Monday, February 11, 2019

Designing Incentive Plans For U.S. Executives Of Global Businesses

Christine Faris, Tax Director, Executive Compensation/Employee Benefits, Baker Tilly in the U.S.

U.S. operations of foreign multinationals often develop incentive compensation arrangements that are similar in design and purpose to the multinationals’ existing incentive compensation arrangements. However, transferring your compensation agreement to the U.S. could lead to troublesome outcomes. Foreign multinationals must consider how the intricacies of the U.S. compensation laws and regulations will affect their inbound incentive compensation arrangements.

Below is an overview of potential issues and solutions that are likely to have the most meaningful impact on the U.S. operations of foreign multinationals.

What is an incentive compensation arrangement?

In the U.S. an incentive compensation arrangement is generally a type of deferred compensation through which an employer provides deferral of compensation income to a future time, such as retirement, death or disability, for one or more selected executives of the company. Such a program is generally intended and designed to be a special program offered to an executive who is a member of the “top hat” group (a select group of management or “highly compensated” employees) to distinguish it from programs intended to benefit a significant portion of the workforce, such as a broad-based bonus programs. For executives, these plans are designed to provide a deferral of taxes and a savings vehicle. The employer will want to flexibly design these arrangements to accommodate both the needs of the company and the needs of the executive.

What are the U.S. tax implications of a deferred compensation program?

U.S. Internal Revenue Code section 409A provides that a deferral of compensation takes place whenever a service provider has a legally binding right during a taxable year to compensation that is or may be payable to the service provider in a later year. Unless certain requirements are met, amounts deferred for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. Section 409A requires that a deferred compensation arrangement be in writing and specify the amount (or a formula), the timing and the form of the distribution of the benefit. As a result, it is critical that the company make certain, in granting nonqualified deferred compensation to its executives, that there is compliance, in form and in operation, with the rules of section 409A at all times. If a nonqualified deferred compensation arrangement fails to comply with the requirements of section 409A deferrals are includible in income at vesting and subject to a 20 percent additional tax. Under some circumstances an underpayment interest payment will also apply.

What are common incentive compensation arrangements?

There are generally two categories of incentive compensation arrangements: short-term and long-term. Short-term incentive plans are usually bonus plans that link awards based on meeting individual or corporate performance criteria and objectives. These types of incentive compensation plans provide for the bonus to be awarded yearly.

Long-term incentive compensation plans typically vary in length from three to five years. These plans typically include equity-based incentives, such as stock options, restricted share grants and other types of equity-based plans like phantom stock or stock appreciation rights. Awards are closely linked to the achievement of company goals and objectives over the three to five-year period.

What are examples of equity-based incentive compensation plans?

Foreign multinationals are often interested in nonqualified stock options, restricted stock, phantom stock and stock appreciation rights.

Nonqualified stock option (NQSO) plan. A NQSO Plan may be used in conjunction with or as an alternative to a phantom stock plan. Unlike a phantom stock plan, a NQSO plan offers equity ownership and is exempt from 409A provided the exercise price is at least equal to the fair market value of the underlying shares as of the grant date, and the stock subject to the NQSO grant is be solely stock of the entity receiving the services of the service provider. The adoption of a similar plan in an inbound context brings an additional layer of complexity if the U.S. executives are offered equity ownership in the stock of a foreign parent company.

Phantom stock plan. A phantom stock plan is an example of a nonqualified deferred compensation plan establishing a hypothetical rate of growth as an “investment,” usually based on the performance of the company’s stock. The theory is that linking the benefit to the performance of the company’s stock will provide the incentive to the executive to perform above his stated performance goals. In the international context, phantom stock plans are often used as an alternative to NQSO plans to provide U.S. executives with benefits aligned with the compensation arrangements adopted abroad.

  • The “traditional” phantom stock plan: Provides the Employee with the financial benefits of stock ownership without the attendant cost and risk. The Employer awards bonuses in the form of hypothetical shares of its stock. The hypothetical shares are credited to the Employee's account as are all cash and stock dividends and stock splits attributable to the hypothetical shares. Upon the date of entitlement, the Employee receives an amount equal to the excess of the market value of all hypothetical shares on the date of entitlement over the value of such shares on the date they were awarded.
  • The "performance share plan": This is a variation of the traditional phantom stock plan. Units corresponding to hypothetical shares of stock are credited to an Employee's account. The number of shares to be credited is based on the fair market value (or book value in closely held corporations) of the Employer's stock. The Employee's account is also credited with dividend equivalents on the hypothetical stock. Upon the date of entitlement, the Employee receives the number of shares credited to his account or the equivalent amount of cash, provided certain individual or group performance goals, or both, are satisfied. Unlike the case of the traditional plan, the Employee in a performance share plan is assured of receiving something for his shares, even if the market value of the stock is less than it was at the time it was awarded to his account.

Stock appreciation right (SAR). SAR is a form of incentive compensation that is tied to increases in the value of the employer’s stock. Under these types of arrangements, the employer promises to pay the participant an amount equal to the difference between the company’s stock on the date the SAR is granted and that value on the date the SAR is exercised or matures. SARs fall within the “stock rights” exception to 409A. Compensation payable under the SAR cannot be greater than the excess of the fair market value of the stock on the date of exercise over the fair market value on the date of grant of a fixed number of shares specified at that time. A SAR is usually granted for a specific period and can be exercised at any time within that period. A SAR may also limit the upside value to a multiple of the stock’s fair market value at date of grant. A SAR may provide for payment in cash or company stock.

Restricted stock plan. A restricted stock plan is a common type of share acquisition arrangement. Restricted stock awards provide that the participant will become vested in shares if he or she meets certain vesting requirements tied to the restricted stock award. The restrictions may be time-based, often three to five years, or tied to certain corporate, departmental or individual performance goals. Restricted stock awards may be granted or purchased for consideration or no consideration. As in NQSO plans, restricted stock option plans require consideration of additional tax and non-tax implications when stock of a non-U.S. company is offered to U.S. executives.

In conclusion

Equity-based incentive compensation for a multinational organization is complex and the various alternatives must be fully considered and understood. For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

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