Following on from our readers’ interest in the exploits of the redoubtable Maurice Brightman and the advice he gave to Stephen Holmes of Polycon Lens Company last month on permanent establishments, we are tackling this month the thorny question of how to incentivise Polycon employees through stock option arrangements. Lara and Dmitry have written the article below which explains many of the pitfalls I have come across when advising international companies on this subject, and have briefly outlined an ‘Alternative Stock Option Plan’ that I have devised for several clients in recent years.
The legislation of each country relating to stock options, as indeed other topics, is carefully scrutinised in the 2010 edition of “International Tax Systems and Planning Techniques” or ITSAPT. This is being published by Sweet & Maxwell and will be available at the end of this month and also (at a 20% discounted price) for those who attend our ITSAPT Conference at the Landmark Hotel in London on 28th October.
As I have explained previously, the ITSAPT Conference analyses the development of the Polycon Group into a worldwide conglomerate, exploring the tax issues arising at each stage of the group’s development. It also carries with it 6 hours of CPD accreditation from the Solicitors Regulation Authority. I hope that you enjoy reading the article on stock options, and would welcome any comments that you have – click here. Also, in the event that you would like further information about the Conference, please click here.
Incentivising Employees through Securities Options
About to leave the office for a well-deserved Christmas break, Stephen Holmes sat down to think about the past year. He thought that although markets fluctuated wildly, his clients never let him down: neither fashion victims, hooked on changing their designer spectacles every month, nor the army, using sophisticated optics to promote their means across the world. Unlike his insatiable customers, satisfied with what they were getting, the same could not be said about Mr Holmes’s employees, and the issue of keeping his staff happy and motivated deeply troubled the benevolent patriarch.
We are reminding you that Mr Holmes is the protagonist of the case study that lies in the beginning of International Tax Systems and Planning Techniques (ITSAPT) – the leading international tax reference book which Roy started over 27 years ago and which completed its 59th loose leaf version in April this year. It has now been re-written, brought up to date as at the end of June 2010 and will be available in a bound version and on-line as from September 2010. Roy would like to thank our colleagues in over 30 jurisdictions for their invaluable contributions to this new book. The case study will also form the basis of the first ITSAPT Conference which will be held at The Landmark Hotel, 222 Marylebone Road, London, NW1 6JQ on Thursday, 28 October 2010 and which will be a unique opportunity to listen to international tax experts from over 20 different jurisdictions discuss the commercial and tax issues relevant to the development of a company as it becomes an internationally renowned brand name and successfully quoted multinational group. For further details and information on how to reserve a place on the conference, click here.
Let us return to Mr Holmes who on his way home met Maurice Brightman to seek advice about the best and the most tax-efficient way to motivate Polycon’s staff across the globe. Mr Brightman agreed with Mr Holmes that giving a pay rise constitutes a very short-term and expensive solution for the company. Instead he suggested instilling the sense of ownership vis-à-vis the corporation through stock options and pushing the employees to perform better in order to reap the benefits when the company’s value appreciates.
He explained that a stock option (or a share option) is a right granted to an employee by a corporation that allows the employee to purchase a certain number of shares at a specified price (the “option price”) at a specified period of time. The corporation is usually either the employer corporation or in the same corporate group. The option price is usually greater than or equal to the market price at the time the option is granted. Typically, there is a “curing period” during which the employee cannot exercise the option. When this period has expired, the option is considered to “vest” with the employee who thereafter can “exercise” the option at any time during the specified period. Frequently, an employee may be granted a number of options with some of the options vesting before the others so that the longer the employee works for the corporate group, the more options that vest with the employee.
The “option benefit” is the difference between the option price and market price at the exercise date. The general rule is that this option benefit is treated as employment income. Maurice explained that while the idea behind stock options is uniform across the developed world, what differs are the specifics that determine the portion of the option benefit that is taxable, whether it is taxable, the timing of the taxable event and the kind of tax, chargeable on granting and exercising the option, as well as on subsequent share disposals. Mr Holmes, conscious that Mrs Holmes would have dinner on the table before long, asked Mr Brightman to highlight in a written memorandum the most important points for him to understand before deciding on how he may incentivise his various employees around the world.
The next day, Maurice reviewed the memorandum again (replicated below) confident that some of the pertinent issues relevant to an international group such as Polycon were sufficiently explained to Mr Holmes, but that he would undoubtedly highlight on the Alternative Stock Option Plan at the end of the memorandum for further discussion.
Memorandum for Polycon Lens Company re Stock Options
A. Timing of taxable event and characterisation of option income
Typically, a country may tax the benefits resulting from an employee stock option plan at one or more of the following events:
* When the option is granted;
* When the option vests;
* When the option is exercised;
* When there are no longer any restrictions on the sale of the shares acquired under the option; or
* When the shares acquired under the option are sold.
The timing mismatch caused by the varying rules of different countries may lead to issues of double taxation or double non-taxation, as described below.
Not only may there be a timing mismatch, but option income is characterised differently in different countries – as employment income in some countries and as capital gains by others.
For example, Belgium taxes stock options on grant like a benefit in kind, irrespective of whether the grant of the option is conditional or otherwise. The interesting consequence of this is that the granting of the option can create a tax charge even if the option is never exercised.
A parallel can be drawn with Luxembourg that does not have any specific legislation in relation to the granting of shares or share options to employees, except that the tax treatment of options depends on their transferability. Transferable share options are regarded as a benefit in kind and hence taxable at the time of the granting of the option. Non-transferable share options, that is, options that cannot be sold by the employee to third parties, are taxable on the date on which they are exercised. Thus, where the option is transferable, this gives rise to an effective asset and it is therefore appropriate for this to be taxed on grant.
Singapore bases its tax jurisdiction on the territoriality principle. Share options exercised or vested on account of the local employment are taxable in Singapore either on the date of grant or on the date of vesting if vesting is imposed. The option gain from stock options granted for non-Singapore employment is exempt from tax even if exercised in Singapore. Equally, in Hong Kong gains on exercise or sale of share options will be deemed employment income of an employee and subjected to salaries tax. However, to be assessable, the gain to be taxed must be from Hong Kong employment leaving open some planning possibilities for employees able to prove that options were granted at a time when they did not have Hong Kong employment.
In Germany, it is not the granting of a stock option to an employee, but its exercise, which is a taxable event, to the extent the market value of the shares at the time of exercise exceeds the exercise price (strike price). According to some commentators, however, the option exercise can produce non-taxable income: any advantage derived therefrom is outside the context of the employee relationship and, as a purely private event, not subject to tax under German law. The exercise of a stock option creates taxable income for the employee, which at high marginal tax rate of some of the employees may have a disincentivising effect. Consequently, to counter the undesired tax consequences companies may have to offer quite expensive stock option packages to its key German personnel.
Compared to the above, the United Kingdom is a state with a clear two-tiered system that separates non-approved and approved employee options schemes. Taxation of the former is reminiscent of the principles applicable in the jurisdictions described above. In limited circumstances employees may incur an income tax liability when the options are granted, inter alia, to non-resident employees or at a discount under the CSOP approved scheme. Other than that, the liability to tax is determined by the individual’s place of residence at the time the option is granted (even if the employee becomes non-resident before the option is exercised). The view taken by HMRC, although this is far from set in concrete, is that if the individual is no longer resident in the UK at the time the option is exercised, assigned or released, there may still be a liability to tax, notwithstanding the fact that the person is non-UK resident since, as stated above, the grant of an option is the taxable event and arises from a UK employment, even if the tax is only chargeable on exercise.
The options granted under extensive HMRC-approved schemes enjoy preferential treatment, and the income tax or National Insurance Contributions charges do not normally apply when the options are granted, or in respect of the acquisition of the shares acquired under their terms. Subsequent disposal of the shares acquired by the option will be chargeable to capital gains tax under normal conditions. However, the limits available under approved schemes are so small for top executives (in US as well as UK) that they are unlikely to be of interest, as explained below.
B. Timing mismatch and problems for mobile employees
Because countries tax option income at different times and characterise it differently, where holders of stock options perform services or reside in different countries, the different rules can lead to potential double taxation or double non-taxation. For example, if a Belgian resident employee of Polycon’s Belgian subsidiary is granted stock options and then moves to Germany, he potentially could be taxed both in Belgium on grant and Germany on exercise. By the same token, if a German resident employee is granted options and then moves to Belgium where he then exercises the option, there would be no tax charge on grant in Germany and no tax charge on exercise under the Belgian rules. Furthermore, the subsequent sale of the shares would not lead to a capital gains tax charge in Belgium.
And so how is this problem addressed by double taxation treaties? There being no specific article in the OECD Model Treaty dealing with stock options, the OECD issued a series of recommendations to clarify how tax treaties should address the differing interpretations of countries on this subject. The 2005 publication, The Taxation of Employee Stock Options is a comprehensive run through of the issues, as summarised below.
In the first example above of potential double taxation, Article 15 of the OECD Model Treaty allows the state of source to tax not only income from employment which is paid, credited or otherwise definitively acquired when the employee is present therein, but also any income obtained or realised before or after such presence that is derived from the services performed in the state of source (Belgium). But this does not necessarily address the problem illustrated above, as it does not prevent the state of residence (say now Germany) from also taxing the same benefit at a different time and in a different way under the domestic rules of that state. The problem of relieving double taxation when the two states do not tax the option at the same time is partly addressed by the fact that the double taxation provisions of the OECD Model Treaty are not restrictive in terms of time i.e. relief must be given even if the state of residence taxes at a different time from the state of source. The OECD added a new paragraph 2.2 to the Commentary on Article 15 which addresses this issue.
Another issue arises where the two states not only tax at different times but also characterise the benefit differently. Although there may be no doubt that the granting by a company of an option provided as part of an employee’s employment package constitutes “salaries, wages and other similar remuneration” for the purposes of Article 15, it could certainly be argued that the holding and subsequent exercise of the option is an investment leading to a capital gain under Article 13, which unlike Article 15 does not allow source taxation of the gain. Some commentators have argued that this analysis should only apply to the part of the gain that accrues after the option has vested since the employee cannot make an investment decision to keep or exercise the option before that time. It has also been suggested, however, that any benefit derived from the option, including any gain realised upon the sale of shares acquired with that option, should be considered as employment income as the employee exercised the option and acquired the share solely because he was remunerated with that option.
Although some countries treat the entire benefit from a stock option as a capital gain, a larger number of countries tax as employment income the whole gain realised at the time of exercising the option, therefore indicating, for the purposes of Article 13 and 15, a dividing line between when the option is exercised and when the employee becomes a shareholder. The OECD shares this view so that any benefit accruing in relation to the option up to the time when the option is exercised, sold or otherwise alienated should be treated as income from employment to which Article 15 applies. Indeed, the new paragraph 32 to the Commentary on Article 13 states these conclusions.
The 2005 Report also addresses other potential areas for difficulty, such as determining to which services the option relates where the services are performed in more than one state and multiple residence taxation. These proposals are in important step in harmonising the disparate tax rules for stock options.
C. Approved schemes vs Non-Approved schemes
The United Kingdom allows for two types of employee option schemes that are selective in nature i.e. offered on a selective basis to key personnel: the company share option plan (CSOP) and the enterprise management incentive share option scheme (EMI). It is these schemes that may interest Polycon, rather than the all employee schemes.
Under a CSOP selected employees, including directors, may be given an option to buy a certain number of shares at a future date at a price fixed at the time the share options are granted at the maximum share value of £30,000 per person. Participation in the scheme is not open to employees who own more than 25% of the company. Subject to the scheme receiving a preliminary HMRC approval, no income tax and National Insurance Contributions (NICs) is charged on the exercise of the option provided the option is exercised between three and ten years after it was granted. Full tax relief is available when the option is exercised early due to exceptional circumstances. Subsequent disposal of the shares acquired by the option will be chargeable to capital gains tax under normal conditions. The base cost would be the exercise price paid for the shares plus the amount chargeable to income tax.
The EMI Scheme is for smaller, higher risk companies. In order to qualify, the company’s gross assets must not exceed £30 million, and conditions are attached to the amount of work that employees must do for the company. Options over shares worth at the date of grant up to £120,000 (including any amount granted under an approved CSOP) can be granted. This is subject to a limit of £3 million of options for the company as a whole. Subject to certain restrictions, income tax and NIC exemption is subject to the condition that an EMI option is exercised within ten years.
In circumstances where share options are granted under the UK approved schemes, the eventual gain on sale of the shares is subject to capital gains tax calculated on the ordinary basis after deducting all costs incurred in acquiring the shares. Where share option schemes are unapproved, and subject to income tax at the date of exercising the options, the subsequent sale of the shares will nevertheless also be subject to capital gains tax calculated by reference to the difference between the basis on which the income tax charge is calculated as above (market value at the time of exercising the options), and the eventual net sale proceeds.
Thus the UK encourages employers to motivate their staff through participation in the company’s share capital through offering substantial tax benefits. These primarily relate to the absence of income tax liability on exercise of the options as any subsequent disposal of shares is uniformly subject to the capital gains charge. The major draw-back of HMRC approved schemes is a frequent inability of foreign corporations to comply with the requirements attached to such option plans or their unsuitability for a particular enterprise. By way of example, failure to have a UK permanent establishment or to exercise a qualifying activity automatically precludes a company from implementing an EMI. Alternatively, the £30,000 share value per person barrier may deter it from introducing a CSOP, particularly for top executives. Therefore, non-approved schemes are often used, leading to the tax consequences explained above.
In the United States, stock option plans are either ‘qualified’ or ‘nonqualified’ in nature. Preferential tax treatment is given to the holders of options issued under qualified plans in that there is no realisation of income for federal income tax purposes when the option is issued by the company or exercised by the holder. In the case of nonqualified stock options an employee will realise income, at ordinary income tax rates, when they exercise their options if the fair market value of the shares purchased exceeds the price they paid for the shares under their option.
Thus, if the fair market value of the shares under a nonqualified plan, when the options are exercised, is greater than the option exercise price, the employee’s tax obligation can be substantial. Since the employee’s profits in the stock may not be liquid (i.e. the stock may be restricted or the market for the stock may be limited) he may have to pay those taxes from his other resources.
By contrast, holders of qualified stock options incur no federal tax obligations until they sell their stock at a profit, with no income being realised when the option is issued or exercised. When the stock is later sold, the gain realised is taxed at the lower personal capital gains rates.
The significant benefits of qualified stock option schemes are conferred only after authorisation has been granted by the IRS, and are subject to shareholder approval within 12 months of adoption by the company’s board of directors. Specific classes of employees must be identified, with each option valid for no more than 10 years. Most important, as with the UK, there is an upper limit so that the total fair market value of stock subject to qualified options that can vest in any one employee in any one year cannot exceed $100,000. If less than the total $100,000 in value is not used in a given year, a portion of the unused part may be exercised in later years.
Any incentive stock option plan that does not meet all of the requirements of a qualified stock plan, is treated by the IRS as nonqualified. This means that although the employee will not receive the tax advantages of holding qualified options, they will not be subject to the $100,000 value limitation or to the requirement that they are employees. Nor does the term of their options need to be tied to their employment.
Nonqualified options issued to employees also entitle the issuing company to deduct against its income tax obligations an amount equal to the compensation income attributed to the employee upon the exercise of the option. The amount of this deduction is the same as the amount of income attributed and taxed to the employee because of his exercise of the option, being the difference between the option exercise price and the fair market value of the shares purchased. To be certain of obtaining the deduction, the company should be sure to withhold the proper amount from the employee’s income.
It is also important not to forget the alternative minimum tax (AMT) consequences of obtaining rights under a qualified plan. The difference between the holder’s exercise price for the shares in a qualified plan and the fair market value of those shares when he exercises the option is a tax preference item that may become subject to the alternative minimum tax. The application of the AMT rules can make qualified options less attractive to these individuals.
D. Alternative Stock Option Plans
A company that wishes to incentivise its employees in a tax efficient manner without necessarily granting them control over their option shares may benefit from alternative arrangements which are designed to create capital gain from investment rather than employment income. The main features of such plans involve the company granting the staff the right to buy say non-voting shares, which can be retained or sold for gain, provided that the employer does well and the shares appreciate in value. The acquisition of such shares will not trigger an income tax or NIC liability, whilst the disposal of such shares will create a capital gains tax liability.
The plan may further be split into separate stages and is best illustrated by an example. The employer may wish to incentivise its employees and grant them the right to buy in aggregate say 20 percent of its non-voting dividend bearing shares. In furtherance of its goal, it sets up a discretionary unit trust that will hold the shares during a relevant period of say 5 years, so that the employees do not have absolute access to these shares during that period. Assume that the shares have an expected dividend yield of 5% p.a.
The company extends non-recourse loans to the employees at say a 5% annual interest rate. The individuals use the proceeds of these loans to acquire units in the unit trust (used as security for the loans). In turn, the trustees of the unit trust use the amounts received from the subscription of the units to subscribe for 20 per cent of non-voting shares in the company. The underlying trust deed provides that through holding the trust unit, the employee is beneficially entitled to the income from the relevant assets of the trust, which in this case comprise the non-voting shares.
The company declares dividends on its non-voting shares, which it distributes to the unit trust. The dividend amount is calculated to be equal to the interest on the loans owed by the employees. The unit trust distributes the dividends to the unit holders, who use them to repay the interest on the loans to the employer.
At the end of say a five year period, the trustees of the Unit Trust exercise their discretion over the trust assets, and redeem the units by distributing the non-voting shares in specie to the employees. The employees are then at liberty to keep the shares and receive dividends or sell them for gain, chargeable to capital gains tax. The original loans plus interest are still accruing, or the employees may repay the loans (which may indeed be a condition of the in specie distribution.
If the employer company is unable to declare dividends on its non-voting shares, thus ceasing the only source of the unit trust’s (and by proxy the employees’) income, the company allows the interest due from the employees to be accumulated until better times. Should the company neither be able to declare dividends nor increase the value of its non-voting shares to grow in excess of the loans plus cumulative interest, the employer waives the loan and covers out of its own funds the income tax and NIC chargeable on the waived loan and interest, thus keeping the employee’s tax position unaffected.
Employer companies often calculate that the limited costs of alternative stock option plans (even with potential income tax charges if the company fails to increase in value) is a much better ‘option’ than incurring the substantial costs of entering into stock option arrangements, accepting the restrictions imposed under approved schemes, and potentially exposing employees to unintended tax costs as outlined above.