Grossed out by gross ups

Companies should stop covering executives’ excise tax in severance payments

Of life’s two certainties — death and taxes — a number of executives at U.S. corporations appear to escape a significant portion of the latter.

Based on a recent RiskMetrics Group analysis using 2008 proxy statement disclosures — the first available under the latest Securities & Exchange Commission compensation disclosure rules — 329 companies in the Standard & Poor’s 500 have agreed to cover executives' excise taxes imposed due to “excess parachute payments” in connection with a change in control of a company.

These excise tax “gross-up” payments end up inflating golden parachute payouts substantially, costing companies — and thus shareholders — millions of dollars. Indeed, the average potential change-in-control payments to top executives of companies providing the benefit stood at $72.5 million as of 2008, 65% higher than the average payment ($43.9 million) reported by the 168 companies that do not provide the benefit. These companies do not mention any excise tax gross-up provisions in their proxy statement disclosure. (The proxy statements of three companies weren’t available for the analysis.)

The excise tax is a 20% levy that executives must pay, on top of their regular income tax on change-in-control payments, if the parachute payout exceeds three times their average taxable income during the five years prior to the change in control. Congress introduced the tax in 1984, as part of a revision of the Internal Revenue Code, in an effort to curb change-in-control payments to executives. If the tax is triggered, companies also lose a substantial tax deduction for the payouts. Companies with gross-up provisions promise to pay their executives an extra amount to cover the excise tax, when it is triggered, plus additional taxes that come due as a result of that payment. However, companies that do not provide excise tax gross-ups may still experience a loss of tax deductions if parachute payments are above the prescribed threshold, even if the executive takes responsibility for the excise tax.

Best practice=abandon tax gross-up

Companies should follow best practices, and abandon the use of excise tax gross-up provisions.

In the context of negotiations of employment agreements between executives and companies, and in terms of cost, the gross-up provision favors only the executives. When executives are accommodated for their excise tax obligations, the payments are costly to companies and shareholders. Companies sometimes present the provision as a competitive necessity. Some companies argue that the excise tax may discriminate against certain employees, such as individuals who do not exercise options or who elect to defer compensation. However, we have not seen any demonstration that these arguments justify the cost to shareholders; rather, our research shows that companies promising gross-ups are generally more inclined to pay large executive severance packages.

The average aggregate gross-up payments to named executive officers at companies reporting gross-ups are $13.9 million. In extreme cases, potential gross-ups reach astronomical figures, exceeding $100 million (e.g., Nabors Industries Ltd. — $160.3 million), and may make up to 45% of an executive’s total change-in-control payment (e.g., for Leslie Moonves, president, chief executive officer and director of CBS Corp.). On average, gross-ups constitute 18% of total potential parachute payments to executives, the analysis found.

Excise tax gross-up payments grow immense due to the circular nature of their calculation, since companies are also obligated to cover additional taxes generated as a result of the initial excise tax gross-up. Compensation consultants and academics have estimated the cost of excise tax gross-ups at between $3 and $4 for each $1 of the executive’s parachute payment subject to the excise tax. But the gross-ups alone do not explain the significant difference between the potential parachute payments of companies that provide gross-ups and those that do not, since the average gross-up amount is about $13.9 million, while the difference in average total payouts (between companies that do vs. those that do not pay gross-ups) is more than $28 million. Thus, it appears that when firms are willing to relieve executives of the penalty tax burden that was intended to curtail “excessive” golden parachutes, they are also more inclined to pay inflated change-in-control severance.

EMC, Fortune Brands, Colgate among the first movers

Some companies are beginning to revise their severance packages to remove tax gross-up provisions. In 2008, EMC Corp., Fortune Brands Inc. and Colgate Palmolive Co. were among a few S&P 500 companies doing away with excise tax gross-ups, citing their commitment to best governance practices. More companies are expected to follow suit this year as investors, politicians and others sharpen the focus on executive pay in the wake of the financial crisis.

Even though regulatory measures are not the optimal solution, sometimes they may be effective. Companies participating in the capital purchase program of the Treasury Department may no longer provide excise tax gross-ups, since their severance payments to executives may not exceed three times salary and bonus. The reduction of parachute payments to avoid triggering the excise tax is seen as the best practice, to avoid the tax and the loss of the tax deduction for the company. Rather than providing a gross-up, many companies promise to pay the greater of the full amount of an executive’s contractual severance package or the maximum amount that avoids triggering an excise tax, thus reducing potential costs for both sides.

Shareholders are active this year in addressing excise gross-ups. As they did last year, the $860 million American Federation of State, County and Municipal Employees Pension Fund, Washington, for example, filed several shareholder proposals targeting gross-ups. Last year, shareholders voted an average 45.3% in support of the proposal at four companies, including majority support from votes cast at CVS Caremark Corp. Politically, the administration of President Barack Obama and a Congress with Democratic majorities may push to curb executive pay by placing further limits on golden parachutes and tax gross-ups.

This commentary does not necessarily reflect the views of RiskMetrics or its clients.

Kosmas Papadopoulos is a research analyst at RiskMetrics Group Inc., New York, and author of its 2008 report “Gilding Golden Parachutes: The Impact of Excise Tax Gross-Ups.”