last month of Q4. It is also common for companies to use a day within the first month of Q4 to identify the median employee.

Measurement Month Prevalence Measurement Date Prevalence
First Month of Q4 29% Last day of Q4 44%
Second Month of Q4 8% First day of Q4 17%
Third Month of Q4 57% Other 33%
Not Disclosed 6% Not Disclosed 6%

Exclusions from Median Employee Determination

Approximately one-third of companies excluded a portion of their workforce when determining the median employee. The most common rationale is the de minimis exemption (approximately 55%) whereby a company can exclude up to 5% of its non-U.S. employee workforce. Companies also commonly cited an acquisition or corporate not responsible for setting pay (e.g., independent contractors) as rationales for excluding certain employee groups.

Conclusion

As more companies continue to file their proxy statements in the coming weeks, we will likely see larger pay ratios, particularly as companies with a significant part-time workforce begin to disclose their ratios. We do not anticipate an increasing trend in the number of companies filing supplemental pay ratios though it will be interesting to see the rationale for those that do. We expect to continue to see companies placing the pay ratio outside of the CD&A with most disclosing it after the Potential Payments upon Termination or Change in Control section.

CAP reviews proxy disclosures of S&P 500 companies on a weekly basis as part of an on-going Say on Pay study. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) mandates that public companies provide shareholders with a non-binding vote on executive compensation every one, two or three years. This study tracks all Say on Pay and Say on Frequency related proposals and the corresponding vote results.

Congress approved the Tax Cuts and Jobs Act on December 20th, 2017, achieving its objective of delivering a bill for President Trump’s signature before Christmas. The Act makes many dramatic changes to the tax code, including sharp reductions in the corporate tax rate, modest reductions in individual tax rates and some progress in simplifying the tax code. The biggest change from an executive compensation perspective involves amendment of Section 162(m).

Since going into effect in 1994, Section 162(m) has limited the deductibility of remuneration to covered employees to the extent the amount exceeds $1,000,000. Under current law, important exceptions to the limits on deductibility apply to stock options, other performance-based compensation and commissions. The amendments in the Act greatly expand the limits on deductibility by eliminating these exceptions.

Highlights of the Amendments to Section 162(m)

Amendment

Implication

Exceptions allowing deductibility of stock options, other qualifying performance-based compensation and commissions are eliminated

Effectively caps deductibility of senior executive compensation to $1 million per year and raises company cost of compensation

Definition of covered employees aligned with SEC disclosure rules

Expands coverage to include any person serving as Principal Executive Officer (PEO) and Chief Financial Officer (CFO) during the tax year, as well as the three highest paid executive officers other than the PEO and CFO

Expands coverage to include compensation of covered employees for all future years of employment whether or not they remain in the proxy, payments made after retirement, death or other termination of employments and payments to beneficiaries

Widens the net by eliminating loopholes allowed under current law, such as leaving the role of PEO before the last day of the year and making non-qualified deferrals of compensation until after termination

Amendments apply to taxable years beginning after December 31, 2017, except that the amendments shall not apply to remuneration provided pursuant to a written binding contract in effect on November 2, 2017, and not modified in any material respect on or after such date

Effectively grandfathers existing arrangements and provides companies with an opportunity to capture tax deductions as existing arrangements wind down over time

Possible Benefit from Amended Section 162(m): More Flexibility for Compensation Committees

Public companies subject to Section 162(m) use a variety of techniques to comply with the current law and maximize tax deductibility. Going forward, for new awards that are not made under grandfathered written binding contracts, these techniques will no longer be needed. Tax deductibility will be capped at $1,000,000 regardless of plan design:

  • “Plan within a plan” structure, also known as an “umbrella plan,” will no longer be necessary, providing companies with an opportunity to simplify current plans
  • Tax incentives to grant performance-based compensation will be eliminated in most instances, encouraging greater use of time-based awards.
  • Potentially more flexible performance metrics may be instituted over time. Non-GAAP metrics, individual goals and metrics that incorporate discretion are likely to occur more frequently.
  • Tax penalties for adjusting or restating performance targets will be eliminated in most instances.
  • Compensation committees will have greater opportunities to exercise discretion, including positive discretion.
  • While amendments clearly raise the cost of compensation for companies, the corporate tax rate cut makes the lost tax deductions less valuable, with a deduction on $1 million of compensation declining from $350,000 to 210,000.

What Should Companies Do Now?

Companies should take the following steps now to develop a clear picture of their particular situation with respect to the amendment of Section 162(m):

  1. Take an inventory. Make a list of outstanding compensation arrangements and awards to determine which may continue to be deductible going forwards. These would include contractual benefits and other awards made under written binding contracts in place on or before November 2, 2017.
  2. Double check your assessment with tax counsel. Make sure internal resources and outside advisors agree with your analysis and conclusions.
  3. Determine administrative processes needed to capture tax deductions going forward. For example, achievement of the goals of a grandfathered performance share award must be certified by the Compensation Committee prior to payment to comply with current Section 162(m) rules.
  4. If contractual arrangements and awards will continue over time, continue to seek re-approval of the material terms of incentive plans every 5 years. Shareholder approval of metrics, maximum awards and the class of participants are required to comply with current law. Obtaining shareholder approval of these proposals is almost always easy to accomplish.
  5. Be wary of making changes. Modification to awards or arrangements in effect on or before November 2, 2017 could result in the loss of valuable tax deductions.
  6. Determine which executives appear in the proxy and become covered employees under amended Section 162(m).
  7. Do your best to limit new entrants into the proxy disclosed group. Once an executive becomes subject to amended Section 162(m), the limits on deductibility become permanent.
  8. Prepare a pro forma showing current law and amended law to review with the Compensation Committee. It is important to brief the Committee and senior management to avoid surprises. All will benefit from understanding the magnitude of lost deductions.
  9. Review your proxy disclosure. Determine how best to address the issue of tax deductibility in the CD&A.
  10. Follow case law as it develops. Without a doubt, companies will test the amendments and new thinking will develop. You will benefit if you track the issue as it is tested in the marketplace.

We will keep our readers informed of new developments. Undoubtedly the Tax Cuts and Jobs Act will have other implications for executive compensation.

Highlights

Requirements of the SEC’s Final Rules:

Disclosure of

  1. the median of the annual total compensation of all employees, excluding the Principal Executive Officer (“PEO”), defined as A;
  2. the annual total compensation of the PEO, defined as B;
  3. the ratio of the amount in B to the amount in A, where A equals one, or alternatively, expressed narratively as a multiple

Example:

If A equals $50,000 and B equals $2,500,000, the pay ratio may be described as either “50 to 1” or “50:1” or the company may disclose that “the PEO’s annual total compensation is 50 times that of the median annual total compensation of all employees.”

Timing:

  • Reporting required for the first full fiscal year beginning on or after January 1 2017.
  • For calendar year companies, this means the proxy statement for the 2018 Annual Meeting

Exclusions: Smaller reporting companies, foreign private issuers, MJDS filers, and emerging growth companies

Assessing the Size and Scope of the Task:

The size and complexity of the task of preparing pay ratio disclosure will vary greatly from company to company. Factors such as the number of employees, their location and the integration of payroll and HRIS systems will determine the amount of work involved.

Complexity of Pay Ratio Disclosure and Information Gathering
Less Complex More Complex
Smaller number of employees Larger number of employees
Full-time employees only Mix of full-time, part-time, temporary or seasonal workers
US only Multiple international locations
Single corporate registrant with no consolidated subsidiaries One or more consolidated subsidiaries in addition to corporate registrant
Single HRIS/payroll system Multiple HRIS/payroll systems
Compensation plans limited to salary, cash bonus and equity Additional compensation plans, such as commissions or multiple incentive plans and “spot” bonuses housed in different systems
Retirement plans limited to defined contribution plans Defined benefit pension plan and/or company contributions to non-qualified deferred compensation plans
Limited perks Extensive perks

Advance Planning

We strongly advise companies to begin the process early, particularly if your company’s situation is “more complex.” In these cases, we advise that you calculate the pay ratio during the last three months of 2016 – a full year in advance. This will give you an opportunity to clearly identify where the data will come from, how the data will be obtained and what type of assumptions must be made.

It will also allow plenty of time to craft the required disclosure language, evaluate any repercussions and communicate it to interested parties – including HR leadership, senior management and the Compensation Committee.

Artboard 3 Pay Ratio Disclosure Flow Chart Project Planning Identifying the Median Employee: Take a First Pass Assess Flexibility Permitted Under the Rules • Exclusions Data PrivacyDe Minimus • Adjustments COLAAnnualization • Statistical Sampling Prepare Final Calculations Draft the Disclosure • Methodology • Assumptions • Supplemental Information Communicate Internally and Externally • Management • Board of Directors • Shareholders • Employees 1 2 3 4 5 6

Overview of the Implementation Process

CAP recommends that companies adopt an implementation process that encompasses six phases:

Phase I: Project Planning

  1. Confirm that your company is required to provide pay ratio disclosure. Make sure your company is not in one of the excluded categories where pay ratio disclosure is not required.
  2. Determine who “owns” the project. In most companies, we expect either HR, Legal or Finance staff to be responsible for preparing pay ratio disclosure.
  3. Identify internal resources. We expect most companies to establish a cross-functional team to complete this work. HR and Finance staff will benefit from assistance from Technology staff, particularly if multiple HRIS and payroll systems exist. A member of the Legal staff can help the team draft the text of the disclosure and coordinate with overall proxy preparation.
  4. Identify external resources. Decide whether the internal team charged with preparation of the pay ratio disclosure would benefit from partnering with outside resources. An outside consultant could provide the team with learnings gleaned from client situations and other experience. If multiple non-US locations are involved, the team will require expertise in data privacy laws, and a legal opinion will be required in certain circumstances.
  5. Create an inventory of data sources. Tally up the number of HRIS or payroll systems. Can you access a single integrated system or will you be forced to tap into multiple systems? Overlay the countries in which your company operates to ensure data source(s) for each country are identified. Obtain samples of the data fields that may be retrieved to begin the process of defining a methodology for identifying the median employee. The answer to these questions will be critical in determining whether to use statistical sampling, as well as identifying the pay elements that determine the median employee.
  6. Create a preliminary time line for the project. Coordinate with the schedule for overall proxy statement preparation. Allow sufficient time for communication to the various stakeholders.

Phase II: Identifying the Median Employee: Take a First Pass

  1. Chart the number and types of employees – full-time, part-time, temporary and seasonal — by country. Approximate as necessary to get a rough headcount. Reach out to your HR network as needed to fill in the blanks.
  2. Identify consolidated subsidiaries and include your best estimate of these employees in the preliminary headcount.
  3. Overlay basic compensation data on the preliminary headcount. Use what is most readily available from the payroll and HRIS systems – for example, the average amount, or the median, of annual cash compensation by location.
  4. Assuming your company’s PEO is paid in US dollars and international employees are part of the picture, convert the international compensation data into US dollars.
  5. Step back and analyze the data. Depending on degree to which employees are concentrated, either by category or by location, it may be obvious where the median employee resides.

Here is an example of employee counts for a major retailer with operations in the U.S., Europe and Canada. Keep in mind that the median employee will be the employee whose pay is higher than one-half of the pay of all employees and lower than the pay of the other half. With a total of 47,000 employees, the median employee at this company will be the employee whose pay is higher than 23,500 employees out of the total. The company in our example has a very large group of part-time employees who are store associate, including more than 27,000 such employees in the US. We know that the typical part-time employee in the US works 20 hours per week at an average rate of $12 per hour and annual compensation of about $12,000. Given the high concentration, of U.S. part-timers, we can conclude that in this company the median employee will almost certainly be found in the U.S. part-time category. While additional work is necessary, a picture begins to emerge.

Full Time Employees Part-Time Employees
U. S. 12,665 27,285
Europe 1,788 3,852
Canada 447 963
Total 14,900 32,100
Estimate: 14,900 full-time employees + 8,600 U.S. part-time employees = Median (ranked 23,500 out of 47,000 total employees)

Naturally, each company will have a unique profile. Many companies may not have an obvious concentration of employees, so the preliminary estimates may not be predictive of the final result. But even in that case, the team will know that more work – and more precise data – will be necessary to complete the picture.

Phase III: Assess Flexibility under the Rules

  1. Determine if the Foreign Data Privacy Law exemption applies. Under this exemption companies are allowed to exclude employees residing in locations where data privacy laws or regulations prevent companies from complying without violating such data privacy laws or regulations.

    But the bar is high, since companies must make “reasonable efforts” to obtain the necessary data. Reasonable efforts include listing the excluded jurisdiction, identifying the specific law or regulation that prevents compliance, explaining how compliance violates the law or regulation, seeking an exemption or other relief and even obtaining a legal opinion from counsel. If you can create a list of the pay for each employee and not include any personally identifiable information (e.g., just number the employees without using their regular employee number), then you likely will have to include them in the calculation.

    We strongly urge clients to bring their privacy officer or legal counsel into the picture early to make this determination up front.

  2. Determine if the De Minimus exemption applies. This exemption allows companies to exclude non-U.S. employees if they account for 5% or less of total employees. If non-U.S. employees exceed 5% of the total U.S. and non-U.S. employees, up to 5% may be excluded. However if any non-U.S. employees are excluded from a particular jurisdiction, all non-U.S. employees in that jurisdiction must be excluded. Both the jurisdiction and the approximate number of employees excluded must be disclosed.
  3. If both exemptions are used, coordinate the two exemptions as required under the rules. When calculating the number of non-U.S. employees that may be excluded under the de minimis exemption, companies much count any non-U.S. employees excluded under the data privacy exemption. This number may exceed 5%, but if it does, the de minimis exemption may not be used to exclude additional non-U.S. employees. On the other hand, if the number of non-U.S. employees excluded under data privacy exemption is less than 5%, additional non-U.S. employees may be excluded under the de minimis exemption provided the total equals 5% or less and all employees in a given jurisdiction are excluded.
  4. Assess efficacy of using COLA adjustments. The final rules allow companies to adjust actual compensation amounts of non-U.S. employees to reflect COLA, or cost of living allowance adjustments. Assuming that the U.S. tends to be a relatively high cost jurisdiction, unadjusted wages in non-U.S. jurisdictions will trend lower, increasing the final pay ratio. Upward adjustments to non-U.S. wage rates will decrease the reported pay ratio – a desirable outcome for most companiesBut once again, meeting the requirements to take advantage of the allowed flexibility will be challenging. Before embarking on this path, companies need to determine if it is indeed worthwhile. Discuss pros and cons and whether additional disclosure is required.
  5. Determine whether to annualize cash compensation of permanent employees. Companies are allowed to correct for mid-year hires of permanent employees by annualizing compensation, but if the number of mid-year hires is small, this adjustment may not be worthwhile.
  6. Evaluate the pros and cons of using statistical sampling to identify the median employee. Remember that to perform valid statistical sampling, the underlying data must be reasonably comprehensive and accurate. In addition, statistical sampling complicates your disclosure, since disclosure of the methodology and your assumptions is required. Best use may be for companies with defined benefit pension plans, since total compensation will be impacted by age and years of service.
  7. Identify how you will measure compensation in a consistent fashion for purposes of identifying the median employee. The rules allow companies considerable flexibility to choose an appropriate methodology for identifying the median employee. Employers can select a methodology that makes sense for them. Reasonable estimates are allowed. In addition, the median employee can be selected by using any compensation measure, provided it is consistently applied. Furthermore, companies may use their actual population to select the median employee or use statistical sampling or any other reasonable method.
    While some companies will take advantage of these flexibilities, others will focus on their actual population and compensation levels. Since statistical sampling depends on valid data, it may not reduce the workload associated with preparing the calculations.
  8. Consider the pros and cons of using various dates within the last three months of the fiscal year. The rules allow employers to identify the median employee on any date within the last three months of the fiscal year. We expect that this decision will most often align with payroll dates when payroll data is used to measure compensation of the median employee.

Phase IV: Prepare Final Calculations

  1. Select a final date during last three months of the year for the calculation based on preliminary analysis.
  2. Obtain updated roster of employees by location as well as final compensation data. Make sure compensation data is consistently applied.
  3. Apply the various exemptions, adjustments and other methodologies reviewed and agreed on during Phases I – III. Review and confirm your methodology and document any assumptions.
  4. Identify the median employee and determine a set of other comparable employees in case of a change in status of the median employee. The rules allow companies to identify the median employee only once every three years. Over time, this will significantly reduce the cost of compliance. Interestingly, the rules require the identification of an actual employee as the median employee, rather than a range of employees or a hypothetical profile employee.

    The exception to the three-year rule involves instances where a change in the employee population or a change in employee compensation arrangements could reasonably result in a significant change in pay ratio disclosure. Assuming no significant changes, the company must calculate annual compensation of the median employee using the methodology for proxy disclosure, subject to reasonable estimates, for years one, two and three. If the median employee leaves the company or has anomalies in his or her compensation, the company may substitute a comparably situated employee.

  5. Evaluate any anomalies related to the PEO’s compensation. Two methodologies are available if turnover resulting in two incumbents during a single year occurs. Under the first approach, a company may add the total compensation reported in the Summary Compensation Table for the two incumbents. As an alternative, companies may annualize the compensation of the PEO in the position on the date selected to identify the median employee.
  6. Determine the final pay ratio. Test and retest. Get a final level of comfort with the data and the methodology.

Phase V: Draft the Disclosure

  1. Prepare a draft of pay ratio disclosure. For disclosure purposes, companies must describe the methodology used to identify the median employee and to determine total compensation and any material assumptions, adjustments (including any cost of living adjustments) or estimates.
  2. Consider whether disclosure of supplemental information would be beneficial. Final rules allow companies to disclose additional ratios or other information to supplement the final ratio. While this is not required, companies may find it beneficial. For example, a company with a large number of part-time or seasonal workers may want to disclose the ratio applicable to full-time employees.

Phase VI: Communicate Internally and Externally

  1. Communication of pay ratio disclosure will be important. The project team has a number of critical stakeholders in the communications process. Plan to communicate progress early and often. Schedule periodic check-ins with HR leaders and senior leadership during the analysis and review process. In addition, brief the board of directors, particularly the Compensation Committee. There is a high potential for negative publicity associated with pay ratio disclosure. Get in front of it and anticipate employee reactions to the disclosure. Provide talking points to the leadership team so that they can respond to employee concerns in a consistent manner.
  2. Talk to peers and outside advisors about trends in disclosure. As companies actually prepare disclosure, trends and best practices will crystallize. Tap into the knowledge and experience that other companies and your advisors can provide.

Interpretive Guidance from SEC

On September 21, 2017 the US Securities and Exchange Commission (SEC) issued interpretive guidance designed to assist registrants prepare their pay ratio disclosures. The interpretive release was designed to respond to concerns raised by registrants about how to identify the median employee and calculate the pay ratio.

Importantly, the SEC confirmed that rules are intentionally crafted to give flexibility to registrants since they allow for reasonable estimates, assumptions and methodologies, including statistical sampling; and reasonable effort to prepare the disclosure. The SEC acknowledged that the ratio may include a degree of imprecision. Further, the SEC clarified that the pay ratio disclosure would not trigger an enforcement action unless the disclosure was made “without a reasonable basis or was provided other than in good faith.” Given that many clients have been intensely debating the pros and cons of various methodologies, this is a very important clarification from the SEC.

The SEC reaffirmed that existing internal records, such as tax or payroll records, may be used to identify the median employee. These records may be used even if they do not include every element of compensation. Use of existing records are certainly in line with the concept of using reasonable estimates.

The SEC also reaffirmed that if the compensation of the selected median employee, as calculated using the Summary Compensation Table methodology, proved to be anomalous, a registrant could select another similarly-situated employee based on the consistently applied compensation measure used in its selection process.

All of this interpretative guidance confirms that the pay ratio calculation is complex. While it is very helpful for the SEC to address concerns about potential liability and reaffirm that registrants have flexibility, one must question whether the pay ratio disclosure actually serves a legitimate business purpose.

The final issue addressed by the SEC involved the definition of independent contractors. In cases where workers are employed by, and whose compensation is determined by an unaffiliated third party, they may be classified as independent contractors and excluded from the calculation. The SEC affirmed that independent contractors defined by widely recognized tests applicable in other legal or regulatory contexts could also be excluded.

Division of Corporation Finance Guidance

In addition to the SEC’s interpretive release, the Division of Corporation Finance released additional guidance and hypothetical examples of the use of statistical sampling and other reasonable methodologies.

This included the following:

  1. Registrants are allowed to combine the use of reasonable estimates with the use of statistical sampling. For example a registrant with multi-national operations or multiple lines of business may use sampling in some areas/businesses and other methodologies or reasonable estimates elsewhere.
  2. Examples of sampling methods that may be used are below. Additionally a combination of methods is acceptable.
  3. Simple random sampling by selecting random number or percentage of employees from the entire population;
  4. Stratified sampling by dividing employees into strata, based on factors like location, business unit, type of employee, etc., and sampling within each strata;
  5. Cluster sampling by dividing employees into clusters, drawing a subset of clusters and sampling within clusters; and
  6. Systematic sampling where every nth employee is included in the sample.
  7. Examples of where registrants may use reasonable estimates include but are not limited to:
  8. Analysis of the workforce;
  9. Characterizing the statistical distribution of the company’s employees;
  10. Calculating a consistent measure of compensation and annual total compensation or its elements;
  11. Determining the likelihood of significant changes from year to year;
  12. Identifying the median employee;
  13. Identifying multiple employees who fall around the middle of the compensation spectrum; and
  14. Using the midpoint of a compensation range to estimate compensation.
  15. Examples of other reasonable methodologies, include:
  16. Making one or more distributional assumptions, provided that the company has determined that the assumption is appropriate given its own distributions;
  17. Reasonable methods of imputing or correcting missing values; and
  18. Reasonable methods of addressing outliers or other extreme observations.

Finally the Guidance provides three hypothetical examples of various approaches that may be applied. While all of the Guidance is helpful, we believe that the extra detail on reasonable assumptions and reasonable methodologies is particularly helpful.

In contrast, complex methods of sampling are less helpful. Our sense at this point in time is that most companies will not employ extensive statistical sampling. Basically the thinking is that if a registrant has the data necessary to perform robust statistical sampling, the registrant will have the data to array employee compensation levels and calculate a median. But we shall see how this plays out next year when the new disclosure is actually implemented.

Conclusion

Pay ratio disclosure represents a significant effort for most companies. It is important to develop an airtight process to support the company’s analysis. The rules are complex and companies will be working through the rules for the first time. The results will undoubtedly get a great deal of scrutiny from senior leadership, the Board, employees and the business press. Recent interpretive guidance gives companies more leeway to employ reasonable estimates and methodologies, but nevertheless companies must be comfortable that their disclosure is accurate. This practical guide to implementation can serve as a guide to achieving a successful result for all.

On September 21, 2017 the US Securities and Exchange Commission (SEC) issued interpretive guidance on the CEO pay ratio calculation and disclosure.  The pay ratio rule was adopted by the SEC on August 5, 2015 under the Dodd-Frank Wall Street Reform and Consumer Protection Act. It requires companies to disclose their CEO’s annual total compensation as a multiple of the annual total compensation of the median employee for the first fiscal year beginning in 2017.

The guidance came in the following three areas:

SEC Guidance

  • As long as the company uses reasonable estimates, assumptions, or methodologies (to identify the median employee or calculating any elements of annual total compensation for employees), the pay ratio itself and related disclosure would not provide the basis for an enforcement action from the SEC
  • A company may use internal records (such as tax or payroll records) to identify its median employee
  • For determining whether independent contractors are “employees”, companies may apply a widely recognized test under another area of law (e.g., tax or employment laws) that they would otherwise use to determine whether their workers are employees

Staff Guidance

  • Provides guidance and detailed examples on the use of statistical sampling

Revised Compliance and Disclosure Interpretations (C&DIs)

  • Adds a new C&DI that issuers can state the ratio is an “estimate”
  • Withdraws C&DI that primarily addressed the treatment of independent contractors and leased workers

The latest guidance now provides more flexibility for companies in determining the median employee, specifically as it relates to the use of statistical sampling and clarification of independent contractors. We will track pay ratio disclosure over the coming year and keep you informed of new developments as they occur.

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Jun 03, 2020

Equilar: Executive Compensation Summit

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