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Tax
Gross-Up
Recruiting Tool, or More Compensation?
By Angela
Andrews, B. Anthony Billings, and Han Yi
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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