Executive compensation optimization

Executive compensation optimization often boils down in one’s mind to tax optimization : substituting to salary a component that is less taxed or charged with social contributions.

The introduction for instance of equity-based payments or defined benefit retirement schemes was in part motivated by a favourable tax treatment. Unfortunately, in France, such components that were once favoured have seen their tax treatment deteriorate over time and even become less efficient than salary (the sole U-turn attempt applicable to full-value share grants under the « Macron law » was repealed again by the legislator only a few months later).

However, there are plenty optimization levers available : a few tax levers, but more importantly those levers besides taxation.

Optimization rests on several levers :

• Tax and social contribution levers ;
• The expertise of the company in the design of remuneration components (incentives, engineering of protection…) ;
• The bargaining power of the company when negotiating with providers (insurers, asset managers, real estate agents…).

A few examples of optimization :

• Article 81 of the French tax code permits tax exemptions for time spent abroad, increases the executive’s net income without raising the company’s cost ;
• Replacement of full-value share or stock-option grants by structured equity instruments (ALVA) whose lever is aligned with ambitious but achievable business plan targets, with a potential substantial payout increase for any given IFRS cost of the plan ;
• The conversion of defined benefit retirement schemes under Article 39 of the French tax code - whose attractiveness is inversely proportional to the expected residual professional lifetime of the executive as these pension rights are not transferable - into an alternative eXtra Long-Term Incentive (XLT) that is transferable, even in case this conversion was tax neutral ;
• Within the context of a customised « a la carte » offer, an executive may choose to swap some of his salary for a death benefit or a private unemployment insurance whose terms and conditions can be more favourably negotiated by the company than by the executive himself.

These examples and many others are discussed below in more detail.

1. TAX OPTIMIZATION

In France, there are not many opportunities for executives to optimize their individual tax level, but some opportunities do exist and yet are not always exploited.

• The Article 81 of the Tax code (CGI) provides tax exemptions in counterpart of :
  
  • Short-term business trips abroad (with a minimum effective duration of 24 hours).
    
    The tax exemptions can be very significant, since they can represent up to 40% of the remuneration paid for the function exercised in France.
    Since 2015, the terms and conditions of this scheme have become much more favorable
  • Long-term business trips abroad.
• The Article 155B of the CGI provides tax exemptions for impatriates, who came from abroad to exercise a job in France.
• Remuneration in capital may sometimes be more favorable from a tax and social point of view than instruments in cash.

2. THE OFFER «A LA CARTE»

The offer « à la carte » consists of allowing each executive to make a choice between the various components of his compensation package, given his expectations and / or needs, at constant cost to the company.

Illustrations :

• Participation in a management training like INSEAD or Stanford, versus a variable remuneration ;
• Implementation of an unemployment insurance for corporate officers rather than an remuneration increase ;
• Or more prosaically, a more performing car versus a waiver of cash compensation ...

The offer « à la carte » implementation demands a lot of attention, as it requires identifying expectations and needs with each beneficiary, and making choices based on good governance practices and corporate culture.

3. THE STATUS OF CORPORATE OFFICERS

Corporate officers sign a corporate officer contract (and not an employment contract) ; they are subject to the Commercial code (C.com) and not to the Labor code.

The majority of companies and executives – mainly corporate officers of unlisted companies/ subsidiaries of listed companies – can combine a corporate officer function with an employment contract, subject to fulfillment of a number of conditions.

This is a fundamental difference, since the employee status offers much more protection, particularly in case of a breach of contract.

Note : corporate officers are subject to various risks in terms of civil and criminal liability, which suppose the implementation of some protective measures.

4. INCENTIVES

Executive compensation packages typically include two types of incentives : short-term incentives (STI) and long-term incentives (LTI).

A company has two levers to optimise incentives :

• The enhancement of incentive design ;
• Tax arbitrage between equity-settled and cash-settled incentives depending on the ever fluctuating taxes and social charges applicable in France to full-value shares and stock-options.

Incentive design enhancement

The more a company creates value, the more shareholders are willing to raise incentive awards. Conversely, in the absence of value creation, investors will be reluctant to pay rewards uncorrelated to company performance.

Regarding equity-based incentives, an Asset with Leverage Vectoring Aptitudes (ALVA), whose leverage is deliberately aligned with the objectives of a value-creating business plan, maximises the exercise gain to IFRS grant value ratio. As an indication, for a given IFRS grant value, ALVAs permit to raise by more than 50% the exercise gain as compared to traditional full-value share grants.

ALVAs can cover a wide range of instruments, including depending on whether the company is listed or not, for instance :

• For public companies, instruments inspired by indexed options structured with full-value shares, offering at the same time leverage regarding absolute and relative share price performance in line with business plan targets and protection against bear markets ;
• For private companies, Phantom shares boosters, complementing traditional Phantom shares, to enhance leverage : the number of shares granted can be increased to raise payout significantly in case of strong value creation.

The choice of performance indicators is also critical in optimising executive incentives: the improvement of their alignment with value creation and of the line of sight they provide support value creation within the company, which in turn allows shareholders to increase awards.

Tax arbitrage

In France, taxes and social charges applicable to equity plans keep changing over time.

The difference in tax effectiveness between on one hand full-value share and stock option grants and on the other hand their cash-equivalent counterparts, phantom shares and Stock Appreciation Rights (SARs), may have exceeded 50% depending on the successive tax treatments applicable.

In this volatile French tax environment, corporations should stay alert and not hesitate arbitraging between equity- and cash-based incentives when spreads are significant.

5. CO-INVESTMENT & LCP

Traditional (or direct) co-investment rests on the investment of executives in the equity of the firm. Executives may acquire shares of the company they manage or more often leveraged instruments such as warrants (BSA in France), preference shares, or shares of a dedicated leveraged management firm invested in the underlying company.

To shareholders, executive co-investment is virtuous as it enhances the alignment of executives with their own interests.

Traditional co-investment is not compensation when executives subscribe the equity instrument at « fair value », i.e. at a price a well-informed at arm’s length investor would be willing to pay. When this is the case, gains are taxed as capital gains, a more favourable tax treatment that taxes and social charges applicable to remuneration.

Nevertheless, in France, traditional co-investment is not tax optimal. A better way is to allow executives to fund the co-investment by foregoing remuneration. The Leveraged Compensation Package (LCP) does precisely this and offers several advantages over traditional co-investment :

• Tax and social effectiveness: the double taxation of compensation and capital gains is avoided ;
• Simplicity : executives do not need to invest their savings or borrow ;
• No risk of requalification: the “invested” foregone remuneration and a possible matching are made out traditional equity-linked incentives (shares, stock-options, phantom shares…) ;
• Flexibility: the company can fine-tune the leverage of the plan through fair value vectoring over targeted share price performance scenarios.

6. PROVIDEND SCHEME

Known and practiced by international groups, the international pooling is a privileged way enabling companies to optimize the efficiency of their provident and medical schemes.

The payout can be very significant. This is why, for some years now, this practice has extended to medium-sized companies, as soon as they are based in at least two different countries.

The principle is quite simple : it consists of entrusting all or part of their provident and medical schemes (plus sometimes of their pension insurance) subscribed by the different entities of the group to an global insurance company. This allows to consolidate results and to give the company a dividend linked to the consolidated accounts on all insurance contracts.

It also makes it possible to use the payout to improve the insurance coverage of beneficiaries.

7. THE END OF THE SUPPLEMENTARY PENSION SCHEME ? YES, BUT …

Many companies have decided or plan to implement an alternative system to the supplementary pension scheme (defined benefits plan Article 39) because of its loss of efficiency.

There are several types of alternative systems that must be adapted to each company (advantages and disadvantages) ; in particular XLT (eXtra Long-Term Incentive), in cash or in shares, inspired by Anglo-Saxon practices.

They generally consist of a lump sum to compensate the abandonment of xxx Article 39, plus annual payments.

These XLT systems have several merits :

• They are portable, and thus definitively acquired even in the event of departure before the date of retirement - which is a decisive advantage for the beneficiaries ;
• They authorize payment in capital or in annuity - the capital payment being generally more favorable ;
• For the company, they generate a substantial saving : for example, a study with a customer indicates a saving of about 25%. The XLT also helps to strengthen the correlation between compensation and long-term performance of the company, a key argument for convincing institutional investors and proxy advisers.

8. ACCUMULATING COMPENSATION AND RETIREMENT PENSION

Many executives wish to pursue a professional activity while receiving unemployment benefits or a retirement pension.

More and more companies are willing to cooperate with their former managers for some time in order to facilitate the transition, thus leveraging their experience and know-how. This collaboration often takes place through the set-up of a consulting company.

The accumulation of a compensation and a retirement pension has been authorized without any limit of resources from January 1, 2009. This regulation makes it possible for people to continue their professional activity in their former company.

For executives, the employment status is an option to be excluded given the weight of social security contributions. A case-by-case study should be carried out.

In France, the executive who has set-up his own start-up has various tax and social opportunities which need to be analyzed and leveraged.