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Federal
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July/August 2007
PPA Technical Amendments Packages Introduced Technical amendments to the 2006 Pension Protection Act (PPA) were introduced in both the House and the Senate just prior to Congress leaving town for their August summer recess. As expected, a change permitting self-insured health plans to be covered by the new public safety retiree medical benefit was included. Action on the technicals package is not expected until later in the fall, possibly in connection with other, more substantive amendments to the PPA. The technical amendments packages (S. 1974 and H.R. 3361) were introduced by the bipartisan leadership of the House and Senate tax and pension committees on August 3, 2007. These bills are described by staff as containing the “truly technical” provisions on which the staff of all four affected committees (House Ways and Means, House Education and Labor, Senate Finance, and Senate Health, Education, Labor and Pensions) could agree. The amendments include a provision clarifying that the “HELPS I” public safety retiree medical benefit covers premiums paid to self-insured accident or health plans. In January, the Internal Revenue Service (IRS) issued guidance indicating that such premiums were not covered by the new benefit. In response to a letter from Congress objecting to this interpretation, and in anticipation of an amendment being introduced to clarify the matter, the IRS has since reversed itself. (See June 2007 NCTR Federal E-news) While these amendments should have no problems receiving Congressional approval, the real question is when. Any tax legislation for the remainder of 2007 will be affected by the upcoming debate over fixing the alternative minimum tax -- and the related issue of how to pay for it. In addition, there will be other, more substantive amendments to the PPA that will be sought, and their nature could also affect whether of not they will need to be packaged together with these technicals in order to pass. Finally, any tax legislation coming late in a year is always subject to becoming a Christmas tree for other, more controversial tax provisions. Therefore, don’t necessarily look for action anytime soon on these PPA technicals. Joint
Tax Committee Explanation of PPA Technicals The Internal Revenue Service (IRS) has issued guidance clarifying that under the final Internal Revenue Code (IRC) section 409A regulations, school districts are not required to offer their employees an election between being paid over the school year and being paid over a 12-month period. Furthermore, school districts that choose to offer such an election need not make any changes prior to 2008 and their employees will not be subject to additional taxes. In April of this year, the IRS issued regulations implementing IRC section 409A, dealing with nonqualified deferred compensation (compensation that is earned in one year but that is not paid until a future year). The provision was passed in an effort to address abuses related to deferred pay arrangements for high-ranking executives. Briefly, it sets forth certain requirements that, if not met, subject such income to certain additional taxes, including a 20% additional income tax. However, the interpretation of the provision by the IRS has raised issues with arrangements that defer pay for entire employee populations, such as can be the case with teachers. There has therefore been some confusion regarding the meaning of the new regulations and what may be required of school districts and teachers. In response, the IRS has issued guidance in the form of a Q&A (News Release IR-2007-142, dated 8/7/07) that confirms that school districts and their employees do not need to make any changes now to the way teachers or other employees elect to annualize their pay. The guidance clarifies that the regulations permitting teachers to elect to defer income beyond the school year will not affect how their pay is taxed during this upcoming school year (i.e., the final regulations will not be applied to annualization elections for school years beginning before January 1, 2008.) The IRS guidance makes it clear that section 409A does not require that an employee be provided any election regarding how he or she is paid. For example, a school district may provide that all teachers will have their pay spread over 12 months, without providing any election option to the teachers. In that case, the election rules would not apply and no additional taxes would be imposed under 409A. While schools that do not annualize salaries are not required to begin doing so under 409A, any schools that do annualize are generally required to meet certain criteria, which are set forth in the guidance. According to Commerce Clearing House (CCH), the American Payroll Association (APA) is urging that teachers should be excluded from 409A. CCH reports that the APA told them on August 6, 2007, that “409A was intended to target tax evaders; not teachers who are merely spreading out their compensation to make ends meet.” Good point! Excerpt
from IRS Guidance on 409A for Teachers Credited Interest Problem in PPA Looks “Fixable” An amendment developed by NCTR and NASRA to address potential age discrimination problems for public plans -- created by limits in the 2006 Pension Protection Act (PPA) on the amount of interest that may be credited by a defined benefit plan -- appears to be acceptable to key Congressional staff. The amendment would provide that rates of interest used by State or local governmental plans in accordance with a statute, ordinance, administrative procedure, collective bargaining agreement or other public process, are to be treated as permissible methods of crediting interest under the PPA. While the amendment was not included in the recently introduced PPA “technical amendments” package, all indications are that it will be added when Congress takes up the legislation later this year. The PPA amends ERISA, the Internal Revenue Code (IRC) and the Age Discrimination in Employment Act (ADEA) to require that cash balance plans and any other “applicable defined benefit plan” must provide that any interest credit they use is set “at a rate which is not greater than a market rate of return” -- essentially the interest rate on long-term investment-grade corporate bonds. Paying a higher rate of interest will constitute age discrimination under all three laws. This so-called “cash balance” provision of the PPA was aimed at problems involved with private sector conversions of DB plans to cash balance arrangements, and had to do with effects created by ERISA rules that do not apply in the public sector. However, the Internal Revenue Service (IRS) is interpreting the statutory definition of an “applicable defined benefit plan” subject to the market rate cap to include not only cash balance plans, but numerous traditional DB plans with features and options that provide interest credit. Therefore, in addition to any public sector cash balance arrangements, Treasury has indicated this would also likely include the vast majority of traditional public DB plans that credit interest on refunds of contributions as well as the many plans that provide interest-bearing deferred retirement option plans (DROPs). Survivor benefits and other optional ancillary forms of benefits could also be affected. While it is true that most of the cash balance provisions of the PPA amend parts of the Internal Revenue Code (IRC) and ERISA from which governmental plans are exempt, ADEA applies to private and public sector plans alike. Furthermore, the ADEA amendment cross-references these definitions in ERISA and parts of the IRC inapplicable to public sector plans. However, because public plans are not subject to these cross-referenced sections, Treasury and the IRS therefore have told NCTR and other public sector organizations that conforming regulations to these IRC sections cannot make special accommodations for the specific designs and protections inherent in State and local government plans. (See the May 2007 NCTR Federal E-news) In short, since state statutes and/or local ordinances guarantee numerous types of interest credit, including set, underlying or minimum rates of return that could be in excess of this new Federal market rate cap in any particular year, the PPA cash balance provisions as they are now being interpreted by the IRS create the potential for violations of ADEA. Anyone who has had the pleasure of dealing with the Equal Employment Opportunity Commission (EEOC), which enforces ADEA, knows that this is not a good thing. Therefore, following a number of meetings with Congressional staff who worked on the original PPA provision, an amendment to ADEA has been developed that would provide that rates of interest used by State or local governmental plans in accordance with a statute, ordinance, administrative procedure, collective bargaining agreement or other public process, are to be treated as permissible methods of crediting interest under the PPA. The proposed amendment language, which has also been shared with public
employee groups and has received their endorsement, has been favorably
received on the Hill to date. However, since some staff viewed the amendment
as technically non-technical, it was not included in the PPA technical
amendments legislation (S. 1974; H.R. 3361) introduced just before Congress
left town for its August recess. Nevertheless, if enough key players
in the process are in agreement that the public plan credited interest
amendment is sufficiently noncontroversial and does not implicate other,
more complex negotiations, then it could still be made a part of a final
technicals package when it is actually taken up. Based on its reception
so far, this appears to be the likely course of action. New 403(b) Rules Finally Issued
The final regulations generally apply beginning in 2009, but there are exceptions for new rules that restrict contract exchanges, prohibit the purchase of life insurance, and impose new withdrawal restrictions. According to the IRS, the final regulations have attempted to address a number of the concerns that were raised by commentators, such as those regarding the requirement for a written plan document and the additional administrative burdens such a requirement could impose. For example, the final regulations clarify the requirement that the written plan include all of the material provisions by permitting the plan to incorporate by reference other documents, including the insurance policy or custodial account, which as a result of such reference would become part of the plan. As a result, a plan may include a wide variety of documents. Furthermore, the IRS and the Treasury Department plan to publish guidance that includes model plan provisions that may be used by public school employers. It is well to note that the final regulations differ from the proposed regulations in certain areas. One significant example deals with non-taxable exchanges or transfers. Generally, such will be permitted if either: (1) it is a mere change of investment within the same plan (contract exchange); (2) it constitutes a plan-to-plan transfer, so that there is another employer plan receiving the exchange; or (3) it is a transfer to purchase permissive service credit (or a repayment to a defined benefit governmental plan). So if you are a sponsor or administrator of section 403(b) contracts,
be sure to have these new regulations carefully reviewed. Iran, Sudan Divestment Legislation Passes House
Just before Congress left town for its August recess, the House of Representatives adopted two divestment bills: H.R. 2347, aimed at certain investments in Iran, and H.R. 180, dealing with business operations in Sudan. Both passed overwhelmingly: the former by a vote of 408 to 6, the latter by 418 to 1. The Iran Sanctions bill focuses on those international corporations investing at least $20 million in Iran's energy sector, selling munitions to Iran or extending credit of $20 million or more to the Iranian government for 45 days or more. The President or his designee is directed to develop a list of such corporations and publish them in the Federal Register with periodic updates. The Sudan bill’s emphasis is on corporations who have direct investments in, or are conducting business operations in Sudan's power production, mineral extraction, oil-related, or military equipment industries. The Secretary of the Treasury, in cooperation with other Federal departments and agencies, is in charge of developing this list and also having it published in the Federal Register. Both bills provide exceptions and safeguards aimed at assuring that corporations mistakenly identified have the ability for redress. Safe harbors from lawsuits are also provided in both bills for managers of mutual funds and corporate pension funds that divest. Finally, both bills also provide explicit authority for a State or local government to adopt such measures for their assets (including pension plans), generally linked to the Federal lists, and no Federal law or regulation would be permitted to preempt them. Finally, the Sudan bill would also prohibit U.S. Government procurement contracts with companies on the Federal list and authorize the prohibition of these types of contracts at the State and local level as well. Congressman Barney Frank (D-MA), the floor manager of the legislation and the Chairman of the House Financial Services Committee that had jurisdiction over the two bills, explained during debate that the measures were intended to address objections to divestment based on fiduciary duty. He said that he thought it was “often more of an excuse than a reason” when opponents of divestment argued, “we can't do that because we have a fiduciary responsibility as the investment entity to maximize returns, and, therefore, we cannot sell this company and that company.” Mr. Frank told his colleagues that the two bills “render that debate moot” because the measures “do not compel any investment entity to do anything.” “These are not bills of compulsion,” he explained. “They fully respect the market. What they say is, if you are a mutual fund, if you are a pension fund manager, and significant numbers of the investors in your entity or the beneficiaries of your entity come to you and say, Clean my hands; I do not want to be financing these outrageous regimes and their terrible practices, you cannot plead, Oh, I am sorry. The law won't let me do it, because these bills have a common theme. They prevent lawsuits against these investment entities who take these issues into account.” Needless-to-say, the Administration and the Federal agencies such as Treasury, State and the SEC, who will have to implement the legislation, have serious problems with these bills. The recent dust-up over the Securities and Exchange Commission’s attempt to develop a list of Sudan-related corporations, and the problems it created that ultimately forced the SEC to suspend the program after less than a month in operation, is a good example of the difficulties that lie ahead for them. (Even Congressman Frank, who clearly supports the idea of a Federal list of “bad actors,” wrote the SEC to complain about their Sudan effort.) Therefore, with the ability of only one Senator to effectively gum up the works, do not expect action in the Senate any time soon. Of course, with Senator Barak Obama (D-IL) sponsoring an Iran divestment bill similar to the House-passed measure (S. 1430), and also cosponsoring a Sudan divestment bill (S. 831) along with Senator Hillary Rodham Clinton (D-NY), Presidential politics could become more of a factor as the year wears on. If the legislation can reach the Senate floor, it should be easily able to pass with veto-proof majorities as it did in the House. Interestingly, provisions in both bills dealing with the Federal government’s own pension plans were deleted before the measures moved to the House floor. Dropped was a requirement in the Sudan bill for research on the Federal employee Thrift Savings Plan's (TSP) holdings in companies that do business in Darfur, mandating the Government Accountability Office (GAO) to submit a report that contains the names of companies with such business interests, and the amount the Federal Retirement Thrift Investment Board, which oversees the TSP, invests in such companies. A provision encouraging – but not mandating -- the TSP to offer a terror-free investment option to Federal workers was also removed form the Iran bill. While the reason given for stripping these provisions from the legislation was the lack of Financial Services Committee jurisdiction over the TSP, it is well to note that earlier in the year, the Federal Retirement Thrift Investment Board opposed such restrictions on the TSP, expressing concern over the precedent such proposals could establish, given that Congress' original intent in creating the plan was to shield it from political and social influence. How does that old saying go about “what’s good for the goose”….? Sudan
Divestment Bill (H.R. 180) IRS Ruling on Use of 1099-R for New Retiree Health Benefit Underscores Needlessness of Burdensome Plan Involvement
Despite early indications from policy staff at the Treasury Department and the IRS that there would be strong resistance to any efforts to make the new public safety retiree health benefit effectively administered on an individual basis instead of by the pension plan, that is exactly what has happened. The $3,000 tax exclusion is to be claimed by individual retirees on their 1040 tax returns; pension plans will not be required to change their reporting on form 1099-R to reflect any eligible premium payments. Initially, IRS and Treasury policy staff indicated that it was their desire to be able to deal with pension plans if there were questions about any exclusion rather than with individual retirees. Public plans were therefore generally advised to be prepared to reflect the reduction of taxable income by any qualified medical deductions taken for public safety members on the 2007 1099-R. However, in what appears to be a classic case of the left hand not knowing what the right hand is doing, the IRS technical advisors on tax forms and publications had a different view. They felt that a retirement plan is not the entity that should properly make the decision that medical premium payments should be excluded from the individual's taxable income. Instead, they insist this is an election that should be made by the individual taxpayer. Furthermore, the IRS technical staff also realized that a retirement plan might not have sufficient information to determine whether an individual can exclude the payments. For example, what if the retiree is also receiving retirement income from a 457 or 403(b) plan and one of these is also making premium payments? Therefore, the new instructions for the 2007 Form 1099-R clearly state “there is no special reporting for … payments of qualified health and long-term care insurance premiums for retired public safety officers. Recipients of these distributions claim the associated tax benefits on their own income tax returns.” Any such premium payments should therefore be included in the gross distribution reported on Box 1 of the 1099-R and such amounts should also be included in the Taxable Amount reported in Box 2a. Retirees are to claim any eligible exclusion on their form 1040 (it is expected to be asked for on line 16b). Despite this clarification of a plan’s reporting obligations in connection with the new benefit, eligibility for the exclusion is still contingent on the premium being paid by a retiree’s pension plan. This can impose significant and costly administrative burdens on plans in order to do so. It can also unduly and unnecessarily involve the plan in dealings between insurance companies and retirees, involving such things as cancelled policies, modified policies, refunded premiums, and increased premiums. Finally, as adoption of the benefit by a plan is optional and can be limited in scope, plan involvement can also potentially delay its use by retirees who could otherwise be eligible to claim the exclusion. If plans are not going to be required to track benefit payments for 1099-R purposes, then why have them involved in the process to begin with? Furthermore, by imposing plans as middlemen between the retiree and the insurance provider, the ability to claim the benefit on form 1040’s by otherwise eligible retirees could be unnecessarily complicated. Therefore, not only should this requirement be deleted from the current law, but also any expansion of the retiree medical benefit to other public employees should not include this onerous and unnecessary burden. A meeting of public plan advocates will soon be held to discuss such
a possible expansion. At that time, NCTR will insist that this requirement
that eligibility be contingent on plan payment of the premium be excluded
from any such new “HELPS II” legislation. NCTR will also
be seeking support for an amendment to the current benefit language
that would also remove the plan payment requirement. SCHIP Reform Passes Both House and Senate,
but Major Differences, Veto Threat Promise Difficult Road Ahead SCHIP is the Federal-state partnership that covers low-income children ineligible for Medicaid; it is currently set to expire on September 30, 2007. The Senate wants $35 billion more for the program over the next five years, while the House voted for a $47.4 billion increase. Provisions to pay for the increased spending by raising the tobacco tax (by $0.61 in the Senate bill, $0.45 in the House) caused concerns, but the substantial cuts to the Medicare Advantage (MA) program in the House bill are the real problems for Republicans. Democrats have long eyed Medicare Advantage for a potential reduction, saying private insurers offering these plans are overpaid. Their goal is to limit reimbursements to MA plans to that of fee-for-service Medicare, and they would raise $50 billion in revenues by so doing. Overshadowing all of this debate is the threat of a veto by President Bush, who only wants a $5 billion expansion of SCHIP over five years. The President claims that the House and Senate bills amount to "government-controlled healthcare" that should be opposed. Health and Human Services (HHS) Secretary Michael O. Leavitt also criticized the legislation, saying the Administration “do[es] not support a massive expansion of government-run health care and higher taxes,” and calling it a “gradual government take-over of health care.” But the program has strong bipartisan support in the Senate, and GOP Senators Orrin Hatch (R-UT) and Chuck Grassley (R-IA) managed to forge a delicate compromise. The Senate ultimately approved their version of the legislation by a vote of 68 to 31, just one vote more than would be needed to override the threatened Bush veto. However, on the House side, the vote was much closer (225-204), with only 5 Republicans voting in support, while 10 Democrats joined the Republican opposition. If a compromise between the House and Senate is to be achieved, it will need to be much closer to the Senate version -- both in overall spending as well as avoidance of cuts to the Medicare Advantage program -- in order for it to obtain final Senate approval. Negotiations will be intense, and will also be complicated by the behind-the-scenes negotiations in connection with the upcoming September Congressional debate over the much-anticipated report on the success of the President’s Iraqi “surge” policy. With a September 30th deadline and a possible Presidential veto override attempt to mount, many think the hurdles are too high to overcome, and that a temporary extension at current spending levels could be the ultimate solution – for now. According to economists, there is a correlation between drops in health insurance coverage and rising health care costs. Many healthcare providers believe that additional costs created by the uninsured are simply passed on to other healthcare providers, and that universal coverage should therefore be an important goal of any comprehensive healthcare reform effort. Universal coverage for children, through an expansion of SCHIP, is seen by some as the first step in that direction – for better or for worse. Summary
of House-passed SCHIP Bill House Votes to Extend SOX 404 Compliance Deadline for Small Business The House of Representatives has voted to give smaller companies more time to comply with the internal controls requirements of Section 404 of the Sarbanes-Oxley Act (SOX). The Securities and Exchange Commission (SEC) had earlier rejected as unnecessary such an extension in its adoption of new 404 compliance rules, but small business advocates have been demanding more time. What will the Senate do? Is this amendment just the opening shot in an all-out assault on SOX that has been long feared by its supporters? During consideration of the legislation appropriating funds for the SEC for fiscal year 2008 (H.R. 2829), the House of Representatives adopted an amendment offered by Congressmen Scott Garrett (R-NJ) and Tom Feeney (R-FL) that would prohibit the SEC from requiring smaller public firms (with a market value of less than $75 million) to comply with the SOX Section 404 requirements during Federal FY 2008 (October 1, 2007, through September 30, 2008). Currently, small companies are to begin filing management reports on internal controls in their first fiscal year that ends on or after Dec. 15, 2007, with their first auditor’s report on internal controls due a year later. Instead of amending SOX itself, the so-called “appropriations rider” would prevent the SEC from spending any monies to enforce SOX Section 404 for these smaller companies. Nevertheless, House Financial Services Committee Chairman Barney Frank (D-MA) adamantly opposed the amendment as “the beginning of an assault on Sarbanes-Oxley in general." Congressman Frank also said that the amendment was unnecessary since the SEC is already attempting to address the problem. He was referring to the recent actions of the SEC to approve new interpretive guidance for management on the evaluation and assessment of its internal controls over financial reporting. (See June 2007 NCTR Federal E-news) Costs of compliance have been an issue with SOX ever since its enactment. Even large companies have complained bitterly about their expenditures in this area. However, SOX supporters argue that these costs have been greatly exaggerated to begin with, and are coming down. They point out that the new SEC and Public Company Accounting Oversight Board (PCAOB) regulations will reduce compliance burdens even more, particularly for smaller companies, once they are given time to work. Finally, they note that the SEC has already extended the deadline for small companies twice. As the Council of Institutional Investors (CII) wrote in a letter opposing the Garrett-Feeney amendment, “more than 1,000 public companies within the Russell 3000 index would not be required to comply with a crucial component of SOX” if the amendment were to become law. The legislation received strong support from the business community, including the National Taxpayers Union, the American Bankers Association and the U.S. Chamber of Commerce, who reportedly contacted all House members, advising them “The Chamber may consider votes on, or in relation to, this issue in our annual How They Voted scorecard.” Not surprisingly, perhaps, all but one Republican supported the amendment, while 74 Democrats voted with them to pass it by a vote of 267-154. The action now shifts to the Senate, where the Appropriations Committee has now reported their version of H.R. 2829, the Financial Services and General Government Appropriations Act for 2008, to the full Senate. The Garrett-Feeney amendment was deleted. Will their be an attempt on the Senate floor to add the amendment back in? While there has been bipartisan support from Senator Kerry (D-MA) and Senator Snowe (R-ME), the leaders of the Senate Small Business Committee, for such an extension, Senator Dodd (D-CT), Chairman of the Senate Banking Committee, has not yet indicated his views on the matter. However, it is well to note that earlier in the year, Senator Dodd, joined by the Ranking Republican on the Banking Committee, Senator Richard Shelby (R-AL), led the successful opposition to an effort by Senator Jim DeMint (R-SC) and others to make Section 404 of SOX optional for smaller companies with market capitalization of less than $700 million, with revenue of less than $125 million, or with fewer than 1,500 shareholders. (See May 2007 NCTR Federal E-news) At that time, Senator Dodd argued that the SEC and the PCAOB should be given adequate time to see their efforts to address small business concerns with Section 404 implementation to completion. Will this still be his view and that of the Senate as a whole when the Financial Services and General Government Appropriations legislation is taken up? Or will the U.S. Chamber and other supporters of the Garrett-Feeney amendment see this as an opportunity to begin unwinding SOX and mount an all-out effort to amend the legislation on the Senate floor? Even if the Senate version is left as it is, there is still the conference with the House. So the outcome on this issue is still up in the air. CII
Letter
SEC Chairman Blasts GASB Critics; Calls for New Federal Disclosure Rules for Muni Bond Issuers Securities and Exchange Commission (SEC) Chairman Christopher Cox recently decried the “lack of uniformly applied, generally accepted accounting standards in the municipal market,” saying it will “undermine the comparability of financial statements, and ultimately the confidence of investors in the integrity” of that market. Cox called on Congress to give the SEC new legislative authority to require municipal disclosure to be more like that required of corporations. Cox also criticized proposals to do away with the Governmental Accounting Standards Board (GASB) as a separate entity, and instead called for its financial independence, saying GASB rules should be mandatory for State and local governments and that the SEC should have oversight authority. In a speech in California in July, SEC Chairman Chris Cox said that the SEC had determined that there is an “urgent need” to improve the quality and the availability of disclosure documents and financial information for municipal securities. “We need to take immediate steps to improve governmental accounting, and to insure that issuers make financial information available more quickly,” Cox warned. He said that there was also a need to “increase the understanding and involvement of issuer officials in the disclosure process, so that process becomes subject to appropriate disclosure controls and procedures.” The SEC Chairman, a former California Congressman from Orange County, used that county’s bankruptcy and the more recent San Diego pension scandal as examples of how a lack of “full and fair disclosure and securities law compliance” not only threatened the interests of individual investors in the City's and County's bonds, but also “threatened the pocketbooks of millions of taxpayers, and the security of every one of the municipalities' current and future retirees.” Cox acknowledged that the SEC has anti-fraud authority over municipal securities: “Yes, we've addressed these issues - after the fact.” However, he noted that this was insufficient, saying that “it's not enough to punish fraud; we've got to work to prevent it.” Cox has subsequently forwarded an SEC staff "white paper" to Congress that calls for legislation imposing new accounting and disclosure standards in the municipal securities market. While the white paper says that the model of full registration, SEC review, and other regulation applicable to non-municipal issuers “is not necessary or appropriate for state and local governments,” it does suggest a “limited regulatory regime designed expressly for the needs of the municipal securities markets.” Possibilities would include requiring that offering documents and periodic reports provided to investors contain information similar to what is required for all other securities offerings in the private sector. The SEC Chairman also sprang to the defense of GASB, recently the target of the Government Finance Officers Association (GFOA), which has proposed that GASB’s current role be “reassessed” and that the responsibility for setting accounting standards for State and local governments be transferred to the Financial Accounting Standards Board (FASB). (See April 2007 NCTR Federal E-news) “Like the wolf wearing grandma's nightcap and innocently addressing Little Red Riding Hood, the issuer associations assert that their initiative, which threatens the very existence of GASB, is not intended to undermine the Board's independence,” Cox said. “But even if GASB were to continue to exist in the face of these so far relatively few defections,” he went on, referencing the recent actions taken against GASB by the Texas and Connecticut legislatures, “the fact that issuers feel free to threaten both the Board's budget and its status whenever they disagree with a rule or a project means that the Board's independence is in fact under full-scale assault.” The SEC white paper therefore recommends that Congress provide an independent funding mechanism for GASB. In addition, State and local government issuers of bonds should be required to use generally accepted governmental accounting standards. Finally, the SEC believes that it should be given oversight of GASB, “just as the Sarbanes-Oxley Act provided for the Financial Accounting Standards Board.” It is unclear what the Congressional response will be to this request for more authority. The overall volume of outstanding municipal debt has increased to $2.4 trillion, which, as Cox points out, is more than the gross domestic product of China. Furthermore, last year alone, more than $430 billion of new municipal bonds and notes were issued. And Cox says that it’s not just that the size of this market has become so significant. He’s particularly concerned that today's municipal securities market has become a favorite of individual investors. “Fully 36% of all municipal securities are owned directly by households,” he points out, with “up to another one-third of the total municipal market…held indirectly through money market funds, mutual funds, and closed-end funds.” Furthermore, Cox notes that municipal trading volume is substantial. It’s not just a buy-and-hold market anymore, with over $6 trillion of municipal securities changing hands in 2006. “That's a trading volume similar to what we see in the corporate bond market,” Cox points out. “And again, reflecting the dominance of the individual investor in this market,” Cox stresses, “the median size of a trade in fixed-income municipal securities is only $25,000.” With the markets in turmoil, and concerns with the economy growing, will Congress decide that it couldn’t hurt to get the SEC involved in this area? If so, it would probably require that Congress modify or repeal the so-called “Tower Amendment,” named after its author, former U.S. Senator John Tower (R-TX). This amendment was adopted when Congress created the Municipal Securities Rulemaking Board (MSRB) in 1975, and prohibits the SEC or MSRB from requiring issuers to file municipal securities documents with either entity before such securities are issued. Clearly, this will be a contentious issue if Congress decides to take
up Chairman Cox’s challenge. It can be assumed that many State
and local government officials will oppose repeal of the Tower Amendment.
Will public pensions be drawn into that debate? If so, what will be
our views be as investors? And what about the GASB recommendations?
Should GASB rules be made mandatory? Should their funding be “independent,”
and if so, how so? And should the SEC have oversight? (Was that a shudder
I saw?) Much to think about.
SEC Finally Takes Action on Proxy Access – But Advances Contradictory Proposals Despite months of effort on the part of Securities and Exchange Commission (SEC) Chairman Christopher Cox to avoid a split vote on how to respond to last year’s AFSCME v AIG court ruling dealing with access to the corporate proxy, the SEC has now submitted two competing proposals for public comment by 3-2 votes. Chairman Cox supported both. Many institutional investors support neither, and with the announced departures of both Democratic Commissioners over the next few months, there is serious concern that the final outcome of the SEC’s efforts could be to “turn back the clock” on meaningful shareowner proxy access. In September of last year, the U.S. Court of Appeals for the Second Circuit ruled in American Federation of State, County and Municipal Employees Pension Fund v. American International Group that AIG did not have the right to exclude AFSCME's shareholder proposal seeking proxy access in order to nominate directors. (See October 2006 NCTR Federal E-news) Although many expected the SEC to promptly respond with a restatement of its existing policy in an effort to effectively overturn the court decision, Chairman Chris Cox surprised many observers by repeatedly postponing action. In the interim -- while Cox grappled with finding a satisfactory response that could both obtain unanimous support from his fellow Commissioners as well as avoid the furor that arose when the SEC last tried to make changes in this area in 2003 -- the 2007 proxy season was permitted to operate under the court ruling. That is, shareholders could offer proposals to amend corporate bylaws to establish procedures permitting shareholders to include in the corporate proxy materials their nominees for the board of directors. Several such proposals were advanced, but were generally unsuccessful, although they did receive significant votes of support. As one proxy access proponent described it, “the sky did not fall.” Intent upon having new rules in place this fall before next year's proxy season, the SEC Chairman decided in late July to accept a split vote. However, apparently unwilling to abandon hopes of enhancing proxy access -- something he has repeatedly said he wants to accomplish – Chairman Cox has refused to simply roll back the clock to the way things operated prior to the AFSCME v, AIG ruling. Thus, while he decided to vote with his two fellow GOP Commissioners, Mr. Atkins and Ms. Casey, to propose a rule that would once again permit the exclusion from a company's proxy materials of all shareholder-proposed bylaws concerning director nominations – he also voted with the two SEC Democratic Commissioners, Mr. Campos and Ms. Nazareth, to put out a proposed rule that would permit an exception, or override, to this general bar. This proposal would allow shareholders with a 5% equity stake in a company, held for at least one year, to propose such election-related bylaw amendments. His given reason for supporting both is that “By advancing two very different proposals, we will have the benefit of the full breadth of commentary about different ways of attacking this issue.” Cox argues that the so-called “5 percent/1 year hold” is an effort to avoid saying that a company's proxy materials, which are produced at the shareholders' expense, should under all circumstances be inaccessible to the shareholder when it comes to nominating directors -- an outcome that, as he put it, “would seem to stand the principle of ‘fair corporate suffrage’ on its head.” However, Commissioner Campos expressed “deep reservations” with the 5 percent equity requirement, noting that this threshold might be so high as to make the rule effectively “useless.” Many shareholders agree with Commissioner Campos’ concerns. “Five percent would be tantamount to overturning the AIG decision" Richard Ferlauto, director of corporate governance and pension investment at AFSCME, is reported as saying. According to Ferlauto, shareholders would not be able to bring proposals under this rule. There are also concerns that the only investors with holdings sufficient to meet the threshold would be hedge funds, whose interests are typically not the same as those of long-term investors. But others think that proxy access is unnecessary. For example, SEC Commissioner Atkins, who opposed the “5 percent/1 year hold” proposal, said that he did not believe that it “takes into account all of the recent changes in corporate governance or other more measured steps that we can take to continue to drive down the costs and improve the efficiency of running short slates of directors — even a short slate of one — that may lead to the attaining of the goals of responsible long-term shareholders concerned with the financial performance of their companies.” Commissioner Atkins also questions whether the SEC has the legal authority to implement this proposed rule. Atkins is not alone. Certainly many in the business community oppose the proposal. And some institutional investors believe that the “5 percent/1 year hold” proposal should be acceptable, expressing general concern that unnecessary shareholder activism may have adverse political consequences. Some also believe that there are other alternatives to proxy access, such as the withhold vote, which is becoming significant in terms of removing directors and could be even more so with the elimination of broker votes. They point out that, given proxy voting services and the general availability of the Internet, getting information to shareholders via the proxy is not nearly as important as it once was. So what happens now? Both rules are open to public comment, which will close on October 2, 2007. There is no set timeframe in which the Commission must then finalize a rule, but Chairman Cox has said “it is my intention as Chairman to have a clear, unambiguous rule in place in time for the next proxy season.” However, Commissioner Campos has announced that he is leaving the Commission, probably sometime in September before the comment period closes. With only four Commissioners left, even if Chairman Cox ultimately decides to support some version of a new rule permitting shareholder access, a tie 2-2 vote would mean that it would fail. Furthermore, Commissioner Nazareth, whose term officially expired in June but who can serve until the end of 2008, has indicated that she also intends to leave, probably by the end of this year. What effect could this have on a proposal? While these vacancies could be filled by appointments made by President Bush (they could not be Republicans, however, as the President cannot have more than three Commissioners of his own party serving on the SEC) the Democratically-controlled Senate must also confirm them. This could be a difficult process, depending upon whom the President might choose. In fact, there are rumors that he intends to let the seats remain vacant for the remainder of his Presidency. In the absence of a final rule, it appears that the 2008 proxy season would be permitted to operate under the same rules as it did this past season – at least based on questioning of the SEC staff by Commissioner Campos during the meeting at which the two rules were proposed. According to staff’s response, if a final rule isn't crafted by next year's proxy season, then the SEC would continue to decline to intervene to block proposed proxy access amendments to corporate bylaws. Therefore, for proxy access advocates, the best outcome for now might
be a deadlocked SEC until a new, possibly more pro-investor President
takes office in 2009. However, there are already questions being raised
about the accuracy of this staff interpretation of the status quo. Therefore,
when it comes to the future of proxy access, everything is still very
much as it has been for the last year: unresolved.
IRS Issues Proposed Regulations for Section 125 Cafeteria Plans On Aug. 3, 2007, the Internal Revenue Service (IRS) proposed new regulations for employee benefit plans under Internal Revenue Code (IRC) section 125, typically referred to as “cafeteria plans.” The regulations replace prior proposed regulations that were issued in 1984, 1989, 1997 and 2000. Comments must be received by November 5, 2007, and a public hearing will also be held on November 15, 2007. Cafeteria plans generally permit employees to make a choice between receiving taxable cash compensation or tax-free employee benefits, such as health care, vision and dental care, group-term life insurance, disability, adoption assistance and certain other benefits. Employers may also offer flexible spending accounts to employees under a cafeteria plan that provides coverage under which specified, incurred expenses may be reimbursed. These include health flexible spending accounts for expenses not reimbursed under any other health plan and dependent care assistance programs. The new proposed regulations reflect changes in tax law since the prior regulations were proposed, including changes in the definition of dependent and the addition of new “qualified benefits” such as adoption assistance and Health Savings Accounts (HSAs). They also generally retain the rules in the prior regulations for health flexible spending arrangements (health FSAs). Finally, the new proposed regulations also clarify that Section 125
is the exclusive means by which an employer can offer employees a choice
between taxable and nontaxable benefits without the choice itself resulting
in inclusion in gross income by the employees. They also make it clear
that cafeteria plans must be in writing and must be operated in accordance
with written plan terms.
The Hedge Fund Wars: A Report from the Front
With the introduction of legislation (H.R. 2834) in the House of Representatives in late June to change the tax treatment of private equity and hedge fund managers’ income, which followed close upon the introduction of a bill in the Senate (S. 1624) to alter the taxation of investment partnerships, the much-anticipated war over private equity and hedge funds has begun in earnest. Hearings quickly followed in July on both sides of the Hill on the subjects of taxation as well as regulation, and more are planned when Congress returns from its August summer break. Here is how the two sides in the struggle are shaping up. Proponents of the tax legislation, almost universally Democrats (with one notable Senate exception discussed below), argue that the issue is essentially all about fairness. Finance Committee Chairman Max Baucus (D-MT), the sponsor of S. 1624, says that he wants to find out if the income that private equity and hedge fund managers are earning is properly capital gains income, or, as he puts it, “are some people of great wealth merely taking advantage of the tax code to pay less than their full and proper share?” (Investment fund managers typically receive a share of their funds’ profits – usually 20% -- as compensation for their investment management services; this share is known as “carried interest” and is currently treated and taxed as capital gains, not ordinary income.) Congressman Sander Levin (D-MI), the chief sponsor of the House carried interest bill, believes that these investment managers “are being paid to provide a service to their limited partners and fairness requires they be taxed at the rates applicable to service income just as any other American worker.” However, not all Democrats are completely on board with the legislation. For example, Senate Finance Committee members Chuck Schumer (D-NY), with Wall Street in his back yard, and John Kerry (D-MA), whose state is home to a substantial number of venture capital firms, have both expressed concern about precipitous action. Schumer is reported to have warned that he would oppose “treating financial-services partnerships one way while all the other partnerships are treated another” and that he would also oppose a tax hike on carried interest if it only applied to managers for private equity and hedge funds. He may even introduce his own “carried interest” legislation with broader application. Some House Democrats are also leery about moving too fast in this area. For example, Congressman Xavier Becerra (D-CA), a member of the House ways and Means Committee and a close ally of House Speaker Nancy Pelosi (D-CA), has been quoted as saying, "It's an important issue...but there's no reason it has to be done in a certain time period." Supporters of new tax rules for private equity include unions, who are very concerned with private equity leveraged buyouts. They also see the overall issue in terms of fairness. For example, the Service Employees International Union (SEIU) argues that the private equity industry enriches a small group of executives, while “hundreds of thousands of portfolio company employees and contract workers have no seat at the table in these deals and do not receive any of the benefits.” In the past, SEIU had said that it wanted to work with private equity groups to see that these employees were treated as stakeholders. Now, however, the union says that top executives at takeover firms and their portfolio companies are “avoiding paying their fair share of tax,” and Andy Stern, SEIU’s president, is now encouraging Congress to look more broadly at the “tax dodges” of private equity groups and hedge funds. Making for somewhat strange bedfellows, even Warren Buffet has expressed concern with the concentration of wealth and its effects. He reportedly told attendees at a fund-raiser for Hillary Clinton in June that a tax system that allowed him to pay a lower tax rate than his receptionists or cleaning ladies was hurting the U.S. economy by stifling opportunity and motivation. Senator Clinton must have been listening. She has subsequently expressed her support for changes in the treatment of carried interest, saying that "It offends our values as a nation when an investment manager making $50 million can pay a lower tax rate on her earned income than a teacher making $50,000 pays on her income." For opponents, however, all the talk about fairness is simply “horse pucky.” For them, it’s really all about the money: hedge fund and private equity managers have it, and Democrats in Congress want it. Leading the Republican campaign against the legislation on Capitol Hill is Congressman Eric Cantor (R-VA), the House Minority Whip. He thinks that the effort by Democrats is based on the need to find monies to pay for their legislative efforts under the new Congressional PAYGO rules. Furthermore, he also thinks this is just the opening skirmish in the real war to come over the Bush tax cuts, particularly on capital gains. Congressman Cantor has formed the Coalition for the Freedom of American Investors and Retirees to fight the tax proposals, and he is finding plenty of support. For example, the Washington Post reported that when Cantor called a meeting of lobbyists to first discuss how to oppose the legislation, his aides had to find a larger room because 75 people showed up instead of the couple dozen they had expected. The Private Equity Council, the new trade group for the industry, as well as the U.S. Chamber of Commerce, the Real Estate Roundtable, the Financial Services Roundtable and a veritable host of contract lobbyists have all joined together to fight the measure. According to a GOP lobbyist, “We’ll raise a lot of money and so will the Democrats.” Even Grover Norquist – the same guy who has said that he wants to take public pension trustees’ authority and “destroy it" – is helping out. Norquist, president of Americans for Tax Reform (ATR), has already written Congress reminding them that 196 Members of the House and 42 Senators have signed ATR’s “Federal Taxpayer Protection Pledge,” and that supporting a change in the current tax treatment of carried interest would be a “clear and resounding example of a blatant pledge violation.” Most Republicans are therefore quickly falling in line behind Congressman Cantor’s efforts, with one notable exception: Senator Charles Grassley (R-IA), the Ranking GOP member of the Senate Finance Committee. Senator Grassley agrees with the Democrats that the issue is about ensuring “that the tax code is operating fairly and consistently.” The examination of carried interest “is not an attack on the investor class or capital formation,” Grassley has told his colleagues. Nor is it “a revenue grab from private equity firms or hedge funds” by the Congress. Senator Grassley insists that, as a Republican who supports lower capital gains rates, he is concerned “that to the extent we permit the dilution of the investment concept, we risk undermining the arguments we have made for the lower [capital gains] rates, and also making it more expensive to extend them.” Grassley firmly believes “We can’t allow the carried interest tail to wag the capital gains dog.” And speaking of dogs, do public pension plans really have one in this fight? To listen to the rhetoric coming from both sides, we are at the very heart of the debate. According to Congressman Cantor, writing in USA Today, “Raising taxes on partnerships is a clear attack on the pensions of every teacher, firefighter, police officer and civil servant whose pension is tied to these funds.” Even our good friend Grover says he has the concerns of public employee defined benefit plans at heart in opposing any change in the taxation of carried interest. As Mr. Norquist explained in Business Week, “Millions of Americans with defined benefit pensions have their retirements wrapped up in private equity firms. Ditto for college endowments and philanthropic trusts. Hiking taxes on these investments will ruin the retirement, education, and charitable hopes of millions of Americans.” Awww. He likes us after all. As an example of this potential impact, the president of the Private Equity Council (PEC) testified before the House Financial Services Committee in May about “a concrete example” of what private equity and hedge fund investments “mean to real people." He cited the Washington State Investment Board (WSIB), which he characterized as “a major private equity investor for 25 years.” Over that period, according to the PEC, the WSIB has realized profits on its private equity investments of $9.71 billion, with annual returns on private equity investments since 1981 averaging 15 percent, compared to 10.1 percent for the S&P 500. “Put another way,” according to the PEC, “the excess returns generated by private equity investments during that period are worth $26,000 per retiree; or expressed another way: these returns have fully funded retirement plans for 10,000 WSIB retirees.” But many proponents of changes in taxation in this area are not falling for it. “What’s happening here is that a handful of extraordinarily wealthy people are hiding behind workers’ pensions in an effort to avoid paying the same taxes everyone else pays,” Damon Silvers, the associate general counsel for the AFL-CIO, is quoted as saying. Senator Baucus has also reportedly said that the argument that a hike in the tax rate on carried interest would hurt pension fund returns is "overstated." Even some in the hedge fund industry question the rhetoric. William Stanfill, founding partner of Trailhead Ventures, a hedge fund located in Denver, told the Senate Finance Committee that “there is more than a hint of Chicken Little” in the industry’s fears. “But our industry won't end or be significantly disrupted if this legislation is enacted any more than the auto industry's dire predictions of doom came to pass after mileage standards, seatbelts, and air bags were mandated,” he said. A “special tax break” for fund managers and private equity execs is simply unfair, in his opinion. “After all, a gifted teacher who is training and inspiring and challenging our children and enriching human capital gets no such special treatment,” he told the Senators. While opinions may vary as to impact, what is clear is that public pensions and our investments in private equity and hedge funds are definitely part of the debate -- for better or worse. For some time now, Congress has been concerned with our involvement in hedge funds, and there have been clear indications from Congressional leaders that there may need to be Federal legislation to either (1) protect us from our own ignorance and gullibility, or (2) protect our participants from our reckless desire to chase returns. Now, some are arguing that we need to be protected from investment losses if private equity’s taxes are increased. It is true that there are public pensions who are invested in private equity and hedge funds. The estimated $3 trillion in public pension holdings are invested among a diverse mix of stocks, bonds, cash, and alternative investments. Based on the latest available data, state and local government employee retirement systems collectively hold 60% of assets in global equities; 30% in government and corporate bonds; 5% in real estate; and the rest in cash and alternatives such as commodities, venture capital, currency, private equity, and hedge funds. The point being, pension fund managers diversify investments to protect the fund, reduce overall risk and ensure long-term financial performance. As a result, the retirement security of the nation’s public workforce does not hinge on any one asset class. It is also true that there is a wide range of views within the public sector on investing in alternatives such as private equity and hedge funds. For example, William F. Galvin, the Massachusetts Secretary of State, has been recently quoted in The Washington Post as saying, "Unfortunately, what's happening is, increasingly, managers of pension funds -- most of whom have large debt or potential debt in the future -- see this [investing in hedge funds] as sort of a panacea for their growth needs. And it's not. It's a very dangerous approach." However, others would disagree. "This is not all about reaching for return," Larry Swartz, executive director of the Fairfax, Virginia, County pension funds' board of directors has been quoted as saying. "It's about developing a smoother return stream and managing the level of volatility in the retirement system year to year," he told The Washington Post. Thus, some plans decide to invest in these alternatives. Some do more so than others. Then there are the plans that consider the option and decline. For example, Gary Dokes, chief investment officer of the Arizona State Retirement System, is authorized to invest in hedge funds but has decided not to do so. He was also quoted in The Washington Post, explaining, "In our shop, we have a problem with the hedge fund structure in terms of visibility, transparency, fees." Despite these clear divisions within the public pension community, the trends indicate that investments in hedge funds and private equity from public institutional investors are steadily increasing. As The Wall Street Journal puts it, “Private equity firms are the fiduciaries for teachers, students, police officers, firefighters and many others across the U.S. In 2006, the 20 largest pension funds (by membership) invested in private equity represented 10.5 million retirees, including plans from California, New York, Texas, Florida, New Jersey, Ohio, Pennsylvania and Michigan. Their collective private equity investment: $111 billion.” So what, exactly, is going to happen next – and how will it affect us? First, there will certainly be an effort to move the carried interest bill as part of legislation to reform the Alternative Minimum Tax (ATM), at least in the House. (Unless Congress acts, 23 million households -- mostly middle-income -- will be affected by the AMT in 2007 to the tune of $45 billion.) Ways and Means Committee Chairman Charles Rangel (D-NY) is quoted as saying “It's the top priority'' to combine these two bills when Congress reconvenes after Labor Day. While increasing the tax on carried interest to the level of ordinary income will raise a lot of money – as much as $12.6 billion annually, according to a recent estimate by the Economic Policy Institute (EPI) – it will not be enough to pay for a permanent repeal of the AMT. However, it will provide for a welcome respite from the tax. In addition, Democrats believe that it will be very difficult for Republicans to vote against such a tax break for millions of middle income Americans because it will be at the partial expense of a much smaller group of billionaires – or so it will be spun. So look for the House to move aggressively in this regard. On the Senate side, things will probably move more slowly. Senate Majority Leader Harry Reid (D-NV) has been quoted as saying that he does not expect the Senate to act on any tax-raising legislation until 2008. But House action on major AMT reform in the fall could change all of this. At a minimum, the Senate Finance Committee will continue to focus on the issue, with a hearing scheduled for September 6th to focus specifically on the potential impact of increased hedge fund/private equity fees on public pensions. The Senate will also continue to look at the tax treatment of private equity partnerships, the territory previously staked out by Senators Baucus and Grassley. Recent interest on the House side with the off-shore structures used by hedge funds to avoid U.S. taxes on lending activities, an issue originally raised in the Senate, could also serve to reinvigorate an examination of the Unrelated Business Income Tax (UBIT). The Administration is already on record opposing any such tax increases in this area. The current system of allowing private equity managers to pay relatively low tax rates on carried interests in funds is good for business and good for the economy, Treasury Assistant Secretary for Tax Policy Eric Solomon told the Senate Finance Committee. It can be expected that this opposition will only stiffen as the legislation begins to move forward. Efforts have also been made to drag the Chairman of the Federal Reserve Board, Ben Bernanke, into the debate. So far, he has avoided taking a specific position on any legislative proposal, but he did express concern in recent testimony before the Senate Banking Committee that raising the taxes paid by private equity fund managers could drive them overseas, observing that such a tax hike “might not affect their activities, but it might affect their locations.” In the meantime, the Treasury Department is creating two private-sector groups, one for hedge-fund managers and another for hedge-fund investors. The President's Working Group on Financial Markets will be in charge of setting these up. They will work with asset managers and investors to define separate sets of best practices that address investor protection, enhance market discipline and mitigate systemic risk. Ironically, it was only a few months ago that this same Working Group issued a report saying that the current system of regulating hedge funds and other private pools of capital was working fine, and "market discipline" was the best way to protect against systemic risk. No new rules were needed, it was concluded then. (See March 2007 NCTR Federal E-news) In the end, it may be that the markets will be the deciding factor in the hedge fund wars. If more hedge funds find themselves in trouble, as did two Bear Stearns hedge funds involved in the market for subprime home loans recently, then the industry’s supporters on Capitol Hill may find it increasingly difficult to defend the current tax treatment of private equity and hedge fund managers’ substantial personal incomes. And if any such hedge fund problems adversely affect public pension fund investments, and given the media attention that this would undoubtedly attract, then it may not be just hedge fund and private equity managers whose wings will be clipped. Pension funds and their investments in this area could also be under the legislative knife. As in any war, one always needs to be prepared to duck.
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