Designing Remuneration Structure and Taxation 1 5 Chapter objectives: Mutual benefit Cash Deferred Fringe benefits Share options Nontax factors Profit sharing bonus Remuneration of employees includes salary and benefits. Benefits that are discussed in this chapter include cash bonus, share options, provident fund, and insurance policies. Bonus is usually paid as incentive bonus for good performance of the employer and the employee. Share options are shares offered to employees at a certain price (exercise price) for a certain years usually ten years in UK (in Bangladesh there are no share options). Provident fund is contributory both by the employer and the employee. Employer's portion is the income for the employee which is tax exempt. Premium of insurance policies and meals are two examples of fringe benefits. Benefits can be taken in cash when offered or deferred for investment and profit. An employee may decide to save his current bonus and other benefits by agreeing with the employer to defer the receipt of these benefits until some future date. The employer shall invest the amount in profitable channels and accumulate the principal and interests and profit in the employee’s account. One important| an Designing Remuneration Structure and Taxation 195 motivation for receiving cash in the current period or deferring depends upon the tax consideration, both income tax and capital gain tax. Mutual benefit Cash or defer strategy must be mutually beneficial both for the employee and employer. The tax consequences of both the employer and the employee must be considered. Employees will look for a time when tax rate is the lowest but employers will look for a time when the corporate tax rate is the highest in order to get maximum tax savings. Both the current and future tax rates of the employee and the employer must be considered. There are also non-tax factors. For example, bonus is paid mainly for incentive purpose not tax purpose. Insurance policies for employees and their premium are tax deductible expense for the employer but these involve separate administration expense and therefore cash benefits may be given to avoid this responsibility. Tax considerations If the employee takes cash he pays income tax at current rates (t,o) but if he defers he pays income tax at future rates (tya). And deferring and investing for example in shares may bring capital gain and taxed at lower rates (te) or exempted. In evaluating whether cash benefits are preferred over deferred benefits, both the current and future tax rates of both employees and employers (tea) and (tan) must be taken into account. Also the different rates of return on investment by employees (t,) and by employers (r.) change the decision. Cash Employee receives cash today (1-tpo) where tp is personal tax rate in the current year Employer's net cost is (I-to) where t.o is the corporate tax rate in the current year196 Advanced Issues in Taxation Deferred Employee receives {( 1 in the current year, and feniS the rat D period, and tp, is the personal income tax at n period (I-teo)(1+tex)”}(l-tpa) Where teo is the comporate tax te of return on investment at n Fringe benefits: meals, insurance policy When provided by employer (1-tp0) When self purchased (1-t,) = x (1-to), employee must receive x amount of benefit to be neutral to (1-tyo) because x is not exempted (insurance premium gets tax credit on investment, though). Cash bonus versus stock option benefit Cash bonus = (1-tpo) Stock option = (-fp,) for regular income and (1-t..) for capital gain tax where t,, is capital gain tax. Example 1 Your employer is considering to pay you deferred benefits in 3 years or a cash bonus today. Other information: too = 30%, ton = 35%, teo = 35%, ten = 25%, discount rate 10% Highest deferred benefits from the employer = rte) (1449)? = (1-0.0.35)(140.1) = 0.86 Minimum deferred benefits if the employee takes cash and then invest (1-to)(1+15)’ = (1-0.3)(1+0,10)= 0.93 Mutually beneficial contract amount when net employment costs at ten = net employment costs at te Da(1-ten) = (1-too)(1++t¢,)" Dar {(44a)} (otali(Ietg) = - LBL Oe ath lts) = 4(1+0.1')(1-0.35)0-0.25) =Designing Remuneration Structure and Taxation 197 Nontax Factors Deferred benefits may be better for the employees by tax considerations but there are nontax factors like they may switch to other employers or their current employers may face serious uncertainties in future that may risk their deferred benefits. Employers also may not agree with the employees regarding fringe benefits like insurance policies which are nontaxable at the hands of employees but employers may prefer cash benefits instead as they may think these involve some extra administrative work. Share Option Share option benefits to employees are common in the developed countries. Bangladeshi public limited companies do not offer this benefit. Share ownership benefits are available in few companies but Share option benefits are entirely absent; some multinational companies may offer though. Share options are different from share ownership benefits. A company may give option to its employees to buy the company’s shares at certain price for a period of minimum of three years. This option benefit may encourage the employees to work hard for the increase in the company’s share price. For simplicity, benefit of the employees is the difference between the exercise price (the price at which option was given) and the market price when the option was exercised. Suppose option price or exercise price on the date of option given, say in 2005 is TK200 a share and the market price on exercise date, say 2008 is TK500, then his option benefit his TK300. But the issue is not so simple. The question remains when this remuneration benefit should be recognized for the employees and when this remuneration expense be an allowable deduction for the company. To address this issue there is an option valuation model called Balack-Scholes model. This model takes into effect: current market price, option or exercise price, variance of the stock, option time or maturity, risk-free interest rate, and the model is based on normal distribution where the share price moves randomly.198 Advanced Issues in Taxation Option valuation by Black-Scholes Option model V=PN [d:) Xe" N (ch) Ln (p/x) + [ef + 57/2)] t 5Nt where d)=d)- dVt ting Standard (IFRS 2) provides for the accounting of this share-based payment. It requires these benefits be recognized in the financial statements like other remuneration expenses. The benefit relates to the option period and therefore is expensed (allocated) over the option period. International Financial Repo Example 1 On January 1, 2005, XYZ Co. Ltd grants company’s executives the options to purchase 10000 shares of the company’s TK 100 par value common share. The options may be exercised at any time between 3 to 10 years of the grant date. Other data: market price of share at grant date TK160, exercise price TK160, variance of the stock return 0.12, risk-free interest rate 6%. Determine (i) value of option using Black- Scholes option model, (ii) journal entry to record the remuneration expense in December 31, 20005, (iii) journal entry to record the exercise of 20% of the options exercised in 2008. Solution () Option value, 2005 d= Ln (p/x) + [rf + 67/2)] t Nt Ln (160/160) + [0.06 + 0.12/2] 3 dja 0.12 V3 4,= 0.6 -0.6=0 V= 160 [ N (0.6) — 160 ¢%x3 v . N@)] = 160 [N (0.6) — 160 x 0.835 x N (0)] = 160 x 0.726 — 160 x 0.835 x 0,5Designing Remuneration Structure and Taxation 199 = 116.16-66. 8 = TK49.4 Note: probability of the area 0.60 = (0.5 + 0. 2257) or 0.726 and probability of the area 0 = 0.5 +0 = 0.5. these values are taken from the Standard Distribution Function Table. () Salary expense, 2005: Salary or remuneration expense dr TK164533 Paid in capital ct TK164533, (49.4 x 10000)/3 = TK164533] (ii) Exercise of option, 2008 Cash (2000 x 160) dt TK320000 Paid in capital- share option (20% of TK10000 x TK49.4) dr 98720 Common share capital 2000x100 cr 200000 Paid in capital inexcess of par er 218720 Profit Sharing and Tax Benefits Profit sharing benefit is an employment cost of the employer where he shares some of his profit with the employees. This employment cost in return brings some benefit for the employer: (i) it motivates the employees to work hard, (ii) it brings alignment between the interests of the employer and the employee, (ii) it reduces monitoring costs like audit, supervision and bonding costs. An employer can design a profit sharing scheme in three ways: (i) a certain percentage say 10% of profit before tax, (ii) a certain percentage say 40% before tax after deducting a minimum return necessary for the investment, (iii) a certain percentage say 40% of profit before tax subject to a maximum bonus of say three months’ basic pay. The first method suffers from the fact that it does not consider the minimum performance or benchmark. The second method has the problem of ‘big bath’ the term. used by Healy (1985). Here because of a benchmark, the accountant may attempt to show losses in the current year by accelerating someNY Advanced Issues j,, », 200 Ssues in Naxation discretionary expenses of the following year if he forecast. that th will not be any profit in the cua year anyway, Ag a Tesult he we show imum profit in the following year, The thitd soho, , addresses the problems in the other two methods by incorporating upper level or maximum available bonus in order to unlimited income manipulation behavior of the accountant, ‘The profit sharing bonus can be given in cash or in shares and bot considered tax allowable expense. If corporate tax rate ig 25%, the net cost is (1 - 0.25) or 0.75 ina taka If bonus is given in shares it is good for both the employers and employees. Dividend is taxable at a maximum of 20% and Capital gain on sale of shares is taxable only at 10% and in some cases exempt. an attack the th are » then Questions 1. Explain the various components of employee remuneration, 2. Would you take cash benefits from your employer now or defer for future? Explain, 3. Explain the relevant tax laws for employee remuneration and benefits in the Income Tax Ordnance 1984, 4. What are the non-tax factors for bonus and fringe benefits from the employer's side? 5. Why might salary (cash benefits) be preferred to deferred benefits even though employees’ tax rate is falling over time? 6. In the developed countries there are share option benefits for the employees but still absent in Bangladesh. What are share option benefits? Why are these absent in Bangladesh? 7. How shall you determine share option benefits? 8. What tax considerations are involved in share options for both the employers and employees? Exercise 1. Suppose you will retire in 8 years. Throughout your life yo" will face a tax rate of 30% and earn an after-tax rate of retu™Designing Remuneration Structure and Taxation 201 of 8.5% on your investments. Your company’s pension plan eams a 11.5% return, and the company itself earns 10.2% after-tax return on its own projects. The company faces a current tax rate of 27.5% and will face a 32% rate in year 8. How much in deferred compensation would the company have to pay you in year 8 to make you indifferent between future compensation and a TK1500 increase in salary now? 2. The employer has done a life insurance policy for the employee with yearly premium of TK4000. If the employees do the insurance policy by himself then how much benefit he shall demand from the employer? Assume tp0 = 30%. 3. You have two options from your employer: cash benefits today or deferred benefits in 5 years. Other information: ty = 25%, ton = 30%, tro = 35%, ten = 25%, return on investment by the employee, r, = 11%, return on investment by the employer, 1, = 11.50%, discount rate 10%. Required: (i) highest deferred benefits from the employer, (ii) minimum deferred benefits if the employee takes cash and then invest, (ii) mutually beneficial contract and the amount. 4, Employer-paid health insurance premiums are deductible expense for the employer and tax free to the employee. Suppose instead only first TK10000 of such premiums are nontaxable, If the employee is in the 15% tax bracket, how much would the employer has to pay in cash to make the employee indifferent between the cash and TK30000 of health insurance premiums? 5. On November 1, 2004, Columbo Company adopted a share option plan that granted options to key executives to buy 30000 shares of the company’s $10 par value common stock. The options were granted on January 2, 2005, and were exercisable 2 years after the date of grant if the grantee was still an employee of the company. The options expire 6 years from the date of grant. The option price was set at $40. Requirements: (i) Compute the fair value of option by Black-Scholes Option Model, (ii) How much employment expense does the company charge in the income statement for the year 2005? (iii) How much of this expense is tax deductible?