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35–775 2007

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 

SANDER M. LEVIN, Michigan 

JIM MCDERMOTT, Washington 

JOHN LEWIS, Georgia 

RICHARD E. NEAL, Massachusetts 

MICHAEL R. MCNULTY, New York 

JOHN S. TANNER, Tennessee 

XAVIER BECERRA, California 

LLOYD DOGGETT, Texas 

EARL POMEROY, North Dakota 

STEPHANIE TUBBS JONES, Ohio 

MIKE THOMPSON, California 

JOHN B. LARSON, Connecticut 

RAHM EMANUEL, Illinois 

EARL BLUMENAUER, Oregon 

RON KIND, Wisconsin 

BILL PASCRELL JR., New Jersey 

SHELLEY BERKLEY, Nevada 

JOSEPH CROWLEY, New York 

CHRIS VAN HOLLEN, Maryland 

KENDRICK MEEK, Florida 

ALLYSON Y. SCHWARTZ, Pennsylvania 

ARTUR DAVIS, Alabama 

JIM MCCRERY, Louisiana 

WALLY HERGER, California 

DAVE CAMP, Michigan 

JIM RAMSTAD, Minnesota 

SAM JOHNSON, Texas 

PHIL ENGLISH, Pennsylvania 

JERRY WELLER, Illinois 

KENNY C. HULSHOF, Missouri 

RON LEWIS, Kentucky 

KEVIN BRADY, Texas 

THOMAS M. REYNOLDS, New York 

PAUL RYAN, Wisconsin 

ERIC CANTOR, Virginia 

JOHN LINDER, Georgia 

DEVIN NUNES, California 

PAT TIBERI, Ohio 

JON PORTER, Nevada 

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. 

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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 

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(1) 

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:] 

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2 

ADVISORY 

FROM THE COMMITTEE ON WAYS AND MEANS 

FOR IMMEDIATE RELEASE CONTACT: (202) 225–3625 

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: 

Please Note: Any person(s) and/or organization(s) wishing to submit for the hearing record must follow the appropriate link on the hearing page of the Committee 

website and complete the informational forms. From the Committee homepage, 

http://waysandmeans.house.gov, select ‘‘110th Congress’’ from the menu entitled, 

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3 

‘‘Committee Hearings’’ (http://waysandmeans.house.gov/Hearings.asp?congress=18). 

Select the hearing for which you would like to submit, and click on the link entitled, 

‘‘Click here to provide a submission for the record.’’ Once you have followed the online instructions, completing all informational forms and clicking ‘‘submit’’ on the 

final page, an email will be sent to the address which you supply confirming your 

interest in providing a submission for the record. You MUST REPLY to the email 

and ATTACH your submission as a Word or WordPerfect document, in compliance 

with the formatting requirements listed below, by close of business Wednesday, 

March 28, 2007. Finally, please note that due to the change in House mail policy, 

the U.S. Capitol Police will refuse sealed-package deliveries to all House Office 

Buildings. For questions, or if you encounter technical problems, please call (202) 

225–1721. 

FORMATTING REQUIREMENTS: 

The Committee relies on electronic submissions for printing the official hearing record. As always, submissions will be included in the record according to the discretion of the Committee. 

The Committee will not alter the content of your submission, but we reserve the right to format 

it according to our guidelines. Any submission provided to the Committee by a witness, any supplementary materials submitted for the printed record, and any written comments in response 

to a request for written comments must conform to the guidelines listed below. Any submission 

or supplementary item not in compliance with these guidelines will not be printed, but will be 

maintained in the Committee files for review and use by the Committee. 

1. All submissions and supplementary materials must be provided in Word or WordPerfect 

format and MUST NOT exceed a total of 10 pages, including attachments. Witnesses and submitters are advised that the Committee relies on electronic submissions for printing the official 

hearing record. 

2. Copies of whole documents submitted as exhibit material will not be accepted for printing. 

Instead, exhibit material should be referenced and quoted or paraphrased. All exhibit material 

not meeting these specifications will be maintained in the Committee files for review and use 

by the Committee. 

3. All submissions must include a list of all clients, persons, and/or organizations on whose 

behalf the witness appears. A supplemental sheet must accompany each submission listing the 

name, company, address, telephone and fax numbers of each witness. 

Note: All Committee advisories and news releases are available on the World 

Wide Web at http://waysandmeans.house.gov. 

The Committee seeks to make its facilities accessible to persons with disabilities. 

If you are in need of special accommodations, please call 202–225–1721 or 202–226– 

3411 TTD/TTY in advance of the event (four business days notice is requested). 

Questions with regard to special accommodation needs in general (including availability of Committee materials in alternative formats) may be directed to the Committee as noted above. 

f 

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. 

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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 

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code, Internal Revenue Code section 470, which applies a passiveloss 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 

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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 businessto-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. 

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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 

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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. 

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9 

1Such a change if known from inception would have changed the IRR. 

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

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 

hmoore on PRODPC68 with HMRPT

10 

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. 

f 

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. 

hmoore on PRODPC68 with HMRPT

11 

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 nonqualified 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 nonqualified 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 unprehmoore on PRODPC68 with HMRPT

12 

dictable 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 commuhmoore on PRODPC68 with HMRPT

13 

nications 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, nonqualified 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 

hmoore on PRODPC68 with HMRPT

14 

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 nonqualified 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 severhmoore on PRODPC68 with HMRPT

15 

ance 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 

hmoore on PRODPC68 with HMRPT

16 

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. 

f 

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 

hmoore on PRODPC68 with HMRPT

17 

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, 

hmoore on PRODPC68 with HMRPT

18 

1Fair Minimum Wage Act of 2007 [H.R. 2 EAS/17], as passed by the Senate, 2/1/07 

2 Ibid, Section 223 

3 Ibid, Section 224 

4 Ibid, Section 226 

5 Ibid, Section 234 

6 Ibid, Section 225 

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: 

• Deny Deductions for Punitive Damage Payments; 2

• Deny Deductions for Settlement Payments; 3

• Limit Deferrals Under Nonqualified Deferred Compensation Plans; 4

• Expand the Definition of Employees Subject to Rules Limiting the Deduction for Salary Payments; 5 and 

• Impose New Taxes on Expatriates.6

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. 

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7 ‘‘The Escalating Cost Crisis,’’ p. 11 The Manufacturing Institute, 2006. 

8 Ibid 

9 517 U.S. 559 

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

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. 

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 activihmoore on PRODPC68 with HMRPT

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10See 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). 11Letter to Sen. Charles Grassley from B. John Williams, Jr. Chief Counsel, Internal Revenue 

Service 4/1/03 12P.L. 108–357 

ties 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 longstanding 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, allencompassing 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. 

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 

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13Senate Report 110–1, p.52 14 Ibid 15 Examples of affected plans are included in Attachment A and specific employee examples 

are included in Attachment B. 

409A) that significantly reformed existing rules for the establishment and operation 

of nonqualified deferral arrangements. 

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 fiveyear 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. 

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. 

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. 

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 rehmoore on PRODPC68 with HMRPT

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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 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. 

move 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. 

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

In addition, the deduction limit applies if the non-performance-based compensa- tion 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 alhmoore on PRODPC68 with HMRPT

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19The effective date of the proposal should permit public companies time to obtain shareholder approval of performance-based plans that may need to be modified. 20Senate Report 110–1, p.68 

ready 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

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 policymaking 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’’. 

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 

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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 21⁄2 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 per- formance 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 

hmoore on PRODPC68 with HMRPT

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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: 

Emp. Years of 

Service 

2006 

Total 

Wages 

5-year 

Average 

Taxable 

Wages 

Account 

Balance 

As of 

12/29/06 

2006 

Deferrals 

And 

Match 

2006 Investment 

Earnings 

Total 

Deferrals 

Deferrals 

Above 5- 

year Avg 

Limit 

1 27 $159,500 $ 90,180 $418,400 $ 66,700 $ 72,300 $139,000 $48,820 

2 13 $175,400 $102,220 $508,300 $ 60,800 $ 52,500 $113,300 $11,080 

3 28 $179,300 $ 62,380 $364,100 $116,400 $ 27,000 $143,400 $81,020 

4 25 $178,300 $126,920 $614,700 $ 47,900 $109,100 $157,000 $30,080 

5 30 $183,700 $126,040 $617,700 $ 38,000 $141,800 $179,800 $53,760 

6 14 $194,400 $128,020 $486,500 $ 62,200 $ 73,200 $135,400 $ 7,380 

7 6 $203,000 $ 92,020 $647,100 $ 76,300 $ 94,700 $171,000 $78,980 

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 

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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 21⁄2 months after the year of vesting.) It is not uncommon, however, 

for employers to find that they cannot meet this strict 21⁄2 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. 

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27 

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 

f 

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 

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28 

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.’’ 

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29 

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 & Hammilton 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. 

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30 

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. 

f 

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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 nondeductible. 

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 

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32 

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 crossreference 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 thenTreasury 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? 

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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. 

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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. 

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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. 

hmoore on PRODPC68 with HMRPT

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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. 

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37 

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 nondeductible 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 

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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? 

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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. 

hmoore on PRODPC68 with HMRPT

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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 

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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. 

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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 

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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 exhmoore on PRODPC68 with HMRPT

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ecutives, 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. 

hmoore on PRODPC68 with HMRPT

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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. 

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46 

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. 

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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 nonqualified 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. 

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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. 

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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. 

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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. 

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51 

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 broadbased 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 

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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 systemwide 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? 

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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. 

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54 

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. 

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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 publiclyheld 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 

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1 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, 

as amended (the ‘‘Code’’). 2Letter 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. 

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 midstream 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. 

f 

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. 

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. 

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 

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3This 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). 

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-ll 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 rankand-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. 

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-andfile 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 catchup 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 

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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. 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. 6See 153 Cong. Rec. S1492 (daily ed. Feb. 1, 2006) (statement of Sen. Grassley). 

7For 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. 8See, e.g., Gallione v. Flaherty, 70 F.3d 724, 729 (2d Cir. 1995) (group consisting of all fulltime officers of union was sufficiently select even though it included over 25% of employees). 

ployer 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. 

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. 

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. 

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. 

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 

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9See, e.g., Wells Fargo & Company v. Commissioner, 120 T.C. 69 (2003); Vinson & Elkins v. 

Commissioner, 99 T.C. 9 (1992). 10Daily Report for Executives, No. 41, at G–4 (Friday March 2, 2007). 

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

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. 

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. 

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11See Joann S. Lublin and Phred Dvorak, How Five New Players Aid Movement to Limit CEO 

Pay, Wall St. J., March 13, 2007, at A1. 

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. 

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. 

f 

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. 

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Section 226—Dollar Caps on Nonqualified Deferred Compensation 

Section 226 would amend Code section 409A to impose a dollar cap on non- qualified 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. 

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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 21⁄2 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 

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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. 

Emp. Years of 

Service 

2006 

Total 

Wages 

5-year 

Average 

Taxable 

Wages 

Account 

Balance 

As of 

12/29/06 

2006 

Deferrals 

And 

Match 

2006 Investment 

Earnings 

Total 

Deferrals 

Deferrals 

Above 5- 

year Avg 

Limit 

1 27 $159,500 $ 90,180 $418,400 $ 66,700 $ 72,300 $139,000 $48,820 

2 13 $175,400 $102,220 $508,300 $ 60,800 $ 52,500 $113,300 $11,080 

3 28 $179,300 $ 62,380 $364,100 $116,400 $ 27,000 $143,400 $81,020 

4 25 $178,300 $126,920 $614,700 $ 47,900 $109,100 $157,000 $30,080 

5 30 $183,700 $126,040 $617,700 $ 38,000 $141,800 $179,800 $53,760 

6 14 $194,400 $128,020 $486,500 $ 62,200 $ 73,200 $135,400 $ 7,380 

7 6 $203,000 $ 92,020 $647,100 $ 76,300 $ 94,700 $171,000 $78,980 

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 longserving 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 nonelective, 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 rehmoore on PRODPC68 with HMRPT

64 

tirement (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 21⁄2 months after the year of vesting.) It is not uncommon, however, 

for employers to find that they cannot meet this strict 21⁄2 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. 

f 

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 benhmoore on PRODPC68 with HMRPT

65 

efit 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 

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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 employ- ees. 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 

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1Section 162(m) is separately the subject of another one of the Senate’s revenue increasing 

proposals. 

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. 

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, 

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any earnings in 2014 or later on undistributed prior deferrals will exceed the fiveyear 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 nonelective 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. 

f 

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 Senatepassed deferred and executive compensation provisions and to exclude them from 

any legislation that the Committee approves. 

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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 taxadvantaged 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 

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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, longservice 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 

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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 Senatepassed 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 longterm 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. 

f 

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 

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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 leaseout 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-performancebased 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 

f 

President and CEO 

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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 

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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 

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which was in effect on December 31, 2006 and which was not modified thereafter 

in any material respect before such remuneration is paid.’’ 

f 

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 

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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. 

f 

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 

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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. 

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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. 

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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. 

f 

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

2 Ibid, Section 223 

3 Ibid, Section 224 

4 Ibid, Section 226 

5 Ibid, Section 234 

6 Ibid, Section 225 

7 ‘‘The Escalating Cost Crisis,’’ p. 11 The Manufacturing Institute, 2006. 

8 Ibid 

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: 

• Deny Deductions for Punitive Damage Payments; 2

• Deny Deductions for Settlement Payments; 3

• Limit Deferrals Under Nonqualified Deferred Compensation Plans; 4

• Expand the Definition of Employees Subject to Rules Limiting the Deduction for Salary Payments, and5

• Impose New Taxes on Expatriates.6

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

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 

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9 517 U.S. 559 

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. 

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 longstanding 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 Servhmoore on PRODPC68 with HMRPT

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10See 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). 11Letter to Sen. Charles Grassley from B. John Williams, Jr. Chief Counsel, Internal Revenue 

Service 4/1/03 12P.L. 108–357 13Senate Report 110–1, p.52 14 Ibid 

ice.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, allencompassing 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. 

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. 

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 fiveyear 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. 

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 

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15 Examples of affected plans are included in Attachment A and specific employee examples 

are included in Attachment B. 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 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. 

will typically be paid at deferral or when the amounts are no longer subject to forfeiture, there simply is no tax avoidance in play. 

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. 

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. 

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

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 

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19The effective date of the proposal should permit public companies time to obtain shareholder approval of performance-based plans that may need to be modified. 20Senate Report 110–1, p.68 

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

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 

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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 policymaking 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’’. 

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 21⁄2 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 

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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 per- formance 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: 

Emp. Years of 

Service 

2006 

Total 

Wages 

5-year 

Average 

Taxable 

Wages 

Account 

Balance 

As of 

12/29/06 

2006 

Deferrals 

And 

Match 

2006 Investment 

Earnings 

Total 

Deferrals 

Deferrals 

Above 5- 

year Avg 

Limit 

1 27 $159,500 $ 90,180 $418,400 $ 66,700 $ 72,300 $139,000 $48,820 

2 13 $175,400 $102,220 $508,300 $ 60,800 $ 52,500 $113,300 $11,080 

3 28 $179,300 $ 62,380 $364,100 $116,400 $ 27,000 $143,400 $81,020 

4 25 $178,300 $126,920 $614,700 $ 47,900 $109,100 $157,000 $30,080 

5 30 $183,700 $126,040 $617,700 $ 38,000 $141,800 $179,800 $53,760 

6 14 $194,400 $128,020 $486,500 $ 62,200 $ 73,200 $135,400 $ 7,380 

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Emp. Years of 

Service 

2006 

Total 

Wages 

5-year 

Average 

Taxable 

Wages 

Account 

Balance 

As of 

12/29/06 

2006 Deferrals 

And 

Match 

2006 Investment 

Earnings 

Total 

Deferrals 

Deferrals 

Above 5- 

year Avg 

Limit 

7 6 $203,000 $ 92,020 $647,100 $ 76,300 $ 94,700 $171,000 $78,980 

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. 

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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 21⁄2 months after the year of vesting.) It is not uncommon, however, 

for employers to find that they cannot meet this strict 21⁄2 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 

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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 

f 

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 revenueraising 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. 

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1 26 U.S.C. § 162(a). 

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. 

f 

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.1ness 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 

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2Tank Trunk Rentals, Inc. v. Commissioner, 356 U.S. 30 (1958). 

3The 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) 7S. Rept. 91–522 at 274, 91st Cong., 1st Sess. (1969). 

8 Rev. Rul. 80–211; 1980–2 C.B. 57. 

9 26 C.F.R. § 601.201(a)(2). 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. 

be deductible as an ordinary and necessary business expense. This provision is a 

result of Congressional action and IRS guidance. 

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

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. 

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. 

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 

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11 26 U.S.C. § 162(f). 12 26 C.F.R. § 1.162–21 (emphasis added). 

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

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 

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13 5 U.S.C. § 554 et seq. 

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

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 

Æ 

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