Canada: Loss Of U.S. Compensation Deduction As IRS Narrows View On “Performance-Based” Exception

US compensation deductions for certain compensation payments are threatened by a recent IRS position that reverses a long-standing interpretation that certain bonus arrangements will qualify for an exception to the Code Section 162(m) deduction limitation for "performance-based" compensation.

Performance-Based Exception

Section Code 162(m) provides that, unless an exemption is available, a public company can generally not deduct more than $1 million in annual compensation paid to its CEO and other officers whose compensation must be disclosed in the annual proxy. (Foreign private issuers, who are not subject to the U.S. proxy disclosure rules, do not have any employees subject to this rule.) The most frequently used exemption is for "performance-based compensation" which applies so long as the compensation arrangement meets certain enumerated requirements and is payable solely if the performance goals are achieved.

Tax regulations further permit payment at a guaranteed level, without regard to actual performance, in the event of a death or disability or a change of control. Historically, the IRS had extended this favorable treatment under the regulations by analogy also to payments on termination without cause and on certain constructive terminations.

IRS Reverses its Position

In a controversial private letter ruling (PLR 200804004) that caused a general uproar among the community of public issuers, the IRS reversed its position about paying bonuses on certain employment terminations, without regard to actual performance. Probably in response to comments from tax practitioners and employers, the IRS clarified its position in a published ruling (Revenue Ruling 2008-13, issued February 21, 2008), applicable to all taxpayers, and offered a transition period for existing compensation periods. In the later ruling, the IRS confirmed its position that compensation payable by a publicly held corporation to a covered employee will not be considered "remuneration payable solely on account of attainment of one or more performance goals" under Code Section 162(m)(4)(C) of the Internal Revenue Code, if the plan or agreement under which the covered employee is paid provides that the compensation will be paid without regard to performance in either of the following situations:

  • the covered employee's employment is involuntarily terminated by the corporation without cause or the covered employee terminates his or her employment for good reason, or
  • the covered employee retires.

Transition Period

The new position will not be applied to compensation paid under a plan or agreement that otherwise satisfies the Code Section 162(m) requirements, if either (i) the performance period for such compensation begins on or before January 1, 2009 or (ii) the compensation is paid pursuant to the terms of an employment contract as in effect (without respect to future renewals or extensions, including renewals or extensions that occur automatically absent further action of one or more of the parties to the contract) on February 21, 2008.

Action Required: Review Bonus Plans and Re-Write Employment Contracts

The transition relief for contracts that were in effect on February 21, 2008 should not be read too broadly. These contracts will often contain provisions requiring automatic renewal or extension which will not serve to extend the transition period. However, employers have some time to evaluate their current employment contracts and bonus plans, and revise their termination payments, so that target bonuses are not paid if the performance goals are not achieved, if it is intended that the payments are to be deductible or qualify as performance-based compensation.

U.S Tax (IRS Circular 230): Nothing in this communication (including in any attachment) is U.S. tax or other legal advice that is intended or written to be used, and it cannot be used, by any person to (i) avoid penalties under U.S. federal, state or local tax law, or (ii) promote, market or recommend to any person any transaction or matter addressed herein.

Sandra Cohen is a partner in the firm's New York office practising in the Pensions and Benefits Department, with a cross-appointment to the Tax Department.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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