ESG & Executive Compensation in Canada

As the momentum around environmental, social and governance (ESG) initiatives accelerates, Canadian corporations increasingly seek deferred compensation tools that align executive priorities with ESG objectives.  Well designed tax policies on executive compensation arrangements can reinforce sustainable change, as ESG initiatives move from trend to traction.  In this article, we add our voices to this crucial conversation.

We believe that private sector adoption of ESG objectives will determine the pace of adoption of ESG objectives.  In a 2017 report published by Ceres, a non-profit organization, it was noted that a formal process for managing sustainability risks would “help capitalize on the market opportunity created by tackling sustainability challenges.” Yet, despite  senor management’s comments at a recent shareholders meeting of a major Canadian financial institution  calling climate change an “existential threat” driving “the most pressing issue of our time”, a majority of shareholders at the meeting rejected a proposal that the company  adopt broad “company-wide, quantitative, time-bound targets for reducing greenhouse gas emissions”.  While promises were made  to boost sustainable financing by 2025 and reach net-zero emissions by 2050, it is evident that there remain obstacles to overcome for shareholders and executives to fully embrace the integration of ESG targets into compensation metrics.  Given this hesitancy, there is an opportunity for government to intervene and encourage ESG participation, particularly through tax policy initiatives.

ESG impact of tax rules limiting deferral of employment income

Governments have shown increasing willingness to rely on business tax measures and income tax incentives to achieve ESG objectives and promote desired behaviour through the imposition of duties, carbon taxes and other measures. (See Deborah L. Jarvie, A Primer on the Federal Carbon Tax: Policy Review and Analysis Canadian Tax Foundation, Prairie Tax Conference 2018; and UK Parliamentary committee report published March 1, 2021 on “Tax after coronavirus”, which directly addressed the role of tax in promoting de-carbonisation.

The Income Tax Act (Canada) (Tax Act) provides  certain ESG-related tax benefits such as accelerated depreciation for zero emission vehicles and investments in clean energy, as well as allowing flow-through shares to be used by companies engaged in clean energy and conservation. In the 2021 federal budget, additional measures were introduced to encourage investment in clean technology incentives through reductions in corporate taxes applicable to eligible zero emission technology manufacturing as well as initiatives for the expansion of the availability of a preferred capital cost allowance regime for clean energy equipment.

In addition, portfolio managers and research analysts are responding to increasing calls from both activists and industry groups to incorporate ESG factors into their analysis and investment decision making.  Prominent in this effort is the world’s largest private money manager, Blackrock.  In its January 2020 shareholder annual report, Blackrock’s founder, Larry Fink, called on all companies (public and private) to report in alignment with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and the Sustainability Accounting Standards Board (SASB). By their count, there was a 363% increase in SASB disclosures and more than 1,700 organizations expressing support for the TCFD.  To further facilitate measurement, they are advising governments to agree on a common set of reporting rules for sustainability to deter corporate issuers from shopping for jurisdictions with less stringent enforcement.  In the U.S., Blackrock asks companies to disclose the diversity of their workforce, including demographics such as race, gender, and ethnicity. From June 2019 to July 2020, Blackrock voted against 55 directors/director-related items on climate-related issues.

Direct integration of ESG metrics (such as emissions, diversity targets and, employee engagement, to name a few) into the design of executive compensation arrangements may be another opportunity to further emphasize sustainable change.   

ESG and executive compensation

The familiar adage that “what gets measured gets managed” remains especially relevant when applied to executive compensation.  Senior executives derive a significant portion of their compensation from incentive pay, with executives in large organizations earning nearly 70% of their total pay through annual incentive and long-term incentive (LTI) payments rather than base salary. The metrics selected and calibrated within these incentive plans are typically linked to the business strategy as approved by the Board Directors.  At least in theory, businesses have the capacity to tie a significant portion of their executives’ incentive payouts to ESG performance.

In practice, implementation of ESG metrics in executive pay has been less than optimal. According to recent statistics, only 9% of the 2,684 companies listed in the FTSE All World Index tied executive pay to ESG in 2020.

In Canada, a 2019 Compensation Governance Partners survey of proxy circulars of 196 companies in the S&P/TSX revealed that 61% of 196 companies measured sustainability metrics in their incentives.  The survey also found that:

• ESG metrics were significantly more prevalent in short-term incentive plans – out of 282 disclosed metrics/goals, only 9 (3%) were part of a long-term incentive plan,

• When used as a weighted component, sustainability typically represented no more than 10% of total compensation, and

• Only 1% of companies weighed sustainability at over 20% of their incentive plan payout.

  
  

Clearly, there is a disconnect between the inherently long-term nature of ESG goals, and the tendency to use ESG metrics mainly in short-term plans. From a compensation perspective, the philosophy driving incentive design is neatly summarized in the Executive Compensation principles of the Canadian Coalition for Good Governance (CCGG), particularly Principle #2 focusing on pay for performance

Matching the performance period (and corresponding incentive payouts) to the risk being taken is key, and LTIs should be aligned with long-term business objectives. However, this begs the question: do existing tax rules (such as the “three-year rule” discussed below) allow an appropriate time period to measure performance in improving ESG metrics, particularly as ESG returns may take significantly longer to materialize?

Existing Canadian tax rules provide limited scope for deferring executive compensation.  These longstanding rules generally do not align with efforts to integrate ESG measures into executive compensation. 

Employment income is generally taxed upon receipt.  Under a broad anti-deferral rule, so-called “deferred amounts” under a “salary deferral arrangement” (SDA) may be taxed prior to receipt.   An SDA is broadly defined to include any arrangement under which any person has a right in a particular year to receive an amount after the year if it is reasonable to consider that “one of the main purposes” for the creation or existence of the right is to postpone tax on salary or wages for services rendered in the particular year or an earlier year.      

One widely used exception to the SDA rules applies to certain time-limited bonus plans.  Specifically, a plan is not an SDA if it is a “...plan or arrangement under which a taxpayer has a right to receive a bonus or similar payment in respect of services rendered by the taxpayer in a taxation year to be paid within three years following the end of the year” (the aforementioned “three-year rule”).  A prevalent LTI vehicle is a Restricted Share Unit (“RSU”) which is effectively a phantom unit tracking the underlying value of a share.  As the Canada Revenue Agency (CRA) considers RSUs to be referable to a particular bonus paid in respect of a particular year, the three-year rule requires that the RSUs referable to the particular bonus be paid out no later than December 31 of the third calendar year following the year in which the services were rendered.   Under this exception, if, for example, a right to an amount arises in respect of a service provided by the employee in 2021, the deferred amount must be fully paid out by no later than December 31, 2024 being no later than the end of the third year following the year of service for which the award is made.

While it is clear from the legislation that the three-year period must be counted from the year in which the services have been rendered by the taxpayer, the Canadian tax authorities have historically taken a restrictive view of how to determine the service year. In a recent technical interpretation (CRA Views Document number 2020-0864831I7 Equity Award Plan and Recharge Agreement dated March 19, 2021) the CRA considered a plan where the units were granted “early” in the first year.  The CRA concluded that if the units have positive value at the time of grant, it is likely that they would relate to past services rendered to the company prior to year of grant, thereby accelerating the mandatory payout date to three years after that prior year.  In effect the CRA adopts a rebuttable presumption that awards made early in the year must relate to employee service provided in the prior year.  This interpretation effectively shortens the deferral period to less than three years after the year of grant.

In addition, the “three-year” exception applies only to a “bonus or similar payment”; ordinary salary, as opposed to a bonus, generally cannot be deferred. Furthermore, other types of remuneration such as directors’ fees would not be eligible for deferral under the three-year rule. 

The CRA has also adopted a broad reading of the requirement in the SDA definition that “one of the main purposes” of the right is to postpone or defer tax (for example, see CRA Document Number 2020-0841961I7 Salary Deferral Arrangements.). While it should be reasonable to conclude that compensation awards that have their performance metrics tied to measurable ESG goals and that defer for periods longer than three years do not have the postponement or deferral of tax as a “main purpose”, this remains unduly uncertain.  The government could clarify the situation – and thereby foster the adoption of ESG-linked compensation – through clarifying amendments or guidance.

Suggested reforms

As explained in the previous section, current Canadian tax policies impede the effective integration of ESG objectives into executive compensation arrangement.  Suggested reforms include (i) clarifying that arrangements to defer employment income that are linked primarily to achieving ESG objectives will generally not be considered to have tax deferral as one of the main purposes for the arrangement, and (ii) adopting a more balanced approach to the application of the three-year rule where arrangements have an ESG component. 

A more ambitious reform would be to add a new exception to the SDA definition for compensation plans linked to ESG metrics.  By permitting the conventional three-year deferral to be rolled over and extended for an additional three years if predetermined ESG green shoots were evident at the end of the initial three-year period, a longer-term horizon to sustainable change through executive innovation and determination could be encouraged without veering too far from the existing deferred compensation regime. Alternatively, the three-year deferral could simply be extended to five years in situations where the metrics on which the payout is based are based on industry-specific sustainability objectives. 

Another approach could be to focus on vesting conditions to better align ESG metrics with executive incentives. Linking the vesting conditions of performance-based LTI awards such as stock options or performance share units to achieving certain measurable and relevant ESG metrics to the organization (e.g., average fatality rates, employment engagement scores, diversity targets as opposed to the more commonly seen IRR or other return metrics) may allow for integration of ESG into executive compensation without requiring material changes to the existing deferred compensation regime.

The 2021 federal budget confirmed the coming into force of certain previously announced changes to the stock option rules.  Citing a disproportionate benefit accruing to a small number of wealthy individuals,  the changes are intended to reduce the attractiveness of stock options to highly compensated individual at large well established companies (see here). Consistent with the stated public policy rationale for affording preferential tax treatment of employee stock options to support young and growing Canadian businesses, the rules were specifically drafted not to apply to Canadian-controlled private corporations or to companies with revenues under a specified threshold.

A modification to include corporations that achieve measurable and pre-determined ESG metrics in the subset of corporations exempt from these new stock option rules could be an effective method of incentivizing both employees and executives to think creatively about maximizing their contributions to ESG.

Even without these reforms, some organizations are already committing to changing executive behaviour, priorities and ultimately, corporate culture. Each of Canada’s six largest banks has added ESG components to the compensation frameworks of their CEOs, and each of them has committed to increasing employee diversity, from student internships to executive appointments.  Practically, this signals to public markets and executives that the Board and shareholders expect and value change.

While direct measurement of the effectiveness of broadening employee diversity at the summer student or junior employee levels may be measurable in the very short term, the limits imposed by the three-year rule are an obstacle to implementation of effective measurement metrics to assess whether these initial diverse hires improve the diversity in the talent and promotion pipeline of employees and potential executives. While we applaud diversity and inclusion initiatives, we anticipate that sustainable change involving talent development and new hire retention requires more than three years to measure whether medium- and long-term social objectives have been achieved in a meaningful manner.

Moreover, the identification of “measurable and relevant” ESG metrics for every industry is not a simple matter; that said, there continues to be rapid development of best practices and standards such as SASB’s Materiality Map which indicates sustainability issues that are likely to “affect the condition or operating performance of companies within an industry”. These guides may provide a starting point from which material metrics for most industries can be selected for use in LTIs.

Conclusion

Achieving critical objectives with a global and societal impact such as climate and social change will require innovative approaches in every corporate boardroom.  Canadians should demand the same commitment to innovation and agility from governments to help investors, directors, and executives clear the initial hurdles to chart a sustainable and equitable future. 

We welcome discussion across industry, academia and government about how Canada’s LTI programs, and the tax rules applicable to them, could be better designed to meet current ESG challenges and drive future opportunities.