Strategic Tax Management

ACT 123
Chapter 6 CHAPTER 6: ATTRACTING AND MOTIVATING
EMPLOYEES AND MANAGERS: COMPANY AND
EMPLOYEE TAX PLANNING

Week 7
Chapter 6
Overview

 Although direct wages form the vast bulk of employer payments, a multitude of schemes
have been used for compensating employees. These plans all have the same basic goal: to
improve labor productivity over that derived from simply paying wages. However, they
reflect two fundamental approaches to accomplishing this. The first is based on better
matching rewards with employee needs. Some of these schemes—such as lifetime
employment—are rooted in the classical economist’s conception of the diminishing
marginal utility of money. Others—such as job enrichment and job sharing—are more
specifically based on the perceptions of differences in employees’ desires as they become
more wealthy or secure, as suggested by management theories like Maslow’s Hierarchy of
Needs.

Week 7
Chapter 6
Overview

 The second fundamental approach is to align employee performance more with a firm’s strategic
goals. Some of these plans, such as piecemeal bonuses for machinists or assembly-line workers,
reflect Taylor’s conception of the value of rewarding measures of enhanced tangible output.
Bonuses for managers, such as those based on Drucker’s theory of Management by Objectives,
instead increasingly have been targeted at specific, less tangible objectives. These have often been
developed during the firm’s strategic planning process, sometimes by the managers themselves.
 Taxes have also been a key factor in designing nonwage forms of employee compensation. This
has particularly been the case when the need to attract and motivate managers is paramount. As
with investments, it is not just what one earns that matters, but also what one keeps. It is the
expected after-tax net present value of an employee’s total compensation that matters. Using the
SAVANT framework, this chapter explores differential tax treatments of nonwage forms of
employee compensation. This is done with an eye toward enhancing worker productivity and the
net present value of an employee’s compensation at the least after-tax cost to employers.

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Chapter 6
Module Objectives:

 After successful Completion of this module, you should be able to:

1. Understand the forms of compensation
2. Distinguish executive and nonexecutive employee compensation
3. Know the limits on deductibility on executive compensation
4. Apply SAVANT to executive compensation

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Chapter 6
Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:

 Schemes for compensating executives/managers have become important in many

companies’ strategic plans. This may be because executive/managerial talent has become
increasingly scarce as firms have become more complex, causing firms to compete for
talent at the top by offering lucrative compensation packages. The scope of these packages
can be seen in annual surveys reported in the business press.

Week 7
Chapter 6
Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:

 The results of surveys like these can vary because compensation packages for managers differ widely. They
often consist of a mix of factors thought to match both employees’ and employers’ varying needs. The array of
factors can be generalized, however, into six basic
 components:
 1. Annual base wages
 2. Year-end bonuses, based on company financial performance measures, such as net income or economic
value-adding (EVA)
 3. Long-term equity participation, most commonly through stock options
 4. Deferred compensation
 5. Fringe benefits like Housing benefits, Vehicle benefits, Expense account benefits and other taxable fringe
benefits
 6. Employment security arrangements, such as employment contracts and golden parachutes (payments
triggered by changes in the firm’s ownership)

Week 7
Chapter 6
Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:

 There are advantages and disadvantages to each component in satisfying employee needs
and motivating labor productivity. For example, salary can be adjusted annually. But
because it is contracted for ahead of time, salary is not ideal as a direct motivator for future
performance. Annual bonus payments can fill this role better, particularly if tied to
attaining specific strategic objectives for the year. Equity compensation may be more
preferable, particularly for senior executives, because the most important objectives may
be long term in nature, and because the rewards are congruent with the basic shareholder
goals of enhancing the value of the firm’s shares.

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Chapter 6
Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:

 In addition, components are taxed in different ways. For example; number 5, Taxable
Fringe benefits given to managers/supervisors are subject to Fringe Benefit tax (FBT) at
rate of 35% (for resident or citizen) of gross up monetary value of benefits given by
employer as provided under the Tax Code; while fringe benefits given to rank and file are
not subject to 35% FBT (instead, subject to Basic income Tax).

Week 7
Chapter 6
Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:

 For Philippine employees, Employers must observe a range of payroll compliance

regulations, which include monthly withholding obligations. The three main statutory
contributions deducted from employee salaries each month are:
a. Social Security: General social insurance covering sickness, disability, maternity and old age.
b. PhilHealth: The Philippine Health Insurance Corporation scheme aims to provide access to
quality medical and health care services for all employees.
c. Home Development Mutual Fund: A housing program designed to provide short term loans and
access to housing programme’s for all workers in the Philippines.

Week 7
Chapter 6 Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:
Example

 Suppose a company can hire either one upper-level supervisor for 100,000 or two middle
staff or rank and file employees for 50,000 each (basic salary). Both will be given a taxable
fringe benefits (housing) with monetary value of 100,000 for one supervisor or 50,000
each to two middle staff or rank and file employees.

Week 7
Chapter 6 Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:
Example

 Suppose a company can hire either one upper-level supervisor for 100,000 or two middle staff or rank and file
employees for 50,000 each (basic salary). Both will be given a taxable fringe benefits (housing) with monetary value
of 100,000 for one supervisor or 50,000 each to two middle staff or rank and file employees.

Description: (Year 2020) One Supervisor Two

Rank and file employee
Basic Salary 100,000 50,000 each (100,000)
Taxable fringe benefits 100,000 50,000 each (100,000)
Fringe benefit tax expense
(100,000/ .65 x .35) 53,846 Zero ( 0)
Phil health-employer contributions (per table)
900 750 each ( 1,500)
(50,000 x .03 x 1⁄2-750 share of employer)
SSS Contributions-employer 1,630 1,630 each (3,260)
Pag Ibig Contributions-employer 100 100 each ( 200)
Total expenses 256,476 204,960
Net difference 51,516

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Chapter 6 Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:
Example

 In this simplified example, the employer saves around 51,516 in payroll expenses which
includes fringe benefit taxes and other benefits by using two senior rank and file staff
instead of one supervisor. The savings is about 25% of payroll costs of two rank and file
employees. Over several employees, this could result in considerable employment tax
savings

Week 7
Chapter 6 Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:
Example

Employee Leasing
One way to reduce employment and transaction costs related to employment is through
employee leasing. Here a company hires whomever it wants, but leases the employees from a
company that specializes in leasing employees. This is depicted in Exhibit below. Here the firm
pays only (tax-deductible) leasing fees to the leasing firm and is not responsible for employee
benefits or payroll taxes. Instead, the leasing firm pays such costs. In many cases, leasing firms
provide a lower level of benefits because these firms are smaller, newer, or less unionized. If so,
these lowered costs can be passed on to buyers in the form of lower leasing fees. Managers
should bear in mind, however, that while leasing may appear to be cost effective, it may not
make good business sense. This is because (especially if done to an extreme) there is potentially
less control over employee availability, effort, and skill. In addition, firms lose some of the
advantages of long-term employee status: innovation, risk taking, and loyalty.

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Chapter 6 Course Materials:
EXECUTIVE/MANAGERS COMPENSATION:
Example

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Chapter 6
PUTTING IT ALL TOGETHER: APPLYING
SAVANT TO EXECUTIVE COMPENSATION
 You are on the compensation committee of a Fortune 500 company, and you are trying to
hire a top executive away from a competitor. You estimate that the executive would bring
$5 million per year of additional value-added to the corporation. Your firm has a tax
NOLCO which is due to expire this year. The company’s financial earnings are positive.

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Chapter 6 The executive’s current compensation at the competitor firm is
$1 million in salary. What sort of contract should be offered?

Strategy
 Hiring the executive away from the competitor is a major strategic advantage. To keep her
from going back to the competitor, a contract to tie her to the firm is needed; stock options
may be the way to accomplish this goal.
Anticipation
 You may want to assure her that your stock’s value will go up in response to her
performance and that the firm anticipates no debt or equity issuance in the near future..
Timing and time-value issues are important here, too. For example, because of the expiring
NOL, it is better for the firm to defer compensation until the next year.

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Chapter 6 The executive’s current compensation at the competitor firm is
$1 million in salary. What sort of contract should be offered?

Value-Adding
 The (after-tax expense) financial-accounting charge to earnings should not exceed $5 million per year,
regardless of the form taken. Adjusting for Risk The fact that she has a pure cash contract at the
competitor may indicate some risk aversion. Thus, some portion of the contract may have to be in cash.
Transactions Costs
 You estimate it will cost 100,000 in legal and accounting fees to draw up a compensation package.
Negotiating
 Because of the expiring NOLCO this year, you would prefer to defer more compensation until next
year. This argues in favor of bonuses or options. However, you may have to pay her more to accept such
deferred compensation. Also, the fact that she receives all-cash compensation currently may mean she is
in a low bracket. In this case, she would see no tax advantage to stock options. Attracting and
Motivating Employees and Managers: Company and Employee Tax Planning 207

Week 7
Chapter 6 Assessment: ATTRACTING AND MOTIVATING EMPLOYEES AND
MANAGERS: COMPANY AND EMPLOYEE TAX PLANNING

 Problem A: Suppose a company can hire either one upper-level supervisor for 50,000 or
two middle staff or rank and file employees for 25,000 each (basic salary). Both will be
given a taxable fringe benefits (housing) with monetary value of 10,000 for one supervisor
or 5,000 each to two middle staff or rank and file employees.
1.Determine the total expenses of employer including the following: a. SSS contributions 2. Phil
health contributions 3. Pag ibig and 4. Fringe benefit tax expenses and the Fringe beneifts 5. Basic
salary.
2. Which one will be chosen by the company that will give savings to the company
3. How much is the savings? What is the treatment of w/tax on salary of employees and share of
employee in SSS, Pag ibig and Phil health.?

Week 7
Chapter 6 Assessment: ATTRACTING AND MOTIVATING EMPLOYEES AND
MANAGERS: COMPANY AND EMPLOYEE TAX PLANNING

 Problem B: Explain and discuss the tax treatment of the following items: 1. Annual base
wages
 2. Year-end bonuses, based on company financial performance measures, such as net income
or economic value-adding (EVA)
 3. Long-term equity participation, most commonly through stock options
 4. Deferred compensation
 5. Fringe benefits like Housing benefits, Vehicle benefits, Expense account benefits and other
taxable fringe benefits
 6. Employment security arrangements, such as employment contracts and golden parachutes
(payments triggered by changes in the firm’s ownership)
 7. Stock Options 8. Dividends

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End