Benefits of stock options as compensation dubai
Equity-based incentive compensation plans allow recipients to gain an ownership stake in the company. By offering share ownership in the company, employers not only reward employees but provide them with a valuable complement to traditional cash-based compensation packages.
As companies continue to expand globally, equity-based compensation is increasingly offered to employees located in countries other than the country where the stock award issuing company is located. Cross-border issuance of equity-based compensation can lead to a number of cross-border tax and transfer pricing issues for multinational companies. In this article, we briefly discuss some of the key international tax and transfer pricing issues that typically arise when equity-based compensation is provided by multinational companies to employees of its foreign subsidiaries.
Our discussion assumes that the company issuing the stock awards is the parent-issuer resident in the United States, although much of the discussion is equally applicable when the parent-issuer is resident in another country.
Equity-based incentive compensation awards come in many forms and include the following:. The exercise price is typically the market price of the stock when the option is granted; the vesting period is generally two to four years; and the option is usually exercisable for a certain period, often five or 10 years.
If the price falls, the option will simply not be exercised; the contract does not obligate the employee to buy the stock. Employee stock options typically cannot be transferred and consequently have no market value.
Some stock awards have special features designed to do more than just increase incentive value. There are other variations. Since a vast majority of equity grants are in benefits of stock options as compensation dubai form of stock options, that is the primary focus of this article. The valuation methods we refer to are typically used for valuing benefits of stock options as compensation dubai options. Key events in issuance of equity-based incentive compensation.
From the standpoint of financial reporting and tax accounting, three key events occur with respect to stock options. Second event is the vesting date when the stock option vests and becomes available for exercise by the recipient. When recipients exercise their stock options, the company provides the shares to the employee by either purchasing the stock from the market, through treasury stock, or by newly issued shares. In each of these scenarios, the base cost to the company is the difference between the market price and the exercise price.
Financial reporting and tax aspects of equity-based incentive compensation. Issuance of equity-based compensation has both financial reporting impact and tax benefits of stock options as compensation dubai. When a US company issues equity-based compensation to its employees, it must recognize that compensation in its financial statements by recording a book expense in relation to issued equity-based compensation.
Generally, these options are not taxed to the employee nor deducted by the employer. The spread between the market price and the strike price is deductible to the employer when the employee includes the proceeds from the exercise in income. For tax purposes, stock options are expensed at the time they are exercised. International equity award grants. Thus, the cost of the equity issued is initially with the US parent. That is, when the granted stock options have vested and are exercised, the US parent would have to incur the cost associated with exercise.
But the cost of equity compensation awards granted to non-US employees is not deductible in the US under the US tax laws and thus, offers no tax benefit to the US parent. In certain circumstances, it may be tax advantageous to push down the cost to a foreign subsidiary where a deduction can be claimed. Figure 1 illustrates the sequence of payments. Payment sequence under a recharge agreement. Tax impact of recharging. If the US parent and subsidiary corporations comply with requirements set forth by regulations issued under Section of the Internal Revenue Code, the recharge payment will be treated for US tax purposes as payment to the parent corporation in consideration for its stock.
This means the recharge payment will not be taxable to the parent corporation as a dividend or otherwise, and serves as a mechanism to repatriate cash to the US.
From benefits of stock options as compensation dubai US perspective, the US parent can use either the grant-date method or the spread-at-exercise method to determine the value of the stock options costs benefits of stock options as compensation dubai purposes of recharging.
Benefits of stock options as compensation dubai the spread-at-exercise method, the value is determined on the date of the exercise and is based on the difference between the market value of the stock price and the exercise price.
The grant-date method could also be used, which as noted above, follows the fair market value principles and is calculated on the date of the grant. However, it bears noting that Section regulations follow the spread-at-exercise method, and to that extent using the grant-date method may result in some tax implications. Foreign subsidiaries may be able to claim a deduction for the payment for equity-based compensation under a recharge agreement. However, local tax and accounting requirements differ in what forms of compensation are eligible, the value of the compensation that can be deducted, and accounting requirements.
Some countries, such as the UK, provide statutory deductions irrespective of any cost in the local entity i. Many countries allow a corporate deduction if the local entity recognizes an appropriate expense i.
Further, in certain countries the deduction may only be available for shares purchased in the open market and not for newly issued shares.
Other countries, such as the Netherlands, generally do not allow a deduction even where there is a local entity expense. Furthermore, in certain jurisdictions, such as China, recharge may not be possible for foreign exchange control reasons. The Appendix below summarizes local tax and accounting requirements applicable to the deductibility of recharged costs in Australia, Brazil, Canada, China, Germany, Hong Kong and the United Kingdom.
In the experience of the authors, companies equally use the grant-date method and the spread-at-exercise method to determine the cost of stock options in recharging equity-based compensation. Due care should be taken in choosing the method for recharging costs because it also impacts transfer pricing relationships as discussed below.
Transfer pricing implications of recharging. Although the grant of equity-based incentive compensation to employees of overseas subsidiaries has limited direct tax implications from the US standpoint, it can have a bearing on intercompany pricing, which could result in additional cost burden on the foreign subsidiaries and also indirectly affect the tax liability of the US parent. Depending on the transfer pricing relationship, foreign subsidiaries can be broadly categorized into two groups: Recharging to an LRE.
First consider the case of an LRE that is provided a guaranteed level of profit though a cost-plus payment by the US parent, illustrated in Figure 2. This implies that the recharged cost is essentially passed back to the US parent though the payment that the US parent provides to the local subsidiary. Alternatively, if the LRE is compensated by a foreign principal, the foreign principal may absorb the cost of the recharge through the payment provided to the LRE. Impact of recharge on intercompany pricing of LREs.
However, if the payment made by the US parent to the foreign subsidiary is deductible in the US, this higher tax burden may be offset by lower taxes for the US parent.
In effect, the cost of equity-based compensation that is pushed down to the foreign subsidiary is round-tripped back to the US parent via the payment to its foreign subsidiary. This effectively allows the US parent to get the same benefit from the deduction that it would have lost had it not recharged the equity grants.
The cost of equity-based compensation included in the cost base becomes important in this scenario because the compensation to the LRE is based on the cost base of the LRE. Companies can use either the grant-date method or the spread-at-exercise method in this regard.
That is, unrelated parties negotiate prices ex-ante on the basis of expected costs likely to be incurred. Thus, pricing takes into account the grant-date value of any equity-based compensation that the company expects to offer to its employees.
Indeed, unrelated parties typically do not adjust prices on the basis of actual stock price performance. This is also reflected in the financial statements released by the companies that disclose the grant-date value of equity-based compensation given to its employees.
In other words, the financial performance disclosed to investors, which forms the basis for their investment decisions, includes the grant-date value of equity-based compensation. However, issues can arise in using the grant-date method because the local tax deduction, if allowed, typically follows the spread-at-exercise method, which can produce a materially different benefits of stock options as compensation dubai from the grant-date method.
This can result in lower than desired level of profitability if the value under the spread-at-exercise method is higher than the value under the grant-date method.
On the other hand, if the spread-at-exercise method value is lower than grant-date method value, it may result in higher-than desired level of profits in the LRE.
This benefits of stock options as compensation dubai that the LRE should only claim a local tax deduction equal benefits of stock options as compensation dubai the grant-date value so that consistency between costs and revenue benefits of stock options as compensation dubai achieved. However, this may not be possible in all countries. The advantage of using the spread-at-exercise method in pricing intercompany fee is that it ensures consistency between the deduction available and the payments that that the LRE will receive and therefore the LRE is more likely to achieve the target level of profitability.
Another advantage of the spread-at-exercise method is that the cost plus fee paid by the US parent or the foreign principal to the LRE may be deductible to the US parent or the foreign principal. Thus, equity compensation award costs, which were not deductible benefits of stock options as compensation dubai the US parent or the foreign principal effectively may become deductible through the service fee paid by the US parent or the foreign principal.
Further, over an extended period of time, the values under the two methods are likely to converge, and the corresponding tax liability is likely to be similar under both methods. Another peculiarity associated with the spread-at-exercise method is that in certain situations the spread can be substantial due to a run up in the stock price this happens most often in the case of a startup company going public. Correspondingly, the cost base and the plus can be also be substantial resulting in an increase the tax burden of a cost plus LRE.
In such situations, it may be more optimal to recharge the equity-based compensation to a foreign principal. In conclusion, neither method is perfect. Taxpayers should evaluate benefits of stock options as compensation dubai choose a method taking into consideration the anticipated results.
More importantly, taxpayers should stick with the chosen method to ensure consistency. Recharging from an RBE. When the local subsidiary is an RBE whose profits are determined by the performance of the business, and the costs from the recharged equity grants are deductible, the tax burden is reduced because the profits are lower due to the recharged costs. This is shown in the figure below. Impact of recharge on benefits of stock options as compensation dubai pricing of RBEs.
Impact of stock-based compensation on cost sharing and intercompany service fees. The US transfer pricing regulations have adopted the view that equity-based compensation is a cost benefits of stock options as compensation dubai transfer pricing purposes.
The cost sharing regulations clarify that equity-based compensation should be taken into account in determining the operating expenses treated as intangible development costs of a controlled participant in a qualified cost sharing arrangement under Treas.
Similarly, the intercompany services related regulations benefits of stock options as compensation dubai clarify that equity-based compensation should be included in the cost base for purposes of determining chargeable costs.
Under the cost sharing regulations, the default position benefits of stock options as compensation dubai that the value of equity-based compensation using the spread-at-exercise method is the cost that should be included in the cost pool for intangible development activities within the scope of a cost sharing arrangement.
Taxpayers can alternatively elect to use the grant-date method when the equity-based compensation is in a regularly traded stock on a US securities market.
Again, the key is to choose a method and use it consistently. The US transfer pricing regulations pertaining to pricing of intercompany services also clarified the IRS intent that total services costs should include equity-based compensation for cost-based services methods e. While the services regulations do not endorse any particular method, the examples provided use the grant-date method.
In relation to tangible and intangible property transactions, the US regulations for the application of the CPM also address equity-based compensation. Ensuring your strategy is cohesive. Equity incentive compensation granted to employees located in foreign countries can lead to a number of tax, accounting and transfer pricing issues. Many of these issues result from the local regulations applicable to the recharge of equity compensation costs, while others arise due to transfer pricing relationships.
A number of high-profile technology companies recently adjusted their equity compensation programs in a manner they hope will help attract employee talent by providing an extended period to exercise vested stock options after termination of employment. In particular, Pinterest and Quora adjusted their stock options to allow employees with at least two years of service to exercise their vested stock options for up to seven years after they benefits of stock options as compensation dubai.
Other benefits of stock options as compensation dubai growth and startup technology companies may be considering benefits of stock options as compensation dubai adjustments to their stock options.
Providing an extended period to exercise vested stock options is not a new idea. In the past, employers have considered this approach, typically on a case-by-case basis, if the employee was in good standing and unique circumstances were present upon termination or if the employee has some degree of leverage in negotiating his or her departure. What is new is the trending consideration to provide an extended post-termination exercise period to employee option holders generally.
Due to certain tax and securities laws, as well as accounting rules, it is very common for stock options issued by private companies have a term of up to ten years from the date of grant. Recognizing that there is flexibility in how long a stock option can remain outstanding following termination of employment, some technology companies have considered providing a longer post-termination exercise period. This Alert outlines some advantages and disadvantages of providing an extended exercise period.
The considerations for both employer and employee are slightly different if the extended exercise period is added by amendment rather than included in the original award. Current employees and future hires may view an extended post-termination exercise period as highly favorable because the decision of choosing to exercise and pay the purchase price for their vested stock options can be delayed if the employee leaves the employer before the option has expired. Less pressure on the employer to gain liquidity: Benefits of stock options as compensation dubai the current economic and capital markets environment, many private companies are delaying their IPOs until much later in their business lifecycle and considering mergers and acquisitions.
Providing an extended period to exercise allows an employee to terminate and still potentially enjoy the liquidity of a later IPO or sale of the company. There may be less administration involving stock option exercises when employees terminate employment because questions regarding deadlines to exercise, loans and secondary sales to third parties to facilitate financing the exercise of stock options may be avoided or postponed.
However, if a terminated employee is able to retain vested stock options for an extended period, the underlying shares will necessarily continue to be reserved for a potential future exercise and more shares will be needed to grant awards to new hires or for refresh grants. As a result, common stockholders will face added dilution from a larger number of outstanding equity awards. Increasing the likelihood of employee terminations: Employees who cannot pay the exercise price for their vested stock options will not feel financially handcuffed to their employer benefits of stock options as compensation dubai of fear of forfeiting vested stock options benefits of stock options as compensation dubai after termination.
Incentive stock option limits will still apply: Incentive stock options ISOs generally convert to nonstatutory stock options NSOs three months and one day after an employee terminates his or her employment except in the case of death or a disability.
As a result, an employee who wants to keep his or her ISO status for tax purposes would not benefit from an extended exercise period. Likely higher employment tax expense for the employer and the employee: The exercise of NSOs requires both employee and employer to pay Social Security and Medicare taxes, as well as income tax withholding. ISOs do not trigger these taxes.
As a result, by extending the period by which stock options may be exercised, the employer likely increases the chances that many of its vested stock options will not be ISOs and will therefore result in greater employer Social Security and Medicare tax liability.
Income tax withholding obligations increase: The exercise of NSOs requires the employer withhold income tax from employees and former employees. ISOs do not trigger income tax withholding upon exercise.
An extended post-termination exercise period is one of the benefits an employer may offer a terminating employee in exchange for a separation agreement and release of claims. If stock option agreements already provide for an prolonged post-termination exercise period, employers will need to find other carrots to entice employees to sign release of claims agreements.
If an outstanding stock option is amended to extend the post-termination benefits of stock options as compensation dubai period, a few additional considerations apply:. An extension of the exercise period will likely require approval of this amendment by the equity plan administrator e. ISO and optionholder consent issues: However, the ISO holding period for capital gain purposes will restart. An amendment to an existing stock option to extend the exercise period likely will be considered a modification for accounting purposes and may lead to an additional non-cash compensation charge on the employer's financial statements.
To avoid adverse employee tax treatment under Section A of the Internal Revenue Code governing certain deferred compensationthe term of otherwise exempt options may not be amended to exceed the ten year anniversary of the original date of grant or the original expiration date of the stock option, whichever comes first. If you are considering an adjustment to your stock option program to provide for extended exercise period generally or to an benefits of stock options as compensation dubai stock option holder, please contact William HoffmanCisco Palao-Ricketts or any member of our Employee Benefits and Executive Compensation group.
Related topics Complying with the regulators Global workforce management.