The executive pay debate continues with the surprise announcement by APRA yesterday that it will be delaying releasing its long-awaited executive pay principles for the financial services sector. The APRA review, which was intended to target “extreme capitalists”, is believed to have bee pre-empted by the Federal Government’s decision to alter the taxation implications for employee share schemes.
The Government’s share scheme proposal has infuriated executives, with the Financial Review reporting this morning that the Australian Mines and Metals Association have called for a meeting between Prime Minister Kevin Rudd and executives from companies such as BHP Billiton, Rio, Woodside and Newcrest to discuss the planned changes. Meanwhile, former Woolworths boss, Roger Corbett, criticized the move, claiming that the alteration would “make it impossible to use this very strong incentive of share entitlements, options or otherwise, to be an incentive to people employed by companies and to align the interest of shareholders with the interests of employees”.
Of course, the proposed changes are hardly worth of the mass hysteria being propagated by the Financial Review in its “Share Scheme Blunder” section. In fact, employee share schemes still receive highly concessional tax treatment (even under the proposed new rules). Employees and executives receiving equity awards will now be required to pay tax at their grant (at a deemed “accounting value” for the instrument, not the nominal value).
When the instrument is eventually exercised and sold, the employee would be required to capital gains tax on any appreciation. So long as the instrument has been owned for longer than a year, the employee or executive is able to receive a concessional CGT rate, effectively lowering their effective tax rate by half. (The discount allowed thousands of wealthy executives like former Macquarie CEO, Allan Moss, who earned more than $30 million annually, to pay tax on their equity instruments at half the rate of someone who earned $200,000). In addition, if the instrument has dropped in value, the employee is able to apply discount to their tax payable.
What do the changes effect? For a start, workers earning more than $60,000 per year will not be able to claim a tax break of up to $1000 for buying shares in their employer. The net difference to employees is therefore a few hundred dollars per year — hardly worth canceling a share scheme over.
The major benefit of the proposed changes though is to require executives and employees to pay tax on the deemed value of the equity at the time of grant — this will effectively prevent executives from avoiding paying tax on their gains. The Financial Review begrudgingly reported this morning that an ATO audit revealed that eight percent of more than 1300 executives audited failed to disclose an average of $180,000 in share scheme benefits. The AFR dubbed the errors a “common mistake”, others would more accurately label the activity “tax evasion”. Under the new laws, such evasion would be prevented.
Therefore, the criticisms coming from companies and the Federal Opposition are completely misguided. Unless they are in favour of executives who earn more than $1 million evading their taxation obligations or are desperately concerned over workers who earn more than double the median wage saving a few hundred dollars from their annual tax bill.
As for the general arguments proffered by the likes of Roger Corbett regarding “alignment of interests” between employees and shareholders (in relation to the removal of the $1,000 tax break), that is one of the great investing myths of the 20th century. Virtually all employee equity schemes (be they share schemes, option schemes or performance rights plans) do not truly align the interests of shareholders and employees at all — that is because generally the equity provided is “free” to employees who will enjoy all the potential upside of shareholders in good times but not expose the holder to any downside risk.
If employers truly wanted to “align” the interests of staff and owners, they would provide employees with full recourse loans to acquire shares. In that case, should the share price drop, the employee would be required to repay the loan (like a shareholder would have to repay a margin loan or lose their initial capital). Full recourse loans are extremely rare for public companies (and in the event where they are provided, when things go wrong, the company usually forgives the loan anyway, such as what occurred with GPT and former CEO, Nic Lyons). The reason why full recourse loans are almost non-existent is simple — they aren’t free kicks to executives.
The respected former CEO and Chairman of Wesfarmers, Trevor Eastwood, took a similar view, telling the Australian Institute of Company Directors yesterday that “the introduction of incentive payments around the world over the past 20 years has played a major role in the executive remuneration blowout … good executives are driven more by dedication and passion of their role then financial carrots.”
The proposed changes to employee share schemes and equity plans are long overdue and will correct the current situation which allows wealthy executives to avoid paying hundreds of thousands of dollars of tax. While the proposed rules do not prevent executives from minimizing tax by paying discounted a capital gains tax on equity growth, it is very much a step in the right direction.
In other executive remuneration news, shareholders in Royal Dutch Shell have delivered an almighty message to their incompetent directors and greedy executives, with 59.4 percent of votes being cast against the company’s non-binding Remuneration Report. Shareholders were furious after the company decided to pay executives short-term bonuses despite the company not meeting the specified criteria for their award. Under a three-year executive share scheme agreed in 2005, Shell executives were able to earn up to 200 per cent of their salaries in shares if the company outperformed three peers, last year the company finished fourth.
Despite the clear failure to meet the specified targets, the Chairman of Shell’s Remuneration Committee, Sir Peter Job, used his “discretion” to award the share payments (which are believed to be worth around £3.6 million). Incidentally, Job was also on the Remuneration Committee of pharmaceutical company, GlaxoSmithKline, when its Remuneration Report was rejected by shareholders in 2003.
A spokesperson for Shell claimed that “we take the outcome of [the] vote very seriously and we will reflect carefully upon it.” Obviously, the Shell Remuneration Committee did not take last year’s vote particularly seriously, when 8% of shareholders rejected the company’s Remuneration Report.
A spokesman for Shell institutional shareholder, Franklin Mutual, stated that Job’s claims were “pathetic” and called for the resignation of Shell’s entire Remuneration Committee, which includes Deutsch Bank boss Josef Ackermann and former ambassador Lord Kerr of Kinlochard.
The Shell rejection was the second-highest vote against a British remuneration report — topped only by the 90 percent “against” vote for former Royal Bank of Scotland CEO, Fred Goodwin’s, £17 million golden parachute. That vote was impacted by the British Government voting its 70% stake against the Report.
Not sure you explained how the old system enabled executives to avoid paying tax on their employee shares. I agree the beneficiaries of these programs haven’t been very good at disclosing the full amount of their employee shares – if they’ve reported them at all – but the problem centres around the non-disclosure or evasion, not the system. If capital gains on the sale of investment properties weren’t disclosed, would you say the problem was caused by the 50% capital gains discount or by the people who don’t disclose this income? Clearly this would be evasion and we would be calling for better disclosure, but not to change the substantive law.
Forcing employers to report the recipients of share schemes in much the same way that salary and wages are reported would have made a great difference. Withholding by employers could also work.
Taxing the share or option at grant is more generous than the existing system, the problem the business community has with the change is that it is completely impractical. It imposes a tax liability on an employee that can’t be funded because the share or option is wrapped up in, typically, a 3 year vesting period. It can’t be sold to fund the tax bill, and this is the fundamental problem with the new rules (not only can’t it be sold, the option may never be earned if performance hurdles aren’t met). Companies can’t continue to grant options to their employees for fear they will burden them with a tax liability that can’t be paid. This doesn’t merely affect people with a $1m tax bill from their options, but mid-level managers who might have a $5k tax bill that puts them under enormous financial stress.
Under the old rules, you will find that most execs would have deferred the tax bill until all the restrictions lifted as they simply couldn’t afford to pay upfront. In this case, the entirety of their gain would have been taxed at their marginal rate (no capital gains discount) and no lower-tax rate benefit would have arisen. Execs wealthy enough to fund the tax bill under the old rules on grant would have obtained the benefit of the lower rate when they eventually sold their shares – but this practice will continue as this has now been supplanted as the new system.
The excessive amount of shares given to some employees is largely a different issue to the design of the tax system. I’m all for sensible remuneration, but this isn’t the right response. In your example with Alan Moss where you say he managed to pay tax at half his normal rate (due to the capital gains tax discount – and unless he has disclosed this information, you have made a massive assumption that even he could afford to pay the upfront tax), he would not pay a cent more under the new rules. In all likelihood, he would have paid more under the old rules.