Final Golden Parachute Regulations Issued

T O O U R F R I E N D S A N D C L I E N T S August 8, 2003 Final Golden Parachute Regulations Issued The Internal Revenue Service has issued final regulations under Section 280G of the Internal Revenue Code of 1986, as amended. The final regulations provide guidance to taxpayers concerning deductibility of certain payments of compensation in connection with a change in control and the imposition of excise taxes with respect to such payments. Under Section 280G, a corporation may not deduct excess parachute payments that are made to certain disqualified individuals in connection with a change in ownership or effective control of the corporation or a change in ownership of a substantial portion of the corporation's assets. Section 4999 of the Code imposes a 20% excise tax on the recipient of excess parachute payments. In addition, the IRS has issued a new 2003 Revenue Procedure that restates and modifies two earlier Revenue Procedures issued in 2002 concerning option valuation for purposes of Section 280G and Section 4999. The IRS first proposed regulations under Section 280G in 1989; these were never finalized. In 2002, the IRS proposed new regulations under Section 280G upon which taxpayers were permitted to rely through the effective date of the final regulations. 1 The final regulations under Section 280G incorporate generally the provisions of the 2002 proposed regulations with some clarifications and modifications. The final regulations are generally effective with respect to any payment contingent on a change in ownership or control if the change in ownership or control occurs on or after January 1, 2004. For a change in ownership or control occurring between now and January 1, 2004, taxpayers may rely on either the 1989 proposed regulations or the final regulations. Set forth below is a summary of several of the more significant of these clarifications and modifications. Accompanying this memorandum is a memorandum that provides a more detailed overview of Section 280G. Class of disqualified individuals. Under the final regulations, a person is a disqualified individual if the individual is an employee or independent contractor of the corporation and is a shareholder, officer or highly compensated individual with respect to the corporation at any time during the determination period. A Partnership Including Professional Corporations New York One New York Plaza New York, NY 10004 212.859.8000 Washington, DC 1001 Pennsylvania Avenue, NW Washington, DC 20004 202.639.7000 Los Angeles 350 South Grand Avenue Los Angeles, CA 90071 213.473.2000 London 99 City Road London EC1Y 1AX United Kingdom 44.20.7972.9600 Paris 5, boulevard de la Tour Maurbourg 75007 Paris France 33.140.62.22.00 www.friedfrank.com 1 We previously discussed the 2002 proposed regulations in a memorandum dated March 4, 2002 entitled New Golden Parachute Regulations Proposed. Copyright August 8, 2003 Fried, Frank, Harris, Shriver & Jacobson

o The final regulations provide that an individual would be considered a shareholder for this purpose if he or she owned stock of the corporation having a fair market value that exceeds 1% of the fair market value of the outstanding shares of all classes of the corporation's stock. For purposes of determining the amount of stock owned by an individual, the final regulations clarify that stock underlying vested options (including options that vest in connection with the change in ownership or control) would generally be considered owned by the individual, whereas stock underlying unvested options would not be considered owned. Under the 1989 proposed regulations, a shareholder that did not meet the 1% test would nevertheless be a disqualified person if he or she owned stock of the corporation having a fair market value in excess of $1 million. o The term highly compensated individual includes generally any individual who is among the highest paid 1% of the employees of the corporation, or, if less, the highest paid 250 employees, and whose annualized compensation during a determination period is at least equal to an amount specified under the Code, which is adjusted periodically for cost of living increases ($90,000 for 2003, as compared with a fixed $75,000 under the 1989 proposed regulations.) o Under the final regulations, an individual with the title of officer is presumed to be an officer unless the facts and circumstances demonstrate that the individual does not possess the requisite authority. An individual without the title of officer may nevertheless be considered an officer if the facts and circumstances demonstrate the requisite authority. o Under the final regulations, the disqualified individual determination period is defined to mean the 12-month period prior to and ending on the date of the change in control. This simplifies the definition under the 1989 proposed regulations, which includes the year ending on the date of the change in control and the 12-month period preceding that date, based on the taxable or calendar year as elected by the corporation. Valuation of stock options. The final regulations provide that the vesting of a compensatory stock option could result in a parachute payment. One of the most difficult questions for practitioners is the determination of the amount of this payment. Under the 2003 Revenue Procedure, the IRS addresses the issue of stock option valuation directly by providing that any valuation methodology permitted by generally accepted accounting principles may be used to value the payment. The 2003 Revenue Procedure also provides a safe harbor valuation method based on the Black-Scholes valuation model, taking into account (1) volatility of the Fried, Frank, Harris, Shriver & Jacobson 2 August 8, 2003

stock subject to the option, (2) the exercise price of the option, (3) the value of the stock on the valuation date, and (4) the remaining term of the option on the valuation date. Furthermore, the IRS clarifies that the valuation of an option may not be based solely by reference to the spread between the exercise price and the value of the stock at the time of the change in ownership or control. Under the final regulations and as clarified by the 2003 Revenue Procedure, options are to be valued at the time of the payment, generally defined to occur upon the grant or vesting of the option in connection with a change in ownership or control. The valuation methods set forth in the 2003 Revenue Procedure do not apply for purposes of valuing a payment in cash or property, even if the payment is determined by reference to cancellation of a stock option. Finally, if an option vests and is substituted with an option on different stock, the valuation is based on the substituted option. Recalculation of stock option valuation. Under the final regulations, the initial valuation of an option would be made on the date of payment. The initial valuation could be subsequently recalculated and the test for determining excess parachute payments reapplied. Under the 2003 Revenue Procedure, the payor and disqualified individual could redetermine the value of an option in certain circumstances during an 18- month re-determination period beginning on the date of the change in ownership or control. If during the re-determination period there is a change in the term of the option due to termination of employment or there is a change in the volatility of the stock, the option valuation could be re-determined for purposes of determining whether there are parachute payments, calculating excess parachute payments, or determining any excise tax liability. One change rule for change in ownership or control. Under the final regulations, a change in ownership or control would occur in the following circumstances: (1) a person or group acquires more than 50% of the total fair market value or voting power of the stock of a corporation ( change in ownership of stock ), (2) a person or group acquires one third or more of the fair market value of the assets of a corporation ( change in ownership of assets ), or (3) a person or group acquires effective control of the corporation by acquisition of 20% or more of the total voting power of the stock or by replacement of a majority of directors during any 12-month period not endorsed by current board ( effective change in control ). The final regulations make it clear that if there is a change in ownership of stock or assets of a corporation, the other corporation that is a party to the transaction would not experience a change in ownership of stock or assets. In addition, an effective change in control of a corporation would not occur if the other corporation that is a party to the transaction experienced a change in ownership of stock or assets. Fried, Frank, Harris, Shriver & Jacobson 3 August 8, 2003

Change in ownership of stock. Under the final regulations, a change in ownership of the stock applies only if there is a transfer or issuance of stock of a corporation and the stock in that corporation remains outstanding after the transaction. The final regulations also clarify that in determining whether two or more persons acting as a group are considered to own more than 50% of the stock of a corporation on the date of a change in ownership of the stock (and for purposes of determining a change in ownership of assets or effective change in control), a person who owns stock in both corporations involved in the transaction is treated as acting as a group with the other shareholders in a corporation only to the extent of such person's ownership of stock in that corporation prior to the transaction and not with respect to his or her ownership in the other corporation involved in the transaction. This is particularly significant in the case of mergers of equals or mergers of corporations in similar businesses where institutional investors are likely to own stock in both corporations. Under the final regulations, the overlapping shareholdings would not be relevant in determining whether a change in ownership of stock has occurred. Change in ownership of assets. The final regulations clarify that, for purposes of the change in ownership of assets test and the private company shareholder approval requirements (described below), gross fair market value of the assets is defined as the value of the assets of the corporation, or the assets being disposed of, without regard to any liabilities associated with those assets. A change in ownership of the assets applies in the case of any transaction, other than one involving the transfer of stock (or issuance of stock) in a parent corporation and stock in such corporation remains outstanding after the transaction. For example, a change in ownership of the assets could occur (1) upon the sale of stock of a subsidiary where the subsidiary and parent are members of the same affiliated group, and (2) in the event of mergers involving the creation of a new corporation or with respect to the corporation that is not the surviving entity. The final regulations make it clear that there would be no change in ownership of assets upon a transfer to a corporation controlled by the shareholders of the transferring corporation immediately before the transfer or upon the transfer of assets to an unrelated corporation that becomes a majority-owned subsidiary of the transferring corporation after the transfer. Restructuring severance arrangements. Reasonable compensation for services provided after a change in control is not a parachute payment. The final regulations provide that if an employee waives a parachute payment under a legally enforceable agreement entered into prior to a change in control as bargained for consideration for benefits under any agreement entered into following a change in control, the value of the Fried, Frank, Harris, Shriver & Jacobson 4 August 8, 2003

benefits under the post-change agreement will be treated as parachute payments to the extent of the value of the benefits under the pre-change agreement. In addition, the final regulations make it clear that individuals who are paid at a significantly higher level after a change in ownership or control for the same services provided before the change in ownership or control risk having a portion of those payments characterized as parachute payments. Covenants not to compete. The final regulations make it clear that compensation in consideration of covenants not to compete will be treated as reasonable compensation (rather than as disguised severance pay) only if the taxpayer demonstrates that the covenant substantially constrains the disqualified individual s ability to perform services and is reasonably likely to be enforced by the taxpayer against the disqualified individual. The final regulations also provide that payments under a nondisparagement agreement are not considered reasonable compensation for this purpose. Treatment of incentive stock options. The final regulations make it clear that incentive stock options are subject to Section 280G and Section 4999 not later than the time at which the options become vested. Private company shareholder approval requirements, timing of vote. Payments made by a private company are not parachute payments if holders of more than 75% of the voting power of all outstanding stock of the company entitled to vote immediately prior to the change in control approve the payments. In order for the shareholder approval to be valid, the shareholders must receive adequate disclosure of the payments. The final regulations make it clear that the disclosure (1) must describe the types and amounts of all parachute payments, not just those for which shareholder approval is sought, as well as the event triggering such payments, and (2) must be provided to every shareholder who is entitled to vote, not just shareholders who hold 75% or more of the voting power. o The final regulations also clarify that, except as otherwise provided under the rules, stock entitled to vote under the normal voting rules of the company is counted as outstanding and entitled to vote. However, if an individual receives or would receive a parachute payment if the shareholder approval requirements are not met, the stock constructively owned by the individual would not be considered outstanding stock entitled to vote or for purposes of determining whether the more than 75% vote had been obtained. o The final regulations further explain the applicability of the voting requirements to entity shareholders. If the person authorized by the entity shareholder to approve the payment is a disqualified individual who would receive a parachute payment if the Fried, Frank, Harris, Shriver & Jacobson 5 August 8, 2003

shareholder approval requirements are not met, the person would not be entitled to vote the shares. In addition, under the final regulations, the entity shareholder would be permitted to appoint another equity interest holder, or another trustee in the case of a trust, to vote the otherwise eligible shares. o With respect to the timing of the vote, the final regulations provide an administrative safe harbor that the determination of who is entitled to vote may be based on the shareholders of record on any day within the six-month period ending on the date of the change in control. This rule expands the administrative safe harbor first proposed under the 2002 proposed regulations that permitted shareholders of record to be determined at the time of the vote within a three-month period ending on the date of the change in control. Under the final regulations, however, the IRS explicitly rejected suggestions by commentators that (1) shareholder approval obtained at the time of the execution of an agreement be treated as sufficient for purposes of these requirements, and (2) shareholders who acquire shares after the original shareholder approval of an agreement be deemed to have consented to any parachute payments made pursuant to such agreement. Interrelationship of Section 280G and Section 4999. The final regulations make it clear that the excise tax under Section 4999 may be imposed regardless of the loss of deduction under Section 280G. This clarification could result in a disqualified individual who is a U.S. employee being subject to the excise tax provisions of Section 4999 even though the employee's employer is a foreign corporation not subject to U.S. income tax. The IRS also suggests in the preamble to the final regulations that the excise tax provisions of Section 4999 could apply to a nonresident alien even where the person is not subject to U.S. income tax on wages earned from the affiliated group. Timing and Payment of Excise Tax. The final regulations contain a special election for disqualified individuals to pay the excise tax earlier than the tax may otherwise be due. Under the final regulations, prepayment of the excise tax is based on the present value of the excise tax that would be due in the year the excess parachute payment would be paid. The payor and disqualified individual are required to treat the payment of the excise tax consistently. Fried, Frank, Harris, Shriver & Jacobson 6 August 8, 2003

Companies should review their change in control and executive severance arrangements to ensure they continue to accomplish their intended purposes in a tax efficient manner and in light of the issuance of the final regulations. New York New York Donald P. Carleen 212.859.8202 Laraine S. Rothenberg 212.859.8745 Howard B. Adler 212.859.8175 Rebecca A. Ditsch 212.859.8118 Jonathan F. Lewis 212.859.8044 Gretchen Harders-Chen 212.859.8515 William P. Burt 212.859.8705 Fried, Frank, Harris, Shriver & Jacobson 7 August 8, 2003