Tax Structuring Executive Compensation Plans on Income Trust Conversions

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Episode 17: Tax Structuring Executive Compensation Plans on Income Trust Conversions

Release date: March 30, 2010
Running time: 8:51 minutes

Tax directors and company executives face significant challenges when structuring executive compensation arrangements, particularly from a tax perspective. In this podcast, we discuss challenges stemming from converting income trust structures to corporate structures, and the need to revisit tax structuring even if compensation arrangements are already in place.

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Tax Structuring Executive Compensation Plans on Income Trust Conversions

You're listening to another episode of PwC's Tax Tracks at www.pwc.com/ca/taxtracks. This series looks at the most pressing technical and management issues affecting today's busiest tax directors.

Gerry Lewandowski: Here with us today is Rick Schubert, a senior member of PwC Canada’s human resource services tax practice based in Toronto and a specialist in tax structuring and accounting for executive compensation plans. Rick has been with PwC Canada for many years and provides Canadian executive compensation tax planning and accounting services to businesses of all sizes and in all industries. Rick is with us today to discuss some of the challenges that tax directors and company executives may face when dealing with the tax structuring associated with executive compensation plans when income trust structures are converted to corporate structures.

Thanks for joining us Rick.

Rick: You're most welcome.

Gerry: Rick, we know that by the end of 2010 all income trust structures will have to be converted to corporate or other structures and that in fact many already have been converted.  What are the implications for equity compensation plans of these conversions?

Rick: Well, I think we have to start by looking at what the key issues are for the income trusts that are converting themselves. Probably the biggest issue is sustainability of the income distribution. There are quite a few different plans, if you will, for post conversion.

Some companies are planning on maintaining their income distribution at its former level, some are planning on having a substantial cut that, when received by a Canadian tax paying recipient in the form of dividends on a net basis, would be about the same and some are planning on much larger cuts than that and repositioning themselves as growth companies.

So one has to look at what the strategy of the individual income trust is in order to determine what the structure of the executive compensation equity comp plan should be. The two obviously have to be in accord. We want to align the interest of the executives with the interests of the new corporation.

Those that are planning on maintaining their distributions at their former levels are often using a LossCo type of strategy. It may be a little more difficult given the recent federal budget which proposes to expand the current acquisition of control rules of reverse takeovers to ensure that the rules apply to situations where the units of a SIFT or partnership are exchanged for shares. Pursuing a LossCo strategy may be more difficult post-budget.

Gerry: I understand that in many cases, businesses that have converted or will be converting their income trust structures are working with traditional compensation advisors in structuring their executive compensation plans going forward.  So why is it necessary to get your team involved in looking at these plans?

Rick: The role of the traditional compensation advisor is generally to benchmark the plans, determine how much the executives should make, and what the performance metrics should be… this type of thing. Our role is to ensure that all of the tax and accounting aspects of the equity compensation design are as advantageous as possible to both the corporation and to the plan participants.

We try to maximize the tax efficiency of the delivery of the benefit and minimize the cost of delivering that benefit, simply put, to the corporation.

Gerry: So what are some of the challenges from a tax perspective that must be considered in structuring an executive compensation plan on an income trust conversion?

Rick: Well, in terms of tax, the key aspect to my thinking is the change from distributions as an income trust to dividends under a share based corporation scenario.

The tax situation for dividends is quite different from that of distributions. And one of the consequences of the difference in the tax treatment of distributions versus dividends is that if I run dividends through an employee benefit plan and many of these equity based compensation structures do that (or the traditional ones do that) I lose all of the advantage of the tax assistance that is given to dividends by way of the dividend gross up. And that’s huge. In a lot of provinces that effectively reduces that tax rate to half. In some provinces it is even substantially less that half of the regular tax rate that an employee would pay.

So there is a huge loss of tax efficiency by using what the conventional employee benefit plan structure, using you know a, share unit, traditional share unit structures on these. Distributions didn’t matter. They were neutral. They would be fully taxed anyway so it didn’t matter what structure you put them through.

Gerry: In addition, what are some of the challenges from an accounting perspective that must be considered?

Rick: Well, executives of income tax trusts have to ask themselves whether their shareholders will have heightened sensitivity to increases in financial statement volatility, for example, that might be caused by the impact of cash settled equity compensation design in stormy share markets.

The profile of shareholders themselves of the equity holders may change. One, for example, if I have alot of tax exempt shareholders right now, they may choose to sell their interests and more on because they will not get the advantage of the tax assistance that dividends have. So for them, that’s just a straight cut.

So, I could end up with a fairly different collection of shareholders who have markedly different interests and sensitivities. Also will there be significant capital have to be tied up in hedging the obligations of the plan, access to capital is probably going to be tighter than it used to be in they hey day of income trusts. Are there ways of dampening volatility without creating a demand for huge hedges? Will I have a heightened sensitivity to diluted EPS under the new structure and with respect to new shareholders? So there are a lot of accounting issues that arise as well.

Gerry: And finally Rick, please tell us about the executive compensation team you work with at PwC. How can they help companies looking for a second set of eyes on their existing or future compensation planning?

Rick: Well, our approach is to lead with our strengths. We’re tax specialists. We’re accounting specialists and our team is composed of people who specialize in those areas in respect of equity based compensation. That’s our single focus and we work as an integrated cross-disciplinary team that seamlessly unites the analysis of both the tax and the accounting consequences of plan design. Consequently, the people on the team are people, with for example, law degrees, CA designations, CPA designations. We have a basket of skill sets that suit that multi-disciplinary approach.

Gerry: Thank you Rick for your perspective on the impact income trusts converted to corporate structures will have on equity compensation plans. For additional information around reward and compensation, please visit our Human Resource Services web page at pwc.com/ca/hrs.

Thank you for tuning into Tax Tracks at www.pwc.com/ca/taxtracks.

The information in this podcast is provided with the understanding that the authors and publishers are not herein engaged in rendering legal, accounting, tax or other professional advice or services. The audience should discuss with professional advisors how the information may apply to their specific situation.

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Through interviews with prominent PwC tax subject matter professionals, Tax Tracks is an audio podcast series that is designed to bring succinct commentary on tax technical, policy and administrative issues that provides busy tax directors information they require.