Stock options are increasingly a significant component of an international executive’s compensation package. There are tax traps and opportunities for both employers and employees, particularly when more than one taxing jurisdiction is involved. Consequently, it is important for employers and employees to address the issues at the outset. Apart from income tax allocations for individuals, there are other often unexpected implications such as U.S. employment tax withholding, even if the employer is a Canadian company, and potential U.S. estate tax for nonresidents. A few of the key questions that should be considered follow.
WHAT TYPE OF OPTION IS THIS?
An employee needs to know how stock options will be characterized under U.S. tax law. Although all stock options are presumably intended as incentives, a special type of option is characterized as an incentive stock option ("ISO") if it meets certain statutory requirements. An individual who receives such an option is not subject to tax on compensation income when the option is granted or exercised. When the recipient sells the shares, the recipient will be taxed at long-term capital gain rates on the gain, assuming a qualifying sale. In contrast, the recipient of a nonstatutory stock option ("NQSO") is taxed on compensation income in the year the option is exercised. The taxable compensation is an amount equal to the difference between the exercise price and the fair market value of the shares on the date of exercise. After an NQSO is exercised and the stock is acquired, the stock is treated for tax purposes as an investment by the employee. If the stock appreciates after the date of exercise, the employee can sell the stock and will pay tax on the resulting capital gain.
WHERE AM I SUBJECT TO TAX?
U.S. residents and citizens are taxed on their worldwide income. Nonresidents who hold NQSOs and move to the United States are taxable on the full amount of option income if the options are exercised while they are U.S. residents. If an individual who is not a U.S. citizen is a nonresident of the United States at the time of exercise of an NQSO, the nonresident will be exempt from U.S. tax on the portion of the option income attributable to services performed while physically outside of the United States. Such an individual may, however, be subject to U.S. tax on income attributable to services performed in the United States. Allocation of option income between United States and foreign sources may be based on the number of days the individual worked in the United States compared with the number of days that the individual worked outside of the United States during the relevant period. It is important for an international executive to keep a careful record of where he or she is on a daily basis and whether each day is a working day or a non-working day. It is also important for employers to comply with the U.S. employment tax requirements. They apply to both foreign and U.S. employers.
An individual who is subject to tax in more than one country or who relocates from one country to another could face double taxation if the countries’ tax laws do not harmonize taxation of options. The taxable event, and therefore the time of taxation, may not be the same or tax credits may not be available. For example, if a U.S. citizen residing and working in Foreign Country receives and exercises Foreign Company NQSOs, the U.S. would tax the option income (subject to foreign earned income exclusion). If Foreign Country does not tax the option income until the U.S. citizen sells the stock four years later, while still a resident of Foreign Country, there would be a mismatch of the timing and amounts, and types of income subject to tax. The potential benefits of foreign tax credits could be lost.
WILL U.S. ESTATE TAX APPLY?
The fair market value of stock options in a U.S. company is included in the taxable estate of a decedent. If the individual is a U.S. citizen, the fair market value of the individual’s worldwide estate is subject to the estate tax. An individual who is not a U.S. citizen or U.S. resident is subject to U.S. estate tax on only U.S. situs assets. Options to acquire stock in a U.S. company are considered by the Internal Revenue Service to be U.S. situs property subject to tax. There may be mismatches of taxation for an individual and his or her estate as a result.
WHAT TO DO?
Before adopting a stock option plan, an employer should consider the tax implications for all employees. Plans can be designed to accommodate the needs of both international companies and their international executives. Individuals who receive stock options should consider the possible U.S. and foreign tax implications in deciding when to exercise the options.
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.