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IRS Releases Preliminary Guidance on Certain Aspects of the Amended Section 162(m) Provisions

The Internal Revenue Service has published Notice 2018-68 (the “Notice”), which provides long awaited, but limited guidance on the recent amendments to Section 162(m) of the Internal Revenue Code (“Section 162(m)”) by the Tax Cuts and Jobs Act of 2017 (the “TCJA”). Specifically, the Notice provides guidance regarding the identification of a “covered employee” and the grandfathering rules governing written and binding arrangements in effect on November 2, 2017. The Notice applies to any taxable year ending on or after September 10, 2018. This post summarizes the key points of the Notice and the likely impact of the Notice on publicly held corporations.

Background. Section 162(m) limits the deductibility of remuneration to “covered employees” of certain publicly held corporations to the extent the remuneration for a taxable year exceeds $1 million. The TCJA made significant changes to Section 162(m) as follows: (1) expanded the definition of covered employees; (2) expanded the definition of “publicly held corporations” subject to Section 162(m); (3) eliminated exceptions to the Section 162(m) deduction limitations for commission and qualified performance-based compensation; and (4) established transition rules for certain outstanding arrangements (i.e., grandfathering rules). The TCJA applies to taxable years beginning on or after January 1, 2018. For more information on the TCJA’s amendments to Section 162(m), please see Proskauer’s previous post related to the passage of the TCJA.

Covered Employees. Amended Section 162(m) provides that the term “covered employee” includes (1) any employee who was the principal executive officer (“PEO”) or principal financial officer (“PFO”) of the publicly held corporation any time during the taxable year and (2) any employee whose total compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the three highest compensated officers for the taxable year (other than the PEO or PFO).     The Notice provides that officers do not need to be serving with the publicly held corporation at the end of the taxable year in order to be covered employees.

The Notice further clarifies that executives may be covered employees if their compensation is not required to be disclosed by the applicable publicly held corporation even under the Securities and Exchange Commission (the “SEC”) rules. For example, covered employees of smaller reporting companies and emerging growth companies are determined in the same manner as other publicly held corporations, regardless of whether the disclosure of their compensation is required under the less expansive disclosure requirements applicable to such companies under the SEC rules.

Based on the Notice, there may be a difference between the executives reported on a publicly held corporation’s summary compensation table and the executives who are treated as covered employees for purposes of Section 162(m). Publicly held corporations should separately identify and track their covered employees for Section 162(m) purposes.

Grandfathering Rules. The amendments made to Section 162(m) by the TCJA do not apply to remuneration payable under a written binding contract which was in effect on, and not materially modified after, November 2, 2017. A contract is considered binding only to the extent that a corporation is obligated under applicable law (e.g., state contract law) to pay the remuneration if the employee performs services or satisfies any applicable vesting conditions.

            Renewal. A contract that is terminable or cancelable by the corporation without the consent of the employee is not grandfathered under the rules. In addition, contracts that are renewed after November 2, 2017 are not grandfathered under the rules, unless that renewal is in the sole discretion of the employee. However, the Notice provides that a contract is not considered terminable or cancelable by the corporation if it can be terminated or canceled only by terminating the employment of the employee.

            Negative discretion. One of the areas of guidance most awaited by practitioners was whether negative discretion on the part of the corporation to reduce or eliminate compensation otherwise payable pursuant to an otherwise grandfathered contract affected the grandfathering provisions under the TCJA. The Notice contains several examples that illustrate the guidance. While the body of the Notice does not directly address the effect of negative discretion on grandfathering, one of the key examples (Example 3 under Material Modification) illustrates the effect. The example implies that the ability of a corporation to exercise discretion to reduce the amount payable to a covered employee eliminates grandfathering for the amount the corporation had the ability to reduce.   In the example, a PEO participates in a bonus plan that would otherwise be qualified performance-based compensation before the TCJA amendments. The example provides that the amount that is not subject to negative discretion by the corporation is grandfathered. The remainder of the bonus in the example is subject to the Section 162(m) limitations even though the bonus is otherwise earned under the terms of the bonus plan and negative discretion is not exercised by the corporation.

            Material modification. If a written binding contract is materially modified after November 2, 2017, it is treated as a new contract. The Notice provides that a modification that increases compensation above a reasonable cost of living increase is generally considered material. Likewise, accelerations of compensation may be viewed as material unless the accelerated amount is discounted to reflect the time value of money. Deferrals of compensation are not material modifications if the increase (or decrease) in the amount deferred is based on a reasonable rate of interest or a predetermined actual investment (although actual investment is not required).

            Supplemental Payments. An agreement to provide increased or additional compensation is treated as a material modification of the underlying contract if the facts and circumstances demonstrate that the increased or additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the contract. For example, an increase in an executive’s base salary that is higher than provided in the executive’s employment contract (and greater than a cost of living increase) would be viewed as a material modification to the employment contract.

Further requests for comment. Further guidance on Section 162(m) is expected from the Treasury Department and the IRS.   In particular, the Notice did not address and the Treasury Department and IRS requested further comment on the application of Section 162(m) to newly public corporations.[1]




[1] Presently, Section 162(m) provides relief for newly public corporations whereby, generally, compensation paid (and, in certain limited cases, equity-linked compensation granted) during a limited period following the corporation’s initial public offering pursuant to a plan or agreement that exists prior to the corporation becoming public, and that is disclosed in connection with the initial public offering of the corporation’s securities, is not subject to the deduction limitation of Section 162(m).

State Tax Law Updates

A number of states have recently proposed or passed new laws related to state-level taxation, some of which are taxpayer-friendly and some of which are expected to impose additional tax burdens on taxpayers. They vary in subject from efforts by states to mitigate the new federal limitation on the deductibility of state and local taxes to proposed changes to state income taxation of “carried interest.” This update reflects some of those recent proposals and laws.

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Finance Bill 2019 – Proposed relaxation of entrepreneurs’ relief rules

The proposed amendment to entrepreneurs’ relief (“ER”) in Finance Bill 2019 is designed to address one of the outstanding issues with the current law when dilution of a company results in the loss of ER. Under the current rules, a shareholder who has held, for at least 12 months prior to disposal, at least 5% of both the ordinary shares and 5% of the voting rights in a trading company (or holding company of a trading group) and is also an officer or employee of the relevant company can benefit from a lower rate of capital gains tax (10%) on the chargeable gain at time of disposal.

However, an issue of new shares, usually upon a new investment into the company, can reduce an individual’s percentage shareholding below the required 5% holding threshold. If this occurs, the individual would lose any ER completely, even in respect of the gain which accrued when the required threshold was satisfied. This consequence has been seen as a barrier to growth for companies.

The proposed amendment will allow individuals, where an issue of shares will lower their holding below the 5% threshold, to elect to crystallise a gain by deeming a disposal and reacquisition of their shares or securities at market value immediately before an issue of shares. Any gain that has accrued up until that point will still qualify for the lower, 10% rate of capital gains tax. The individual can also elect to carry forward the gain, retaining the 10% ER rate, to a time when the individual actually sells the shares to avoid a dry tax charge. Further gains which accrue after the issue of shares will be taxed at the standard 20% CGT rate.

The new proposals will only apply where the share issue which creates the dilution is made wholly in cash, for genuine commercial reasons and not to secure a tax advantage. The new rules will apply for share issues which occur on or after 6 April 2019.

UK Finance Bill 2019 published – UK commercial property tax regime for non-resident investors to change, but some relief for trading businesses

On 6 July 2018 the UK Finance Bill 2019 was published by the UK Government. The draft Finance Bill contains the details of the new regime on taxation of non-UK resident investors in UK real estate that had been proposed in a consultation by HMRC following the November 2017 Budget (see Proskauer Tax Talks blog entry of 22 November, here). The rules will come into force on 6 April 2019 and, for the first time, the charge to UK capital gains tax will be extended to include gains made by non-UK investors in UK commercial property and in certain “property-rich” vehicles.

In general, the structure of the new regime will be as proposed in the November consultation with a few amendments. One of the key changes from the consultation is the inclusion in the draft legislation of an exception from the scope of the new charge for trading entities (described in more detail below).

Alongside direct disposals of UK land, disposals of “property-rich” assets will be caught by the new legislation (such as shares in a company) that derive at least 75% of their value from UK land. Where a number of companies or other entities are disposed of in a single arrangement, the assets of all of the entities will be aggregated in order to establish whether this 75% test is satisfied. Indirect disposals will be within the charge to tax where the investor holds at the date of the disposal, or has held within two years prior to disposal, a 25% or more interest in a property-rich asset (either directly or through a series of entities). This test has been relaxed from the consultation, as the draft Finance Bill reduces the look-back period from five years to two, and includes an additional exception allowing an investor to disregard a holding of 25% or more during the two years prior to a disposal if the holding was only greater than 25% for an insignificant proportion of the total length of the holding period.

Under the revised proposals in the Finance Bill, an offshore investor will be exempt from UK tax on any gain on disposal of a property-rich company if the investor can reasonably conclude that the underlying UK land is, to all but an insignificant extent, used in the course of a trade carried on by the company or a person connected to the company. The trade must have been ongoing for 12 months prior to the disposal, and must be expected to continue. How this exemption will be applied in practice remains to be seen, but this could be an important development for investors in companies carrying on UK businesses such as hotels and some retail businesses.

The rebasing rules as proposed in the consultation have also been relaxed in the draft Finance Bill:

  • Investors will now be able to rebase their holding in indirect assets to April 2019 market value – this is something that had been lobbied for by the industry and is a helpful change. Previously rebasing was only going to be possible for direct disposals of UK property.
  • Non-UK resident companies which become UK resident after April 2019 will also now be able to elect to rebase to the April 2019 value.

Disappointingly, the application of the new law to collective investment vehicles, in particular real estate funds, will be the subject of further consultation by HMRC.

Digital Economy: Supreme Court Overturns Physical Presence Requirement for State Sales Tax

In a landmark decision changing course on decades of precedent, the United States Supreme Court decided on June 21, 2018 South Dakota v. Wayfair, Inc., et al. Justice Kennedy, writing for the Court’s 5-4 majority, expressly overruled the physical presence rule established over fifty years ago in Bellas Hess[1] and affirmed over twenty-five years ago in Quill,[2] which prohibited states from collecting sales tax from online vendors lacking an in-state physical presence. While the Court stopped short of formally declaring the South Dakota tax statute constitutional, instead remanding the case to the South Dakota Supreme Court to resolve any other potential arguments under the Court’s “dormant Commerce Clause”[3] jurisprudence and under other existing case law,[4] the case strongly supports the view that the physical presence rule in Quill inadequately addressed the realities of the digital economy and its effects on interstate competition and state tax revenues.

Even under Quill, many states had passed a variety of measures aimed at recouping tax revenue from the expanding digital economy. These measures intended to capture sales and use tax revenue that had been lost from declining sales at brick-and-mortar retailers—where the right of a state to impose sales tax (regardless of the residence of the purchaser) is in no doubt. Wayfair is widely expected to be taken as a go-ahead for other states to adopt laws based on South Dakota’s model statute (likely with an eye to the details noted in the Court’s opinion). As a result, many internet-trade companies, especially smaller retailers, may face significant burdens in complying with the differing tax regimes of thousands of state and local jurisdictions.

The Majority Opinion’s Reasoning

The Court’s majority opinion declared that Quill was “unsound and incorrect.”[5] The physical presence rule was 1) not a necessary interpretation of the Complete Auto substantial nexus requirement; 2) created rather than resolved market distortions; and 3) imposed an “arbitrary, formalistic distinction” of the type rejected by the Court’s modern dormant Commerce Clause precedents. In addition, the Court noted that the physical presence rule was “an extraordinary imposition by the Judiciary on States’ authority to collect taxes and perform critical public functions.”

Throughout its opinion, the Court explained how the expansion of e-commerce had changed economic realities. Quill was decided prior to the Internet revolution, which exacerbated its shortcomings. As a result, the Court said, Quill “increased the revenue shortfall faced by States seeking to collect their sales and use taxes” and “put both local businesses and many interstate businesses with physical presence at a competitive disadvantage.”

The Future of Taxation of Interstate E-Commerce

As noted, though the Wayfair decision overturned Quill’s physical presence standard, it left open the possibility of challenging state taxes on other grounds under existing general dormant Commerce Clause jurisprudence. As a result, the statute, upon remand (and any similar tax statutes passed by other states) generally will be subject to the four-pronged test from Complete Auto[6]. According to Complete Auto, state taxes are valid under the Court’s dormant Commerce Clause jurisprudence so long as they 1) apply to an activity with a substantial nexus with the taxing state; 2) are fairly apportioned; 3) do not discriminate against interstate commerce; and 4) are fairly related to the services the state provides.

Applying the first element to South Dakota’s statute, the Court stated that the nexus was “clearly sufficient” because the sellers’ significant quantity of business could not have occurred unless they had availed themselves of “the substantial privilege of carrying on business in South Dakota.”

The Court suggested, without deciding, that several limitations in South Dakota’s statute would satisfy the second and third elements of the Complete Auto test. First, the law protected small retailers by setting a threshold requiring tax collection only from online vendors who conducted more than 200 separate in-state transactions or had annual in-state sales exceeding $100,000. Second, the obligation to collect tax did not apply retroactively. Third, South Dakota is one of more than 20 states that has adopted the Streamlined Sales and Use Tax Agreement, which reduces the administrative costs of compliance for retailers.

While states are widely expected to model legislation on the South Dakota statute, it remains to be seen just what modifications they will make, especially given the wide disparities between existing state tax regimes. States may attempt to lower the economic thresholds, even though they already provide scant protection in large states, such as California. Nor did the Court provide a clear answer on whether a retroactive statute would be unconstitutional. Finally, as acknowledged in the majority opinion, Congress may choose to resolve these remaining issues by taking action.

Please contact any of the authors listed here or any other Proskauer tax attorney with whom you normally consult to discuss the implications of Wayfair in your particular circumstances.

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The substantial assistance of summer law clerk Scott Tan in preparing this post is gratefully acknowledged by the authors.


[1] National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753 (1967).

[2] Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

[3] U.S. Const. Article 1, Section 8, Clause 3.

[4] Specifically, the opinion remanded for consideration of the other prongs of the four-pronged test of Complete Auto Transit, Inc. v Brady, 430 U.S. 274 (1977). The first prong, requiring a substantial nexus, was the prong at issue in Quill and Wayfair.

[5] As noted, the Opinion of the Court was written by Justice Kennedy and joined by Justices Thomas, Ginsburg, Alito and Gorsuch. Importantly, Chief Justice Roberts’s dissent (joined by Justices Breyer, Kagan and Sotomayor) takes little to no issue with the majority view that Bellas Hass and Quill were likely wrongly decided, but disagrees with the decision of the majority to overrule those decisions and would instead have put the issue squarely on Congress, where a number of bills to reach this result have been proposed over the years with no success.

[6] Complete Auto Transit, Inc. v Brady 430 U.S. 274 (1977).