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Improving executive incentive compensation plan efficiency

With the global economic crisis still in the news, executive compensation remains a hot topic of discussion. Many corporations spend more than necessary to deliver net incentive dollars to their executives. At the same time, these organizations often tie up tens of millions of dollars more than necessary in hedging equity-based compensation obligations.

Currently, share unit plans are designed in such a way that all income eventually paid to participants (whether in respect of value existing at the time of grant or that which accrues as a result of post-grant increases in share price) is taxed at regular employment income rates. This applies to restricted share units (RSUs), performance share units (PSUs), deferred share units (DSUs) or combinations thereof. In Ontario, for example, this would generally translate into taxation at the top marginal rate of 46.21%. There is a design modification available, a hybrid approach (hybrid) that reduces the tax rate in respect of increases in the unit value to half that of current levels1.

The benefit of this increase in tax efficiency can deliver substantial cash savings to the corporation without reducing the net payout under the plan to the executives. It can also deliver a greater net benefit at a reduced cash cost. Furthermore, if the plan obligation is hedged, as many are, this results in the ability to release up to 30% of assets held in the hedge pool. With broader-based plans, this can mean the release of tens of millions of dollars into working capital or debt retirement.

All of this can be accomplished without modifying the existing incentive structure, corporate tax deductibility or accounting treatment while delivering the same or a greater net benefit to the plan participants.

The hybrid involves two features:

  • Capping all share units at today’s depressed share values (the payout value of a capped share unit can only reflect any decrease in the value of the underlying share)
  • Pairing a percentage of those capped share units (CSUs) with tandem stock options2, designed to be eligible for the 50% deduction under the Income Tax Act (Canada).

This results in the entire benefit of all post-grant share price increases being captured within the tandem options rather than the share units, thereby reducing the tax rate in respect of that portion of the incentive compensation to half of what it would have otherwise been.

Conclusion

The increase in the use of share units as a key element of executive and senior management incentive compensation, coupled with current depressed share prices, gives rise to an excellent opportunity to significantly reduce the cost of paying and hedging share unit plan obligations. Such plans can be amended to use hybrids that reduce the tax rate applicable to post-amendment share unit value increases to half of what it would otherwise be with much or all of the benefit of that increased tax efficiency benefiting the corporation and its shareholders by way of decreased cash costs and increased working capital.

  1. In all provinces other than Quebec. The tax rate in respect of the Quebec portion of the taxes would be reduced by 25%
  2. A tandem option is a regular option paired with a cash-settled share appreciation right, which effectively offers the option holder the choice of exercising the option or accepting a cash payment equal to the intrinsic or “in-the-money” value of the option. Both forms of settlement are eligible for the 50% deduction allowed to the option holder in respect of the benefit under the Income Tax Act (Canada). If the option holder elects to receive the cash settlement, as is commonly the case, the cash payout is tax deductible to the corporation when made. From an accounting perspective, tandem options are treated as a cash liability, as are cash-settled share units, thereby resulting in the same accounting treatment in this respect as would have been the case had the cash-settled share units in their prior form not been modified.