Worldwide: Global Insight

This article has been prepared by professionals in the member firms of Deloitte Touche Tohmatsu

AMERICAN JOBS CREATION ACT SIGNIFICANTLY ALTERS LANDSCAPE OF DEFERRED COMPENSATION, PART 3

Last fall Congress passed the American Jobs Creation Act of 2004 (the Act), which made extensive changes to tax laws governing executive compensation. This third segment of a four-segment series focuses on the changes in basic rules for nonresident aliens, and stock compensation of insiders in inverted corporations.

Foreign Pension Plans -- Prior to the Act, a resident alien’s basis (i.e., investment in the contract) in a funded foreign pension plan generally included amounts contributed to the plan by both the employer and the employee, even if these amounts were not previously taxed in any tax jurisdiction. This was generally the case when an alien individual performed services and contributed to a funded foreign pension plan during a period of non-U.S. residency, but received payment from the plan after becoming a U.S. resident. In this situation, generally only the earnings and accretions portion of the distribution were taxed in the U.S. as foreign source income. However, if the plan’s vested accrued benefits were subject to tax annually based on the U.S. rules (i.e., discriminatory benefits paid to a highly compensated individual), the entire amount, both the contributions and the earnings, was considered as basis and not subject to U.S. taxation.

Under this regime, it was possible for a U.S. resident alien to receive a distribution from a funded foreign pension plan totally tax-free. The Act eliminates this opportunity to increase basis in foreign pension plans under the scenario presented above. Under the Act, employer and employee contributions and earnings on those contributions will not be includible as basis unless they were previously subject to income tax under the laws of the U.S. or a foreign country.

The Act does not change the rules applicable to basis with respect to contributions or earnings while an employee is a U.S. resident. For example, suppose an alien individual is a participant in a foreign pension plan and employer contributions are made during a period of non-U.S. residency of the alien and are not subject to tax in either the U.S or the foreign jurisdiction. In addition, suppose the contributions are in a discriminatory nonexempt trust as determined under U.S. rules, so that the vested accrued benefits would be subject to tax on a current basis annually if the individual was a U.S. resident. While the individual is a nonresident, no tax is imposed on the contributions or the earnings and therefore the amounts do not have basis. However, if the individual subsequently relocates to the U.S and becomes a U.S. resident, the earnings accruing in the plan during U.S. residency would be taxable for U.S. tax purposes and would create basis in the plan.

The information and examples above demonstrate the treatment of distributions from foreign pension plans under the U.S. domestic legislation, both before and after the Act. However, some U.S. tax treaties specifically address pension taxation.

Property Received for the Performance of Services -- The Act also changes the rules for determining basis in property received by a nonresident alien for services performed while outside the U.S. Obtaining basis in this case is contingent upon whether: (1) the property would have been taxed by the U.S. (or any foreign country) and (2) the individual paid tax upon the receipt of the property. For example, if the property distribution would have been taxed by the U.S. or any other foreign country (had the services been performed within those taxing jurisdictions), but the individual paid no tax upon receipt of the property, the individual will not obtain basis for U.S. tax purposes.

Effective Date -- The provisions are effective for distributions occurring on or after October 22, 2004.

Believing that executives of inverted companies (i.e., businesses locating offshore to secure certain tax benefits) escape the tax consequences and obligations incurred by general shareholders of businesses involved in those transactions, Congress has approved a provision that levies an excise tax on stock compensation held by corporate insiders of companies that invert.

The Act imposes a nondeductible 15 percent excise tax (20 percent for years beginning after 2008) on stock-based compensation ("specified stock compensation") held at any time during a period near the date of an inversion transaction by a "disqualified individual" with respect to an expatriated corporation. The provision applies only where shareholders are required to recognize stock gains on the expatriation, and where the exercise, sale or other payment of the compensation does not otherwise result in full income, gain or loss recognition during the period.

"Disqualified individual" is anyone who is directly or indirectly the beneficial owner at any time during the 12-month period beginning on the date which is six months before the expatriation date of more than 10 percent of any class of any equity security of the expatriated corporation or a member of its expanded affiliated group, or any officer or director of such corporation. The "expanded affiliated group" concept generally includes companies related by stock ownership of more than 50 percent.

"Specified stock compensation" is generally a payment, or right to payment, granted by the expatriated corporation (or a member of its expanded affiliated group) in connection with the performance of services, if the value of the payment or right is based on, or determined by reference to, the value or change in value of stock in the corporation (or any such member). However, specified stock option does not include certain incentive stock options. Payment of the excise tax by the expatriated corporation would be treated as specified stock compensation. Specified stock compensation would be valued without regard to restrictions other than those that, by their terms, will never lapse; the removal of such restriction would be treated as a grant. The excise tax does not apply to a stock option exercised during the six-month period before the expatriation date or any stock acquired pursuant to such exercise, if income is recognized on or before the expatriation date with respect to the stock acquired pursuant to the exercise.

The amount of the tax generally is the excise tax rate times the value of specified stock compensation held during the 12-month period beginning six months before the expatriation date.

Effective Date -- The excise tax is effective March 4, 2003, except that periods before that date are not taken into account in applying the excise tax to specified stock compensation held or cancelled during the six-month period before the expatriation date.

The fourth and final segment of this article will run in the Volume 3, 2005 issue of Global InSight, and will cover recent increased IRS scrutiny of executive compensation.

Many of the tax changes announced in the 2005 U.K. Budget on March 16, 2005 are directed against avoidance, this time mainly against avoidance by multinational corporations. The new measures have been prompted in part by information provided under the tax shelter disclosure rules introduced last year, and it would seem, by increased cooperation between tax authorities to combat international tax avoidance.

The main features affecting international assignees and their employers are:

• Tighter rules for taxing former U.K. residents on capital gains realized after leaving the U.K.;
• Reducing capital gains tax avoidance by non-U.K. domiciliaries;
• Taxation of awards to employees in full-time university education;
• Further measures on pensions tax simplification;
• Increase of basic stamp duty land tax threshold;
• Tax recognition of same sex marriages; and
• Confirmation that the review of residence and domicile tax rules continues.

Normally the U.K. charges capital gains tax only where the individual making the disposal is resident, or ordinarily resident at some point in the tax year. However, capital gains realised in a complete year of non-residence may also be taxed if the individual:

• Was resident in any four of the seven years before leaving the U.K.;
• Owned the asset before he left, and;
• Resumes residence in the U.K. after less than five complete years of non-residence.

It was widely believed that the U.K.’s right to tax is overridden by a double tax treaty where the individual sells the asset while treaty resident in another country and where, under the double tax treaty, the residence country has the sole right to tax the gain. Many of the U.K.’s treaties would anyway allow the UK to tax gains realized up to five or six years after cessation of U.K. residence. Some, though, including the treaties with Switzerland, Belgium and certain other European countries, allow a former U.K. resident to avoid U.K. capital gains tax by moving abroad for as little as a year (depending on timing).

The law will be changed so that, in accordance with the rules outlined above, the U.K. capital gains tax charge operates in the year of return to the U.K., regardless of the treaty. Any foreign tax charged may be credited against the U.K. liability. Also, these temporary non-residence rules are to apply where the absent individual remains U.K. resident under domestic law, but is treaty non-resident. This again will allow the U.K. to tax capital gains realized after departure, despite the treaty.

These changes affect expatriates who leave the U.K. and become non-resident from March 16, 2005.

Individuals who are domiciled outside the U.K. are taxed on gains realized from foreign assets only to the extent the disposal proceeds are remitted to the U.K.. Capital gains tax planning for non-U.K. domiciliaries therefore often involves using non-U.K. situs assets. To restrict this, the rules for determining whether assets are U.K. or foreign have been changed.

From March 16, 2005, any share, debenture or security in a U.K. incorporated company, whether registered or not, is treated as a U.K. asset for capital gains tax purposes. Membership rights in U.K. companies where there is no share capital will be treated similarly. This prevents the use of "bearer shares" to transfer the situs of a U.K. company’s shares outside the U.K.. Under existing rules these are located where the owner is present. Further, registered shares in a U.K. incorporated company are now U.K. situs even if the company has its main share register and stock exchange listing outside the U.K.. The change also puts beyond doubt that an American Depository Receipt relating to a share in a U.K. incorporated company is a U.K. asset.

From September 2005, employers may make a tax free payment of up to £15,000 per annum (previously £7,000) to an employee attending a full-time course at a recognized university or college. Currently, this exemption is lost completely where the tax-free threshold is exceeded.

The unified tax treatment of pensions promised in 2002 and due to take effect from April 6, 2006 is still far from complete as the Revenue continues to identify anomalies and loopholes in the legislation enacted last year. A Technical Note published in February 2005 identified 49 changes to be made. The Budget and the Finance Bill add to the list. Fine-tuning of the legislation will seemingly continue throughout 2005 and perhaps beyond.

One of the main problems is in achieving a consistent treatment of pensions and benefits, while preventing tax avoidance. Members may take a tax-free lump sum of up to 25% of their pension pot on retirement. Where a guaranteed scheme pension is paid the maximum lump sum is indirectly linked to the pension level on retirement. Some members want to maximize their immediate retirement pension in order to increase their tax-free lump sum. There will be rules which prevent them from artificially inflating their pension for a time. Others want to reduce their immediate retirement pension in order to depress the value of their fund and avoid the 25% recovery charge imposed where pension funding exceeds £1.5m (2006/2007). There will be rules to bring in the value of dependants’ pensions etc.

Currently, contributions to overseas schemes may, subject to conditions, qualify for tax relief on the same basis as contributions to U.K. registered schemes. But there is concern that highly-mobile "international cadre" employees may not qualify if they do not receive tax relief on contributions to a third country scheme in the country where they are resident (State A) immediately before being assigned to the U.K.. The Revenue now appears ready to allow U.K. tax relief even if the member’s contributions to a foreign scheme are not tax relieved by State A. The position will be clarified in regulations.

Where residential property is acquired the charge to stamp duty land tax (SDLT) will only apply where the consideration for the acquisition exceeds £120,000, instead of £60,000. Where the threshold is exceeded the entire amount is liable to SDLT. This measure applies broadly to transactions from March 17, 2005. The actual rates of stamp tax have not been changed.

Although this provision is unlikely to have much of an effect in the London property market due to the high average value of property, it may eliminate the SDLT on lease premium arrangements companies set up to provide accommodation for their assignees outside the London area.

From December 5, 2005 the U.K. Civil Partnerships Act will allow same sex couples to register their union. Those who do will now receive the same tax treatment as married couples, including the right to pass capital assets between them at nil cost or gain for capital gains tax purposes, and to gift wealth to the partner with full exemption from inheritance tax.

Under European law equivalent exemption is likely to apply to expatriate same sex couples from elsewhere in the EU. The position for unions registered outside the EU is not clear.

The full review of the tax rules relating to residence and domicile continues and a further consultation paper may be published after the U.K. general election. New rules may eventually result in less favorable tax treatment for long-term U.K. residents who remain domiciled outside the U.K..

The Chancellor’s fiscal strategy of not increasing tax-free allowances and rate bands beyond inflation, in order to fund tax credits for low income households and increased public expenditure, has resulted in the 40% "higher" tax rate for individuals often becoming the standard rate, especially for the great majority of expatriates.

Having in effect stopped the marketing of employment tax shelter products through the 2004 disclosure rules, the Chancellor is now directing his anti-avoidance campaign at large multinationals.

On January 22, 2005, the MOFE announced revisions to the Presidential Decree of Tax Laws. The following revision was made with respect to the Individual Income Tax Law.

Rental Expenses -- Prior to the revision, actual expenses were deducted for purpose of calculating the income derived from the transfer or rent of intangible property such as trademark or goodwill. If related expenses were not determinable, then 80% of the transaction amount was considered to be the deductible expense. After the revision, if the actual expenses are more than 80% of the revenue, then the actual expenses are deducted. However, if the related expenses are not determinable or the actual expenses are less than 80% of the revenue amount, then the 80% of the revenue is considered to be the deductible expense.

Recent Tax Rulings and Cases

Special Tax Treatment For Foreign Workers -- The revised Article 18-2-1 of the Tax Incentive Limitation Law (TILL) provides that 30% of compensation earned by foreign executives or employees in Korea is exempt from income tax. The National Tax Services (NTS) issued a ruling stating that not only foreign workers expatriated from a foreign affiliated company or foreign head office, but also foreign workers locally hired in Korea are eligible for such tax exemption.

Retirement Bonus And Accrued Severance Indemnity -- Where the company additionally pays a retirement bonus to its directors or employees in accordance with the company’s regulation or the agreement between labor and management, the payment should be offset against the accrued severance indemnity first, rather than directly being charged to the profit and loss statement (P&L). Under the Korean GAAP (generally accepted accounting principle), it is charged to a P&L as a non-operating expense or extra-ordinary expense.

Income Classification Of The Equity Linked Securities -- The NTS issued a ruling stating that when the holders of Coupon Type Equity Linked Securities receive coupons or earnings based on a yield to maturity, such earnings are treated as dividend income. Furthermore, the NTS stated that the withholding tax paid on dividend income is not refundable when the holders suffer loss in principal amount at maturity, due to a decline in the stock price.

The tax convention between Korea and the United Arab Emirates (UAE) was signed on September 22, 2003, and became effective as of March 2, 2005. The following introduces you to the major sections (not all-inclusive) of the convention:

• A building site, construction, assembly or installation project, or supervisory activities constitute a PE only if such site, project or activities continue for a period of more than 18 months.
• The furnishing of services, including consultancy or managerial services by an enterprise through employees, or other personnel engaged by the enterprise for such purpose, constitutes a PE only if activities of that nature continue for a period or periods aggregating more than 18 months.
• Where a person other than an agent of an independent status is acting on behalf of an enterprise, that enterprise shall be deemed to have a PE if such a person:
• Has and habitually exercises a general authority to negotiate and conclude contracts for or on behalf of such enterprise; or
• Maintains a stock of goods or merchandise from which he regularly sells goods or merchandise for or on behalf of such enterprise.
• An insurance enterprise shall, except in regards to re-insurance, be deemed to have a PE if it collects premiums in the territory or insures risks situated therein through a person other than an agent of an independent status.

Dividends -- 5% withholding tax applies to the gross amount of dividends if the beneficial owner is a company or enterprise (other than a partnership) which holds directly at least 10% of the capital of the dividend paying company, otherwise, 10% withholding rate applies.

Interest -- 10% withholding rate on the gross amount of the interest applies.

Royalties -- Royalties are not subject to tax in the sourcing country unless the beneficial owner of the royalties has a PE in that country.

Capital Gains --

• Gains derived by a resident of a contracting state from the alienation of immovable property (including shares deriving more than 50% of the value directly or indirectly from immovable property) and situated in the other contracting state may be taxed in that other state.
• Gains from the alienation of shares other than real estate shares (mentioned above) representing a participation of at least 10% in a company which is a resident of a contracting state may be taxed in that state.
• Gains from the alienation of any property other than the properties mentioned above shall be taxable only in the country of which the alienator is a resident.

Other Income -- Income derived by a resident of a contracting state not dealt with in the foregoing Articles of this convention shall be taxable only in that state.

Entry Into The Force -- The provisions of the convention shall have effect in both contracting states:

1. In respect of taxes withheld at source, for amounts paid or credited on or after January 1, 2003; or
2. In respect of other taxes, for taxable periods beginning on or after January 1, 2003.

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FOCUS ON VISA & MIGRATION

Chinese Immigration Requirements: An Overview

As the Chinese economy continues to be the fastest growing economy in the world, more and more Western companies are focusing their attention on this vast marketplace of 1.3 billion people. This of course entails an ever-increasing flow of expatriates to China, and we are seeing many companies not only increase their presence in the "main" cities of Beijing, Guangzhou and Shanghai, but are also starting to include other "lesser" cities such as Suzhou, Chengdu, Dalian and many others.

This article attempts to summarize the immigration aspects of seconding a foreigner to China. Because all areas of China have differing practices, specific advice should always be sought from the appropriate destination city prior to the expatriate leaving home.

Various permits and processes are required for foreigners wishing to work in China. The requirements vary from area to area within the PRC, and there are countless variations on the requirements and procedures. Below is a simplified explanation of the main steps to be followed. Please note that different procedures are required for individuals from Hong Kong, Macau, Taiwan and PRC nationals with overseas permanent residence. For updated information or advice, please consult with your immigration advisor.

Generally speaking, foreigners can now take one of two routes to obtain the various permits. The first and more traditional route is to obtain a Z visa prior to arrival in China. This is the more cumbersome of the routes, but the authorities in some cities still insist this route is taken by all foreigners. The second and easier route is where the foreigner arrives on an F (business) visa. Some cities, including Shanghai (but not Beijing) will even accept expatriates arriving on L (tourist) visas.

Please refer to the flowcharts below:



The requirements for foreigners wishing to work in the People's Republic of China include the following:

• Z visa (Route 1 only)
• Employment License (Routes 1&2)
• Work Permit (Routes 1&2)
• Residence Permit (Routes 1&2)
• Health Check (Routes 1&2)

Other permits/licenses may be required in certain circumstances, i.e., for Chief Representatives of a Head Office, for lawyers wishing to practice law in China and others.

A brief explanation of the various applications follows.

1. Employment License (Routes 1 & 2)

This is required by the employer in order to employ the (named) foreigner.

Processing Time -- 5 working days

2. Z Visa Notification (Route 1 only)

This is required for individuals taking "Route 1". The Z visa notification may be regarded as a provisional pre-approval for a work permit. It authorizes the PRC embassy concerned to grant the applicant a Z visa. The visa notification is applied for at the local office of the Foreign Trade and Economic Committee.

Processing Time -- 3 working days

3. Visas

This is required for all individuals. The visa needs to be obtained from the PRC embassy in the country of residence. Documentation and processing times can vary between embassies and it is suggested that up-to-date confirmation is sought directly from the local embassy, details of which can be found at: http://www.china.org.cn/e-zhuwai/index.htm

• Application for a Z visa (route 1) will inevitably require the original Employment Permit and Z visa notification.
• Business visas ("F") usually only require an invitation letter from the China company.
• Tourist visas ("L") can often be acquired by the travel agent purchasing the tickets to China.

Always check with your advisor to confirm which visas are acceptable for your destination in mainland China.

4. Health Check

All foreigners wishing to work in China are obliged to undergo a health check. In theory, the health check can be carried out at approved clinics outside China. However, we do not recommend this option. Although these Chinese clinics may be efficiently organized, the overseas clinics do not often meet all of the Chinese authorities’ requirements. It is therefore more reliable to undergo the health check in China.

However, having said that, some embassies (Singapore included) insist on a Health Check before issuing a Z visa (Route 1 only), in which case there is no alternative but to take the Health Check in the country of residence prior to departure. The embassy should be able to provide a list of these "approved" hospitals. In most cases, where an overseas Health Check is deemed acceptable for the Z visa, there is usually no need to undergo another check in China. The foreigner should ensure they bring all appropriate Health Check records with them to China.

The health check is relatively thorough and includes the following tests:

• Eyesight
• Blood sample
• Blood pressure
• Abdominal ultra-sound scan
• Chest x-ray
• Physical examination (non-invasive)
• Personal history questionnaire

The health check is required of the employee and all adult dependents. No food should be consumed for four hours before the health check.

Processing Time -- An appointment at the clinic usually needs to be made at least 3 working days in advance.

Allow half a day for the health check. Expect to wait at least four working days before receiving the medical report. (Note: Occasionally, an applicant may "fail" the first health check but "pass" after further investigations.)

5. Work Permit

Almost all foreigners wishing to work in China for more than three months should obtain a work permit from the Labor Bureau. Work permits will, generally speaking, be granted to qualified foreigners (either through educational qualifications, work experience or both), filling positions of technology, management or to others requiring skills that cannot be filled by domestic candidates.

Processing Time -- At least 3 working days for Route 1 and at least 5 working days for Route 2.

6. Residence Permit

With effect from early 2005, Residence Permits are pasted inside the foreigner's passport. Prior to this, a separate booklet was issued. The Residence Permits pasted into passports also supersede multiple entry permits. Residence Permits are sought from the Public Security Bureau.

It should be noted that the foreigner (and dependents) should apply for a temporary residence permit within 72 hours of arrival in China. Such applications are normally handled by the hotel at which the foreigner is staying.

Processing Time: 5 working days

The above outline is simply an overview of the minimum requirements needed to work in the complex and vast nation that is the People’s Republic of China; specific advice should always be sought for each destination location.

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GLOBAL REWARDS

Rewards, Inc.: Run Compensation and Benefits like a Business, Part 2

Part 1 of this article appeared in the Volume 1, 2005 issue of Global InSight. In this section, we will review the Value Management component of Rewards, Inc. In the third and final segment of this article, which will appear in the next issue of Global InSight, we will review the strategy and design behind Rewards, Inc., and putting rewards to work.

Value Management: Understanding Costs, Countering Risks

To manage rewards costs and risks, companies must first know where to find them. Our experience shows that rewards-related issues at most organizations tend to fall into five major areas of risk (and corresponding opportunity):

• Controls
• Legal and regulatory compliance
• Cost-effectiveness
• Operations and vendor management
• Capital market risk

Does this list look familiar? It should – because all of these issues, without exception, have their counterparts in the larger corporation, the "parent" of Rewards, Inc. And just as the "parent’s" success depends on managing these issues at the enterprise level, Rewards, Inc.’s success depends on understanding and controlling them in a rewards-specific context. The following are some common challenges in each area:
Controls

The Sarbanes-Oxley Act of 2002 has put processes and controls related to financial reporting under the microscope as never before. Unfortunately, the prevailing practices for pension plans and other benefit-related accounting can make rewards a fertile breeding ground for material weaknesses. Many organizations, for example, leave the procedures and controls over pension plan reporting solely in the hands of local offices around the world and outside vendors such as actuaries. However, many critical steps of the valuation process take place within the corporation itself, and many more steps by company employees are important to ensuring data and process integrity. Without well-defined policies and procedures to regulate every stage of the process, as well as a clear assignment of responsibilities and effective communication among management, plan administrators, and actuaries, a company may never know about possible missteps until it is too late.

Establishing strong internal controls over rewards accounting also pays off in increased efficiency and improved performance. Effective internal control and monitoring procedures reduce the time and expense of preparing disclosures and reports. In addition, the ability to reliably track rewards-related expenditures allows management to accurately measure global rewards spend and align programs with the company’s overall HR objectives. A reputation for good corporate governance may even boost a company’s standing and performance in the capital markets.

Legal & Regulatory Compliance

Sarbanes-Oxley is only one of many laws and regulations, both domestic and international that pose continuing compliance challenges. To mention only a few other compliance initiatives:

• The IRS’ Employee Plan Team Audit (EPTA) program specifically targets large (2500 or more participants), single-employer, qualified defined benefit and defined contribution plans for intensive audits.
• In 2004, the IRS also announced that it had hired more than 100 new corporate tax examiners to perform executive compensation audits at a number of larger companies.
• Taxing and regulatory authorities around the world are increasingly focusing on compliance related to global equity plans. In Sweden and the Netherlands, for example, tax inspectors are actively contacting local subsidiaries of foreign parent companies requesting details on global share plan participants (even if terminated or departed from the country) and social security payments made on global share plan income.

To be confident of compliance, companies must not only understand and obey the relevant statutes but also keep abreast of the continual stream of changes. Tracking rewards-related legislative and regulatory developments is a must, as is a process for monitoring ongoing compliance. If an organization does discover rewards-related compliance issues, it should familiarize itself with remediation options, such as the IRS’ Employee Plans Compliance Resolution System (EPCRS), that may allow it to rectify the situation without seriously damaging its reputation or its bottom line.

Cost-Effectiveness

Containing rewards costs isn’t simply a matter of cutting compensation and benefits programs. It’s about finding a mix of rewards programs that drive the most employee performance at the most reasonable price. The challenge, of course, is putting this idea into practice.

Though "performance" is relatively easy to define, from hours worked per day to customers served per hour to amount in sales per quarter, connecting its ups and downs to specific rewards practices requires more research into a company’s workforce than most organizations are equipped to perform. Lacking a reliable way to measure the impact of rewards on employee performance, HR and finance executives typically base rewards decisions on external benchmarks. Unfortunately, more often than not, these benchmarks tend to lead finance and HR to opposite conclusions.

There’s no easy answer to determining how best to assess performance and its sensitivity to various rewards practices; every organization needs to find its own unique solution. In the meantime, companies can draw on the usual corporate cost-control strategies to improve rewards’ cost-effectiveness: reducing administrative inefficiencies, renegotiating vendor contracts, leveraging tax savings, and the like. To soften the impact on productivity and morale, employers may want to look for cost-cutting options that are relatively invisible to the workforce. Changing pension plan funding strategies or consolidating investment managers, for example, can yield significant savings without forcing undue change on employees.

Operations & Vendor Management

Even the best rewards programs are only as good as how well they’re executed and delivered. However, the dynamic nature of rewards at most companies presents special difficulties to maintaining operational excellence: frequent changes to rewards programs may demand numerous process adjustments, rapidly evolving technologies may call for multiple upgrades or add-ins, and organizational realignments may require extensive clarification of roles and responsibilities. Failure to address operational issues can lead, not only to excessive costs and customer service issues, but also to significant risk exposures due to process and control lapses.

Companies that outsource rewards activities to external service providers face the additional challenge of managing and supervising their vendors, which may provide everything from payroll and HR services to benefits administration and executive tax planning. Merely keeping track of all of a large company’s outsourced relationships can be a challenge. Evaluating vendors’ internal control environments every year, as required by the Sarbanes-Oxley Act, adds further complications. And the potential for cost, quality of service, and customer satisfaction issues is just as great, if not greater, at an outside provider as within one’s own organization, with the added complication that problems with vendors may be much trickier to resolve.

Capital Market Risk

Investment losses, low interest rates, and rising benefits costs have turned corporate pension plans, once seen as the perfect hedge investment, into a significant financial risk. As a result, many companies are reexamining their pension plans in an effort to reduce cash volatility and expenses. A Deloitte & Touche survey released in April 2004 found that 52% of 125 companies polled are considering or have already made pension plan changes in the past year. The need to understand and assess capital risk exposures arising from all compensation and benefit plans, especially but not limited to pension plans, will only become more urgent as companies continue to expand globally.

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GLOBAL EQUITY UPDATES

Summary

This article summarizes the new developments affecting global equity plans that took place during the months of January – April 2005. View the original Global Equity Updates.

Argentina: Removal of Monthly Earnings Limit for Employer Pension Fund Contributions

The monthly earnings cap of AR$4,800 (approximately US$1,600) on mandatory pension fund contributions will be increased from June 2004 until there is no longer a monthly earnings cap as of October 1, 2005. Employer’s pension fund contribution rate is either 23% or 27% depending on the main business activity and the average 3-year gross revenue (net of taxes). The monthly earnings limit for employer contributions to the Health Care Scheme and Federal Health Insurance System are still capped at AR$4,800. This may potentially increase the costs of employee share plans in Argentina.

Australia: Proposed Bill Provides Clarity on Taxation of Equity for Mobile Employees

The new International Tax Arrangements (Foreign-owned Branches & Other Measures) Bill 2005 confirms that employee stock compensation should be treated as employment-related income, and therefore:

• Relevant period for sourcing is from date of award to the date the award ceases to be at risk of forfeiture (typically, at vesting);
• Employee stock compensation granted prior to arrival in Australia is exempt from Australian tax where forfeiture conditions still apply – only Capital Gains Tax applies at sale;
• Foreign tax credit is available in respect of foreign tax paid on employee stock benefit;
• Remove potential double taxation of employee stock benefit under Australia’s Foreign Investment Fund rules; and
• Removes potential double taxation of employee stock benefit on departure from Australia.

The Bill is expected to become law shortly.

Brazil: Central Bank Eases Exchange Control Rules

Approval is no longer required when there is a remittance of funds outside of Brazil. In addition, there is no obligation to return the proceeds from sale of foreign shares acquired under an employee share plan back into Brazil at termination or sale of shares as of March 14, 2005.

Canada: Stock Option Benefit Eligible for Investment Tax Credit

A recent Tax Court of Canada decision on February 24, 2005 may allow companies to include the stock option benefit for employees performing eligible scientific research and experimental development (SR&ED) activities as part of the investment tax credit (ITC), calculated as 20% of current and capital expenditures, against federal tax payable. The taxable benefit equal to the spread at exercise may be included in the calculation of ITC.

To claim a deduction of SR&ED expenses and the corresponding ITC, a company must file prescribed forms within 18 months from tax year end.

France: Qualifying Plan Legislation for Free Share Plans

Under the new legislation, qualified employee free share plans could result in:

• Exemption from French social security charges;
• Application of a flat income tax rate of 41% on the benefit realized at vesting;
• Deferral of the flat income tax charge on the benefit realized at vesting until the date the shares are sold;
• Application of flat tax rate of 27% on the capital gain realized at sale;

Requirement to respect a minimum vesting period of 2 years and a minimum holding period (after vesting) of at least 2 years.

Please note that the rules pertaining to qualified employee free share plans resemble those currently applicable to stock option plans in France.

IASB: IFRS 2 Share-Based Payment and Effect On Non-EU HQ Companies

Under IFRS 2, companies have to charge to their profit and loss account the "fair value at grant date" of stock options and stock awards, granted after November 7, 2002 but which have not vested as of the first full financial year for IFRS reporting (i.e. for Dec 31 year-end: January 1, 2005; for June 30 year-end: July 1, 2005).

Non-EU headquartered companies whose foreign entities have to report under local GAAP may have to expense stock options and other equity awards to their employees, including equity awards made by the non-EU parent company.

India: Deductibility of Equity Compensation Expense

Based on a recent decision of the Chennai Bench of the Tribunal in the case of SSI Limited, an Indian-listed company, a corporate tax deduction is available for stock options based on the discount at grant (i.e. the difference between the exercise price and the fair market value of the underlying shares at grant). This deduction is allowed over the vesting period of the discounted stock option.

This decision supports an argument for a corporate tax deduction for foreign companies if the costs of the stock options are recharged to the local Indian entity.

Ireland: Proposed Statement of Practice to Adopt OECD Recommendations on Cross-Border Stock Options

A Statement of Practice is expected to be issued to clarify the treatment in Ireland of stock compensation gains for mobile employees. The statement is expected to address:

• Relief for foreign taxes paid;
• Apportionment of taxable income over the number of work days; and
• Eliminate double taxation and adopt common OECD approach in applying double tax treaties.

Japan: Rulings State Stock Option Gains Constitute Employment Income

The Japan Supreme Court upheld a Tokyo High Court ruling that stock option income should be taxed as employment income, rather than occasional income. The taxation of stock option income for taxpayers in Japan is still in a state of flux as there are approximately 100 similar court cases centering on whether the income received at the time of exercise of a stock option is:

• A payment in respect of services rendered, and therefore employment income; or
• An irregular payment and therefore, occasional income.

We will report further developments as they arise.

Malaysia: Public Ruling on Employee Stock Option Benefits

On December 9, 2004, the Malaysian Inland Revenue Board (MIRB) issued Public Ruling No. 4/2004 to explain the tax treatment of income from an employee stock option plan, the method of determining the taxable value, and the employee’s and employer’s compliance requirements. Public Ruling No. 4/2004 concludes that:

• Point of taxation for stock options is at exercise;
• Taxable benefit for stock options of publicly listed companies is the excess of the average of highest & lowest share price on the date of grant over the exercise price;
• Taxable benefit for stock options of non-listed companies is the excess of the total net tangible assets divided by the total number of common stock, and the exercise price; and
• Taxable benefit for free shares is the fair market value of the shares on the date when the shares are transferred into the employee’s account.

In addition, the ruling also clarifies the withholding and reporting responsibilities for the employer and the employee.

Mexico: New Tax Rules Requiring Taxation of Stock Options at Exercise, Regardless of Chargeback

As of January 1, 2005, the spread at exercise is taxable as employment income, regardless of chargeback.

If the costs are recharged to the local Mexican entity, the local Mexican entity has to withhold and report the spread at exercise and the spread will be subject to both income and social taxes. If the costs are not recharged to the local Mexican entity, the employee has to determine the taxable income at exercise and file an estimated tax payment by the 17th of the following month.

There is a transition rule such that if the stock option was granted prior to January 1, 2005, the taxable benefit is equal to the excess of the fair market value at December 31, 2004 and the exercise price paid by the employee.

Netherlands: Taxation at Exercise

New legislation states that as of January 1, 2005, stock options will be subject to Dutch income and social tax at exercise. The election to pay income tax at vest or defer income tax to exercise will no longer be available.

In order to avoid double taxation due to the changes in the law, stock options that where granted prior to January 1, 2005 and that have already been subject to income tax will remain taxable according to the taxation regime in place prior to January 1, 2005. For social tax purposes, stock options which have been subject to social security premiums prior to January 1, 2005 will not be subject to social tax at exercise.

Poland: Taxation of Dividends & Capital Gains from Sale of Foreign Company Shares

Previously, investment income (e.g. dividends, proceeds from sale of shares, income from participation in capital funds, etc.) received prior to January 1, 2005, were taxed differently depending on their source. Capital gains derived from Polish sources were taxed at a flat rate of 19%, while the capital gains derived from foreign sources were subject to progressive income tax rates of up to 40%.

Effective January 1, 2005, all capital gains, regardless of their source, are subject to tax at a flat rate of 19%.

South Africa: New Legislation Regarding Tax-Favorable Treatment for Broad-Based Share Plans

As of October 26, 2004, the Minister of Finance introduced the availability of tax-favorable treatment for broad-based employee stock plans where the fair market value of the shares at grant does not exceed ZAR9,000 (approximately US$1,500) in aggregate in any 3 calendar year period.

The tax favorable treatment available is:

• Employees can receive the shares tax free (no fringe benefit tax triggered);
• If shares sold more than 5 years after acquisition, the capital gain on sale is taxed at a lower capital gains tax rate. Otherwise, the capital gain is taxed as employment income at the employee’s marginal income tax rate; and
• The employer can claim a tax deduction for the market value of the shares issued.

In addition, the existing rules relating to share plans have been amended to address the numerous types of equity-based plans that are currently used. The new legislation provides for the taxation of income made on share plans only when the shares have "vested". This is a substantial change from the old legislation, in terms of which the tax event was the "acquisition of the right" to the shares.

Saudi Arabia: New Securities Regulations May Affect Share Plans

On December 3, 2004, the Saudi Capital Market Authority (CMA) issued Implementing Regulations (IR) which provide rules and instructions to comply with the Saudi CML.

While stock options and other employee stock plans are not specifically mentioned in the IR, such plans may be considered a public offer of securities and must meet the IR Listing Rules, including:

• Appointment of one of its directors to act as a representative before the CMA;
• Appointment of an authorized financial advisor to apply for admission to the official securities list;
• Submission of audited financial accounts, prepared in accordance to Saudi GAAP, for the last 3 financial years; and
• Prospectus filing requirements.

United Kingdom: New Rules on Sourcing of Stock Option Income for Cross-Border Employees

As of April 6, 2005, the United Kingdom will follow the revised OECD Commentary on cross-border stock options issues such that:

• Apportionment basis for sourcing of stock option income will be from grant to vest;
• Apportionment will be on the basis of work days versus calendar days;
• If the individual was resident in the U.K. at grant, 100% taxable in the U.K.; and
• Treaty relief will continue to be available only where the employee is resident in another treaty country at exercise.

There is an exception such that for mobile employees in the U.K./U.S. context, the apportionment basis will remain as stated in the U.S./U.K. treaty notes (i.e. from grant to exercise).

There will be no apportionment of any National Insurance Contribution (NIC) liability on any stock option income.

The Inland Revenue will be issuing guidelines shortly on these rules.

United Kingdom: New Law Requiring Formal Information & Consultation Procedures with Employees

As of April 6, 2005, a U.K. employer must put in formal procedures for information & consultation with employees if a valid employee request for information is made.

If companies do not initiate negotiations within a certain time from the initial employee request, then the standard consultative provisions, as stated by the Information and Consultation of Employees Regulations 2004, kicks in.

Companies proposing changes to employee equity plans may face a request for information and disclosure from their employees. Therefore, U.K. companies should consider what negotiating procedures they currently have in place for consultations and whether these procedures meet statutory requirements.

United Kingdom: Form 42 Reporting of Unapproved Stock Plan Benefits

On March 8, 2005, the Inland Revenue issued a 23-page guidebook on completing Form 42. Form 42 will need to be completed by all companies who have unapproved stock plans in the U.K. and returned to the Employee Shares and Securities Unit by July 7, 2005. We do not expect any extension of the deadline similar to last year.

Companies will have to spend significant amounts of time collating the information required for Form 42, which includes:

• The employee’s name, NIC number, and residence status (if applicable);
• Details of all grants, exercises and cancellations of stock options;
• Details of securities acquired, including acquisition date, price paid and whether a restricted securities election was made and whether PAYE was operated;
• Details on any restrictions attached to shares and the value of the shares on a restricted and unrestricted basis.

Otherwise, penalties of up to £300 per reportable event may be imposed.

United States: IRS Clarifies "Deferred Compensation," Provides Exception to SARS

On December 20, 2004, the Internal Revenue Service (IRS) issued Notice 2005-1, which provides the first of a series of anticipated statements providing guidance on the new deferred compensation rules under the American Jobs Creation Act of 2004. Under these rules, the IRS has concluded that plans providing short-term deferrals will not fall into the scope of deferred compensation. Therefore, the following will not be considered "deferred compensation" under the new Internal Revenue Code section 409A:

• Restricted stock & long-term bonus plans;
• All plans where the employer has a binding legal obligation to pay the deferred amount in a future year and the employee is vested as of December 31, 2004;
• Stock Appreciation Rights (SARs) on stock of publicly traded companies;
• Stock Appreciation Rights (SARs) on stock of privately held companies which were granted under plans on or before October 3, 2004; and
• Stock Appreciation Rights (SARs) with no built-in gains at grant, traded on an established securities market, the recipient can only receive stock when right is exercised, and only income deferral feature is the deferral of income recognition until exercise.

There is a transition rule such that amounts received on SARs granted under a plan before October 3, 2004 are not deferred compensation if:

• SARs’ exercise price is not less than the fair market value of the stock at grant; and
• Only income deferral feature is the deferral of income recognition until exercise.

However, the IRS warned that it may tighten the exception on a prospective basis where the employer reserves the right to repurchase the shares.

In addition, Notice 2005-1 stated that items not treated as a change in control for applying deferred compensation rules include a corporate initial public offering and that the concept of "change of control" applies only for corporate entities, and cannot occur for businesses operated as a limited liability company or partnership. Non-corporate entities (e.g. businesses operated as LLC or Partnership).

Finally, the IRS’ position is that where there is a material modification of the plan after October 3, 2004, a plan sponsor needs to use the new section 409A rules. Termination of a plan with inclusion of income by December 31, 2005 is not considered a material modification.

United States: Executive Stock Options Settlement Initiative for Sale of Stock Options to Related Parties

On February 22, 2005, the IRS offered a settlement program such that where an executive made a sale of stock options to a related person in exchange for an amount, the executive, company and/or related person may notify the IRS and pay the relevant taxes without penalty.

The settlement program requires the executive to recognize:

• Compensation income (& pay FICA) equal to the FMV at exercise less exercise price paid by the related person and the amount paid for the option by the executive;
• Gain if the deferred payment and any other cash or property received from the related person is more than amount computed above; and
• Interest income on the deferred payment obligation when interest is paid.

Under the settlement program, a company with an executive who made a sale of stock options to a related person in exchange for an amount has to:

• Pay its share of FICA;
• Pay employee’s share of FICA and an amount equal to the supplementary withholding rate times the compensation income for each executive not participating in the settlement program;
• Issue a Form w-2c, Corrected Wage and Tax Statement for each executive; and
• Disclose the identity of all current and former executives selling stock options to related persons in exchange for amounts that include any deferred payment of money or property.

There are several advantages to participating in the program. The advantages for the company are:

• No penalties with respect to non-withholding or reporting;
• Availability of a compensation deduction equal to the compensation income recognized by the executive; and
• No interest on FICA or supplemental withholding amounts.

The advantages to the executive are:

• Compensation income is recognized at exercise (versus taxation at both the transfer of stock options and exercise);
• Transaction costs will be deductible; and
• No 20% accuracy-related penalty.

United States: SEC Defers Effective Date of FAS 123(R) for Certain Companies

Under FAS 123(R), all SEC-registered companies have to expense employee stock plans once FAS 123(R) becomes effective.

FAS 123(R) is now effective for registrants as of the beginning of the first fiscal year beginning after June 15, 2005, instead of at the beginning of the first quarter after June 15, 2005. Therefore, the effective date for calendar year-end public companies is January 1, 2006 (not July 1, 2005). Early adoption of FAS 123(R) is still permitted.

Public companies with June 30, July 31, or August 31 year-ends are still required to adopt FAS 123(R) on July 1, 2005.

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PRESS ROOM

Retiring Workforce, Widening Skills Gap, Exodus of 'Critical Talent' Threaten U.S. Companies: Deloitte Consulting Survey

Looming Talent Crisis Signals Need for Organizations to Employ New Strategies

NEW YORK, February 15, 2005 -- Impending Baby Boomer retirements, a widening skills gap driven by declining educational standards, and outdated and ineffective approaches to talent management are combining forces to produce a "perfect storm" that threatens the global business economy, according to new research conducted by the Human Capital practice of Deloitte Consulting LLP ("Deloitte Consulting") and Deloitte Research, a part of Deloitte Services LP.

In a recent U.S. survey of human resources executives nationwide conducted by Deloitte Consulting, more than 70 percent of the 123 respondents say incoming workers with inadequate skills pose the greatest threat to business performance over the next three years, followed by Baby Boomer retirement (61 percent), and the inability to retain key talent (55 percent). These survey findings are underscored in Deloitte Research’s report, "It’s 2008: Do You Know Where Your Talent Is? Why Acquisition and Retention Strategies Don’t Work." "The overwhelming accumulation of data, including Deloitte Consulting’s new research, points to an inescapable conclusion: the widening skills gap, particularly among the categories of workers who disproportionately drive companies’ growth and performance, is a global phenomenon that will create unprecedented challenges for businesses," said Ainar Aijala, Vice-Chairman, Deloitte Consulting and global service area leader of Deloitte Consulting’s Human Capital practice. "The confluence of demographic and social trends – the full force of which will begin to be felt in as little as three years -- will leave behind companies that do not begin to rethink and redesign their approach to managing human capital."

Draining the Global Labor Pool

In only three years, the first wave of Baby Boomers will turn 62, the average retirement age in North America, Europe and Asia. According to the Deloitte Consulting survey, one-third of U.S. companies expect to lose 11 percent or more of their current workforce to retirements by 2008.

"While the ‘greying’ of the workforce will independently create large vacancies across industries, additional factors, such as low birth and immigration rates in Europe and the single-child policy in China, present further perils to companies worldwide," explains Aijala. "Companies will also continue to face inadequate skills among an increasingly diverse, virtual, global, and disengaged workforce."

Life sciences, energy and the public sector will be the hardest hit with manufacturing, consumer business and financial services industries close behind. For example, Canada, Australia and the U.S. could lose more than a third of their government employees by 2010. The National Association of Manufacturers revealed in a recent survey that more than 80 percent of U.S. manufacturers face a shortage of skilled machinists, craft workers and technicians. Further, the U.S. Department of Education predicts that 60 percent of new jobs in the 21st century will require skills possessed by only 20 percent of the current workforce.

The Critical Talent Factor

Among the many threats affecting the global workforce over the next few years, the exit of "critical talent" could be the most damaging. Deloitte Consulting defines "critical talent" as the individuals and groups who drive a disproportionate share of their company’s business performance and generate greater-than-average value for customers and shareholders. These individuals are "critical" to their company’s ability to meet strategic goals and objectives.

"When we talk about critical talent, we are not necessarily referring to the ‘A players’ or senior executives," explains Mike Fucci, principal and U.S. leader of Deloitte Consulting’s Human Capital practice. "Critical talent represents those individuals who possess highly developed skills and deep knowledge of not just the work itself, but of how to make things happen within a company, such as the couriers within package delivery companies who have daily client contact and direct knowledge of the supply chain, or researchers and clinicians within drug companies."

Unfortunately, few organizations have talent management processes in place to address the impending workforce shifts that will negatively impact critical talent segments. In fact, only half of the organizations surveyed by Deloitte Consulting have identified a list of the critical skills they need for future growth. Even more alarming, more than a quarter of respondents say defining critical skills as a workforce tool is "unimportant."

"Employers need to focus quickly on understanding which skills will make or break their business, where those skilled individuals will come from, and how to keep these workers engaged and committed within the organization," Fucci cautions. "Only those organizations that respond swiftly and plan effectively will find themselves on top of these new challenges."

Talent Management Shortcomings

Traditional approaches to talent management frequently focus on acquisition and retention. When the talent pool tightened in the 1990s, companies responded by offering rich compensation packages and "hot skills" bonuses. The end result, however, was often disappointing – recruiting costs soared while investments in training languished. In addition, such compensation packages were often matched by competitors, contributing to high attrition rates of talented personnel.

Despite the changing landscape, organizations still plan to increase their investment in traditional talent solutions for 2005. Approximately 60 percent of survey respondents plan to increase experienced employee recruitment, while 42 percent plan to increase campus recruitment. Additional investment will also be given to rewards packages for experienced employees (39 percent) and new recruits (30 percent).

"Acquisition and retention strategies remain important parts of talent management. Such strategies, however, attend to the "end-points" of the process and only offer a quick fix to these new workforce challenges," says William Chafetz, national practice leader of Deloitte Consulting’s Organization and People Performance Services. "To survive the changing labor landscape, organizations must employ more comprehensive talent management strategies that reflect an understanding of critical workforce segments and satisfy the conditions those employees need to succeed."

Getting to the Heart of Talent Management

According to Deloitte Research, talent-savvy organizations build strategies around what matters most to their critical talent – their personal growth or development, their need to be deployed in positions and assignments that engage their interests and curiosities, and their connection to others in ways that drive performance for the company as a whole.

Many of the companies Deloitte Consulting surveyed seem to understand the importance of development and training their employees, with nearly three-quarters (70 percent) of respondents planning to increase investments for mentoring and coaching in 2005, e-learning (64 percent) and classroom training (49 percent).

"It is a great sign that most organizations are committed to strengthening the skills and knowledge of their workforce, but they need to do more," states Chafetz. "No single part of the talent management process can sustain an organization or generate superior business performance on its own – organizations must adapt a new way of thinking and use critical talent as a competitive advantage and a long-term investment."

Deloitte Consulting’s "Develop-Deploy-Connect" model is a distinct departure from traditional talent management strategies in that it zeroes in on the center, or heart, of the talent management process: the development, deployment and connection of critical talent. Combined with supporting programs, organizations that build strategies to develop, deploy and connect their critical talent generate the workforce contributions for superior business performance. When this happens, attraction and retention largely take care of themselves.

Companies can avoid sustaining a direct hit from the looming talent crisis, and in fact convert these challenges into an opportunity, by rethinking and reinventing their talent management processes into a well-designed talent strategy that truly utilizes critical workforce as a competitive advantage and, therefore, differentiates a company from its competitors.

The Deloitte Consulting/Deloitte Research report provides specific examples from well-known organizations that are adapting well to this new talent environment. The report is the first in a series of talent management points of view dedicated to analyzing the forthcoming workforce challenges and providing a forward-thinking solution through "Develop-Deploy-Connect." A copy of "It’s 2008: Do you Know Where Your Talent Is? Why Acquisition and Retention Strategies Don’t Work" can be found on Deloitte’s Web site at www.deloitte.com/us/talentpov.

The electronic survey of 123 U.S. human resources executives nationwide was conducted in late-December 2004 and early-January 2005.

This article is intended as a general guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems that they encounter. This bulletin should not be relied on as a substitute for such advice. While all reasonable attempts have been made to ensure that the information contained in this bulletin is accurate, Deloitte Touche Tohmatsu accepts no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it.

Copyright ©2005, Deloitte Touche Tohmatsu. All rights reserved.
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