Tax Gross-Up
Recruiting Tool, or More Compensation?

By Angela Andrews, B. Anthony Billings, and Han Yi

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JULY 2008 - Exorbitant compensation packages received by CEOs of major companies have been the subject of considerable public debate. Not only are the media scrutinizing salaries and bonuses, they are also bringing attention to a little-known perquisite called the “tax gross-up,” which is the tax payment for a given perquisite, such as air travel. It is essentially a perk on a perk. (Some companies’ proxy statements refer to the tax gross-up as a tax reimbursement. For this article, the authors summed both categories to arrive at the final tax gross-up numbers.) For example, in 2004, Home Depot’s then–CEO Robert Nardelli was given an additional $3.3 million in compensation to cover his personal taxes on various perks, including family travel on the corporate jet and forgiveness of a personal loan.

The media suggest that the tax gross-up is another tool that compensation committees use to provide CEOs with additional compensation while hiding this fact from shareholders. The value of the tax gross-up may be disclosed in the footnotes if it exceeds a certain threshold, or it may be detailed in the executive’s employment agreement. The limited amount of detail and disclosure leaves both media and shareholders wondering whether the tax gross-up is just another attempt to hide additional compensation.

Managements generally maintain that the tax gross-up is a valuable tool for hiring and retaining talented executives. In 2005, a spokesman for Ryland Group of California suggested that tax gross-ups allow executives to hold a larger equity stake in the firm than they would be able to if they had to pay taxes on restricted stock grants. The increased equity stake leads to better alignment of the incentives of management with shareholders.

This article examines the extent to which Fortune 500 companies use tax gross-ups as a basis for determining whether new disclosure rules promulgated in 2006 affected their use as a component of CEO compensation. Changes in the disclosure rules effective for fiscal years on or after December 15, 2006, allow a glimpse of the extent to which the tax gross-up is used as compared to better-known perquisites. The article first discusses the changes in how perquisites must be disclosed, then examines the descriptive statistics of the Fortune 500 companies that are also S&P 1500 companies and whose proxy statements were released between January 1, 2007, and June 30, 2007. CPAs may want to consider the role tax gross-ups play in compensation plans and how their use should be presented to shareholders.

Increased Disclosure Required

Prior to the change in regulation for fiscal years on or after December 15, 2006, Item 402(b) of SEC Regulation S-K required that the value of perquisites be included in the “Other Annual Compensation” column of the Summary Compensation Table in the annual proxy statement if the aggregate exceeded the lesser of $50,000 or 10% of the executive’s total annual salary and bonus. For the type and amount of a perquisite to be described in a footnote or accompanying narrative, the individual perquisite had to exceed 25% of the total perks reported for the executive. This high threshold enabled many companies to disclose a number in the “Other Annual Compensation” column without a further individual breakdown for the type and amount of the individual perquisite provided. The opaqueness of the resulting disclosures had been debated by shareholder activists and the media to no avail until 2002, when corporate governance became a hot topic.

After the financial disasters that included Enron, Tyco, and WorldCom, public companies were under tremendous political pressure to hold executives more accountable for their actions. As a result of public hearings on Capitol Hill, the Sarbanes Oxley Act of 2002 (SOX; Public Law No. 107-204, 116 Stat. 745) was passed. This legislation addressed corporate governance but did little to address another concern that arose during the hearings: exorbitant pay packages for CEOs of failing companies. In an effort to at least provide shareholders with more transparent information concerning executive compensation, the SEC began to address the issue publicly.

In 2004, Allen Beller, director of the SEC’s Division of Corporation Finance, gave a speech that included several references to the disclosure of perquisites. Specifically, Beller mentioned the proper characterization of business expenses such as housing and the installation of home security systems. Beller also mentioned the need to disclose the use of company aircraft and automobiles for personal use. The general theme of the speech was that many companies present disclosures that do not provide adequate information to shareholders. To address this issue, the SEC issued regulations titled “Executive Compensation and Related Party Disclosure,” which became final on August 29, 2006, and applies to proxy statements submitted to the SEC on or after December 15, 2006.

The final rule lowered the threshold for the disclosure of perquisites to $10,000. If the aggregate exceeds $10,000, then the perquisite must be identified and disclosed in the footnotes. In addition, if the value of a perquisite is the greater of $25,000 or 10% of total perquisites, then its value must be disclosed. This new regulation provides an opportunity to quantify the extent of use and value of tax gross-ups. Comparisons to years prior to 2006 can be made only anecdotally, because of the change in the threshold required for reporting. Prior to 2006, the threshold for reporting was the lesser of $50,000 or 10% of the executive’s total salary and bonus.

Returning to the case of Home Depot, according to the footnotes of the compensation table in 2005, Nardelli did not receive any tax gross-ups. His successor, Francis Blake, who was the executive vice president in 2005, received $30,053 in tax gross-ups, which covered the taxes on the personal use of a corporate car and jet. In 2006, the first year that compensation had to be reported under the new disclosure rules (i.e., quantified in the compensation table), Blake, as the new CEO, received $70,218 in tax gross-ups; Nardelli received $305,355 in tax reimbursements to cover the use of the company airplane for personal use and company-provided security. The tax gross-ups received by both executives after the change in the disclosure rules seem modest in comparison to the $3.3 million that Nardelli received in 2004. Although this is only one example, it supports the media’s perception of tax gross-ups as a way to provide additional compensation.

The authors found, however, that in 2006—the first year after the rule change—three of the five executives who had the highest value of tax gross-ups were from one company: Oceaneering International. T. Jay Collins, the new CEO of Oceaneering, had the highest value of tax gross-ups in the authors’ sample. In 2006 he was promoted from chief operating officer to CEO. The $1,186,039 that he received in tax gross-ups was disclosed in the compensation table with an explanation that the payment was associated with the vesting of restricted stock and stock options. In addition, in 2005, the year before Collins’ promotion, his perquisites were not reported. According to the notes, the aggregate amount of his perquisites did not exceed the lesser of $50,000 or 10% of the total annual salary and bonus reported. In the case of all three executives at Oceaneering, the explanation reported in the notes to the compensation table supports the statements noted above by Ryland executives. As a result of using the tax gross-up, the executives at Oceaneering are able to own more of a stake in the company than if they had to pay the taxes themselves. In the case of Oceaneering, all of the tax gross-ups were provided to individuals who were just promoted to a more senior position, with no mention of the tax gross-up in the previous year’s proxy statement.

Gross-Ups Compared to Other Perquisites

Although the authors have looked at the value of the tax gross-up anecdotally, Exhibit 1 compares the tax gross-up with two other popular perquisites: aircraft usage (which includes the use of the aircraft by the executive for personal and spouse travel as reported in the proxy statements) and automobile usage (which includes auto expenses, insurance, and leases as reported in the proxy statements) by Fortune 500 companies. Exhibit 1 reports averages for the five executives listed in the compensation table for 2006, based on the new disclosure rules. A total of 755 executives received a tax gross-up, at an average amount of $33,856. In comparison, the average amount of airplane usage was $82,203, received by 432 executives. Finally, auto usage was an average of $15,956, received by 831 executives. Based on the average value of two of the more popular perquisites, the tax gross-up does not appear to be exorbitant. Although the tax gross-up is a little-known perquisite, it is more widely used than the corporate airplane. In addition, the highest amount of tax gross-up in the sample belonged to a company that appears to use the perquisite for its intended purpose—recruiting talented executives. The level and value of usage, on average, contradict the message set forth by the media that the tax gross-up is another way to hide compensation from investors.

Exhibit 2 compares the level of gross-up usage before and after the change in the disclosure rules. Drawing conclusions from this information is problematic, however, because the threshold for reporting perquisites also changed in 2006. Exhibit 2 reports the before and after perquisite amounts only for the CEOs.

Exhibit 2 shows that the average value of the tax gross-up decreased from 2005 to 2006, but the level of usage increased. The average value of airplane usage was nearly unchanged, as was the number of CEOs receiving the perk. (The authors tested for statistical significance between the pre-change and post-change compensation amounts using both the Wilcoxon nonparametric test and the T test. The Wilcoxon test makes no assumptions regarding the underlying distributions of the data. The T test assumes the two populations are normal, with identical variances.) Examining the extreme observations for aircraft usage shows that the CEO of Abercrombie and Fitch, Michael Jeffries, had the highest amount of personal air travel in the sample, $961,513. The CEO of eBay, Margaret Whitman, had the second highest amount of personal air travel, $773,467. In addition, she had $230,992 of tax gross-ups related to airplane usage. This means that in addition to paying for Whitman to fly, the company paid her taxes on this personal benefit.

The average value of automobile usage was relatively unchanged from year to year, but the level of usage almost doubled. The CEO of Brunswick Corporation, Dustan McCoy, had the highest amount of automobile usage for 2006, $222,678; and the CEO of Tenet Healthcare Corporation, Trevor Fetter, had the second highest amount, $186,838. Although the largest amounts for automobile usage are far smaller than those for tax gross-ups, the descriptive statistics suggest that a larger number of executives take advantage of the automobile usage perquisite than the tax gross-up.

Although the descriptive statistics provide a glimpse of the level of perquisites, they say nothing about the differences that have occurred in the level of perquisites as a result of the new reporting requirements. Based on the sample, it appears that, on average, the level of tax gross-up is not excessive and is little different from other types of perquisites. Because they represent a tax payment on a perquisite, however, tax gross-ups allow an executive to be awarded more perquisites without increasing the tax bill—essentially representing a perk on a perk.

Clarifying Intent Through Disclosure

In the years leading up to the change in disclosure requirements, one amount was given for perquisites, and companies either chose to provide additional information about what types and amounts of perquisites were given, or just reported an aggregate amount. This means that, except in a few instances, one cannot determine if the disclosure led to a decrease in the value of perquisites given in anticipation of the new disclosure rules, or if the reported statistics are representative of what the value of perquisites has historically been. These caveats should be kept in mind when reviewing the level of perquisites reported under the new disclosure rules.

CPAs should become familiar with the new executive compensation disclosure requirements, including the perquisites discussed above. Although the media may have exaggerated the value and usage of the tax gross-up, CPAs should be cognizant of how they are perceived by the public. To that end, as in the case of Oceaneering, increased transparency can dispel the negative connotation surrounding the tax gross-up. Oceaneering explicitly stated that the tax gross-up was used as a recruiting tool. In this regard, the new rules have the intended effect of making the disclosure of perquisites less opaque.

Angela Andrews, PhD, is an assistant professor of accounting, Wayne State University, Detroit, Mich.
B. Anthony Billings, PhD, is a professor of accounting, also at Wayne State University. Han Yi, PhD, is an assistant professor of accounting in the School of Accounting at the University of Oklahoma, Norman, Okla.




















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