Granting stock options to expats: What employers can’t afford to overlook

Many employers implement tax equalisation protections for employees who are being deployed internationally to mitigate the effects of higher taxation and lower net take-home pay in destinations where the tax rates are higher than in the employee’s home country. Even in countries with lower tax rates than the home country, tax equalisation may be necessary to protect employees from being taxed on foreign benefits or to help the employer recoup some of the assignment costs.

In order to lower risks and set realistic budgets, employers that provide equity rewards to expat employees must understand when and how the home and host countries tax the rewards. This article outlines some of the common pitfalls of equity rewards taxation so multinational employers can protect themselves and their employees.

Cross-border equity awards

Traditionally, stock options have been awarded almost exclusively to upper management. In recent years, however, options are increasingly granted to employees of all levels as part of their overall compensation. Some companies offer a blend of non-qualified and incentive stock options, along with restricted stocks, to compensate employees for continued service as the company moves from private pre-IPO to public post-IPO status. This process involves a vesting or earnings period during which the employee must remain with the company or lose out on the stock’s potential future appreciation.

When companies move employees who were either awarded equity in the home country prior to or during their international assignment, the equity awards will vest. This creates taxable income in the host country at vest or at exercise, whenever the taxable event occurs.

For employees on international assignment, most host countries will tax equity based on the sourced portion — that is, the total equity income that relates to the time in the host country during the vesting period. (As we’ll see, one example of an exception is a US-UK assignment where income is sourced from grant to exercise, not grant to vest, according to Article 14 of the US-UK double taxation agreement.) For restricted stock units (RSUs) and even non-qualified stock options (NQSOs), home- and host-country tax rules will typically be aligned as far as the release or exercise of equities. Importantly, the income will be characterised as ordinary wages. (For more information, read our article on common equity reward plans).

Incentive stock options for expat employees

Unlike RSUs and NQSOs, incentive stock options, or ISOs, often present problems for internationally mobile employees. These problems are particularly prevalent in the US, so we’ll use that host country as an example.

ISOs are given preferential tax treatment in the US under IRC Section 422. This allows ISOs to avoid regular US income tax at exercise. Instead, ISOs are taxed as alternative minimum tax (AMT) income.

Given this treatment, it’s possible that even by adding the spread income (that is, the difference between the strike or exercise price and the fair market value) of the exercised stock as AMT income, the taxpayer may not see any additional tax if regular income tax is still greater than the AMT. Provided the employee holds the stock for more than one year from exercise and two years from grant, the characterisation of the income at sale will be capital gain subject to the preferential US tax rates between 15 and 23.8 percent (the rates at the time of writing). This compares favourably to NQSOs, which are taxed at exercise as ordinary wage income on the above spread up to 37 percent, and then again at sale on further appreciation from exercise at the 15 to 23.8 percent rates if held beyond one year from exercise.

The problem arises when an employee goes to work in another country that doesn’t recognise preferential tax treatment granted in the home country, in this example the US. If the exercise occurs while working in another country (absent a treaty exclusion, such as being on a short-term assignment of less than six months), then it’s possible, even likely, that the income sourced to the host country, as noted above, will be subject to tax at exercise in the host country, provided some of the income was due to vesting in that country. This creates three issues:

1. mismatched timing of taxable events (host country at exercise versus home country at sale)
2. mismatched tax treatment (ordinary in host country versus preferential in home country)
3. mismatched character of income (wage income in host country versus capital gain income in home country)

Add to this that the US categorises its foreign tax credits based on the character of the income taxed in the host country, and there are additional hurdles to overcome.

Another consideration is how an employer’s tax equalisation policy may be affected by the differences in tax treatment between the home and host countries. If not tax equalised, the employee will bear any burdens. If the employee’s income is tax equalised, mismatches can produce headaches for the employer. The different treatments between the actual tax filings that the employer is responsible for, and the hypothetical taxes per the equalisation that the employee is responsible for, may lead to disparate results. Resolving this kind of situation is particularly difficult if it involves a departing employee.

A sample incentive stock option scenario

Another challenge for employers granting expats equity rewards involves a possible mismatch between the home and host countries regarding the timing and treatment of taxable events.

To illuminate the problem, let’s review an example involving a US citizen on a tax-equalised assignment to the UK. The employee has been awarded US ISOs pre-assignment. This example highlights the mismatched timing of taxable events, tax treatments and income characters between the US and UK. Here is the scenario:

• The employee is awarded 2,000 ISOs on 1 January 2019, with four-year vesting at $10 per share strike price.
• The employee begins a tax-equalised assignment to the UK for two years on 1 January 2022.
• The employee exercises all 2,000 vested ISOs on 1 January 2023 at $60 per share FMV (fair market value) while in the UK.
• The employee returns from the assignment on 31 December 2023.
• The employee sells the exercised shares at $100 per share FMV on 1 February 2024.

In this example, we have two taxable events:

• First taxable event: On 1 January 2023, while in the UK.
• Second taxable event: On 1 February 2024, after returning to the US.

Taken separately, and assuming the US ISO plan does not conform to a UK-approved share option plan, here are the results of the two taxable events:

Results of first taxable event of two

On 1 January 2023, the ISO exercise will be treated as taxable ordinary wages in the UK, while only subject to US tax as AMT income.

• The income taxed in the UK on this exercise would be: $60 - $10 = $50 x 2,000 shares = $100,000 x 25 percent (UK sourced income of one year over vesting period of four years) = $25,000. The income taxed is characterised as wage income in the UK.
• If UK tax is 45 percent on this income, that’s $11,250 of UK tax, and if the gross-up for taxes paid by the employer (tax on tax effect), that would equate to $20,455 of UK tax.
• As this is an ISO exercise, the company would not withhold any hypothetical taxes on the exercise, so in effect the company is funding 100 percent of the UK tax with no employee subsidy.
• Further assume that the $100,000 of AMT income from the ISO exercise does not result in any additional tax in the US (i.e. the AMT is not greater than regular income tax).
• The net result of this transaction is that the company funded $20,455 of UK tax, while the employee got the preferential tax treatment under tax equalisation.

Results of second taxable event of two

On 1 February 2024, the ISO-exercised shares are now sold after returning from the UK assignment and are subject to US tax as capital gain income.

• The previously taxed income in the UK on the 2023 exercise above was characterised as wage income in the UK. The UK tax was $20,455 and treated as foreign tax credits on wage income.
• The employee returned from the UK assignment and then sold the shares in the US at $100 per share. The original strike price of $10 results in $180,000 of long-term capital gain income subject to US tax at an assumed rate of 23.8 percent, or $42,840.
• The net result of this transaction is that the company funded $20,000 of UK tax, while the employee got the preferential tax treatment after tax equalisation ended, so the company never recovered any of the $20,000 of UK tax from the employee.

The above scenario is just one example of many in which the employer, and sometimes the expat employee, can end up in a worse position than expected because ISOs were awarded and subject to tax in the host country.

Tax treaties and options

Tax treaties aim to reconcile differences between countries’ domestic tax laws and provide an equitable solution for the countries involved. The goal is to eliminate double taxation where possible — this includes the possible double taxation of stock options.

Let’s continue with our US-UK example. The US-UK tax treaty attempts to avoid double taxation by providing rules that re-characterise and re-source the option income to better allocate the income and tax between the countries. Article 14 of the treaty eliminates the US-UK domestic law differences in the “earnings or sourcing” period between countries to be from grant to exercise of the award, whereas in US domestic law the period is from grant to vest. In addition, Article 24 of the treaty allows for re-sourcing of income subject to tax in the UK as foreign-sourced income against US taxes for purposes of applying foreign tax credits. This can eliminate double taxation in instances where income sourced to one country could also be considered sourced to the other country due to citizenship.

Tax treaties, however, do not account for every situation. For instance, tax equalisation can result in differences between the tax returns as filed and the hypothetical tax that the expat employee would have paid had they not gone on foreign assignment. As tax equalisation is essentially an employer-employee arrangement, it is not accounted for under tax treaties. Therefore, unexpected results may occur that either benefit or harm the employee or employer, unless tax-equalisation policy exceptions are developed to provide equitable solutions for both parties.

Key considerations when granting stock equity to expat employees

There are almost 200 countries in the world and each has its own tax laws and regulations. Given these variations, you cannot assume that any two country’s tax laws concerning equity are alike. Your international stock equity plans must therefore be flexible enough to minimise unwanted outcomes while maximising company objectives and promoting employee engagement. When trying to achieve this difficult goal, consider the following:

• Payroll taxes. When compensating expats, you must comply with the withholding and income reporting requirements of both the home and host countries. Failure to do so could lead to fines and other consequences, such as the inability to do business in the host country.
• Employee taxes. Taking advantage of tax-preferential equity schemes in the home and host countries is important, but you also must consider how tax equalisation and hypothetical taxes are affected by each country’s unique tax rules.
• Regulatory requirements. Employee stock equity requirements vary by country. In general, the laws and regulations of the country where the issuing company is incorporated govern stock equity plans. To obtain similar preferential treatment in the host country, the home-country plan may need to be modified to achieve compliance in the host country.
• Timing of vesting and exercises. Shifting tax events from the host country to the home country (after repatriation) can in some cases decrease the overall tax or assignment equity cost to a lower, non-resident tax rate. In some cases, shifting events to the home country may eliminate host-country tax obligations. That said, trailing tax liabilities must be considered after repatriation if equity vesting occurred while on foreign assignment.
• Tax equalisation. A flexible, well-designed and equitable corporate tax equalisation policy is critical to mitigating risk and effectively planning for employer and employee tax costs related to equity. An effective policy will account for the types of equity granted, the vesting period, assignment timing and equity caps. All these considerations and more will play a part in limiting unexpected costs and other surprises.