III. Stock Options
A phenomenon in current compensation schemes is the bundling of a portion of compensation to the economic fortunes of the employer, as measured by the change in the market price of the employer's stock.53 This type of compensation can be taxed on the date of grant, on the vesting of the option (when it is no longer subject to any condition on the right to exercise), on exercise or disposition of the option, or when the stock is sold.54
In many countries, there are two types of stock options, tax- advantaged stock options and ordinary stock options. Tax-advantaged stock options are generally subject to one or more specific restrictions with respect to the selection of the employees to whom the option may be granted, the relationship of the exercise price to the current value of the underlying shares, the number of shares that may be granted to all employees (and to any one employee in particular), the term of the option, and the holding period of the option (or the option shares). Tax-advantaged stock options generally may be granted to an employee without an immediate tax effect. Frequently, the exercise of such options is also not a taxable event. All other options are not tax advantaged and are generally taxable at the time of grant or exercise.
An employee's change of residence between the time an option is granted and the time it is exercised may produce disparate tax consequences. Although the income may have been "earned" in one country, it is ultimately realized in another. Since two countries may differ concerning their interpretations of when or where the income is earned, there is the potential both for tax avoidance and double taxation. Moreover, the tax consequences may vary depending on whether the option is tax advantaged or ordinary option.
Since the factual situations are so varied, a myriad of tax issues may arise in connection with stock options. Relevant facts and circumstances include: (i) whether the options are tax-advantaged (frequently called qualified stock options); (ii) whether the options are vested (nonforfeitable) at the time of grant; (iii) whether, if the options are not vested at the time of grant, they become vested before or after a change in residence; (iv) whether the value of the options is taxed at the time of grant, the time of change of residence, the time of exercise, or only at the time of sale of the shares; and (v) whether the services resulting in the grant were rendered wholly or partly before or after the grant, the change of residence, or over a period of years in more than one country. The variety of possible factual situations makes presentation and analysis difficult.55
To simplify the presentation and analysis, the following discussion first describes in a general manner qualified and nonqualified stock options, highlighting the advantages of qualified stock options, and describes the different times at which stock options may be subjected to tax, and at what rates. It then considers the impact of a change in residence on the taxation of stock options and the potential for multiple taxation and its relief.
B. Summary of Tax Laws Applicable to Stock Options in the Absence of Treaties
1. Qualified Stock Options
Australia, Belgium, Canada, France, Italy, the United Kingdom,56 and the United States each distinguish between qualified and nonqualified stock options. To be classified as what we call a qualified stock option, the option (or the plan pursuant to which the option was issued) must normally satisfy a number of requirements with respect to, inter alia, the timing of the grant, the terms of the options, and the persons to whom options may be granted.
In general, qualified stock options, as we use the term, are not subject to tax in these countries at the time of grant or exercise, deferring tax until the employee disposes of the shares acquired upon exercise. All other options are nonqualified options. In countries that tax capital gains at lower rates than ordinary income, qualified stock options also provide the benefit of a lower tax rate than if the gain were taxed as employment income at the time of grant or exercise. Some notable variations from these general statements are described below.
In Australia, the holder of a qualified stock option is taxed on the discount in relation to the option in the year the "cessation time" occurs, unless the employee makes an election to have the discount taxed in the year the option is acquired. The "cessation time" is the earliest of when the option is exercised, when the option is sold, the employment is terminated, or 10 years from grant. Thus, Australian qualified stock options do not permit employees to defer tax to the same extent as the other countries listed above.
In Belgium, the holder of stock options obtains no deferral of tax. Rather, the holder of a qualified stock option is subject to tax upon the grant of the option, just as if they were holding a nonqualified stock option. The option, however, is subject to a beneficial valuation regime; they are generally valued at one-half of the value of nonqualified stock options (as described in further detail below).
In Canada, the extent to which stock options are tax-advantaged depends on the identity of their issuer. If qualified stock options are issued by a Canadian-controlled private corporation (CCPC) and the exercise price is not less than the value of the optioned shares when granted, then the holder of the qualified stock option is entitled both to deferral and preferential capital gain rates when the stock is sold. If, however, stock options are issued by a corporation other than a CCPC, the holder will benefit from deferral only until the option is exercised. The amount subject to tax is the difference between the fair market value of the stock and the sum of the exercise price and amount paid for the option, if any. The holder of the qualified stock option issued by a non-CCPC will, however, be taxed on this income at preferential capital gain rates if the value of the shares is not greater than the option price when the option is granted. These rules are to be amended by legislation to be enacted pursuant to the Canadian government's budget of February 28, 2000.57
In France, if a stock option is granted with an exercise price discounted more than 5 percent below the fair market value of the underlying stock at the date of grant, then the portion of the discount exceeding 5 percent is treated as ordinary income subject to tax (at rates approaching 60 percent) at the time of exercise. Upon the subsequent disposition of the stock, the difference between the fair market value on the date of exercise and the sale price (subject to the portion of any discount already taxed) is taxed at capital gain rates, but only if the total proceeds derived from shares sold by the employee in a given year exceed a predetermined ceiling.
In Italy, the grant of qualified stock options is not deemed taxable income if the shares are offered to all employees, the shares are kept for at least three years, the option price equals or exceeds the fair market value of the shares at the date of grant, and the value of the shares does not exceed ITL 4 million per year.58 If the exercise price of the option is less than fair market value, the entire gain may be subject to ordinary income rates, although arguably the income should be limited to the difference.
In the United States, the holder of a qualified stock option will only be entitled to deferral and preferential capital gain rates if a holding-period requirement and an exercise-price restriction are satisfied.
2. Other Stock Options
Nonqualified stock options and stock options issued in countries that do not distinguish between qualified and nonqualified stock options (e.g., Germany, the Netherlands, and Switzerland) do not benefit from the tax advantages discussed above. These options are normally taxed at the time of grant, vesting, or exercise (minimizing or eliminating any possibility of deferral), and the income is normally considered ordinary income, preventing the application of preferential capital gain rates. Any gains accruing after the time of grant or exercise, as the case may be, are normally subject to the same rules as any other capital gains recognized by an investor in the company.
In Canada, France, Germany, Italy, Japan, Sweden, the United Kingdom, and the United States, with limited exceptions, nonqualified stock options are subject to tax at the time of exercise. At that time, the spread between the exercise price and the fair market value of the stock is taxable to the employee as employment income.59 Any appreciation accruing after exercise will constitute capital gain and be taxed accordingly.
In Australia, the discount in relation to a nonqualified stock option is included in the employee's income in the year the option is acquired. Upon the subsequent disposition of the shares, the gain (calculated by reference to the fair market value of the shares when the option was granted) is taxed as capital gains. In Belgium, a nonqualified stock option is subject to tax when granted. The value of a nonqualified stock option is equal to 15 percent of the value of the underlying shares at the time of offer, and that percentage is increased 1 percent for each year (or portion thereof) that the option is exercisable in excess of five years. Gain realized on the exercise of the stock option, or upon a later disposition of the stock acquired, will not be subject to tax in Belgium.
In the Netherlands, the grant of an unconditional stock option to an employee or the vesting of an earlier conditional stock option is a taxable event. The "taxable benefit" of the option, which is calculated in accordance with a statutory table, constitutes employment income subject to tax at progressive rates. After the date of grant or vesting, as the case may be, the option is considered a private asset, and any gain or loss realized by the employee on its exercise or disposition, or upon the disposition of the stock acquired, is generally not subject to tax. If, however, the employee exercises or disposes of the option within three years of the date of grant, then the market value of the option at that time (less the taxable benefit, if any, taxed at the time of grant) is taxed as employment income. In addition, if the employee (together with related persons) owns or holds options to purchase at least 5 percent of the issued share capital of the company (a "substantial interest"), then gain from the disposition of the option, or from the disposition of the shares acquired, will be subject to tax at a flat 25 percent rate.
In Sweden, the grant to an employee of a right to purchase stock in the future at a predetermined price, or otherwise at beneficial conditions, is not taxed until it is exercised or sold. However, a stock option that an employee can dispose of freely (qualifying as a security) will be taxed at the time of the grant if acquired below market value. Future gains or losses will be taxed as capital gains at a flat 30 percent rate. An employee stock option that does not qualify as a security is taxed when exercised at market value. Whatever the employee has paid his employer to acquire the stock option is deductible, but not until the option is exercised or sold. As the difference between the market value and deductible costs is taxed as employment income, social security fees are paid by the employer based on the employment income. The imposition of social security fees may make it very expensive for Swedish employers to use employee stock options. It may be difficult to predict how large future social security fees will be and, consequently, uncertainty exists about the size of the future reserves the company should set aside on its balance sheet.
In Switzerland, the grant of a stock option to an employee is a taxable event. The difference between the fair market value of the option and any amount paid by the employee constitutes employment income subject to tax at progressive rates. If the optioned stock is publicly traded, then the fair market value of the option is equal to the quoted value at the time of grant. A valuation formula (Black-Scholes) is generally used to determine the fair market value of an option if the stock is not publicly traded. After the date of grant, the option is considered a private asset, and any gain or loss realized by the employee on its exercise or disposition, or upon the disposition of stock acquired upon exercise, is generally not subject to tax.
In the United Kingdom, whether a nonqualified stock option will be taxed at the time of grant or at the time of exercise depends on the length of the exercise period. If the exercise period is 10 years or less, the employee will not be subject to tax at the time of grant. In this situation, the employee will be subject to tax at the time of exercise on the difference between the fair market value of the stock at exercise and the sum of the exercise price and the amount, if any, paid for the option. If the option can be exercised more than 10 years after the date of grant, the employee will be subject to tax both at the time of grant and at the time of exercise. At the time of grant, the employee will be subject to tax on the fair market value (at the date of grant) of the shares that are the subject of the option, less the exercise price and the amount, if any, paid for the option. At the time of exercise, the employee will be taxed on the fair market value of the shares at the time of exercise less the exercise price and the amount, if any, paid for the option with a credit for the tax paid on the grant of the option.60
C. Change in Residence
Whether a change in residence will trigger or limit the taxation of stock options (or the stock acquired on exercise) depends on a number of factors, including whether a distinction is made between qualified and nonqualified stock options, whether options are taxed at grant or at a later time, and where the services were performed that gave rise to the option and perhaps to the vesting of the option. Rather than making broad generalizations about the impact of a change in residence on the taxation of stock options, we have set forth below a brief description of each country's tax rules that apply to stock options.
In Australia, if an employee were to cease being a resident of Australia between the time an option was granted and the "cessation time" (in the case of qualified stock options),61 then the employee would be subject to tax in Australia when the "cessation time" occurred, provided the discount had an Australian source.62 If an employee were to cease to be a resident of Australia between the time the option was exercised and the subsequent disposition of the stock acquired upon exercise, the employee would be deemed to have disposed of the stock (for fair market value) at the time he ceased to be a resident of Australia, and would be subject to capital gains tax at that time. If the employee was a resident of Australia for fewer than 5 of the 10 years immediately preceding the change in residence, then the employee would be exempt from capital gains tax on non-Australian assets owned at the time he last became an Australian resident.
In Belgium and Switzerland, a change in residence will not affect taxation of stock options (or option shares) because stock options are subject to tax at the time of grant and gain realized on the exercise of a stock option, or upon a later disposition of the stock acquired, is not subject to tax.
In Canada, if an employee was a Canadian resident when an option was granted, but ceased to be a resident before the option was exercised, the employee would be subject to tax at the time of disposal of the stock, if the corporation is a CCPC or the stock is listed at a value less than C $100,000 when the option was granted. Otherwise, the employee would be subject to tax at the time of exercise, regardless of whether the option was vested prior to the change in residence.
If the services giving rise to the benefit were performed partly within and partly outside of Canada but, in each case, while the employee was a resident of Canada, the same tax results would apply. Although the Canadian Customs and Revenue Agency may take a contrary view, if the option has not vested when the employee ceases to reside in Canada and it later vests after the employee has been employed in the same corporate group outside Canada, only a portion of the benefit arising on exercise or the sale of the stock may be taxable in Canada. This would depend on the terms of the stock option plan and its interpretation as to whether it is reasonable to consider that the benefit is earned partly while a Canadian resident, and partly while a nonresident, from employment outside Canada. The employee, as a nonresident of Canada (in cases where the stock option benefit is taxed when exercised), would also be subject to tax on any further gain on a subsequent disposition of the stock acquired on exercise, but only if the stock constituted taxable Canadian property.63
In France, there is no authority or official position on the taxation of the exercise of an option after a change in residence. Since the income from nonqualified stock options (or from qualified stock options where the holding period requirement is not met) is usually treated as additional compensation, France would undoubtedly attempt to tax the income under its domestic law.64 Income from qualified stock options exercised after a change in residence may not be taxable.
In Germany, if an employee was a German resident at the time an option was granted, but ceased to be a German resident before the option was exercised, then the income realized on exercise would be subject to tax in Germany if the options were still considered to be derived from German employment at the time of exercise. In addition, under normal exit tax rules, if an employee who had been a German resident for at least 10 years ceased to be a German resident while owning more than 10 percent of the stock of a German corporation, the employee would be deemed to have disposed of the stock. The employee would recognize a capital gain equal to the difference between the fair market value of the interest and its cost basis.
In Italy, whether an employee who was an Italian resident when an option was granted, but who ceased to be a resident before the option was exercised, will be subject to Italian tax on exercise of the option will depend on the place of performance of the services that are remunerated through the stock option. If the stock option related entirely to the performance of services in Italy, it would be subject to Italian tax upon exercise. If the stock option related entirely or at least partially to the performance of services outside Italy, then the option would not be subject to Italian tax upon exercise (or would only be subject to Italian tax in part, but on what basis is currently unclear). Whether the employee will also be subject to tax on a subsequent disposition of the stock acquired on exercise of the option will depend on whether the stock is of an Italian resident company (generally taxable) or of a company that is not resident in Italy (generally not taxable). The location where the services were performed is irrelevant for this purpose.
Japan distinguishes between an option on shares of Japanese companies and foreign companies. If the employee is given an option on shares of a Japanese company, she will be taxed. If the option is on shares of a foreign company, the employee will not be taxed, because the economic benefit does not relate to an asset located in Japan.
In the Netherlands, holders of vested options who do not have a substantial interest65 are not subject to any tax on the exercise of the option or the sale of the stock, because they were taxed at vesting. If the individual exercises the option within three years of the grant, additional tax is payable at progressive rates. If the employee emigrates, there is no departure tax and the normal rules apply. If the options are exercised within the three-year period, but after the employee has emigrated, regardless of whether the options were vested at the time of departure, tax is imposed on the nonresident employee because the deemed income will most likely be attributed to employment exercised in the Netherlands.
In Sweden, an employee who emigrates after having received a stock option that was not taxed on grant will be taxed on departure if the option has vested. If not, the gain on the option may under certain circumstances be subject to final withholding tax of 25 percent on employment income paid to nonresidents, or, if the gain is classified as capital gain, it may be subject to the trailing tax. In the converse situation, an immigrant is not taxable on the exercise of an option that was vested prior to immigration.
In the United Kingdom, if an employee was resident and ordinarily resident in the United Kingdom at the time an option was granted, but ceased to be a United Kingdom resident before the option was exercised, the charge to income tax would still arise when the option was exercised -- even though the option was exercised while the employee was not a U.K. resident. There is no apportionment of this income based on where the employee's services were provided.
In the United States, if there is a change in residence between the time a nonqualified stock option66 is granted and the time the option is exercised, then the employment income that results from the exercise of the option must be allocated between U.S. and foreign sources to determine the extent to which it will be subject to U.S. tax.
The first step in making this allocation is determining in which period(s) the employee rendered the services for which the option was granted. This inquiry will depend on the facts and circumstances of each particular situation. Once this period has been determined, then the employment income realized on the exercise of the option will generally be allocated between U.S. and foreign sources on the time basis. Accordingly, the portion of the employment income derived from U.S. sources and subject to United States tax will be equal to the total employment income multiplied by a fraction, the numerator of which is the number of days that services were performed in the U.S. during the relevant period. The denominator of the fraction is the total number of days that services were performed during the relevant period.
D. Areas of Conflict Under OECD Model Treaty
If an employee's former country of residence (that does not tax on grant) asserts that the employee is subject to tax at a later time on all or a portion of the income attributable to a compensatory stock option, double taxation will result, unless the new country of residence grants an exemption or a credit for the foreign taxes paid to the former country of residence.
Article 23 of the OECD Model Treaty requires the country of residence to grant a credit or exemption when the income of the resident may be taxed by the source country in accordance with other provisions of the treaty. In this respect, the interpretation of article 15, defining when the former country of residence can tax income from dependent personal services, is crucial. Under paragraph 1 of article 15, salaries, wages, and other similar remuneration derived by a resident of a contracting state in respect of employment may be taxed where the employment has been exercised. This, in turn, may depend on an analysis of where the services were performed for which the option was granted. The addition of the term "similar" to remuneration in paragraph 1 of article 15 indicates that not all remuneration, but only remuneration that is similar, is covered.67 The extent of that limitation is not covered in this article but it was assumed, for purposes of the article, that stock options and deferred compensation are "similar" remuneration and, thus, covered.
In those situations, when one country treats the grant of the stock option as consideration for services performed prior to the grant of the option, and the other country treats the grant of the stock option as remuneration for services performed after the grant of the option, or taxes on the exercise of the option, there may be a conflict as to source. The employee may be subjected to double taxation without any offsetting exemption or foreign tax credit. This is a present conflict between the U.S. and Canada.
CCRA treats income from the exercise of a stock option as consideration for services performed in Canada when the taxpayer had performed services in Canada prior to the date of grant, even if the taxpayer emigrates to the U.S. and continues employment there (with an affiliate) before the option vests. The United States, on the other hand, adopts a facts and circumstances approach. Under this approach, the services for which an option has been granted may be those services rendered by the employee subsequent to the grant of the option. Similar issues were recently decided by the Tax Court of Cologne,68 holding the award of the option to be for past services.
Where the option is nonvested and contingent on future services, paragraph 1 of article 15 should require an allocation of the income attributable to the stock option based on the place of service after the date of grant, if both countries assume that the value of the stock option has increased proportionately during the years between the time the stock option was granted and the time that it was exercised.
Paragraph 2 of article 15 provides that, notwithstanding paragraph 1, the remuneration derived by a resident of a contracting state in respect of employment will be taxable only in the country of residence if: (a) the recipient is present in the other state for a period or periods not exceeding in the aggregate 183 days in a 12-month period commencing or ending in the fiscal year concerned; (b) the remuneration is paid by, or on behalf of, an employer who is not a resident of the other state; and (c) the remuneration is not borne by a permanent establishment or a fixed base the employer has in the other state. This gives rise to the same problem that we previously discussed concerning deferred compensation.
In many cases, the recipient will not have been present in the former country of residence for 183 days in the year she exercises the option. Thus, it may be necessary to determine whether the remuneration was "paid by, or on behalf of" an employer who is a resident of the former country of residence. How should this determination be made in the context of an exercise of compensatory stock options? Is "paid by" a tax concept or an economic concept? If the spread between the value of the stock and the exercise price is simply due to appreciation in the stock that has resulted from market forces outside the control of the employer, should such appreciation be considered "paid by" the employer? One could argue the employer should be treated as having paid the remuneration, because the employer could have issued the stock on the public market in exchange for cash, and could then have taken that cash and used it to pay for the employee's services. The problem is that, in fact, this is not what occurred.
Even more problems arise in determining whether a permanent establishment or a fixed base has borne the remuneration. The OECD Report on Partnerships equates the phrase "borne by" with "deductible by," which is a tax concept.69 Whether a permanent establishment or fixed base has deducted the spread on exercise is an objective test that can be easily applied to the compensatory stock option context. Nevertheless, the Netherlands Supreme Court cast doubt on this interpretation. The court interpreted the phrase "borne by" as a normative term, indicating that employment costs should be allocated under economic criteria.70 The court determined that the bookkeeping entries in the books of the permanent establishment are decisive.71
A conflict may also arise in determining whether article 13 (capital gains) or article 15 controls the taxation of the gain recognized on the disposition of stock acquired on exercise of compensatory stock options.
Consider the following situation: an employee who is a U.S. resident is granted a qualified stock option that is clearly meant as compensation for past services in the United States. The employee exercises the option while still a U.S. resident. The exercise is not a taxable event because the option is a qualified stock option. The employee then moves shortly after exercise to a country that taxes the employee only on the grant of stock options, thereafter treating the options and stock acquired on their exercise as private assets exempt from tax. The employee then sells the stock before satisfying the U.S. holding-period requirement, causing a portion of the gain on the sale to be considered employment income for U.S. tax purposes. In this situation, should article 13 or 15 apply to the portion of the gain recharacterized as employment income? If article 13 were applied, only the new country of residence would have taxing jurisdiction. If article 15 were applied, the U.S. would also have taxing jurisdiction, assuming that article 15(2) was inapplicable because of the short time frame between the exercise of the option, the move to the new country of residence, and the sale of the stock acquired on exercise of the option.
Given the current uncertainties in applying articles 13, 15, and 23, there is a significant risk of multiple taxation. Similarly, there is a possibility the employee may be able to avoid taxation completely.
Stock options, although a distinctive form of compensation, are becoming more prevalent. Because of their increased use, their peculiarities, and the differences in internal law, the OECD Model Treaty may not be able to specifically address the cross-border issues raised by the grant of stock options as a form of compensation. The authors believe that in negotiating bilateral treaties, the two contracting states should accomplish this goal by including specific provisions to relieve double taxation and double nontaxation.
The issues that should be addressed are the type of income,72 the source of the income, and whether the income should be taxable based on residence at the date of grant (or vesting) or based on the location(s) where services were performed. If based on the location where services were performed, the relevance of whether the services were performed during the period before the date of grant should be considered. Where the employee has emigrated before vesting or exercise, or after vesting or exercise, when such events were not taxable events, each country must determine whether the emigration is a taxable event and, if not, whether the future event is a taxable event and how the income should be allocated. Assuming that the compensation will be taxed in both countries, the contracting states should decide whether it should be shared based on the value of the option at the time of emigration, such as Switzerland's Black-Scholes valuation method, or shared on a linear basis over the relevant time of employment. Importantly, the credit or exemption in article 23, exemption method or credit method, should be harmonized with articles 13 and 15 to prevent the complete avoidance of taxation as well as double taxation.
Even with such clarifications, there may still be a need to initiate competent authority proceedings because of the difficult factual distinctions that must be made in allocating income. These fine distinctions are, necessarily, beyond the scope of the specific provisions of treaties. As an example, consider the problems raised in allocating income on the exercise of an option when the right to exercise is contingent on the performance of future services after the date of the grant. How should the income be allocated when an individual has been employed for five years and is given an option contingent on five years of future service? Compare that individual to an individual who is a new employee and is given the same option. What if the employee, in either situation, is given the option conditioned on service in another country?
One assumption, that an option increases in value in a uniform arithmetic progression during the period between its grant and exercise, should also be reexamined. For example, suppose an individual who resides and is employed in country A is granted an option with a term of five years and an exercise price of US $10. The employee retires to another country, B, after four years and when the fair market value of the underlying shares does not exceed US $10. One year later, the fair market value of the shares spikes to US $30 and the employee exercises the option. How much, if any, of the income should be taxed in country A? Will country B agree to cede all or a portion of its taxing jurisdiction to country A and grant a credit for the tax paid on the income that country A believes was earned there?
Another issue is the tax cost or basis of the shares when the option has been exercised. The employee will not be able to prove the basis merely by supplying the checks used to purchase the shares. Will the new country of residence consider the services rendered as an additional cost?
IV. Death and Gift Taxes
Estate, gift, generation skipping, inheritance, and capital transfer taxes (transfer taxes) present a similar, and often greater, problem to the emigrating or expatriate taxpayer. Again, the focus of this article is not on the normal issues that arise when a domiciliary, citizen, or resident of one country owns assets in another country. This is not to denigrate these problems. They are even more complex than the income tax issues described above, because more than two countries are frequently involved.73
The focus here is on the transfer tax problems resulting solely from a change in residence or a change in domicile74 and the desire by the former country of residence or domicile to avoid surrendering its right to tax individuals who had been afforded protection under its laws for a significant period of time.
There are at least two problem situations. The first is an individual who has departed for a limited period of time, but who intends to return to her country of former domicile. The second is the retention by the former country of domicile of its power to tax an individual who, under objective factual criteria, is no longer a domiciliary.
The first problem is mentioned, but left to the member countries to solve in the commentaries to the OECD Model Double Taxation Convention on Estates and Inheritances and on Gifts (OECD Model Estate Tax Treaty).
Special problems may arise when a person is domiciled in one of the states and is resident, and therefore domiciled for purposes of article 4, in the other state, but not permanently. This scenario would arise when an executive of an international company is assigned to work for a certain period outside her own country. Some conventions provide a minimum period of residence before the individual is treated as "domiciled" in the state. The aim of article 4 is to avoid assessing the merits of national rules of law governing the circumstances in which a person is treated as domiciled in a contracting state. Member countries, especially those with domestic laws determining a liability to tax, are significantly different, and they may deal with this special case by including such a provision in their bilateral conventions. (Commentaries, art. 4, para. 13.)
To solve this problem, some countries have adopted special provisions. The U.S. has a special provision in its Treasury Department's Model Estate and Gift Tax Treaty of November 20, 1980. The provision states:
Where an individual was:
(a) a citizen of one Contracting State, but not the other Contracting State,
(b) within the meaning of paragraph 1 domiciled in both Contracting States, and
(c) within the meaning of paragraph 1 domiciled in the other Contracting State in the aggregate less than 7 years (including periods of temporary absence) during the preceding ten-year period,
then the domicile shall be deemed, notwithstanding the provisions of paragraph 2, to have been in the Contracting State of which he was a citizen.
The provision is limited to citizens, perhaps because citizenship is a practical substitute for permanent residency. Notwithstanding the OECD Model Estate Tax Treaty, the provision appears in only 3 of the United States' 13 estate tax treaties: the treaty with France, in which the test is 5 out of the preceding 7 years; the treaty with the Netherlands, in which the test is 7 out of the preceding 10 years, if the presence was attributed to employment; and the treaty with the United Kingdom, in which domicile is required for 7 out of the preceding 10 years.75 The United Kingdom also uses this provision in all of its recent estate tax treaties.76
The second problem is retention of the power to tax by the former country of domicile, notwithstanding that an actual change of domicile has occurred. The countries that have extended their power to tax former residents who are no longer domiciled in their countries include Germany,77 the Netherlands,78 the United Kingdom79, and the United States.80
The OECD restricts the scope of the Model Estate Tax Convention to estates of, or gifts made by, persons domiciled in one or both countries, disregarding any other criteria that under domestic law of a member country may lead to comprehensive tax liability.81 Thus, under the OECD Model Estate Tax Treaty, the potential for multiple taxation arises where a country taxes a decedent on a basis other than domicile or the situs of assets.
Australia does not have an estate or inheritance tax. A tax is due on the individual changing residence. This exit tax was discussed previously.
Belgium imposes an inheritance tax on residents. It does not retain the power to tax persons who have moved their residence elsewhere, except for Belgium situs real property. The issue of an individual who has departed for a limited period of time intending to return to the country of former domicile is not specifically addressed in Belgian law or in any of its two treaties with France and Sweden on inheritance tax.
Canada does not have an estate or inheritance tax. It deems property to be disposed of at fair market value immediately before death, imposing capital gains tax on appreciated assets. A tax is also due on the individual change of residence. This exit tax was discussed previously.
France imposes an inheritance tax on residents. It does not tax persons who have moved their residence elsewhere, except for taxation of French situs real property and under recent legislation, where the heirs are residents of France, regardless of whether decedent was ever a resident of France. The issue of an individual who has departed for a limited period of time (five out of seven years) intending to return to the country of former domicile is addressed only in its treaties with Sweden and the United States.
Germany taxes worldwide assets of German residents, generally including individuals having a permanent home or a habitual abode in Germany. German nationals with a habitual abode abroad, who have not retained a permanent home in Germany, remain subject to unlimited liability to tax if their stay abroad lasts less than five years. Moreover, if the decedent was (at the time he became liable to tax) a resident in a low-tax country, had important economic interests in Germany, and was for 5 uninterrupted years liable to tax in Germany during the 10-year period before departure, then an extended limited liability applies to domestic property (including certain property which would not otherwise be treated as having a German situs) and property received from domestic sources. Relief from double taxation is available in the form of a foreign tax credit for taxes paid on any property that does not have a German situs.
Under Italian tax laws, a taxable estate includes worldwide property if the deceased person was a resident of Italy at the time of death, or only Italian situs assets if the deceased person was not a resident of Italy at the time of death (article 2 of legislative decree no. 346 from October 31, 1990).
Japan does not have an estate or death tax. In Japan, the sole criterion of the unlimited liability to tax is the acquisition of property by inheritance by an heir domiciled in Japan. The domicile of the deceased is completely immaterial. Thus, the issue of the decedent changing residence is not relevant. There are serious risks of tax for an individual, such as an employee or director, who moves to Japan, inherits property, and does not leave Japan within one year. In addition, proposed article 69 of the Japanese Special Tax Measurements Law will provide that if non-Japanese domiciliary acquires property situated outside Japan by gift or inheritance, he will be subject to Japanese gift or inheritance taxation if he is a Japanese national and if either the donor or the donee, or the decedent or the heir, has been domiciled in Japan at any time during the five years preceding the gift or inheritance.
The Netherlands imposes its inheritance and gift taxes when the deceased or donor is a resident of the Netherlands. In addition, it provides for deemed residency with respect to Netherlands nationals residing abroad who died or made a gift within 10 years after their date of emigration from the Netherlands if they maintained Netherlands nationality. Gifts by departing aliens are subject to gift tax for one year after emigration. A foreign tax credit is available in these situations if the decedent's representative (or donor) can show that the foreign tax would not have been imposed if the deceased had remained resident in the Netherlands. The trailing period is occasionally reduced in its treaties.
Sweden has both an inheritance tax and a gift tax. The gift and inheritance tax is imposed on property inherited from or given by a Swedish citizen or spouse of a Swedish citizen within 10 years after departure from Sweden. The person receiving the property is liable for the tax.
Most Swiss cantons impose an inheritance tax on residents. No canton taxes persons who have moved their residence elsewhere. The issue of a person who has come into Switzerland for a limited period of time but who does not intend to remain permanently in that state, such as an executive of an international company, is not specifically addressed in the cantonal legislation, and the concept of residency is the same as the one used for income tax.
K. United Kingdom
In the United Kingdom, an individual who has abandoned her U.K. domicile under the general rules of law retains a deemed U.K. domicile for the following three years.82 The definition of domicile in the U.K. also includes any person who has been resident in the U.K. during 17 of the preceding 20 tax years. The effect of these provisions is that the U.K. continues to tax under internal law the deceased's (or donor's) worldwide assets during the period of deemed domicile. Under its estate tax treaties, the U.K. treats this extended tax as taxation on account of domicile so that the dual domicile provision applies, which may result in the other country being the country of domicile for treaty purposes. In other cases, under U.K. internal law, a partial credit is available to offset double taxation in this situation.83 This credit is determined by the following formula:
United Kingdom Tax
United Kingdom Tax + Foreign Tax
X Lower of United Kingdom Tax and Foreign Tax
The effect of this formula is that if the country imposing the foreign tax grants a credit using the same formula, then the total tax will be equal to the greater of the two taxes. No country, other than Germany and the United Kingdom, provides a credit for foreign taxes on property located in a third country paid by a former domiciliary to a country where the taxpayer is not actually domiciled. To preserve its right to tax, both in the case of being the loser under a dual domicile provision and on the basis of situs of assets other than those on which the treaty permits taxation, the U.K. includes in its treaties a provision to protect its taxing rights for a period of years84 so that the new state of residency does not retain the sole taxing right and the U.K. will give relief for the other state's tax.
L. United States
The U.S. extends its power of taxation to former citizens who lost their U.S. citizenship for purposes of avoidance of tax.85 Comparable treatment is applicable to long-term, lawful, permanent residents who ceased to be taxed as residents. The United States, under its normal rules, taxes the U.S. situs property of nonresidents of the U.S. with limited exceptions for portfolio debt and bank deposits. These exceptions are eliminated for expatriates, for 10 years. Shares in certain foreign corporations, when an individual has attempted to change the situs of the U.S. assets by transferring them to or investing through a foreign corporation, are also included in the expatriate's estate. In that case, for purposes of imposing its estate tax, the U.S. taxes that proportion of the fair market value of the stock of a foreign corporation owned by the decedent at the time of death that the fair market value of any assets owned by such corporation and situated in the U.S. at the time of death bears to the total fair market value of all assets owned by such foreign corporation.
The provision is applicable only to a foreign corporation in which the decedent owned at the time of death 10 percent or more of the total combined voting power of all classes of stock entitled to vote, or in which the decedent owned or is considered to have owned, by applying certain broad attribution rules, more than 50 percent of the total combined voting power of all classes of stock entitled to vote of such corporation or the total value of the stock of such corporation. To avoid double taxation in this situation, the U.S., in its internal law, grants a credit for the taxes imposed by a foreign country under its estate, inheritance, legacy, or succession taxes on the corporation to the extent of the proportion of its U.S. situs assets. Lifetime transfers of intangible property by an expatriate, which are not generally taxed where the transferor is a nonresident, are subject to the gift tax if the intangible property has a U.S. situs. A credit is available for taxes paid to any foreign country with respect to such a transfer.
The OECD Model Estate Tax Treaty works well, in principle, when all countries tax on the basis of domicile, nationality, and situs. When a country retains the right to impose comprehensive tax liability or extended tax liability on certain assets of its former domiciliaries or nationals, or an inheritance tax on immigrants, or imposes an income tax rather than an estate or inheritance tax, the treaty is deficient and should be amended to provide for the granting of a deduction, a tax credit, or exemption by the country that uses such criteria.
V. Summation and Suggestions on Change of Residence
The purpose of this article was neither to present a definitive analysis of the laws of each country nor to suggest perfect solutions to the many tax problems that face individuals when they change residence. Rather, its purpose was to make tax advisors aware of, and urge the various tax authorities to address, these problems.
The OECD Model Treaty has not addressed all of the areas of potential multiple taxation of an individual who changes residence, particularly from a country that has an exit tax, which is a tax regime that is becoming more prevalent. With the changing times, the many problem areas discussed in this article should be revisited, or, in some cases, visited. Countries are quick to act when they believe that individuals are obtaining unintended benefits as a result of a change in residence. They should be equally quick to act when an individual is caught between differing regimes of taxation.
It is incumbent upon countries in negotiating bilateral income tax or estate tax treaties to bear in mind the taxation issues that can arise on the change of residence, domicile, or citizenship discussed in this article. The countries should include in their treaties provisions that the negotiators consider appropriate to avoid both double taxation and double nontaxation of individuals who change their residence, taking into account the countries' respective internal laws and tax policies.
53This section does not deal with investment options. It only addresses compensatory options.
54Based on a recent 60-country survey by Ernst & Young, 46 countries taxed at exercise, 4 at grant, 2 at vesting, 4 at sale, and 4 have no rules for taxing stock options.
55See Flipsen, Peter and Poetgens, Frank, "Tax Treaty Issues and the Cross-Border Taxation of Employee Share Options," European Taxation, volume 39, no. 8 (August 1999) and Adrion, "Compensating the International Executive Using Stock Options," Tax Notes Int'l, Mar. 27, 2000, p. 1481.
56The United Kingdom has both a generally available qualified option limited to £30,000, and a special one (known as enterprise management incentives) for certain companies with gross assets of up to £15m carrying on a limited definition of trades, which can grant options up to £100,000 for a maximum of 15 employees.
57In cases when stock options are issued by corporations that are not CCPCs, the options will gain the same tax benefit as options issued by CCPCs if the following additional conditions are met:
• the shares are listed on a prescribed Canadian or foreign stock exchange, and the option holder does not hold more than 10 percent of the shares of any class of the employer corporation or the corporation granting the options;
• the value of the optioned securities, together with any related securities, which vest in any particular year does not exceed C $100,000 on the date that the option is granted;
• the employer or its agent puts a system in place to monitor the C $100,000 annual limit and to report all dispositions giving rise to taxable benefits to both CCRA and the employee; and
• the options are exercised after February 27, 2000, regardless of whether they were awarded before or after that date.
58Article 48(2)(g) CTD.
59In Canada, the inclusion in income is based on the same portion of a capital gain which is so included, namely, 75 percent of the benefit for options exercised prior to February 28, 2000, and 66 percent for options exercised after February 27, 2000.
60This is on the basis that the employee was resident and ordinarily resident in the U.K. at the time of the grant of the option and that the employment did not relate to a United Kingdom resident, non-U.K. domiciled employee working wholly outside the United Kingdom for a non-U.K. resident employer. There could be tax on the grant of the option if the option price were below the market value of the shares at the time of the grant. There would be no charge on exercise of the option if at the time of the grant of the option the employee were either resident or ordinarily resident in the United Kingdom, but not both. Instead, in respect of the proportion of work carried out in the United Kingdom, there would be an annual charge on the amount of interest on a notional loan equal to the undervalue at the time of exercise, plus a tax charge on that undervalue at the time of disposal of the shares. Similar charges would arise if at the time of grant of the option the employee was U.K. resident, non-U.K. domiciled, working for a non-United Kingdom employer wholly outside the United Kingdom. This amount taxed on disposal would be added to the base value of the shares for capital gains tax.
61The change in residence issue should not arise in the case of nonqualified stock options, because the taxable event with respect to such options occurs at the time of grant. The normal change of residence exit tax rules would, however, apply to the stock acquired on exercise of the options, with the employee/shareholder being taxed on the difference between the market value of the shares at exercise and the market value at the time of the change of residence.
62The exit tax does not apply in this case. The only Australian case law on this situation holds that the source of the gain is determined by the place where the contract for the acquisition of the option was made (AAT Case 11,185 (1996) 33 ATR 1178), but the decision must be regarded as doubtful. The Review of Business Taxation has proposed that the exit tax should apply in this case. Nor does Canada impose its exit tax on stock options. ITA 115(1)(a)(i) and 128.1, 4(b)(vii).
63"Taxable Canadian property" includes (i) stock of a corporation resident in Canada (other than listed stock of a public corporation) and (ii) listed stock of a public corporation (provided that, at any time during the five-year period immediately preceding the disposition, the nonresident person (together with persons with whom the nonresident did not deal at arm's length) held not less than 25 percent of the issued shares of any class of stock of the corporation).
64In order to avoid a potential timing mismatch for a U.S. citizen, the U.S.-France treaty permits an election to defer income in France, in certain circumstances. U.S.-France, article 29(7).
65Holders of a substantial interest are deemed to have sold their options immediately prior to emigration.
66These rules apply to qualified stock options only if there is a premature sale of the stock acquired on exercise of the qualified stock options that triggers the recognition of employment income.
67Para. 2.1 of the commentary on article 15 states that the provision applies to benefits in kind received in respect of an employment.
68October 21, 1998 (AZ:11K 1662/97) and September 9, 1999 (AZ:11K 5153/97).
69The Application of the OECD Model Tax Convention to Partnerships, section II, 90.
70Flipsen & Poetgens, supra note 83, at 323.
71Hoge Raad, December 9, 1998, NR 32709 BNB 267.
72Article 13, capital gains, versus article 15, dependent personal services.
73Examples include deferred compensation or pension rights owned at death, but earned in a foreign country of residence; rights to assets in qualified individual plans, such as IRAs in the United States; company death benefits, group life insurance, etc. See e.g., Lyons, Timothy, "Double Taxation of Estates, Inheritances and Gifts in the EU and the Anglo-American Trust," 37 Eur. Tax'n 74, 76 (1997). For a comparative study of inheritance and gift taxes, see 34 Eur. Tax'n No. 10/11 (1994).
74The term "domicile" will be used hereafter to cover the relationship between the individual and the state that subjects the individual to tax.
75United States-United Kingdom Estate and Gift Tax Treaty, article 4.
76United Kingdom inheritance tax treaties with South Africa, the United States, the Netherlands, Sweden, and Switzerland (no time limit, but limited to residence for employment purposes only).
77A German citizen who is either a decedent or a beneficiary will be deemed to be a German resident for five years following the surrender of residence in Germany, section 2(1)(b), Erb S&G.
78The Dutch Succession Duties Act provides that gifts made by any person emigrating from the Netherlands within one year of emigration are subject to gift tax, and that gifts made or bequests left by emigrating Dutch citizens within 10 years of emigration are subject to gift tax or succession duties, art. 3(1).
79Inheritance Tax Act 1984, section 267.
80Lyons, Timothy, "Double Taxation of Estate, Inheritance & Gift in the EU," 37 Eur. Tax'n 74 (1997).
81Commentaries III, paragraph 21.
82Inheritance Tax Act 1984, section 267.
83Ibid., section 159.
84United States (10 years); Ireland (10 years); South Africa (10 years); Netherlands (10 years); Sweden (10 years); Switzerland (five years for dual domicile).
85IRC section 2107.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.