Granting share options to motivate employees is increasingly an attractive option. But beware the tax implications for assignees, say Rebecca Darling, ECA’s product manager.
Forced to slash bonuses and implement salary freezes, how can employers affordably motivate and incentivise their key talent during the recession? Many companies may be considering share schemes as a possible solution. Following recent record lows, share prices are generally expected to increase over the next two or three years; newly granted share options therefore have the potential to yield significant rewards for employees at a lower set-up cost to the employer than providing the equivalent benefit in cash.
In many countries, a further advantage of share options is that income tax exemptions are available for plans that are structured in such a way as to qualify for approval by the tax authorities. However, when share options are granted to internationally mobile employees, the tax situation is usually far more complex, with significant repercussions for both the assignee and their employer.
Consider a non-mobile employee who is granted a share option that qualifies as "approved" in the country where they are resident. Typically, the plan rules will specify that after a certain period of time has elapsed (the vesting period), the employee will be permitted to exercise their option i.e. they can buy a certain number of shares in the company at a fixed price, which is often the market value of the shares at the date of grant. Providing the market value has risen during the vesting period, the employee who exercises their option makes a financial gain that is entirely or partially exempt from income tax due to the award’s approved status.
Now consider an employee who is granted the same option then sent on assignment to another country. The employee is still on assignment when the award subsequently vests and is exercised. A share option that is approved under the home country tax rules is unlikely to meet requirements for approval under another country’s rules. If the host country taxes unapproved options at the point of exercise, then the assignee may find that they are now liable to foreign tax on an award that was originally intended to avoid tax altogether.
To avoid restrictions on plan design, many share options are not set up to meet approval requirements and a tax liability is expected to arise somewhere from the outset. For international assignees, however, unexpected double taxation can arise due to the different points at which countries tax share option income. The majority of countries tax option gains at exercise, but there are notable exceptions. In Australia, for example, "unqualified" share awards are taxed at the point of grant (tax on "qualifying" awards is deferred until a later point in time; under recently drafted legislation, this is effectively at vest for awards granted after 30 June 2009). Having already paid Australian tax on the share option granted to them in their home country, Australian assignees may then find themselves liable to tax a second time if they exercise the option in a country that taxes at exercise.
The act of expatriation itself may be sufficient to trigger a tax liability. Share options granted to foreign nationals working in Singapore are deemed to have been exercised if the individual leaves Singapore for a period of at least three months. Under certain circumstances the employer can apply for a Tracking Option and defer taxation until the time when the options are genuinely exercised.
Double taxation can also arise when countries adopt different positions on how to source income from share option gains. Consider an assignee granted an option in his home country which he exercises in the host. If both countries tax at exercise, should the income be attributed to employment in the home country, as the award was granted there, or to the host country, where the gain actually crystallised? Or does the income relate to employment in both locations, to be apportioned between the two; and how? In reality any of these positions and more could be and are applied, resulting in double taxation where countries take different sourcing positions.
Once the tax due in each country has been calculated, there may be potential to relieve double taxation through domestic provisions or through a double taxation treaty. Treaties which follow the OECD model convention instruct that share option income should be apportioned according to the time worked in each country between the dates of grant and vest. Not all treaties follow this guidance; the treaty between the USA and the UK, for example, explicitly states that income should be sourced from grant to exercise.
A multi-jurisdictional tax liability is not just an issue for the assignee. As more and more tax authorities realise there are significant revenues to be made from share options and legislate accordingly, in an increasing number of countries there is a legal requirement to withhold tax due on share options and pay it over to the relevant authorities. Reporting requirements are also increasing and social security contributions may be due too. Large scale failure to meet all these obligations can result in significant penalties and interest, not to mention negative publicity.
Even where no withholding is required, assignees may still be obliged to pay tax through the end of year tax return process, otherwise they too will be subject to penalties. Whilst there is no legal requirement to assist assignees with their multiple filing and payment obligations it is worth remembering that the most sizeable share awards, which have the greatest potential for late payment penalties and unwanted publicity, are often received by very senior employees.
Delivering share option gains to employees in a timely fashion, having withheld the right tax and social security contributions and complied with reporting requirements in multiple countries, is undoubtedly a challenge, so it doesn’t help that the tax compliance rules relating to share awards are constantly changing. In India, for example, it has recently been proposed that Fringe Benefits Tax, currently paid by employers on the value of various employee benefits including share options, should be abolished. Share options will instead be taxable as income in the hands of the employee, so employers will be required to comply with withholding regulations rather than FBT regulations. A possible advantage to mobile employees is eligibility for Foreign Tax Credits now that the tax paid is classed as income tax rather than Fringe Benefits Tax. Interestingly, the income tax exemptions that previously applied to qualified share options when they were taxed as income prior to the introduction of FBT are not being reintroduced.
In addition, whilst the focus of this article has mainly been on share options, in recent years more and more companies have been using alternative vehicles such as Restricted Share Units (RSUs) to reward their employees with equity, and further legislation is being introduced worldwide in response. China, for example, issued a circular this year that effectively extended to RSUs and Share Appreciation Rights the specific tax treatment and reporting requirements that had previously applied only to share options.
Another consideration is if the company applies tax equalisation or tax protection as part of its international assignment policy. Should the policy apply to share scheme income? Many companies don’t apply tax equalisation or protection to share option gains, or consider them personal rather than employment income and by extension don’t equalise personal income. Other companies do tax equalise or protect the income realised from some or all types of share scheme offered to their mobile employees, adding yet more complexity to proceedings. Deducting a hypothetical tax amount from the employee’s gain does not exempt the employer from its various withholding obligations. Further, if the total tax due exceeds hypo-tax withheld then an additional gross-up will be required to cover the additional tax paid by the employer in each jurisdiction where tax is due.
As tax authorities worldwide continue to increase their focus on compliance in this complicated area, it is more important than ever that those with responsibility for international assignments keep track of their assignees’ movements and collaborate with their professional advisers and colleagues in tax, legal and payroll to ensure that the company meets its obligations. Even after the assignment has ended, the requirement to pay and withhold tax in multiple jurisdictions may still arise if the employee exercises a share option in their home country that they held whilst on assignment elsewhere.