Editor: Mary Van Leuven, J.D., LL.M.
Non-U.S.-headquartered entities (inbound employers) seeking global expansion of business operations will often look to U.S. markets and bring employees into the United States in search of growth. While it may seem that a decision to expand business operations or send employees to the United States would be based on a straightforward cost/benefit analysis from a business perspective, the complex U.S. tax consequences associated with certain compensation arrangements are frequently overlooked. In particular, compensatory equity, such as company stock, held by employees that was acquired in connection with the performance of services may result in unexpected issues.
For ease of reference, this item refers to employers and employees; however, the same rules and issues may be relevant to other types of service recipients and service providers. Further, this item focuses only on U.S. federal income tax issues associated with inbound employers and employees (other than U.S. citizens or green-card holders) and is not intended to address other potential U.S. tax and reporting consequences.
General property transfer rules
Under Sec. 83, property transferred to an employee in connection with the performance of services generally results in taxable compensation for the employee when the employee vests in the property and in a corresponding compensation deduction for the employer. The amount of taxable compensation is the fair market value (FMV) of the property at vesting, less any amount paid by the employee for the property. However, if a Sec. 83(b) election is made by the employee within 30 days of the initial transfer of the restricted (unvested) property, then the taxable compensation is equal to the FMV of the property less the amount paid at the time of the initial transfer.
Property for these purposes includes real and personal property, but it does not include money or an unfunded promise to pay money or property in the future (Regs. Sec. 1.83-3(e)). Property becomes vested when it is no longer subject to a substantial risk of forfeiture. For Sec. 83 purposes, a substantial risk of forfeiture exists only if the rights in the property are conditioned, directly or indirectly, either on the future performance (or refraining from performance) of substantial services or on the occurrence of a condition related to a purpose of the transfer, if the possibility of forfeiture is substantial (Regs. Sec. 1.83-3(c)(1)). A classic example of a substantial risk of forfeiture is a service-based vesting provision under which the right to full ownership does not occur until a service period is completed and the property is forfeited if employment is terminated at any point before the end of the service period.
Common issues for inbound employers and employees that become U.S. taxpayers
Is it property?: One starting point for any Sec. 83 analysis is to ask whether property has been transferred. Often, property transfers involve the issuance of company stock to an employee. Careful review of the award agreement or plan document is often necessary, however, to determine whether the employee has been granted a current beneficial ownership in property as opposed to a right to receive something in the future that is more properly characterized at grant as an unfunded, unsecured obligation to pay deferred compensation.
For example, under a virtual share plan or a deferred share plan, it may appear that the employee acquires a right to receive company stock upon grant; however, a more thorough review may indicate that, from a U.S. tax perspective, the employee acquires only a promise to be paid company shares in the future (see, e.g., IRS Letter Ruling 9308022). As a result, consideration of the Sec. 409A nonqualified deferred compensation rules, which may result in additional U.S. tax, is necessary.
Is there a substantial risk of forfeiture?: Non-U.S. equity-based plans frequently include "good," "bad," and "intermediate" leaver provisions. Although there are many variations, these provisions often require compulsory transfer of property to the employer or other shareholders at a specified price (which may not be FMV) on the occurrence of certain leaver events (e.g., termination due to death, disability, voluntary resignation, or termination with or without cause). The employee may be entitled to retain a certain percentage of shares based on the reason for the termination.
Whether these leaver provisions create a substantial risk of forfeiture for Sec. 83 purposes and when that risk lapses depend on how the provisions are drafted. For example, although forfeiture in the event of termination due to the commission of a crime or fraud is generally not considered a substantial risk of forfeiture, a broadly drafted "bad" leaver provision may include voluntary resignation. In Austin, 141 T.C. 551 (2013), the Tax Court concluded that a broadly drafted "for cause" provision created a substantial risk of forfeiture.
Thus, reviewing leaver provisions before the performance of services in the United States — to determine (1) the extent to which a substantial risk of forfeiture exists, and (2) whether they would continue to apply while services are performed in the United States — provides an opportunity to mitigate any potential unexpected U.S. federal tax consequences under Sec. 83. After services are performed in the United States and while property is unvested, it is often too late to mitigate the application of Sec. 83. Note that U.S. citizens and green-card holders are generally taxable on worldwide income, and, therefore, they may be subject to U.S. taxation regardless of where services are performed.
What if no Sec. 83(b) election was made?: While an inbound employer and its employees may be familiar with the relevant income tax elections in their home country (e.g., a U.K. Section 431 election), they may not realize that a U.S. election is available and required for similar tax treatment. In particular, a Sec. 83(b) election may be made to shift the U.S. federal income tax point from vesting to transfer so that appreciation in value following the initial transfer is capital gain. Even if the employee is a nonresident when the property is transferred, the opportunity to make a Sec. 83(b) election is likely still unavailable (see, e.g., IRS Letter Ruling 8711107).
If the Sec. 83(b) election is not made at transfer, then the employee may be subject to U.S. federal income taxation when the property vests. The amount subject to U.S. taxation may depend on whether the employee becomes a resident during the vesting period or remains a nonresident throughout the vesting period. As indicated above, however, if the Sec. 83(b) election is timely made, then no amount is subject to U.S. federal income taxation at vesting.
Is the Sec. 83(b) election timely?: Considering the lack of a Sec. 83(b) election in hindsight often raises questions about when the 30-day period starts. The election timing is tied to the property transfer date. Thus, the Sec. 83(b) election is timely only if it is made within 30 days of transfer of the property. There is no special exception that permits an employee to make the Sec. 83(b) election within 30 days of the date the employee begins to perform services in the United States.
If an election is going to be made, care should be exercised to make sure that it is done in a timely manner. Whether the election is considered timely is generally determined by reference to the postmark date on the envelope in which the election was mailed to the IRS, and if the 30th day following the property transfer falls on a Saturday, Sunday, or legal holiday, the election is considered timely if postmarked by the next business day (see Rev. Proc. 2012-29). Appropriate documentation to establish timely filing is often recommended.
In an effort to ease any administrative burden on its employees, an employer may offer to gather Sec. 83(b) elections voluntarily made by its employees and file them with the IRS. This approach appears sufficient to satisfy the timely filing requirement (see, e.g., IRS Letter Ruling 201606015). However, employers may want to consult with their legal advisers to understand whether there are legal implications if, for example, the Sec. 83(b) election is postmarked late or is not actually mailed due to an inadvertent administrative error.
Is there a requirement to make a Sec. 83(b) election?: From a U.S. tax perspective, whether an employee makes a Sec. 83(b) election is purely within the employee's discretion, as long as it is not otherwise prohibited through contract. Further, the decision to make the election may hinge on a number of factors, including, for example, the employee's personal financial situation, the likelihood that the property will increase in value, and whether the employee expects to continue employment without a forfeiture of the employee's right to the full ownership of the property. While an employer may want certainty regarding whether and when the employee has made the Sec. 83(b) election, any requirement by an employer that an employee make the election should be vetted with legal counsel. Note that an employee who makes a Sec. 83(b) election is also required to provide a copy of the election to the person for whom the services were performed; thus, an employer should be aware of the election (see Regs. Sec. 1.83-2(d)).
What if the property is purchased with nonrecourse debt?: To facilitate the purchase of property, an employer may provide the employee a loan equal to the purchase price of the property. To the extent the loan is substantially nonrecourse, then the transaction may be recharacterized as the grant of an option, with exercise and transfer occurring when the loan is substantially repaid (see Regs. Sec. 1.83-3(a)(2)). This recharacterization may have unexpected consequences for the employee. In particular, the employee likely cannot make a valid Sec. 83(b) election because an option that does not have a readily ascertainable FMV is generally not considered property for purposes of Sec. 83 (see Sec. 83(e)(3) and Regs. Sec. 1.83-7). Because there is no opportunity to treat the future appreciation in value as capital gain by making the Sec. 83(b) election, there is likely compensation income when the debt is substantially repaid.
If the employer-provided loan includes no interest, or an interest rate below the applicable federal rate, then the employee may be subject to U.S. taxation on the imputed income (see Sec. 7872). This loan discussion is premised on the notion that the loan is, in fact, a bona fide loan. Depending on the particular loan terms, if the loan will or may be waived, there is a risk that the loan may be considered compensation from the outset (see Technical Advice Memorandum 200040004). An inbound employer and its employees should consider a review of the underlying award and loan to determine the potential U.S. tax treatment and whether any changes may be made prior to the performance of services in the United States.
Are there any special considerations in transactions?: Changes to outstanding equity-based awards held by employees are frequently made in connection with a corporate transaction (e.g., an initial public offering, merger, or other event). Prior to making changes to an outstanding equity-based award, employers should consider the U.S. federal income tax consequences.
For example, accelerated vesting of property due to a corporate transaction generally results in compensation income at vesting. Absent an election under Sec. 83(b), there is likely taxable compensation income at the accelerated vesting event, and U.S. federal income tax may be due. If the underlying stock is sold immediately following the accelerated vesting event, then there is unlikely to be any capital gain on the sale because the FMV of the stock would likely not increase between the time of accelerated vesting and the time of the sale.
For a nonresident providing U.S. services for a limited portion of the vesting period (or an individual who becomes a U.S. tax resident) in the above example, the U.S. federal income tax result may be unwelcome news, and the inbound employer and employee may be interested in ways to mitigate the U.S. federal income tax consequences. One potential mitigation technique that is often considered is the cancellation of the existing award and the grant of a new award. While this may seem to be an ideal solution, consideration may need to be given to whether, from a legal and tax perspective, there has been an effective cancellation of the existing award, whether any potential risk of forfeiture added to a new award would be respected, and if an effective Sec. 83(b) election may be made on transfer of the new award.
The exchange of vested for unvested property in connection with the corporate transaction, however, is very different from accelerated vesting. In these exchange situations, Rev. Rul. 2007-49 provides guidance regarding the Sec. 83 consequences. The IRS addressed three scenarios in Rev. Rul. 2007-49: (1) the imposition of restrictions on vested founder's stock; (2) the exchange of vested stock for nonvested stock in a Sec. 368(a) reorganization; and (3) the exchange of vested stock for nonvested stock in a taxable stock acquisition. With respect to the addition of restrictions on founder's stock, the IRS found that there is no "transfer" for Sec. 83 purposes when restrictions are imposed on previously vested stock, and, therefore, there is no taxation when these restrictions lapse. In the second and third scenarios, the IRS found that the exchange of vested stock for nonvested stock in a Sec. 368(a) reorganization or a taxable stock acquisition constitutes a transfer of property for Sec. 83 purposes. Employees may want to consider the benefits of making the Sec. 83(b) election in the event of a taxable or nontaxable transaction to reduce or eliminate any taxable compensation.
In contemplating business opportunities and potential employee transfers to the United States, inbound employers and their employees will want to review the potential U.S. tax consequences associated with equity and other property transfers prior to the performance of services in the United States. Aside from the issues outlined in this discussion, other considerations may be relevant, including, for example, payroll reporting, withholding, deductions, and recharges. Depending on the situation, there may be opportunities to preemptively address the U.S. tax issues to better align the U.S. federal income tax treatment of equity or property transfers with those of the non-U.S. jurisdiction or, at the very least, manage the expectations of the parties.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Contributors are members of or associated with KPMG LLP.
The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.