Financial and Tax Wisdoms

A number of recent developments, not least the disclosure of significant incentive payments to certain senior executives, have placed executive pay and share-based incentives under the spotlight. Responsible companies are now reviewing their own approach to these schemes. Among recent trends are: the crusade for improved corporate governance, compliance and risk management; regulatory requirements for disclosure; emerging trends overseas in long-term incentivisation.

A number of recent developments, not least the disclosure of significant incentive payments to certain senior executives, have placed executive pay and share-based incentives under the spotlight. Responsible companies are now reviewing their own approach to these schemes. Among recent trends are: the crusade for improved corporate governance, compliance and risk management; regulatory requirements for disclosure; emerging trends overseas in long-term incentivisation.

Implementation of IFRS2 accounting for share-based payments; recent tax legislation which has attacked and precluded the continuing use of certain types of schemes; the resultant demise of certain traditionally adopted schemes as the ‘obvious’ and ‘preferred’ choices of long-term incentive; and the need to balance the often-conflicting design impacts associated with accounting, tax and legal issues.

It is a wide, varied and complex field, and we recommend that companies should review and revisit their remuneration practices, not from a defensive standpoint, but rather to optimise shareholder value in what is essentially a new environment.

The views that follow are those of the authors and are general and informal.  We would urge companies to take formal advice and opinion before making any material decision in this regard.

Companies will have to reconsider their reward strategies in total and, in the spotlight of the regulators and the public domain, look to the appropriate design which addresses their own strategy, equity markets and the broader economic and socio-economic trends. Extensive modelling should be undertaken to explore the robustness of the scheme to the various elements that may impact on it.

Companies and particularly their Remuneration Committees need to be concerned about the reputational risk associated with both the nature and implementation of share schemes.  They should seek solutions that are not solely reliant on one single share scheme vehicle.  They will need to assess their own requirements and look to the scheme that best delivers on balance.

Many companies will likely choose to implement more than one scheme. Each scheme would be differentially applied within the organisation, and in that way better address both the specific and general reward strategy requirements of: earnings/cashflow/dilution implications; retention and loyalty characteristics; long-term performance orientation; individual wealth creation; tax neutrality; accounting treatment; legal compliance and corporate governance; ownership; downside risk potential; and complexity in communication and administration.

No one scheme can achieve all the above attributes satisfactorily. Only a balanced portfolio can come close.

A number of companies are converting their existing schemes into share appreciation right schemes, which are less dilutive than the traditional share option scheme, and offer more flexibility. Additionally, the recent introduction of a number of performance restricted share schemes in South Africa is an initiative reflecting the trends in international best practice. Other companies are contemplating the introduction of forms of deferred bonus schemes. Such schemes are not particularly aggressive or tax advantageous but they can, with good design, more certainly align rewards with shareholder value and long-term sustainable performance.

The significant features of a performance share scheme are:

• periodically, usually on an annual basis, participants are awarded restricted shares in the company (a Rolling Allocation approach);
• the award can be termed a performance share, a conditional award or a nil cost option;
• a value of shares is conditionally offered which converts, at the market price as at grant date, into a number of such shares;
• the restrictions are usually a combination of time and company financial and business performance (absolute and/or comparative);
• at vesting, the number that was previously offered will be reduced if the financial targets have not been achieved;
• there is usually a defined vesting date, with no re-testing;
• as the awards are conditional on a participant still being employed in the future and certain company performance targets having to be met, the award of the shares is only taxable at the time of vesting, but will be on the full value of the shares as at the time of their release.

The demands of corporate governance require remuneration committees to focus on and to some extent take charge of the contracting, assessment and rewarding of individual and business performance. Increasingly, annual reports are submitting evidence that this is being taken seriously, although not yet to the standards being implemented in the UK, for example.

We are of the opinion that individual performance will be increasingly factored in to the allocations and awards that are made. Furthermore, there is no doubt that very few share schemes will be introduced from now on that do not have company performance (absolute or comparative) factored into vesting. The performance share and deferred bonus type schemes particularly lend themselves to this form of performance orientation.

To sum up, we recommend that companies address the following trends:

• Any existing share based incentivisation should be revisited to establish its efficacy in the light of the changing accounting, tax and regulatory environments.
• If an appreciation scheme is considered to be an essential part of the long-term incentive mix, consideration should be given to introducing or converting to a share appreciation right scheme.
• Depending on a pragmatic view of the likely share price movement, consideration should be given to whether the scheme should be equity or cash settled.
• A solution may be to provide in the documentation for a grant in any one year of either one or the other, depending on the current view.
• Additionally, in equity settled, the documentation should allow for either issue and allotment, or purchase and transfer.
• Consideration should be given to diluting or removing the reward influence of the appreciation scheme, and supplementing or replacing it with either one, or both, of a performance share scheme and a deferred bonus scheme.
• An assessment of individual performance should be factored into annual allocations of whichever schemes are in place.
• Company performance vesting should feature in whichever schemes are in place.
• In the case of the appreciation scheme, performance vesting could either be linked to an inflationary index or to a threshold earnings per share growth.
• In the case of a performance share scheme absolute and comparative Total Shareholder Return (TSR) performance should dictate the number of shares that vest in any one tranche.
• In the case of the deferred bonus scheme, if it is to be equity settled with share matching, the matching shares should be based on an assessment of absolute and/or comparative (TSR) performance.

Issued on behalf of:
Deloitte
Contact: Nick Icely, Executive Compensation, Consulting, Deloitte
Tel No: + 27 11 517 4256
Mobile: +27 84 585 8064
OR
Murray Dicks, Director, Deloitte Legal
Tel No: +27 11 806 5000
Mobile: +27 82 829 4433