Backdating Blamed on 1993 Tax Rule

Disturbed by the manipulation of option grants, Congress is toying with eliminating the $1 million tax cap on executive compensation.

Some Senators, along with SEC Chairman Christopher Cox, are placing some of blame for the stock-options-backdating scandal on a tax law more than 10 years old. Congress is considering whether to repeal the law, which limits the tax deductibility of top executives’ cash compensation to $1 million.

At a Senate Banking Committee hearing on Wednesday, Cox and Public Company Accounting Oversight Board Chairman Mark Olson contended that federal tax code Section 162(m) unintentionally sparked a trend in the mid-1990s for companies to get more creative with incentives for their executives. A popular way to circumvent a tax penalty on executives’ compensation has been to offer stock options, which aren’t restricted under the tax code sections if the options are granted at fair market value. That has led some companies— more than 100 of which are under investigation by the SEC—to boost individual profits and executive pay by changing the date a stock-option was granted or exercised.

“One of the most significant reasons that non-salary forms of compensation have ballooned since the early 1990s is the $1 million legislative cap on salaries for certain top public company executives that was added to the Internal Revenue Code in 1993,” Cox testified.

At a separate Senate hearing on backdating on Wednesday, the discussion about executive compensation went beyond looking into changing a 1993 tax law. The Senate Finance Committee talked about whether to give CFOs, as well as top corporate attorneys and board chairs, a fixed salary and ban performance-based compensation for them.

Still, the senators at that meeting did point fingers at the tax code section, which Sen. Charles Grassley (R-Iowa) considers “broken” and full of holes. “[It] seems to have encouraged the options industry,” he said.

During the Banking Committee hearing, Sen. Mike Crapo (R-Idaho) pressed Cox on whether Congress should put an end to the rule. But Cox, who was a member of Congress when the rule was enacted, demurred in sharing his personal take on the issue and said he would keep his response limited to the views of the SEC. The $1 million curb on deductibility is “unworkable,” he testified.

In his prepared remarks, Cox said that “for companies that wanted or needed to pay compensation in excess of $1 million per year, the tax code outlawed deducting it if it was paid in a straightforward way through salary, but permitted a deduction if the compensation was paid through at-the-money options.” (Such stock options are ones in which the exercise price is set as the market price of the stock on the grant date.)

While the law was intended to limit what the government considered the exorbitant salaries of corporate heads, companies’ actual response in turning to option grants should have been expected, Olson said.

Sen. Robert Bennett (R-Utah), went further, contending that the law moved corporations to manipulate stock options to maximize the pay of top executives. While he refrained from directly blaming the compensation tax deduction for the accounting scandals of four years ago, he said it did lead to companies finding “clever” ways to pad compensation packages—and that sometimes meant pushing stock options grants to a more advantageous time period.

The government should lift the limit on the compensation deductible, he said. “If a company wants to pay the CEO $5 million in cash, it should do so and be able to deduct it as a legitimate business expense. We in the Congress have created an unintentional way for people to cheat,” the senator added.

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