Global employers: Stock option plans are not your only choice for equity rewards

23 December 2015

When it comes to employee compensation, equity reward is often seen as a complex area to be avoided. In reality, equity rewards — including stock option plans — are becoming an increasingly integral part of many global employers’ remuneration packages, and something that many top prospects have come to expect. In this blog, I summarise the most common types of equity reward plans and then outline some typical reporting and compliance requirements.

Stock options

Stock option plans are the most common form of equity rewards and are relatively straightforward to set up and administer.

A stock option gives an employee the right, not the obligation, to purchase company stock at a predetermined price at some point in the future. When an employee exercises his or her right to purchase the stock, the employee is issued, or “granted,” the stock options. The cost to the employee of purchasing stock under a stock option plan is the fair market value at the date of grant, sometimes known as the option price.

The difference between the market value at the date of exercise and the fair market value at the date of grant is the “gain on exercise,” and is liable to income and social security taxes.

Restricted stock units

Restricted stock units (RSUs) are units of company stock subject to certain restrictions. RSUs are associated with vesting schedules. Upon reaching a fixed vesting date, the restrictions on the RSUs are lifted and the stock is transferred to the employee.

RSUs have no employee cost attached, so the employee’s taxable gain is the full market value at the vesting date.

Employee stock purchase plans

Employee stock purchase plans (ESPPs) allow employees to purchase company stock at a discounted price to the stock’s market value. Purchases must be made through payroll deductions during set periods.

The discount applied is liable to income and social security taxes.

Phantom stock plans

Phantom stock plans issue employees hypothetical stock based on the company’s stock price at the time of issuance. The hypothetical stocks are issued in the form of cash payments that are liable to income and social security taxes.

Phantom stock plans are common in countries where it is complex to set up and administer a stock plan.

Tax efficient plans

Some countries, such as the UK, have so-called “tax efficient stock plans” that must be approved by local tax authorities. When an employee exercises his or her right to purchase company stock under a tax efficient stock plan, and holds that stock for a required period of time, then the employee will be taxed only when he or she eventually sells the stock and will only be liable to the lower capital gains tax on that eventual sale.

There are specific criteria that companies must meet in order to be eligible for these plans. For example, a company’s gross assets may not be able to exceed a certain value level, or the number of employees in the group company may not exceed a certain number. A company that offers this kind of plan must maintain strict compliance with local regulations or risk forfeiting the plan’s tax efficient status.

Notes on employee terminations and stock plans

When an employee leaves a company, any un-exercised stock options or un-vested RSUs will lapse on termination. Depending on the specific terms and conditions of the company’s stock plan, however, a terminated employee may be eligible for accelerated vesting. In this kind of situation, the employee’s contract will state that he or she will be deemed to have been employed by the company for a longer period than the actual period of employment. This will enable the employee to acquire more stock than he or she would have been entitled to under typical circumstances.

An employee may also be able to exercise stock options or acquire vested RSUs for a period (usually 30 or 90 days) after his or termination date. Employers that offer this option must be mindful that, if exercised, payroll will need to be re-opened in order to process the taxable gain and enable the withholding of income and social security taxes.

Reporting and compliance considerations for stock option plans

In most countries, taxable stock transactions are reported through the employer’s payroll, with the required income and social security taxes withheld. However in some countries, such as the UK, there is an additional requirement to file a year-end stock return. Employers must take care to ensure that all stock transactions are reported on this return, including those that are non-taxable (e.g., grants, lapses, etc.).

As with any kind of legislation, multinationals with stock option plans must keep abreast of, and comply with, any ongoing related regulatory changes in all their countries of operation. For example, effective April 2015, UK employers must submit year-end stock returns electronically through the HM Revenue & Customs website. (Previously, the required forms had to be submitted on paper through the post.) To enable electronic submission, employers were required to set up an account on the HMRC website and register their stock plans.

It should be noted that some countries, such as Australia, have no requirement to report stock rewards throughout the year through an employer payroll. Instead, these countries require only a year-end submission.

In short, reporting and compliance requirements for equity reward plans vary significantly by country and are constantly changing. Understanding these obligations and keeping on top of changes are critical to lowering your financial and reputational risks.