Do we need legislation to enable the clawback of executive remuneration?

Federal Government seeks submissions

In December 2010, the Federal Government asked interested parties (including Freehills) to make submissions to it in relation to its proposal to introduce legislation to clawback remuneration where financial statements have been materially misstated.

Bodies such as the Australian Institute of Company Directors strongly opposed the introduction of such legislation on the basis that it is ‘totally unwarranted, would add to existing red tape in an already cluttered area for little or no benefit, and increase the compliance costs incurred by a large number of companies.’

Summary of Freehills submissions

Freehills submissions may be summarised as follows:

1. To the extent the government decides to implement a clawback proposal, it should be included in the ASX’s Corporate Governance Principles and Recommendations rather than in legislation.
2. The Boards of a number of non-bank entities have agreed with executives to defer performance-based remuneration for an extended period (including after cessation of the relevant executive’s employment on the basis that this constitutes ‘best practice’ in this area). In some cases this determination has been made as a consequence of APRA’s guidelines relating to executive remuneration.
3. To incentivise companies to comply with best practice and defer remuneration for an extended period, the government should amend the taxation legislation relating to employee share schemes and provide for the taxing point to be on the date the equity vests in all cases, rather than the date on which the relevant employee’s employment ends (or sooner), as recommended by the Productivity Commission’s report, ‘Executive Remuneration in Australia’ (released 4 January 2010).

Benefits of deferring performance-based remuneration

Since the implementation of APRA’s guidelines in relation to executive remuneration, Freehills has noticed a shift by companies (even if they are not APRA regulated), towards requiring senior executives’ remuneration to include a significant deferred component that remains ‘at risk’ even after cessation of employment.

Freehills suggests that this may be due to a combination of:

1. a view that executives’ ‘at risk’ remuneration should be based on the long-term performance of the company given the experience during the GFC
2. the introduction of the new termination benefits legislation from 24 November 2009 (which excludes a ‘deferred bonus’ from the definition of a termination benefit which may require shareholder approval), and/or
3. the effective payment for post employment restraints on conduct such as non-compete obligations.

Amend employee share scheme legislation

Freehills considers that in order to encourage companies to implement deferred compensation as part of senior executives’ remuneration packages, the government should consider amending the taxation legislation relating to employee share schemes so that the taxing point is the date the equity vests and becomes available for employees, rather than the date on which an employee’s employment ends, or earlier.

This change would reflect recommendation 13 of the Productivity Commission’s report, Executive Remuneration in Australia (released 4 January 2010) which states:

The Australian Government should make legislative changes to remove the cessation of employment trigger for taxation of equity or rights that qualify for tax deferral and are subject to risk of forfeiture. These equity-based payments should be taxed at the earliest of: the point at which ownership of, and free title to, the shares or rights is transferred to the employee, or seven years after the employee acquires the shares.

Until such amendments are made, senior executives are likely to continue to seek:

1. higher base salaries
2. structures driven by tax deferral (which may distort the structure of the incentive itself), and
3. other fixed benefits,

in order for them to meet early tax liabilities which will arise on termination of their employment (or earlier) and often regardless of whether the ultimate benefit is actually received.

Removing the cessation of employment taxing point for employee equity awards:

• will enable companies to align executive and shareholder interests in the period up to and beyond cessation of employment (where incentive plan participants are permitted to retain their awards post-termination)
• would prevent potentially significant cash flow implications for employees who are taxed at cessation before awards vest, and
• would be consistent with the taxation rules in the majority of Australia’s international trading partners.

We understand that the potential impact on Federal tax revenue of removing the termination taxing point for equity awards would be a short-term timing issue only. Indeed, deferring the taxing point until awards vest could result in absolute tax revenue increasing, since it will result in a greater portion of the benefit being taxed as income (at marginal tax rates), rather than as a concessionally treated capital gain (which is potentially the case under the current rules).

This article was written by Justine Turnbull, Partner and Michael Gonski, Solicitor, Sydney.

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