International Employment

International Employment

The OECD Solution

SARA COHEN reviews recent OECD proposals for the tax treatment of stock options for internationally mobile employees.

THE CROSS-BORDER tax issues which can arise for internationally mobile employees with stock options were the subject of a report recently published by the Organisation for Economic Co-operation and Development (OECD). The report only deals with stock options since, because they are often taxed at a time which is very different from the time the relevant employment services are rendered, the risks of double taxation tend to be greater than in the case of other share-based incentives.

The OECD long ago recognised the need for international consensus on the tax treatment of stock options, and two consultation periods and the publication by the OECD Committee on Fiscal Affairs of two discussion drafts, culminated in the publication on 23 August 2004 of the OECD 'Report on Cross-Border Issues arising from Employee Stock-Option Plans'. This report makes recommendations aimed at achieving a common interpretation of the application of tax treaties to the taxation of the gains arising from stock options.

There are infinite permutations and combinations depending on the tax rules of the particular jurisdictions involved in each case and any specific double taxation treaty provisions in place. This article is not an in-depth analysis of those issues but rather an explanation of the types of issue which can arise and the OECD recommendations for dealing with them.

Before looking in more detail at these new recommendations, it may be helpful to put them into context by looking at how typical stock options work and how they are taxed in different jurisdictions.

Why have share options?

Recent accounting changes (International Financial Reporting Standard 2 and its UK counterpart, FRS 20), which require companies to recognise the provision of share-based incentives as a profit and loss account expense, may have dented the popularity of stock options but they are still, and will continue to be, a widely used form of incentive for various reasons. They are straightforward and flexible and, by determining when and subject to what conditions they can be exercised, companies can structure them in such a way as to support their business objectives. Options can also align the interests of executives and shareholders by focusing executives on the overall company performance as opposed to their own individual performance and reward.

A typical stock option

In a typical stock option, the employee is granted a right to acquire a specific number of shares at some point in the future, usually three or five years after the date of grant. The price payable on the exercise of the option is usually equal to the market value of the underlying stock at the date the option is granted, but sometimes it can be at a discount and sometimes even at a premium. In many countries, including the UK and, increasingly, the US, institutional investors will expect executive options to be subject to the satisfaction of objective performance conditions based on corporate performance, such as growth in earnings per share or total shareholder return (a combination of increase in share price and reinvested dividend returns) measured against an index or a comparator group of companies. If an employee is a 'good leaver', for example because of illness, disability, retirement or redundancy, he will normally have a short time to exercise any outstanding options, often on a time-apportioned basis and/or to the extent that the performance conditions have been met. Bad leavers normally forfeit their options immediately on cessation of employment.

Stock options and tax

Some countries have legislation which allows executives and employees to benefit from tax-advantaged treatment provided certain conditions are met such as the UK company share option plan (CSOP) and the incentive stock option (ISO) in the US. However, usually because of legislative limits on the value of tax-advantaged options which can be granted to individuals, the unapproved option is more common, and this article focuses on their tax implications.

Options are taxed differently in different countries, but it is generally the case that there is no tax to pay when an option is granted, and no tax to pay on vesting (when the option becomes capable of exercise when the continued employment and/or performance conditions are satisfied). There is usually an income tax liability when the option is exercised on the difference between the market value of the shares at the date of exercise and the option exercise price paid. Growth in value between exercise and subsequent disposal of the stock is usually subject to CGT.

Exceptions

Unfortunately, the position in practice is not so straightforward since there are exceptions which prove the rule.

Belgium, for example, imposes an income tax at grant on an amount equal to 15% of the underlying value of the stock plus 1% for each year by which the exercise period exceeds five years, though this is halved if the option cannot be exercised for a minimum period of three years and the exercise price is fixed at grant. In Ireland, there is also an income tax charge at grant if the option is capable of exercise more than seven years later and the exercise price is less than the market value of the shares at grant.

The Netherlands has two types of option, with different tax implications. If:

it will be regarded as unconditional, and there will be a tax on grant in accordance with a complex formula. In the case of a conditional option, which will only become capable of exercise if certain conditions are satisfied, tax is imposed on its intrinsic value at vesting unless the employee and employer make an election to defer the tax until exercise. Switzerland has a similar régime to that of the Netherlands.

In Norway, the actual vesting of the option itself is not taxed, but after an option has vested, the Norwegian tax authorities include the shares subject to the option in the individual's assets for the purposes of wealth tax. This is on the basis that the employee has become entitled to the option, and whether or not he exercises it is simply an investment decision.

Many countries impose an income tax charge on exercise and, where tax has also been paid on grant, such as in Ireland on a discounted option capable of exercise more than seven years after grant, there will generally be a credit for the tax paid on the earlier event. Some countries, such as Sweden, do not impose a charge at all on grant, vesting or exercise but only when the shares are sold.

In the case of countries, such as the UK, which impose a capital gains tax charge on sale, there is normally a credit for the income tax already paid on exercise.

Timing mismatch

As will be apparent, an employee who moves between jurisdictions could end up paying tax on different elements of the option gain in more than one jurisdiction because different jurisdictions tax different events at different times.

A theoretical worst-case scenario could be Mr Globetrotter who is resident in Belgium when he is granted an option and is taxed at that point. It is a conditional option and, by the time it vests, he has moved to the Netherlands. There will not necessarily be a credit for the charge at grant because the Netherlands does not recognise the grant of an option as a taxable event. By the time he exercises the option, Mr Globetrotter has moved to Austria, which imposes a charge at exercise not at grant, so again, there will not be any credit for the tax already paid. Mr Globetrotter has moved to Sweden by the time he sells the shares and, because Sweden imposes a charge on sale on the difference between the exercise price and the disposal proceeds, he pays tax on the whole lot again.

Tax mismatch

There is also a double tax risk because of tax mismatches where, for example, the employee pays income tax on vesting or exercise in one country and capital gains tax on disposal in another country which does not recognise any of the earlier events for income tax purposes and does not give any credit for the tax paid.

Double tax treaty solution

It would seem obvious to look to the relevant double tax treaty provisions to resolve the potential double tax issue but, until the OECD report, they were of limited use. Income and gains realised by employees on the exercise of stock options fall within Article 15 of the OECD Model Double Tax Treaty which allows a state to tax not only employment income paid when the employee is resident in that state, but also income derived from employment in that state regardless of when it is actually paid.

That is fine so far as it goes, but Article 15 does not go far enough to address issues which can arise from timing mismatches, i.e. the employee being taxed on grant in one country and vesting or exercise in another, and tax mismatches, i.e. the employee being liable for income tax on vesting or exercise in one country and capital gains tax on disposal in another without any credit for the income tax paid.

Another issue was the fact that the different countries interpret the article in different ways. For example, the UK Inland Revenue gives relief on a time-apportioned basis between the dates of grant and exercise. Other countries will time-apportion the gain between grant and vesting on the basis that, by the time the option vests, it has been earned and when to exercise it is an investment decision for the employee and not relevant or applicable to his employment.

OECD recommendations

The OECD report addresses these issues by recommending amendments to the commentary on the model treaty. These recommendations are summarised below.

Timing mismatch

Where the model treaty provides that an item of income or capital may be taxed by the state of source, it follows that double taxation relief must be provided regardless of when the tax is levied by the state of source. The state of residence must therefore provide relief from double taxation through the credit or exemption method even though the state of source may tax it in an earlier or later year.

Related services

The determination of whether and to what extent a stock option is derived from employment exercised in a particular state must be done in each case on the basis of the relevant facts and circumstances, including the conditions attaching to the relevant options. The general principles that should be followed for this purpose are:

Services provided in more than one state

Where a stock option benefit is deemed to be derived from employment exercised in more than one state, the benefit attributable to a particular country should be the proportion of the number of days during which the employment was carried out in that country to the total number of days of the employment services attributable to the option.

Multiple residence taxation

Where, as in Mr Globetrotter's case, an employee is subject to tax in more than just the state of source and the state of residence, there may be unrelieved residence-residence double taxation. In these cases, the relevant states should mutually agree to provide relief for residence-based tax levied by a state on the part of the benefit attributable to the services rendered by the employee in that state.

The dividing line

The dividing line between employment income and capital gain should be the date of exercise. Article 15 applies to any benefit derived from the option until it has been exercised or otherwise alienated (such as cash cancellation on a takeover). Any subsequent gain after exercise will be derived by the employee in his capacity as investor/shareholder and will be covered by Article 13.

Directors

Directors' fees and similar payments are covered by Article 16, not 15, but the report says that the rules should generally apply to options granted to directors in the same way as options granted to employees.

Improvement

The OECD recommendations should make life much easier in practice, but care must still be taken since, as the OECD recognises, not all countries necessarily wish to follow the model treaty. For example, the UK/US tax treaty apportions the benefit of the option to employment rendered services rendered between the dates of grant and exercise (not vesting) since that is how both these jurisdictions tax them in practice.

Sara Cohen is an associate with Hewitt Bacon & Woodrow.

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