The “Tax Cut and Jobs Act” imposes significant reforms to the tax code that will impact households, businesses – and CEO bonuses. In particular, the act’s ramifications may roll back executive compensation practices that have developed over the years in relation to the existing $1 million threshold under Internal Revenue Code Section 162(m).

Tax Benefits under Section 162(m) of the Internal Revenue Code in its present status

As it currently stands, Section 162(m) grants companies tax deductions for qualified performance-based compensation in excess of $1 million for the CEO and the three-highest compensated NEOs of the Company, CFO excluded. In order to qualify, performance-based compensation must be subject to the achievement of specific objectives, rather than just a discretionary assessment of performance.

Currently, companies are also required to seek shareholder approval of the performance objectives under Section 162(m) through a vote that occurs every five years. This process provides shareholders with a greater say on the terms of equity plans that govern pay for executives and other employees, and promotes dialogue regarding both pay and strategy, ultimately enhancing the alignment of shareholder interest with the company.

Policies presently outlined in Section 162(m) have garnered robust shareholder support in 2017. On average, there has been 97.55% approval across 147 companies for proposals seeking the approval of material terms of performance goals under Section 162(m). The current system seems to work: companies receive tax benefits on high payouts, those payouts are aligned with performance goals, and shareholders get to weigh in – and are largely supportive in doing so.

However, that system is about to change.

The amendment to Section 162(m) repeals the tax benefit associated with the inclusion of performance-based compensation. While there is a level of uncertainty surrounding the short and long-term implications of the above amendment, it raises the question:

Will repealing 162(m) deductions lead to reduced use of performance-based incentives?

For companies that have yet to adopt performance-based pay, it’s likely that removing the tax deduction incentive from Section 162(m) of the Internal Revenue Code will slow the future migration towards performance-based programs. However, tax benefits attributed to Section 162(m) are not the only impetus for companies to adopt performance-based practices. Other performance-based compensation plans should not be overlooked, as executive pay tied to performance objectives has become common practice over the years. As such, a significant number of companies adopted performance-based incentive plans outside of Section 162(m).

From a different perspective, removing performance-based structure does not seem economical for companies that have already developed qualified performance-based pay programs under Section 162(m). As resources and time have already been invested in developing and implementing such compensation programs, it appears less likely that the amendment will drastically impact the compensation programs currently in place.

That said, some companies may move to a discretionary pay structure in response to the amendment. Rather than the degree to which specific, disclosed targets are achieved, payouts would simply reflect the board’s discretionary assessment, likely reducing transparency and making it difficult for shareholders to assess company pay practices. As performance-based pay serves as a vehicle for closer alignment between executive pay and company performance, it becomes imperative for shareholders to assess potential implications on executive compensation practices triggered by the amendment of Section 162(m).

Will amending 162(m) affect compensation levels of executives in the U.S.?

Without the deductions, payouts exceeding $1 million will get more costly for companies. Yet as compensation levels have stabilized over time, and companies constantly compete for talent, a significant decline in executive pay seems unlikely.

It is more likely that compensation that sits near the $1 million threshold will face greater impact from the amendment. Lowering compensation that is slightly above $1 million seems feasible without significant retention concerns arising. It would also save companies significant tax payments that would accrue under the amended Section 162(m).

Executives making slightly below $1 million may be in for a longer wait before receiving a raise that takes them above the threshold. In this scenario, a gap may arise between those compensated stuck below $1 million and those paid significantly higher than the threshold, widening compensation disparities.

How can shareholders voice their interest regarding executive compensation?

As noted, one of the benefits of the historical 162(m) structure has been dialogue arising from shareholder votes every five years on performance goals. While the amendment to Section 162(m) removes the opportunity for shareholders to (re-)approve the material terms of the performance goals, companies are still required to seek shareholder approval for other equity plans, and shareholders retain a range of other rights and opportunities to weigh in on executive pay, including the advisory say-on-pay vote. Moreover, the increased profile of say-on-pay and growing prevalence of engagement programs has yielded additional dialogue between companies and their owners, which should continue even without the quinquennial 162(m) votes.

Carolin is an analyst covering executive compensation in North America.