Recent Changes and Trends in Legislation Related to Equity Income Sourcing

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1 International Executive Mobility Recent Changes and Trends in Legislation Related to Equity Income Sourcing Originally published in The Journal of Corporate Taxation (WG&L), September / October 2013 Author: Tulsi Patel Tulsi Patel is an associate in the Chicago office of Baker & McKenzie LLP Over the course of the last year, legislators around the world have taken an interest in the income sourcing rules and laws in their countries. This may be partly due to the fact that governments, now more than in the past, are focused on regulatory compliance and tax revenue collection where possible. At the same time, governments are looking to increase economic growth by attracting multinational corporations. As a result, there are a number of countries where the equity income sourcing rules have been amended recently. The purpose of this article is to explore these changes in the law. General rules: OECD model tax convention The Organization for Economic Co-operation and Development (OECD) Model Tax Convention on Income and Capital ( OECD Model Tax Convention ) provides for a uniform basis to settle common issues related to double taxation that arise at an international level. 1 Specifically, Article 15 of the OECD Model Tax Convention prescribes the general rule of taxation of income from employment. Under Article 15, salaries and wages are taxable in the country in which the employment is exercised. 2 The commentary on Article 15 further specifies that salaries, wages, and other similar compensation are understood to include income from benefits-in-kind (e.g., stock options). 3 Accordingly, the employment benefit derived from stock options (as opposed to the capital gain derived upon sale) is subject to tax in the country of source, that is, the country where the employee exercised employment. 4 This is the case even where the tax is levied at some time later, after the employee is no longer employed in that particular country. 5 1

2 The determination of whether and for how long employment is exercised in a particular country is made on a case by case basis, taking into consideration all the relevant facts and circumstances of the stock option award. 6 Where employment is exercised in more than one country, the employment benefit attributable to the stock option is considered to be derived from a particular country in proportion to the number of days during which the employment was exercised in that specific country to the total number of days during which employment services are required to be exercised to acquire the right under the stock options (e.g., until the employee vests in the stock option and is able to exercise the right). This is generally referred to as the grant-to-vest rule of sourcing equity income. General rules: United States In the United States, the general rule for sourcing equity income is prescribed under Section 861 and certain regulations thereunder. Specifically, Section 861 provides that gross income related to compensation for labor or personal services performed in the United States will be treated as income sourced within the United States (except where the labor or services are performed by a nonresident alien and other specific requirements are met). 7 For purposes of multi-year compensation arrangements, Reg (b)(2)(ii)(F) provides that the source of income is generally determined on a time basis over the period to which such compensation is attributable. 8 Multi-year compensation is defined as compensation that is included in an individual s income in one tax year but is attributable to a period that is two or more tax years. 9 The amount of compensation for labor or personal services performed within the United States determined on a time basis is the portion of total compensation that is the same ratio as the number of days of performance of labor or personal services by such individual in the United States to the total number of days of performance of labor or personal services over the applicable period. 10 The period to which the compensation is attributable is determined based upon the facts and circumstances. In the case of stock options, the applicable period to which the compensation is attributable will generally be the period between the grant date of an option and the date on which all employment-related conditions for its exercise have been satisfied (e.g., the vesting date of the option). 11 In other words, the general rule for sourcing equity income in the United States is to look to the period between the grant date and the vesting date, determine the proportion of days of the total performance period the individual was in the United States, and apply that proportion to the total income received at the time the stock option is exercised. Where the award vests ratably over a period of time, each tranche is deemed earned in the calendar year in which it vests and the income is sourced based on the days within the United States during such year. If the award is subject to cliff vesting, the portion of total compensation based on the ratio of days in the United States to the total days of service during the 2

3 applicable period is the amount of compensation attributable for labor or personal services performed within the United States. As stated above, this is referred to as the grant-to-vest rule of sourcing equity income. Based on the foregoing, the OECD Model Tax Convention and U.S. income sourcing rules for stock options are consistent in that they look to (1) where the employment services were rendered and (2) the proportion of days employment services were rendered in that particular country to the total days of the applicable time period (e.g., the vesting period). The taxable compensation for a particular country is then determined by multiplying the proportion of days worked in that country by the total employment benefit derived from the stock options (e.g., in many cases, income upon exercise). By way of example, an employee of Subsidiary ABC, a Brazilian corporation, receives an award of 100 stock options for shares of Corporation ABC, a U.S. corporation, with an exercise price of $5.00 on 1/1/10. The award vests upon the completion of three years of service from the date of grant (i.e., 100% of the options vest on 1/1/13). The employee is assigned to the United States for three months from 9/1/11-12/1/11 (e.g., 91 days). On the day the employee exercises the award, the fair market value of the shares is $10. For purposes of determining the U.S. source income, the proportion of days the employee was in the United States over the course of the vesting period is (e.g. 91 days out of 1,095). When the employee exercises the stock options, the U.S. source income will be determined as follows: (100)*($10 - $5)*(0.0831) = $41.55 This example will further lend itself to better understanding the legislative changes detailed below. Recent changes and trends Within the last year, a number of countries have reviewed the legislation governing the sourcing of income derived from stock options (and other similar equity awards) for income tax purposes. Many countries have either issued clarifications to the income sourcing rules currently in place, while others have revised the sourcing rules to more closely reflect the OECD Model Tax Convention (and U.S. rules). Some of the countries that have recently issued guidance on their equity income sourcing rules are Australia, Canada, Hungary, India, and Ireland. Australia. On 6/13/13 the Australian Tax Office (ATO) published guidance regarding the Employee Share Scheme (ESS) income tax reporting for temporary resident employees and resident employees engaged in foreign service ( mobile employees ). 12 To clarify, temporary resident employees are generally inbound employees and resident employees engaged in foreign services are generally outbound employees. The guidance specifically states that mobile employees in Australia may be assessed only on the portion of income derived from the shares and 3

4 rights acquired by employees under employee share schemes ( ESS Interest ) (which includes stock options and restricted stock units) that relates to the employment services rendered in Australia. 13 Practically, this is determined by taking the proportion of days worked in Australia to the total number of days in the time period between the grant date and the vesting date and multiplying it by the total income derived from the ESS Interest. The ATO is advising that this apportioned amount must be reported on the ESS Statement and ESS Annual Report. 14 The ATO s approach is in line with the OECD Model Tax Convention and further aligns with the changes/confirmations we have seen in other countries described below. The guidance is effective for ESS income tax reporting for the year ended 6/30/13. Canada. Recently, the Canada Revenue Agency (CRA) issued a technical interpretation related to stock options. Under the technical interpretation of 9/25/12, Allocation of Cross-Border Employee Stock Options (Document No C6), the CRA adopted the OECD Model Tax Convention income sourcing rules for stock options (e.g., grant-to-vest) for domestic purposes. 15 Previously, the income sourcing rules implemented by the CRA presumed that stock options were awarded for services rendered prior to the grant and therefore were to be sourced based on the employee s days of services rendered during the year of grant, unless there was clear evidence to the contrary or a treaty provision to the contrary. 16 In light of this technical interpretation, the presumption now is that stock options are awarded for future services and the benefit relates to the period of employment that is required as a condition to acquire the right to exercise the stock option (e.g., vesting period). 17 This revised position applies only to non-residents. For individuals that are Canadian tax residents, at the time the stock option is exercised, the individual will be subject to tax on the full amount of the income derived at such time (subject to any applicable foreign tax credits). This technical interpretation is effective for stock options exercised after 12/31/ For stock options exercised prior to 12/31/12, the CRA is permitting the taxpayer to choose which method they prefer for purposes of determining taxable compensation. 19 Although this initial guidance does not specifically address other types of equity awards or deferred compensation, it is reasonable to expect the CRA to expand the grant to vest income sourcing rule to other equity awards in the future. 20 Hungary. The Hungarian Ministry for National Economy issued nonbinding guidance changing their interpretation on the income sourcing rules for equity compensation. Previously, under Hungarian law the time period used to determine the income derived from stock options for employment services rendered in Hungary was based on the time period between the grant date and exercise date. The newly issued guidance revises this position to adopt the OECD Model Tax Convention s position on income sourcing for stock options. Accordingly, the portion of the income derived from stock options that will be considered 4

5 Hungarian source income is the portion attributable to employment services rendered in Hungary during the period between the grant date and the vesting date. Similarly, where the employee rendered services in another country for a portion of the time period between the grant date and vesting date, such portion of the income derived from the stock option will be sourced to that other country. The Hungarian government has not issued any specific guidance as to when the new income sourcing rule will be effective or to which tax years the new sourcing rule will apply. India. In May 2013, the Delhi Tribunal ruled on a case regarding the apportionment of stock option income. 21 In this case, an individual who was a Resident 22 (but not Ordinarily Resident, which means, for tax purposes in the relevant year, an individual who has been in India for 182 days or more; or who has stayed in India for 60 days or more in that year and, during the four years preceding that year, was in India for 365 days or more) exercised stock options and received taxable compensation as a result. The individual was a Resident in India for only a portion of the time period between the grant date and the vesting date. Initially, the Assessing Officer recognized the full amount of the benefit (i.e., the spread at exercise) as taxable income, however the Commission of Income Tax (Appeals) (the Commission ) did not agree. On appeal, the Commission indicated that only that benefit attributable to the period of services rendered in India, accrues in India and is taxable in India. 23 The Commission specifically relied on the OECD Model Tax Convention guidance on treatment of stock options, among other rulings and publications. The Assessing Officer appealed to the Delhi Tribunal, which affirmed the Commission s decision. 24 This ruling does not necessarily revise or update the previous legislation in place to determine the income sourcing of stock options in India. However it does provide an example of how the equity income sourcing law is an agenda item for certain governments and how these rules/laws can impact a multinational s employee population. Ireland. On 12/14/12, the Irish Revenue issued guidance regarding how the income derived from restricted stock units should be treated for income tax purposes in cross-border situations. Previously, the Irish Revenue had detailed the tax treatment of restricted stock units granted to employees and directors in the Irish Revenue Tax Briefing Issue 63, in May Under the recent guidance, the Irish Revenue clarified that the income derived from restricted stock units is fully taxable in Ireland at the time the restricted stock units vest, without apportionment, if the employee is an Irish tax resident at the time of vesting. 26 Where the employee is not an Irish tax resident at the time of vesting, the income derived from the restricted stock units is not taxable in Ireland, even if the employee was an Irish tax resident at the time of grant (and/or for a part of the vesting period). 27 5

6 This position is referred to as the all in/all out approach and is not in line with the OECD Model Tax Convention s position on the taxation of stock options. Regardless, it is worth noting that the Irish Revenue is acknowledging that there are income sourcing issues related to cross border employees and publishing guidance on this topic as it could lead to additional changes in the income sourcing rules in Ireland. Conclusion It is not surprising that governments are focusing on the issue of income sourcing in light of the increased attention given to regulatory compliance and tax revenue collection. The general trend appears to be in favor of the OECD Model Tax Convention income sourcing rule. However, there are countries, such as Ireland, that have not adopted this approach. Where the income sourcing rules are not in line with the OECD Model Tax Convention, there is increased risk of mobile employees being subject to double taxation. For example, in Belgium, stock options are taxed at grant in certain instances. If an employee is subsequently placed on assignment after the grant of stock options and that country does not have an income tax treaty in place with Belgium, the employee may be subject to double taxation on the benefit derived from the stock options when the employee later exercises the options. The impact of the income sourcing rules to mobile employees and multinational corporations becomes apparent when designing a tax equalization agreement or determining the assignment structure. In practice, the mobile employee population usually involves senior level employees. As such, understanding the income sourcing rules and trends of changing legislation is key to avoiding increased costs. Furthermore, these rules impact a corporation s tax reporting and withholding obligations in a particular country. Determining which country the portion of the income derived from the stock options (and other equity awards) is attributable to results in accurate withholding and reporting of applicable taxes. Generally, under-withholding or non-compliance with tax withholding and reporting laws could result in a corporation facing fines and penalties in addition to back pay of taxes. As depicted above, the income sourcing rules for stock options and other equity vehicles appear straight forward at first glance. However, after taking into consideration an employee s tax residency status, multi-country assignments over the applicable time period, any applicable income tax treaties, withholding and reporting rules, andmore, the application of these rules is anything but straight forward. 6

7 1 OECD Model Tax Convention on Income and Capital, Updated 7/22/10. 2 Id. 3 OECD Model Tax Convention on Income and Capital, Updated 7/22/10, Commentary on Article 15, paragraph OECD Model Tax Convention on Income and Capital, Updated 7/22/10, Commentary on Article 15, paragraph OECD Model Tax Convention on Income and Capital, Updated 7/22/10, Commentary on Article 15, paragraph OECD Model Tax Convention on Income and Capital, Updated 7/22/10, Commentary on Article 15, paragraph Section 861(a)(3). 8 Reg (b)(2)(ii)(F). 9 Id. 10 Reg (b)(2)(ii)(E). 11 Reg (b)(2)(ii)(F). 12 Australian Tax Office, Employee Share Scheme Annual Reporting, 6/13/ Australian Tax Office, Employee Share Scheme Annual Reporting, 6/13/ Australian Tax Office, Employee Share Scheme Annual Reporting, 6/13/ CRA Technical Interpretation, Allocation of Cross-Border Employee Stock Options (Document No C6), 9/25/ Id. 17 Id. 18 Id. 19 Id. 20 Id. 21 ACIT v. Robert Arthur Keltz, ITA No.3452/ Del/ 2011 dated 24 May Resident in any previous year for tax purposes is defined as a person who is in India in that year for a period or periods amounting in all to 182 days or more; or having within the four (4) years preceding that year been in India for a period or periods amounting in all to 365 days or more, is in India for a period or periods amounting in all to 60 days or more in that year. 23 Id. 24 Id. 25 Irish Revenue, Revenue ebrief No. 69/12, 12/14/ Id. 27 Id Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a partner means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an office means an office of any such law firm. This may qualify as Attorney Advertising requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome.