Foreign Income & Taxpayers
More and more companies operate on a global basis to expand their market reach, create cost efficiencies, and leverage their resources. To attract, motivate, and retain their employees, these multinational companies reward their worldwide workforce with equity grants.
In the past, the long-term incentive generally was a plain vanilla stock option granted at fair market value (FMV), with a ten-year term and vesting period of three or four years. However, with the U.S. adoption of Statement of Financial Accounting Standards (FAS) No. 123R, Share-Based Payment , which requires stock options to be expensed on the balance sheet, companies have granted more and more equity alternatives, including restricted stock, restricted stock units, stock appreciation rights, phantom stock, and indexed options. When granting a stock option before the adoption of FAS 123R, multinational companies faced difficulties in complying with the various tax and accounting rules that were unique to each country. This task has become even more difficult with the granting of these various other long-term incentives.
Another compounding problem is that although U.S. tax laws regarding equity awards have remained fairly consistent over the past 15 or 20 years, international tax laws have not. Many foreign countries’ equity requirements for income and social tax and withholding obligations change annually, and sometimes more often than that. Foreign countries have also been slow to adapt and provide guidance for the many long-term equity award alternatives such as restricted stock units and indexed options. Therefore, careful consideration is needed before a company begins to issue long-term incentives in foreign tax jurisdictions.
The following is a brief review of recent developments in four countries.
In the past, Italy had one of the most share scheme–favored regulations in Europe. In recent years, however, Italy has imposed regulations that are increasingly strict and challenging. In 2004, stock-based benefits to employees required qualified intermediaries. In 2006, the qualified stock option plan required a three-year vesting period and a five-year holding period. By complying with the qualified plan rules, an individual could avoid both income and social taxes, but due to the complexity of all the qualified requirements and the administrative hassles, Italy changed its rules again. The new rules subject the equity gain to income tax but exempt social taxes. However, the new rules are prospective, so if an option was exercised prior to their inception, a careful tracking will be needed to determine which tax regime was applicable at the time of the grant. This has created a challenging environment.
Previous legislation: Under Law Decree 262/06, qualified stock options benefited from income tax and social security exemption. Qualifications were based on five criteria:
- Exercise price is equal to or greater than the price of the share on the grant date;
- An employee cannot hold more than 10% of the company’s voting rights or capital;
- The vesting period is at least three years;
- The company is listed on a recognized stock exchange at vesting; and
- An employee retains an investment in the shares underlying the options at least equal to the gain from the transaction for a holding period of five years at the exercise date.
Stock options that did not qualify were subject to both income tax and social security contributions.
New legislation: Under Law Decree 112/2008, qualified stock options benefit from social security exemption only. The new decree applies to options exercised on or after June 25, 2008. Options exercised prior to this date are not affected. Taxable employment income arises upon exercise of the options. The difference between the normal value of the shares on the exercise date and the exercise price is subject to income tax. Employers are considered withholding agents having an obligation to withhold income tax.
Implications: The elimination of the income tax exemption entails more responsibilities on the part of the employers. Employers should have proper income tax withholding procedures in place for stock option exercises and must proactively inform their employees that stock options are no longer exempted from income taxation.
For years, India’s tax regulations on stock options were concerned with exchange controls. Over time, as India’s global presence expanded, the government changed the tax rules to benefit individuals. The government implemented tax-favored plans that allowed option holders to defer taxation until the holder sold the shares acquired via the option exercise. With the rise of the global economy during the mid-2000s, the India stock exchange grew at an annual rate of 20%. As the stock market performance transformed many citizens into paper millionaires, the tax authorities changed the regulations to capture more of this growing wealth.
In 2007, the Indian government created a fringe benefit tax (FBT), which was assessed against the employer, who in turn could shift the taxation to the employee (Finance Act, 2005, amending India Income Tax Act, 1961, ch. XII-H). The amount of taxable income was generally calculated at more than one-third of the option’s vesting value. Ideally, the FBT would be able to capture revenues from large gains earlier than an exercise or resale date. When stock market performances declined, however, the FBT failed to generate large or even adequate revenue because the vested values were dramatically lower than anticipated. Furthermore, employers incurred significant administrative costs in complying with the FBT regulations. The calculations for the taxable gain were complex and tedious. In the fall of 2009, the FBT was eliminated (Finance Act (No. 2), 2009, enacting India Income Tax Act, 1961, §115WM).
Previous legislation: Employers were required to pay the FBT when stock options and other equity awards vested. The FBT was assessed on the difference between the FMV on the vesting date and the exercise price paid by the employee at a rate of 33.99%. The employer could not withhold the tax from employees, nor could it deduct the FBT as an expense. The compliance and administration costs were greater than the tax revenue collected.
New legislation: With the repeal of the FBT, employees pay income tax upon exercising options or other equity awards. Income tax is assessed on the difference between the FMV of the shares on the exercise date and the purchase price paid. Employers are obligated to withhold income taxes on the occurrence of such events.
Implications: Compared with the FBT, the new legislation is much simpler for companies to implement. However, employers should have proper income tax withholding procedures in place to ensure a smooth transition.
In a departure from its share scheme system that followed the United Kingdom and generally provided tax-favored opportunities for employees and employers, new rules were proposed in the spring of 2009. The draft 2009–2010 federal budget proposed new, strict regulations for equity awards. The proposed effective date was May 12, 2009, with no tax deferral alternatives available. The government was met with strong opposition from the business community. After further consideration, the effective date was pushed back to July 2009, and the deferral of tax is allowable under “real risk of forfeiture” situations. Generally, a real risk of forfeiture would be similar to a typical vesting schedule in which the options are forfeited if services are not performed.
Previous legislation: Under the 2008–2009 federal budget, employees awarded qualifying shares or rights under an employee share scheme were taxed at cessation time, which is generally one of the following:
- Vesting date;
- Exercise date; or
- Purchase date.
Employees could also elect to be taxed on the grant date. In such a case, up to AU$1,000 of the taxable amount may be exempt from taxation.
New legislation: The changes in the 2009–2010 federal budget are applicable only to shares and rights acquired after July 1, 2009. Shares and rights awarded to employees under an employee share scheme are subject to taxation on the grant date, with the AU$1,000 exemption available only to employees meeting the necessary requirements. An employee may defer tax liability in certain limited circumstances, including the existence of a real risk of forfeiture. A real risk of forfeiture includes situations where a share or right is subject to meaningful performance hurdles or where the shares or rights will be forfeited if a minimum term of employment is not completed. The taxing point is deferred to when the risk no longer exists.
Implications: While tax deferral is still possible, employers must consider the uncertainties associated with real risk of forfeiture. There is no clear definition or specific guidance provided for qualifying under this safe harbor. Employers have the additional administrative responsibilities of monitoring employees’ payment dates. Because the taxing points depend on the structure of the employee share schemes, employers may have to restructure the employee equity award plans to obtain the optimum overall tax treatment.
People’s Republic of China
The current tax system in China is still young compared with the United States and most European countries. While the central government implements tax regulations in a strict manner, emphasizing consistency, local governments are still relatively inconsistent and disorganized in their implementation. In addition to implementation issues, similar to India, Chinese tax regulation in the past mainly focused on the regulation of currencies in and out of China. Between 2005 and 2008, the Chinese government issued various circulars, all dealing with administration, registration, and currency control. With the publication of Circular 461, however, China introduced its first operational focused tax regulations.
Previous legislation: Circular 35 (2005) provided that income derived from employees’ stock options should be treated as stand-alone income, taxed at progressive rates. Circular 902 (2006) clarified that the above legislation is applicable only to publicly listed companies. Circular 5 (2009) extended the preferential tax treatment of stock options to both stock appreciation rights and restricted share units.
New legislation: Circular 461 (2009) builds on previous legislation by providing clarification and additional guidance on actual operational procedures. Stock appreciation rights (SARs) are taxed at the time of exercise. The taxable amount is the difference between the shares’ FMV on the exercise date and the grant date.
Restricted share units (RSUs) are taxed when they become fully vested. The taxable amount is calculated using an average of the shares’ FMV on the grant date and the vesting date. The taxable amount is then multiplied by the number of shares vesting minus the portion of the total price paid by the employee for the award at grant allocated to the vesting shares.
Limitations and clarifications:
- A listed company includes its subsidiaries that have at least a 30% direct or indirect shareholding interest.
- The equity plan must be set up after the company has become listed; any plan that was in place before the company became listed would not qualify.
- The listed company must register its share options and SAR plans with the in-charge local tax bureaus before the plans are implemented and must provide additional relevant information before options and SARs are exercised and taxable income is reported.
- Circular 461 made it clear that the registration requirements apply to listed overseas companies as well as to domestic Chinese companies.
Implications: As with any new tax legislation, employers should take the necessary preoperational steps to ensure compliance with the new requirements. Furthermore, employers must understand how to calculate the taxable amount according to the new provisions.
The complexity of these tax legislations cannot be explained thoroughly in a short summary. The above represents just a brief overview of the tax changes for each country. Beyond tax requirements, multinational companies need to comply with registration requirements, accounting issues, data privacy rules, and various other issues that may be unique to each foreign country in which equity is granted and eventually exercised by the employee.
Editor: Kevin D. Anderson, CPA, J.D.
Kevin Anderson is a partner, National Tax Services, with BDO Seidman, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.