The BNA Tax and Accounting Center is the only planning resource to offer expert analysis and practice tools from the world's leading tax and accounting authorities along with the rest of the tax...
By Scott P. Spector, Esq., and Elizabeth A. Gartland, Esq.
On August 5, 2015, the Securities and Exchange Commission (the "SEC") voted 3-2 to adopt the final "pay ratio" disclosure rule. This long-awaited, controversial rule is issued pursuant to §953(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, close to five years after its enactment. The pay ratio rule requires disclosure of the reporting company's CEO's annual total compensation, the median annual total compensation of substantially all employees other than the CEO and the ratio between the two amounts. The final pay ratio rule is similar to the proposed rule, with certain changes intended to alleviate compliance costs and to provide companies with additional time to prepare for the disclosure.
Highlights of Final Pay Ratio Rule
All reporting companies (with a few exceptions discussed below) are required to disclose for fiscal years beginning on or after January 1, 2017:
General Compliance Date
Reporting companies are required to report the pay ratio disclosure for their first fiscal year beginning on or after January 1, 2017. For calendar year companies, this means that the first pay ratio disclosure (relating to compensation paid in 2017) will be made in the 2018 proxy season.
Exceptions to General Compliance Date
Two key exceptions to the general compliance date are:
Steps for Calculating the Pay Ratio
1. Identify the Employee Population
A company must first identify the employee population out of which it will determine the median annual total compensation. The final pay ratio rule requires that a company consider the annual total compensation of all of its employees (other than the CEO), including worldwide full-time, part-time, temporary and seasonal workers employed by the company and its "consolidated subsidiaries." However, a company may exclude independent contractors and "contract workers" employed by an unaffiliated third party, though to do so, the company must not be able to determine the worker's compensation. This suggests that a company would be required to include an independent contractor that is retained directly by the company, rather than through a third party (we assume that this will be the subject of many comments). The employee population may be determined and measured as of any date within the last three months of a company's fiscal year. Note, however, that if the date changes year over year, a company will need describe the rationale for the change.
The final rule provides two important exemptions from the employee population for non-U.S. employees:
Data Privacy Exemption. A company may exclude non-U.S. employees in a jurisdiction where employee data privacy laws would preclude the company from complying with the pay ratio rule.
To rely upon the Data Privacy Exemption, a company would need to exclude all employees in that jurisdiction. A company would also need to demonstrate that it used reasonable efforts in its attempts to comply with the pay ratio rule, which include seeking an exemption from the foreign country's privacy law. The company would be required to obtain (and file) a legal opinion regarding its inability to comply with the rule and disclose its rationale for relying upon the exemption, the excluded jurisdiction and the number of employees excluded.
De Minimis Exemption. If non-U.S. employees comprise 5% or less of all of a company's employees, all of the non-U.S. employees may be excluded. To use this exemption, however, the company must exclude all of its non-U.S. employees.
Pursuant to the De Minimis Exemption, if non-U.S. employees comprise more than 5% of all of a company's employees, a company may exclude up to 5% of all of its employees that are non-U.S. employees. However, to rely upon the De Minimis Exemption, a company would need to exclude all employees from any excluded jurisdiction (it cannot pick and choose employees to exclude within a jurisdiction). This means that if a jurisdiction accounts for more than 5% of the company's total employees, employees of that jurisdiction cannot be excluded (unless they can be excluded by the Data Privacy Exemption). Also, any employees excluded by the Data Privacy Exemption would count towards the 5%. Thus, employees excluded by the Data Privacy Exemption are not subject to the 5% cap, but if the 5% cap is met by employees excluded by the Data Privacy Exemption, no additional non-U.S. employees may be excluded.
For example, if a company has employees in the U.S. (84% of total), France (12% of total) and Canada (4% of total), the company could exclude all Canadian employees under the De Minimis Exemption and no French employees under the De Minimis Exemption (it could not exclude only the 1% comprised of French employees). If, however, the company could exclude the French employees under the Data Privacy Exemption, it could exclude all French employees under such exemption. In this case, it would not be able to exclude any Canadian employees because the French employees (representing 12% of total employees) would be counted toward the De Minimis Exemption and the company would have surpassed its 5% maximum.
The company would need to disclose the exemption, the excluded jurisdictions, the number of employees excluded from the employee population, and the total number of its U.S. and non-U.S. employees.
Also, a company may exclude employees that become employees as a result of an acquisition for the fiscal year in which the acquisition occurs. Such employees must be included in future years. The company would need to disclose the exemption and the number of employees excluded from the employee population.
2. Identify the Median Employee
General Methodology for Identification. After identifying the employee population, a company must next identify the employee with the median total annual compensation from within the employee population. To do so, a company may establish a methodology based on its own facts and circumstances, including using the entire population, a statistical sampling or other reasonable methods. A company may use either total compensation as determined in accordance with Item 402(c)(x) of Regulation S-K (the requirements of the Summary Compensation Table) or any other measure that is consistently applied (for example, pay roll or tax records). In doing so, a company may use cost of living adjustments, but if so, the company must use it to both identify the median employee as well calculate such employee's compensation. A company may also annualize the compensation of permanent full-time or part-time employees who are not employed for the full fiscal year, but a company may not annualize the compensation of temporary or seasonal workers even when compensation is annualized for other employees. Each method used must be disclosed.
Timing of Identification. A company need only identify the median employee once every three years unless there are changes to the company's employee population or compensation that would reasonably result in a significant change. Importantly, even though the median employee need only be identified once every three years, the annual total compensation of such median employee must be calculated each year based on such employee's total annual compensation for each of the three years. The final rule provides flexibility to substitute a similar employee in the event the previously identified median employee ceases to be employed or has a significant compensation change. For example, if a company identifies the median employee in year one and such employee is no longer employed by the company in year two or such employee gets a large promotion in year two, the company can substitute a new median employee that had similar compensation to the median employee in year one.
3. Calculate Annual Total Compensation
After both the employee population and the median employee are identified, a company must calculate the annual total compensation of the median employee and its CEO for the applicable fiscal year. The annual total compensation of each must be determined in accordance with Item 402(c)(2)(x) of Regulation S-K. A company may use reasonable estimates (with disclosure) as needed.
4. Disclosure & Filings
The pay ratio may be disclosed as a numerical ratio in which the compensation of the median employee is one (CEO to median employee = XXX to 1). Alternatively, it may be disclosed narratively (the CEO's annual compensation is XXX times the median employee's annual compensation). An example from the final rules states that if the median total annual compensation is $50,000 and the CEO's total annual compensation is $2,500,000, the disclosure can be made only in one of the following two ways:
As described above, a company must also describe the methods used to identify the employee population, the median employee and calculate the annual total compensation, including any material assumptions or estimates. Likewise, a company will need to disclose any material change from the methodology, assumptions or estimates used in prior years.
A company may, but is not required to, supplement its pay ratio disclosure with narrative description or additional ratios. In both cases, the supplemental disclosure must be clearly identified, not misleading and not more prominent than the required ratio disclosure.
The pay ratio disclosure for the most recently completed fiscal year must be made no later than 120 days after the end of such fiscal year. The disclosure is required to be "filed" (rather than "furnished") in annual reports on Form 10-K, registration statements and proxy and information statements when these filings require executive compensation disclosure under Item 402(c)(2)(x) of Regulation S-K. As discussed above, newly public companies have a transition period before they are required to provide the pay ratio disclosure, so the pay ratio disclosure is not required in Form S-1, Form S-11 or Form 10.
We note that there has been vocal dissent to the final pay ratio rule. Likewise, Congress has introduced legislation to repeal §953(b) of the Dodd-Frank Act, which mandates the pay ratio rule. However, we recommend companies begin preparing to comply with the rule and suggest companies consider the following next steps.
The SEC's Fact Sheet describing the final rules can be found here.
The SEC release of the final rules can be found here.
For more information, in the Tax Management Portfolios, see Maldonado and Daley, 362 T.M., Securities Law Aspects of Employee Benefit Plans.
©2015 Fenwick & West LLP. All Rights Reserved.
The views expressed in this publication are solely those of the author, and do not necessarily reflect the views of Fenwick & West LLP or its clients. The content of the publication ("content") should not be regarded as advertising, solicitation, legal advice or any other advice on any particular matter. The publication of any content is not intended to create and does not constitute an attorney-client relationship between you and Fenwick & West LLP. You should not act or refrain from acting on the basis of any content included in the publication without seeking the appropriate legal or professional advice on the particular facts and circumstances at issue.
IRS Circular 230 disclosure: to ensure compliance with requirements imposed by the IRS, Fenwick & West LLP informs you that any U.S. federal tax advice in this communication (including attachments) is not intended or written by Fenwick & West LLP to be used, and cannot be used, for the purpose of (i) avoiding penalties under the internal revenue code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
Copyright©2015 by The Bureau of National Affairs, Inc.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to firstname.lastname@example.org.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to email@example.com.
Put me on standing order
Notify me when new releases are available (no standing order will be created)