The Definitive Guide to Setting Executive Compensation: From New Startups to Listed Companies

How much do you think company executives are paid?

At listed companies, compensation can be unusually low—even zero—depending on performance or scandals, so there is no single answer. But the figures are public, so let's take a look.

Here is one example at the high end: printed circuit board manufacturer Kyoden, for the fiscal year ended March 2014.

Retirement benefits of ¥1.26 billion. Quite a sum. Base compensation, though, looks relatively modest at ¥11 million. Or so I thought: the executive receives ¥11 million from each of two companies, making ¥22 million in total.

For high base compensation, here is another example: Carlos Ghosn of Nissan Motor.

Annual cash compensation of ¥1.035 billion. Another remarkable figure.

Today's Nikkei also carries this report.

On May 26, SoftBank Group released the notice of its annual general shareholders' meeting to be held on June 22, disclosing that Vice President Nikesh Arora, 48, received approximately ¥8 billion in compensation for fiscal 2015. (Nikkei, May 26, 2016)

SoftBank Group's meeting notice shows approximately ¥6.5 billion in compensation from its three principal companies and ¥1.5 billion from other subsidiaries.

Putting these extraordinary people aside, executive compensation is a recurring management issue from the moment you start a company. Here, I will explain how it works.

A peek at other companies: average executive compensation by company size in the National Tax Agency survey

First, let's establish a benchmark for compensation levels. These are the National Tax Agency's survey results for 2014. Compensation tends to rise with the amount of a company's capital.

Back to the basics: what is executive compensation?

"Executive compensation is compensation for executives! Isn't it simple?"

You're right. Compensation paid to executives is called executive compensation.

It means any economic benefit provided to an executive, in whatever form—not just cash.

Because it is not limited to cash, forgiving a loan to an executive or charging a purely personal leisure trip to the company may count as compensation.

Bear in mind that spending that makes it look as though you treat the company as your personal property may be deemed executive compensation.

Executive compensation in tax law is a world of its own

First, get a taste of how tangled executive compensation becomes in tax law. The Corporate Tax Act alone says all of the following (please don't actually read the statutory text).

Article 34 Of the remuneration paid by a domestic corporation to its officers (excluding retirement remuneration; remuneration in the form of stock acquisition rights provided for in Article 54, paragraph 1 (Special Provisions on the Business Year to Which Expenses Paid in Stock Acquisition Rights Are Attributable, etc.); other remuneration paid to officers who also perform duties as employees for those employee duties; and remuneration to which paragraph 3 applies; hereinafter the same applies in this paragraph), amounts that do not fall within any of the following categories shall not be deductible in calculating the domestic corporation's income for each business year.
(i) Remuneration paid at fixed intervals of one month or less (referred to as "regular remuneration" in the following item), in the same amount on each payment date during the business year, and other equivalent remuneration specified by Cabinet Order (referred to as "regular fixed remuneration" in the following item).
(ii) Remuneration paid under an arrangement to pay a fixed amount at a prescribed time for the officer's duties (excluding regular fixed remuneration and profit-linked remuneration (meaning remuneration calculated on the basis of profit-related indicators; the same applies in the following item); except for remuneration paid to officers who do not receive regular remuneration (limited to remuneration paid by domestic corporations that are not family companies), this is limited to remuneration for which the details of the arrangement have been notified, as prescribed by Cabinet Order, to the head of the tax office with jurisdiction over the place of tax payment).
(iii) Profit-linked remuneration paid by a domestic corporation that is not a family company to its executive officers (meaning officers specified by Cabinet Order as those who execute its business; hereinafter the same applies in this item), meeting the following requirements (limited to cases in which profit-linked remuneration meeting the following requirements is paid to all other executive officers).
(a) The calculation method must be objective and based on indicators relating to the business year's profits (limited to indicators stated in an annual securities report prescribed in Article 24, paragraph 1 (Submission of Annual Securities Reports) of the Financial Instruments and Exchange Act (referred to as an "annual securities report" in (3))), and must satisfy the following requirements.
(1) It must have a fixed monetary ceiling and use the same type of calculation method as the profit-linked remuneration paid to other executive officers.
(2) By the date prescribed by Cabinet Order, the method must have been determined by a remuneration committee (meaning the remuneration committee under Article 404, paragraph 3 (Authority of Nominating Committees, etc.) of the Companies Act, excluding a committee whose members include executive officers of the domestic corporation or persons with a special relationship to those executive officers as prescribed by Cabinet Order), or have undergone another procedure specified by Cabinet Order as an equivalent appropriate procedure.
(3) Its details must be disclosed in an annual securities report or by another method specified by Ministry of Finance Order, without delay after the date of the decision or completion of the procedure in (2).
(b) Other requirements prescribed by Cabinet Order.
2 Of the remuneration paid by a domestic corporation to its officers (excluding remuneration to which the preceding or following paragraph applies), the amount specified by Cabinet Order as the unreasonably high portion shall not be deductible in calculating the domestic corporation's income for each business year.
3 Remuneration paid by a domestic corporation to its officers through accounting that conceals facts or records fictitious transactions shall not be deductible in calculating the domestic corporation's income for each business year.
4 Remuneration under the preceding three paragraphs includes benefits from forgiveness of debt and other economic benefits.
5 Officers who also perform duties as employees under paragraph 1 means officers (excluding presidents, chairpersons of boards of directors, and others specified by Cabinet Order) who hold an organizational position as an employee of the corporation, such as department head or section chief, and regularly engage in employee duties.
6 In addition to the matters set out in the preceding two paragraphs, matters necessary for applying paragraphs 1 through 3 shall be prescribed by Cabinet Order.

Did that convey how complicated it is?

Tax law's basic stance on executive compensation

The thinking behind corporate tax is: "When a company makes a profit, its executives will pay themselves more to reduce that profit and avoid corporate tax. Let's make sure they cannot dodge corporate tax that way."

The overriding principle is therefore that you may pay executive compensation in any amount and by any method, but only compensation paid by an approved method will be accepted as a company expense for tax purposes!

What does it mean for a payment not to be deductible for tax purposes?

Suppose a company makes ¥10 million in profit and pays the whole amount as executive compensation. Comparing deductible and nondeductible treatment reveals a staggering difference. (To give you a feel for the difference, I have ignored resident tax and deductions and left out finer tax points.)

[Example: executive compensation that is deductible for tax purposes versus compensation that is not]

• When compensation is deductible: corporate and related taxes are zero; income tax is about 18%, or ¥1.76 million. Total tax: ¥1.76 million
• When compensation is not deductible: corporate and related taxes are about 36%, or ¥3.6 million; income tax is about 18%, or ¥1.76 million. Total tax: ¥5.36 million

The same ¥10 million paid as executive compensation can produce this much more tax. Do you see the destructive power of the tax treatment of executive compensation?

Still, this reasoning makes rather little sense if you look at it from the tax collector's perspective.

The corporate tax rate is around 30%, while the highest rate on individual income exceeds 50%. If companies pay out a lot of their profit as executive compensation, the recipients could pay more than 50% in tax. Ordinarily, paying more executive compensation would therefore raise more tax revenue than restraining it, because the income tax rate is higher. Dividends, meanwhile, generate tax twice—corporate tax on the company's profit and income tax on the individual's dividend—so they increase tax revenue too.

Tax-approved methods of paying executive compensation

Executive compensation paid by any method other than those below cannot be deducted for tax purposes, costing the company a great deal of cash. Be thorough about using the following methods.

Regular fixed compensation

Regular fixed compensation is "executive compensation paid regularly in the same amount."

Just pay the same amount every month.

The point to watch is that "regularly" means at intervals of one month or less. Weekly or monthly payments are fine; quarterly payments are not.

In principle, you can change the amount once a year, by the date three months after the accounting period begins. Think of closing the accounts and deciding the revised amount at the shareholders' meeting.

An exceptional reduction is possible. If continuing to pay high compensation would bring down a company, being unable to change it would create a social problem.

Examples of circumstances in which regular fixed compensation can be reduced include:

• The company is clearly struggling because its performance has deteriorated.
• Unavoidable circumstances change a director's duties (an increase is also permitted): for example, an ordinary director becomes representative director, or vice versa.
• Illness or a similar circumstance prevents the executive from performing their duties.
• Compensation is reduced as a penalty for a scandal or similar misconduct.

Keep it conventional; don't try anything too clever.

One easily misunderstood point: an executive receives a full month's compensation even after working just one day. Be careful—executives are treated differently from employees. There is no daily proration, so prorating the payment is unacceptable for tax purposes.

Regular fixed compensation is the most important method. It is not exciting at all, but it is the safest and easiest to manage from a tax perspective.

My basic recommendation is to consider other methods only when regular fixed compensation simply cannot achieve your purpose. For example, even if you contract with a part-time outside director for ¥600,000 a year, you must not pay it in one lump sum. It is fiddly and inconvenient, but pay ¥50,000 each month. That makes it regular fixed compensation and avoids a tax problem.

One workaround when cash flow temporarily deteriorates is to record executive compensation as unpaid compensation and get through the shortage that way. Be careful, though: conditions apply, including handling withholding and similar matters as though the compensation had been paid. A little knowledge can do a lot of damage here, so work with a tax accountant.

There has also been a somewhat unusual case of a listed company accumulating unpaid compensation and stopping cash payments because it desperately needed positive operating cash flow to avoid delisting. It did not reduce executive compensation; it simply stopped paying it.

Advance-notification fixed compensation

Decide the payment dates and amounts in advance, notify the tax office, and pay the specified amounts when those dates arrive.

There is a fixed deadline for notifying the tax office.

• Within one month of the shareholders' resolution
• Within four months of the fiscal year-end

The earlier of these two dates is the deadline.

The notification is a simple document, so the company can prepare it in-house.

This method was popular for a while. Why? Pay the specified amount at the specified time and it is deductible. Change your mind along the way and make no payment at that time, and no problem arises: there is no payment to disallow in the first place. This led to a practice of notifying the tax office of every payment one might possibly make, then deciding each time whether to pay exactly as notified or make no payment. But that attracts the tax office's attention and leaves a bad impression. It is a double-edged sword that could bring a rigorous tax audit later. Don't do it.

There are only two choices: pay the notified amount on the notified date, or pay nothing at all. Even ¥1 too much or too little is unacceptable for tax purposes, so take care.

Another key point is that this system was not designed for executive bonuses. Paying an executive a bonus through advance-notification fixed compensation simply because the year's results were good is, in principle, unacceptable; this can cause trouble in a tax audit.

This method carries various risks and points to watch. Although the procedure is simple enough to handle in-house, I do not recommend using it without a thorough discussion with a tax accountant.

Profit-linked compensation

The criteria must be stated in an annual securities report, so this method is effectively available only to listed companies. Unlisted companies need not concern themselves with it.

It can be linked only to profit, and the requirements are so strict that it is practically unusable. Calls to make it workable have come from various quarters, and changes through tax reform are being considered.

Stock options

Stock options give recipients the right to buy shares in their own company at a predetermined price. They are very useful for a company working toward a stock exchange listing. Tax-qualified options are not taxed until the shares are sold, and they encourage recipients to work hard to grow the company. They are arguably essential for ventures aiming to go public.

Issuing them costs money: they must be designed with both company law and tax in mind, which means fees for professional advice, registration, and related procedures.

Stock options can bring talented people on board at relatively modest salaries, unite everyone behind the company, and let them share in its success.

The issuance costs are not small, but you can expect benefits that exceed them. You do need to grant options strategically to capable people expected to contribute to the company. Keep personal likes and dislikes out of the decision.

I may sound a little enthusiastic, but let's see the power of stock options. Take Metaps, which listed in August last year.

Here is its management team—an impressive lineup. The following is from the Metaps website as of December 24, 2015 (Japanese).

Naturally, Metaps uses stock options to attract talented people. Take its first stock option issuance, for example.

These options give the right to buy 250,000 shares at ¥5 per share. After five years of hard work starting in 2010, how much are they worth now that the company has succeeded...?

(¥2,951 − ¥5) × 250,000 shares = ¥765 million

A sum that makes the hard work worthwhile.

Retirement benefits

This is compensation paid on retirement—a way of saying, "Thank you for building the company to this point."

Retirement benefits receive extremely favorable tax treatment for the recipient: (1) a generous deduction, (2) halving of the remaining amount so that only half is taxable, and (3) separate taxation. The system really does look after the recipient. It is designed on the premise that a payment to someone retiring and leaving a job will support their subsequent livelihood. At least half is treated as income on which no tax is due.

However, the portion the tax office considers unreasonably high will not be accepted. Work with your tax accountant to decide the amount and assemble evidence that it is not excessive.

One approach is the merit multiplier method. If you exceed the amount calculated by such a method, prepare more than ample justification before facing a tax audit. As a basic rule, the amount calculated by the merit multiplier method or a similar method serves as the ceiling.

Even above the tax ceiling, payment as retirement benefits may still be a rational choice. As noted earlier, the recipient benefits from the highly favorable tax treatment of retirement income, so even if the company cannot deduct the payment, the retiring executive may ultimately keep a substantial amount of cash. Consider the various methods before choosing.

An extra point: directors who also serve as employees

For a director who also serves as an employee, the employee-duty portion can be paid flexibly, rather than being restricted to fixed payments like executive compensation. The ability to pay a performance-based bonus is a particularly significant difference.

Conditions for being treated as a director who also serves as an employee include the following:

• The person must be an ordinary director, not a representative director, senior managing director, or managing director. A director "in charge of" a function is fine—for example, a director responsible for administration who also heads the accounting and finance department.
• The person must actually perform employee duties, such as those of a department head or section chief.
• The person must not fall within the family-company criteria concerning relatives and similar relationships.

I am reluctant to recommend this arrangement because it often leads to disputes with the tax office. Its benefits are essentially the ability to pay bonuses and enroll in employment insurance. In my view, unemployment cover offers little benefit to someone capable enough to become a director, so the practical benefit is mainly the bonus.

Refer to the National Tax Agency's guidance (Japanese) on the amount payable for employee duties. In principle, use the same pay rules as for other employees and stay within the director compensation ceiling set in the articles of incorporation or by the shareholders' meeting.

An extra point: social insurance premiums when setting executive compensation

Once a company is on track, there is no need to worry about social insurance premiums when deciding the amount of executive compensation.

At the startup stage, though, they deserve a little attention.

Japan's social insurance premiums rise in steps: crossing a threshold can cause a sudden jump in cost. A ¥10,000 pay increase could raise premiums enough to reduce take-home pay. The trade-off is difficult, because future pension benefits may also rise. Even so, I think a startup should preserve as much cash as possible. A sensible approach is to consult a labor and social security attorney or tax accountant and set compensation just below the next premium threshold.

An extra point: beware of excessive executive compensation

If executive compensation or retirement benefits are too high, a tax audit may find them nondeductible. Keep the amount within a range you can defend as reasonable by ordinary social standards: comparable businesses pay similar amounts, and your company has achieved—or expects to achieve—results that justify it.

Extra Q&A: taking no compensation immediately after incorporation, then starting payments later

A new company often has yet to find its feet, so its founder may want to take no executive compensation at first, work hard for a while, and start drawing pay once the business is on track. This is common. For a founder who owns 100% of the shares, the reasoning makes a certain sense: compensation simply moves the same amount of cash out of the company and into the owner's hands. With the earlier explanations in mind, let's look at some less conventional payment patterns.

Example: no compensation at incorporation, then payments after six months when profits are expected

You establish a company but want to keep as much cash in it as possible while preparing and developing the business. In this example, compensation begins when the business or service actually launches, perhaps six months after incorporation.

Regular fixed compensation will not work in this case. Instead, submit the advance notification within two months of incorporation and pay executive compensation under that arrangement.

Because this uses advance-notification fixed compensation, you must decide the amounts beforehand. They need not be regular and identical: July can have one amount and August another. The amount can differ from month to month.

Example: no compensation at incorporation, then payments after three months

This is another case of keeping cash in the company by paying no executive compensation during a period of preparation after incorporation.

Here, there are two options: advance-notification fixed compensation and regular fixed compensation.

The regular fixed compensation rules allow "revisions to regular remuneration made at a prescribed time each year, by the date three months after the start of the accounting period." A shareholders' meeting held by that date, measured from incorporation (the start of the accounting period), can revise executive compensation and begin identical monthly payments. This therefore qualifies as regular fixed compensation. If incorporation was not on the first of the month, it is technically possible to start payments in the fourth month.

The same payment pattern can also use advance notification. If holding a shareholders' meeting is a hassle, or the monthly amounts will differ, advance-notification fixed compensation is a suitable option.

Putting it together: my recommended way to set executive compensation

I think each company can set executive compensation according to its circumstances and individual values. The amount is up to you.

But some payment methods produce more tax than others.

Take care not to erode precious funds for the company's growth by choosing a poor method.

Step 1: make a business plan and decide how much compensation to take—or aim for

Draw up a business plan and calculate (1) the sales and profits you intend to generate and (2) how much cash and bank deposits will accumulate in the company.

Then decide freely on the total pool for executive compensation, within a range that will not put the company in difficulty.

Allocate that pool among the executives according to their contributions and other relevant factors.

Step 2: decide how to pay executive compensation

Of the several methods discussed, I recommend just two: regular fixed compensation and retirement benefits.

Even when you say, "Business went well this year—let's give employees an extra year-end bonus!", leave executive compensation unchanged and increase the following year's regular fixed compensation instead. The extra cost weighs on the next year and squeezes that year's profit. But that is a matter of the numbers; accept it as a rule of the tax world. This approach is simple and easy to understand. Few people leave knowing that their pay will rise next year, so it also creates an incentive to retain executives who have delivered excellent results.

Retirement benefits are very attractive: the recipient's take-home amount receives favorable tax treatment, and the company can deduct the payment within certain limits. Still, the executive leaves when you pay it, so it is probably not where you should focus too much effort. Clear rules showing how much someone will receive after a given number of years can encourage capable executives to stay longer. For an owner-manager's retirement benefits, using insurance products is generally more advantageous than building up funds inside the company. Consult a tax accountant.

A special case is a company aiming to go public, where stock options are preferable to retirement benefits. I recommend regular fixed compensation and stock options.

As we have seen, the payment method changes the corporate tax borne by the company, the income tax borne by the individual, and the social insurance premiums borne by both.

The taxes to watch are corporate tax and income tax.

To repeat: the amount reflects your own values, so I think you can choose freely within what you can afford. But plan the payment method carefully, consulting a tax accountant, so that you get it right.