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IMPACT OF REVENUE INCREASES INCLUDED IN THE SMALL BUSINESS AND WORK OPPORTUNITY ACT OF 2007 ON BUSINESSES

 

FEI is a professional association representing the interests of 15,000 CFO’s, treasurers, controllers, and other senior financial executives from over 8,000 major companies throughout the United States and Canada.  FEI represents both the providers and users of financial information.  Furthermore, FEI acts on behalf of the business community to advocate policies which will rationalize corporate operations, improve global competitiveness, and promote long-term business stability.

 

This testimony addresses the concerns raised by FEI’s Committee on Taxation with certain revenue raising provisions included in the Senate-passed version of H.R. 2, the Fair Minimum Wage Act of 2007.  This testimony represents the views of FEI’s Committee on Taxation.

 

I.          INTRODUCTION

 

The FEI Committee on Taxation commends the Committee for holding this hearing to consider the impact on businesses of revenue increases passed by the Senate.  Hearings are an important part of the legislative process because they provide an open forum in which to consider the potential impact of proposed tax policy changes.  We recognize the pressure to produce revenue-neutral tax legislation, especially in light of "pay-as-you-go" budget requirements.  However, we believe it is vitally important that hearings be held to fully consider the potential impact of revenue raisers in order to avoid imposing new costs and burdens on business that might undermine economic growth and job creation, as well as the ability of U.S. companies compete in the global marketplace. Last year, several business tax increases were enacted as part of the Tax Increase Prevention and Reconciliation Act that would have benefited from hearings.  These included provisions to impose withholding on government payments for property and services, amend the section 911 housing exclusion, modify the wage limitation under section 199, and repeal the FSC-ETI binding contract relief.  As a result, these revenue-raising tax provisions were enacted without a full understanding of their potential negative impact on businesses and the economy in general. 

 

II.        SMALL BUSINESS AND WORK OPPORTUNITY ACT OF 2007

 

On February 1, 2007, the U.S. Senate passed H.R. 2, the Fair Minimum Wage Act of 2007, which would increase the federal minimum wage and provide $8.3 billion in small business tax relief over the next 10 years.  The federal revenue loss associated with this small business tax relief package is fully offset by 14 revenue-raising tax provisions, many of which were passed by the Senate during the previous Congress.  The Senate revenue offsets include provisions affecting foreign leases, executive compensation, the deductibility of punitive damages and certain settlement payments, corporate inversions, individual expatriation, contingent convertible debt instruments, and offshore financial arrangements.

 

The FEI Committee on Taxation is concerned about several tax provisions in the Senate bill.  In particular, we strongly object to two revenue-raising tax provisions in the Senate bill that would impose new limits on executive compensation.  The tax code is neither an appropriate nor an effective means of regulating executive compensation.  Corporate governance issues such as this are appropriately handled under securities laws by the Securities and Exchange Commission ("SEC").  We also oppose provisions in the Senate bill that would deny deductions for punitive damages and certain settlement payments.

 

A.        Executive Compensation

 

The Senate bill would amend Code section 409A to impose a dollar cap on the aggregate annual amount of compensation that may be deferred by an individual.[1]  The cap would be equal to the lesser of $1 million or the individual's average annual compensation over the previous five years.  If there are any deferrals in excess of this limit all deferrals would be subject to current income taxation, interest at the underpayment rate plus 1%, and a 20-percent penalty.  The provision generally would be effective for amounts deferred after 2006.  The Senate bill also would expand the scope of the $1 million cap on deductible compensation under section 162(m).[2]

 

Limit on Annual Deferrals under Section 409A

 

Section 409A is unprecedented in its depth and breadth.  Section 409A, and its 20 percent tax penalty, may be applied to any employee - from rank-and-file employees to the CEO - who is deemed to have a deferral of compensation.  Section 409A, as interpreted in proposed Treasury regulations, broadly defines what is considered deferred compensation.  In general, deferred compensation is any right to compensation that becomes vested in one tax year and is paid in a subsequent tax year.  This definition sweeps under section 409A many arrangements that have not previously been thought of as deferred compensation, including certain severance arrangements.  In addition, earnings on deferred compensation, even deferred compensation that was earned prior to the enactment of section 409A, are treated as current deferrals under Section 409A.  When all of its current provisions are considered, Section 409A applies to many non-abusive arrangements for middle managers, including severance plans that are paid out over more than two years, and traditional nonqualified plans that seek to allow middle managers to maximize elective deferrals that are otherwise limited because other employees choose not to make contributions to a qualified 401(k) plan. 

 

The effectiveness of restrictions on nonqualified deferred compensation under section 409A, which has still not been fully implemented because of its complexity, should be evaluated before further restrictions are enacted.  Deferred compensation, if properly structured, actually aligns management interests with those of shareholders because the executives only receive payments to the extent the employer remains solvent and financially healthy after they retire.

 

The proposed limitation on the amount of deferred compensation will taint many traditional, beneficial arrangements. Consider a severance arrangement under which an employee receives one month's salary for each year of service to be paid out in monthly installments.  A long-term employee with 25 years of service will receive 25 months of salary, or 208% of his last year's salary, paid out over 25 months.  This arrangement would be treated as a deferred compensation arrangement, and would violate the new restrictions because the "deferral", calculated as of the date of separation, would exceed the employee's annual salary.  Thus, under the Senate proposal the employee would be subject to immediate income tax on the full amount of the severance plus an additional 20 percent tax penalty.  This result would apply whether the employee was earning $20,000 a year or $200,000 a year. 

 

Under Section 409A, increases in amounts previously deferred, whether interest credits on deferred compensation account or additional accruals in a supplemental defined benefit-type retirement plan, are treated as additional deferrals for the year of the increase.  The Senate proposal would therefore cause some individuals to exceed the limit even when they have not deferred additional current compensation, but only as a result of increases credited on prior deferrals.  Similarly, many deferred compensation arrangements require payments over a long period after retirement.  The long-term payment schedule is intended to provide the employee with retirement income to supplement qualified plans and Social Security payments.  In cases where the deferred compensation is credited with interest to be paid out over the future years, this interest is considered to be additional deferrals.  If the individual is not working, his average compensation will decrease to nothing, so that, under the Senate proposal, no further interest credits could be received.  In an age where employers, and the federal government, are seeking to find ways to provide long-term retirement income for employees, the Senate provision would eliminate this part of the solution. 

 

The proposed $1 million limit on deferrals of executive compensation also would create traps for unwary employees, and administrative and enforcement nightmares for companies and for the IRS.  Nonqualified deferred compensation limits and conditions enacted in 2004 are so complicated that final regulations have not yet been issued.  A basic requirement that companies simply report the amount deferred each year has not been implemented because the IRS has not yet been able to craft guidance on how to value accruals under nonqualified defined benefit plans and other deferrals.  This is a particular problem for non-elective, defined-benefit plans where the value of each year’s accrual depends on complex actuarial computations and assumptions regarding interest rates, salary growth, and mortality.  If the IRS cannot determine the amount of annual deferrals, how can Congress expect an employee to calculate such amounts, in advance, in order to avoid violating the new limitations?  Any cap on deferred compensation should only include easily computed, voluntary deferrals, such as elective deferral account balance plans; otherwise employers and employees cannot take actions that ensure compliance. 

 

Furthermore, even if the formulas were in place, the earnings component for many nonqualified arrangements is unpredictable.  Many qualified and nonqualified plans offer the ability to have the investment return based on the appreciation in the employer's stock.  This aligns employees' interests with those of shareholders.  However, if a company's stock appreciates significantly, the mere earnings on prior deferrals may result in deemed current deferrals in excess of the proposed limits.  An artificial limit on earnings on deferrals could create a bizarre situation where the tax law punished employees for an increase in the value of the company, in direct contradiction to the interests of shareholders.

 

In addition, deferral of compensation increases our national savings rate and permits the deferred amounts to be reinvested in the employer's business unit until it is paid out.  One of the "unintended consequences" of the proposal will be to weaken employers financially and to reduce the cash they have available to reinvest in the business.

 

Expansion of Executives Covered by Deduction Limits under Section 162(m)

 

The proposed modification to the limitation on deductions for compensation paid to certain key executives was approved by the Senate without the benefit of any hearings or debate but appears to be designed to impose new limits on executive compensation. 

 

However, as the staff of the Joint Committee on Taxation has observed, "It is often difficult for tax laws to have the desired effect on corporate behavior."[3]  This is seen quite clearly in the impact of the current $1 million limit on the employer deduction for certain compensation paid to top executives.  While the provision was intended to address corporate governance concerns that senior executives were receiving excessive compensation, many companies either decided to continue paying the compensation without the benefit of a tax deduction or redesigned their compensation programs and obtained shareholder approval to compensate their executives in ways not subject to this limit.  Thus, the amount of total compensation paid to executives was not reduced, while it merely became more expensive for corporations, and ultimately shareholders, to provide the level of compensation demanded by the market. 

 

The JCT staff concluded the $1 million deduction limit is ineffective and should be repealed.  The JCT staff also recommended "that any concerns regarding the amount and types of compensation be addressed through laws other than the federal income tax laws."[4]  Rather than following the advice of the JCT staff, however, the Senate bill includes a proposal to expand the base of executives who are subject to this limit.  We believe this goes in the wrong direction, and will be equally ineffective (or even counterproductive) at accomplishing the policy objective of Congress.  In addition, because section 162(m) is only applicable to public companies required to be registered under United States securities laws, it reduces the competitiveness of United States companies in their ability to attract and compensate key executives.

 

The SEC, not the IRS, is the appropriate government agency to address corporate governance concerns related to executive compensation.  The SEC last year issued new rules that expand executive compensation disclosure requirements in proxy statements, annual reports, and registration statements.  The SEC rules are designed to provide transparency so that shareholders and directors have better information with which to determine for themselves the appropriateness of compensation to senior executives.  We believe this approach is preferable to attempts by Congress to use the tax laws to regulate compensation levels for executives.

 

However, if Congress does decide to further limit the deductibility of executive compensation, we believe that the effective date of such provision should preserve the deduction for compensation that was earned before the date that such change is made.   Congress has generally limited the retroactive impact of tax law changes that affect compensation and benefits. (See, e.g., sections 162(m), 280G, and 409A, each of which had effective dates based upon binding contracts).   This reflects an appropriate desire to allow employers and employees to plan ahead, and also a recognition that changing taxpayer behavior, which is often a goal of such legislation, is a naturally forward-looking exercise.  With respect to this proposed legislation, the change making an employee a covered employee for life could affect payouts of compensation earned years or even decades prior to the effective date of the legislation and prior to the time the executive became a covered employee.  Since the policy reasons to amend section 162(m) presumably relate to the perceived influence and amount of pay of the very top and most senior executives, to limit the deductibility of compensation earned years before the employee reached that status is unnecessary.

 

Finally, we note that the changes to section 162(m) would have immediate, and in some cases significant, financial implications.   For example, accounting rules require that employers record deferred tax deductions on all accruals for deferred compensation due to an executive.   If such liabilities already on the books were made nondeductible retroactively, the employer would have to now write off the deferred tax deduction, creating a reduction in financial statement earnings attributable to compensation awarded long before the deduction was limited.

 

 

B.        Punitive Damages and Settlement Payments

 

The Senate bill would deny a deduction for punitive damages that are paid or incurred as a result of a judgment or in settlement of a claim.[5]  If the liability for punitive damages was insured, any punitive damages paid or reimbursed by the insurer would be included in gross income of the insured person even though the payment would not be deductible. Compensatory damages would continue to be deductible.

 

The Senate bill would expand the current non-deductibility of fines and penalties paid to a government for the violation of any law to include payments made in settlement of government investigations of potential wrongdoing, including those where there is no admission of guilt or liability and those made for the purposes of avoiding further investigation or litigation.[6]

 

Our analysis of both proposals starts with the general proposition that the corporate income tax is just that – a tax on net income, not on gross receipts.  Denying a tax deduction for expenses that a corporation deems valid business expenses erodes that concept.   One such expense is the cost of civil damage awards and settlement agreements emanating from the operation of that trade or business.

 

Our discussion of the deductibility of punitive damages goes back to 1969, when Congress drew a “bright line” with regards to the deductibility of fines and penalties by including Section 162(f) as part of the Tax Reform Act of 1969. [7] Section 162(f) denies deductions for fines and penalties paid to a government for the violation of any law.  In the report accompanying the 1969 bill, the Senate Finance Committee noted that the list in Section 162(f) was meant to be all-inclusive.  It did not include punitive damage awards, which are currently deductible.

 

We believe the current bright-line test works because it ties deductibility to whether the payment is made under or by virtue of a statute that creates a penalty.  Punitive damages, however, are routinely paid not because a legislature has defined an act as illegal and deserving of punishment, but because a jury decided that it wanted to “send a message” by providing additional damages for a plaintiff.

 

We would also like to address an argument raised by the Senate Finance Committee in the report accompanying H.R. 2.  In its report, the Committee expressed its concern that,”….allowing a deduction for [punitive damage award] payments in effect shifts a portion of the penalty to the Federal Government and to the public.”  Nothing could be further from the truth for the simple reason that punitive damage awards are treated as taxable income to the recipient.  Consequently, the dollar amount of the punitive damage award remains taxable, thereby ensuring that the general public is not in fact subsidizing any deduction allowed to the payor. 

 

 Another point we would like to raise concerns the adverse public policy implications of both proposals.  By disallowing a tax deduction for settlement payments and punitive damage awards, Congress would make it much harder to settle litigation without going to trial.  This will delay resolution for plaintiffs, overtax the court system, and encourage the devotion of resources to litigation rather than the compensation of injured parties.  For example, it is now common for plaintiffs in employment cases routinely to include a punitive damages count, even if the employer’s conduct was not illegal or outrageous.  If such a case is settled (and punitive damages are nondeductible), the IRS will argue that some portion of the settlement payment must be allocated to punitive damages regardless of the strength of the punitive claim.  The IRS and the employer will inevitably disagree about the allocation, and the employee typically will be indifferent because both punitive damages and most employment damages are taxable income.  If on the other hand the case goes to trial and the jury awards no punitive damages, then the employer’s entire payment will be deductible.  Thus, the employer has a strong disincentive to settle the employment litigation if it believes that the punitive claim is weak

 

We would like to close this section by reiterating the point we made at the outset: the general proposition of the income tax is that taxpayers will be taxed on their net income, not gross receipts.  Both of these proposals represent a departure from this proposition.  They would result in tax being paid on amounts in excess of net income, thereby imposing a tax penalty in addition to the awarded damages or negotiated settlement.    Imposing these additional costs on U.S. businesses would make it more difficult for them to compete globally and increase pressure that could threaten U.S. economic growth.  And by inappropriately injecting tax considerations into the determination and negotiation of damage awards and settlement amounts, both proposals inevitably would distort the results that otherwise might obtain, thereby undercutting the broader public policy goals to which civil penalties and punitive damages are directed.

 

 

 

 

C.        Retroactive Tax Increases

 

The Senate bill contains several retroactive tax increases.  For instance, the bill includes a provision to modify the effective date of leasing provisions in the American Jobs Creation Act of 2004 to disallow future losses on certain foreign leases entered into on or before March 12, 2004.[8]  In addition, the proposed expansion of section 162(m) would apply retroactively to amounts earned before 2007 and payments to which the employer is already contractually obligated.

 

The FEI Committee on Taxation believes that adverse changes in tax law should not take effect earlier than the date reasonable notice is provided to the public.  Individuals and businesses that make costly and irreversible financial and investment decisions should be protected from ex post facto enactments that increase the amount of income subject to taxation from these investments or deny investment incentives.  Certainty and predictability of tax and other commercial laws are critical to investment and entrepreneurship, which are the engines of economic growth.

 

III.       CONCLUSION

 

In summary, we strongly oppose Senate proposals to impose new tax costs and penalties on executive compensation and to deny deductions for punitive damages and certain settlement payments.  We urge the House to reject these unwarranted business tax increases in negotiations with the Senate on a compromise minimum wage bill that includes small business tax relief.

 

We appreciate the opportunity to share with you our concerns and again commend you for holding this important hearing.  The FEI Committee on Taxation looks forward to continuing to work with Congress as it considers this and future tax legislation.

 

Going forward, we hope you will continue to hold hearings on any potential revenue-raising tax provisions.  For example, we would welcome the opportunity to discuss our concern that codifying the "economic substance" judicial doctrine would inhibit legitimate and necessary business transactions and may actually reduce the courts’ ability to deal with abusive tax schemes.  In addition, we are troubled by reports that recent liberalizations of U.S. international tax rules could be repealed, and would welcome the opportunity to describe the positive impact of these changes on global competitiveness and job creation. 

 

Should you have any questions or concerns about these comments, please contact Mark Prysock at FEI.  He can be reached at 202-626-7804.

 

 

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