posted in its entirety with the permission of the author

Backdating Returns to the Spotlight

The
IRS released new tax guidance this month related to so-called backdated
stock options. But discounted options are still not considered
"qualified performance based compensation."

Robert Willens
- CFO.com | US

July 27, 2009

In 2006, the Internal Revenue Service became aware of instances in
which stock options were granted with exercise prices that were less
than the fair market value of the stock on the date of grant. In many
cases, this discount resulted from a discrepancy between the purported
grant date (on which date the strike price of the option and the stock
price were identical) and the actual grant date (on which date the
strike price of the option was below the applicable stock price).

In some cases, in which the executive had already exercised the
option, the employer attempted to "reprice" the option by obtaining a
"voluntary" repayment from the executive in the amount of the discount.
In cases where the executive had not yet exercised the option, the
executive agreed to an increased share price based upon the value of
the stock on the actual grant date. The IRS legal memorandum, AM
2009-006, released on July 6, 2009, addresses the issue of whether the
compensation emanating from these discounted options constitutes
"qualified performance based compensation." The answer is an
unequivocal no.

Applicable Employee Remuneration
The tax code, specifically Section 162(m)(1), states that for any publicly-held corporation, no deduction is allowed for applicable employee remuneration with respect to any covered employee
to the extent that the amount of such remuneration for the taxable
year exceeds $1 million. However, under Section 162(m)(4)(C),
applicable employee remuneration does not include remuneration payable
solely on account of the attainment of one or more "performance goals."

Looking at tax rules more carefully, practitioners will find that
under Regulation Section 1.162-27(e)(2)(vi)(A), compensation
attributable to a stock option is deemed to satisfy the performance
goal requirement if, under the terms of the option, the amount of
compensation the employee could receive is based solely on an increase
in the value of the stock after the date of the grant. Conversely, in
the case of an option that is granted with an exercise price that is
less than the value of the stock as of the date of grant, none of the
compensation is qualified performance based compensation.

Grant Date
However, there is something else to consider.
Section 162(m) does not define the term grant date, nor do the
regulations provide a standard for determining grant date.
Nevertheless, the IRS concluded that the standard for determining the
grant date in the regulations addressing incentive stock options and
deferred compensation is a reasonable standard for purposes of Section
162(m). To be clear, the options and deferred compensation is based on
the date the corporation completes the corporate action constituting an
offer of sale of a certain number of shares of stock to a designated
individual at a set price.

"The
regulations do not provide a mechanism to retroactively reprice an
option to transform compensation resulting from the exercise of the
option into performance based compensation." — Robert Willens

The
IRS reckoned that basing the grant date on the date that certain
corporate actions are completed and verifiable is an administrable
standard for both the government and taxpayers. Therefore, taxpayers,
in ascertaining grant date, should apply the standards in the
regulations under Section 421 or the very similar standards under the
Section 409A regulations.

In addition, APB Opinion No. 25, Accounting for Stock Issued to Employees,
provides guidance for determining the "measurement date" (i.e., the
grant date) for grants made before 2002. Under APB No. 25, the
measurement date is "the first date on which are known both the number
of shares that an individual employee is entitled to receive and the
option price."

When the backdating crisis became well understood, the staff of the
Securities and Exchange Commission advised its constituents that
"completion of all required corporate granting actions" is generally
necessary for there to be a grant of options. But the staff noted that
a grant may occur at an earlier date, depending on when the facts and
circumstances establish that the terms and recipients "were determined
with finality" on an earlier date.

Further, the IRS concludes that, although the accounting standards
are "less stringent" than existing tax standards, it is reasonable to
use the measurement date determined by taxpayers for purposes of their
accounting restatements as the grant date for purposes of Section
162(m). However, the IRS warned that "in future cases" the agency
reserves the right to insist on determining grant date in accordance
with the standards under the Section 421 and Section 409A regulations.

Repricing
Whether a stock option satisfies the
requirements of Regulation Section 1.162-27(e)(2)(vi)(A) is determined
as of the date of grant of the option. The regulations do not provide a
mechanism to retroactively reprice an option to transform compensation
resulting from the exercise of the option into performance based
compensation. Because the compensation arising from the option grants
in this case was not based solely on an increase in the price of the
stock after the grant date, none of the compensation attributable to
the options in question was qualified performance based compensation.

Therefore, it does not seem to matter whether a company determines
at the time of grant that a stock option is qualified performance based
compensation. That's because subsequent actions, such as a repayment by
an employee, cannot change the fact that the option was issued at a
discount. Moreover, the grant and exercise of an option, and a later
voluntary repayment of a compensatory amount are separate transactions
for tax purposes.

Also, the July legal memorandum released by the IRS states that in
some cases, employers repriced options before the options were
exercised. However, whether an option satisfies the requirements is
determined as of the date of grant. Once again, the actions to reprice
the options did not change the fact that the options were issued at a
discount.

Accordingly, the IRS memorandum concludes that the remuneration
resulting from the exercise of "discounted" stock options that may have
been repriced before exercise is not qualified performance based
compensation. Thus, as most observers suspected would be the case, once
it is ascertained that a stock option was issued at a discount, the
resultingh remuneration cannot constitute qualified performance based
compensation. Moreover, there are no "curative" steps the corporation
can take, ex post facto, to alleviate the problem. It is the
situation existing on the grant date that controls the outcome and
steps taken thereafter will not, under any circumstances, relate back
to such grant date.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com