The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSIS• Executives were required to hold stock acquired through option exercises for three years(rather than six months under the 1950 Act) in order to be taxed at the lower capital gainsrate.• Exercise prices to be set at no less than 100% (rather than 85% under the 1950 Act) of thegrant-date market prices.• The maximum option term was reduced from ten years to five years.• Repricing of options were prohibited.To distinguish options meeting these new requirements from restricted options grantedunder the Revenue Act of 1950 provisions, the 1964 Act referred to new grants as “qualifiedstock options” rather than restricted stock options.Finally (but perhaps most importantly), the 1964 law reduced the top marginal tax rateon ordinary income from 91% to 70%, which significantly reduced the attractiveness ofqualified options over “non-qualified stock options” (in which the gains upon exercise aretaxed as ordinary income for the recipient, and deductible as a compensation expense to thecompany cash compensation). Figure 2.7 provides a historical comparison of the taxadvantages of restricted or qualified stock options relative to cash compensation or “nonqualifiedstock options.” As a result of the 1964 tax law, the after-tax cost to investors ofconveying an after-tax Euro to the CEO in cash compensation fell from €5.56 to €1.73,while the cost of conveying an after-tax dollar in restricted or qualified stock options (taxedas capital gains) remained at €1.33.-29-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISFigure 2.7The USA Tax Acts of 1964 and 1969 reduced the tax advantages of restricted stock optionsNote: The figure shows the after-tax cost to investors of conveying an incremental €1 in after-tax income under two taxregimes: (1) ordinary compensation (taxable to the recipient at the top marginal rate for earned income (t I ), anddeductible by the firm at the top marginal rate for corporate income (t C )), and (2) capital gains (taxable to the recipientat the capital gains rate (t G ), but not deductible by the firm). The cost for ordinary income is computed as (1-t I )/(1-t C ),while the cost for capital gains is 1/(1-t G ).The popularity of qualified stock options fell as a result of the 1964 tax law 38 andcollapsed following the Tax Reform Act of 1969, which gradually reduced the top marginaltax rate on earned income from 77% in 1969 to 50% by 1972, reduced the corporate tax ratefrom 52.8% to 48%, and raised the top capital gains tax rate from 25% in 1969 to 36.5%. Inaddition, the 1969 Act defined gains from exercising restricted or qualified options as a “taxpreference” item subject to a new Alternative Minimum Tax (AMT) on high wage earners. 39Once the new rates were fully implemented (and ignoring AMT issues), it cost investorsapproximately €1.04 in after-tax profit to convey an incremental €1 in after-tax income to38 See Stanton, “Cash Comeback: Stock Options Begin to Lose Favor in Wake of Tax Law Revision,” WallStreet Journal (August 10, 1964), p. 1. Stock options briefly resurged in 1966, following at 25% increase in theDow Jones average from 1964 to early 1966 (Elia, “Opting for Options: Stock Plans Continue in WidespreadFavor Despite Tax Changes,” Wall Street Journal (July 15, 1967), p. 1).39 In particular, if the option gains exceed 50% of the executive’s total income (including option gains), theamount of the option gain over 50% would be treated as fully taxable ordinary income.-30-
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