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[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]

 
                 THE REVENUE-INCREASING MEASURES IN THE

               ``SMALL BUSINESS AND WORK OPPORTUNITY ACT

                               OF 2007''

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON WAYS AND MEANS
                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

                             MARCH 14, 2007

                               __________

                           Serial No. 110-10

                               __________

         Printed for the use of the Committee on Ways and Means

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                      COMMITTEE ON WAYS AND MEANS

                 CHARLES B. RANGEL, New York, Chairman

FORTNEY PETE STARK, California       JIM MCCRERY, Louisiana
SANDER M. LEVIN, Michigan            WALLY HERGER, California
JIM MCDERMOTT, Washington            DAVE CAMP, Michigan
JOHN LEWIS, Georgia                  JIM RAMSTAD, Minnesota
RICHARD E. NEAL, Massachusetts       SAM JOHNSON, Texas
MICHAEL R. MCNULTY, New York         PHIL ENGLISH, Pennsylvania
JOHN S. TANNER, Tennessee            JERRY WELLER, Illinois
XAVIER BECERRA, California           KENNY C. HULSHOF, Missouri
LLOYD DOGGETT, Texas                 RON LEWIS, Kentucky
EARL POMEROY, North Dakota           KEVIN BRADY, Texas
STEPHANIE TUBBS JONES, Ohio          THOMAS M. REYNOLDS, New York
MIKE THOMPSON, California            PAUL RYAN, Wisconsin
JOHN B. LARSON, Connecticut          ERIC CANTOR, Virginia
RAHM EMANUEL, Illinois               JOHN LINDER, Georgia
EARL BLUMENAUER, Oregon              DEVIN NUNES, California
RON KIND, Wisconsin                  PAT TIBERI, Ohio
BILL PASCRELL JR., New Jersey        JON PORTER, Nevada
SHELLEY BERKLEY, Nevada
JOSEPH CROWLEY, New York
CHRIS VAN HOLLEN, Maryland
KENDRICK MEEK, Florida
ALLYSON Y. SCHWARTZ, Pennsylvania
ARTUR DAVIS, Alabama

             Janice Mays, Chief Counsel and Staff Director

                  Brett Loper, Minority Staff Director

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public 
hearing records of the Committee on Ways and Means are also published 
in electronic form. The printed hearing record remains the official 
version. Because electronic submissions are used to prepare both 
printed and electronic versions of the hearing record, the process of 
converting between various electronic formats may introduce 
unintentional errors or omissions. Such occurrences are inherent in the 
current publication process and should diminish as the process is 
further refined.

                            C O N T E N T S

                               __________
                                                                   Page

Advisory of March 7, announcing the hearing......................     2

                               WITNESSES

The Honorable Kenneth E. Bentsen, Jr., President, Equipment 
  Leasing and Finance Association, Arlington, Virginia...........     4
Greg Heaslip, Vice President--Benefits, PepsiCo, Inc., Purchase, 
  New York.......................................................    10
Kenneth R. Petrini, Vice President--Taxes, Air Products and 
  Chemicals, Inc., Allentown, Pennsylvania, on behalf of the 
  National Association of Manufacturers..........................    16
Edward D. Kleinbard, Partner, Cleary Gottlieb Steen & Hamilton 
  LLP, New York, New York, on behalf of the Securities Industry 
  and Financial Markets Association..............................    27

                       SUBMISSIONS FOR THE RECORD

American Bankers Association, statement..........................    54
American Bar Association Section of Taxation, statement..........    56
American Benefits Council, statement.............................    60
Association for Advanced Life Underwriting, statement............    64
ERISA Industry Committee, statement..............................    68
Financial Services Roundtable, letter............................    71
Hogan & Hartson LLP, statement...................................    73
HR Policy Association, statement.................................    75
Richard D. Ehrhart, statement....................................    76
Statement of Air Products and Chemicals, Inc., Allentown, PA, 
  statement......................................................    80
U.S. Chamber of Commerce, statement..............................    89
Working Group for Certainty in Settlements, statement............    90

                 THE REVENUE-INCREASING MEASURES IN THE

                 ``SMALL BUSINESS AND WORK OPPORTUNITY

                             ACT OF 2007''

                              ----------                              

                       WEDNESDAY, MARCH 14, 2007

                     U.S. House of Representatives,
                               Committee on Ways and Means,
                                                    Washington, DC.

    The Committee met, pursuant to notice, at 10:15 a.m., in 
room 1100, Longworth House Office Building, Hon. Charles B. 
Rangel (Chairman of the Committee) presiding.
    [The advisory announcing the hearing follows:]

ADVISORY

FROM THE 
COMMITTEE
 ON WAYS 
AND 
MEANS

                                                CONTACT: (202) 225-3625
FOR IMMEDIATE RELEASE
March 07, 2007
FC-11

                Chairman Rangel Announces Hearing on the

               Revenue-Increasing Measures in the ``Small

              Business and Work Opportunity Act of 2007''

    House Ways and Means Committee Chairman Charles B. Rangel (D-NY) 
today announced that the Committee will hold a hearing on the revenue-
increasing measures that are included in the Senate-passed version of 
H.R. 2, the ``Small Business and Work Opportunity Act of 2007.'' The 
hearing will take place on Wednesday, March 14, 2007, in the main 
Committee hearing room, 1100 Longworth House Office Building, beginning 
at 10:00 a.m.
      
    In view of the limited time available to hear witnesses, oral 
testimony at this hearing will be from invited witnesses only. However, 
any individual or organization not scheduled for an oral appearance may 
submit a written statement for consideration by the Committee and for 
inclusion in the printed record of the hearing.
      

BACKGROUND:

      
    On January 10, 2007, the House of Representatives passed H.R. 2, 
the ``Fair Minimum Wage Act of 2007,'' which would increase the Federal 
minimum wage for the first time in ten years. On February 1, 2007, the 
Senate passed its own version of H.R. 2. The Senate-passed version 
coupled an increase in the Federal minimum wage with a package of tax 
benefits costing $8.3 billion over ten years. In order to offset the 
cost of these tax benefits, the Senate bill includes over a dozen 
separate provisions that, in the aggregate, would raise $8.3 billion 
over ten years. These offsetting revenue increases would, among other 
things, change the tax treatment of certain leases entered into before 
March 12, 2004, deny deductions for certain government-required 
payments and punitive damages in civil actions, enact new limitations 
on deferred compensation plans, and change the tax treatment of certain 
financial instruments. The Committee on Ways and Means has not held 
prior hearings on these issues.
      
    In announcing the hearing, Chairman Rangel said, ``The Senate tax 
relief package includes a number of revenue-raising provisions that 
would have a significant impact on the business community. Since the 
Senate-passed bill was intended to help offset the costs associated 
with an increase in the Federal minimum wage, it seems only fair that 
the business community should be given an opportunity to explain the 
effect these revenue increases would have on businesses.''
      

FOCUS OF THE HEARING:

      
    This hearing will focus on the impact that the revenue increases 
included in the ``Small Business and Work Opportunity Act of 2007'' 
would have on businesses.
      

DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:

      
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March 28, 2007. Finally, please note that due to the change in House 
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FORMATTING REQUIREMENTS:

      
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noted above.

                                 

    Chairman RANGEL. Good morning. As you know, we are supposed 
to be going to conference with the Senate on the minimum wage 
bill. This Committee did provide a $1.3 billion tax relief bill 
for small businesses.
    However, even though there is no indication when we are 
going to conference, they have begun an $8.6 billion tax bill, 
and many of the Members of this Committee have been approached 
by people who would be affected by the provisions in the Tax 
Code they have suggested would pay for the $8.6 billion.
    Since when we go to conference, these issues would be in 
contention, the ranking Member and I thought that the Members 
of the Committee should have a better understanding of what we 
will be faced with in the conference. So, I look forward to 
hearing from the witnesses, and it's with great pleasure that I 
yield to the ranking Member, Mr. McCrery, for opening remarks.
    Mr. MCCRERY. Thank you, Mr. Chairman. Thank you, in 
particular, for calling this hearing today to explore several 
tax increases recently passed by the Senate in conjunction with 
an increase in the minimum wage.
    My position on the small business tax relief bill is well-
documented. I have told virtually anyone who will listen that 
Congress needs to provide more tax relief to small businesses, 
in particular, to help offset the cost of the minimum wage 
increase. These small businesses are crucial to the growth of 
our economy.
    As the Congressional Budget Office pointed out, a minimum 
wage increase will impose, over the next five years, a burden 
on employers of more than $16 billion. Thus, it would be my 
preference to see an even larger tax package than the one 
approved by the House last month. I would even like the total 
amount of relief to be greater than the $8 billion in the 
Senate-passed bill.
    We cannot ignore the requirements imposed upon us by the 
new pay-as-you-go (PAYGO) rules. Early experience with these 
rules suggests to me that avoiding an ill-advised tax increase 
can be just as important, and sometimes maybe even more so, 
than an acting on desirable tax relief. Today's hearing will 
give us an opportunity to hear directly from some of those who 
would be most effected by the revenue-raising proposals in the 
Senate-passed bill.
    I look forward to gaining a better understanding of the 
impact of these items, and I yield back the balance of my time.
    Chairman RANGEL. Our first witness would be the Honorable 
Kenneth Bentsen, president of Equipment Leasing and Finance 
Association (ELFA), from Arlington, Virginia. Thank you.

STATEMENT OF THE HONORABLE KENNETH E. BENTSEN, JR., PRESIDENT, 
 EQUIPMENT LEASING AND FINANCE ASSOCIATION, ARLINGTON, VIRGINIA

    Mr. BENTSEN. Thank you, Mr. Chairman, Ranking Member 
McCrery, and Members of the Committee. Mr. Chairman, I would 
ask that, if I could, summarize my statement to stay within the 
5 minutes.
    I appreciate the opportunity to present the views of ELFA 
on the proposal contained in the Senate-passed version of H.R. 
2, the Small Business and Work Opportunity Act of 2007, that we 
believe would retroactively impose taxes on certain cross-
border leasing transactions.
    The ELFA is a trade association representing 770 members, 
including banks, financial services companies, and 
manufacturers in the equipment finance industry. Our members 
are engaged in a broad sector of commercial finance, including 
business-to-business leasing and financing of capital equipment 
and software. Our industry's members are the major financiers 
of transportation, manufacturing, mining, medical, office, 
construction, information, and technology equipment, and our 
members' customers include Fortune 100 companies, small and 
medium-sized enterprises, and State and local governments.
    Nearly 3 years ago, Congress passed the American Jobs 
Creation Act of 2004 (P.L. 108-357). As part of that 
legislation, and in response to concerns regarding certain 
domestic and cross-border leasing transactions, Congress 
created a new section of the tax code, Internal Revenue Code 
section 470, which applies a passive-loss type regime to 
certain leasing transactions involving property used by 
governments or other tax-exempt entities.
    Importantly, in 2004, Congress recognized a sweeping change 
in law as a policy change, and decided on a prospective 
effective date which applies to the new rules to leases entered 
into after March 12, 2004.
    Moreover, the conferees specifically decided that no 
inference is intended regarding the appropriate present law tax 
treatment of transactions entered into prior to the effective 
date, namely that no intent was given with respect to the 
appropriateness of transactions entered into that prior 
effective date.
    To go back now and retroactively change the agreement is, 
in effect, reopening the conference negotiations between the 
House and the Senate 3 years later, and creating double 
jeopardy for taxpayers. The proposal in the Senate version 
would undermine the decisions made by the conferees of the Jobs 
Act, and retroactively change the effective date for cross-
border leases entered into on or before March 12, 2004.
    Specifically, the Senate proposal would reach back and 
impose taxes that could never have been expected on 
transactions that were completed years before the original jobs 
act was ever contemplated. Indeed, under recently issued 
Financial Accounting Standards Board (FASB) guidance, any 
change of the timing of cashflows caused by changes in the tax 
treatment of a lease will require recalculation of earnings 
dating back to the inception of the lease.
    As a consequence, the Senate provision would result in 
significant new tax liabilities on U.S. taxpayers, as well as 
significant adverse financial statement consequences caused by 
such recomputations for those affected U.S. companies which are 
publicly listed.
    Additionally, as crafted, the provision would result in 
consequences for transactions never targeted by the proponents 
or the Government. As an example, one of our members states 
that the proposed retroactive change in section 470 would 
eliminate net deductions for tax years 2007 and beyond on a 
number of lease transactions entered into years ago that the 
Internal Revenue Service (IRS) does not consider abusive.
    The Committee on Ways and Means appropriately rejected the 
Senate proposal earlier this year in developing the House 
version of the Small Business Tax Relief Act of 2007. In fact, 
Mr. Chairman, you wisely stated that such retroactive tax 
changes were ``bad policy.''
    We also believe that this provision undermines taxpayer due 
process. Proponents of the provision have asserted that the 
provision would be beneficial to the IRS in litigation efforts 
against certain U.S. taxpayers involved in such transactions. 
Ultimately, any legal issues surrounding the transactions 
completed prior to the Jobs Act effective date would be--should 
and will be properly addressed by the IRS in the courts on the 
basis of the laws that were in effect at the time of the 
transactions.
    On due process grounds alone, U.S. taxpayers deserve to 
have their day in court, without interference from the 
Congress, before any judgement has been rendered. To date, 
there have been no judgements involving such cross-border 
transactions.
    Furthermore, nothing in the Senate provision would 
preclude--nor could the taxpayer expect--that the Government 
would discontinue to pursue a case against the taxpayer, as 
such cases relate to tax treatment of prior years. If this is 
allowed, there is no reason Congress could not simply 
retroactively change the law and favor the IRS on any issue the 
IRS is currently challenging in the courts, or otherwise. This 
is not the way our U.S. rule of law works, and it's not a 
change this Committee should endorse.
    With all due respect to the proponents, I would submit to 
the Committee that the issue before the congress is not the 
merits of the underlying transactions in question, as many of 
those are properly being reviewed by the IRS on independent 
facts and circumstances, just as Congress intended.
    The real issue is one of policy and process, the use of 
retroactive tax law changes to raise revenue, as the Senate 
version of H.R. 2 clearly does, and the due process rights of 
taxpayers, which the Senate bill undermines. We believe such 
actions are fundamentally unfair and unwise.
    [The prepared statement of Mr. Bentsen follows:]
    Statement of The Honorable Kenneth E. Bentsen, Jr., President, 
     Equipment Leasing and Finance Association, Arlington, Virginia
    Mr. Chairman, Ranking Member McCrery, and members of the Committee, 
thank you for the opportunity to present the views of the Equipment 
Leasing and Finance Association (ELFA) on the proposal contained in the 
Senate-passed version of H.R. 2 the ``Small Business and Work 
Opportunity Act of 2007,'' that would retroactively impose taxes on 
certain cross-border leasing transactions.
    ELFA is a trade association representing 760 members, including 
banks, financial services companies, and manufacturers, in the 
equipment finance industry. ELFA's members are engaged in a broad 
sector of commercial finance including business-to-business leasing and 
financing of capital equipment and software. The industry size, 
domestically, is estimated to comprise one-third of fixed business 
investment annually and its members are the major financiers of the 
transportation (aircraft, maritime, rail, and trucking), manufacturing, 
mining, medical and office equipment, construction and information 
technology fields. Our members' customers include Fortune 100 
companies, small and medium sized enterprises, and state and local 
governments. Our members also provide financing for equipment globally, 
much of it domestically produced.
    Nearly three years ago, Congress passed the American Jobs Creation 
Act of 2004 (Pub. Law 108-357) (the ``JOBS Act''). As part of that 
legislation, and in response to concerns regarding certain domestic and 
cross-border leasing transactions, Congress created a new section of 
the tax code, IRC section 470, which applies a ``passive-loss'' type 
regime to certain leasing transactions involving property used by 
governments or other tax-exempt entities. Generally, under the 
provision tax losses incurred over the course of the lease are deferred 
and offset against future income from the property. The provision 
contains an exception if a taxpayer meets the requirements of all of 
four specifically described rules involving certain types of property, 
availability of funds, and where the lessor makes a substantial equity 
investment, and the lessee does not bear more than a minimal risk of 
loss.
    Importantly, in 2004, Congress recognized this sweeping change in 
law as a policy change and decided on a prospective effective date 
which applies the new rules to leases entered into after March 12, 
2004. Certain grandfather rules were also provided to avoid retroactive 
application of the new regime.
    Moreover, the conferees specifically decided that ``[N]o inference 
is intended regarding the appropriate present-law tax treatment of 
transactions entered into prior to the effective date,'' . . . namely 
that no intent was given with respect to the appropriateness of 
transactions entered into prior to the effective date. See, H. Rpt. 
108-755, p. 647, 650. To now go back and retroactively change this 
agreement is in effect reopening the conference negotiations between 
the House and the Senate 3 years later and creating ``double jeopardy'' 
for taxpayers.
RETROACTIVE TAX INCREASE
    The current proposal in the Senate version of H.R. 2 would 
undermine the decisions made by the conferees of the JOBS Act and 
retroactively change the effective date of IRC section 470 for cross-
border leases entered into on or before March 12, 2004. The Senate 
proposal would reach back and impose taxes that could never have been 
expected on transactions that were completed years before the original 
JOBS Act was ever contemplated.
    The Ways and Means Committee appropriately rejected the Senate 
proposal earlier this year in developing the House version of the 
``Small Business Tax Relief Act of 2007'' (H.R. 976) on February 12, 
2007. And, in fact, Mr. Chairman you wisely stated that such 
retroactive tax changes were ``bad policy.''
    Proponents of the retroactive change to Section 470 as contained in 
the Senate bill assert that the provision is: a) not retroactive 
because it applies to future tax years albeit of transactions completed 
prior to March 12, 2004; and b) necessary to relieve the Internal 
Revenue Service of the burden of challenging certain transactions on 
economic substance and other grounds. Proponents further argue that the 
facts related to the transactions in question justify such actions.
    In fact, as crafted: the provision is retroactive, the provision 
will result in consequences for transactions never targeted by the 
proponents or the government, and the provision will undermine 
taxpayer's due process rights.
    With all due respect to the proponents of the Senate provision, I 
would submit to the Committee that the issue before the Congress is not 
the merits of the underlying transactions in question, as many of those 
are properly being reviewed by the IRS based on independent facts and 
circumstances, just as the Congress intended. The real issue is one of 
policy and process--the use of retroactive tax law changes to raise 
revenue, as the Senate version of H.R. 2 clearly does; and the due 
process of taxpayers, which the Senate bill undermines. We believe such 
actions are fundamentally unfair and unwise.
    If retroactive tax policy is pursued in this instance, there is no 
reason retroactivity would not be pursued elsewhere thus undermining 
all reliance on our U.S. tax laws. The imposition of this retroactive 
provision would result in irreparable damage to investor confidence in 
the leasing market going forward, and impede the Congress' ability to 
utilize the tax code as a means to spur investment. For this reason, 
the Congress historically has opposed such retroactive tax policy.
RECOMPUTATION OF U.S. TAXPAYER'S BOOKS
    Proponents of the Senate provision have asserted that the proposal 
is not retroactive because it applies to taxable years beginning after 
December 31, 2006. Clearly this is incorrect as the proposal applies to 
leases executed years ago. Indeed, under recently issued FASB guidance 
(FSP FAS 13-2), any change in the timing of cash flows caused by 
changes in the tax treatment of a lease will require a recalculation of 
earnings dating back to the inception of the lease. As a consequence, 
the Senate provision would result in significant new tax liabilities on 
U.S. taxpayers and significant adverse financial statement consequences 
caused by such recomputations for those affected U.S. companies which 
are publicly listed.
    The retroactive impact on a taxpayer's books under FASB rules is 
described in more detail in an attachment, hereto.
    The bottom line is that the provision would have the effect of 
disrupting the economics of multiyear transactions entered into years 
ago by U.S. financial institutions in reliance on existing law. This is 
exacerbated since the Senate provision would be unlimited in its 
application and would apply to transactions completed well into the 
last century, long before any changes along the lines of Section 470 
were contemplated by the Senate.
UNDERMINES TAXPAYER DUE PROCESS
    Proponents of the Senate provision have asserted that the provision 
contained in the Senate version of H.R. 2 would be beneficial to the 
Internal Revenue Service in litigation efforts against certain U.S. 
taxpayers involved in certain lease transactions. Ultimately any legal 
issues surrounding transactions completed prior to the JOBS Act 
effective date should properly be addressed by the IRS and in the 
courts on the basis of the laws that were in effect at the time the 
transactions were entered into. On due process grounds alone, U.S. 
taxpayers deserve to have their day in court without interference from 
the Congress before any judgment has been rendered. And to date, there 
have been no judgments involving such cross border transactions.
    Furthermore, nothing in the Senate provision would preclude, nor 
could a taxpayer expect, that the government would not continue to 
pursue a case against the taxpayer, as such cases relate to the tax 
treatment of past tax years. To reopen such cases would mean that the 
taxpayer would be subject to double jeopardy.
    Adopting legislation that goes back and retroactively changes the 
law in favor of the government on any provision of law is simply unfair 
and potentially unconstitutional. The tax system is currently working 
as intended, with the IRS reviewing facts and circumstances of 
transactions and challenging taxpayer positions, as warranted. Changing 
the law and economics midstream creates an unfair bias against 
taxpayers in favor of the government. If this is allowed, there is no 
reason Congress could not simply retroactively change the law in favor 
of the IRS on any issue the IRS is currently challenging in courts or 
otherwise. That is not the way our U.S. rule of law works, and it is 
not a change this committee should endorse.
UNINTENDED CONSEQUENCES
    We believe that imposing Section 470 retroactively would result in 
unintended consequences, specifically by retroactively subjecting 
otherwise common cross-border transactions to a regime designed to 
address questioned transactions. That is, as drafted, the Senate 
provision would impose Section 470 on existing transactions never 
targeted by the proponents. Just as Section 470 has impacted such 
things as the leasing of medical equipment to non-profit institutions 
(an otherwise common and efficient practice) on a going forward basis, 
imposing Section 470 retroactively would cause a number of such 
previously executed cross border transactions to become uneconomic 
without cause.
    For instance, one of the members of our organization states that 
the proposed retroactive change to Section 470 would eliminate net 
deductions for tax years 2007 and beyond on a number of lease 
transactions entered into years ago (with original equipment cost in 
excess of $800 million) that the IRS does not consider abusive. 
Examples include leases entered into during the mid to late 1990's such 
as rail leases to various European entities and a large lease of 
manufacturing equipment to a Canadian subsidiary of a U.S. company.
    Another member highlights an existing problem with Section 470 that 
will only be exacerbated by applying it retroactively. Current Section 
470's complex loss-trapping rules have inadvertently put not-for-profit 
hospitals at a competitive disadvantage, as the 9-year class life of 
medical equipment causes a fixed price purchase option to trigger 
adverse treatment to the lessor. Accordingly, a not-for-profit hospital 
must either face a higher lease rate by choosing to have a fixed price 
purchase option or lose significant flexibility by forgoing a fixed 
price purchase option. Not only should this existing inequity under 
Section 470 be fixed to recognize business realities in the area of 
medical equipment leases, but it should not be imposed retroactively.
    Indeed, the leadership of the House Ways and Means Committee and 
Senate Finance Committee have recognized that as it exists today, 
Section 470 results in unintended consequences. On December 15, 2005, 
after the enactment of Section 470 in the JOBS Act, then Chairman 
Grassley, Senator Baucus, then Chairman Thomas, and Congressman Rangel 
wrote to then Treasury Secretary Snow and stated that ``it has come to 
our attention that Section 470 may have . . . unintended 
consequences.'' ``Specifically, Section 470 as currently drafted . . . 
may apply to certain non-abusive transactions. . . .''
    As part of their letter, Senators Grassley and Baucus, and 
Congressmen Thomas and Rangel requested an extension of transition 
relief and non-enforcement of Section 470 for certain transactions.
    Because of these well-recognized unintended consequences, the 
Treasury Department has provided relief and non-enforcement of Section 
470 for certain transactions in each of the last three (3) years. See, 
IRS Notice 2005-29 (2005-13 I.R.B. 796), IRS Notice 2006-2 (2006-2 
I.R.B. 278), and IRS Notice 2007-4.
    In addition, the tax-writing committee staffs and the staffs of the 
Joint Committee on Taxation and the Treasury Department have been 
trying to develop legislation that would correct the unintended 
consequence problems that exist with current Section 470. Just last 
year, on September 29, 2006, technical corrections legislation was 
introduced in Congress to address, among other things, the problems of 
Section 470 having unintended consequences. See, ``Tax Technical 
Corrections Act of 2006.'' However, to date, those problems still 
exist.
    It seems illogical to now retroactively impose a provision of the 
tax code that is well-recognized by the tax-writing committees as 
already having unintended consequences, thereby creating additional 
confusion and exacerbating IRS compliance and enforcement problems. 
Moreover, it is irrational to impose it retroactively so as to capture 
transactions that have never been in question.
CONCLUSION
    Mr. Chairman, we believe taxpayers enter into transactions in full 
reliance on current tax law. This reliance and confidence is the 
bedrock of the Federal income tax system. Undermining the system by 
imposing retroactive tax increases is simply unfair as a matter of 
fundamental tax fairness. Further, it will serve to undermine the 
confidence of investors to deploy capital, which would devalue any 
attempt by Congress to use the Code as a means to incent investment.
    Accordingly, I urge you and this committee to reject the Senate 
leasing proposal as part of the minimum wage bill or any other tax 
legislation. This does not let anyone ``off the hook'' or absolve any 
questions of substance, as that process is well underway in the courts, 
just at Congress intended when it gave the IRS the power to pursue such 
cases, and just as the Constitution provides for taxpayers to have 
their day in court.
    Thank you for the opportunity to offer our views on this matter and 
I would be happy to answer any questions you may have.
                                 ______
                                 
ATTACHMENT
    Effects of Retroactive Application of Section 470 on Financial 
Statement Earnings and Capital
Summary
    The Senate proposal to make Section 470 retroactively applicable to 
transactions entered into prior to March 12, 2004, coupled with a 
current change in the GAAP treatment of leveraged leases, could have 
potentially significant adverse financial statement consequences to 
many U.S. corporations.
Financial Accounting Treatment of Leveraged Leases
    The economic impact of a leveraged lease is determined by its cash 
flows, including tax payments and refunds, and the associated GAAP 
financial statement effect is computed under Statement of Financial 
Accounting Standards No.13 (``SFAS 13''). SFAS 13 employs a two-step 
methodology under which the internal rate of return (``IRR'') derived 
from cash flows is first determined, followed by application of this 
IRR to the unamortized investment in the lease. The result is the 
amount of GAAP financial statement income that is recognized each 
period. Because incoming cash flows resulting from tax refunds are 
typically greatest in the early years of a leveraged lease, this 
methodology has the effect of increasing the IRR, which in turn 
increases the amount of GAAP financial statement earnings that are 
recognized. In other words, financial statement earnings are usually 
the greatest during the early portion of a lease when positive cash 
flows are at their peak.
    Until recently, SFAS 13 did not require a recomputation of GAAP 
financial statement earnings in situations where the timing of cash 
flows changed, but the total amount of income recognized over the life 
of a lease did not change. In other words, a change in the stream of 
financial statement earnings to be reported over the life of a lease 
would not change even though the timing of the underlying cash flows 
was altered.\1\
---------------------------------------------------------------------------
    \1\ Such a change if known from inception would have changed the 
IRR.
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    Subsequent to enactment of IRC Section 470 in 2004, the FASB issued 
a FASB Staff Position (``FSP'') that became effective on January 1, 
2007. See, FSP FAS 13-2. In a significant departure from the SFAS 13 
approach described above, the FSP provides that changes in the timing 
of cash flows caused by changes in tax treatment of a leveraged lease 
will require a recalculation of earnings dating back to the inception 
of the lease. When such changes in cash flows occur, the revised 
approach will result in a cumulative adjustment equal to the difference 
between the amount of GAAP income previously reported and the amount 
that would have been reported if the change in tax treatment had been 
known at lease inception. The entire amount of the cumulative 
adjustment must be reported when a change in tax treatment occurs, 
which will affect both current period earnings and retained earnings or 
capital.
Financial Statement Impact of Retroactive Application of Section 470
    When IRC Section 470 was enacted it was applicable only to 
transactions entered into after March 12, 2004. Accordingly, neither 
SFAS 13 nor the FSP would require any change in the GAAP financial 
statement treatment with respect to transactions consummated before 
that date. The Senate has now included a provision in H.R. 2 (the 
``Small Business and Work Opportunity Act of 2007'') that would make 
IRC Section 470 applicable to all transactions with a foreign entity or 
person, regardless of when they were entered into. This retroactive 
change to IRC Section 470 would virtually eliminate the benefit of 
deductions over the remaining lives of the leases. As a result, future 
cash flows would be dramatically reduced for a substantial period of 
time, and the FSP would require recalculation of the IRR from inception 
of the lease. Since the originally calculated IRR was heavily dependent 
on all future cash flows, not just those already realized, the GAAP 
financial statement impact on many affected lessors would be severe.
    Apart from the negative tax policy considerations of retroactive 
application of IRC Section 470, the effect on capital markets and the 
economy, and on financial institutions in particular, would be 
extremely undesirable. These charges could also reduce retained 
earnings, and the regulatory capital of affected financial 
institutions, with potentially severe consequences such as limiting the 
ability to make loans, pay dividends, violation of debt covenants, 
rating agency downgrades, and a decrease in share values. Taxpayers 
clearly never anticipated that the tax law might be retroactively 
changed in a manner that would lead to such dire consequences.

                                 

    Chairman RANGEL. I thank the former Member from Texas, and 
welcome back to the House of Representatives.
    Mr. BENTSEN. Thank you, Mr. Chairman.
    Chairman RANGEL. The Chair recognizes Greg Heaslip, from 
the great State of New York, and the great firm of PepsiCo and 
its very progressive way in which you are handling the 
retirement problems of the employees.
    We may be calling you back to assist us in giving aid to 
other multi-nationals to see how we can best protect our 
employees. Welcome to the Committee on Ways and Means.

 STATEMENT OF GREG HEASLIP, VICE PRESIDENT, BENEFITS, PEPSICO, 
                    INC., PURCHASE, NEW YORK

    Mr. HEASLIP. Thank you, Chairman Rangel, Ranking Member 
McCrery, and Members of the Committee, for the opportunity to 
discuss executive compensation proposals contained in the 
Senate's Small Business Work Opportunity Act of 2007.
    PepsiCo is a leader in the food and beverage industry. We 
employ over 155,000 people, worldwide, 60,000 in the United 
States in over 400 locations. Our employees are in every 
congressional district in America, and I hope you are familiar 
with some of our brands, which include PepsiCola, Frito-Lay, 
Quaker Oats, Gatoraid, and Tropicana.
    At PepsiCo, we are proud of our overall approach to 
employee compensation and benefits, including our practices in 
the area of retirement plans and savings. We offer a variety of 
broad-based programs to ensure that employees who spend a 
career with our company and perform consistently well can 
retire with secure lifetime income.
    These programs include a traditional defined benefit plan, 
which is well funded, and a 401(k) plan with a company match 
that increases with tenure. In combination, these programs 
achieve our goal of providing retirement security of 70 to 80 
percent of pre-retirement income to career employees.
    Now, as big as these programs are, a challenge facing many 
of our employees is that as their earnings increase, qualified 
plans and Social Security replace less and less of their pre-
retirement income. This is due to internal revenue code limits 
on qualified plan benefits, and limits on Social Security 
benefits.
    Consequently, non-qualified plans and personal savings play 
a more and more important role in achieving retirement 
security, as earnings increase. In response to these 
challenges, PepsiCo has instituted non-qualified savings and 
retirement programs, which are subject to internal revenue code 
section 409A. These plans restore benefits to employees 
affected by qualified plan limits, and encourage employees to 
save for retirement.
    While it appears that the Senate bill is aimed at top 
executives, its applicability goes far beyond. At PepsiCo, the 
bill would impact over 1,000 employees, and the individual 
impacts would be harsh and inequitable. At the same time, we 
see little benefit to shareholders or to the Government, from a 
revenue perspective. Allow me to provide three specific 
examples of the problems the Senate provisions--proposals--
would create.
    The first is with respect to a restoration plan for defined 
benefits. PepsiCo sponsors a non-qualified restoration plan 
that mirrors its qualified pension plan. It is designed to 
treat employees equitably by restoring benefits that are lost 
due to qualified plan limits. In our qualified pension plan, as 
in many traditional defined benefit plans, the value of an 
employee's pension increases significantly when they become 
eligible for early retirement.
    At PepsiCo, this step up in benefit value generally occurs 
at age 55. The same feature is mirrored in our non-qualified 
plan. The Senate's proposal would include the benefit accrual 
and a non-qualified plan against a deferral cap equal to one 
times pay--the lower of one times pay or $1 million.
    To assess the impact of this on employees, we measured the 
size of the age 55 accrual for 1,000 plan participants. We were 
startled to learn that in almost every situation, over 90 
percent of the time, the age 55 accrual exceeded the one times 
pay cap.
    As a result, under the Senate's approach, the employee 
would be taxed on the value of all accruals in all non-
qualified plans, and pay a 20 percent penalty, even though he 
or she is not retiring, or in constructive receipt of the 
money.
    This result would create the unfortunate effect of forcing 
the company to limit, or eliminate, non-qualified restoration--
its non-qualified restoration plan. Clearly, this would cause a 
significant loss of retirement security for a sizeable group of 
middle and senior managers, and prevent them from receiving the 
same level of benefits that other employees are entitled to.
    An additional concern is the broader effect this could have 
on the retirement security of all employees. In today's 
environment, traditional defined benefit plans already face 
many challenges. Disenfranchising middle and senior managers 
from these plans would add another huge challenge to the 
continuation of these plans. At a time when we're fighting 
desperately to maintain the defined benefit pension system, it 
is hard to imagine that this is what the Senate intended with 
this provision.
    PepsiCo offers the opportunity to elect to defer base 
salary or bonus as a means of encouraging personal and 
retirement savings. Under the Senate bill, investment earnings 
on non-qualified deferrals would count against the cap, and 
could trigger non-compliance, either in isolation or in 
combination with other plans. The unpredictable and harsh 
effect of this can be seen from a simple example.
    Consider the example of a 45-year-old employee earning 
about $200,000, who voluntarily defers 30 percent of salary 
each year. Assume the account earns 7 percent interest, based 
on market performance. The account generally increases in 
value, due to the continued annual deferrals and steady 
investment returns.
    As the employee's account balance increases, however, it 
becomes more likely that 1 year of unexpected high investment 
returns, combined with accruals from other plans, would throw 
the employee over the deferral cap. In our example, 1 year of 
12 percent returns for a 61-year-old would throw them over the 
cap, trigger taxes, and trigger penalties, again, even though 
they're not in receipt of the money, and they haven't retired.
    I have other examples that I would like to share with the 
Committee, but let me suggest that before we issue any 409A 
regulations, or expand upon it, we should finalize the current 
regulations that are issued but don't have final guidance 
available.
    If further regulations are deemed necessary, I would 
encourage that we focus on Chief Executive Officers (CEOs) or 
National Exchange Officers (NEOs), which is where the perceived 
abuses have been identified, implement a uniform cap of $1 
million or more with annual indexation--in other words, 
eliminate the ``lesser of'' test--exclude broad-based 
restoration plans that don't provide extra benefits, exclude 
elective deferral programs and the investment earnings on those 
programs, and, if implemented, make any changes prospective, 
without the need to modify or review current year deferral 
elections.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Heaslip follows:]
 Statement of Greg Heaslip, Vice President--Benefits, PespsiCo, Inc., 
                           Purchase, New York
    Chairman Rangel, Ranking Member McCrery and members of the 
Committee, thank you for the opportunity to discuss the executive 
compensation provisions in the Senate ``Small Business Work Opportunity 
Act of 2007.''
    PepsiCo is a world leader in the food and beverage industry and is 
headquartered in Chairman Rangel's great state of New York. PepsiCo 
employees 155,000 people worldwide with 60,000 employees in the United 
States at over 400 locations. In fact, we have employees in every 
congressional district in America. I am sure you know and enjoy our 
great company by its brands: Frito-Lay, Pepsi-Cola, Gatorade, Quaker 
Oats and Tropicana.
    As Vice President of Benefits for PepsiCo, let me begin by stating 
that I share your belief that corporate America has a responsibility to 
ensure executive compensation is consistent with company performance 
and in line with shareholder interests. I applaud your efforts to call 
attention to the vital issues raised by the Senate bill and for 
providing an appropriate forum to discuss this important topic. At the 
core, these issues have a direct impact on retirement security and 
personal savings for millions of Americans, global competitiveness, 
shareholder interests and tax policy. Any changes to the law in this 
area should not be taken lightly and should be thoroughly vetted and 
considered before moving forward. Your commitment to a deliberative 
process should be commended and I look forward to working with you to 
arrive at the right public policy outcome.
    At PepsiCo we are proud of our overall approach to employee 
compensation and benefits, including our practices in the area of 
savings and retirement benefits. We offer a variety of broad-based 
programs designed to provide retirement security to all employees who 
spend their career with the company and consistently perform well. 
These programs include a traditional defined benefit pension plan 
(which is fully funded) and a 401(k) plan with a company match that 
increases with tenure. We supplement these programs with an investment 
in ongoing employee communications about the importance of savings, 
pre-retirement planning seminars and personalized planning tools.
    In combination, these programs achieve our goal of providing 
retirement security to career employees by replacing 70 to 80 percent 
of their pre-retirement income through a combination of company-
sponsored programs, Social Security and personal savings.
    As good as these plans are, however, a challenge many of our 
employees face is that, as earnings increase, qualified plans and 
Social Security replace less of the employee's pre-retirement income. 
This is due to Internal Revenue Code limits on qualified plan benefits 
and limits on Social Security benefits. Consequently, non-qualified 
plans and personal savings play a larger role in achieving retirement 
security as earnings increase.
    In response to these challenges and in order to enable all 
employees to meet their retirement savings target, PepsiCo has 
instituted non-qualified savings and retirement programs, which are 
subject to Internal Revenue Code Section 409A. These programs apply to 
a large group of middle and senior level managers. They restore 
benefits to employees affected by qualified plan limits and encourage 
employees to save for retirement.
    The non-qualified ``pension restoration plan'' currently applies to 
approximately 900 senior managers whose benefits are subject to 
qualified plan limits. The restoration plan is mandatory and does not 
provide executives with ``extra benefits.'' It merely seeks to ``keep 
them whole'' with respect to the benefits other employees are entitled 
to (and which they would receive were it not for the qualified plan 
limits). Because the primary objective of the plan is to provide 
retirement benefits, employees do not have any ability to take benefits 
under the restoration plan in current cash.
    In addition we provide an opportunity for approximately 1,000 
middle and senior managers to save for retirement by voluntarily 
deferring a portion of their pay into a non-qualified deferral plan. 
These voluntary deferrals are not matched. Investment of the deferrals 
is participant-directed. Investment options essentially match those 
offered in the 401(k) plan; there are no ``above-market'' investment 
options offered.
    These programs are not just for the CEO and Named Executive 
Officers. They are unfunded, meaning the benefits are at risk. In 
addition, because they are non-qualified, no company deduction is taken 
until the employee is taxed on their money. The plans are subject to 
existing 409A requirements on the timing of elections and payouts, the 
form of payout and the treatment of key employees. In fact, we are 
still awaiting final regulations on the sweeping 409A reforms enacted 
by Congress in 2005.
    While it appears the Senate bill is aimed at the compensation 
packages of top executives, its scope and applicability go far beyond 
and have the potential for tremendous negative impact. At PepsiCo, the 
bill would impact over a thousand employees who participate in the 
programs outlined above, and the individual impacts would be harsh and 
inequitable. At the same time we see little or no benefit to 
shareholders or to government revenue from the proposal. Following are 
some specific examples of how the Senate non-qualified deferred 
compensation provision would turn employee-friendly programs into a 
nightmare for over a thousand of PepsiCo's employees.
Traditional Defined Benefit Restoration Plan
    PepsiCo's non-qualified restoration plan mirrors its qualified 
plan. It is designed to treat employees equitably by restoring benefits 
from the pension plan that are lost due to qualified plan limits. As 
indicated above, the restoration plan does not provide extra or 
supplemental benefits. It is designed to keep employees whole with 
respect to the benefits obtainable within the company's broad-based 
plan.
    In PepsiCo's qualified pension plan, as in many traditional defined 
benefit plans, the value of an employee's pension benefit increases 
significantly when they become eligible for early retirement. At 
PepsiCo this ``step up'' in benefit value generally occurs at age 55, 
with 10 or more years of service. The same feature is mirrored in the 
non-qualified plan.
    The Senate's NQDC proposal would include the benefit accrual in a 
non-qualified pension plan against the deferral cap of the lower of 1x 
pay or $1,000,000. To assess the impact of this, we measured the size 
of the age 55 accrual for nearly 1,000 employees who participate in 
PepsiCo's non-qualified restoration plan. We were startled to learn 
that in virtually all situations (90%+ of the time), the age 55 benefit 
accrual exceeded the 1x pay cap. As a result, under the Senate's 
approach the employee would be taxed on the value of all accruals in 
all non-qualified plans and pay a 20 percent penalty even though he/she 
is not retiring or in constructive receipt of the money.
    This result would create the unfortunate effect of forcing the 
Company to limit or eliminate the non-qualified restoration plan. 
Clearly, this would cause a significant loss of retirement security for 
a sizable group of middle and senior managers, and prevent them from 
receiving the same level of benefits other employees are entitled to.
    An additional concern is the broader effect this could have on the 
retirement security of all employees. In today's environment, 
traditional defined benefit plans already face many challenges. 
Disenfranchising middle and senior managers from these plans would add 
another huge challenge to the continuation of these plans. At a time 
when we are fighting desperately to maintain the defined benefit 
pension system, it is hard to imagine that this is what the Senate 
intended with its provision.
Voluntary Deferral Plan
    PepsiCo offers eligible employees the opportunity to elect to defer 
base salary or bonus payments as a means of encouraging personal and 
retirement savings. As mentioned above, the plan is subject to 409A, 
the employee directs how the money is invested and there are no 
``above-market'' investment options or company matching contributions.
    Under the Senate bill, investment earnings on non-qualified 
deferrals would count against the proposed annual cap and could trigger 
non-compliance in isolation or in combination with accruals under other 
plans. The unpredictable and harsh effect of this can be seen from a 
simple example.
    Consider the example of a 45-year-old employee at a salary of 
$207,000 who voluntarily defers 30 percent of salary each year (typical 
among our plan participants). Assume the account earns 7 percent 
investment return each year based on market performance. The account 
gradually increases in value due to continued annual deferrals and 
steady investment returns. As the employee's account balance increases, 
however, it becomes more likely that one year of higher-than-expected 
investment returns, combined with accruals in other plans, will throw 
the employee over the deferral cap. In our example, one year of 12% 
market returns when the employee is age 61, combined with accruals from 
other programs, would throw him over the 1x cap.
    As a result, the employee would be taxed on the value of all 
accruals in all non-qualified plans and pay a 20 percent penalty even 
though he did not access the deferred funds and the funds are still at 
risk. This draconian penalty is triggered by disciplined saving over 
time coupled with one year of high market returns and is most likely to 
happen to long service employees as they are nearing retirement. This 
does not seem to be the type of behavior we should be punishing with 
the tax code.
    One potentially perverse outcome of this scenario is that 
triggering taxes and severe penalties on an employee who has not 
received the money could cause the employee to leave the company so 
that he would receive the funds and have the cash to pay the taxes and 
penalties. Public policy should help us retain our workers, not drive 
them away.
    In addition to the examples above, there are other situations in 
which the Senate's proposal could produce broad, harsh and undesirable 
outcomes.
Severed Employees
    Unfortunately, the Senate non-qualified deferred compensation 
proposal does not make a distinction between CEOs who are terminated 
for poor performance and other employees who lose their jobs for 
reasons beyond their control and receive economic consideration.
    It is occasionally necessary through corporate restructuring and/or 
reorganization to close plants or other facilities. When this occurs at 
PepsiCo, the company often provides employees who are within five years 
of retirement with a special retirement benefit that exceeds the value 
of what they would otherwise be entitled to as a terminated employee. 
The special retirement benefit equals what they would have received if 
they had been eligible for retirement when the facility was closed.
    As an example, take the case where Frito-Lay closes one of its 
manufacturing plants. Consider a plant manager who is 53 years old (2 
years from retirement eligibility), makes $100,000 and is losing his 
job because of the plant closing. Because the employee is close to 
retirement and his job is being eliminated, the Company provides a 
special early retirement benefit as part of the employee's severance. 
The benefit is paid from the non-qualified pension plan in order to 
comply with qualified plan non-discrimination rules. In this case, the 
employee could hit the cap in the year he was severed due to job 
elimination as the value of the non-qualified severance benefit is 
greater than 1x pay. The employee would be taxed on the value of his 
special early retirement benefit and pay a 20 percent penalty at a time 
when he has lost his job and is entering retirement or a financially 
uncertain time.
    This is a circumstance that reaches deep into the rank-and-file at 
PepsiCo--it could affect any employee who makes $100,000 or more and is 
close to retirement--that we would hope Congress would avoid.
Retention Bonus
    In order to maintain an alignment of interests and retain 
employees, particularly those at the executive level who have advanced 
career experience, PepsiCo has a mandatory bonus deferral program. 
Under the terms of the mandatory bonus deferral, a portion of an 
executive's annual bonus is deferred for three years. The executive 
must remain with the Company for the deferral period in order to 
receive their deferred bonus. This is an essential tool for encouraging 
and rewarding tenure. These bonuses are taxable when they are received 
at the end of deferral period and the employee has no ability to 
control the bonus amount or timing of this event.
    If arrangements such as this were subject to the deferral cap, 
companies would have to consider replacing employee retention features 
with current year compensation. From a shareholder perspective the 
Senate-passed legislation would be counterproductive in that it would 
likely result in this type of change.
Grandfathering and Transition
    In reviewing the Senate executive compensation provisions, it is 
extremely troubling that the effect of the provisions is to apply new 
rules retroactively. As someone who must confront the challenge of 
helping employees plan for retirement in a way that complies with an 
increasingly complex thicket of regulations, I would emphasize that 
certainty is essential. Plan sponsors and individual employees are 
already challenged with making significant financial decisions in the 
face of incomplete guidance. In the case of non-qualified deferred 
compensation, the recent changes to 409A impose strict new penalties 
and require that binding elections be made well in advance of actual 
deferrals. The Senate approach changes the rules after the fact and has 
put employees and employers in a bind. There is no correction option 
under 409A and, in fact, we still do not have final regulations on how 
to interpret a law that was enacted two years ago. The Senate bill 
creates many new headaches by ignoring the mechanics of how 409A is 
being implemented.
    Given the severity of penalties for non-compliance, it is likely we 
will need to modify existing non-qualified deferred compensation plans 
to meet the requirements of any change in law. To do so in the right 
fashion, we must have an opportunity to transition to the new rules in 
the least disruptive manner. In the absence of an actual change in law, 
we also need to be able to move forward with the election and deferral 
decisions that are locked in place and moving forward as we speak. 
Grandfathering money that has already been deferred is a matter of 
fairness and providing adequate transition relief will ensure that 
employee attempts to save are not inappropriately and unfairly 
undermined. I applaud and appreciate the Chairman and Ranking Member 
for their unified opposition to retroactive changes in the law.
162(m)
    The ``Small Business Work Opportunity Act of 2007'' also contains a 
provision that would modify the definition of ``covered employee'' for 
purposes of the deductibility of executive compensation. While PepsiCo 
is not directly impacted by this provision, I think it is important to 
make a few comments. First, the same principle of opposing 
retroactivity applies here. To the extent employment agreements and 
compensation decisions were based on current law and executed as such, 
it is very troubling that Congress would even consider changing the law 
and applying it retroactively. This sort of action undermines taxpayer 
confidence and makes it exceedingly difficult to set compensation and 
benefit policy at a company. The original 162(m) legislation contained 
an explicit grandfather of binding contracts and arrangements. This 
approach should be maintained. There is also an effort to extend the 
``covered employee'' group beyond the current SEC definition. While 
this does not seem to be problematic at face value, I would caution 
that it adds complexity. To the extent we can unify the rules and speak 
in consistent terms, it makes for a more coherent and easily 
identifiable policy. It seems logical that the tax code and the SEC 
should be able to agree on who constitutes the ``covered employee'' 
group.
Constructive Reforms
    Based on a critical analysis, the nature and scope of the Senate 
bill gives rise to myriad issues that should be resolved prior to 
determining the need to act. Given the potential impact on retirement 
security, personal savings, competitiveness and shareholder interests, 
I would hope that Congress will proceed with great caution and 
restraint. The issues are too important to not get this right.
    Prior to any new legislation, we would like to see final guidance 
on current 409A regulations. The impact of the recently enacted 
sweeping new reforms of 409A is still being absorbed by most companies. 
Enacting new changes before we know how the current rules work seems 
premature. However, if expansion of the rules governing non-qualified 
deferred compensation is necessary for political or substantive 
reasons, we recommend a more focused approach:

      Issue final guidance on current 409A regulations before 
expanding 409A's application to deferred compensation
      If further regulations are necessary:
        Focus on CEOs or NEOs, where perceived issues have been 
identified, rather than a broad slice of employee population
        Implement a uniform cap ($1 million or more) with 
annual indexation (i.e., eliminate the ``lesser of'' test)
        Exclude broad-based pension restoration plans that 
offset limits in the qualified pension plan and do not provide 
``extra'' benefits
        Exclude elective deferral programs and the earnings on 
account balances so long as these earnings are market-based
        Exclude mandatory bonus deferrals
        If implemented, make any changes prospective, without 
the need to review and modify current year deferral elections
        Provide for a ``correction'' mechanism to allow for 
plan participants who run afoul of 409A to comply without triggering 
penalties

    PepsiCo is committed to being a world leader in corporate 
governance. We take very seriously our responsibilities to our 
employees, shareholders and customers. I appreciate the opportunity to 
share our view of the Senate executive compensation proposals and your 
willingness to consider them in an open venue with a healthy public 
discourse. Most importantly, we look forward to working with you to 
arrive at the appropriate public policy. I would be happy to discuss 
any of these issues with you or answer any questions. Thank you.

                                 

    Chairman RANGEL. Thank you.
    The Chair recognizes Kenneth Petrini, vice president of 
taxes, Air Products and Chemicals, Inc.

  STATEMENT OF KENNETH R. PETRINI, VICE PRESIDENT, TAXES, AIR 
   PRODUCTS AND CHEMICALS, INC., ALLENTOWN, PENNSYLVANIA, ON 
      BEHALF OF THE NATIONAL ASSOCIATION OF MANUFACTURERS

    Mr. PETRINI. Mr. Chairman and Members of the Committee, 
thank you for inviting me to testify on behalf of the National 
Association of Manufacturers (NAM), on the revenue-raising 
provisions included in the legislation currently pending in 
Congress. My name is Ken Petrini, and I am vice president of 
taxes at Air Products and Chemicals. I also serve as the Chair 
of the tax and budget policy Committee of NAM.
    The NAM is the Nation's largest industrial trade 
association, representing small and large manufacturers in 
every industrial sector, and in all 50 States. Many NAM members 
believe that tax relief is critical to economic growth and job 
creation. In contrast, revenue raisers, like those that we will 
talk about in our testimony, will impose new taxes on those 
businesses, making it more difficult for them to compete in the 
global marketplace.
    In particular, H.R. 2, as passed by the Senate, includes 
several tax increases that are of particular concern to 
American manufacturers. A common theme with these proposed 
changes is that while they may be rooted in some valid policy 
concerns, they are drafted in such a way to be overly broad, 
and threaten to ensnare transactions and expenses well beyond 
their intended scope.
    Manufacturers currently face some of the highest legal 
costs in the world. Based on a recent study by NAM's 
Manufacturing Institute, court costs for U.S. businesses are at 
historical highs, and are higher than similar legal costs in 
other countries. Yet, two provisions in the Senate bill would 
add to the current anti-competitive legal cost burden facing 
U.S. manufacturers.
    The proposals to eliminate tax deductions for punitive 
damages and settlements of potential violations of law 
represent significant changes to, and an unnecessary expansion 
of, current law that will increase the cost of doing business 
in the United States for manufacturers.
    Under current law, taxpayers generally can deduct damages 
paid or incurred, as a result of carrying out a trade or 
business, regardless of whether those damages are compensatory 
or punitive. The proposed change to make punitive damages--
damage payments in civil suits non-deductible, whether made in 
satisfaction of a judgement or settlement of a claim, runs 
counter to fundamental and well-established tax principles, and 
represents unsound public policy.
    In particular, the proposal violates the principle that 
income should be taxed only once. Since punitive damages would 
not be excluded from income, both the payor and the recipient 
would be subject to tax on the punitive damages, thus imposing 
a double tax on the same income.
    The proposal also violates another principle of Federal tax 
policy, and that is to provide similar tax treatment for 
similar behavior. Different standards and guidelines apply in 
different jurisdictions in this country, and that could result 
in punitive damages in one jurisdiction that are not punitive 
damages in another.
    For a broader policy perspective, the proposal is based on 
a false premise that punitive damages are the same as non-
deductible criminal or civil fines that are fixed in amount, 
and are imposed for specific activities that are defined in 
advance. In contrast, punitive damages are often awarded under 
vague and unpredictable standards.
    Clearly, too, the issue of settlement agreements with 
governments, as in the proposal discussed earlier, this 
provision runs counter to fundamental and well-established tax 
principles, and represents unsound public policy. Currently, a 
business cannot deduct from income any fine or similar penalty 
paid to a government for violation of any law.
    This proposal would extend this provision to the non-
penalty portion of settlement payments, thus eliminating the 
deduction for most, if not all, settlement agreements with the 
government on a wide range of issues, regardless of whether 
there was any wrongdoing. We are concerned that, regardless of 
the intended scope of the provision, that it could be greatly 
expanded in subsequent administration by tax auditors to deny 
deductions and to prevent resolutions of many issues that can 
be beneficial to all.
    Manufacturers operating in the United States today face a 
significant regulatory burden. These regulations are often 
ambiguous, and subject to interpretation, making it difficult, 
if not impossible, to ensure 100 percent compliance at all 
times. We have a strong policy reason to have a system that 
allows businesses to voluntarily settle and pay Government 
claims.
    NAM, also in its testimony--and in the interest of time, I 
will try to summarize very briefly--has expressed concern about 
the non-qualified deferred compensation provisions, and also 
section 162(M) of the proposals dealing with executive 
compensation. We agree with the comments of the prior witness, 
and we would only add that, with respect to deferred 
compensation, that we ask the Committee to consider the policy 
reasons behind the deferral of compensation, and the reasons 
why businesses actually allow for deferred compensation, and 
also to consider that in enacting section 409A in 2004, you 
enacted provisions that would make it very difficult for senior 
executives, key employees, to cash out of a business while it 
was failing.
    Those provisions are, in fact, consistent with the policy 
behind deferred compensation, which seeks to align the 
interests of the shareholders with those of the executive, and 
we should be encouraging the deferral of compensation, in an 
unfunded fashion, by executives, because it does, in fact, 
align those interests with those of the shareholders. Thank you 
again for this opportunity to testify.
    [The prepared statement of Mr. Petrini follows:]
 Statement of Kenneth R. Petrini, Vice President--Taxes, Air Products 
and Chemicals, Inc., Allentown, Pennsylvania, on behalf of the National 
                      Association of Manufacturers
    Mr. Chairman and Members of the Committee,
    I am pleased to have the opportunity to testify this morning on 
behalf of the National Association of Manufacturers (NAM) on several 
revenue raising provisions included in legislation currently pending in 
Congress. We applaud the Committee's initiative in holding the hearing.
    My name is Ken Petrini and I am Vice President, Taxes at Air 
Products and Chemicals, Inc., in Allentown, Pennsylvania. I also serve 
as the Chairman of the NAM's Tax and Budget Policy Committee. The NAM 
is the nation's largest industrial trade association, representing 
small and large manufacturers in every industrial sector and in all 50 
states. NAM members believe strongly that tax relief is critical to 
durable economic growth and job creation. In contrast, revenue 
raisers--like those I will describe in my testimony--would impose new 
taxes on many businesses, making it more difficult for them to compete 
in the global marketplace.
    In particular, the Small Business and Work Opportunity Act of 2007 
(H.R. 2) as amended by the Senate on February 1, 2007,\1\ includes 
several tax increases that are of particular concern to American 
manufacturers. These include proposals to:
---------------------------------------------------------------------------
    \1\ Fair Minimum Wage Act of 2007 [H.R. 2 EAS/17], as passed by the 
Senate, 2/1/07

      Deny Deductions for Punitive Damage Payments; \2\
---------------------------------------------------------------------------
    \2\ Ibid, Section 223
---------------------------------------------------------------------------
      Deny Deductions for Settlement Payments; \3\
---------------------------------------------------------------------------
    \3\ Ibid, Section 224
---------------------------------------------------------------------------
      Limit Deferrals Under Nonqualified Deferred Compensation 
Plans; \4\
---------------------------------------------------------------------------
    \4\ Ibid, Section 226
---------------------------------------------------------------------------
      Expand the Definition of Employees Subject to Rules 
Limiting the Deduction for Salary Payments; \5\ and
---------------------------------------------------------------------------
    \5\ Ibid, Section 234
---------------------------------------------------------------------------
      Impose New Taxes on Expatriates.\6\
---------------------------------------------------------------------------
    \6\ Ibid, Section 225

    A common theme with these changes is that, while they may be rooted 
in some valid policy concerns, they are drafted in such a way to be 
overly broad and threaten to ensnare transactions and expenses well 
beyond their intended scope.
Increasing Legal Costs for American Manufacturers
    Manufacturers currently face some of the highest legal costs in the 
world. Based on a recent study by NAM's research and education arm, the 
Manufacturing Institute, tort costs for U.S. businesses are at 
historical highs and are higher than similar legal costs in other 
countries.\7\ Moreover, the tort burden on manufacturers (as a 
percentage of manufacturing output) is roughly 2.2 times larger than 
the burden of these costs on other sectors of the economy.\8\
---------------------------------------------------------------------------
    \7\ ``The Escalating Cost Crisis,'' p. 11 The Manufacturing 
Institute, 2006.
    \8\ Ibid
---------------------------------------------------------------------------
    Two provisions in the Senate-passed version of H.R. 2, if enacted, 
would add to the current, anti-competitive legal cost burden facing 
U.S. manufacturers. Specifically, the proposals to eliminate tax 
deductions for punitive damages and settlements of potential violations 
of law represent significant changes to, and unnecessary expansion of, 
current law that will increase the cost of doing business in the United 
States for manufacturers.
Punitive Damages
    Under current law, taxpayers generally can deduct damages paid or 
incurred as a result of carrying on a trade or business, regardless of 
whether the damages are compensatory or punitive. The proposed change 
to make punitive damage payments in civil suits non-deductible, whether 
made in satisfaction of a judgment or in settlement of a claim, runs 
counter to fundamental and well-established tax principles, and 
represents unsound public policy.
    From a tax policy perspective, the proposal represents a sharp 
departure from the income tax principle that taxpayers should be taxed 
on net income. To measure net income accurately, all expenses 
associated with the production of income are properly deductible.
    Similarly, the proposal violates the principle that income should 
be taxed only once. Since punitive damage awards would not be excluded 
from income, both the payor and the recipient would be subject to tax 
on the punitive damages, thus imposing a ``double tax'' on the same 
income. The United States Treasury would get a windfall, but businesses 
would receive a ``tax penalty.''
    The proposal also represents a departure from another objective of 
federal tax policy--to provide similar tax treatment for similar 
behavior. Because of different standards and guidelines in the current 
civil justice system, conduct that results in punitive damages in one 
state may not result in punitive damages in another. For example, 
standards for awarding punitive damages vary widely among states--a 
number of states have ``caps'' on punitive damages and some states do 
not allow punitive damage awards at all.
    NAM also is concerned about significant tax administration issues 
under the proposal. Under current law, it is often difficult to 
determine the character of awards (i.e., compensatory vs. punitive), 
particularly in cases that are settled in a lump sum while on appeal. 
The term ``punitive'' is not defined in the tax code or regulations nor 
is the term defined in the proposal. The Tax Court has held that state 
law determines whether awards are punitive or compensatory in nature, 
which suggests that the proposal could result in dramatically different 
treatment of otherwise similarly situated taxpayers in different 
locales.
    Moreover, one jury may award damages while another may decide there 
is no liability even where the facts are very similar. A prime example 
is BMW of North America v. Gore.\9\ In this case, a jury awarded the 
plaintiff $4 million in punitive damages because BMW had sold as new a 
car that had received touch up paint treatment. In contrast, a few 
months earlier, another jury in the same county in a case with the same 
defendant and nearly identical facts found no liability.
---------------------------------------------------------------------------
    \9\ 517 U.S. 559
---------------------------------------------------------------------------
    Another area of concern for NAM members is the effective date of 
the proposal. Disallowing deductions for amounts paid or incurred on or 
after the date of enactment would interfere with a taxpayer's decision 
today whether to appeal an initial award of punitive damages. Because 
the deduction would continue to be available only for amounts paid 
before the enactment date, taxpayers recently hit with initial damages 
awards would be discouraged from exercising their right to appeal. 
Moreover, existing damage award amounts have been based on the 
assumption that such amounts would be deductible. Disallowing 
deductions for these existing awards would impose a far greater penalty 
on taxpayers than was intended by judges and juries.
    From a broader public policy perspective, the proposal is based on 
the false premise that punitive damages are the same as non-deductible 
criminal or civil fines. Criminal or civil fines are fixed in amount 
and are imposed for specific activities that are defined in advance. In 
addition, criminal liability must be proven ``beyond a reasonable 
doubt,'' i.e., the jury must be virtually certain of its decision. In 
contrast, punitive damages are awarded after the fact under vague and 
unpredictable standards such as ``reckless'' or ``wanton'' or ``gross 
negligence'' or all three.
Settlement Payments
    NAM members also have significant concerns about the impact of the 
proposal that would prevent companies from deducting the cost of 
settlement agreements with the government. Like the proposal discussed 
earlier, this provision runs counter to fundamental and well-
established tax principles, and represents unsound public policy.
    Under current law, a business cannot deduct from income ``any fine 
or similar penalty paid to a government for the violation of any law.'' 
The proposal would significantly extend this provision to the non-
penalty portion of settlement payments, thus eliminating deductions for 
most, if not all, settlement agreements with the government on a wide 
range of issues, regardless of whether there was any wrongdoing.
    NAM members believe that the language as drafted would sweep in a 
large number of unintended and legitimate expenses. In particular, the 
``inquiry into the potential violation of any law'' clause included in 
the proposal could be read to include almost all payments made by a 
business in connection with daily, routine interaction with government 
agencies. By eliminating a deduction for an ordinary and necessary 
business expense, the proposal represents a dramatic change in long-
standing tax policy that would act as a disincentive for companies to 
enter into these agreements.
    Manufacturers operating today in the United States face a 
significant regulatory burden. In many cases, these regulations are 
ambiguous and subject to interpretation making it difficult, if not 
impossible, to ensure 100 percent compliance at all times. 
Consequently, there is a strong public policy reason to have a system 
that allows businesses to voluntarily settle and pay government claims.
    Moreover, current law establishes a distinction between punitive 
and nonpunitive payments that has a long history in the courts and with 
the Internal Revenue Service.\10\ According to IRS officials, the IRS 
is committing ``significant resources'' to ensure the proper treatment 
of settlement payments.\11\ In contrast, the proposed change would 
replace this well-established and workable precedent with a new, all-
encompassing standard with which the courts and the IRS would have to 
struggle. The approach taken by the proposal is to disallow a broad 
category of deductions (legitimate and otherwise), and require 
taxpayers to rely on limited exception language to claim clearly proper 
deductions. Ironically, the need to fit oneself into the narrow scope 
of the exception would limit some of the flexibility that exists today 
in responding to real or perceived violations of laws and regulations 
and would limit the ability of business and government to agree on 
certain remedies that benefit society.
---------------------------------------------------------------------------
    \10\ See Talley Inds., Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 
1997); Middle Atlantic Distributors, Inc. v. Commissioner, 72 T.C. 1136 
(1979); see also Field Serv. Adv. 200210011 (Nov. 19, 2001).
    \11\ Letter to Sen. Charles Grassley from B. John Williams, Jr. 
Chief Counsel, Internal Revenue Service 4/1/03
---------------------------------------------------------------------------
    Clearly, American consumers and businesses would lose if the 
proposals on punitive damages and settlements were adopted.  U.S. 
manufacturers face significant government regulation and operate in a 
world where no product is or can be absolutely perfect. These proposals 
would hamper entrepreneurship, innovation, and product development by 
further adding to the cost of doing business. This, in turn, would 
increase the price of goods and services for consumers, chill 
innovation, put jobs at risk and undermine U.S. competitiveness.
Unwarranted Attacks on Benefits and Compensation
Nonqualified Deferred Compensation
    NAM members strongly oppose a provision in the Senate-passed 
version of H.R. 2 that would impose significant limitations on 
nonqualified deferred compensation plans. The proposal, which is not 
targeted at any abuse of deferred compensation rules, is a solution in 
search of a problem that would effectively eliminate the ability of 
employers to use deferred compensation as a retention tool for valued 
employees.
    In 2004, Congress adopted significant changes to nonqualified 
deferred compensation laws that were designed to address perceived 
abuses. The legislation--the American Jobs Creation Act of 2004 \12\--
created a new tax code section (Section 409A) that significantly 
reformed existing rules for the establishment and operation of 
nonqualified deferral arrangements.
---------------------------------------------------------------------------
    \12\ P.L. 108-357
---------------------------------------------------------------------------
    In particular, Section 409A was designed to address perceived 
abuses of nonqualified deferred compensation plans, principally whether 
the individual making the deferral had control of the deferred assets. 
Under 409A, amounts deferred under nonqualified arrangements must 
remain at a substantial risk of forfeiture to the employee. Final 
regulations to implement Section 409A (which are expected to run to 
hundreds of pages) have yet to be finalized by the Treasury Department. 
NAM members believe that Congress should allow the new law to work 
before considering additional changes.
    In contrast, the proposal included in the Senate bill would further 
restrict the rules on nonqualified plans by limiting annual deferrals 
to the lesser of the five-year average of an individual's taxable 
compensation or $1 million. The legislative history of the provision 
\13\ makes clear that earnings inside a deferred compensation plan 
should be counted towards the annual cap on deferrals. As a result, 
violations of the new rule could occur merely as the result of the 
passage of time and not as a result of any action by the employee or 
the company. The potential penalties are severe. An individual who 
intentionally or unintentionally violates the provision would be 
subject to immediate taxation on the entire deferred balance plus an 
additional 20 percent excise tax.
---------------------------------------------------------------------------
    \13\ Senate Report 110-1, p.52
---------------------------------------------------------------------------
    Although tax avoidance on deferred amounts is cited as the primary 
reason behind the proposal,\14\ there is no avoidance of taxation under 
a nonqualified deferred compensation plan. Rather, tax is deferred 
until a future period. There is no tax consequence to deferrals into 
nonqualified plans because the matching principle applies, i.e., a 
deduction is only taken by the employer when the deferred amounts are 
actually received by the employee and taken into income. Furthermore, 
though we believe the proposal is aimed at large deferrals (although as 
explained later, it does not just pertain to large deferrals), it is 
unlikely that there will be a significant benefit from lower tax 
brackets when amounts are paid out. Since employment taxes will 
typically be paid at deferral or when the amounts are no longer subject 
to forfeiture, there simply is no tax avoidance in play.
---------------------------------------------------------------------------
    \14\ Ibid
---------------------------------------------------------------------------
    Nonqualified deferred compensation arrangements are used by many 
manufacturers to motivate and reward their workforce and to align the 
interests of employees with the interests of the company. Sometimes 
these plans are non-elective restoration plans, effectively restoring 
benefits to individuals that have been eliminated from tax qualified 
plans because of income limits. In other cases, these plans are used as 
supplemental retirement plans or incentive plans.\15\ Still, in other 
cases, the decision to defer is a voluntary one, made by the employee 
under the rules of Section 409A. The Senate proposal essentially takes 
away an important human resources and management tool that businesses 
both large and small utilize to retain and attract employee talent.
---------------------------------------------------------------------------
    \15\ Examples of affected plans are included in Attachment A and 
specific employee examples are included in Attachment B.
---------------------------------------------------------------------------
    When a business chooses to pay its employees through deferred 
rather than current compensation, it ties the employee to the business 
in a meaningful way. By voluntarily deferring compensation into a 
nonqualified plan, the employee gives up the right to receive that 
compensation and puts its eventual payment at the risk of the future 
performance of the company. If the plan offers the chance to invest the 
deferred funds in company stock, the alignment is even stronger. These 
arrangements should be encouraged, not restricted. The legislation 
enacted in 2004 adds safeguards to prevent employees from taking the 
deferred money and running when times are bad. As a result, employees 
who defer compensation know that if the company fails, it is unlikely 
they will ever receive those funds. This is a powerful corporate 
governance tool that aligns the interests of executives and 
shareholders.
    The proposed limits on nonqualified deferred compensation also 
would have unintended consequences when applied to a typical 
supplemental pension plan that pays annual lifetime benefits in 
retirement. In many cases, the vesting of these benefits in a single 
year could push an employee's deferred compensation above the 
provision's annual cap, leaving the employee liable for an immediate 
tax and penalty on amounts they will receive over their lifetime. For 
example, the present value of a modest lifetime annuity payable at 
retirement could easily exceed the cap since the payment is assumed to 
continue as long as the retired employee lives. To avoid this problem, 
employers would have to pay the discounted value of the pension as a 
lump sum. Forcing lump sum payments would be bad pension policy and 
would remove a significant corporate governance benefit that is 
achieved when an employee is tied to the company for life.
    It also is important to note that because the proposal would apply 
to amounts that exceed the lesser of the five-year average of an 
individual's taxable compensation or $1 million, it would create an 
arbitrary limit on deferred compensation that applies not just to top 
corporate executives, but also to middle managers, sales people, and 
other employees of both public and private employers. Furthermore, the 
proposed limit on annual deferrals would act as a highly intrusive tax 
penalty on a company's fundamental business decision to pay employees 
through deferred rather than current compensation.
New Limits on Deducting Salary Payments
    NAM members also have serious concerns about a provision in the 
Senate bill that would expand the definition of a covered employee 
under Section 162(m) of the tax code, which limits the deduction of 
salary payments. In recent years, the Joint Committee on Taxation \16\ 
as well as a number of public and private sector witnesses before the 
Senate Finance Committee \17\ has criticized this provision. In 
contrast, the Senate proposal would add a far-reaching new compensation 
limit to the tax code.
---------------------------------------------------------------------------
    \16\ ``Present Law and Background Relating to Executive 
Compensation, `` Joint Committee on Taxation, JCX-39-06, 9/5/06
    \17\ Executive Compensation: Backdating to the Future, 9/6/06
---------------------------------------------------------------------------
    Section 162(m) currently denies an employer a deduction for non-
performanced based compensation in excess of $1 million paid to an 
individual who is a ``covered employee'' of the employer, i.e., the 
taxpayer's chief executive officer (``CEO'') or one of the four highest 
paid executive officers of the company at the end of the year (the 
``Top 4'') whose compensation is required to be disclosed under the 
Securities and Exchange Commission's (SEC) proxy rules.\18\
---------------------------------------------------------------------------
    \18\ Note that, because the SEC recently amended the proxy 
disclosure rules to no longer include ``the Top 4,'' Section 162(m) is 
no longer congruent with the proxy rules. ``Executive Compensation and 
Related Person Disclosure; Final Rule and Proposed Rule'' Federal 
Register Vol. 71, No. 174 (8 September 2006): 33-8732A.
---------------------------------------------------------------------------
    In addition, the deduction limit applies if the non-performance-
based compensation in excess of $1 million is paid to an individual who 
is a covered employee on the last day of the year in which the payment 
is made. Therefore, an employer might contractually commit to pay 
compensation to an employee on separation from service, at which time 
the employee would not be a ``covered employee'' under Section 162(m).
    The Senate proposal would expand the definition of covered employee 
under Section 162(m) to include (i) any person who was CEO during any 
part of any year (not just the end of the year) and (ii) any person who 
ever was a ``covered employee'' in any year after 2006 (even if that 
person is not a covered employee in the year that the compensation 
payments are received or the year the services are performed). In 
effect, the proposal creates a new rule that if an employee is ever a 
covered employee, he will always be a covered employee--even if current 
compensation eliminated them from the ``high five'' of a corporation.
    Under the proposal, compensation earned or payable in the future to 
an employee who at any time in a taxable year beginning after December 
31, 2006, was a covered employee would remain subject to Section 162(m) 
in perpetuity. As drafted, this proposal represents a significant 
expansion of the scope of Section 162(m), rather than an attempt to 
close an inadvertent loophole.
    The Senate proposal also modifies the definition of covered 
employee by dropping a cross reference to the securities law from 
existing Section 162(m). The SEC's new proxy rules (which apply to 
proxies filed for fiscal years ending on or after December 15, 2006), 
require detailed disclosure for any person who acts as CEO during the 
fiscal year, any person who acts as CFO during the fiscal year, and the 
three other most highly compensated executive officers other than the 
CEO and CFO. In order to retain the previous group for tax purposes 
(i.e., the CEO and the Top 4), the statutory change to Section 162(m) 
removes from the definition of ``covered employee'' a requirement that 
``the total compensation of such employee for the taxable year is 
required to be reported to shareholders under the Securities Exchange 
Act of 1934.'' This approach has serious unintended consequences and 
may significantly and inadvertently expand the category of employees 
who may be covered.
    In addition, as drafted, the proposal would be retroactive, denying 
corporations' deductions for compensation that was earned before 2007, 
by any employee who becomes a covered employee after 2006. Many 
employers today have outstanding compensation obligations that were 
structured in reliance on current law, but that would become non-
deductible under the proposed amendment. Unfortunately, there is little 
or nothing a corporation could do to protect the deduction it thought 
it already had--existing contractual arrangements are legally binding 
on the employer and cannot simply be rewritten by the employer to 
reflect an unanticipated retroactive change in law.
    By denying a deduction for pre-2007 compensation an employer is 
obligated to pay, the proposal will raise taxes on corporate employers 
without changing corporate compensation practices. While a retroactive 
application of the new rule will not affect executives who will be paid 
what they are owed, corporate shareholders stand to lose because of the 
corporation's tax increase. Note that this was not the case when 
Section 162(m) was originally enacted and Congress expressly 
grandfathered all compensation payable under written binding contracts 
that were already in effect.
    While we oppose enactment of the changes to Section 162(m), if 
these changes are made they should only apply prospectively since 
employers cannot control past compensation arrangements. At a minimum, 
the proposal should expressly provide that amended Section 162(m) will 
only apply to tax years beginning after the date of enactment and will 
not apply to any compensation to which an employee had a legally 
binding right, whether or not contingent, on or before the last day of 
the taxable year including [the date of enactment] or which relate to 
services performed before such last day.\19\
---------------------------------------------------------------------------
    \19\ The effective date of the proposal should permit public 
companies time to obtain shareholder approval of performance-based 
plans that may need to be modified.
---------------------------------------------------------------------------
    The NAM also believes that delinking Section 162(m) from proxy 
rules is not in the public interest. Current law defines a covered 
employee by reference to the SEC's proxy rules. This makes sense for 
two reasons. It is easier for taxpayers (and the IRS) to figure out who 
is a covered employee in advance of paying compensation. In addition, 
it targets the rule to ``executive officers'' of a company within the 
meaning of the Securities Exchange Act, i.e., officers who have policy-
making functions and therefore arguably can influence their own 
compensation.
    Based on legislative history,\20\ the proposal is intended to 
``delink'' the definition of a ``covered employee'' from the definition 
used by the SEC as a result of changes in the SEC's proxy rules. The 
SEC has recently revised the proxy rules to now cover the CEO, the CFO 
and the next three most highly compensated employees. The policy reason 
for ``delinking'' is not clear. As drafted, the proposal represents a 
significant expansion of the scope of Section 162(m) to cover employees 
with no policy-making authority who are not in a position to influence 
their own compensation and ambiguity as to what compensation counts for 
determining whether an employee is one of the ``Top 4''.
---------------------------------------------------------------------------
    \20\ Senate Report 110-1, p.68
---------------------------------------------------------------------------
    The proposal also deletes references in Section 162(m) to ``total 
compensation . . . for the taxable year [that] is required to be 
reported to shareholders under the Securities Exchange Act of 1934.'' 
Accordingly, proposed changes to Section 162(m) could be read to apply 
to all ``officers'' of an employer, even those with no policy-making 
authority. Neither Section 162(m) nor the Senate proposal defines the 
word ``officer,'' thereby creating ambiguity where none exists today. 
SEC proxy disclosure is limited to ``executive officers,'' which means 
those officers who have significant policy-making authority for the 
issuer. We do not believe that the proposal was intended to broaden the 
scope of covered employees in this way and urge that, if enacted, 
Congress clarifies the proposal to state that covered employees 
continue to include only executive officers for whom proxy disclosure 
could be required.
    In addition, while the proposal provides that the four ``highest 
compensated'' officers in the year would be covered, it does not 
specify a definition of ``compensation.'' Under current law, that 
answer is well understood by corporations because a ``covered 
employee'' is determined by reference to the SEC's proxy rules. New SEC 
rules capture executive officers' total compensation for each year, 
including equity awards and deferred compensation, which may not be 
taxable until several years in the future. By deleting the reference in 
Section 162(m) to the SEC's proxy rules, the Senate proposal leaves no 
definition of compensation whatsoever.
    In sum, the NAM strongly believes that corporate governance 
issues--like executive compensation--should be addressed through 
corporate governance changes, not through the tax code.
New Tax on Ex-Pats
    Among the revenue-raisers in the Senate proposal is a little 
noticed but potentially devastating provision that would change the 
rules for taxation of foreign persons who are long-term residents of 
the United States and are leaving the country. The provisions would 
levy a new ``mark-to-market'' tax on the unrealized appreciation in all 
their property, on the day before expatriation. In effect, the 
expatriate is treated as having ``sold'' all his or her property, for 
its fair market value, on the day before expatriation. Property subject 
to the provision includes personal property, interests in qualified 
retirement plans, and interests in nonqualified trusts.
    This provision could have a significant negative impact on resident 
aliens employed by U.S. manufacturers. For example, a resident alien 
who has worked for a U.S. company and decides to return to his or her 
home country to retire or for other business or personal reasons could 
find the value of their assets significantly eroded--especially if 
there is an acceleration of tax payable on 401(K) or other retirement 
accounts.
    Finally, another general concern of NAM members is the inclusion of 
retroactive tax provisions in the Senate bill as well as other tax 
legislation. It has long been the position of the NAM that a 
retroactive imposition of taxes is fundamentally unsound and unfair.
    In sum, NAM members believe strongly that tax relief will go a long 
way to ensuring that our economy keeps growing. Conversely, tax 
increases, like those outlined above, will negate much of the positive 
impact of tax relief and, in some cases, threaten continued economic 
growth. We appreciate the opportunity to present our views on these 
issues to the committee and we thank you in advance for rejecting these 
revenue raisers.
Attachment A
Examples of Benefit Plans and Company Types Affected by Section 226
    Restricted Stock Units: In recent years, many employers have 
redesigned their equity programs to increasingly rely on the use of 
restricted stock units (RSUs). Typically, employees are awarded a 
specified number of RSUs, with a fixed percentage of the RSUs vesting 
on a quarterly or annual basis or the entire block of RSUs vesting 
after a specified performance period. Generally, upon vesting of an RSU 
award, RSUs are converted into shares of the employer's common stock 
and the employee is taxable on the fair market value of such stock. 
Some RSU programs fit within the regulatory exception from 409A for 
compensation that is paid upon vesting (or within 2\1/2\ months after 
the year of vesting.) It is not uncommon, however, for employers to 
find that their RSU program does not meet the short-term deferral 
exception and that compensation paid under the program is subject to 
409A. In some instances, an employee may vest in the RSUs in increments 
over the performance period but is not paid until full vesting is 
attained at the end of the performance period. In other instances, an 
employee may vest fully upon reaching a specified retirement age during 
the performance period. Under the legislation, such RSU grants would be 
subject to the one-time pay limit and could cause employees to exceed 
the limit.
    For example, a newly hired employee of a Fortune 500 company 
receives a grant of RSUs that is subject to 409A. The employee is 
granted 6,000 RSUs at a time when the value of the company's stock is 
$30 (i.e., value of the grant is $180,000). The employee is scheduled 
to vest in \1/5\ of the RSUs each year over a 5-year performance 
period. The employee receives a base salary of $140,000, which under 
the Senate provision would be the employee's one-time pay limit for the 
first year. Because the value of the RSU grant exceeds the one-times 
pay limit, a 409A violation would occur and the employee would be 
subject to a 20 percent additional tax on the value of the RSUs as they 
vest (i.e., 20 percent of the RSUs per year) over the 5-year period.
    Because ``earnings'' on the underlying shares of the company's 
stock also are subject to the limit, employees could have a tax penalty 
under 409A merely because the company was successful and the value of 
the RSUs increased beyond the limit.
    For example, an employee is granted 1,000 RSUs at the beginning of 
employment with a technology company. The employee ``vests'' in these 
units after 5 years of service and the RSUs are designed to pay out 
after 10 years. The employer believes that this plan aligns the 
employee's interest with growing the company value rather than 
maximizing current salary. At the beginning of employment, the RSUs 
were valued at $15 per share. The employee earns approximately $100,000 
per year and receives modest increases (based on CPI of 3 percent). The 
employee's 5-year average taxable compensation from the company is 
$110,000 at the end of year 5. The company stock price stays relatively 
flat, but in year 6 the company becomes highly successful and the 
valuation of the stock takes off eventually to exceed 10 times the 
original price. The one-times-pay limit would be exceeded because the 
increase in the RSU value in year 6 will exceed $110,000.
    Supplemental 401(k) Plans: Employees who cannot fully defer under a 
401(k) plan because of the compensation limits under the Code may 
participate in a supplemental or ``mirror'' 401(k) plan. Unlike 
qualified plans, these programs are unfunded and the employer's 
deduction is delayed until the time of payment. If the company becomes 
insolvent, the employees are not paid. The legislation counts 
``earnings'' that accrue under the supplemental plan as additional 
deferrals that count against the one-time pay limit and could cause the 
employee to exceed the limit.
    For example, a Fortune 500 company offers a nonqualified 
supplemental plan to certain employees, including mid-level management 
employees receiving approximately $150,000 to $200,000 per year in 
total wages from the company. Many of these mid-level management 
employees are long-serving employees who typically defer 20 to 40 
percent of their wages. Employees who participate in the plan receive a 
small matching contribution (typically between $3,000 and $6,000) from 
the company based on their deferrals. Investment earnings are credited 
to an employee's bookkeeping account in the plan based upon deemed 
investments chosen by the employee from among the same mutual funds as 
those offered in the company's 401(k) plan. Using 2006 data, the 
company has calculated that at least seven such employees would have 
exceeded their 5-year average taxable compensation. The following chart 
summarizes the relevant information:

 
----------------------------------------------------------------------------------------------------------------
                                                            Account
                                           2006    5-year   Balance     2006       2006                Deferrals
             Emp.              Years of   Total    Average   As of   Deferrals  Investment    Total     Above 5-
                                Service   Wages    Taxable   12/29/  And Match   Earnings   Deferrals   year Avg
                                                    Wages      06                                        Limit
----------------------------------------------------------------------------------------------------------------
  1                                 27   $159,50  $ 90,180  $418,40  $ 66,700   $ 72,300    $139,000   $48,820
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  2                                 13   $175,40  $102,220  $508,30  $ 60,800   $ 52,500    $113,300   $11,080
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  3                                 28   $179,30  $ 62,380  $364,10  $116,400   $ 27,000    $143,400   $81,020
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  4                                 25   $178,30  $126,920  $614,70  $ 47,900   $109,100    $157,000   $30,080
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  5                                 30   $183,70  $126,040  $617,70  $ 38,000   $141,800    $179,800   $53,760
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  6                                 14   $194,40  $128,020  $486,50  $ 62,200   $ 73,200    $135,400   $ 7,380
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  7                                  6   $203,00  $ 92,020  $647,10  $ 76,300   $ 94,700    $171,000   $78,980
                                          0                  0
----------------------------------------------------------------------------------------------------------------

    Since earnings that are tied to a publicly-traded investment are 
often very unpredictable, employees would have to leave a large cushion 
below the one-time pay limit to take into account potential earnings. 
An employee who participates over a number of years could easily exceed 
the one-time pay limit solely because of earnings.
    For example, assume employee 5 in the above example stopped making 
deferral elections after 2006, and that the employee receives modest 
increases in wages each year (based on CPI of 3 percent). Also assume 
that the employee elected to have all of his account balance as of 
December 29, 2006 ($617,700) be deemed invested in the plan's S&P 500 
index fund, and that for the 4-year period from 2007 to 2010 that 
fund's annual return was 20 percent per year (which would be consistent 
with the S&P 500's performance in the late 1990s). By 2010, there would 
be a 409A violation solely because the ``earnings'' credited to the 
employee's bookkeeping account ($213,477) exceeded the employee's 5-
year average taxable compensation from the company ($189,376).
    Supplemental Pension Plans: Some companies maintain supplemental 
pension programs to serve as retention tools and assist management 
employees in saving for retirement. Unlike qualified plans, these 
programs are unfunded and any employer deduction is delayed until the 
time of payment. If the company becomes insolvent, the employees are 
not paid. The nature of many of these plans is to provide the most 
valuable accruals in the years right before retirement (e.g., age 65) 
and, therefore, they incent employees to stay in their jobs. The 
legislation would require employers to change or abandon these 
arrangements because later-year accruals may exceed the one-time pay 
limit under common plan designs for long-service employees. The problem 
would be further exacerbated if the employer wanted to manage its 
employee headcount by offering an early retirement incentive in the 
qualified and supplemental pension plans (such as payment of the full 
pension without a reduction for early commencement). The increased 
value of the pension in the year that the early retirement incentive 
was offered could cause the one-time pay limit to be exceeded.
    For example, one Fortune 500 company sponsors a supplemental 
pension plan that is available to middle managers making a little over 
$100,000 per year, many of which work for the company's retail entity. 
The company noted the difficulty in calculating annual accruals for 
this type of plan and the fact that the value of annual accruals often 
varies significantly from year to year due to interest rate changes and 
eligibility for early retirement. To the extent an accrual under the 
supplemental pension plan exceeded the limit, it is not clear how the 
company could ``fix'' the pension plan formula to avoid an excess 
accrual. The company also noted that the impact of the one-time pay 
limit would be even more severe because other forms of compensation 
provided to these managers, such as RSUs, performance units and 
severance pay, would also be aggregated with accruals under the 
supplemental pension plan in applying the limit. As a result, the 
company advised us that they may discontinue the supplemental pension 
plan if the annual limit is enacted.
    Another Fortune 500 company provides a supplemental pension plan to 
its key executives (about 4,000 U.S. employees). The covered employees 
do not elect into the plan, it is provided automatically. The assets 
are also at a substantial risk of forfeiture until the employee reaches 
age 60. If an employee leaves the company before age 60, he or she 
receives nothing from the plan. The plan benefit is unfunded before and 
after an employee attains age 60. It is paid out on retirement as a 
life contingent annuity (either single life or joint & survivor) with a 
five year guarantee. The Senate proposal appears to apply to the 
supplemental pension plans at the time the plan vests (i.e. at age 60). 
Under the plan, until an employee reaches age 60, the benefit is 
subject to a substantial risk of forfeiture. At age 60, the benefit is 
vested and also deferred, since the employee has no choice but to defer 
payment of the vested benefit as a life annuity when that employee 
retires. The amount of the deferral at age 60 presumably would be the 
then present value of the life annuity. A modest lifetime annuity 
viewed that way would violate the $1 million cap and the employee would 
be subject to a regular income tax and 20 percent penalty tax that 
would significantly reduce their benefit.
    For other employers whose supplemental pension plan may follow the 
vesting schedule of their qualified plan, the situation is more acute. 
In such a case, the vested annual accrual is likely to be subject to 
the new limitations. The calculation of that amount (which can depend 
upon salary levels and incentive compensation payouts) may be 
impossible until after the fact, meaning that the employee will never 
know, until it is too late, whether he has ``deferred'' too much.
    Bonuses and Incentive Programs: Many employers structure their 
bonus programs to fit within the regulatory exception from 409A for 
compensation that is paid upon vesting (or 2\1/2\ months after the year 
of vesting.) It is not uncommon, however, for employers to find that 
they cannot meet this strict 2\1/2\ month rule. Employees may vest at 
the end of the year or at the end of the performance period, but 
business issues may necessitate a delay in payment that results in the 
payment being subject to 409A. Some employers may need to wait longer 
for performance criteria to be ascertained, financials certified, etc., 
resulting in the payment being subject to 409A and the one-time pay 
limit. In other instances, an employee may vest in increments over the 
performance period or upon reaching retirement age but is not paid 
until the end of the period, which also would result in the payment 
being subject to 409A and the one-times pay limit. Finally, employers 
may, to align their interests with those of their managers, encourage 
or allow that bonuses be deferred until retirement rather than being 
paid currently. Section 409A specifically allows for voluntary deferral 
of performance-based pay. The new limits would make such a voluntary 
deferral difficult and often impossible.
    Private Equity: Many private companies (including start-ups) cannot 
readily conform to the specific administrative rules provided under the 
409A regulatory exceptions for equity grants (e.g., stock options and 
stock appreciation rights) because there is no public market to ensure 
a true fair market value price for the grant. As a result, many private 
companies' equity grants are subject to 409A. Under the Senate bill, 
private companies could not provide this type of equity grant to 
employees unless the grant does not exceed the one times pay limit. 
Because ``earnings'' on the equity also are subject to the proposed 
limit, employees could have a tax penalty under 409A merely because the 
company was successful and the value of the equity increased beyond the 
limit.
    Cash Flow and Start Ups: Small and emerging businesses may pay 
modest current compensation during the early stages of the business but 
promise significant future compensation, including retirement payments, 
in order to attract and retain talented employees. The Senate bill 
limits the business from making any promise that exceeds one-time pay 
for employees.
Attachment B
Real Examples of Employees Affected by Section 226
Asian male manager, age 57
Base Salary: $180,500
Average 5-year W-2: $142,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005): 
$59,000
SERP earnings (not payable until after termination by irrevocable 
distribution election): $80,000
Deferred Compensation earnings (irrevocable distribution election): 
$6,500
Total 2006 ``deferrals'': $145,500
Amount above allowance: $3,500
    Presumably, this would mean a 20% excise tax plus the income tax on 
the entire amount.
Caucasian female manager, age 50
Base Salary: $197,000
Average 5-year W-2: $144,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005): 
$72,000
SERP earnings (not payable until after termination by irrevocable 
distribution election): $75,000
Deferred Compensation earnings (irrevocable distribution election): 
$8,000
Total 2006 ``deferrals'': $155,000
Amount above allowance: $11,000
    Presumably, this would mean a 20% excise tax plus the income tax on 
the entire amount

                                 

    Chairman RANGEL. Thank you, Mr. Petrini. As an aside, are 
you familiar with the International Labor Organziation (ILO) 
suggestions, provisions in the trade laws, as relates to the 
NAM?
    Mr. PETRINI. No, Mr. Chairman, I am not.
    Chairman RANGEL. It's not on today's schedule, I just 
thought--thank you so much for your testimony.
    Edward Kleinbard, partner, Cleary Gottlieb Steen & 
Hamilton, New York, on behalf of the Securities Industry and 
Financial Markets Association. Thank you so much for taking 
time to share your views with us this morning.

 STATEMENT OF EDWARD D. KLEINBARD, PARTNER, CLEARY, GOTTLIEB, 
  STEEN & HAMILTON, LLP, NEW YORK, NEW YORK, ON BEHALF OF THE 
     SECURITIES INDUSTRY AND FINANCIAL MARKETS ASSOCIATION

    Mr. KLEINBARD. Thank you, Chairman Rangel, Ranking Member 
McCrery, and Members of the Committee. Thank you all for 
inviting me to testify today on behalf of the Securities 
Industry and Financial Markets Association.
    I am here to speak in opposition to a Senate proposal that 
would reverse settled law by increasing the tax burden on 
contingent payment convertible bonds. Contingent payment 
convertible bonds are simply publicly issued debt instruments 
with two additional features.
    First, the holder of a contingent payment convertible bond 
can convert that instrument into the issuer's stock at the 
holder's option, just as is true of a traditional convertible 
bond.
    Second, issuers of contingent payment convertibles make an 
economically meaningful promise to pay additional cash bonus 
interest, if certain future conditions are met. In this 
respect, contingent convertibles are similar to other 
contingent payment bonds, such as one indexed to the price of 
gold or to the S&P 500.
    Contingent payment debt instruments may sound exotic, but 
they in fact are a common and important financing tool that 
many American corporations have used over the last few years to 
raise over $90 billion in capital. The IRS and Treasury have 
extensively reviewed the tax analysis of contingent payment 
convertibles, and these experts confirmed the legal analysis 
that the Senate bill now proposes to reverse.
    The Senate bill would undo settled law by cutting back the 
interest deduction available to an issuer of contingent payment 
convertibles. Instead of deducting its true cost of borrowing, 
an issuer would be limited to deducting no more interest than 
it could have deducted if it had issued traditional convertible 
bonds.
    At the same time, investors would be taxed on much higher 
amounts of income, as if they had purchased a pure contingent 
payment bond linked, for example, to the price of gold.
    Why is the Senate proposal wrong, as a matter of tax 
policy? Why should simply adding a promise to pay bonus 
interest to a traditional convertible bond change the tax 
results for bond issuers and investors, alike? That, in 
essence, is the Senate Finance Committee's argument.
    Our response is that the Senate Finance Committee's 
reasoning is problematic for four reasons. First, it claims to 
treat contingent payment convertible bonds like other 
convertibles, when, in fact, it does not do this.
    The proposal creates a worst of all worlds result, in which 
issuers' deductions are capped at an artificially low number, 
just like traditional convertible bonds, but a holder's income 
is not similarly capped. Instead, holders are required to 
include, as taxable interest income, their entire economic 
profit, including the value of any stock they obtain on 
conversion.
    Second, the Senate proposal denies issuers a full deduction 
for the real economic cost of their borrowings. The Senate 
proposal overlooks the economic reality that an issuer's true 
cost of borrowing includes the value of the conversion option 
that it conveys to investors, just as the issuance of 
compensation options has real value to an employee, and a real 
cost to the issuer.
    Third, the Senate proposal will be difficult for the IRS to 
administer, because it mistakenly assumes that there is a 
single, typical convertible bond yield for every issuer.
    Fourth, the Senate Finance Committee's underlying 
assumption was that the extra contingent payment features in 
contingent payment convertible bonds are economically 
meaningless, and therefore, should not drive the tax results. 
This assertion is incorrect. The IRS today audits exactly this 
question, and requires an issuer to demonstrate that its 
promise to pay bonus interest have substantial economic 
substance.
    The Senate Finance Committee acknowledged in its 
legislative history that there was an irreducible logical 
inconsistency in the current taxation of convertible 
instruments. The Finance Committee argued that the resolution 
of the question should be deferred until it can ``be addressed 
legislatively through comprehensive reform of the tax treatment 
of financial products.''
    We agree with this sentiment, but we respectfully submit 
that it is the Senate proposal that is introducing piecemeal 
change, without regard to the larger context. The tax experts 
at Treasury and the IRS exhaustively considered how contingent 
payment convertible bonds should fit into the larger tax 
system, and came to a carefully reasoned conclusion. That 
conclusion should not now be overturned in this ad hoc fashion. 
Thank you.
    [The prepared statement of Mr. Kleinbard follows:]

Statement of Edward D. Kleinbard, Partner, Cleary Gottlieb Steen & Ham-
    milton LLP, New York, New York, on behalf of the Securities 
Industry
    and Financial Markets Association

    Chairman Rangel, Ranking Member McCrery, and members of the 
Committee, thank you for inviting me to testify. I am a lawyer in 
private practice with the firm of Cleary Gottlieb Steen & Hamilton LLP, 
and I am testifying today on behalf of the Securities Industry and 
Financial Markets Association (``SIFMA'').
    I am here today to speak in opposition to Section 230 of the 
Senate-passed version of H.R. 2, which would reverse settled law by 
changing the taxation of ``contingent convertible'' debt instruments. 
Before addressing this issue, I would like to note SIFMA's opposition 
to other provisions in the Senate bill. Specifically, SIFMA has serious 
concerns with the Senate bill's provisions that would deny the 
deductibility of settlement payments, impose an arbitrary cap on 
nonqualified deferred compensation arrangements and expand the Section 
162(m) limit on the deduction of executive compensation. These 
proposals have unintended consequences that would go beyond the stated 
goal of closing loopholes and tax shelters.
    Turning to the purpose of my testimony, contingent convertible 
bonds are simply debt instruments that are publicly issued by U.S. 
corporations, just like any other debt offering. These bonds have two 
additional features. First, a holder of a contingent convertible bond 
can convert it into the issuer's stock at the holder's option. (This 
feature is common to both contingent convertible bonds and traditional 
convertible bonds.) Second, contingent convertibles also contain an 
economically meaningful promise to pay additional cash ``bonus'' 
interest if certain future conditions are met. (This feature is common 
to other forms of contingent payment debt obligations as well.)
    Contingent convertible debt instruments may sound exotic, but they 
in fact are a common and important financing tool that many American 
corporations have used over the last few years to raise over $90 
billion in capital. These corporations often are growing companies with 
lower credit quality ratings for which the markets for more traditional 
capital markets instruments are foreclosed, or prohibitively expensive.
    The Senate bill would undo settled law by cutting back the interest 
deduction available to issuers of contingent convertible bonds. Instead 
of deducting an amount of interest comparable to what they can deduct 
on all of their straight debt or on other contingent debt obligations, 
issuers would be limited to a smaller deduction equal to their cash 
interest payments, as is also true for traditional convertible bonds. 
This result in turn understates an issuer's true cost of borrowing.
    The IRS and Treasury have extensively reviewed the tax analysis of 
contingent convertible bonds, and these experts confirmed the legal 
analysis that the Senate bill proposes to reverse. In doing so, these 
experts also confirmed that the current law has a built-in bias that 
favors the government because issuers' tax deductions for these 
instruments are subject to a special cap, while investors' taxable 
interest income inclusions are not. As a result, under current law, a 
contingent convertible bond investor's ultimate taxable interest income 
will often exceed the issuer's interest deductions.
    For example, imagine a typical issuer that normally could borrow at 
8 percent, but, in order to conserve its cash, decides to issue a 
contingent convertible note. Because the right to convert the debt into 
issuer stock is valuable, one might expect, in a typical issuance in 
today's market, for the issuer to pay cash interest on the debt of, 
say, 2 percent. Under current law, the issuer would be allowed a 
deduction of 8 percent, which represents the expected total cost of the 
issuer's debt. Under the Senate proposal, the issuer would deduct only 
2 percent for its out-of-pocket cash costs. This is the same deduction 
that would be allowed for a traditional convertible bond. If, at the 
end of the day, the bond gets converted into stock, and it turns out 
that the holder realized an effective yield on the bond of 20 percent, 
that entire 20 percent is included in the investor's taxable income, 
but the issuer's effective interest deduction will be subject to a cap 
of 8 percent.
    Why is the Senate proposal wrong as a matter of tax policy? After 
all, it appears to conform the taxation of contingent convertibles to 
the rules for traditional convertible bonds. That sounds superficially 
sensible. Phrased differently, why should the addition of a contingent 
interest feature give issuers a different tax treatment? That in 
essence is the Senate Finance Committee's argument.
    The Senate Finance Committee's reasoning is problematic for four 
reasons:
    First, it claims to treat contingent convertible bonds like other 
convertible bonds. However, it does not do this. The proposal applies 
the convertible bond rules for purposes of taxing the issuer, but does 
not apply the convertible bond rules for purposes of taxing the 
investor. This creates a ``worst of all worlds'' result in which 
issuers' deductions are limited to their out-of-pocket cash expenses, 
but holders' interest income is not similarly capped. Instead, holders 
are required to include as taxable interest income their entire 
economic profit--both the cash they receive and the value of any stock 
they obtain on conversion.
    Second, the Senate proposal denies issuers a full deduction for the 
real economic cost of their borrowings. The Senate proposal overlooks 
the economic reality that an issuer's true cost of borrowing includes 
the value of the conversion option that it conveys to investors. A 
conversion option has real value to investors, and a real cost to the 
issuer, just as the issuance of compensation options has real value to 
an employee, and a real cost to the issuer.
    Third, the Senate proposal will be difficult for the IRS to 
administer because it mistakenly assumes that there is a single typical 
convertible bond yield for every issuer. In fact, convertible bonds are 
complex instruments to construct, and the relative mix of cash interest 
payments and conversion premium varies from deal to deal.
    Fourth, the Senate Finance Committee's underlying assumption was 
that the ``extra'' contingent payment features in contingent 
convertible bonds are ``economically meaningless,'' and therefore 
should not drive the tax results. This assertion is incorrect. The IRS 
today audits exactly this question, and requires an issuer to 
demonstrate that the additional contingent interest that it promises to 
pay is economically meaningful--the contingency must be non-remote and 
substantial.
    Taking a step back, I believe that a persuasive case can be made 
that it is the taxation of traditional convertible bonds, not the 
taxation of contingent convertible bonds, that is the logical outlier 
in the current system. Indeed, traditional convertible bonds are the 
only debt instruments of which I am aware that are not taxed under the 
``economic expectations '' model. This model, which is based on the 
observation that rational issuers and investors expect that all debt 
instruments, however constructed, will over time produce a yield 
approximately the same as the issuer's normal cost of borrowing. The 
treatment of traditional convertible bonds is an historical anomaly, 
and its preservation in today's tax law can best be understood as a 
``grandfathering'' of a preexisting market instrument.
    In reality, the grandfathered tax rules for traditional convertible 
bonds contain a hidden, and underappreciated, tax deduction for 
investors. That is, in a traditional convertible bond, investors are 
permitted to take what should be ordinary interest income and use that 
to acquire a capital asset--an option to purchase issuer stock. 
Effectively, then, the traditional convertible bond analysis permits 
investors to make tax-deductible investments in capital assets.
    The Senate Finance Committee describes the taxation of traditional 
convertible bonds as consistent with ``the current operation of the 
Code and general tax principles.'' But why do we want to elevate to a 
general principle of law a tax result that gives investors the 
equivalent of tax-deductible investments in capital assets, and that at 
the same time takes away from issuers--often relatively young companies 
trying to preserve their cash flows--a tax deduction for their true 
economic cost of borrowing?
    In its explanation of the Senate bill, the Senate Finance Committee 
acknowledges that there is an irreducible logical inconsistency in the 
current taxation of convertible instruments, and argues that the 
resolution of the question be deferred until it can be ``addressed 
legislatively through comprehensive reform of the tax treatment of 
financial products.'' We agree with this sentiment, but we respectfully 
submit that it is the Senate proposal that is introducing piecemeal 
change, without regard to the larger context. The tax experts at the 
Treasury Department and the Internal Revenue Service exhaustively 
considered the issue of how contingent convertible bonds should fit 
into the larger tax system, and came to a carefully-reasoned 
conclusion. We submit that these experts' analysis of the ``the current 
operation of the Code and general tax principles'' is correct, and 
should not be overturned in this ad hoc fashion.

                                 
    Chairman RANGEL. I want to thank all of you for taking time 
out. Could each of you very briefly illustrate an example of 
the negative impact of the retroactivity of the deferral bill? 
We will start with you, Mr. Kleinbard.
    Mr. KLEINBARD. Yes. section 162(M)'s retroactive impact 
means that if a company has a written contract with an employee 
that is legally enforceable, legally binding against the 
company, but which requires compensation to be paid this year 
or next year, the consequence of the Senate bill would be to 
subject that existing contractually binding agreement to the 
limitations of revised section 162(M).
    So, these are contracts which the company simply can't tear 
up. They are enforceable today by the employee against the 
employer. Yet, the consequences will be a punitive effect by 
disallowing the interest expense, a punitive tax to the 
employer, in the respect of a pre-existing arrangement with 
respect to existing compensation.
    Chairman RANGEL. Changing the tax law would not be a 
defense to your contractual obligation?
    Mr. KLEINBARD. No, sir. No. The contract does not typically 
contain a change of law ``out'' that would permit the company 
to tear up the contrast.
    Chairman RANGEL. Mr. Petrini.
    Mr. PETRINI. I think, sir, in that regard, it wasn't 
unusual for companies to try to avoid violating the provisions 
of 162(M). Many companies made it a policy and put it in their 
policy statements that they would not pay compensation that 
would exceed the 162(M) limits, and as a result, required 
certain executives to defer compensation that would not 
otherwise have been deferred, but would have been paid 
currently, requiring those executives to put that compensation 
at risk of the company, and the company's continued 
performance, in unfunded deferred compensation, taking 
advantage of the fact that under the 162(M) that's currently 
drafted, that after an executive retired, he was no longer one 
of those who was subject to 162(M).
    To now retroactively change that, means that we have in 
place many deferral arrangements which were specifically 
designed, and which were done basically involuntarily, and 
forced upon executives in order to comply with the 162(M), 
which, as a result of the change in 162(M) now, would cause 
those very payments to be non-deductible.
    So, the entire rationale for requiring deferral of certain 
amounts in excess of $1 million would have been defeated. It 
doesn't change what executives can be paid, it doesn't do 
anything to change their pay policies retroactively. Frankly, 
we believe that if executive pay is the issue, then it should 
be addressed through the work that Chairman Frank's Committee 
is doing, not through the tax code.
    Chairman RANGEL. Thank you. Mr. Heaslip.
    Mr. HEASLIP. I generally agree with Mr. Petrini. 
Individuals and corporations made deferral decisions based on 
the rules as they existed at that time. It's troubling that 
Congress would consider changing the law and applying it 
retroactively. I think it under-

mines taxpayer confidence in the system, and makes it very, 
very difficult to set compensation policy within a company.
    The original 162(M) legislation had an explicit grandfather 
of binding contracts and agreements. We think this approach 
should be maintained. There is also an effort to extend the 
covered employee group and the current Securities and Exchange 
Commission definition. While this might not seem to be 
problematic, I caution that it adds complexity. To the extent 
that we can unify the rules, and speak in consistent terms, it 
makes for a more coherent and identifiable policy.
    So, retroactivity is something that we think is 
problematic, and we applaud your efforts so far to make any 
changes applied prospectively.
    Chairman RANGEL. Mr. Bentsen.
    Mr. BENTSEN. Enforcing the passive-loss retroactively would 
trap a number of transactions with an original equipment cost 
in excess of $800 million. There are transactions that the IRS 
has already passed on, and not found--not challenged, and these 
are transactions that go back to the mid-1990s, multi-year 
transactions involving the financing of rail equipment, 
manufacturing equipment, and the like.
    In addition, Mr. Chairman, as you know, the existing 
provision has already had unintended consequences as it relates 
to the cross-reference rules that were included. In fact, the 
final rules have not fully been promulgated because of concerns 
about the unintended effects of the existing Act.
    Mr. Chairman, you and the prior Chairman, Thomas, and the 
respective Chairmen Bachus and Grassley had written to the 
then-Treasury Secretary Snow, in 2005, raising concerns about 
the cross-reference rules. We believe the Senate bill would 
then impose that cross-reference provision retroactively, as 
well, which would exacerbate the problem.
    Chairman RANGEL. The Chair would like to recognize, for 
questioning, the ranking Member, Mr. McCrery.
    Mr. MCCRERY. Thank you, Mr. Chairman. Mr. Bentsen, would 
this retroactive application of the Senate provision in any way 
undermine the financial viability of some of those arrangements 
that were entered into in the mid-1990s?
    Mr. BENTSEN. Our understanding, from--is that under FASB 
guidance, imposing 470 prospectively would cause members to 
have to go back and recompute their books from the inception 
date of the lease. That would cause them--because it would be a 
changing in the cash flow stream, that would cause them to have 
to restate--potentially, to restate their books. So, in 
addition to a tax increase retroactively, it also could have 
financial reporting consequences, as well.
    I might add, Mr. McCrery, that my members tell me that they 
view this as having--the retroactive nature of this--as having 
a dramatic impact on the leasing market, from an investor 
perspective, going forward, as well, well beyond the intent.
    Mr. MCCRERY. Thank you. Mr. Heaslip, why do companies like 
PepsiCo have these non-qualified deferred compensation plans, 
in a nutshell?
    Mr. HEASLIP. Let's take the case of an elective deferral 
program. There are three primary reasons. The first is that 
they incur savings for retirement, which we think is good 
public policy.
    Since the plans are unfunded, and the deferrals are at 
risk, they provide an extra incentive for employees to ensure 
the continuing health and success of the organization, so that 
the obligations can be paid out at that point in the future, 
when they retire.
    Then, third, companies can use the deferred moneys to 
invest in their businesses. Instead of paying them out in 
current cash, we can take the funds and provide jobs, or buy 
equipment, or build plants, or use them elsewhere.
    Mr. MCCRERY. Well, you didn't mention, as one of the 
reasons, that the employee who defers his income avoids 
taxation. Does the employee, in fact, avoid taxation on that 
income, should he receive it in the future?
    Mr. HEASLIP. The employee defers taxation.
    Mr. MCCRERY. That's different from avoiding it.
    Mr. HEASLIP. They don't avoid taxation, they defer 
taxation, and the matching principle still applies, so that the 
company does not get a tax deduction for the payment until the 
employee realizes the payment and pays taxes on it.
    Mr. MCCRERY. Now, you mentioned, in the course of one of 
those reasons, that the deferred compensation was ``unfunded 
and at risk.'' What does that mean?
    Mr. HEASLIP. What that means is that, unlike a traditional 
pension plan, for example, assets are not set aside or secured, 
in order to pay those obligations. The company pays those 
obligations out of cash flow at that point in the future, when 
they become due.
    Mr. MCCRERY. Is that by choice of the corporation, or is 
that by law?
    Mr. HEASLIP. That is by law.
    Mr. MCCRERY. In fact, the American Jobs Creation Act that 
we passed recently tightened that criteria, didn't it?
    Mr. HEASLIP. The American Jobs Creation Act imposed a 
series of additional requirements around the timing of election 
deferrals, the payout of election deferrals, the form of 
election deferrals, and it put in special provisions for 
executives that are considered key employees, in respect to 
when they can take their deferrals.
    We are still digesting those new regulations. Final 
guidelines have not yet been issued. We would propose for final 
clarification of existing law before we introduce new 
complexities.
    Mr. MCCRERY. So, since the deferred compensation is taxable 
when it's finally given to the employee, and since that 
deferred compensation is unfunded and at risk, as you say, it 
really does make the employee very interested in the 
performance of the company, because, as you said, the ultimate 
payout of that deferred compensation is not dependent upon 
tapping into some fund that is set aside. That would be 
illegal. It is dependent on cash flow of the corporation.
    Mr. HEASLIP. Exactly.
    Mr. MCCRERY. It really does tie that employee's interest to 
the interest of the shareholders, the interests of the 
corporation, the interests of the officers of the corporation.
    Mr. HEASLIP. That's correct.
    Mr. MCCRERY. Which all goes into, we would hope, better 
corporate governance.
    Mr. HEASLIP. Better performance for shareholders.
    Mr. MCCRERY. Right. Now, if the Senate provision were 
enacted into law, would it impact only the bigwigs in the 
corporation, the top executives?
    Mr. HEASLIP. In our corporation, approximately 1,000 
individuals are limited in the amount that they can receive 
from the qualified pension plan, and receive a portion of their 
pension benefits from the non-qualified restoration plan that I 
mentioned. So, far beyond the scope of the CEO or the named 
executive officers.
    Mr. MCCRERY. Thank you. Thank you, Mr. Chairman.
    Chairman RANGEL. Thank you. Mr. Levin.
    Mr. LEVIN. Thank you, Mr. Chairman. Yes, I think you have 
presented very articulately some problems. Have any of you 
testified before the Senate on these issues?
    Mr. HEASLIP. No.
    Mr. LEVIN. No. Do you know, have there been hearings on 
these issues before the Senate? Maybe you don't know that. Mr. 
Bentsen, do you know of any hearings?
    Mr. BENTSEN. Certainly not this year, I don't believe. 
There were hearings back in 2003, during the initial--as the 
Jobs Act, I guess, was initially being created. I might add, 
during those hearings when the legislation was introduced, as 
it relates to our concern, it was stated as prospective. So the 
retroactive nature is a relatively new phenomenon.
    Mr. LEVIN. I take it, Mr. Chairman, there is nobody here 
from Treasury?
    Chairman RANGEL. No, they declined to testify.
    Mr. LEVIN. The punitive damages play a role, and there are 
differing opinions as to how effective it might be. I think 
your testimony should be taken not as an attack on the basic 
structure, but whether we should change the taxation of 
punitive damages. Isn't that correct?
    Mr. PETRINI. That is absolutely correct. The issue really, 
again, gets to be the matching principle, that if punitive 
damages are income to the recipient, it makes sense that they 
be deductible to the payor.
    It is also the issue that the punitive damages is such a 
vague concept, or it's a concept that isn't consistent from 
jurisdiction to jurisdiction, and it is very difficult to have 
a--what effectively would be a punitive tax treatment a payment 
that is being made that is both taxable to the recipient and is 
non-deductible to the payer.
    Again, the question was asked about retroactivity. It would 
have a chilling effect on cases that are currently pending, or 
that may be an initial decision in, and a decision being made 
as to whether they will appeal.
    So, we are not at all questioning the validity of punitive 
damages as a substantive matter of law. We are just saying that 
the tax treatment shouldn't be singled out from the general 
principles that we have of an item being taxable to one person 
and deductible to another.
    Mr. LEVIN. Mr. Heaslip, you said in your testimony that 
there were about 1,000 employees who could be affected of your 
company. Mr. McCrery questioned you, I think, very effectively 
about that. Is there any reason to believe that the situation 
in your company would be unique, or that this issue would apply 
to a substantial number of employees, other than the CEOs and 
the higher echelon personnel, in other companies? Do you have 
any insight into that?
    Mr. HEASLIP. The limits upon qualified plan benefits apply 
to all plan sponsors. So, any company who sponsors a defined 
benefit plan, like we do, is going to be subject to the same 
qualified plan limits.
    I would further kind of suggest that this is a growing 
problem, because those qualified plan benefits are not moving 
at the same rate as pay is. For example, the qualified plan 
limit in 1989 was about $200,000. Today, 16 or 17 years later, 
it is $225,000. So, we have a much, much larger group of 
employees who receive benefits from the restoration plan today 
than we did 15 years ago, and I would expect that trend to 
continue.
    Mr. PETRINI. Mr. Levin, if I could, because we can also 
offer a perspective, being a much smaller employer than Pepsi--
we have roughly 10,000 employees in the United States, which 
I'm sure is dwarfed by PepsiCo--and we would have about 300 
employees who would be potentially impacted, because we allow 
all employees who receive annual cash bonuses to voluntarily 
defer bonuses, and they have other forms of deferred 
compensation.
    So, if Air Products is an example, on an employee base of 
10,000, we have 300 that are affected. So, it's a very large 
problem.
    Mr. LEVIN. For those of us who have been very sensitive to 
the future of defined benefit plans, it strikes me that this 
testimony should be taken into account. Thank you very much.
    Chairman RANGEL. Thank you. Mr. Johnson, from Texas.
    Mr. JOHNSON. Thank you, Mr. Chairman. I appreciate your 
testimony. I tell you, the--I used to be on the education 
Committee, as you know, and Mr. Heaslip was a witness over 
there a couple of times. You have always been clear and very 
useful in your testimony.
    This misguided revenue measure that we have been talking 
about here that our friends in the Senate have passed, in your 
testimony you said that the Senate provision would penalize 
early retirement benefits that simply mirror those in 
traditional defined benefit pension plans.
    When we revised the pension plans here last year, we tried 
to do it in a way to keep those plans in force, and it was 
tough. As you know, it was marginal whether some companies kept 
them. I guess yours did. What I would like to know is if this 
retroactivity goes into force, would you all do away with your 
defined benefit plans?
    Mr. HEASLIP. It certainly would add another challenge to 
the many that already face defined benefit plan sponsors. As I 
said in my testimony, although I have a specific concern about 
how the individuals in our restoration plan would be affected, 
I have a broader concern about the implications of this for the 
plan in general.
    I think once we disenfranchise middle and senior managers 
from a defined benefit plan, it just simply adds another 
challenge or barrier in an already challenging environment.
    Mr. JOHNSON. Well, it's a difficult position to be in. You 
also said it might force managers to leave the company, so they 
could just pay taxes on their deferred compensation. You talked 
about deferral and various forms of compensation all lumped 
together, a 20 percent penalty because of--the income is above 
the annual base.
    Isn't it possible that this might undermine long-term 
corporate planning, and just further induce corporate raiders 
to buy companies, or figure out how to get around the law, if 
the law is not fair?
    Mr. HEASLIP. That's true, sure.
    Mr. JOHNSON. Do you want to comment?
    Mr. HEASLIP. It certainly makes individual planning 
challenging, and could have the effect that you hit on, which 
is somebody who triggers taxes and penalties if they need to 
leave the company in order to get the cash to pay those taxes 
and penalties, and that's certainly not something that we want 
the tax law to encourage.
    Mr. JOHNSON. Thank you. Ken, it's good to have another 
Texan with us today. Thanks for being here.
    I think you hit it right on the head when you talk about 
increased taxes retroactively. They're just not right. I do not 
think we can travel back in time to undo transactions that were 
legal at the time. The laws of physics and good tax policy 
prevent, or prohibit, time travel, I would say.
    One of the cries we used in 1994, when we won control of 
this place, was opposition to retroactive taxes. I don't think 
we can go back to that. I would like your comments on it.
    Mr. BENTSEN. Well, Mr. Johnson, I agree with you from the 
standpoint that I think retroactive tax policy is something 
that this Committee and the congress, generally, has opposed, 
because of the impact that it has on both investors and how 
they will deploy capital for any length of time, and quite 
frankly, on the ability of Congress to incent investment as 
they see fit.
    So, I think you are accurate. I would, if I might, very 
briefly clarify in response to Mr. Levin regarding any 
hearings, there had not been any hearings on the retroactive 
nature of this. The Senate did, subsequent to the introduction 
of the Jobs Act, take up amendments to this effect to go 
retroactive. The House wisely and consistently rejected those 
amendments, as it has as late as this year.
    I just wanted to make sure I clarified that point. Yes, I 
think you're right, Mr. Johnson, that this is something that is 
quite out of character for how the congress has addressed tax 
policy.
    Mr. JOHNSON. Right on. Thank you, sir. Thank you, Mr. 
Chairman.
    Chairman RANGEL. Thank you, Mr. Johnson.
    Dr. McDermott.
    Mr. MCDERMOTT. Thank you, Mr. Chairman. This Committee has 
changed in the years I have been here. Last week we had a 
hearing on global warming, and we had a whole panel, and they 
all agreed, both the Republican witnesses and the Democratic 
witnesses, that there was global warming. The question was what 
you ought to do about it.
    Today we have a panel of four people, and I guess they 
couldn't find anybody to come in and testify that there was 
some good in what's been proposed by the Senate. How--explain 
to me how the Senate could have looked at these provisions and 
thought, some way, it was good for business. I assume this is 
what it is, because if we raise the minimum wage, that's bad 
for business. Now we've got to give business something that is 
good for business to balance that out.
    What in the world did they think they were giving to 
business, or--out of this, that would somehow ameliorate the 
problem of raising the minimum wage? Can you help me understand 
what the thinking might have been over there? Somebody. Mr. 
Petrini, you could start.
    Mr. PETRINI. Thank you. I don't know whether there was any 
intent to do something that was good for business. I think one 
can look at the four provisions that I talked about, and see 
how somebody could think that there was a policy behind them. 
As we suggested, we think that the policy was misguided, 
because the provisions themselves are not drafted tightly 
enough.
    The settlement provision, for example, one can look at that 
and say, ``Yes, it makes sense that a company shouldn't be able 
to deduct the cost of paying a settlement where they have a 
violation of law, and they have reached a settlement with a 
government agency.''
    However, a lot of what we think would be the restitution 
part of that settlement, it would be deductible. The parts that 
become non-deductible are those parts that we often do that go 
over and above the perceived violation. So, we think that the 
way it was drafted is just too broad. You look at the deferred 
compensation. Everybody agrees--and one can assume that the 
deferred compensation changes had their genesis in this belief 
that executives are overpaid.
    As I suggested, I think that if you want to align 
executives and shareholders alike, you should be encouraging 
executives to take their compensation in a deferred manner, 
rather than taking it currently, because that way, they have a 
lot of skin in the game, as they like to say.
    So, I don't think that there was necessarily any intent to 
help big business, but I think there are some policy reasons 
behind some of these changes that are proposed. We just don't 
think that the policy was well thought-out, or that the 
proposals get at the harm that was really being addressed.
    Mr. KLEINBARD. Mr. McDermott, I think Mr. Petrini's remarks 
are absolutely on point. What I would--to summarize our 
thoughts on it, is that in several respects--perhaps not in the 
contingent payment converts, but in some of the other cases--
there is a core of an issue that deserves to be thought about 
and addressed, but that the Senate proposals, as they have been 
enacted in the Senate bill, are just profoundly undercooked.
    They are not yet fully developed proposals. They have lots 
of collateral consequences, which we believe to be completely 
unintended, or underappreciated. The ideas need to go back in 
the oven for a proper set of--for the appropriate time, to 
develop properly targeted, narrowly focused issue that does no 
harm, as well as solving the very narrow problems that were the 
original target.
    Mr. MCDERMOTT. It's probably a good time, with St. 
Patrick's Day, to enact Murphy's Law. That sounds like what 
you're saying. Mr. Bentsen?
    Mr. BENTSEN. Dr. McDermott, I think there is a sense that 
perhaps imposing this provision retroactively, in the most 
compassionate sense, is trying to go after certain transactions 
that have been challenged by the Government.
    However, in the way that it's done, first of all, serves to 
undermine confidence in our tax system by doing it 
retroactively, and I think has far reaching implications beyond 
just those provisions that may be in question, and certainly 
captures many more.
    Second of all, I think undermines our whole system of due 
process rights that we have in this country. Cases that should 
be challenged will be challenged. The idea that this is somehow 
relieving the Government from bringing suit is something 
generally the congress doesn't do, just as it's something that 
Congress generally doesn't do retroactive tax policy.
    So, ironically, I think it has far-reaching unintended 
consequences.
    Mr. MCDERMOTT. Thank you. I still have my question as to 
what did they think they were doing? Thank you, Mr. Chairman.
    Chairman RANGEL. We may find out. Mr. Weller is recognized 
for 5 minutes.
    Mr. WELLER. Thank you, Mr. Chairman, and I commend you for 
conducting this hearing today. As one who supports increasing 
the minimum wage, I also want to commend you for the bipartisan 
approach you have taken in putting together a package of tax 
relief for small business, as part of the package which helps 
both workers, as well as small business. The bipartisan 
approach that you and Mr. McCrery have worked out I commend you 
on. It sets a great precedent for this Committee and this 
congress. I want to thank you for showing that kind of 
leadership.
    Mr. Chairman, I want to thank you and the panel for this 
hearing. Clearly, decisions that investments by business make, 
many of them are based on tax consequences. Many of us on this 
Committee have raised concerns about what we call retroactive 
tax increases.
    I particularly want to ask about the decision by our 
friends in the other body to expand transactions subject to the 
2004 conversion rules. I was going to direct this question to 
Mr. Petrini, if you would. If others want to respond--but I 
will direct it to you, Mr. Petrini--is when the Senate voted to 
expand transactions subject to 2004 inversion rules, would you 
classify that as a retroactive tax increase?
    Mr. PETRINI. Yes, I think you would have to.
    Mr. WELLER. I guess I have always been told that 
consistency and confidence in tax policy will remain the same 
in the foreseeable future is a factor on businesses making 
decisions on investing and job creation.
    This precedent that would be set when it comes to a 
retroactive tax increase, what will that do to the confidence 
level, business decisionmakers, when it comes to making 
business decisions when they consider tax policy with this 
retroactive tax increase?
    Mr. PETRINI. Well, I think it's very difficult. Considering 
my role as a chief tax officer in a company, it's very 
difficult if you have to give senior management answers to 
their questions, whether it's inversions, deferred 
compensation, or anything where you say, ``Well, that's the law 
today, and the law may change.'' They accept the fact that the 
law may change, and they will take the risk that it will change 
in the future for things that they do in the future.
    If there is an inability to tell people that what you do 
today will be taxed under the rules that are applied today, and 
exceptions for binding contracts and commitments made, and you 
know, often billions of dollars--we're talking about 
significant capital projects--if you can't give that kind of 
certainty, it makes it much more difficult to operate in the 
U.S. tax system. Perhaps places U.S. companies, or companies 
wanting to do business in the United States, places the ability 
to do business at a global competitive disadvantage.
    Mr. KLEINBARD. Mr. Weller, if I could?
    Mr. WELLER. Mr. Kleinbard.
    Mr. KLEINBARD. Thank you. If I could give a parallel 
answer, but from the perspective of the capital markets, as 
opposed to the corporate employer itself, Congressman Bentsen 
made a very important point, I thought, in his earlier 
testimony, that the retroactive change in the law, one, changed 
the perspective of participants in the leasing market.
    The reason for that observation, I believe, is that if 
participants in the leasing market or in the capital markets, 
generally, believe that settled law is not, in fact, settled, 
there is a risk of retroactive change in law, the consequence 
of that is that they are going to have to charge more money. 
They are going to have to charge a risk premium for the risk 
that the law itself will change, as opposed to just credit risk 
or market risks.
    So, every time you introduce a new kind of risk, the 
capital markets, which are very efficient, price that risk. 
Now, what you're effectively doing, is asking the capital 
markets to price not simply credit risk and market risks, and 
those kinds of risks, but also the change of law risk that 
settled, contractual expectations will not be honored by virtue 
of change in the tax outcomes, so that the allocation of income 
from a transaction will not be honored through the retroactive 
changes in law. That raises the cost of capital for every 
company.
    Mr. WELLER. Of course, my classmate and former colleague is 
with us--good to see you, Ken, thank you for joining us today. 
Do you agree, have the same perspective on this retroactive----
    Mr. BENTSEN. Absolutely, Mr. Weller, and I think that the 
counselor is absolutely correct. You think of the situations--
say, United Airlines, for instance, in your State of Illinois, 
that investors will underwrite the cost of their airplanes.
    The airline industry, as we know, is already fairly tight 
on margins in most cases--in many cases, negative margins from 
time to time. Their ability to operate is to have aircraft that 
they can put into the air on a regular basis. They have to pay 
a cost for that. If the cost for capital rises in that, that 
directly effects their ability to be an operating, or a going 
concern.
    So, yes. I think this is very serious, far beyond the 
intended target.
    Mr. WELLER. Thank you. Thank you, Mr. Chairman, you were 
generous with my time. Thank you.
    Chairman RANGEL. The Chair would like to recognize the 
gentleman from Georgia, Mr. Lewis.
    Mr. LEWIS OF GEORGIA. Thank you very much, Mr. Chairman. 
Thank you very much for holding this hearing. I thank members 
of the panel for being here today. Mr. Bentsen, it is good to 
see you again.
    Mr. Bentsen, you must have some friends in the Senate that 
you could talk to and not just come before this Committee? I'm 
sure you have some wonderful friends there.
    Mr. BENTSEN. Well, I think I do, Mr. Lewis. We finally have 
been talking to the Senate about this, as well. I think, as--
and let me say I appreciate the Chairman for calling this 
hearing, and having not just us at this panel here, because it 
does give us an ability to really air these issues out.
    I believe that the intentions of the Senate are well 
intentioned. I think that they have perhaps not taken the time 
to look at the implications of what they are trying to do here, 
as it relates----
    Mr. LEWIS OF GEORGIA. One member of the panel said it's 
like cooking a meal, and I think you suggested it's not 
completely baked, and maybe they should put it back in the 
oven? Can I hear a reaction to----
    Mr. BENTSEN. Well, in our case, I would say as it relates 
to retroactively tax policy, I don't know that retroactive tax 
policy is ever going to be fully baked. I think that it's 
something that is just a bad idea, which, if you go back and 
look--at least from my recollection--at prior tax acts, 
generally, consistently, the congress has tried to avoid 
retroactive tax policy where it involves the long-term 
deployment of capital, because of the impact.
    So, I just don't think there is ever a situation where the 
congress is going to say, ``Well, if we do something 
retroactive, we can raise a lot of revenue doing it,'' that the 
congress has just generally said, ``That's just not a good 
idea.'' So I don't think there is every going to be a situation 
where you would come back and say, ``Well, we looked at the 
issue, we studied it more closely, and maybe this works 
better.''
    Perhaps when--certainly on more complex financial issues, 
like the convertible bond issue, which I am not at all informed 
to speak on, but there are certainly technical things that I do 
think take time. Generally, the congress has always done that.
    Mr. LEWIS OF GEORGIA. That's what he said. Mr. Heaslip, in 
your testimony you describe a plan that covers an approximate 
1,000 senior managers at PepsiCo. The program seemed to mimic 
the company 401(k) plan. You described the program as a 
voluntary savings plan.
    How would the section 409A provision affect this plan and 
its participants? What impact would it have?
    Mr. HEASLIP. The plan that I am referring to is the 
elective deferral program, where executives can voluntarily 
defer a portion of their salary or bonus each year. It is 
similar to the 401(k), in that it offers the same investment 
options, but it's very different from the 401(k), in that the 
money is at risk. There is no company match on this plan, as 
well.
    This is the plan where, because earnings are being included 
in the deferral toward the one times cap, the amount of the 
deferrals become very unpredictable. A year of good investment 
performance could wind up triggering taxes and penalties on 
money that the executive has not received.
    So, in effect, somebody who has saved for their entire 
career would wind up paying taxes and penalties because they're 
a disciplined saver, they are putting money away for 
retirement, and they weren't able to predict the stock market.
    Mr. LEWIS OF GEORGIA. Do you have an estimate for 
retirement savings for the rank and file employees of a 
company, compared to the retirement savings for your high-
level, well-paid executives?
    Mr. HEASLIP. I do. Again, we provide a defined benefit plan 
that provides the primary vehicle for retirement security for 
all of our employees, and that's completely funded by the 
company. So, rank and file doesn't pay anything for that. Rank 
and file, about 65 percent participate in our 401(k) plan. Of 
our executives, about 30 percent participate in the elective 
deferral program.
    Mr. LEWIS OF GEORGIA. Would the benefits under the plan be 
caught on the----
    Mr. HEASLIP. Yes, the elective deferral plan would be.
    Mr. LEWIS OF GEORGIA. So, you are telling Members of the 
Committee that what the Senate is proposing would have a 
negative impact?
    Mr. HEASLIP. On savings?
    Mr. LEWIS OF GEORGIA. Yes.
    Mr. HEASLIP. For the individuals in that plan? Absolutely.
    Mr. LEWIS OF GEORGIA. Thank you very much for being here.
    Mr. HEASLIP. Thank you.
    Mr. LEWIS OF GEORGIA. Thank you, Mr. Chairman.
    Chairman RANGEL. Thank you. Mr. Brady.
    Mr. BRADY. I am not aware of any taxpayers entering into 
transactions after Congress enacted the legislation in 2004. 
Are you?
    Mr. BENTSEN. No, sir, not to our knowledge. From what our 
members tell us, these transactions are effectively stopped 
with the passage of the Jobs Act.
    Mr. BRADY. Well, it seems to me that with both the 
provisions, basically the Senate is trying to squeeze more 
money out of a problem that Congress worked together to solve 
already.
    While I am not a big proponent of raising the minimum 
wage--I am a Chamber of Commerce executive by profession, 
worked a lot with small businesses, I think mandating a $5,000 
pay raise will have a real impact on some of our small 
businesses--nonetheless, Chairman Rangel worked hard with the 
minority to craft a tax package in the House that actually 
tried to ease some of the impact of that minimum wage. I am 
very grateful for that.
    I look at the Senate, and I think they're way off the mark, 
both in their tax provisions and their revenue raisers. I look 
at this provision as one of those issues.
    To talk about the negative--or to reveal the negative 
impact Mr. Lewis just talked about, the Senate is not just 
changing rules in the middle of the stream, they are changing 
the rules 5 years after you crossed the stream. I think it has 
a real impact in the future, and can for you and Mr. Kleinbard.
    Looking forward, what signal does this retroactivity send 
to taxpayers who are thinking about making future capital 
investments? Well, what does it say to them?
    Mr. BENTSEN. Well, Mr. Brady, I would say, ironically, if 
you look at the Senate package, for instance, it contains 
certain provisions to create investment going forward, over a 
multi-year basis. A taxpayer who would be looking--an investor 
who might be looking at that would also be thinking, ``Well, 
there is another provision within this bill that actually 
steps--reaches back and imposes a tax on me.''
    So, I would think twice about whether or not I would follow 
the other provisions that are contained in this bill, where I 
am going to be expensing benefits to make a long-term 
investment, because who is to say that next year they're not 
going to come back and reach back and take that back from me? 
Whereas, I might go put my capital elsewhere, where I feel more 
confident.
    So, I just think it is quite problematic, the way it's 
structured, and quite frankly, undermines some of the other 
provisions that are in that bill.
    Mr. BRADY. Encourage on one hand, and discourage and raise 
uncertainty on the other hand?
    Mr. BENTSEN. Yes, sir.
    Mr. BRADY. Thank you.
    Mr. KLEINBARD. I would agree with what Congressman Bentsen 
said, and I would emphasize the theme that economics teaches us 
that the success of our country's economy has always been based 
on a notion of a rule of law, and the importance of having 
clear property rights, having clear enforceability of those 
property rights, and a clear relationship between--in 
connection with this Committee--the taxpayers and the 
Government, makes it possible to predict, with some certainty, 
what the consequences of your actions will be.
    Let me take an over-the-top example, just to illustrate the 
point. If we had a world in which every homeowner was at risk, 
that 1 out of every 1,000 homes would just be randomly seized 
by virtue of a lottery by the Government, to be used to pay a 
shortfall in the revenue bill, that would affect housing 
prices.
    Mr. BRADY. It's called eminent domain.
    Mr. KLEINBARD. Eminent domain doesn't work by lottery, and 
in eminent domain you could get paid. In my example, it's just 
a lottery, the house gets taken away from you. It would affect 
your willingness to own a house.
    The same is true here. Any time you have rules where there 
is a shadow of uncertainty, the capital markets will respond by 
pricing in that risk. The consequence of pricing in risk is 
that the cost of capital goes up.
    Mr. BRADY. Well, thank you. You finished the point, I 
think, that Chairman Rangel has made, which is while Congress 
frequently changes rules in the middle of the stream, this 
Committee has gone out of its way, historically, to not change 
those rules retroactively, to try to provide some consistency 
in Tax Code, in tax policy, especially in the areas of 
investment. Thank you, Chairman Rangel.
    Chairman RANGEL. Thank you, Mr. Brady. The Chair recognizes 
Mr. Neal for 5 minutes.
    Mr. NEAL. Thank you very much, Mr. Chairman. Mr. Heaslip, 
you have testified about the problems you see in the non-
qualified deferred comp proposal. Many of us have also heard 
from businesses in our districts that this provision could hit 
middle or senior managers, not just necessarily CEOs.
    Your testimony refers to one example of a manager earning 
$100,000 annually, who was laid off because of downsizing. This 
person's pay could be subject to the higher taxes because of 
the proposed revision.
    Could you explain how this would work, and might you make 
some recommendations about how to better target this proposal, 
including a $1 million uniform cap, and limiting the provision 
to CEOs and certain other executive officers?
    Finally, are these legislative changes--or, could they be 
done in an administrative manner?
    Mr. HEASLIP. The example that you referred to is the 
example of where a manager is--loses his or her job because of 
a restructuring or a plant closing. In our company, we have a 
practice where, if an employee is within 5 years of retirement, 
and they lose their job because of downsizing, we provide a 
special early retirement benefit to them from the non-qualified 
pension plan.
    The goal for the non-qualified benefit is to treat them 
more like an early retiree than a terminated employee, and to 
avoid the substantial loss in pension benefits that they would 
otherwise experience because of the plant closing.
    We pay this benefit from the non-qualified plan, in order 
to comply with discrimination rules on the qualified plan. If 
this payment from the non-qualified plan were subject to the 
Senate's proposals, it could easily trigger the one times 
deferral cap, and invoke taxes and penalties at the same time 
that somebody is losing their job and entering a more uncertain 
financial future.
    This scenario could be avoided through technical changes to 
the law, but it would be much simpler, and I think fairer, if 
it were resolved with something like the $1 million cap that 
you suggested.
    Mr. NEAL. Okay. Mr. Petrini.
    Mr. PETRINI. If I may, because we have a slightly different 
view, and that is that we continue to believe that it's a 
misguided notion that somehow deferred compensation is CEO-
friendly and shareholder unfriendly. We believe that, one, you 
should get input from shareholder groups, so they see the 
alignment from deferred compensation.
    We do believe, and our members believe, that when senior 
executives defer compensation, and the more they defer, it 
aligns their interests with the interests of the shareholders, 
as far as the going concern of the company, because those 
shareholders and the executives then have the same interests. 
The executive essentially becomes an unsecured creditor, really 
of the lowest rank, as far as security, in the company. That's 
not a bad place to have your executives, where they have a 
great amount invested in that company, and their ability to get 
that payout depends upon the company's ability to perform.
    So, we would suggest that trying to limit CEO deferred 
compensation may, in itself, be one of those things that is 
half-baked. Somebody should really look at whether deferred 
compensation doesn't align CEO interests and shareholder 
interests better, and should be something that we should 
encourage, rather than discourage.
    Mr. NEAL. Thank you. Thank you, Mr. Chairman.
    Chairman RANGEL. The Chair recognizes Mr. Linder, from 
Geogia, for 5 minutes.
    Mr. LINDER. Thank you, Mr. Chairman. Mr. Heaslip, explain 
again why you have this non-qualified plan. You said it was to 
make up a shortfall in other provisions?
    Mr. HEASLIP. Yes.
    Mr. LINDER. Explain that again.
    Mr. HEASLIP. We have a defined benefit plan that we offer 
to all employees. The IRS code limits the benefits that can be 
paid from such a plan. So, we sponsor a non-qualified 
restoration plan to essentially mirror, or restore, the 
benefits that would normally be available from the qualified 
plan----
    Mr. LINDER. How does that get around the IRS rule?
    Mr. HEASLIP. Since the benefits are not funded, and they do 
not receive the favorable tax treatment that qualified plan 
benefits receive.
    Mr. LINDER. Okay. It's just cash flow.
    Mr. HEASLIP. It's just cash flow, unsecured.
    Mr. LINDER. That is entirely elective?
    Mr. HEASLIP. It is--no. There are no decisions.
    Mr. LINDER. I see.
    Mr. HEASLIP. The benefits are based on the same formula as 
we have in the qualified pension plan. There is no discretion 
or decisions or a choice between current cash and retirement 
benefits, on the part of the executive. It's simply a 
restoration adjunct to the----
    Mr. LINDER [continuing]. The electability of it----
    Mr. HEASLIP. That's correct.
    Mr. LINDER. That's correct. Mr. Kleinbard, explain to me 
what an exit tax is, for people who have spent a long time 
living in the United States from Great Britain, and work for a 
foreign company. I assume they don't pay taxes on the money 
they make here.
    Mr. KLEINBARD. An individual who is a citizen of Great 
Britain, sir, is your example, and who lives in the United 
States, and is a current resident of the United States?
    Mr. LINDER. Yes.
    Mr. KLEINBARD. Is taxed on his worldwide income by the 
United States, just as a U.S. citizen is, if they are permanent 
residents of the United States.
    Mr. LINDER. What is the exit tax?
    Mr. KLEINBARD. The exit tax--and this is an issue, 
obviously, to which--in the nature of my practice, I always 
like to do it with the books open in front of me, so I 
apologize if I don't get it quite right.
    The idea of current law is that if it's a U.S. citizen, for 
example, who wishes to move to a foreign jurisdiction, we 
impose a tax on the unrealized gain, in respect of his or her 
assets and other contractual rights to income that they might 
have, so there is no advantage, you can't make money by simply 
tendering in your U.S. passport.
    Mr. LINDER. What if it's a foreign citizen?
    Mr. KLEINBARD. I don't know how the exit tax works for 
foreign citizens.
    Mr. PETRINI. This was actually part of our written 
submission. If the individual is either a citizen or a green 
card holder, and gives up the citizenship or the green card, 
the exit tax applies. It has gone through various iterations. 
It seems like there was always some form of a revenue-raiser 
that is getting at expatriation.
    It is revenue driven. Its original form was expatriation 
that was designed to avoid income tax, and it made a lot of 
sense, because it was getting at an abuse, where people were 
giving up citizenship, or giving up green cards, to avoid tax.
    The situation our members see is that we try to bring 
foreign nationals in as--just as we send U.S. citizens abroad 
as expatriates, we bring foreign nationals into this country to 
work, sometimes for fairly long-term assignments. Someone, for 
reasons--often personal reasons--will obtain their green card. 
There is a natural flow of things. When they return to their 
home country, they will give up that green card. They are not 
expatriating to avoid tax, they're basically going home. It has 
become a very difficult situation for companies that employ 
both expatriates and inpatriates.
    I suggest that it may actually be an issue that companies 
have to take into account considering where they locate their 
headquarters, because in this global economy, you want a 
continued flow of people of all nationalities in and out of 
your headquarters, so that you can really mirror the way your 
customers look.
    Mr. LINDER. Do other nations, to your knowledge, do other 
nations have a tax like this?
    Mr. PETRINI. I don't know of another nation that has this 
kind of a mark to market tax, simply because you have given 
up--especially as a permanent resident--non-citizen, and I 
don't know of another country that has it.
    Mr. LINDER. Thank you. Thank you, Mr. Chairman.
    Chairman RANGEL. Thank you. The Chair would recognize Mr. 
Tanner for 5 minutes.
    Mr. TANNER. Thank you very much, Mr. Chairman. I will try 
not to utilize all of the time. Thank all of you for being 
here.
    I came here this morning, primarily interested in hearing 
the discussion regarding the compensation and retroactivity 
issues, and I think you all have adequately covered them, and I 
thank you. I also will welcome Ken back. I am always interested 
in your observations of where we are here.
    Now, one question. I was reading about part of the bill 
that has to do with trying to help the IRS discern what's a 
fine or a penalty, and there may be some problems with that, in 
terms of some unintended consequences. Mr. Petrini, could you 
address that, please?
    Mr. PETRINI. Sure. The basic provision causes certain 
payments that were made as a result of a settlement to be non-
deductible. I think the problem we see with it is that it--the 
way it's drafted, and the reach of the bill may be a bit too 
broad.
    The example that I am going to use is it would deal with 
any payment that is made in settlement of an inquiry into 
violation of--possible violation--of law. So, take the example 
that we have all seen of a spill of chemicals, or another item 
somewhere, that has caused a problem in a stream. You deal with 
the EPA, and you agree you're going to clean up the stream.
    You have also had some bad press, so you decide you're 
going to build a park--on the bank of a stream, maybe build 
some areas for fish to spawn in the stream, and actually make 
the stream better than it was before.
    Well, under this provision, your expenses in cleaning up 
your spill would probably be deductible, but the expenses that 
you incur in building that park, and in building that spawning 
area for fish, and in making the stream better than it was 
before, those go beyond what's necessary, so therefore, they 
would be non-deductible. To me, that's sort of counter to what 
you would think public policy would be, to try to encourage 
more of that kind of a civic spirit.
    Mr. TANNER. That would represent a change in present law?
    Mr. PETRINI. Yes. Under present law, these types of amounts 
you would spend are deductible, and they are not treated the 
same as a fine or a penalty would be.
    Mr. TANNER. If a fish issue comes up again in conference, 
maybe we could get you to help us with some language. It would 
actually accomplish a good public policy in this area.
    Mr. PETRINI. We would be very happy to do that.
    Mr. TANNER. Thank you. I yield back the balance of my time, 
Mr. Chairman.
    Chairman RANGEL. Thank you. Mr. Porter is recognized for 5 
minutes.
    Mr. PORTER. Thank you, and I appreciate the panel being 
here this morning. This may have been addressed, so bear with 
me.
    What I hear regularly from families and businesses is that 
we are constantly changing the rules. Small investors and even 
folks that are of modest incomes have tried to plan their 
future. Some of these changes being retroactive and back to 
2004, how does that impact the expansion of business, the 
expansion of an individual that would like to reinvest, create 
more jobs to help our economy? This changing the rules, how is 
that impacting?
    Mr. KLEINBARD. Mr. Porter, I would answer that question by 
saying that I think that the point that we would like to make, 
at least, is that a small investor is not directly affected by 
the change in ILO rules. So, in that narrow sense, using that 
as an example, there is no effect.
    The same is true for some of the other retroactive 
provisions of the bill. The question is if retroactivity is 
viewed not as extraordinary, but as ordinary practice by the 
congress, then the risk of retroactivity has to be priced into 
everything that people do. That, in turn, has a direct impact 
on the markets. It is another risk that needs to be priced, and 
the consequence of that is that the cost of doing business in 
the general sense, the cost of raising capital, goes up.
    So, it's not the specific provision that necessarily 
affects the economy as a whole, but it's the question of the 
erosion of a principle, the principle being that tax laws are 
a--are something that--to which people can predict with 
certainty how they will apply.
    Mr. PORTER. From the equipment leasing perspective, what 
impact does it have on--long-term, for your industry?
    Mr. BENTSEN. Well, I would agree with Mr. Kleinbard. 
Investors, the people who are underwriting investments, and 
whether it's commercial aircraft, or if it's construction 
equipment, or rigs, or you name it, are going to--they will 
price that risk in. They are going to look at actions by the 
congress, and if they're making a 5, 7, 20, or 30-year 
investment, and they see the congress coming back and changing 
the rules retroactively, that will set a precedent that will 
apply to other types of transactions.
    The gentleman is correct, is doesn't--the specific 
provision itself may only apply to some investors, but the 
market, as a whole, will look at this, and look at the 
precedent, and they will ultimately--markets are fairly 
efficient, and they will ultimately price that in, because the 
view will be, ``Well, if Congress feels that it can be 
retroactive in this sense, in this instance, why can't they in 
others?'' That's to say, ``Well, we did it before, what's to 
stop us from doing it again?''
    Mr. PORTER. Thank you.
    Chairman RANGEL. The Chair recognizes Ms. Tubbs Jones for 5 
minutes.
    Ms. TUBBS JONES. Mr. Chairman, thank you very much, and 
thank you for hosting this hearing. Like my colleagues, I heard 
from my banking institutions and small businesses with regard 
to these changes.
    Let me also say hi to my colleague, Mr. Bentsen, it's nice 
to see you. Welcome back to the House.
    Let me start, if I can, with the gentleman from PepsiCo, 
Mr. Heaslip. In your testimony--and I don't believe you spoke 
specifically about this, but it is in your written testimony--
about the impact of these proposals with regard to deferred 
comp would have laid-off workers or severed workers--maybe you 
did talk about this, maybe I missed it--about coming and going.
    If you would, just very briefly, reiterate the impact 
this--these changes would have on laid-off workers, in terms of 
diverted comp.
    Mr. HEASLIP. Sure. It's not clear. We did touch on it 
earlier, but there is a potential that severance benefits we 
pay from the non-qualified plan to severed employees could be 
swept up in this proposal.
    While it's not clear if they are or not, it would seem to 
be a harsh and unintended consequence if we further penalized 
someone who had just recently lost their job as a result of 
reorganization with taxes and penalties on a payment that was 
supposed to represent some kind of retirement security for 
them.
    Ms. TUBBS JONES. If you had your opportunity to mark the 
legislation, what would you propose that we would do? Leave it 
as it is, or make some other change?
    Mr. HEASLIP. Without trying to be facetious, I would 
probably resort first to a shredder. Then I would--I actually--
--
    Ms. TUBBS JONES. That specific provision, I apologize.
    Mr. HEASLIP. That specific provision. I think if you stuck 
with a $1 million cap, it would eliminate most of the 
individual issues that I cited in my testimony.
    Ms. TUBBS JONES. Great.
    Mr. HEASLIP. Help to narrow this more--focuses more 
narrowly on very senior executives, which I believe was its 
intent.
    Ms. TUBBS JONES. Mr. Bentsen, again, I have been coming and 
going, so I apologize. This seems to be the day that every 
constituent in my congressional district wanted to see me at 
this hour.
    Stick for a moment about the ILOs. Even though they are no 
longer taking place, there are existing ones that still have 
time to run their course. What would you propose that we would 
do with regard to them?
    Mr. BENTSEN. Good question, Congresswoman. There are such 
transactions in place. Those that are--and there are some that 
have been questioned by the IRS. The bottom line is that, as 
Congress intended by establishing the tax courts and the whole 
process of it, the transactions that the Service feels are 
questionable or should be challenged, are in fact, being 
challenged.
    So, the process itself is working. If, in fact, the service 
prevails in that challenge to record or direct negotiations, 
then the Government and the taxpayers, as a whole, will get 
their due.
    What this provision would do--would do, really, two things. 
One, it would impose this retroactive tax on every type of 
transaction, whether they were challenged or not. So, it's a 
very blunt instrument, in that regard.
    Second, it really would tilt--it would undermine the due 
process rights of taxpayers that is a basic standard and right 
in this country, and would tilt the balance in the favor of the 
Government.
    The proponents have made the argument--perhaps well-
intentioned, but I think faulty--in saying, ``Well, this would 
relieve the Service of having to bring suit. In fact, we 
believe the Service is going to win all these cases.'' Well, 
they haven't won any cases yet. There have been no judgements 
rendered.
    Again, I don't think it's appropriate to intervene at this 
point on the assumption that something is going to happen that 
has not yet happened, and to deny a taxpayer their day in 
court. If, in fact, the Government proves their case, then, as 
I said, the Government will get its due.
    Ms. TUBBS JONES. I thank you for your answer. To the other 
gentleman, I have run out of time. I had questions for you, but 
the Chairman is running a close clock. Thank you, Mr. Chairman.
    Chairman RANGEL. Mr. Pascrell.
    Mr. PASCRELL. Thank you, Mr. Chairman. Sorry I had to duck 
out for another meeting. I know some of these things have been 
touched, but I would like to ask the panel your reaction to 
what I have to say.
    I have deep reservations about the Senate's version of 
deferred compensation, I really do. It hurts too many people, 
and we should be targeting those that are greedy, instead of 
looking at the entire--I respect the attempt made by the Senate 
to limit the levels of compensation of senior officials who can 
electively defer, in an effort to avoid paying taxes. What that 
number is, is quite interesting.
    I have a couple of concerns. First, the Senate provision is 
retroactive. I believe wholeheartedly that it is the duty of 
Congress to remedy laws that are potentially being abused. I 
believe it is often inherently unfair to go back in time and 
penalize individuals for actions taken at a time when the law 
was permissive of a particular activity.
    I think this Committee needs to ensure that any 
restrictions that may be adopted will be completely 
prospective. I think that it should be a general rule that any 
action we take, regardless of what specific section we're 
talking about, will in no way, shape, or form, apply to any 
prior actions, including prior deferrals. That's my opinion. 
Or, decisions taken prior to the date of the enactment. I hope 
you agree with that.
    I am also concerned about the overly broad applications the 
Senate provision would entail. There are many legitimate uses 
for deferred compensations, including employee retention, the 
alignment of shareholder/employee/employer interests. I would 
hate to see these programs lose their effectiveness because the 
congress was not precise, as well as incisiveness in shaping 
and drafting the legislation.
    I would like to work to ensure that if some form of the 
Senate's provision is included in the final small business tax 
package, that it be carefully crafted to affect only its 
intended targets. I would like your quick responses to that, 
please.
    Mr. PETRINI. Mr. Pascrell, I have to respectfully disagree 
with one premise that you started with--actually, two parts of 
it.
    One is the provision should only affect the greedy, because 
I don't think that deferred compensation has anything to do 
with greed, but let me explain. When we're talking deferred 
compensation here, the issue of how much an executive should be 
paid, I don't think that is an issue where the issue of greed 
comes in.
    Let's assume that it's been decided that the executive is 
going to be paid $10 million a year, and we can agree whether 
or not that is greedy. If that executive is going to be paid 
$10 million a year in cash, versus being paid $1 million in 
cash and $9 million deferred, there is no greed involved in 
deferring that $9 million.
    In fact, I think the shareholders are much better served by 
the fact that instead of this person taking $10 million of cash 
out of the company today, he has actually left $9 million at 
risk. The other part of that----
    Mr. PASCRELL. Just to respond to that----
    Mr. PETRINI. Sure.
    Mr. PASCRELL. I am talking about those folks who are at the 
top of the ladder. I am not talking about middle management. 
Those people have been caught up--or would be caught up--if 
that legislation passed.
    Mr. PETRINI. No, I'm talking about an executive who would 
make $10 million, otherwise.
    Mr. PASCRELL. All right.
    Mr. PETRINI. I think we should encourage him to defer as 
much of that $10 million as possible. I think it's a totally 
different issue, how much he should be paid, but whatever he is 
being paid, we should ask him to defer as much as possible.
    Mr. PASCRELL. I agree, I agree, I agree.
    Mr. PETRINI. The other issue is there is no tax avoidance 
involved in deferred compensation, because non-qualified 
deferred compensation perfectly follows the matching principle. 
The executive is not taxed until he receives the money, the 
company does not get the corporate tax deduction until it is 
paid. It is perfect matching, there is no tax avoidance 
involved. There is tax deferral.
    In fact, the way the system works, the company has to give 
up its deduction. It's the same as if the company had borrowed 
money from the executive. So, there is really no tax avoidance 
here.
    That's the issue I have tried to make a few times today, is 
that executive deferred compensation, whatever you believe 
executives should be paid, having them defer compensation is 
good. It's good for aligning their interests with those of the 
shareholders, because if they run that company into the ground, 
they get none of that. It's consistent with what you enacted in 
section 409A, which basically requires key employees to leave 
their money at risk of the company, and avoids cut and run type 
of things on the pass.
    So, I would actually urge a lot more thought on whether 
deferred compensation is bad, even for those who make a real 
lot of money.
    Mr. PASCRELL. I did not say, nor did I imply, that deferred 
compensation, in and of itself, is inherently bad. That I did 
not say, did not infer. So, I listen to what you're telling me, 
but I didn't say that.
    I am concerned about fairness, and I am concerned about 
what goes into the tax revenue, what goes into revenue, what 
does not go into revenue. If you defer the tax, you are not--at 
the time, we may need that in the revenue cycle.
    Mr. PETRINI. Remember, if the executive defers his tax, the 
company is also deferring its deduction. So, other than the 
difference between the executive's rate and the corporate rate, 
which currently is not all that great, there is no real loss of 
revenue, just because the income has been deferred, since a 
deduction is also being deferred.
    Mr. PASCRELL. Thank you.
    Chairman RANGEL. The gentleman from California is 
recognized for questions, Mr. Becerra.
    Mr. BECERRA. Thank you, Mr. Chairman, and thank you to the 
four of you for your testimony. Mr. Heaslip, let me ask you a 
couple of questions. Deferred compensation has become an issue 
over the last few years, especially with regard to CEOs. You 
make some good points. I think you are trying to say, ``Be 
careful how you move on this, because it could have an impact 
far beyond just a CEO.''
    You also--very quickly, because you were running out of 
time--had some potential recommendations, if we were to try to 
consider acting on this. I'm wondering if you can give me a 
sense of, not just with regard to the specific proposals that 
were included in the Senate, but just generally, some 
guideposts that you might want to offer us as we continue to 
examine deferred compensation, because I think you made a very 
good point about how the consequences of what we could do--and 
if I could quote you directly, I think you mentioned that the 
potential impact could affect things like retirement security, 
personal savings, competitiveness, and shareholder interest. I 
think you're right about that.
    So, give me a more broad answer to the general question of 
this issue of deferred compensation, obviously with a focus on 
what the Senate did, but just, generally, some guideposts.
    Mr. HEASLIP. Sure. We agree that executive compensation is 
kind of one of the most important aspects of good corporate 
governance. I think to the conversation that just took place, I 
would like to make a distinction between how much we pay 
executives and how we pay executives.
    I think the broader issue is how much we pay executives 
that is being addressed or swept up into this discussion about 
deferred compensation, which is more about how we pay them and 
when we pay them.
    In my opinion, if you want to get at the issue of executive 
compensation, we should be looking at governance, shareholder 
advocacy, disclosure, and transparency in our compensation 
practices. We shouldn't be focusing on tax legislation.
    If, however, for political or substantive reasons, it is 
felt necessary to take a look at the rules surrounding deferred 
compensation, and further regulations are necessary, we think 
we do need to narrow the focus to CEOs or named executive 
officers. We think a uniform cap would be more appropriate than 
the very broad-based one-time earnings test that is currently 
proposed.
    We would exclude broad-based restoration plans that simply 
provide the benefits that other employees are entitled to. We 
would exclude elective deferral programs for the kinds of 
reasons that Mr. Petrini has outlined, in connection with the 
revenue neutrality. Kind of the additional incentive to 
perform, in the interest of shareholders.
    Mr. BECERRA. I appreciate that. I wanted to say welcome to 
former Member and colleague, Mr. Bentsen, for being here. We 
thank you for your testimony. Hopefully, this will help us 
shape something that may come out of conference that does 
address the various concerns that you have all raised. So, 
thank you very much.
    Mr. LEWIS OF GEORGIA [presiding]. Well, thank you very 
much. The gentleman from North Dakota, Mr. Pomeroy, is 
recognized for questioning.
    Mr. POMEROY. Thank the Chair. I will start with 
acknowledging my friend and former colleague, Mr. Bentsen. We 
still miss you. Bentsen is known as having made a significant 
contribution in the Senate. Maybe less known, but still known 
to many of us who worked with you. You served with great 
distinction in the House, too. That's a good name, that 
Bentsen.
    Mr. Heaslip, I want to talk to you about pensions, 
generally. I appreciated your testimony, in terms of the 
deferred compensation issue, but in a broader context of 
employee benefits.
    You indicate that the PepsiCo pension is well funded. How, 
in fact, has it been doing in recent years, in light of an 
improving stock market, relatively strong interest rate 
environment, what is the funding level?
    Mr. HEASLIP. Yes, it's been a rough ride over the past 5 
years. As you know, we had poor equity returns in the early 
2000s, interest rates have been low, which have increased 
liabilities, and we are fortunate to have a growing, thriving 
company that has allowed us to fund the plan over this period 
of time. Not all companies have been able to do that.
    Over the past 5 years, we have contributed about $2.4 
billion to our pension plan in order to retain its health and 
funded status. As a result, we are currently at about 105 
percent of liabilities, which obviously provides security to 
our existing----
    Mr. POMEROY. I think that that's excellent. I think that 
there was a misperception, promoted by the Department of Labor, 
that this rough ride you speak of was a bumpy road toward a 
system-wide failure, in terms of private sector pensions.
    Recently, the Wall Street Journal reported that the Fortune 
100 are, on average, 102 percent funded, and that the recovery 
of the stock market--because that's bouncing around a little 
these days--but fundamentally looks strong, and the sustained 
interest rate environment have substantially improved the long-
term outlook for pension plan funding, even before the Pension 
Act passed by Congress last year takes effect. Is that your 
read?
    Mr. HEASLIP. All of those are beneficial to defined benefit 
plans.
    Mr. POMEROY. I am very concerned that the increase funding 
requirements passed in the bill are going to lead toward a slew 
of actions freezing pension programs.
    Do you have an evaluation of that, and what are PepsiCo's 
plans?
    Mr. HEASLIP. We are going to continue to monitor our 
industry and the marketplace. We did a very thorough pension 
review last year. We concluded that the plan is appropriate for 
our workforce. We are trying to encourage people to spend a 
career with PepsiCo, have valuable industry and customer 
knowledge that we want to retain in our workforce.
    We are not interested in them working for us for 5 years or 
10 years, and then going to a competitor. A plan is a very 
effective means of encouraging people to spend their career at 
PepsiCo. At the same time, we have to be competitive in the 
marketplace, and we have to make sure we monitor what our 
industry is doing, and what our peer companies are doing. We 
have to maintain flexibility to make changes, if necessary, to 
stay competitive.
    I don't know that there is any one thing that are going to 
drive these plans out of business. When I look at the 
amalgamation of financial challenges, the types of challenges 
that are presented by this legislation in combination, it does 
generate concerns about the future health of the system.
    Mr. POMEROY. I will get to this legislation. Just one 
moment, one final question, first, and that would be the 
importance of lifelong income, as provided by a pension. It's 
70 to 80 percent, I believe you indicated, income replacement, 
and guaranteed, then, over the lifetime the retired employee 
will have in retirement, that, to me, is a very optimal benefit 
for someone in the workforce, worrying about what they're going 
to do in retirement years.
    The--given your expertise, do you see anything--have you 
been able to--have you perceived, either from Congress or the 
Department of Labor, or anywhere else in the Administration, 
support for your efforts to continue pensions?
    Mr. HEASLIP. I think, from a policy standpoint, it's very 
clear that Congress would like to see continuation of the 
defined benefit system, but from time to time, we get 
conflicting signals.
    Mr. POMEROY. My own thought is that we are still--we are 
protecting people right out of their pensions by putting 
onerous funding requirements that are not necessarily 
reflective of today's long-term solvency picture, and that 
we're going to pressure companies.
    One final issue--and this is the last question I would have 
for you--if you take the deferred comp provision of the Senate, 
and so that you would look at a provision where your upper 
management, those making the decisions on whether to retain the 
pension or not, would get a similar income replacement than the 
rest of the workforce.
    Wouldn't it further disincent PepsiCo and other companies 
to continue pensions for employees?
    Mr. HEASLIP. I think that is one highly likely outcome from 
this legislation. If you disenfranchise middle and senior 
managers, I believe it could throw these types of plans at risk 
for all employees.
    Mr. POMEROY. My own thought, Mr. Chairman, is that we need 
to send a very clear and unequivocal signal that pensions for 
the 20 million workers who have them are vitally important, and 
we want to help companies keep them in place. I thank the 
gentleman for his testimony. Thank you, Mr. Chairman.
    Mr. LEWIS OF GEORGIA. Thank you, the gentleman from North 
Dakota, for his comments. The Chair will recognize the 
gentleman from New York, Mr. Crowley, for questioning.
    Mr. CROWLEY. Thank you, Mr. Chairman. Thank you to the 
gentlemen, for their testimony today. I know time is of the 
essence, we have a number of votes before us, so I will just 
state that I don't have a question for the panel, but I do want 
to make a statement into the record, and direct that statement 
to you, Mr. Chairman.
    I have deep reservations about the Senate deferred 
compensation provision. While I respect the attempt made by the 
Senate to limit the levels of compensation, and a senior 
official can electively defer in an intent or an effort to 
avoid the payment of taxes, I have several fundamental 
concerns, some of which have already been expressed already.
    Second, the provision is retroactive. While I believe it is 
the duty of Congress to remedy laws that are potentially being 
abused, I believe it is inherently unfair to go back in time 
and penalize individuals for actions taken at a time when the 
law was permissive of a particular activity.
    Mr. Chairman, I am also concerned about the overly broad 
application the Senate provision would entail. There are many 
legitimate uses for deferred compensation programs, including 
employee retention, and the alignment of shareholder and 
employee/employer interests. I would hate to see these programs 
lose their effectiveness because the congress was not precise 
in its drafting of its legislation.
    Mr. Chairman, I would like to work with you to ensure that 
if some form of the Senate provision is included in the final 
small business tax package, that it be carefully drafted to 
affect only its intended targets.
    Mr. Chairman, I would like to work with you to ensure that 
taxpayers are not subject to the retroactive provisions of the 
bill in section 162(M), executive compensation that exceeds $1 
million, or annual non-qualified compensation. Now, Mr. 
Chairman, I hope to work and cooperate with you in those 
efforts, and I hope to have your acknowledgment of that.
    Mr. LEWIS OF GEORGIA. Let me thank the gentleman for the 
comments, and thank each member of the panel for participating 
and for being here today. I think your testimony has been quite 
helpful, more than helpful.
    Mr. CROWLEY. Thank you, Mr. Chairman. I would like to give 
a special hello to a former colleague, as well as one of New 
York State's greatest companies, PepsiCo, for testifying today.
    Mr. LEWIS OF GEORGIA. I believe the record will stay open 
for 14 days, for any Members who may have comments to issue. 
Thank you for being here.
    Chairman RANGEL. [presiding] Let me join in thanking this 
panel for your knowledge and your patience. Thank you very 
much.
    [Whereupon, at 12:05 p.m., the hearing was adjourned.]
    [Submissions for the record follow:]
             Statement of the American Bankers Association
    Mr. Chairman and members of the Committee, this statement is being 
submitted for the record by the American Bankers Association (``ABA''). 
ABA, on behalf of the more than two million men and women who work in 
the nation's banks, brings together all categories of banking 
institutions to best represent the interests of this rapidly changing 
industry. Its membership--which includes community, regional and money 
center banks and holding companies, as well as savings associations, 
trust companies and savings banks--makes ABA the largest banking trade 
association in the country.
    The ABA appreciates the opportunity to submit this statement for 
the record regarding the Small Business and Work Opportunity Act of 
2007, H.R. 2. We are troubled by three revenue raising provisions 
(Sections 206, 214, and 201) that have been included in the bill by the 
Senate, and are particularly concerned that they tax businesses 
retroactively.
    Retroactive tax policy is bad tax policy. America's business 
community must be able to depend on the certainty of the law in order 
to make informed business decisions. Enacting retroactive tax policy 
completely changes the economics of those past decisions and could 
result in excessive and arbitrary costs. Moreover, it adds to the risk 
and uncertainty of any business decision and could force businesses to 
delay or shun decisions for fear that later changes in the law will 
render such decisions illegal or financially burdensome, or both. 
Hence, retroactive changes to tax law should be avoided. The ABA, 
therefore, urges this Committee to remove these sections from the bill.
    In this statement, the ABA wishes to express our concerns regarding 
the three revenue raising provisions embodied in H.R. 2:

      Congress should not impose an arbitrary limit on income 
that can be deferred under non-qualified deferred compensation plans, 
particularly since recent changes in law affecting these plans have yet 
to be implemented and the consequences of those previous changes are 
unknown. (Sec. 206)
      Expanding the definition of ``covered employees'' would 
retroactively tax deferred compensation amounts even though decisions 
about these amounts have been made under existing law for many years. 
(Sec. 214)
      Changing the effective date for SILO transactions will 
result in a retroactive tax increase on banks. (Sec. 201)

    Each of these concerns will be addressed below.
I. Limitation of Deferrals for Non-Qualified Deferred Compensation is 
        Inappropriate
    The bill seeks to limit the aggregate amount of executive 
compensation that can be deferred under Internal Revenue Code Section 
409A. Under that section, deductibility of deferred compensation is 
limited to $1 million or the average annual compensation over five 
years, whichever is lesser. Furthermore, this provision is made 
applicable to deferred compensation plans for all employees, not simply 
to deferred compensation for senior executives.
    However, many employers offer deferred compensation plans to middle 
management and other non-executive employees as a way to create 
incentives, reward hard work, and retain valuable employees. If the 
provision in question is enacted, it will create an arbitrary limit on 
deferred compensation plans, which in turn would reduce the overall 
compensation of the employee. Moreover, many employees find these plans 
provide additional resources for retirement. Thus, arbitary 
restrictions would put a greater strain on the ability to save for 
retirement for these individuals. Additionally, deferred compensation 
plans that are already in existence will become subject to this 
provision. This has the potential of punishing employees and employers 
for compensation agreements reached long before this provision was 
considered.
    It should also be noted that Congress recently changed the rules 
for non-qualified deferred compensation arrangements when it enacted 
the Pension Protection Act of 2006. The Department of the Treasury 
(``Treasury'') was directed to promulgate regulations implementing 
these changes, but it has not yet finalized its rules. We believe that 
it is inappropriate for Congress to make further changes to the law 
concerning deferred compensation arrangements, when the impact of 
previous changes in this law are still unknown. Prior to any further 
changes to the law governing non-qualified deferred compensation plans, 
employers and Congress should be afforded time to study the rules 
promulgated by Treasury (once finalized) in order to understand and 
evaluate their impact.
II. Expanding the Definition of ``Covered Employees'' Will Result in 
        Retroactive Taxation
    As passed by the Senate, H.R. 2 expands the definition of ``covered 
employees'' in an effort to limit the amount of executive compensation 
that publicly-held companies can deduct from their taxes. Under 
existing law, both the CEO of a publicly-held company, and the four 
officers with the highest compensation levels, are considered ``covered 
employees.'' Any compensation that ``covered employees'' receive that 
is in excess of $1 million is not tax deductible by the company.
    H.R. 2 expands the definition of ``covered employee'' to include 
any employee that was a ``covered employee'' for any preceding taxable 
year beginning after December 31, 2006. The language of the provision 
indicates that it is applicable only to executives that are subject to 
reporting after 2006. However, this does not mean that the tax burden 
is limited to compensation after 2006. In fact, the provision captures 
the full amount of deferred compensation from all prior years for 
``covered employees'' that the employer is contractually obligated to 
fulfill. This represents a significant problem for deferred 
compensation plans designed to accommodate executives that are 
currently considered ``covered employees.''
    As an example, consider the case of senior executives of a bank who 
have been covered employees for several years and have received 
deferred compensation in the form of company stock. Over time, the 
price of the stock received has appreciated and the value of their 
account has grown substantially. Under the deferred compensation plan 
created many years earlier, the bank expected that it would be able to 
pay the deferred amounts upon retirement or termination of the 
executives. Since the executives would no longer be considered 
``covered employees,'' the bank would then be able to deduct this 
expense.
    However, the provision in H.R. 2 will result in the bank losing its 
ability to deduct those previously deferred amounts. This in turn will 
increase the bank's tax liability by millions of dollars, resulting in 
a retroactive tax increase.
    A retroactive tax increase of this nature will punish businesses 
for legitimate decisions that were based on the certainty of existing 
tax law. It will also create great uncertainty and risk with respect to 
future issues of compensation. Businesses should be able to continue to 
rely on the certainty of the law and any restrictions imposed should 
apply prospectively only.
III. Changing the Effective Date for SILO Transactions Results in 
        Retroactive Taxation
    The proposed changes to the effective date for leasing provisions 
under the American Jobs Creation Act (``AJCA'') of 2004 are also of 
concern. With the passage of the AJCA, Congress enacted limitations on 
the deductibility of losses from future sale-in/lease-out (``SILO'') 
transactions. Effective March 14, 2004, deductions from property leased 
to a tax-exempt entity were limited to the taxpayer's gross income 
generated from the lease for that tax year. Significantly, Congress 
made clear at the time that this change to the tax law would be applied 
only on a prospective basis.
    Prior to the passage of the AJCA, several issues impacting the 
effective date of the new provisions were debated. These included: (1) 
the fact that most transactions had been based on long-standing tax 
law; (2) that several transactions were in mid-stream and a loss of tax 
benefits would have negatively impacted them financially; and (3) that 
the effective date for any such change in the law should be 
prospective. As a result of these considerations, the final version of 
AJCA included appropriate grandfathering for transactions entered into 
before March 12, 2004.
    Now, three years later, the Senate is attempting to change the 
effective date. If enacted, the net effect will be a retroactive tax 
increase on banks, punishing them for entering into transactions that 
were, in some cases, crafted many years ago.
    We would like to thank the committee for holding this hearing and 
giving us the opportunity to comment. Additionally, we look forward to 
working with you on these and other issues during the 110th Congress.

                                 

     Statement of the American Bar Association Section of Taxation
    This statement is submitted on behalf of the Section of Taxation of 
the American Bar Association. It has not been approved by the House of 
Delegates or the Board of Governors of the American Bar Association. 
Accordingly, it should not be construed as representing the policy of 
the American Bar Association.
    The Section of Taxation appreciates the opportunity to provide 
input to the Committee on Ways and Means (the ``Committee'') on the 
revenue increase measures in the ``Small Business and Work Opportunity 
Act of 2007''--the Senate-passed version of H.R. 2 (the ``Bill''). Our 
comments address the limit on the amount of annual deferrals under 
nonqualified deferred compensation plans that would be added to section 
409A \1\ by section 206 of the Bill.
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    \1\ Unless otherwise indicated, all section references are to the 
Internal Revenue Code of 1986, as amended (the ``Code'').
---------------------------------------------------------------------------
    We have followed these provisions with interest since they were 
first proposed. On February 2, 2007, we wrote a letter to Chairman 
Baucus and Senator Grassley of the Senate Finance Committee on behalf 
of the American Bar Association expressing concern about the inclusion 
of provisions in the Bill without the benefit of public hearings or 
public comment. On February 7, 2007, we wrote a letter to Chairman 
Rangel and Congressman McCrery of this Committee also urging that 
proposed amendments to the tax laws, such as these, be exposed for 
public comment, preferably through hearings, before Committee action. 
We, therefore, commend the Committee for holding hearings on the 
revenue increase measures in the Bill, and hope that our comments below 
will be useful in the Committee's deliberations.
    We believe that these provisions would impose enormous and 
disproportionate (relative to the abuses they are designed to correct) 
administrative burdens on taxpayers, their advisers, employers and 
others. We previously urged the leadership of the tax-writing 
committees ``to hold comprehensive hearings and otherwise gather 
information about the potential impact of [section 409A], including the 
estimated costs of compliance.'' \2\ At that time, we explained the 
important policy reasons for conducting a thorough review of section 
409A prior to the law becoming fully effective, which is now scheduled 
for January 1, 2008. We continue to urge that the Committee hold such 
hearings.
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    \2\ Letter dated July 31, 2006, from the ABA Section of Taxation to 
William M. Thomas, Chairman, House Committee on Ways and Means, Charles 
B. Rangel, Ranking Member, House Committee on Ways and Means, Charles 
E. Grassley, Chairman, Senate Committee on Finance, and Max S. Baucus, 
Ranking Member, Senate Committee on Finance.
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Limit on amount of annual deferrals under nonqualified deferred 
        compensation plans
    Section 206 of the Bill would amend section 409A to require 
nonqualified deferred compensation plans subject to that section to 
limit an individual employee's annual deferrals to the lesser of $1 
million or the employee's average taxable compensation over the 
previous five years. Earnings on previous deferrals would be treated as 
additional deferrals for this purpose, and all nonqualified deferred 
compensation plans of the same employer would be aggregated. Failure to 
comply with the limit would trigger penalty taxes and interest under 
section 409A. The $1 million limit would not be indexed for inflation.
    Rationale for new limitations. We have a number of concerns about 
the proposal. To begin with, we question several of the premises on 
which it is based. The Finance Committee's report on the Bill states 
that:
    The Committee is concerned with the large amount of executive 
compensation that is deferred in order to avoid the payment of income 
taxes. Rank and file employees generally do not have the opportunity to 
defer taxation on otherwise includible income in excess of the 
qualified plan limits. However, it is common for nonqualified deferred 
compensation arrangements to allow executives to choose the amount of 
income inclusion they wish to defer. [footnote omitted] The Committee 
is concerned that the ability to defer unlimited amounts of 
compensation gives executives more control over the timing of income 
inclusion than rank and file employees. S. REP. No. 110-__ at 58-59 
(2007).
    We respectfully disagree with the suggestion in the first sentence 
that executive compensation is deferred primarily to avoid the payment 
of income taxes. In our experience, executives defer compensation for 
the same principal reason that rank-and-file employees do, namely to 
save for retirement. This is a worthy goal regardless of an employee's 
income level. We also disagree with the implicit assumption that 
deferring compensation in a nonqualified deferred compensation plan 
reduces tax revenues. Section 404 prohibits a taxable employer from 
deducting nonqualified deferred compensation until it is included in 
the employee's gross income.\3\ Income earned on the deferrals is 
taxable to the employer. Thus, the net revenue effect of such deferrals 
is close to zero.
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    \3\ This creates a ``tax tension'' between a taxable employer and 
an employee who want to defer compensation. There is no such tension in 
the case of a nontaxable employer. That is the main reason that has 
been given for imposing a dollar limit (currently $15,500) on annual 
deferrals under nonqualified deferred compensation plans maintained by 
governmental and tax-exempt employers. See Code  457(b). ``In 
contrast,'' according to the Department of the Treasury, ``such 
limitations are not necessary for private, taxable employers because 
the tax tension between the employers' preference for a current 
deduction and the employees' incentive for deferral will provide 
inherent restraints on the amount of deferred compensation that is 
provided.'' Department of the Treasury, Report to The Congress on The 
Tax Treatment of Deferred Compensation Under Section 457, at 10 (Jan. 
1992) (emphasis added).
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    Furthermore, based on our experiences, the suggestion in the 
remainder of the paragraph that rank-and-file employees have much more 
limited deferral opportunities than executives because they only 
participate in the employer's tax-qualified plans ignores several 
important points:

      Differences in deferral opportunities are more likely to 
reflect the structure of the Employee Retirement Income Security Act 
(``ERISA'') than any kind of income-based discrimination. Any enhanced 
deferral opportunities that executives have must be provided under a 
nonqualified deferred compensation plan. Under ERISA, employees who are 
not part of a ``select group of management or highly compensated 
employees'' (often called a ``top-hat'' group) generally may not 
participate in a deferred compensation plan which defers compensation 
to termination of employment or later unless the plan is funded, and a 
nonqualified deferred compensation plan that is funded is no longer 
able to defer taxes. Thus, for the most part ERISA effectively 
prohibits rank and file employees from participating in nonqualified 
deferred compensation plans.
      Tax-qualified plans provide as much opportunity to save 
for retirement as many rank-and-file employees are willing or able to 
use. It is unusual for rank-and-file employees to make elective 
contributions up to the current dollar limit ($15,500, or $20,500 if 
the employee is 50 or over and the plan permits catch-up 
contributions). Also, nonelective and matching contributions, and 
accruals under pension plans, are subject to much higher limits. 
Congress may want to examine ways to increase deferral opportunities--
and retirement savings generally--for rank-and-file employees who are 
interested in saving more. We strongly support such consideration. We 
do, however, question the purported constraints imposed by the existing 
rules.
      A large percentage of nonqualified deferred compensation 
is provided under supplemental retirement plans (``SERPs'') or benefit 
equalization plans (``BEPs'')--plans designed to provide the benefits 
that the executives would have received under the employer's tax-
qualified plans but for the Code-imposed limits on compensation, 
contributions and benefits that apply to those plans. SERPs and BEPs, 
by their nature, replicate the benefits and limitations (other than the 
statutory limitations) that are imposed in the underlying tax-qualified 
plans. For example, if the underlying tax-qualified plan provides for 
an employer contribution of 6% of compensation up to the $225,000 limit 
under section 401(a)(17), a SERP might provide a credit of 6% on 
compensation over $225,000. Participants in such plans do not really 
have more opportunities to defer compensation: they simply have more 
compensation to defer and can only do so in a nonqualified plan, 
because of the way that ERISA is structured.\4\ Congress may be 
concerned when executives have much higher compensation than rank-and-
file employees, but that issue is a general economic matter, not a 
structural problem with the existing tax system.

    \4\ As noted above, amounts deferred under nonqualified plans do 
not generate current tax deductions for the employer, and income 
attributable to deferred amounts is taxed to the employer during the 
deferral period. Also, participants in such plans have far fewer 
protections than they would under a tax-qualified plan. For example, 
amounts set aside to provide benefits are subject to the claims of the 
company's creditors in bankruptcy.

    The foregoing observations are based on our extensive experience 
with employee benefit matters. There is, however, sparse data on 
nonqualified deferred compensation.\5\ In part because of the absence 
of data, we believe Congress should proceed carefully in this area, 
after gathering as much information as possible through public hearings 
and other means.
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    \5\ At the same time that it enacted section 409A, Congress added a 
requirement to report the amount deferred under a nonqualified deferred 
compensation plan on Form W-2. However, that requirement is not yet in 
effect, partly because the IRS has recognized how hard it is to value 
those amounts.
---------------------------------------------------------------------------
    Scope of limit. We think the scope of the limit goes beyond even 
what is required by the stated rationale. First, the passage quoted 
above suggests that the Finance Committee was concerned primarily or 
exclusively with elective deferrals, not retirement savings generally. 
However, the limitation is not restricted to elective deferrals. To the 
contrary, it appears to apply to any amounts that would be considered 
deferred compensation under section 409A and the regulations under that 
section. That section covers a wide range of nonelective arrangements, 
including, for example, SERPs and BEPs that supplement benefits under 
traditional defined benefit pension plans. Many companies also have 
automatic deferrals of annual or long-term bonuses to which section 
409A applies, as well.
    Second, Senator Grassley's floor statements suggest that the Senate 
thought the limit would apply mostly to ``the wealthiest 
[individuals]--i.e., those individuals receiving more than $1 million 
annually in nonqualified deferrals.''\6\ In practice, however, the new 
limitation will apply to many other employees. The limit by its terms 
is the lower of $1 million or the employee's average taxable 
compensation over the past 5 years. Thus, it is certain to apply to 
some middle-management employees deferring much less than $1 million. 
It also treats earnings on previous deferrals as additional deferrals. 
Thus, even without the 5-year look-back rule it could apply to middle-
management employees with substantial account balances and earnings who 
defer relatively little from their current compensation.
---------------------------------------------------------------------------
    \6\ See 153 Cong. Rec. S1492 (daily ed. Feb. 1, 2006) (statement of 
Sen. Grassley).
---------------------------------------------------------------------------
    In his floor statements, Senator Grassley did not dispute this. 
Instead he said the Joint Committee on Taxation had estimated that 
eliminating the five-year look-back rule would reduce the revenue score 
by less than $100 million out of $806 million, and that this suggested 
that only about 10% of the individuals affected by the limit were 
deferring less than $1 million. However, since the revenue estimates 
are based on deferrals, this actually suggests that middle management 
will make up more--perhaps much more--than 10% of the affected group on 
a headcount basis.\7\ Senator Grassley also said that including middle 
management in nonqualified deferred compensation plans ``raises other 
red flags''--suggesting, perhaps, that it does not or should not occur. 
We agree that not all individuals in middle management are part of the 
``top-hat'' group that can participate in nonqualified deferred 
compensation plans. However, this group can be relatively large,\8\ 
there are no clear guidelines, and in our experience most employers try 
to cover as many individuals as they are allowed to cover.
---------------------------------------------------------------------------
    \7\ For example, if three executives earned $200,000 each and 
deferred half of that amount under a nonqualified deferred compensation 
plan, and one executive earned $5.4 million and deferred half of that 
amount under the same plan, the first three executives would defer 10% 
of the total amount deferred under the plan, but make up 75% of the 
plan participants.
    \8\ See, e.g., Gallione v. Flaherty, 70 F.3d 724, 729 (2d Cir. 
1995) (group consisting of all full-time officers of union was 
sufficiently select even though it included over 25% of employees).
---------------------------------------------------------------------------
    Third, a violation will occur any time an individual's deferrals 
(plus earnings on previous deferrals) exceed the limit in any given 
year. For this purpose, all nonqualified plans (not just plans of the 
same type) would need to be aggregated. Nonelective deferrals, and 
earnings on previous deferrals, can be very uneven and difficult to 
value or predict. If deferrals are not counted against the limit until 
they vest, this problem is exacerbated and applies to elective 
deferrals as well. Thus, even individuals whose regular deferrals (plus 
earnings) are much less than the limit will, on occasion, have excess 
deferrals which will have to be forfeited or corrected in some fashion.
    Fourth, this type of limitation tends to favor new hires over long 
term employees whose compensation is averaged over a longer period. It 
tends to treat similarly situated employees differently based on quirks 
on their compensation histories, such as option exercises which would 
increase compensation in the particular year of exercise. It also tends 
to disfavor employees at companies such as start-ups with relatively 
low levels of cash compensation.
    Practical difficulties implementing limit. We also think that the 
limit, as currently drafted, will be difficult to implement--both by 
employers and by the Internal Revenue Service (the ``IRS'')--and is 
likely to have unexpected and unfair consequences. As noted above, 
nonelective deferrals, and earnings on previous deferrals, can be 
uneven and difficult to value or predict. For example, benefits under 
non-account balance (defined benefit) plans, especially those that are 
integrated with Social Security or that provide early-retirement 
subsidies; equity-based plans that are treated as deferred compensation 
under section 409A; and post-termination benefit continuations, are 
particularly difficult to value as they accrue. In order to apply the 
limit to such plans, the IRS will have to prepare elaborate valuation 
guidance and train its auditors on how to apply it, which will require 
substantial tax administrative resources. If it does not, it might 
prove difficult for the IRS to challenge taxpayers' actuarial 
valuations.\9\
---------------------------------------------------------------------------
    \9\ See, e.g., Wells Fargo & Company v. Commissioner, 120 T.C. 69 
(2003); Vinson & Elkins v. Commissioner, 99 T.C. 9 (1992).
---------------------------------------------------------------------------
    One alternative would be to wait to value deferrals until they are 
``reasonably ascertainable.''. That is what the regulations provide 
under section 3121(v), which subjects deferred compensation to FICA 
taxes when they accrue or vest, whichever is later. However, this would 
tend to bunch up deferrals in a single year and substantially increase 
the chances of violating the limit.
    It might also be appealing to count deferrals against the limit 
only when they vest, since it seems unfair to treat a plan as violating 
the limit and trigger penalties taxes because of benefits that an 
employee might never receive. That is the way the dollar limit in 
section 457(b) is applied. However, this, too, would tend to bunch up 
deferrals in a single year and substantially increase the chances of 
violating the limit.
    Finally, treating earnings on previous deferrals as additional 
deferrals will punish employees whose deemed investments do well, and 
will make it progressively harder for a long-service employee to avoid 
the limit as his or her account--and the earnings on that account--grow 
over time. This is likely to be perceived as unfair and even age-
discriminatory.
    It has taken the IRS over two years to draft final regulations on 
the major provisions of section 409A, and, according to an IRS 
official, when those regulations are issued they will be 
``voluminous.''\10\ To address concerns like those noted above, we 
think that regulations implementing the proposed limit are likely to 
take just as long to draft and be just as voluminous.
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    \10\ Daily Report for Executives, No. 41, at G-4 (Friday March 2, 
2007).
---------------------------------------------------------------------------
    Effective date issue. It is unclear whether the limit will apply to 
amounts deferred on or before December 31, 2006, if they vest after 
that date. For purposes of the effective date of the original section 
409A, which used nearly identical language, amounts were not considered 
deferred until they vested. Taking this approach under the proposed 
limit would subject an even larger amount of deferred compensation to 
the limit. Furthermore, it is unclear how the limit would apply to 
existing deferrals. Applying it to existing deferrals when they vested 
would create the bunching problem noted above. Applying it 
retroactively to the years in which the deferrals occurred would, in 
our view, be unfair to taxpayers who relied in good faith on prior law.
    Effect on defined benefit plans. We think the limit, as currently 
drafted, could indirectly discourage employers from maintaining tax-
qualified defined benefit plans. That is because, as noted above, in 
our experience a large percentage of nonqualified deferred compensation 
is provided under SERPs and BEPs that provide benefits that would have 
been received under the employer's tax-qualified plans but for various 
statutory limits, and benefits under SERPs and BEPs that supplement 
defined benefit plans will be the most difficult to predict and value 
under the proposed limit. This will impose one more burden on employers 
that still maintain those plans, and add to the reasons they have for 
freezing or terminating them.
    Composition of deferred compensation. If the proposal is enacted, 
it will inevitably reduce certain types of deferred compensation. Our 
experience suggests, however, that total compensation will not be 
significantly affected. This is borne out by experience after the 
enactment of sections 280G and 162(m), and is likely to be the result 
here as well. Instead, the new law may be expected to induce 
distortions in executive pay, many of which will be undesirable for 
non-tax reasons. For example, current cash compensation may increase, 
thereby reducing the employee's interest in the long-term prospects of 
the employer. Alternatively, greater emphasis may be placed on various 
types of equity-based compensation that are not subject to the 
proposal. This may cause over-utilization of stock options and 
restricted stock. Any such changes may have significant ramifications 
for executive compensation and corporate governance in general.
Conclusion
    Fundamentally, we think that publicity and the activism of 
shareholders and unions are more appropriate mechanisms for 
counterbalancing excess executive compensation than one-size-fits-all 
limits imposed by the Code. While certain CEO severance packages have 
received a great deal of press recently, such arrangements have also 
gotten the attention of shareholder activists.\11\ Furthermore, a 
number of public companies have taken steps on their own following the 
highly publicized--and criticized--large severance packages for the 
Home Depot and Pfizer CEOs. For example, Waste Management, Inc., 
Marathon Oil Corporation and Wachovia Corporation have all published in 
SEC filings that they have policies regarding when the Board must seek 
shareholder approval of an executive officer's severance package when 
it exceeds certain specified limits. These trends are likely to 
continue as a result of the enhanced SEC disclosure requirements for 
executive compensation which went into effect this year.
---------------------------------------------------------------------------
    \11\ See Joann S. Lublin and Phred Dvorak, How Five New Players Aid 
Movement to Limit CEO Pay, Wall St. J., March 13, 2007, at A1.
---------------------------------------------------------------------------
    We would like to thank the Committee for the opportunity to express 
our views on the executive compensation provisions in the Senate-passed 
version of H.R. 2. We believe that, especially as currently drafted, 
they are unlikely to achieve the purpose for which they are intended; 
will unnecessarily complicate the Code and burden the IRS; may harm 
many middle-management employees; and may well induce serious adverse 
consequences outside of the tax system. By discouraging SERPs and BEPs 
that supplement benefits under tax-qualified defined benefit plans, the 
limit on annual deferrals could even end up hurting the rank-and-file 
employees that it is intended to benefit.

                                 

                 Statement of American Benefits Council
    The American Benefits Council submits this statement in connection 
with the hearing of the House Committee on Ways and Means on the Small 
Business and Work Opportunity Act of 2007 (the ``Act''). We 
respectfully request that this statement be included in the record of 
the hearing.
    Our comments address two revenue raising provisions included in the 
Act: (i) Section 226, which expands Internal Revenue Code section 409A 
to impose dollar caps on nonqualified deferred compensation plans, 
including all earnings under those plans, equal to the lesser of ``one 
times pay'' or $1 million; and (ii) Section 234, which expands Internal 
Revenue Code section 162(m) to deny employer deductions for certain 
compensation payments to both current and former top executives of 
publicly-held companies, including payments that are already scheduled 
to be made under legally binding contracts.
    The American Benefits Council is a public policy organization 
representing more than 250 members that are primarily major U.S. 
businesses providing employee benefits to active and retired workers. 
The Council's members do business in most, if not all, of the states. 
The Council's membership also includes organizations that provide 
employee benefit services to employers of all sizes. Collectively, the 
Council's members either sponsor directly or provide services to 
retirement and health plans that cover more than 100 million Americans.
    The Council's members have raised significant concerns about both 
the policy and practical effects of sections 226 and 234 in the Act. We 
believe that both of these revenue raising provisions are significantly 
flawed and we urge that they be rejected.
Section 226_Dollar Caps on Nonqualified Deferred Compensation
    Section 226 would amend Code section 409A to impose a dollar cap on 
nonqualified deferred compensation that is the lesser of $1 million or 
``one times pay'' for an employee. The penalty for exceeding this 
dollar cap is immediate income inclusion of the total nonqualified 
deferred compensation earned by the employee plus a 20-percent addition 
to tax and interest. The Council has serious concerns with this 
provision because it would impose arbitrary limits on deferred 
compensation plans and impose draconian tax penalties if those limits 
are exceeded. The dollar cap is not limited to the pay packages of 
senior executives. If enacted, the dollar cap in Section 226 would 
apply to any arrangement that falls within the technical definition of 
a ``nonqualified deferred compensation plan'' under Code section 409A. 
These include non-elective plans, such as retirement-type and 
supplemental pension plans, incentive compensation, and certain equity 
arrangements, such as restricted stock units and stock appreciation 
rights that do not squarely fit within the current regulatory 
exceptions under section 409A.
    Although section 226 of the Act may have been viewed as addressing 
perceived problems with ``executive'' pay, the broad spectrum of plans 
that would be subjected to the dollar cap lead us to conclude that 
middle management employees likely would see the most drastic changes 
in their benefit programs should section 226 be enacted. The 
uncertainties and administrative burdens created by a dollar cap may 
discourage some employers from providing such programs for middle-
management, many of which are designed to complement the employer's 
tax-qualified retirement plans by allowing employees to save for 
retirement on their total compensation. We have attached to our 
statement a number of examples taken from companies, which illustrate 
the scope of the dollar cap.
    Moreover, the effect of the dollar cap included in section 226 of 
the Act would be to subject nonqualified plan dollars to income 
inclusion and a potential 20-percent addition to tax before funds are 
actually paid or made available to an employee. This is a fundamental 
and, in our view, unwise shift in basic tax principles. Contrary to 
some erroneous news reports, nonqualified plans are not ``funded'' or 
secured like qualified retirement plans. Employees are not guaranteed 
to receive the money in the event of the employer's insolvency, for 
example. If such were the case, these amounts would already be subject 
to income tax under current law. Rather, section 226 of the Act would 
tax employees before they are actually paid on funds that are ``at 
risk'' and on amounts that might never be paid or that might end up 
being lower in value when they are ultimately paid.
    Our members also question why the U. S. income tax system would 
favor current cash payments in lieu of deferred payments to employees. 
Employers may have legitimate cash-flow and long term business goals 
for designing compensation programs that defer payments into the future 
rather than providing for current cash. Consider, for example, the 
start-up company that instead of paying higher current salaries 
promises bonuses or incentive compensation in the future based on the 
growth and success of the business. At the time that the bonus is 
promised, it may be worth a relatively small amount. But, if as hoped, 
the business succeeds, the increased value of that bonus, (i.e., the 
``earnings'') could easily exceed the one-times pay or the $1 million 
limit in any future year. Section 226 of the Act would preclude such an 
arrangement.
    There are also troubling technical aspects of section 226 of the 
Act that would make it difficult to administer and, therefore, easy to 
inadvertently violate when applied in the real world. As the attached 
examples illustrate, the ``one times pay'' prong of the dollar cap and 
the inclusion of ``earnings'' in the annual deferrals subject to the 
cap are both particularly pernicious. Section 223 of the Act would 
impose the Code section 409A tax penalty on earnings in excess of the 
applicable dollar limit--even if the earnings are based on the growth 
of the business or another market rate of return--which cannot be 
predicted with certainty.
    Our members are also mindful that it was just a little over two 
years ago that Congress enacted the current-law section 409A provisions 
to regulate deferral elections and the timing of payouts for deferred 
compensation. These new rules have required sweeping changes in the 
design of deferred compensation plans and have generated literally 
hundreds of pages in interim regulatory guidance. Employers have 
already made significant changes to deferred compensation plans to 
conform to these complicated new rules and are still awaiting final 
regulations. Adding arbitrary dollar limits to the 409A rules on the 
cusp of the publication of final regulations will create excessive 
regulatory burdens. The massive employer effort required to conform to 
409A and modify the design of nonqualified plans since 2005 will, in 
many cases, have been futile if a dollar cap is now imposed. Design 
decisions, administrative programs, and legal analyses for nonqualified 
plans all would have to be revisited in light of the dollar caps.
    Finally, experience shows that imposing dollar limits under the 
Internal Revenue Code skews behavior. Sections 162(m) and 280G, two 
provisions that impose tax penalties for exceeding compensation dollar 
limits, have been uniformly criticized as causing greater harm than 
benefit. Our members are concerned that imposing dollar limits under 
409A will inevitably lead to the same result--excessive complexity and 
arbitrary ``winners'' and ``losers.'' Employers should be designing 
compensation systems to further their business goals rather than 
avoiding disincentives created by the Internal Revenue Code. 
Section 234_Expansion of Code section 162(m)
    Section 234 of the Act would expand the definition of ``covered 
employee'' as defined under section 162(m) to include anyone who was 
ever a covered employee or anyone who served as CEO at any point during 
the year. The expansion of section 162(m) would expand further a 
provision that experts unequivocally agree is ``broken.'' The staff of 
the Joint Committee on Taxation (JCT) recommended in 2003 that section 
162(m) be repealed altogether. The recommendation was based on the JCT 
staff's conclusion that the provision is ``ineffective at accomplishing 
its purpose [and] overrides normal tax principles.'' The JCT staff also 
noted that ``[t]he concerns reflected in the limitation can better be 
addressed through laws other than the Federal tax laws.'' To that end, 
the Securities and Exchange Commission has promulgated expansive new 
proxy disclosure rules on executive compensation. Those provisions 
should be given time to work rather than embark on an attempt to once 
again use the tax laws to address perceived corporate governance 
problems.
    Our members are also concerned that the section 162(m) proposal 
applies retroactively to amounts earned before 2007 and payments to 
which the employer is already contractually obligated. The lack of a 
binding contract exception is punitive. When Congress enacted the 
section 162(m) deduction limit in 1993, an exception was included for 
payments made under existing binding contracts that were not materially 
modified. We urge that Congress not retroactively change the tax laws 
with respect to binding compensation arrangements.
Examples
    Restricted Stock Units. In recent years, many employers have 
redesigned their equity programs to increasingly rely on the use of 
restricted stock units (RSUs). Typically, employees are awarded a 
specified number of RSUs, with a fixed percentage of the RSUs vesting 
on a quarterly or annual basis or the entire block of RSUs vesting 
after a specified performance period. Generally, upon vesting of an RSU 
award, RSUs are converted into shares of the employer's common stock 
and the employee is taxable on the fair market value of such stock. 
Some RSU programs fit within the regulatory exception from 409A for 
compensation that is paid upon vesting (or within 2\1/2\ months after 
the year of vesting.) It is not uncommon, however, for employers to 
find that their RSU program does not meet the short-term deferral 
exception and that compensation paid under the program is subject to 
409A. In some instances, an employee may vest in the RSUs in increments 
over the performance period but is not paid until full vesting is 
attained at the end of the performance period. In other instances, an 
employee may vest fully upon reaching a specified retirement age during 
the performance period. Under the legislation, such RSU grants would be 
subject to the ``one times pay'' limit and could cause employees to 
exceed the limit.
    For example, a newly hired employee of a Fortune 500 company 
receives a grant of RSUs that is subject to 409A. The employee is 
granted 6,000 RSUs at a time when the value of the company's stock is 
$30 (i.e., value of the grant is $180,000). The employee is scheduled 
to vest in \1/5\ of the RSUs each year over a 5-year performance 
period. The employee receives a base salary of $140,000, which under 
the Senate provision would be the employee's ``one times pay'' limit 
for the first year. Because the value of the RSU grant exceeds the 
``one times pay'' limit, a 409A violation would occur and the employee 
would be subject to a 20% additional tax on the value of the RSUs as 
they vest (i.e., 20% of the RSUs per year) over the 5-year period.
    Because ``earnings'' on the underlying shares of the company's 
stock also are subject to the limit, employees could have a tax penalty 
under 409A merely because the company was successful and the value of 
the RSUs increased beyond the limit.
    For example, an employee is granted 1,000 RSUs at the beginning of 
employment with technology company. The employee ``vests'' in these 
units after 5 years of service and the RSUs are designed to pay out 
after 10 years. The employer believes that this plan aligns the 
employee's interest with growing the company value rather than 
maximizing current salary. At the beginning of employment, the RSUs 
were valued at $15 per share. The employee earns approximately $100,000 
per year and receives modest increases (based on CPI of 3 percent). The 
employee's 5-year average taxable compensation from the company is 
$110,000 at the end of year 5. The company stock price stays relatively 
flat, but in year 6 the company becomes highly successful and the 
valuation of the stock takes off eventually to exceed 10 times the 
original price. The one-times-pay limit would be exceeded because the 
increase in the RSU value in year 6 will exceed $110,000.
    Supplemental 401(k) Plans. Employees who cannot fully defer under a 
401(k) plan because of the compensation limits under the Code may 
participate in a supplemental or ``mirror'' 401(k) plan. Unlike 
qualified plans, these programs are unfunded and the employer's 
deduction is delayed until the time of payment. If the company becomes 
insolvent, the employees are not paid. The legislation counts 
``earnings'' that accrue under the supplemental plan as additional 
deferrals that count against the ``one times pay'' limit and could 
cause the employee to exceed the limit.
    For example, a Fortune 500 company offers a nonqualified 
supplemental plan to certain employees, including mid-level management 
employees receiving approximately $150,000 to $200,000 per year in 
total wages from the company. Many of these mid-level management 
employees are long-serving employees who typically defer 20 to 40 
percent of their wages. Employees who participate in the plan receive a 
small matching contribution (typically between $3,000 and $6,000) from 
the company based on their deferrals. Investment earnings are credited 
to an employee's bookkeeping account in the plan based upon deemed 
investments chosen by the employee from among the same mutual funds as 
those offered in the company's 401(k) plan. Using 2006 data, the 
company has calculated that at least seven such employees would have 
exceeded their 5-year average taxable compensation. Below is a chart 
summarizing the relevant information.

 
----------------------------------------------------------------------------------------------------------------
                                                            Account
                                           2006    5-year   Balance     2006       2006                Deferrals
             Emp.              Years of   Total    Average   As of   Deferrals  Investment    Total     Above 5-
                                Service   Wages    Taxable   12/29/  And Match   Earnings   Deferrals   year Avg
                                                    Wages      06                                        Limit
----------------------------------------------------------------------------------------------------------------
  1                                 27   $159,50  $ 90,180  $418,40  $ 66,700   $ 72,300    $139,000   $48,820
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  2                                 13   $175,40  $102,220  $508,30  $ 60,800   $ 52,500    $113,300   $11,080
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  3                                 28   $179,30  $ 62,380  $364,10  $116,400   $ 27,000    $143,400   $81,020
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  4                                 25   $178,30  $126,920  $614,70  $ 47,900   $109,100    $157,000   $30,080
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  5                                 30   $183,70  $126,040  $617,70  $ 38,000   $141,800    $179,800   $53,760
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  6                                 14   $194,40  $128,020  $486,50  $ 62,200   $ 73,200    $135,400   $ 7,380
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  7                                  6   $203,00  $ 92,020  $647,10  $ 76,300   $ 94,700    $171,000   $78,980
                                          0                  0
----------------------------------------------------------------------------------------------------------------

    Two of these employees (5 and 7) would have exceeded their 5-year 
average taxable compensation based solely upon their 2006 earnings. 
Since earnings that are tied to a publicly-traded investment are often 
very unpredictable, any employee participating in a supplemental 401(k) 
plan would have to leave a large cushion below the ``one times pay'' 
limit to take into account potential earnings. Moreover, a long-serving 
employee could exceed the annual deferral limit based upon earnings 
even if the employee stopped making deferral elections.
    For example, assume employee 5 in the above example stopped making 
deferral elections after 2006, and that the employee receives modest 
increases in wages each year (based on CPI of 3 percent). Also assume 
that the employee elected to have all of his account balance as of 
December 29, 2006 ($617,700) be deemed invested in the plan's S&P 500 
index fund, and that for the 4-year period from 2007 to 2010 that 
fund's annual return was 20% per year (which would be consistent with 
the S&P 500's performance in the late 1990s). By 2010, there would be a 
409A violation solely because the earnings credited to the employee's 
bookkeeping account ($213,477) exceeded the employee's 5-year average 
taxable compensation from the company ($189,376).
    Non-elective, Supplemental Pension Plans. Some companies maintain 
non-elective, supplemental pension programs to serve as retention tools 
and assist management employees in saving for retirement. Unlike 
qualified plans, these programs are unfunded and any employer deduction 
is delayed until the time of payment. If the company becomes insolvent, 
the employees are not paid. The nature of many of these plans is to 
provide the most valuable accruals in the years right before retirement 
(e.g., age 65) and, therefore, they incentivize employees to stay in 
their jobs. The legislation would require employers to severely limit 
or abandon these arrangements because later-year accruals may exceed 
the ``one times pay'' limit under common plan designs for long-service 
employees. The problem would be further exacerbated if the employer 
wanted to manage its employee headcount by offering an early retirement 
incentive in the qualified and supplemental pension plans (such as 
payment of the full pension without a reduction for early 
commencement). The increased value of the pension in the year that the 
early retirement incentive was offered could cause the ``one times 
pay'' limit to be exceeded.
    For example, one Fortune 500 company sponsors a non-elective, 
supplemental pension plan that is available to middle managers making a 
little over $100,000 per year, many of which work for the company's 
retail entity. The company noted the difficulty in calculating annual 
accruals for this type of plan and the fact that the value of annual 
accruals often varies significantly from year to year due to interest 
rate changes and eligibility for early retirement. To the extent an 
accrual under the supplemental pension plan exceeded the limit, it is 
not clear how the company could ``fix'' the pension plan formula to 
avoid an excess accrual. The company also noted that the impact of the 
``one times pay'' limit would be even more severe because other forms 
of compensation provided to these managers, such as RSUs, performance 
units and severance pay, would also be aggregated with accruals under 
the supplemental pension plan in applying the limit. As a result, the 
company advised us that they may discontinue the supplemental pension 
plan if the annual limit is enacted.
    Bonuses and Incentive Programs. Many employers structure their 
bonus programs to fit within the regulatory exception from 409A for 
compensation that is paid upon vesting (or 2\1/2\ months after the year 
of vesting.) It is not uncommon, however, for employers to find that 
they cannot meet this strict 2\1/2\ month rule. Employees may vest at 
the end of the year or at the end of the performance period, but 
business issues may necessitate a delay in payment that results in the 
payment being subject to 409A. Some employers may need to wait longer 
for performance criteria to be ascertained, financials certified, etc., 
resulting in the payment being subject to 409A and the ``one times 
pay'' limit. In other instances, an employee may vest in increments 
over the performance period or upon reaching retirement age but is not 
paid until the end of the period, which also would result in the 
payment being subject to 409A and the ``one times pay'' limit.
    Private Equity. Many private companies (including start-ups) cannot 
readily conform to the specific administrative rules provided under the 
409A regulatory exceptions for equity grants (e.g., stock options and 
stock appreciation rights) because there is no public market to ensure 
a true fair market value price for the grant. As a result, many private 
companies' equity grants are subject to 409A. Under the Senate bill, 
private companies could not provide this type of equity grant to 
employees unless the grant does not exceed the one times pay limit. 
Because ``earnings'' on the equity also are subject to the proposed 
limit, employees could have a tax penalty under 409A merely because the 
company was successful and the value of the equity increased beyond the 
limit.
    Cash Flow and Start Ups. Small and emerging businesses may pay 
modest current compensation during the early stages of the business but 
promise significant future compensation, including retirement payments, 
in order to attract and retain talented employees. The Senate bill 
limits the business from making any promise that exceeds ``one times 
pay'' for employees.

                                 

        Statement of Association for Advanced Life Underwriting
I. INTRODUCTION
    The Association for Advanced Life Underwriting (``AALU''), the 
National Association of Insurance and Financial Advisors (``NAIFA''), 
and the National Association of Independent Life Brokerage Agencies 
(``NAILBA'') appreciate the opportunity to submit this statement to the 
Committee on Ways and Means in connection with its review of the 
revenue increasing measures approved by the Senate as part of the 
``Small Business and Work Opportunity Act of 2007.'' These comments 
focus on the Senate proposal to place an annual limit on the amount of 
compensation that may be deferred under a nonqualified deferred 
compensation plan.
    AALU is a nationwide organization of life insurance agents, many of 
whom are engaged in complex areas of life insurance such as business 
continuation planning, estate planning, retirement planning, and 
deferred compensation and employee benefit planning. AALU represents 
approximately 2,000 life and health insurance agents and financial 
advisors nationwide.
    Founded in 1890 as the National Association of Life Underwriters, 
the National Association of Insurance and Financial Advisors comprised 
800 state and local associations representing the business interests of 
225,000 members and their employees nationwide. Members focus their 
practices on: life insurance and annuities, health insurance and 
employee benefits, multiline, and financial advising and investments. 
NAIFA's mission is to advocate for a positive legislative and 
regulatory environment, enhance business and professional skills, and 
promote the ethical conduct of its members.
    The National Association of Independent Life Brokerage Agencies 
(NAILBA) is a nonprofit trade association with over 350 member agencies 
in the U.S., representing 100,000 producers who deliver more than one 
billion dollars in first year life insurance premiums annually.
    AALU, NAIFA, and NAILBA strongly oppose the nonqualified deferred 
compensation proposal approved by the Senate. If enacted, the NQDC 
proposal would severely limit (if not eliminate) a vehicle many mid-
level managers and employees now use to supplement their retirement 
savings. These mid-level managers are at times caught in a vise between 
limited social security benefits and a cap on 401(k) contributions that 
can be further reduced when overall employee participation in such a 
plan is lackluster. AALU, NAIFA, and NAILBA believe that concerns 
relating to nonqualified deferred compensation plans have been 
addressed by legislation enacted in 2004, which has been the subject of 
extensive (but as yet incomplete) guidance from the Treasury Department 
and the IRS.
    Employers are struggling to implement the 2004 nonqualified 
deferred compensation rules and should not be subjected to additional 
burdens that may cause them to reconsider these important retirement 
savings vehicles.
II. BACKGROUND ON NONQUALIFIED DEFERRED COMPENSATION
    Nonqualified deferred compensation is sometimes mistakenly confused 
with ``executive compensation.'' It goes far beyond the ranks of top 
management and is integral to the ability of hundreds of thousands of 
mid-level managers and employees to save for retirement and for 
employers to recruit and retain high-quality employees.
    A typical nonqualified deferred compensation plan is an arrangement 
under which a portion of an employee's salary is deferred until a 
future date. Generally, the employee is at risk for the deferred 
portion of their salary. Individuals typically enter into these 
arrangements as a means of saving for retirement, in many cases 
augmenting amounts saved through 401(k) and other qualified plans. 
Limits on such qualified plans--for example, a maximum annual 
contribution limit of $15,500 for 401 (k) plans--and a lengthening life 
expectancy make nonqualified deferred compensation plans particularly 
important savings tools for employees. Such plans are increasingly 
important in light of concerns regarding the future availability of 
social security benefits to retirees at middle to upper income levels. 
Both large and small employers view these plans as valuable tools for 
retaining and attracting talent.
    In setting up a nonqualified deferred compensation agreement, the 
employer and employee typically will specify the percentage of current 
salary to be deferred and how earnings on the deferred amounts will be 
computed. In some cases, the agreement will specify a rate of return on 
the deferred amounts. In other cases, employees maintain an account in 
which they may make hypothetical investments that will govern the 
amount ultimately received by the employee. Some nonqualified deferred 
compensation arrangements--referred to as ``non-elective'' 
arrangements--do not involve voluntary deferrals by employees.
    A nonqualified deferred compensation plan is not eligible for the 
tax benefits granted to qualified plans. Under a qualified plan, the 
employer may deduct the deferred compensation currently, as amounts are 
contributed to the plan, while the employee is able to defer paying 
taxes until receiving distributions from the plan. By contrast, in a 
nonqualified plan, the employer's deduction is postponed until the 
employee recognizes the compensation for income tax purposes. This 
matching of deductions and income inclusion effectively eliminates any 
revenue concerns on the part of the federal government and provides a 
cost-effective way for the government to encourage additional 
retirement savings beyond those for which qualified plan tax benefits 
are allowed.
    Another key difference between nonqualified and qualified plans is 
that amounts deferred in a nonqualified plan are not protected in the 
event of the employer's bankruptcy. Assets intended to fund 
nonqualified deferred compensation must remain subject to the claims of 
the employer's general creditors. Thus, if the employer becomes 
insolvent, there are no assurances that the deferred amounts will ever 
be paid to the employee. In this case, the employee simply becomes 
another unsecured creditor of a bankrupt company. Thus, employees with 
nonqualified deferred compensation balances have a greater interest in 
building a financially strong enterprise for the very reason that their 
retirement income is dependent on the long-term financial stability of 
the company.
EXHAUSTIVE RULES ALREADY ENSURE RESPONSIBLE USE
    In 2004, Congress enacted sweeping additional requirements 
(Internal Revenue Code section 409A) on deferred compensation. The 
legislation imposed strict rules affecting deferral elections, funding, 
and distributions and imposed tax and penalties for violations of these 
rules. These rules were designed to ensure that employees do not have 
control over the receipt of income that is deferred. Regulations to 
implement the 2004 changes, which still have not been finalized, will 
run to hundreds of pages. Employers have already incurred, and will 
continue to incur significant legal and administrative expenses trying 
to navigate through the quagmire of these new rules. Code Section 409A 
and subsequent regulations surely address adequately any concerns about 
nonqualified deferred compensation.
BROAD BENEFITS OF DEFERRED COMPENSATION PLANS
    With longer life expectancies, the need for substantial retirement 
savings, and restrictive limits on qualified retirement plans, deferred 
compensation plans have become important to a wide-range of employees 
and businesses. According to a recent survey by Clark Consulting, 91% 
of Fortune 1000 respondent companies have nonqualified deferred 
compensation plans.
    Smaller businesses also commonly offer nonqualified deferred 
compensation programs. For large and small businesses alike, deferred 
compensation can be used as a tool to increase productivity and to 
retain employees who make important contributions to the businesses' 
bottom lines.
    Of survey respondents with nonqualified deferred compensation 
plans, 28% allow employees with compensation below $100,000 to 
participate, and 63% allow employees with compensation below $150,000 
to participate.
    The following are some examples of plans now in operation:
    1. A nationwide retailer based in the Midwest offers its 
nonqualified deferred compensation plan to 1,120 employees. Of the 962 
participants, 68% have annual salaries between $66,000 and $120,000.
    2. A nationwide specialty retailer based in the Southwest offers it 
nonqualified deferred compensation plan to 335 participants, 73% of 
whom have annual salaries below $120,000.
    3. One of the nation's leading homebuilders offers its plan to 
almost 500 employees. 60% of those employees have annual salaries below 
$140,000, and 40% have annual salaries below $120,000.
    These numbers counter any perception that individuals making less 
than $100,000 have little ability to save after they have ``maxed out'' 
contributions to 401(k) plans and IRAs. In reality, there are many 
reasons mid-level managers and employees need to utilize nonqualified 
plans. A common scenario is a ``two-earner'' couple whose combined 
income affords significant additional savings capacity. There also are 
situations where a worker making less than $100,000 is prevented--by 
operation of the tax law's nondiscrimination rules--from making his or 
her full contribution to a qualified plan. At the same time, 
particularly for small businesses, business leaders might see less 
merit instituting or maintaining a deferred compensation plan if they 
themselves were unable to benefit from a deferred compensation plan.
    In summary, nonqualified deferred compensation represents a major 
source of personal savings for many employees. In light of the 
dramatically low rate of U.S. individual savings--the personal savings 
rate has dropped from 9% to a negative 1% since 1985--policymakers 
should consider ways to make it easier, not more difficult, for 
employees at all levels to save for retirement.
III. SENATE PROPOSAL
    The nonqualified deferred compensation proposal approved by the 
Senate would limit an individual's annual deferral under a nonqualified 
deferred compensation plan to the lesser of (1) $1 million or (2) the 
individual's average taxable compensation from the employer during the 
preceding five years. The proposal would be effective for taxable years 
beginning after December 31, 2006. Earnings (whether actual or 
notional) attributable to post-December 31, 2006, nonqualified deferred 
compensation would be treated as additional deferred compensation 
subject to the proposal.
    The Senate proposal applies to all amounts deferred under 
nonqualified deferred compensation plans (as defined under section 
409A), including plans of both private and publicly-held corporations. 
The proposal applies to non-elective deferrals as well as those that 
are elective.
    Any deferrals in excess of those permitted by the Senate proposal 
would trigger severe tax sanctions. As a result of an excess deferral, 
all amounts deferred under the nonqualified deferred compensation plan 
for all taxable years (after 2006) would become immediately taxable (to 
the extent not subject to a substantial risk of forfeiture and not 
previously included in gross income).
    In addition to current income inclusion, interest would be imposed 
as if the compensation had been taxable when first deferred (or, if 
later, when first vested). Finally, the amount required to be included 
in income would be subject to a 20-percent additional tax.
SENATE PROPOSAL DOES NOT MATCH STATED GOALS OF SPONSORS
    Senator Charles Grassley has stated that the Senate's nonqualified 
deferred compensation proposal was intended to backstop the rules of 
Internal Revenue Code section 162(m),\1\ which generally limits to $1 
million a public company's deduction for compensation paid to the top 
five executives.
---------------------------------------------------------------------------
    \1\ Section 162(m) is separately the subject of another one of the 
Senate's revenue increasing proposals.
---------------------------------------------------------------------------
    However, the Senate nonqualified deferred compensation proposal is 
not limited to public companies or to the top five employees of a 
company. It applies to all companies, public or private, and it applies 
to all employees participating in a nonqualified deferred compensation 
arrangement. Moreover, the Senate's nonqualified deferred compensation 
proposal is not limited to those deferring more than $1 million per 
year; the Senate's proposed annual deferral limit is the lesser of $1 
million or the employee's average taxable compensation from the 
employer during the prior five years. As a result, the Senate proposal 
would limit deferred compensation for many mid-level managers and 
employees who would otherwise be making deferrals of far less than $1 
million.
    Senator Grassley has acknowledged problems with the proposal he and 
Senate Finance Committee Chairman Baucus placed before the Senate 
Finance Committee. During a January 31, 2007, interview with CNBC, 
Senator Grassley stated that the nonqualified deferred compensation 
proposal had ``overreached.''
COUNTING EARNINGS TOWARDS ANNUAL DEFERRAL LIMIT WILL CAUSE SIGNIFICANT 
        PROBLEMS
    The feature of the Senate proposal that would count earnings on 
previously deferred compensation towards the annual deferral limit is 
not administratively feasible and will cause significant problems. 
These include the possible triggering of tax, interest, and penalties 
on prior deferrals without any action on the part of the employee.
    Because earnings on nonqualified deferred compensation are often 
variable, depending on the performance of underlying investment 
benchmarks (e.g., S&P 500), an employee cannot know with any certainty 
the amount of earnings that will be generated with respect to prior 
compensation deferrals. As a result, the employee cannot calculate with 
any certainty the maximum amount of salary that would be eligible to be 
deferred under the Senate proposal. For example, if an employee's 
average taxable compensation (after 401(k) contributions, health 
insurance withholdings, and dependent care withholdings) for the prior 
five is $50,000, the maximum amount the employee can defer, through a 
combination of salary reductions and earnings on prior deferrals, is 
$50,000. Because even inadvertent and de minimis deferrals exceeding 
the Senate limits would have significant adverse consequences, 
employees will be forced to seek only predictable, but relatively low 
earnings on their previously deferred compensation.
    The longer the employee has participated in the nonqualified 
deferred compensation plan, the more significant the earnings component 
will be. At some point, just the earnings themselves on previously 
deferred compensation could cause an employee to exceed the permissible 
annual deferral. For example, if the employee above had previously 
deferred $550,000 and earned $55,000 on those prior deferrals during 
the current year, the earnings alone, without any additional salary 
deferrals, would cause the employee to violate the new deferral limit 
and trigger taxation of all prior deferrals plus a 20-percent penalty 
tax and retrospective interest.
    For employees with nonqualified plan distributions occurring in 
years after the termination of employment, any earnings (even $1) on 
past deferrals could trigger the adverse tax consequences. For example, 
in the case of an employee who terminates employment in 2008, the 
average taxable compensation from the employer during a rolling five-
year period will decline until it reaches zero after 2013. Thus, any 
earnings in 2014 or later on undistributed prior deferrals will exceed 
the five-year average taxable compensation (i.e., zero) and trigger 
draconian tax results.
PROBLEMS WITH APPLICATION TO NON-ELECTIVE PLANS
    Many employers provide deferred compensation to groups of employees 
on a non-elective basis; the employee groups covered by these 
arrangements can be quite broad. These arrangements (e.g. defined 
benefit arrangements), under which employers unilaterally defer the 
payment of a portion of current compensation, serve valuable employer 
goals such as employee retention. From a policy perspective, it makes 
no sense to limit an employee's deferred compensation under these non-
elective deferred compensation plans where the employee has no choice 
as to whether the deferral is made.
    In addition, the Senate proposal gives absolutely no guidance on 
how to apply the rules to such non-elective arrangements. The proposal 
does not provide any indication of how to compute the amount that is 
being deferred under a defined benefit arrangement and, instead, leaves 
this task to the Treasury Department and the IRS in regulations.
IV. CONCLUSION
    AALU, NAIFA, and NAILBA believe that the Senate's proposed 
limitation on annual deferrals under nonqualified deferred compensation 
arrangements should not be adopted. Employers are still struggling to 
comply with restrictions on deferred compensation enacted in 2004, and 
guidance on many key issues involved in that earlier legislation has 
not even been proposed. The Senate's new proposed limits, with their 
operational complexity and potential for significant adverse tax 
consequences for even de minimis violations, may prompt employers to 
simply abandon nonqualified deferred compensation arrangements. Such a 
result would clearly run counter to the goal of encouraging Americans 
to save as much as possible towards retirement.

                                 

                 Statement of ERISA Industry Committee
    Chairman Rangel, Ranking Member McCrery, and Members of the 
Committee, thank you for the opportunity to present the views of The 
ERISA Industry Committee (``ERIC'') on the Senate revenue increasing 
provisions in H.R. 2 related to deferred and executive compensation.
    ERIC is a nonprofit association committed to the advancement of 
America's major employer's retirement, health, incentive, and 
compensation plans. ERIC's members' plans are the benchmarks against 
which industry, third-party providers, consultants, and policy makers 
measure the design and effectiveness of other plans. These plans affect 
millions of Americans and the American economy. ERIC has a strong 
interest in protecting its members' ability to provide the best 
employee benefit, incentive, and compensation plans in the most cost 
effective manor.
PERCEPTION IS NOT REALITY
    Recent media reports have highlighted the size of the compensation 
packages of some highly compensated senior corporate executives. These 
reports have created the erroneous perception that deferred 
compensation plans are abusive and available to only the most senior 
executives. They are not. Hundreds of thousands of dedicated, 
hardworking middle managers participate in deferred compensation 
programs. Far from being abusive, these programs serve legitimate 
purposes that benefit both employers and employees. They provide 
recruitment and retention tools for employers and needed retirement 
security for employees.
    The ill-conceived deferred compensation provisions in the Senate-
passed version of H.R. 2, the Fair Minimum Wage Act of 2007, are based 
on these erroneous perceptions. They represent bad employment policy 
and bad tax policy. In particular, the broad sweep of the provisions is 
unsuitable for legislation that purports to be aimed solely at the 
highest-paid executives. These provisions will cause many thousands of 
the nation's most talented and productive people--scientists, 
engineers, and researchers on whom the nation and its enterprises 
depend for economic vitality--to be blindsided by an egregious and 
retroactive tax increase.
    ERIC strongly urges the House Ways and Means Committee to reject 
the Senate-passed deferred and executive compensation provisions and to 
exclude them from any legislation that the Committee approves.
THE CAP ON DEFERRED COMPENSATION EXCEEDS THE SCOPE OF ANY PERCEIVED 
        PROBLEM
    The limit on deferred compensation in the Senate bill goes far 
beyond its stated objective. The Senate Finance Committee's report 
indicates that the limit on deferred compensation is intended to target 
``the large amount of executive compensation'' provided by arrangements 
that ``allow executives to choose the amount of income . . . they wish 
to defer . . . in order to avoid the payment of income taxes.'' The 
limit imposed by the Senate bill, however, would curtail the 
compensation and benefits of many more employees than the executives 
referred to in the Senate Finance Committee report. Specifically, the 
deferred compensation limit would--
    1) Apply to all employees, not just to executives;
    2) Apply to nonelective plans--plans that provide deferred 
compensation automatically, without allowing the employees covered by 
the plan to elect how much they will defer--not just to elective plans;
    3) Restrict the deferred compensation that an employee may earn in 
a year to an amount equal to the lesser of (a) $ 1 million or (b) the 
employee's average annual pay over a five-year base period--a limit 
that is much less than $ 1 million for the vast majority of employees;
    4) Treat as additional deferred compensation any earnings that are 
credited in a given year on an employee's post-2006 deferred 
compensation, so that such earnings (a) are subject to the bill's limit 
on the amount of deferred compensation for that year and (b) reduce--
possibly to zero--the limit on any other deferred compensation that the 
employee may earn in the same year;
    5) Impose an annual limit on the aggregate of all of the benefits 
that an employee may earn under all of the employer's deferred 
compensation plans; and
    6) Apply to every employee who participates in a plan that is 
treated as a deferred compensation plan by the Tax Code--regardless of 
whether the employee elected to participate in the plan, regardless of 
whether the employee had any influence over the amount of the deferred 
compensation that he or she is credited with under the plan, and 
regardless of the employee's motive or intent.
    Contrary to the impression that the Senate Finance Committee report 
creates, many of the deferred compensation plans that would be affected 
by the deferred compensation limit, if it is enacted, do not give 
employees the option to defer part of their current pay. For example, a 
great many of the deferred compensation plans sponsored by employers 
are benefit restoration plans that are designed to provide pension 
benefits that the employer considers appropriate and would have 
provided through its tax-advantaged pension plan were it not for the 
limits that the Tax Code imposes on tax-advantaged plans. Benefit 
restoration plans are not optional plans that employees use for tax 
avoidance purposes. Eligible employees earn benefits under these plans 
automatically and pay income tax on the benefits they receive when they 
receive them.
    Congress has limited the benefits that tax-advantaged plans may 
provide because of the tax benefits that those plans receive. In 
general, a tax-advantaged plan's investment income is exempt from 
income tax; the employees who participate in the plan are not taxed on 
their benefits until they actually receive them (and even then, 
participants can further defer the tax on some distributions by rolling 
them over into an IRA or into another tax-advantaged plan); and within 
limits, the employer can currently deduct its contributions to the 
plan--even though plan participants are not taxed on the employer's 
contributions to the plan, and are not taxed until the plan distributes 
benefits to them--often many years after the employer funded those 
benefits. Deferred compensation plans do not receive any of these 
benefits and, as a result, are not subject to the restrictions that 
apply to tax-advantaged plans.
    The limits that the Tax Code imposes on tax-advantaged plans apply 
to such aspects of the plan as benefits, contributions, and the 
employee compensation on which plan benefits and plan contributions are 
based. These limits are designed to restrict the tax benefits that tax-
advantaged plans receive and to assure that tax-advantaged plans 
provide benefits that do not favor highly compensated employees.
    In many cases, however, the Tax Code limits have been imposed, or 
have been frozen or reduced, in order to achieve federal budgetary 
objectives, rather than retirement-income objectives. As a result, the 
Tax Code limits have not kept up with inflation and have prevented tax-
advantaged plans from providing an increasing percentage of the 
benefits that they would otherwise provide to a growing number of mid-
level employees. Employers have established benefit restoration plans 
and other nonelective deferred compensation plans to provide affected 
employees with the benefits that the Tax Code prevents a tax-advantaged 
plan from providing.
    One example of the Senate's deferred compensation limit 
demonstrates the extreme penalty that an employee would be subjected to 
without any action on her part. A Caucasian female manager, age 50, 
whose average five-year W-2 earnings is $144,000, would have been 
subjected to a $31,000 excise tax plus income tax on her deferred 
earnings if the provision had been in place for 2006. Her deferrals 
included irrevocable elections under a supplemental employee retirement 
plan, a bonus deferral plan, and earnings on previous deferrals. The 
egregious penalty on this hardworking middle manager's deferrals are 
the result of total deferral exceeding her five-year average W-2 
earnings by a mere $11,000. As a result, the Senate's limit on deferred 
compensation triggers a 20 percent excise tax penalty plus income tax 
on the amount deferred even though the employee cannot receive any 
income from the deferrals until after retirement.
    This example illustrates that the Senate bill's limit on deferred 
compensation will needlessly harm mid-level employees and raise a host 
of practical problems, including the following:

      If the value of an employee's deferred compensation 
benefit takes into account the value of an early retirement subsidy, 
the annual limit could harm many mid-level employees in the year when 
the value of their benefit restoration plan benefits ``spike'' as a 
result of the employee's entitlement to subsidized early retirement 
benefits. (The bill does not make clear whether the value of the 
subsidy can be ignored in a year if the employee does not actually 
retire in that year.)
      The annual limit would likely cause mid-level employees 
who participate in an early retirement window program to exceed the 
annual limit where a benefit restoration plan provides some or all of 
the window benefits.
      The annual limit also could cause mid-level employees to 
exceed the annual limit when they are laid off and become entitled to 
severance benefits that the Tax Code treats as deferred compensation.
      The compensation-based prong of the annual limit on 
deferred compensation would have a disproportionately severe effect on 
the benefits of mid-level employees whose annual compensation declines 
(and for whom the annual limit therefore declines) as a result of 
shifting to a part-time or seasonal position or participating in a 
phased retirement program.
      The annual limit would have a disproportionately severe 
effect on loyal, long-service employees who, by reason of their long 
service with their employer, have accumulated significant deferred 
compensation benefits that could be credited with substantial 
investment earnings in a single year.
      The treatment of investment earnings as additional 
deferred compensation could cause a mid-level employee to exhaust the 
annual limit on deferrals solely as a result of investment performance 
equaling or exceeding the annual limit for the year, and could thereby 
prevent the employee from accruing any other deferred compensation in 
that year.
      The treatment of investment earnings as additional 
deferred compensation also would make it impossible for an employee to 
engage in reliable advance planning designed to avoid exceeding the 
annual limit. For example, where the earnings that are credited on 
deferred compensation are tied to the performance of an equity security 
or an equity index, the earnings (and therefore the employee's 
deferrals) for the year could not be known until the last day of the 
year.
      The treatment of investment earnings as additional 
deferred compensation would perversely penalize employees for making 
successful investment decisions.
      Because the annual limit on deferrals appears to apply to 
foreign, as well to U.S., deferred compensation plans, a U.S. citizen 
who participates in both U.S. and foreign deferred compensation plans 
could be taxed on the deferred compensation under the U.S. plan as a 
result of being pushed over the limit on deferrals by the benefits that 
he or she accrues under the foreign plan.
      The compensation prong of the annual limit could stop 
outside directors from engaging in the benign practice of accepting 
deferred stock units instead of current directors' fees.
      Retirees who are credited with additional deferred 
compensation in years in which they receive no current pay would appear 
to exceed the annual limit for those years (zero).

EXPANDING THE 162(m) LIMIT WOULD PENALIZE COMPANIES FOR COMPLYING WITH 
        CURRENT LAW
    The Senate-passed version of H.R. 2 would also expand the limit 
that Section 162(m) of the Tax Code imposes on the deductibility of the 
compensation that a public company pays to certain current officers. 
The provision would make the Section 162(m) limit applicable to 
compensation that the company pays to individuals who were covered by 
the deduction limit in any prior taxable year beginning after December 
31, 2006.
    Under current law, the Section 162(m) limit does not apply to 
compensation paid to former employees. If Section 162(m) is amended, in 
accordance with the Senate-passed bill, to apply to payments made after 
2006 to former employees who were covered by Section 162(m) at any time 
after 2006, the limit would apply to payments that employers and 
employees deliberately deferred in the past in order to assure that, in 
accordance with the law then in effect, the deductibility of those 
payments would not be disallowed by Section 162(m).
    It is bad tax policy to penalize employers for having done 
precisely what the tax law encouraged them to do. The Committee should 
reject the Senate provision.
EXORBITANT ``TOLL CHARGE'' FOR LEAVING THE U.S.
    The Senate bill also contains a provision that would impose a 
``mark-to-market'' regime on certain U.S. citizens who relinquish their 
U.S. citizenship and certain long-term U.S. residents who terminate 
their U.S. residency. In general terms, the bill would tax these 
individuals on the net unrealized gain in their property as if the 
property had been sold for its current fair market value. Subject to 
certain exceptions, the bill treats an interest in a Section 401(a) 
plan, a deferred compensation plan, or an IRA as property for purposes 
of this ``deemed sale'' rule.
    The provision also includes a special rule for certain retirement 
plans, including Section 401(a) plans and certain foreign retirement 
plans. Under the special rule, instead of being subject to the ``deemed 
sale'' rule, the individual would be treated as having received an 
amount equal to the present value of the individual's vested accrued 
benefit on the day before he or she relinquishes U.S. citizenship or 
terminates residency in the U.S. If the plan later makes a distribution 
to the individual, the amount otherwise includible in the individual's 
gross income as a result of that distribution would be reduced to 
reflect the amount previously included in the individual's gross 
income.
    A covered expatriate also would be allowed to make an irrevocable 
election to continue to be taxed as a U.S. citizen with respect to all 
property otherwise covered by the expatriation tax. If he or she makes 
this election, the individual would be required to continue to pay U.S. 
income tax on the income produced by the property, the individual would 
be required to post collateral to ensure payment of the tax, and the 
amount of the ``mark-to-market'' tax that otherwise would have been due 
(but for this election) would become a lien in favor the U.S. on all of 
the individual's U.S. property.
    If enacted, these provisions would impose an exorbitant ``toll 
charge'' on individuals who leave the United States. Because the toll 
charge requires a departing long-term U.S. resident to pay tax on 
income that he has not received and may have no right to receive, this 
provision would, if enacted, discourage talented foreign employees from 
accepting assignments in the United States. It is bad policy to create 
such barriers to becoming a U.S. resident.
CONCLUSION
    ERIC strongly urges the House Committee on Ways and Means to reject 
the Senate-passed deferred and executive compensation provisions and to 
exclude them from any legislation that the Committee approves. They are 
ill-conceived solutions to a problem that do not exist. If enacted, the 
provisions' principal effect will be to harm hundreds of thousands of 
mid-level employees who earn far less than the Senate Finance 
Committee's report and recent media coverage would suggest.

                                 

                                      Financial Services Roundtable
                                                     March 13, 2007
The Honorable Charlie Rangel, Chairman
Committee on Ways and Means
United States House of Representatives
Washington, DC 20515

    Dear Chairman Rangel,

    The Financial Services Roundtable supports your efforts to examine 
the consequences of revenue raisers contained in the ``Small Business 
and Work Opportunity Act of 2007'' (the Act).
    We oppose the revenue raisers in the Act which retroactively change 
the tax treatment of certain leasing transactions, which limit the 
opportunity and incentive for employees to contribute to certain 
retirement plans, and which retroactively deny the deductibility of 
accrued compensation.
(1) Retroactive Tax Changes
    The Roundtable opposes all retroactive tax changes because they 
undermine the entire foundation of the tax code. Retroactive changes 
create uncertainty and the inability to rely on the tax code. It makes 
it almost impossible for Americans businesses to price deals and to be 
competitive in a global economy.
    The Roundtable opposes the Senate's retroactive revenue raiser on 
sale-in lease-out transactions. Removing the grandfather protection for 
these leasing transactions is simply wrong. It is particularly harmful 
to the companies which entered into these transactions legally and 
under the guidance of the federal government. For the government to now 
reach back and punitively tax these transactions is unfair and will 
have negative economic consequences. This change would adversely impact 
the stock market, the regulatory capital of the affected banks and 
further produce a weakening on investor confidence in corporate 
earnings.
    During the 108th Congress, as part of the American Jobs Creation 
Act of 2004 (P.L. 108-357), a provision was included to make a 
prospective change to the tax treatment of certain leasing 
transactions, applying new rules to leases entered into after March 12, 
2004. In the last Congress, a provision was proposed that would have 
changed the effective date for leases entered into on or before March 
12, 2004. This provision was wisely rejected and should be rejected 
again.
(2) Limitations on Savings
    The Roundtable is opposed to the provisions in the Act that would 
limit deferrals into nonqualified deferred compensation plans. These 
revenue raisers are overbroad and include many benefit programs outside 
of the intended scope.
    The Act and would impose a dramatic shift in tax policy relating to 
the receipt of income. The proposals will force some employers to 
significantly reduce or abandon retirement and savings programs that 
benefit middle management employees in favor of current cash 
compensation. Further, the Act reduces the opportunity and incentive 
for employees and employers to plan for the retirement of their 
employees, and will make it harder to attract and retain employees. The 
flawed tax policy contained in the Act would result in a cash drain for 
many employers, resulting in less flexibility and needlessly add 
complexity in the administration of compensation arrangements.
    Additionally, the Senate bill makes changes to Sec. 162(m) relating 
to the deductibility of executive compensation. These changes are 
intended to target large compensation payments to executives when they 
are no longer ``covered'' executives and thus no longer subject to the 
$1 million cap on the deduction for non-performance-based pay. 
Unfortunately, the Senate bill as currently drafted applies 
retroactively because a company would be denied a deduction for pre-
2007 accrued compensation paid to an employee after 2006, if that 
employee is a CEO or one of the top four at any point in time after 
2006. This section should be amended so it doesn't apply to any 
compensation to which an employee had a legally binding right, whether 
or not contingent, on January 17, 2007 or which relates to services 
performed before January 17, 2007.
    The Financial Services Roundtable represents 100 of the largest 
integrated financial services companies providing banking, insurance, 
and investment products and services to the American consumer. Member 
companies participate through the Chief Executive Officer and other 
senior executives nominated by the CEO
    Roundtable member companies provide fuel for America's economic 
engine, accounting directly for $65 trillion in managed assets, $1 
trillion in revenue, and 2.4 million jobs.
            Best regards,
                                                     Steve Bartlett
                                                  President and CEO

                                 

                    Statement of Hogan & Hartson LLP
Transition Relief under Proposed Change to Section 162(m) Definition of 
        Covered Employee--Necessary to Avoid Retroactively Denying the 
        Employer's Deduction for Its Current Binding Obligation to Pay 
        Compensation Already Earned for Services Already Performed
Background
    Under current law, compensation in excess of $1 million paid by a 
public company to its ``covered employees'' is not deductible unless it 
is performance-based and has been approved by shareholders. (I.R.C.  
162(m)). ``Covered employees'' for this purpose are defined as the 
chief executive officer as of the close of the taxable year and the 
four other most highly compensated officers of the company whose 
compensation is required under the federal securities laws to be 
reported in the company's proxy statement for the year. The limitation 
applies in the year in which the compensation is paid out and the 
company takes the deduction.
    It has been the longstanding rule since the enactment of section 
162(m) in the Omnibus Reconciliation Act of 1993 that once an employee 
terminates employment with the company, he or she is no longer a 
``covered employee''. As the House-Senate Conference Report adopting 
section 162(m) stated: ``Of course, if the executive is no longer a 
covered employee at the time the options are exercised, then the 
deduction limitation would not apply.'' (House Rept. No. 103-213, at p. 
585 n. 45 (Conference Report); House Rept. No. 103-111, at p. 647, n. 
21 (Identical statement)). This rule has been repeatedly re-affirmed in 
longstanding IRS guidance. (See, e.g., IRS Private Letter Rulings 
200547006, 200042016, 200039028, 200019010, 199928014, and 199910011).
Proposed Change
    Citing recent changes by the Securities and Exchange Commission to 
the group of company executives for whom compensation is required to be 
disclosed, the Senate's tax component of the minimum wage legislation 
proposes to adopt a new definition of ``covered employee'' and in so 
doing to reverse this longstanding current law rule under section 
162(m) that once a person has terminated employment, he or she is no 
longer a ``covered employee''. (H.R. 2, sec. 234). Under the Senate 
provision, once having been a ``covered employee'', the person would 
remain so in perpetuity, even years after leaving the company. (Sen. 
Rept. No. 110-1). This proposed change would apply to taxable years 
beginning after December 31, 2006.
Transition Relief Is Necessary for Existing Binding Contracts
Entered into in Reliance on Longstanding Current Law Rules
    The proposed change would have a retroactive effect of denying the 
company's deduction for its binding contractual obligation to pay 
compensation already earnedfor services already performed_all 
undertaken in reliance on the current law rules
    Because the proposal would apply to taxable years beginning after 
December 31, 2006 and the section 162(m) limitation applies in the year 
in which the compensation is paid out, the proposed reversal of the 
longstanding definition of covered employee will apply retroactively to 
compensation that already has been earned for services that were 
rendered years ago. Since the section 162(m) limitation is a 
disallowance of the employer's deduction, the proposal has the effect 
of disallowing a deduction for compensation that an employer is 
contractually obligated to pay under binding contracts entered into 
years, even a decade or more ago, in reliance on the longstanding 
current law rule on covered employees as reflected in the legislative 
history of section 162(m) and repeatedly re-affirmed in IRS guidance.
    Taxpayers enter into business agreements relying on the laws in 
effect at the time. Accordingly, Congressional tax-writers historically 
have been reluctant to adopt retroactive tax changes to avoid upsetting 
such reliance on the governing law at the time and imposing unexpected 
penalties or windfalls after-the fact
Congress has provided transition relief in similar situations for pre-
        Act deferrals and subsequent earnings
Original enactment of section 162(m)
    In originally enacting section 162(m), Congress adopted broad 
transition relief for existing binding contracts, providing that the 
limitation did not apply to ``any remuneration payable under a written 
binding contract which was in effect on February 17, 1993, and which 
was not modified thereafter in any material respect before such 
remuneration is paid.'' (Section 162(m)(4)(D)). This broad transition 
relief extended to services to be performed in the future under the 
contract.
Section 409A rules for nonqualified deferred compensation arrangements
    In enacting new section 409A which adopted broad changes to the 
rules governing nonqualified deferred compensation arrangements, 
Congress grandfathered not only pre-Act deferrals of compensation but 
also to post-Act earnings on such deferrals. Congress provided that 
``[t]he amendments made by this section apply to amounts deferred after 
December 31, 2004'' and that such amendments ``shall apply to earnings 
on deferred compensation only to the extent that such amendments apply 
to such compensation.'' (American Jobs Creation Act of 2004, P.L. 108-
357, Sec. 885(d)).
Proposed cap on annual deferrals of nonqualified deferred compensation
    Indeed, elsewhere in the same Senate minimum wage tax package, 
under the proposed new cap on annual deferrals of nonqualified deferred 
compensation, a grandfather is provided for both pre-Act deferrals of 
compensation and post-Act earnings on such deferrals. Under the Senate 
bill, the new cap applies ``only to amounts deferred after December 31, 
2006 (and to earnings on such amounts).'' (Sec. 226(b) of H.R. 2).
Proposed Transition Rule
    Consistent with the approach taken by Congress in these similar 
contexts, the proposed transition rule would provide a binding contract 
exception. Indeed, the transition rule would be even tighter, being 
limited to compensation that has been earned for services that already 
have been performed. More specifically, the proposed change to the 
section 162(m) definition of covered employee would not apply to 
remuneration (as defined under section 162(m)(4)(E), including amounts 
deferred and earnings on such deferrals) for services that were 
rendered in a taxable year beginning before January 1, 2007 and payable 
under a written binding agreement which was in effect on December 31, 
2006 and which was not modified thereafter in any material respect 
before such remuneration is paid.
Possible Amendment to Section 162(m) Proposal to Provide Transition 
        Relief to Protect
Existing Binding Contracts Entered Into in Reliance on Longstanding 
        Current Law Rules
    Section 234 (regarding modifications of definition of employee 
covered by denial of deduction for excessive employee remuneration) of 
Title II (the ``Small Business and Work Opportunity Act of 2007'') of 
H.R. 2 is amended to read as follows:
SEC. 234. MODIFICATIONS OF DEFINITION OF EMPLOYEE COVERED BY DENIAL OF 
        DEDUCTION FOR EXCESSIVE EMPLOYEE REMUNERATION
    ``(a) IN GENERAL.--Paragraph (3) of section 162(m) is amended to 
read as follows:
    ``(3) COVERED EMPLOYEE.--For purposes of this subsection, the term 
`covered employee' means, with respect to any taxpayer for any taxable 
year, an individual who--
    ``(A) was the chief executive officer of the taxpayer, or an 
individual acting in such a capacity, at any time during the taxable 
year,
    ``(B) is 1 of the 4 highest compensated officers of the taxpayer 
for the taxable year (other than the individual described in 
subparagraph (A)), or
    ``(C) was a covered employee of the taxpayer (or any predecessor) 
for any preceding taxable year beginning after December 31, 2006.
    In the case of an individual who was a covered employee for any 
taxable year beginning after December 31, 2006, the term ?covered 
employee' shall include a beneficiary of such employee with respect to 
any remuneration for services performed by such employee as a covered 
employee (whether or not such services are performed during the taxable 
year in which the remuneration is paid).'.
    ``(b) EFFECTIVE DATE.--
    ``(1) IN GENERAL.--The amendment made by this section shall apply 
to taxable years beginning after December 31, 2006.
    ``(2) EXCEPTION FOR EXISTING BINDING CONTRACTS.--The amendment made 
by this section shall not apply to remuneration (within the meaning of 
section 162(m)(4)(E) of the Internal Revenue Code of 1986, as amended, 
including amounts deferred and earnings thereon) for services that were 
rendered in a taxable year beginning before January 1, 2007 and payable 
under a written binding agreement which was in effect on December 31, 
2006 and which was not modified thereafter in any material respect 
before such remuneration is paid.''

                                 

                   Statement of HR Policy Association
    Thank you for holding this hearing and for this opportunity to 
present the views of the HR Policy Association regarding the impact of 
Sections 206 and 214 of H.R. 2, the Small Business Work and Opportunity 
Act. We believe that these sections, which would impose substantial 
limits on annual deferrals of nonqualified deferred compensation and 
significantly change the treatment of nonqualified deferred 
compensation for former ``top five'' executive officers, would create 
significant unintended consequences and should be eliminated from any 
final bill that is sent to the President.
    HR Policy Association is a public policy advocacy organization 
representing the chief human resource officers of over 250 leading 
employers doing business in the United States. Representing nearly 
every major industry sector, HR Policy members have a combined U.S. 
market capitalization of more than $7.5 trillion and employ more than 
18 million employees world wide. Our members are particularly 
interested in sound executive compensation practices because they are 
responsible for assisting boards of directors and board compensation 
committees in developing compensation programs for executives. Our 
members are very concerned that Congress consider the full effects of 
tax law changes intended to limit executive compensation. In the past, 
such changes have had the opposite effect from that intended, and may 
have accelerated increases in executive compensation.
    Section 206 of the Small Business Work and Opportunity Act would 
amend section 409A of the tax code to cap the amount an individual 
could defer into a nonqualified deferred compensation arrangement 
annually. The cap would be the lesser of (a) $1 million or (b) the 
average of the individual's gross income over the five years preceding 
the year in which the deferral election is made. As described below, 
the cap would have a significant impact on middle managers and would 
make even more complex an extremely arcane tax law provision.
Nonqualified Deferred Compensation Plans Used to Provide Benefits 
        Restoration to Managers and Executives
    Nonqualified deferred compensation plans generally are used as 
retirement savings vehicles. Their underlying purpose is to permit 
managers, sales employees, and executives to defer until retirement a 
percentage of their regular pay that is more comparable to the 
percentage of regular pay deferred in qualified retirement plans by 
lower-level employees. Like qualified retirement plans, nonqualified 
plans permit the deferral of compensation, which in this case means 
that compensation is credited to the plan for later withdrawal, usually 
at retirement. The plans are nonqualified, meaning that they do not 
receive the special tax advantages of ``qualified'' retirement plans, 
including that employers are not allowed to deduct plan contributions 
in the year they are made. Instead, the company must wait to deduct the 
compensation as an expense until the year the employee receives the 
income. The mechanics of this are strictly regulated by tax code 
section 409A, which Congress passed in 2004 and for which the IRS and 
Treasury Department have not yet finalized regulations.
    The deferral of compensation in nonqualified arrangements comes 
with a risk that the individual will never receive the money, because 
the arrangements generally are unsecured. Unlike qualified plans, no 
money is set aside for participating employees, and there is no 
guaranty that the funds will be paid. The arrangements normally do not 
provide participating employees protection from creditors in bankruptcy 
or insolvency. This lack of security acts as an incentive to all 
employees, and particularly senior executives, to manage the company 
prudently. It also enables companies to preserve resources for 
operating the company, rather than paying it directly to the employees.
Restrictions on Deferred Compensation Will Affect Many More Employees 
        Than Senior Executives
    The expansion of section 409A in Section 206 will affect far more 
employees than just senior executives, because a broad array of 
employees--from middle managers, to junior executives, to CEOs--often 
participate in their employer's nonqualified deferred compensation 
programs. There is no one-size-fits-all program. In fact, among HR 
Policy member companies, the type of arrangements and number of 
participants varies with the size of the company and their overall 
compensation structure. Most large companies have several hundred 
employees participating, and in some companies, several thousand 
participate. Especially at the lower levels, those who participate most 
often do so because of the opportunity for benefits restoration.
Cap on Nonqualified Deferred Compensation Would Have Unintended 
        Effects, Limit Severance Programs
    The cap on nonqualified deferred compensation would limit the 
opportunity for benefits restoration, especially for the lower tier of 
employees who participate in these arrangements. The proposal's 
deferral limitation, which is an average of the five years of gross 
income before the year in which a deferral election is made, will 
significantly limit the percentage of compensation middle and senior 
managers can defer. This would be an issue for those employees who have 
risen rapidly into or beyond the middle management ranks and whose 
income has increased proportionately during that time.
    In addition, the proposal will affect arrangements that fall within 
the scope of 409A, but that have traditionally not been considered 
deferred compensation. For example, the limit on deferred compensation 
would impose a 20 percent excise tax penalty on individuals who may 
automatically be eligible for broad-based severance programs that 
provide more than one year's salary. Severance benefits often include 
two years' salary for senior managers, for example, to protect trade 
secrets or to provide a transition in the event of a merger or 
acquisition.
Proposal Would Limit Further Complicate Arcane Deferral Rules Under 
        Section 409A
    The $1 million cap on nonqualified deferred compensation also will 
further complicate the extremely complex area of tax law under section 
409A of the tax code. Congress passed 409A in 2004, and because of the 
complexities involved in applying the law to uniquely tailored 
programs, the Treasury Department has not yet finalized implementing 
regulations. Thus, it is difficult to determine the effects this change 
will have on nonqualified deferred compensation programs, especially 
those that are already in effect or that may be arranged through 
employment contracts.
Retroactive Changes to Section 162(m) Would Perpetuate Unintended 
        Consequences
    Section 214 of the proposal also would extend the application of 
162(m) by expanding the definition of ``covered employee'' to include 
any individual who had previously served as CEO or one of the other 
four most highly compensated executive officers. The change would apply 
retroactively to amounts employers are already contractually obligated 
to pay and would provide for no transition to enable employers to alter 
their compensation strategy prospectively.
    More importantly, this change expands a tax code section that, as 
Securities and Exchange Commission Chairman Christopher Cox recently 
described, was intended ``to control the rate of growth in CEO pay.'' 
He added: ``With complete hindsight, we can now all agree that this 
purpose was not achieved. Indeed, this tax law change deserves pride of 
place in the Museum of Unintended Consequences.'' This lack of 
effectiveness led the Joint Committee on Taxation staff to recommend 
repealing Section 162(m) altogether in its 2003 report on Enron. HR 
Policy opposes this provision because rather than heed the lessons of 
history, the bill expands and complicates section 162(m) further.
    In sum, we oppose the restriction on nonqualified deferred 
compensation imposed by Sections 206 and 214 of the tax code. We 
believe the restrictions in Section 206 would encourage companies to 
eliminate the benefit for lower-level executives while keeping senior 
executives whole in other ways. Moreover, the change would remove an 
important incentive for many senior executives to manage the company 
prudently. Likewise, the restrictions in Section 214 would undermine 
assumptions companies had made when originally entering into 
compensation arrangements with senior executives and would further 
complicate a section of the Code that has failed to accomplish its 
intended purposes.
    Thank you for the opportunity to express our views on this 
important legislation. Please do not hesitate to contact us if you have 
any questions.

                                 

                    Statement of Richard D. Ehrhart
    My Background. I am a deferred compensation expert with a unique 
combination of perspectives developed over 26 years of work in the 
deferred compensation industry. For 18 years I was a tax and benefits 
attorney specializing in deferred compensation. For the past 8 years, I 
have been a small business owner and executive running Optcapital. 
Optcapital helps employers design and administer deferred compensation 
plans. We work with public and private companies from large Fortune 
1000 firms to small businesses. I have written extensively about 
deferred compensation. Most recently, I published ``Section 409A: 
Treasury Newspeak Lost in the Briar Patch,'' 38 The John Marshall Law 
Review 743 (Spring 2005). For more than 20 years, I have been a member 
of the Employee Benefits Committee of the Tax Section of the American 
Bar Association.
    The Bill's Background. On January 10, 2007, the House of 
Representatives passed H.R. 2, the ``Fair Minimum Wage Act of 2007,'' 
which would increase the Federal minimum wage for the first time in ten 
years. On February 1, 2007, the Senate passed its own version of H.R. 
2. The Senate-passed version coupled an increase in the Federal minimum 
wage with a package of tax benefits costing $8.3 billion over ten 
years. In order to offset the cost of these tax benefits, the Senate 
bill includes over a dozen separate provisions that, in the aggregate, 
would raise $8.3 billion over ten years. These offsetting revenue 
increases would, among other things, change the tax treatment of 
certain leases entered into before March 12, 2004, deny deductions for 
certain government-required payments and punitive damages in civil 
actions, enact new limitations on nonqualified deferred compensation 
(``NQDC'') plans, and change the tax treatment of certain financial 
instruments.
    The bill includes two separate NQDC limitations. The first would 
limit annual deferrals under NQDC plans to an employee's average 
taxable compensation from the employer during the preceding five years 
or, if less, $1 million (the ``409A CAP''). Additionally, the proposal 
contains an expansion of the class of individuals who are subject to 
the $1 million cap on deductible compensation under Code Section 162(m) 
to include all individuals who qualify as ``covered employees'' at any 
time on or after January 1, 2007 (the ``162(m) EXPANSION'').
    The Joint Committee on Taxation (``JCT'') has projected the 409A 
CAP to generate $800 million of tax revenues over 10 years. It has 
projected the 162(m) EXPANSION to raise $100 million over 10 years.
    My Recommendation. As explained below, the 409A CAP is ill 
conceived and would damage the economy, the competitiveness of American 
businesses and U.S. financial markets. It would not raise tax revenues, 
but reduce them. It would not reduce executive pay, but greatly expand 
the use of stock options. It would also expand the use capital gains 
for services.
    The 409A CAP is a ``mega-ton nuclear bomb'' sort of legislation 
that would kill all NQDC for all companies, public and private, large 
and small. Private companies (which can't use stock options) would be 
disadvantaged versus public companies. More important, U.S. companies 
would be handicapped in competing with foreign companies, inasmuch as 
no other industrialized nation limits NQDC.
    The 162(m) EXPANSION, by contrast, is a ``smart missile'' approach 
that can be effective in reducing executive pay, without hurting the 
competitiveness of U.S. companies in global markets for talent. Instead 
of killing NQDC, and the long-term wealth that NQDC helps to generate, 
it simply raises the cost of ``excessive'' pay for the top 5 executives 
of public companies.
    In its September 5, 2006 Report entitled ``Present Law and 
Background Relating to Executive Compensation, the JCT identified two 
major loopholes in Section 162(m) and recommended that they be closed. 
The Senate Finance Committee's proposal would only partially close just 
one of the two loopholes. By closing all the loopholes in Section 
162(m), the revenue tag of the 162(m) EXPANSION would probably be in 
the billions.
    In sum, if NQDC must be restricted, then we strongly urge Ways and 
Means to abandon the 409A CAP and fashion a 162(m) EXPANSION amendment 
that plugs the loopholes the JCT has identified.
    NQDC Is Essential to the Competitiveness of U.S. Business. Most 
employers use NQDC. They use NQDC to reward key employees. NQDC 
consists of promises to pay specified benefits in the future. For many 
businesses, NQDC is essential for sustainable growth. The market for 
top talent is highly competitive. U.S. companies compete globally for 
management, sales and marketing labor. The ability to provide long-term 
incentives is vital to attracting and retaining key employees. It is 
also absolutely critical to ensure that motivations and contributions 
of key employees are aligned with shareholders' interests.
    For example, we started Optcapital in 1998. NQDC enabled us to 
attract some of the best minds available. Most of them came from the 
big companies like Wachovia, Bank of America, U.S. Trust and Deutsche 
Bank. We could not compete with these firms on the basis of current 
compensation. Without the ability to promise substantial NQDC, we could 
not have acquired the talent we needed.
    NQDC Is Tax Revenue Neutral. NQDC is ``nonqualified'' because it is 
for a select group of higher-paid employees over and above the limits 
of qualified retirement plans. Because it is nonqualified, the employer 
does not receive a tax deduction for NQDC until the employee realizes 
the NQDC as gross income. See Section 404 of the Internal Revenue Code 
(the so-called ``matching rule'').
    When a U.S. business provides NQDC to a U.S. service provider, the 
U.S. business does not receive a federal income tax deduction until the 
NQDC is includible in the service provider's gross income. Because 
federal tax rates on ordinary income are about the same for 
corporations and individuals, NQDC should be tax revenue neutral. For 
example, if an employee defers a $10,000 bonus, the employee would 
avoid $3,500 of income taxes currently. The corporation's taxable 
income would increase by $10,000, causing a $3,500 increase in its 
federal income taxes.
    The JCT estimates that the 409A CAP would generate $800 million 
over 10 years. The projection is badly flawed. It attempts to take into 
account tax effects from activities that are related to NQDC, but are 
not NQDC. Many taxable corporations informally fund their NQDC using 
corporate-owned life insurance (``COLI''). If a bank uses it, it is 
commonly called ``BOLI.'' COLI and BOLI are tax-exempt investments. The 
JCT assumes that if NQDC is capped or killed, then the use of COLI or 
BOLI will decrease, and tax revenues will increase.
    Keep in mind that NQDC is nothing more than the employer's 
unfunded, unsecured promise to pay a specified benefit in the future. 
An employer may or may not choose to informally fund its NQDC 
obligations. Informal funding is not a necessary consequence of NQDC. 
Many employers do not informally fund their NQDC. And many that do 
choose to informally fund use taxable investments rather than COLI or 
BOLI.
    It should also be noted that the use of COLI and BOLI as informal 
funding has expanded far beyond NQDC. Banks are probably the biggest 
user, and they use it to informally fund post-retirement medical and 
other employee and executive benefits.
    Each year, COLI and BOLI cause billions of direct tax revenue 
losses.
    The JCT's tax revenue analysis is incomplete because it fails to 
take into account all the effects the 409A CAP would have on tax 
revenues. It does not account for the damage to competitiveness, nor 
how the 409A CAP would drive public companies to a much heavier use of 
stock options, and private companies to a much heavier use of capital 
gains-type income.
    The estimate of the amount of tax revenue that the 162(m) EXPANSION 
would raise is far more defensible. The effects of limiting NQDC 
deductibility are directly measurable. Although the 162(m) EXPANSION 
that closed all the loopholes could be expected to have a moderating 
effect on executive pay, its potential negative effects to tax revenues 
would be minimal. Moreover, if all the 162(m) loopholes were closed, 
the 162(m) EXPANSION would raise billions over 10 years.
    The Problems with the 409A CAP. The proponents of the 409A CAP 
contend that it merely limits an employee's deferred comp to $1 million 
each year. Do not be fooled. Its practical effect would be to kill the 
use of deferred comp. First, the 409A CAP is virtually impossible to 
administer. It applies across all plans, including account balance 
plans (defined contribution plans), nonaccount balance plans (e.g., 
defined benefit plans), severance plans and stock plans. It ostensibly 
includes earnings on principal credits. The limit is not $1 million, 
but the lesser of (A) $1 million or (B) the employee's 5-year average 
pay.
    Bear in mind that the 409A CAP would be an added requirement of 
Section 409A. The existing 409A rules, now in proposed regulation form, 
run 240 pages. They are highly technical and complex. Most important, 
however, is that a failure to comply with all the 409A requirements 
subjects all plan participants to immediate taxes, interest and a 20% 
penalty. Thus, the 409A CAP is not simply a ceiling on the amount that 
can be tax-deferred. The consequence of providing more than the limit 
is not simply current taxation on the excess, but taxes, interest and 
penalties on all the deferred compensation of all participants.
    The proposed CAP is like a speed limit that is based on your weekly 
average speed where the penalty for speeding is loss of your car. The 
CAP carries such drastic consequences, our prediction is that employers 
would decide that the ``game is not worth the candle.''
    The 162(m) EXPANSION. The 162(m) EXPANSION is an amendment to Code 
Section 162(m). Congress enacted 162(m) in 1993. It provides that a 
public corporation may not deduct amounts paid to a ``covered 
employee'' during a taxable year to the extent such amounts exceed $1 
million. A ``covered employee'' includes the CEO as of the close of the 
taxable year and the four highest compensated officers as of the close 
of the taxable year (other than the CEO) whose compensation is required 
by the SEC to be reported under the Securities Exchange Act of 1934.
    Unless specifically excluded, the deduction limitation applies to 
all remuneration for services, including cash and the cash value of all 
remuneration paid in a medium other than cash. The following types of 
compensation are specifically excluded:
    (1) commissions;
    (2) performance-based compensation;
    (3) contributions to tax-qualified retirement plans;
    (4) amounts excluded from gross income such as health benefits and 
Section 132 fringe benefits; and
    (5) remuneration payable under a binding contract that was in 
effect on February 17, 1993.
    In its September 5, 2006 Report entitled ``Present Law and 
Background Relating to Executive Compensation, the JCT notes as 
follows:
    The legislative history states that section 162(m) was motivated by 
then-current concerns regarding the amount of executive compensation in 
public companies, and that the purpose of the provision was to reduce 
``excessive'' compensation. While not specifically mentioned in the 
legislative history, the exception to the limitation for performance-
based compensation reflects the view that such compensation, by its 
nature, is not ``excessive''. A provision similar to section 162(m) was 
also proposed by the Clinton Administration. The rationale behind this 
provision was stated a bit differently, and focused on the ``unlimited 
tax benefit'' provided to executive compensation. This tax benefit was 
described as particularly inappropriate in cases in which executive 
compensation increased while company performance suffered. The 
Administration proposal also had as a stated objective the intent to 
provide an incentive to link compensation to business performance. 
Since the enactment of section 162(m) the appropriateness of executive 
compensation has remained a topic in the public eye.
    The Report also notes that ``According to a number of studies, 
Section 162(m) has not reduced the growth in executive compensation.'' 
The Report cites studies that conclude that 162(m) contains various 
``loopholes'' that should be closed to effect the desired reduction of 
executive compensation. First, the performance-based compensation 
exception is overly broad. Second, the limitation does not apply once a 
covered employee terminates employment. Thus, it has been easy for 
employers to evade the limit simply by shifting pay to performance-
based compensation and by deferring pay to after termination of 
employment. The Report suggests the following ways of plugging the gaps 
in 162(m):
    (1) eliminate the performance-based compensation exemption and 
apply a limit to all remuneration;
    (2) instead of exempting all performance-based compensation, exempt 
only a specified dollar amount;
    (3) restrict the performance-based compensation exemption to 
compensation that is truly performance-based (such as indexed options 
or options that are granted at a specified premium strike price above 
the current market price); and
    (4) expand the definition of covered employee to include any 
employee or former employee who was a covered employee at any time in 
the past.
    The proposed 162(m) EXPANSION takes approach No. 4. It contains an 
expansion of the class of individuals who are subject to the $1 million 
cap on deductible compensation under Code Section 162(m) to include all 
individuals who qualify as ``covered employees'' at any time on or 
after January 1, 2007.
    162(m) is a Better Mousetrap. The 162(m) EXPANSION approach--
disallowing the deductibility of compensation deemed excessive--is far 
superior to the 409A CAP as a means of curbing executive compensation. 
It makes deferred comp for the top 5 executives of public companies 
substantially more expensive. If a compensation committee were to 
provide compensation in excess of the 162(m) limits, it would have to 
answer to shareholders. Such nondeductible compensation would come 
under intense scrutiny and would need to be justified. Moreover, the 
162(m) approach would not kill deferred comp, but merely ration it by 
increasing its cost at the upper levels.
    A simple way to change would be to delete the phrase ``at any time 
on or after January 1, 2007.'' This would pick up all former ``covered 
employees.'' We suspect this change alone would produce close to $1 
billion of revenue.
    Any of approaches Nos. 1 through 3 would also generate many 
billions of revenues. My personal preference would be to eliminate the 
performance-based compensation exemption altogether, and simply apply a 
higher limit to all compensation. For example, why not simply apply a 
$5 million deductibility limit to all compensation. Such a law would be 
relatively easy to administer, and avoid the definitional and 
interpretation problems that comes with carving out exceptions.

                                 

      Statement of Air Products and Chemicals, Inc., Allentown, PA
    I am pleased to have the opportunity to testify this morning on 
behalf of the National Association of Manufacturers (NAM) on several 
revenue raising provisions included in legislation currently pending in 
Congress. We applaud the committee's initiative in holding the hearing.
    My name is Ken Petrini and I am Vice President, Taxes at Air 
Products and Chemicals, Inc., in Allentown, Pennsylvania. I also serve 
as the Chairman of the NAM's Tax and Budget Policy Committee. The NAM 
is the nation's largest industrial trade association, representing 
small and large manufacturers in every industrial sector and in all 50 
states. NAM members believe strongly that tax relief is critical to 
durable economic growth and job creation. In contrast, revenue 
raisers--like those I will describe in my testimony--would impose new 
taxes on many businesses, making it more difficult for them to compete 
in the global marketplace.
    In particular, the Small Business and Work Opportunity Act of 2007 
(H.R. 2) as amended by the Senate on February 1, 2007,\1\ includes 
several tax increases that are of particular concern to American 
manufacturers. These include proposals to:

    \1\ Fair Minimum Wage Act of 2007 [H.R. 2 EAS], as passed by the 
Senate, 2/1/07

      Deny Deductions for Punitive Damage Payments; \2\
---------------------------------------------------------------------------
    \2\ Ibid, Section 223
---------------------------------------------------------------------------
      Deny Deductions for Settlement Payments; \3\
---------------------------------------------------------------------------
    \3\ Ibid, Section 224
---------------------------------------------------------------------------
      Limit Deferrals Under Nonqualified Deferred Compensation 
Plans; \4\
---------------------------------------------------------------------------
    \4\ Ibid, Section 226
---------------------------------------------------------------------------
      Expand the Definition of Employees Subject to Rules 
Limiting the Deduction for Salary Payments, and \5\
---------------------------------------------------------------------------
    \5\ Ibid, Section 234
---------------------------------------------------------------------------
      Impose New Taxes on Expatriates.\6\
---------------------------------------------------------------------------
    \6\ Ibid, Section 225

    A common theme with these changes is that, while they may be rooted 
in some valid policy concerns, they are drafted in such a way to be 
overly broad and threaten to ensnare transactions and expenses well 
beyond their intended scope.
Increasing Legal Costs for American Manufacturers
    Manufacturers currently face some of the highest legal costs in the 
world. Based on a recent study by NAM's research and education arm, the 
Manufacturing Institute, tort costs for U.S. businesses are at 
historical highs and are higher than similar legal costs in other 
countries.\7\ Moreover, the tort burden on manufacturers (as a 
percentage of manufacturing output) is roughly 2.2 times larger than 
the burden of these costs on other sectors of the economy.\8\
---------------------------------------------------------------------------
    \7\ ``The Escalating Cost Crisis,'' p. 11 The Manufacturing 
Institute, 2006.
    \8\ Ibid
---------------------------------------------------------------------------
    Two provisions in the Senate-passed version of H.R. 2, if enacted, 
would add to the current, anti-competitive legal cost burden facing 
U.S. manufacturers. Specifically, the proposals to eliminate tax 
deductions for punitive damages and settlements of potential violations 
of law represent significant changes to, and unnecessary expansion of, 
current law that will increase the cost of doing business in the United 
States for manufacturers.
Punitive Damages
    Under current law, taxpayers generally can deduct damages paid or 
incurred as a result of carrying on a trade or business, regardless of 
whether the damages are compensatory or punitive. The proposed change 
to make punitive damage payments in civil suits non-deductible, whether 
made in satisfaction of a judgment or in settlement of a claim, runs 
counter to fundamental and well-established tax principles, and 
represents unsound public policy.
    From a tax policy perspective, the proposal represents a sharp 
departure from the income tax principle that taxpayers should be taxed 
on net income. To measure net income accurately, all expenses 
associated with the production of income are properly deductible.
    Similarly, the proposal violates the principle that income should 
be taxed only once. Since punitive damage awards would not be excluded 
from income, both the payor and the recipient would be subject to tax 
on the punitive damages, thus imposing a ``double tax'' on the same 
income. The United States Treasury would get a windfall, but businesses 
would receive a ``tax penalty.''
    The proposal also represents a departure from another objective of 
federal tax policy--to provide similar tax treatment for similar 
behavior. Because of different standards and guidelines in the current 
civil justice system, conduct that results in punitive damages in one 
state may not result in punitive damages in another. For example, 
standards for awarding punitive damages vary widely among states--a 
number of states have ``caps'' on punitive damages and some states do 
not allow punitive damage awards at all.
    NAM also is concerned about significant tax administration issues 
under the proposal. Under current law, it is often difficult to 
determine the character of awards (i.e., compensatory vs. punitive), 
particularly in cases that are settled in a lump sum while on appeal. 
The term ``punitive'' is not defined in the tax code or regulations nor 
is the term defined in the proposal. The Tax Court has held that state 
law determines whether awards are punitive or compensatory in nature, 
which suggests that the proposal could result in dramatically different 
treatment of otherwise similarly situated taxpayers in different 
locales.
    Moreover, one jury may award damages while another may decide there 
is no liability even where the facts are very similar. A prime example 
is BMW of North America v. Gore.\9\ In this case, a jury awarded the 
plaintiff $4 million in punitive damages because BMW had sold as new a 
car that had received touch up paint treatment. In contrast, a few 
months earlier, another jury in the same county in a case with the same 
defendant and nearly identical facts found no liability.
---------------------------------------------------------------------------
    \9\ 517 U.S. 559
---------------------------------------------------------------------------
    Another area of concern for NAM members is the effective date of 
the proposal. Disallowing deductions for amounts paid or incurred on or 
after the date of enactment would interfere with a taxpayer's decision 
today whether to appeal an initial award of punitive damages. Because 
the deduction would continue to be available only for amounts paid 
before the enactment date, taxpayers recently hit with initial damages 
awards would be discouraged from exercising their right to appeal. 
Moreover, existing damage award amounts have been based on the 
assumption that such amounts would be deductible. Disallowing 
deductions for these existing awards would impose a far greater penalty 
on taxpayers than was intended by judges and juries.
    From a broader public policy perspective, the proposal is based on 
the false premise that punitive damages are the same as non-deductible 
criminal or civil fines.   Criminal or civil fines are fixed in amount 
and are imposed for specific activities that are defined in advance. In 
addition, criminal liability must be proven ``beyond a reasonable 
doubt,'' i.e., the jury must be virtually certain of its decision. In 
contrast, punitive damages are awarded after the fact under vague and 
unpredictable standards such as ``reckless'' or ``wanton'' or ``gross 
negligence'' or all three.
Settlement Payments
    NAM members also have significant concerns about the impact of the 
proposal that would prevent companies from deducting the cost of 
settlement agreements with the government. Like the proposal discussed 
earlier, this provision runs counter to fundamental and well-
established tax principles, and represents unsound public policy.
    Under current law, a business cannot deduct from income ``any fine 
or similar penalty paid to a government for the violation of any law.'' 
The proposal would significantly extend this provision to the non-
penalty portion of settlement payments, thus eliminating deductions for 
most, if not all, settlement agreements with the government on a wide 
range of issues, regardless of whether there was any wrongdoing.
    NAM members believe that the language as drafted would sweep in a 
large number of unintended and legitimate expenses. In particular, the 
``inquiry into the potential violation of any law'' clause included in 
the proposal could be read to include almost all payments made by a 
business in connection with daily, routine interaction with government 
agencies. By eliminating a deduction for an ordinary and necessary 
business expense, the proposal represents a dramatic change in long-
standing tax policy that would act as a disincentive for companies to 
enter into these agreements.
    Manufacturers operating today in the United States face a 
significant regulatory burden. In many cases, these regulations are 
ambiguous and subject to interpretation making it difficult, if not 
impossible, to ensure 100 percent compliance at all times. 
Consequently, there is a strong public policy reason to have a system 
that allows businesses to voluntarily settle and pay government claims.
    Moreover, current law establishes a distinction between punitive 
and nonpunitive payments that has a long history in the courts and with 
the Internal Revenue Service.\10\ According to IRS officials, the IRS 
is committing ``significant resources'' to ensure the proper treatment 
of settlement payments.\11\ In contrast, the proposed change would 
replace this well-established and workable precedent with a new, all-
encompassing standard with which the courts and the IRS would have to 
struggle. The approach taken by the proposal is to disallow a broad 
category of deductions (legitimate and otherwise), and require 
taxpayers to rely on limited exception language to claim clearly proper 
deductions. Ironically, the need to fit oneself into the narrow scope 
of the exception would limit some of the flexibility that exists today 
in responding to real or perceived violations of laws and regulations 
and would limit the ability of business and government to agree on 
certain remedies that benefit society.
---------------------------------------------------------------------------
    \10\ See Talley Inds., Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 
1997); Middle Atlantic Distributors, Inc. v. Commissioner, 72 T.C. 1136 
(1979); see also Field Serv. Adv. 200210011 (Nov. 19, 2001).
    \11\ Letter to Sen. Charles Grassley from B. John Williams, Jr. 
Chief Counsel, Internal Revenue Service 4/1/03
---------------------------------------------------------------------------
    Clearly, American consumers and businesses would lose if the 
proposals on punitive damages and settlements were adopted. U.S. 
manufacturers face significant government regulation and operate in a 
world where no product is or can be absolutely perfect. These proposals 
would hamper entrepreneurship, innovation, and product development by 
further adding to the cost of doing business. This, in turn, would 
increase the price of goods and services for consumers, chill 
innovation, put jobs at risk and undermine U.S. competitiveness.
Unwarranted Attacks on Benefits and Compensation
Nonqualified Deferred Compensation
    NAM member s strongly oppose a provision in the Senate-passed 
version of H.R. 2 that would impose significant limitations on 
nonqualified deferred compensation plans. The proposal, which is not 
targeted at any abuse of deferred compensation rules, is a solution in 
search of a problem that would effectively eliminate the ability of 
employers to use deferred compensation as a retention tool for valued 
employees.
    In 2004, Congress adopted significant changes to nonqualified 
deferred compensation laws that were designed to address perceived 
abuses. The legislation--the American Jobs Creation Act of 2004 \12\--
created a new tax code section (Section 409A) that significantly 
reformed existing rules for the establishment and operation of 
nonqualified deferral arrangements.
---------------------------------------------------------------------------
    \12\ P.L. 108-357
---------------------------------------------------------------------------
    In particular, Section 409A was designed to address perceived 
abuses of nonqualified deferred compensation plans, principally whether 
the individual making the deferral had control of the deferred assets. 
Under 409A, amounts deferred under nonqualified arrangements must 
remain at a substantial risk of forfeiture to the employee. Final 
regulations to implement Section 409A (which are expected to run to 
hundreds of pages) have yet to be finalized by the Treasury Department. 
NAM members believe that Congress should allow the new law to work 
before considering additional changes.
    In contrast, the proposal included in the Senate bill would further 
restrict the rules on nonqualified plans by limiting annual deferrals 
to the lesser of the five-year average of an individual's taxable 
compensation or $1 million. The legislative history of the provision 
\13\ makes clear that earnings inside a deferred compensation plan 
should be counted towards the annual cap on deferrals. As a result, 
violations of the new rule could occur merely as the result of the 
passage of time and not as a result of any action by the employee or 
the company. The potential penalties are severe. An individual who 
intentionally or unintentionally violates the provision would be 
subject to immediate taxation on the entire deferred balance plus an 
additional 20 percent excise tax.
---------------------------------------------------------------------------
    \13\ Senate Report 110-1, p.52
---------------------------------------------------------------------------
    Although tax avoidance on deferred amounts is cited as the primary 
reason behind the proposal,\14\ there is no avoidance of taxation under 
a nonqualified deferred compensation plan. Rather, tax is deferred 
until a future period. There is no tax consequence to deferrals into 
nonqualified plans because the matching principle applies, i.e., a 
deduction is only taken by the employer when the deferred amounts are 
actually received by the employee and taken into income. Furthermore, 
though we believe the proposal is aimed at large deferrals (although as 
explained later, it does not just pertain to large deferrals), it is 
unlikely that there will be a significant benefit from lower tax 
brackets when amounts are paid out. Since employment taxes will 
typically be paid at deferral or when the amounts are no longer subject 
to forfeiture, there simply is no tax avoidance in play.
---------------------------------------------------------------------------
    \14\ Ibid
---------------------------------------------------------------------------
    Nonqualified deferred compensation arrangements are used by many 
manufacturers to motivate and reward their workforce and to align the 
interests of employees with the interests of the company. Sometimes 
these plans are non-elective restoration plans, effectively restoring 
benefits to individuals that have been eliminated from tax qualified 
plans because of income limits. In other cases, these plans are used as 
supplemental retirement plans or incentive plans.\15\ Still, in other 
cases, the decision to defer is a voluntary one, made by the employee 
under the rules of Section 409A. The Senate proposal essentially takes 
away an important human resources and management tool that businesses 
both large and small utilize to retain and attract employee talent.
---------------------------------------------------------------------------
    \15\ Examples of affected plans are included in Attachment A and 
specific employee examples are included in Attachment B.
---------------------------------------------------------------------------
    When a business chooses to pay its employees through deferred 
rather than current compensation, it ties the employee to the business 
in a meaningful way. By voluntarily deferring compensation into a 
nonqualified plan, the employee gives up the right to receive that 
compensation and puts its eventual payment at the risk of the future 
performance of the company. If the plan offers the chance to invest the 
deferred funds in company stock, the alignment is even stronger. These 
arrangements should be encouraged, not restricted. The legislation 
enacted in 2004 adds safeguards to prevent employees from taking the 
deferred money and running when times are bad. As a result, employees 
who defer compensation know that if the company fails, it is unlikely 
they will ever receive those funds. This is a powerful corporate 
governance tool that aligns the interests of executives and 
shareholders.
    The proposed limits on nonqualified deferred compensation also 
would have unintended consequences when applied to a typical 
supplemental pension plan that pays annual lifetime benefits in 
retirement. In many cases, the vesting of these benefits in a single 
year could push an employee's deferred compensation above the 
provision's annual cap, leaving the employee liable for an immediate 
tax and penalty on amounts they will receive over their lifetime. For 
example, the present value of a modest lifetime annuity payable at 
retirement could easily exceed the cap since the payment is assumed to 
continue as long as the retired employee lives. To avoid this problem, 
employers would have to pay the discounted value of the pension as a 
lump sum. Forcing lump sum payments would be bad pension policy and 
would remove a significant corporate governance benefit that is 
achieved when an employee is tied to the company for life.
    It also is important to note that because the proposal would apply 
to amounts that exceed the lesser of the five-year average of an 
individual's taxable compensation or $1 million, it would create an 
arbitrary limit on deferred compensation that applies not just to top 
corporate executives, but also to middle managers, sales people, and 
other employees of both public and private employers. Furthermore, the 
proposed limit on annual deferrals would act as a highly intrusive tax 
penalty on a company's fundamental business decision to pay employees 
through deferred rather than current compensation.
New Limits on Deducting Salary Payments
    NAM members also have serious concerns about a provision in the 
Senate bill that would expand the definition of a covered employee 
under Section 162(m) of the tax code, which limits the deduction of 
salary payments. In recent years, the Joint Committee on Taxation \16\ 
as well as a number of public and private sector witnesses before the 
Senate Finance Committee \17\ has criticized this provision. In 
contrast, the Senate proposal would add a far-reaching new compensation 
limit to the tax code.
---------------------------------------------------------------------------
    \16\ ``Present Law and Background Relating to Executive 
Compensation,'' Joint Committee on Taxation, JCX-39-06, 9/5/06
    \17\ Executive Compensation: Backdating to the Future, 9/6/06
---------------------------------------------------------------------------
    Section 162(m) currently denies an employer a deduction for non-
performanced based compensation in excess of $1 million paid to an 
individual who is a ``covered employee'' of the employer, i.e., the 
taxpayer's chief executive officer (``CEO'') or one of the four highest 
paid executive officers of the company at the end of the year (the 
``Top 4'') whose compensation is required to be disclosed under the 
Securities and Exchange Commission's (SEC) proxy rules.\18\
---------------------------------------------------------------------------
    \18\ Note that, because the SEC recently amended the proxy 
disclosure rules to no longer include ``the Top 4,'' Section 162(m) is 
no longer congruent with the proxy rules. ``Executive Compensation and 
Related Person Disclosure; Final Rule and Proposed Rule'' Federal 
Register Vol. 71, No. 174 (8 September 2006): 33-8732A.
---------------------------------------------------------------------------
    In addition, the deduction limit applies if the non-performance-
based compensation in excess of $1 million is paid to an individual who 
is a covered employee on the last day of the year in which the payment 
is made. Therefore, an employer might contractually commit to pay 
compensation to an employee on separation from service, at which time 
the employee would not be a ``covered employee'' under Section 162(m).
    The Senate proposal would expand the definition of covered employee 
under Section 162(m) to include (i) any person who was CEO during any 
part of any year (not just the end of the year) and (ii) any person who 
ever was a ``covered employee'' in any year after 2006 (even if that 
person is not a covered employee in the year that the compensation 
payments are received or the year the services are performed). In 
effect, the proposal creates a new rule that if an employee is ever a 
covered employee, he will always be a covered employee--even if current 
compensation eliminated them from the ``high five'' of a corporation.
    Under the proposal, compensation earned or payable in the future to 
an employee who at any time in a taxable year beginning after December 
31, 2006, was a covered employee would remain subject to Section 162(m) 
in perpetuity. As drafted, this proposal represents a significant 
expansion of the scope of Section 162(m), rather than an attempt to 
close an inadvertent loophole.
    The Senate proposal also modifies the definition of covered 
employee by dropping a cross reference to the securities law from 
existing Section 162(m). The SEC's new proxy rules (which apply to 
proxies filed for fiscal years ending on or after December 15, 2006), 
require detailed disclosure for any person who acts as CEO during the 
fiscal year, any person who acts as CFO during the fiscal year, and the 
three other most highly compensated executive officers other than the 
CEO and CFO. In order to retain the previous group for tax purposes 
(i.e., the CEO and the Top 4), the statutory change to Section 162(m) 
removes from the definition of ``covered employee'' a requirement that 
``the total compensation of such employee for the taxable year is 
required to be reported to shareholders under the Securities Exchange 
Act of 1934.'' This approach has serious unintended consequences and 
may significantly and inadvertently expand the category of employees 
who may be covered.
    In addition, as drafted, the proposal would be retroactive, denying 
corporations' deductions for compensation that was earned before 2007, 
by any employee who becomes a covered employee after 2006. Many 
employers today have outstanding compensation obligations that were 
structured in reliance on current law, but that would become non-
deductible under the proposed amendment. Unfortunately, there is little 
or nothing a corporation could do to protect the deduction it thought 
it already had--existing contractual arrangements are legally binding 
on the employer and cannot simply be rewritten by the employer to 
reflect an unanticipated retroactive change in law.
    By denying a deduction for pre-2007 compensation an employer is 
obligated to pay, the proposal will raise taxes on corporate employers 
without changing corporate compensation practices. While a retroactive 
application of the new rule will not affect executives who will be paid 
what they are owed, corporate shareholders stand to lose because of the 
corporation's tax increase. Note that this was not the case when 
Section 162(m) was originally enacted and Congress expressly 
grandfathered all compensation payable under written binding contracts 
that were already in effect.
    While we oppose enactment of the changes to Section 162(m), if 
these changes are made they should only apply prospectively since 
employers cannot control past compensation arrangements. At a minimum, 
the proposal should expressly provide that amended Section 162(m) will 
only apply to tax years beginning after the date of enactment and will 
not apply to any compensation to which an employee had a legally 
binding right, whether or not contingent, on or before the last day of 
the taxable year including [the date of enactment] or which relate to 
services performed before such last day.\19\
---------------------------------------------------------------------------
    \19\ The effective date of the proposal should permit public 
companies time to obtain shareholder approval of performance-based 
plans that may need to be modified.
---------------------------------------------------------------------------
    The NAM also believes that delinking Section 162(m) from proxy 
rules is not in the public interest. Current law defines a covered 
employee by reference to the SEC's proxy rules. This makes sense for 
two reasons. It is easier for taxpayers (and the IRS) to figure out who 
is a covered employee in advance of paying compensation. In addition, 
it targets the rule to ``executive officers'' of a company within the 
meaning of the Securities Exchange Act, i.e., officers who have policy-
making functions and therefore arguably can influence their own 
compensation.
    Based on legislative history,\20\ the proposal is intended to 
``delink'' the definition of a ``covered employee'' from the definition 
used by the SEC as a result of changes in the SEC's proxy rules. The 
SEC has recently revised the proxy rules to now cover the CEO, the CFO 
and the next three most highly compensated employees. The policy reason 
for ``delinking'' is not clear. As drafted, the proposal represents a 
significant expansion of the scope of Section 162(m) to cover employees 
with no policy-making authority who are not in a position to influence 
their own compensation and ambiguity as to what compensation counts for 
determining whether an employee is one of the ``Top 4''.
---------------------------------------------------------------------------
    \20\ Senate Report 110-1, p.68
---------------------------------------------------------------------------
    The proposal also deletes references in Section 162(m) to ``total 
compensation . . . for the taxable year [that] is required to be 
reported to shareholders under the Securities Exchange Act of 1934.'' 
Accordingly, proposed changes to Section 162(m) could be read to apply 
to all ``officers'' of an employer, even those with no policy-making 
authority. Neither Section 162(m) nor the Senate proposal defines the 
word ``officer,'' thereby creating ambiguity where none exists today. 
SEC proxy disclosure is limited to ``executive officers,'' which means 
those officers who have significant policy-making authority for the 
issuer. We do not believe that the proposal was intended to broaden the 
scope of covered employees in this way and urge that, if enacted, 
Congress clarifies the proposal to state that covered employees 
continue to include only executive officers for whom proxy disclosure 
could be required.
    In addition, while the proposal provides that the four ``highest 
compensated'' officers in the year would be covered, it does not 
specify a definition of ``compensation.'' Under current law, that 
answer is well understood by corporations because a ``covered 
employee'' is determined by reference to the SEC's proxy rules. New SEC 
rules capture executive officers' total compensation for each year, 
including equity awards and deferred compensation, which may not be 
taxable until several years in the future. By deleting the reference in 
Section 162(m) to the SEC's proxy rules, the Senate proposal leaves no 
definition of compensation whatsoever.
    In sum, the NAM strongly believes that corporate governance 
issues--like executive compensation--should be addressed through 
corporate governance changes, not through the tax code.
New Tax on Ex-Pats
    Among the revenue-raisers in the Senate proposal is a little 
noticed but potentially devastating provision that would change the 
rules for taxation of foreign persons who are long-term residents of 
the United States and are leaving the country. The provisions would 
levy a new ``mark-to-market'' tax on the unrealized appreciation in all 
their property, on the day before expatriation. In effect, the 
expatriate is treated as having ``sold'' all his or her property, for 
its fair market value, on the day before expatriation. Property subject 
to the provision includes personal property, interests in qualified 
retirement plans, and interests in nonqualified trusts.
    This provision could have a significant negative impact on resident 
aliens employed by U.S. manufacturers. For example, a resident alien 
who has worked for a U.S. company and decides to return to his or her 
home country to retire or for other business or personal reasons could 
find the value of their assets significantly eroded--especially if 
there is an acceleration of tax payable on 401(K) or other retirement 
accounts.
    Finally, another general concern of NAM members is the inclusion of 
retroactive tax provisions in the Senate bill as well as other tax 
legislation. It has long been the position of the NAM that a 
retroactive imposition of taxes is fundamentally unsound and unfair.
    In sum, NAM members believe strongly that tax relief will go a long 
way to ensuring that our economy keeps growing. Conversely, tax 
increases, like those outlined above, will negate much of the positive 
impact of tax relief and, in some cases, threaten continued economic 
growth. We appreciate the opportunity to present our views on these 
issues to the committee and we thank you in advance for rejecting these 
revenue raisers.
Attachment A
Examples of Benefit Plans and Company Types Affected by Section 226
    Restricted Stock Units: In recent years, many employers have 
redesigned their equity programs to increasingly rely on the use of 
restricted stock units (RSUs). Typically, employees are awarded a 
specified number of RSUs, with a fixed percentage of the RSUs vesting 
on a quarterly or annual basis or the entire block of RSUs vesting 
after a specified performance period. Generally, upon vesting of an RSU 
award, RSUs are converted into shares of the employer's common stock 
and the employee is taxable on the fair market value of such stock. 
Some RSU programs fit within the regulatory exception from 409A for 
compensation that is paid upon vesting (or within 2\1/2\ months after 
the year of vesting.) It is not uncommon, however, for employers to 
find that their RSU program does not meet the short-term deferral 
exception and that compensation paid under the program is subject to 
409A. In some instances, an employee may vest in the RSUs in increments 
over the performance period but is not paid until full vesting is 
attained at the end of the performance period. In other instances, an 
employee may vest fully upon reaching a specified retirement age during 
the performance period. Under the legislation, such RSU grants would be 
subject to the one-time pay limit and could cause employees to exceed 
the limit.
    For example, a newly hired employee of a Fortune 500 company 
receives a grant of RSUs that is subject to 409A. The employee is 
granted 6,000 RSUs at a time when the value of the company's stock is 
$30 (i.e., value of the grant is $180,000). The employee is scheduled 
to vest in \1/5\ of the RSUs each year over a 5-year performance 
period. The employee receives a base salary of $140,000, which under 
the Senate provision would be the employee's one-time pay limit for the 
first year. Because the value of the RSU grant exceeds the one-times 
pay limit, a 409A violation would occur and the employee would be 
subject to a 20 percent additional tax on the value of the RSUs as they 
vest (i.e., 20 percent of the RSUs per year) over the 5-year period.
    Because ``earnings'' on the underlying shares of the company's 
stock also are subject to the limit, employees could have a tax penalty 
under 409A merely because the company was successful and the value of 
the RSUs increased beyond the limit.
    For example, an employee is granted 1,000 RSUs at the beginning of 
employment with a technology company. The employee ``vests'' in these 
units after 5 years of service and the RSUs are designed to pay out 
after 10 years. The employer believes that this plan aligns the 
employee's interest with growing the company value rather than 
maximizing current salary. At the beginning of employment, the RSUs 
were valued at $15 per share. The employee earns approximately $100,000 
per year and receives modest increases (based on CPI of 3 percent). The 
employee's 5-year average taxable compensation from the company is 
$110,000 at the end of year 5. The company stock price stays relatively 
flat, but in year 6 the company becomes highly successful and the 
valuation of the stock takes off eventually to exceed 10 times the 
original price. The one-times-pay limit would be exceeded because the 
increase in the RSU value in year 6 will exceed $110,000.
    Supplemental 401(k) Plans: Employees who cannot fully defer under a 
401(k) plan because of the compensation limits under the Code may 
participate in a supplemental or ``mirror'' 401(k) plan. Unlike 
qualified plans, these programs are unfunded and the employer's 
deduction is delayed until the time of payment. If the company becomes 
insolvent, the employees are not paid. The legislation counts 
``earnings'' that accrue under the supplemental plan as additional 
deferrals that count against the one-time pay limit and could cause the 
employee to exceed the limit.
    For example, a Fortune 500 company offers a nonqualified 
supplemental plan to certain employees, including mid-level management 
employees receiving approximately $150,000 to $200,000 per year in 
total wages from the company. Many of these mid-level management 
employees are long-serving employees who typically defer 20 to 40 
percent of their wages. Employees who participate in the plan receive a 
small matching contribution (typically between $3,000 and $6,000) from 
the company based on their deferrals. Investment earnings are credited 
to an employee's bookkeeping account in the plan based upon deemed 
investments chosen by the employee from among the same mutual funds as 
those offered in the company's 401(k) plan. Using 2006 data, the 
company has calculated that at least seven such employees would have 
exceeded their 5-year average taxable compensation. The following chart 
summarizes the relevant information:

 
----------------------------------------------------------------------------------------------------------------
                                                            Account
                                           2006    5-year   Balance     2006       2006                Deferrals
             Emp.              Years of   Total    Average   As of   Deferrals  Investment    Total     Above 5-
                                Service   Wages    Taxable   12/29/  And Match   Earnings   Deferrals   year Avg
                                                    Wages      06                                        Limit
----------------------------------------------------------------------------------------------------------------
  1                                 27   $159,50  $ 90,180  $418,40  $ 66,700   $ 72,300    $139,000   $48,820
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  2                                 13   $175,40  $102,220  $508,30  $ 60,800   $ 52,500    $113,300   $11,080
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  3                                 28   $179,30  $ 62,380  $364,10  $116,400   $ 27,000    $143,400   $81,020
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  4                                 25   $178,30  $126,920  $614,70  $ 47,900   $109,100    $157,000   $30,080
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  5                                 30   $183,70  $126,040  $617,70  $ 38,000   $141,800    $179,800   $53,760
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  6                                 14   $194,40  $128,020  $486,50  $ 62,200   $ 73,200    $135,400   $ 7,380
                                          0                  0
----------------------------------------------------------------------------------------------------------------
  7                                  6   $203,00  $ 92,020  $647,10  $ 76,300   $ 94,700    $171,000   $78,980
                                          0                  0
----------------------------------------------------------------------------------------------------------------

    Since earnings that are tied to a publicly-traded investment are 
often very unpredictable, employees would have to leave a large cushion 
below the one-time pay limit to take into account potential earnings. 
An employee who participates over a number of years could easily exceed 
the one-time pay limit solely because of earnings.
    For example, assume employee 5 in the above example stopped making 
deferral elections after 2006, and that the employee receives modest 
increases in wages each year (based on CPI of 3 percent). Also assume 
that the employee elected to have all of his account balance as of 
December 29, 2006 ($617,700) be deemed invested in the plan's S&P 500 
index fund, and that for the 4-year period from 2007 to 2010 that 
fund's annual return was 20 percent per year (which would be consistent 
with the S&P 500's performance in the late 1990s). By 2010, there would 
be a 409A violation solely because the ``earnings'' credited to the 
employee's bookkeeping account ($213,477) exceeded the employee's 5-
year average taxable compensation from the company ($189,376).
    Supplemental Pension Plans: Some companies maintain supplemental 
pension programs to serve as retention tools and assist management 
employees in saving for retirement. Unlike qualified plans, these 
programs are unfunded and any employer deduction is delayed until the 
time of payment. If the company becomes insolvent, the employees are 
not paid. The nature of many of these plans is to provide the most 
valuable accruals in the years right before retirement (e.g., age 65) 
and, therefore, they incent employees to stay in their jobs. The 
legislation would require employers to change or abandon these 
arrangements because later-year accruals may exceed the one-time pay 
limit under common plan designs for long-service employees. The problem 
would be further exacerbated if the employer wanted to manage its 
employee headcount by offering an early retirement incentive in the 
qualified and supplemental pension plans (such as payment of the full 
pension without a reduction for early commencement). The increased 
value of the pension in the year that the early retirement incentive 
was offered could cause the one-time pay limit to be exceeded.
    For example, one Fortune 500 company sponsors a supplemental 
pension plan that is available to middle managers making a little over 
$100,000 per year, many of which work for the company's retail entity. 
The company noted the difficulty in calculating annual accruals for 
this type of plan and the fact that the value of annual accruals often 
varies significantly from year to year due to interest rate changes and 
eligibility for early retirement. To the extent an accrual under the 
supplemental pension plan exceeded the limit, it is not clear how the 
company could ``fix'' the pension plan formula to avoid an excess 
accrual. The company also noted that the impact of the one-time pay 
limit would be even more severe because other forms of compensation 
provided to these managers, such as RSUs, performance units and 
severance pay, would also be aggregated with accruals under the 
supplemental pension plan in applying the limit. As a result, the 
company advised us that they may discontinue the supplemental pension 
plan if the annual limit is enacted.
    Another Fortune 500 company provides a supplemental pension plan to 
its key executives (about 4,000 U.S. employees). The covered employees 
do not elect into the plan, it is provided automatically. The assets 
are also at a substantial risk of forfeiture until the employee reaches 
age 60. If an employee leaves the company before age 60, he or she 
receives nothing from the plan. The plan benefit is unfunded before and 
after an employee attains age 60. It is paid out on retirement as a 
life contingent annuity (either single life or joint & survivor) with a 
five year guarantee. The Senate proposal appears to apply to the 
supplemental pension plans at the time the plan vests (i.e. at age 60). 
Under the plan, until an employee reaches age 60, the benefit is 
subject to a substantial risk of forfeiture. At age 60, the benefit is 
vested and also deferred, since the employee has no choice but to defer 
payment of the vested benefit as a life annuity when that employee 
retires. The amount of the deferral at age 60 presumably would be the 
then present value of the life annuity. A modest lifetime annuity 
viewed that way would violate the $1 million cap and the employee would 
be subject to a regular income tax and 20 percent penalty tax that 
would significantly reduce their benefit.
    For other employers whose supplemental pension plan may follow the 
vesting schedule of their qualified plan, the situation is more acute. 
In such a case, the vested annual accrual is likely to be subject to 
the new limitations. The calculation of that amount (which can depend 
upon salary levels and incentive compensation payouts) may be 
impossible until after the fact, meaning that the employee will never 
know, until it is too late, whether he has ``deferred'' too much.
    Bonuses and Incentive Programs: Many employers structure their 
bonus programs to fit within the regulatory exception from 409A for 
compensation that is paid upon vesting (or 2\1/2\ months after the year 
of vesting.) It is not uncommon, however, for employers to find that 
they cannot meet this strict 2\1/2\ month rule. Employees may vest at 
the end of the year or at the end of the performance period, but 
business issues may necessitate a delay in payment that results in the 
payment being subject to 409A. Some employers may need to wait longer 
for performance criteria to be ascertained, financials certified, etc., 
resulting in the payment being subject to 409A and the one-time pay 
limit. In other instances, an employee may vest in increments over the 
performance period or upon reaching retirement age but is not paid 
until the end of the period, which also would result in the payment 
being subject to 409A and the one-times pay limit. Finally, employers 
may, to align their interests with those of their managers, encourage 
or allow that bonuses be deferred until retirement rather than being 
paid currently. Section 409A specifically allows for voluntary deferral 
of performance-based pay. The new limits would make such a voluntary 
deferral difficult and often impossible.
    Private Equity: Many private companies (including start-ups) cannot 
readily conform to the specific administrative rules provided under the 
409A regulatory exceptions for equity grants (e.g., stock options and 
stock appreciation rights) because there is no public market to ensure 
a true fair market value price for the grant. As a result, many private 
companies' equity grants are subject to 409A. Under the Senate bill, 
private companies could not provide this type of equity grant to 
employees unless the grant does not exceed the one times pay limit. 
Because ``earnings'' on the equity also are subject to the proposed 
limit, employees could have a tax penalty under 409A merely because the 
company was successful and the value of the equity increased beyond the 
limit.
    Cash Flow and Start Ups: Small and emerging businesses may pay 
modest current compensation during the early stages of the business but 
promise significant future compensation, including retirement payments, 
in order to attract and retain talented employees. The Senate bill 
limits the business from making any promise that exceeds one-time pay 
for employees.
Attachment B
Real Examples of Employees Affected by Section 226
Asian male manager, age 57
Base Salary: $180,500
Average 5-year W-2: $142,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005): 
$59,000
SERP earnings (not payable until after termination by irrevocable 
distribution election): $80,000
Deferred Compensation earnings (irrevocable distribution election): 
$6,500
Total 2006 ``deferrals'': $145,500
Amount above allowance: $3,500
    Presumably, this would mean a 20% excise tax plus the income tax on 
the entire amount.
Caucasian Female manager, age 50
Base Salary: $197,000
Average 5-year W-2: $144,000
Bonus deferral (deferred in 2006 by irrevocable election made in 2005): 
$72,000
SERP earnings (not payable until after termination by irrevocable 
distribution election): $75,000
Deferred Compensation earnings (irrevocable distribution election): 
$8,000
Total 2006 ``deferrals'': $155,000
Amount above allowance: $11,000
    Presumably, this would mean a 20% excise tax plus the income tax on 
the entire amount
Supplemental Sheet
Witness:
    Kenneth R. Petrini
    Vice President, Taxes
    Air Products and Chemicals, Inc.
    7201 Hamilton Boulevard
    Allentown, PA 18195
On Behalf of:
    National Association of Manufacturers
    1331 Pennsylvania Avenue, NW
    Suite 600
    Washington, DC 20004
    NAM contact: Dorothy Coleman

                                 

                 Statement of U.S. Chamber of Commerce
    The U.S. Chamber of Commerce, the world's largest business 
federation representing more than three million businesses and 
organizations of every size, sector, and region, is pleased to have the 
opportunity to express our views on the revenue-raising provisions 
contained in the Senate-passed version of H.R. 2, the ``Small Business 
and Work Opportunity Act of 2007.''
    The Chamber strongly opposes the permanent tax increases used to 
offset the cost of the Senate legislation. The denial of deductions for 
settlements and punitive damages would discourage the out-of-court 
settlement of legal cases and will increase the burden on the judicial 
system. Imposing limitations on non-qualified deferred compensation 
interferes unnecessarily in the management labor market and retroactive 
changes to the Tax Code unfairly penalize companies for engaging in 
legal behavior. Together, these provisions run counter to the goal of 
promoting economic growth and job creation.
Disallowance of Tax Deductions for Government Settlements
    Increased Burden on Judicial System. This proposal runs counter to 
the goal of settling disputes without litigation and will increase the 
volume of cases in our court system. It would impose a chilling effect 
on the ability and willingness of parties to settle cases that would 
not ultimately merit prosecution to a conclusion. The blanket denial of 
otherwise allowable tax deductions for settlement of potential 
violations of laws, or mere investigations of such, is overly broad and 
unfair.
    Reduction in Settlement Amounts. The proposal likely will have the 
perverse impact of lowering settlement recoveries if such settlements 
are nondeductible or if there is uncertainty regarding what portion of 
settlements may be deductible.
    Overturns 30 years of Precedent. The proposal turns 30 years of 
well-established policy as to what are deductible settlement payments 
and what are fines and penalties on its head. Under this provision, the 
regulatory agency always is right and the payment always is non-
deductible unless a company can prove it is making payments directly to 
the specific persons harmed. This narrow definition of restitution is 
not in sync with long-established current law allowing restitution to 
cover a class of similarly situated persons.
Limitations on Non-qualified Deferred Compensation
    Deferred Compensation is not Executive Compensation. Deferred 
compensation is a contractual agreement under which the employee elects 
to defer current payment. These arrangements apply to multiple 
management levels--not just the top executives--who, for various 
reasons, may be limited in the amounts that they can save in qualified 
plan arrangements.
    Additional Changes to Deferred Compensation are Premature. The 
Treasury Department has yet to release final regulations interpreting 
the 2004 statute due to the complexity of these issues. Including new 
provisions at this time will only add to the uncertainty about the 
application of Section 409A. In addition, the Securities and Exchange 
Commission recently issued regulations requiring enhanced disclosure of 
executive compensation generally. The impact of these changes has not 
yet been realized and additional changes at this time are premature at 
best.
    Arbitrary Compensation Limits are Bad Tax Policy. In a 2003 report, 
the Joint Committee on Taxation concluded that Code section 162(m), 
which limits cash compensation, is ``ineffective at accomplishing its 
purpose [and] overrides normal tax principles.'' Accordingly, the 
imposition of similar restrictions on nonqualified deferred 
compensation does not address the perceived abuses and would similarly 
be bad policy.
Retroactive Tax Increases
    Unfairly Penalizes Legal Behavior. The companies that would be 
affected by the retroactive Sale-In Lease-Out and corporate inversion 
proposals were engaged in perfectly legal behavior at the time. 
Congress had previously passed legislation to limit these transactions. 
Adopting the Senate position would unfairly change the tax rules after 
the fact.
    Increase Uncertainty for Business Planning. The business community 
requires predictability in order to plan appropriately. The proposed 
retroactive changes require companies to second-guess congressional 
intent and create unnecessary uncertainty, which run counter to the 
goal of producing a stable economic environment.
    Erodes Faith in the Tax System. Changes to the tax code should not 
be made lightly absent strong policy considerations. The Senate bill 
would further modify changes to the tax code that were passed by 
Congress in 2004. Repeated changes to the same provisions of our tax 
laws erode their reliability and stability.

                                 

        Statement of Working Group for Certainty in Settlements
    On behalf of the thousands of businesses we represent, we 
appreciate the opportunity to express our strong opposition to Sections 
223 and 224 of the Senate-passed version of H.R. 2, the ``Small 
Business and Work Opportunity Act of 2007.'' As Chairman Rangel stated, 
``the Senate tax relief package includes a number of revenue-raising 
provisions that would have a significant impact on the business 
community.'' Because of significant negative impacts, the Working Group 
for Certainty in Settlements strongly opposes Sections 223 and 224.
    The denial of deductions for punitive damages by Section 223 runs 
counter to 30 years of strong public policies and applies principles of 
tort law to the tax code. Section 223 will have not only a significant 
negative impact on the business community by forcing them to spend more 
resources litigating claims, but will also adversely affect victims by 
reducing the likelihood of prompt settlement and forcing more cases to 
lumber through trial. This will also increase litigation costs for 
states. Finally, disallowing a deduction for payment of punitive 
damages, and requiring insurance proceeds to be taxed as income, will 
add unnecessary and unmitigated strains on United States taxpayers. As 
such, Section 223 should be removed from H.R. 2.
    Similarly, the Working Group for Certainty in Settlements strongly 
opposes Section 224 of H.R. 2. As passed by the Senate, Section 224 
would deny a deduction for all types of settlements that currently are 
entered into in the normal course of business. Consequently, ordinary 
and necessary business expenses that, under the well-established 
principles of taxation, are not considered fines or penalties would now 
be non-deductible under this provision. Worse, Section 224 would deny a 
deduction for any such payments, including those where there is no 
admission of guilt or liability. Accordingly, Section 224 should also 
be removed from H.R. 2.
I. Section 223, Denial of Deduction for Punitive Damages
    Section 223 would have a significant impact on business by denying 
any deduction for punitive damages that are paid or incurred by the 
taxpayer as a result of a judgment or in settlement of a claim. If the 
liability for punitive damages is covered by insurance, any such 
punitive damages paid by the insurer would be included in gross income 
of the insured person and the insurer would be required to report such 
amounts to both the insured person and the Internal Revenue Service 
(``IRS''). Section 223 runs counter to 30 years of legislative history 
and strong public policies. If enacted, the provision will have 
significant negative effects on the business community and injured 
victims. Finally, disallowing a deduction for payment of punitive 
damages and requiring insurance proceeds to be taxed as income, will 
implement a harmful ``double-tax'' on United States taxpayers.
A. Background on Deductible Business Expenses
    The Internal Revenue Code allows the taxpayer a deduction for all 
ordinary and necessary expenses that are paid or incurred by the 
taxpayer during the taxable year in carrying on any trade or 
business.\1\ness expenses are the cost of carrying on a trade or 
business. Current law allows amounts paid by a taxpayer as punitive 
damages that arose as a result of the ordinary conduct of its business 
activities to be deductible as an ordinary and necessary business 
expense. This provision is a result of Congressional action and IRS 
guidance.
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    \1\ 26 U.S.C.  162(a).
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    In 1969, Congress, through codification of Tank Truck Rentals, Inc. 
v. Commissioner,\2\ recognized that public policy restricts deductions 
for certain business expenses.\3\ However, Congress expressly limited 
the denial of deductions on public-policy grounds to a limited group of 
expenditures. Section 162(f) denied deductions of fines and 
penalties.\4\ Section 162(g) denied deduction for a portion of treble 
damage payments resulting from a criminal conviction under the 
antitrust laws. Section 162(c)(1) denied deductions for bribes paid to 
public officials.\5\ Finally, Sections 162(c)(2) and (3) denied 
deduction for other unlawful bribes or kickbacks.\6\ In the 
accompanying Senate Finance Committee report, the Committee stated 
``the provision for the denial of the deduction for payments in these 
situations which are deemed to violate public policy is intended to be 
all inclusive. Public policy, in other circumstances, generally is not 
sufficiently clearly defined to justify the disallowance of 
deductions.'' \7\
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    \2\ Tank Trunk Rentals, Inc. v. Commissioner, 356 U.S. 30 (1958).
    \3\ The Tax Reform Act of 1969, Pub. L. No. 91-172,  902, 83 Stat. 
487, 710-711.
    \4\ 26 U.S.C.  162(g).
    \5\ Id at  162(c)(1).
    \6\ Id at  162(c)(2) and (3)
    \7\ S. Rept. 91-522 at 274, 91st Cong., 1st Sess. (1969).
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    Later, in 1980, the IRS issued a revenue ruling clarifying whether 
the amounts paid as punitive damages that are incurred in the ordinary 
conduct of the taxpayer's business operations are deductible as an 
ordinary and necessary business expense.\8\ A revenue ruling is a 
``written statement issued to a taxpayer or his authorized 
representative by the National Office which interprets and applies the 
tax laws to a specific set of facts.'' \9\ There, a company was sued by 
another corporation for acts and contractual violations perpetuated in 
the ordinary conduct of its business activities. The IRS wrote that if 
the issues were not based on any prohibited activities outlined in  
162, then the judgment, including amounts identified as punitive 
damages, were an ordinary and necessary cost of doing business.
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    \8\ Rev. Rul. 80-211; 1980-2 C.B. 57.
    \9\ 26 C.F.R.  601.201(a)(2).
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B. Impact of Section 223 on the Business Community and Public Policy
    The deductibility of punitive damages is also rooted in strong 
public policies. It is a reflection that no product can be absolutely 
safe. The worst effects of Section 223, however, may be felt by the 
injured. The ability of taxpayers to deduct punitive damages encourages 
settlement which makes the victim quickly whole. Additionally, 
requiring insurance proceeds to be taxed as income to the extent such 
proceeds are used to pay for punitive damages further increases the 
actual costs of any settlement thereby reducing the likelihood that 
cases will settle short of trial. Discouraging settlement in our 
already overheated and strained court systems makes little sense for at 
least three reasons.
    First, Section 223 would apply principles of strict product 
liability to the tax code. This legal theory provides that an injured 
plaintiff need only show that a company, regardless of its level of 
care, sold a defective product and that the product proximately caused 
the plaintiff's injuries. This principle, having grown since the 1960s, 
has made it substantially easier for plaintiffs to recover damages. 
Under this theory, United States companies must operate in a world 
where no product is or can be absolutely perfect. Examining the issue, 
the Congressional Budget Office reported that ``such high costs 
sometimes have perverse negative effects on safety, they argue--for 
example, by discouraging firms from conducting safety research that 
could create a legal `paper trail' or by raising the prices of risk-
reducing goods and services, such as medical care. Critics also contend 
that plaintiffs frequently bring frivolous lawsuits when they know that 
the defendant is inclined to settle out of court to avoid the costs of 
litigation.'' \10\ Applying these principles of strict liability to the 
tax code will only further hamper entrepreneurship, innovation, and 
product development. As such, Section 223 should be removed from H.R. 
2.
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    \10\ ``The Economics of U.S. Tort Liability: A Primer,'' chapter 1 
(Congressional Budget Office October 2003), available at http: // 
www.cbo.gov / showdoc.cfm?index =4641&sequence=2.
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    Second, Section 223 will discourage settlements in an already 
overburdened judicial system and negatively affect the injured. Under 
current law, companies may settle their cases without admitting guilt. 
In many cases involving products regulated by the Food and Drug 
Administration or the United States Department of Agriculture, for 
example, having to admit guilt would have extremely harsh business 
ramifications. Having the costs be non-deductible may be deemed to many 
businesses as tantamount to an admission of guilt and may discourage 
many of these settlements. Because of this, Section 223 will discourage 
efforts to make victims whole. Current law allows a company to deduct 
settlement payments, thereby encouraging companies to spend fewer 
resources litigating claims and to make victims whole as quickly as 
possible. Allowing companies to deduct all settlement payments as an 
ordinary business expense resulting from events undertaken in the 
ordinary course of business (outside of punitive damages for 
wrongdoing) encourages a rapid and cost-efficient response to genuine 
claims. As enactment of Section 223 will effectively drive up 
settlement costs, thereby prolonging litigation and discouraging 
settlement, it should be removed from H.R. 2.
    Third, removing the deduction for payment of punitive damages, and 
requiring insurance proceeds to be taxed as income to the extent such 
proceeds are used to pay for punitive damages, will unnecessarily 
strain the corporation, its shareholders, and the economy by taxing the 
corporation on unearned income. Also, Section 223 will force the 
corporation to pay such taxes out of its cash reserves, thereby 
reducing the shareholders' value in the corporation. This policy 
basically penalizes the company thrice for the same act. First the 
court slaps punitive damages on the company. Second, the corporation is 
also forced to pay tax out of pocket on any insurance payments. Third, 
the payment to the plaintiff will not be deductible to the company. 
This will significantly increase how much a company has to pay for any 
punitive damage award. As Section 223 will tax insurance proceeds as 
income, it will increase the penalty to the corporation, without 
benefiting the injured party. It will also increase the costs to the 
States by forcing more cases to go to trial. Indeed, the only 
beneficiary would be the federal government, and we believe that the 
added increase in tax revenues will be far less than the added costs 
incurred by the states in trying the additional cases. As such, Section 
223 should be struck from H.R. 2.
II. Section 224, Denial of Deduction for Certain Fines, Penalties and 
        Other Amounts
    Section 224 would have a significant negative impact on businesses 
by radically modifying the rules regarding the deductibility of fines 
and penalties. This significant extension would deny a deduction for 
all types of positive settlements that are currently entered into in 
the normal course of business. As such, the Working Group for Certainty 
in Settlements strongly opposes Section 224 of H.R. 2.
A. Background on Deductions for Fines and Penalties
    In 1969, Congress specifically limited the deductibility of payment 
for certain fines or penalties to a government for the violation of 
law.\11\ Specifically, implementing regulations provide that the 
following fines and penalties are not deductible as legitimate business 
expenses: (1) amounts paid pursuant to a conviction or a plea of guilty 
or nolo contendere for a crime (felony or misdemeanor) in a criminal 
proceeding; (2) amounts paid as a civil penalty imposed by Federal, 
State, or local law, including additions to tax and additional amounts 
and assessable penalties; (3) amounts paid in settlement of the 
taxpayer's actual or potential liability for a fine or penalty (civil 
or criminal); or (4) amounts forfeited as collateral posted in 
connection with a proceeding which could result in imposition of such a 
fine or penalty.\12\
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    \11\ 26 U.S.C.  162(f).
    \12\ 26 C.F.R.  1.162-21 (emphasis added).
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B. Impact of Section 224 on the Business Community and Public Policy
    Congress correctly denied the deduction as a business expense for 
the payment of certain fines or penalties to a government for the 
violation of law. However, Section 224 of H.R. 2 would radically modify 
these rules by providing that amounts paid or incurred (whether by 
suit, agreement, or otherwise) to a government for the violation of any 
law or the investigation or inquiry into the potential violation of any 
law are nondeductible, even if these payments are not fines or 
penalties. While we strongly support measures to combat corporate 
wrongdoing, this provision will have significant unintended and 
negative impacts on the business community, government agencies, and 
nongovernmental regulatory entities by reducing the likelihood of 
prompt settlements and forcing more litigation.
    Beyond the extension of listed fines and penalties to nearly all 
``fines, penalties, and other amounts,'' the Working Group for 
Certainty in Settlements is extremely concerned with the ``guilty until 
proven innocent'' nature of Section 224. As passed by the Senate, the 
provision denies a deduction for any such payments, including those 
where there is no admission of guilt or liability and those made for 
the purpose of avoiding further litigation. Rather than providing 
clarity and certainty, Section 224 would deny a deduction for all types 
of settlements that are positively entered into in the normal course of 
business and are more properly and logically viewed as remediation 
rather than punishment. For example, the following types of settlements 
are illustrative of the types of costs companies incur in the ordinary 
course of business that might no longer be deductible if this provision 
were to become law: rate refunds made by regulated utilities; rate case 
settlements for alleged violations of tariff; royalty settlements; 
automobile manufacturer costs associated with safety recalls; bank 
examination fees that banking institutions, as a regulated industry, 
are required to pay; and, EPA information requests which are routinely 
sent to companies. It appears Section 224, if enacted, would deny the 
deductibility of all these expenses.
    The Working Group for Certainty in Settlements strongly opposes the 
non-deductibility of nearly all ``fines, penalties, and other amounts'' 
paid by taxpayers regardless of whether the actions were the result of 
actual wrongdoing or not. Because of this, Section 224 will 
significantly interfere with the regulatory system by increasing the 
incentive for companies to force regulatory agencies to prove up their 
cases at formal hearings, as now required in many instances by the 
Administration Procedure Act.\13\
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    \13\ 5 U.S.C.  554 et seq.
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III. Conclusion
    The Working Group for Certainty in Settlements urges elimination of 
Sections 223 and 224 of the Senate-passed version of H.R. 2, the 
``Small Business and Work Opportunity Act of 2007.'' Both Sections 
would remove certainty from the tax code, run counter to strong public 
policies, and further strain already overtaxed United States 
corporations.
    We appreciate your consideration of our views on Sections 223 and 
224. We look forward to continuing to work with you and your staff to 
develop tax policy that encourages economic growth and helps us better 
compete in the global marketplace.

The Working Group for Certainty in Settlements
American Chemistry Council
American Petroleum Institute
American Tort Reform Association
Associated Builders and Contractors
Association of American Railroads
Business Roundtable
Edison Electric Institute
The Financial Services Roundtable
National Association of Manufacturers
National Association of Mutual Insurance Companies
National Foreign Trade Council
Securities Industry and Financial Markets Association
Small Business and Entrepreneurship Council
U.S. Chamber of Commerce

                                 
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