Multinational companies seeking to roll out incentive compensation plans to a global workforce must comply with a myriad of rules and regulations in the various foreign jurisdictions. In addition, organizations may not be aware of various tax planning or cost-reduction opportunities that exist in foreign jurisdictions. The primary challenges in implementing a global incentive plan have historically included the following:
- Understanding the individual income tax implications of granting awards in each foreign jurisdiction;
- Implementing methods to ensure compliance with local payroll requirements, including the tracking of a mobile work force in order to properly allocate compensation amongst countries in which employees have provided services;
- Implementing local country planning to take advantage of available corporate cost savings;
- Determining whether granting awards in a particular country may constitute a public offering, requiring detailed local prospectus filing requirements;
- Achieving compliance with local data privacy and other employment laws; and
- Implementing effective employee communications in order to ensure that global participants understand the program and the implications of participation.
Another overlooked issue that must be considered with respect to a global incentive plan is the income tax implications of expensing equity awards pursuant to Financial Accounting Standard 123R ("FAS 123R" or the "Statement"). The Statement is generally effective for calendar-year companies beginning on January 1, 2006. The income tax implications of expensing equity awards include the requirement to establish a deferred tax asset (DTA) under FAS 109 and the development of a hypothetical APIC pool under FAS 123R. For a detailed discussion of these rules, see A&M Tax Advisory Weekly, 2006- Issue 9 "Expensing Stock Options: Income Tax Impact". This article discusses the often overlooked aspect of FAS 123R-the treatment of awards granted to employees of a US multinational's foreign affiliated companies.
A US multinational must expense all equity compensation awards it grants, even when these grants are made to foreign affiliate employees. In order for a deductible temporary difference to be established for such grants, there must be an expectation that the award would result in a later corporate income tax deduction. If the foreign affiliate is a branch of the US parent company, generally any income tax deduction will lie with the US parent (and potentially also qualify for a local deduction), as the branch is a pass-through entity. If the foreign affiliate is not a pass-through entity then the US company generally cannot claim a deduction for the compensation expense and the deduction will belong solely to the foreign affiliate if allowed under local tax law. If there is an expectation of a deduction, the foreign affiliated company generally will record a DTA based on its effective tax rate. The foreign affiliate then determines the ultimate excess tax benefit or shortfall at the time it claims an actual corporate income tax deduction (which can differ from the timing under US tax law). Therefore, determining whether or not a DTA can be established for grants to employees of foreign subsidiaries requires an understanding of the corporate income tax laws of the foreign locations. If a DTA is not established for a grant, the result can be an increase in the book effective tax rate. Accordingly, planning for foreign corporate income tax deductions may now be imperative for companies that have not previously implemented a deduction strategy.
There are very few foreign jurisdictions that allow a local company to claim a corporate income tax deduction with respect to a US parent company's incentive plan without the local company bearing an actual cost related to the award. Therefore, in order for a foreign subsidiary to claim a tax benefit related to the equity compensation program, a corporate income tax deduction strategy generally must be implemented. A common approach involves the implementation of inter-company chargeback agreements between the parent and its affiliates. However, there are often other requirements, such as documentation of a contractual obligation prior to the grant date, among other requirements, in addition to the chargeback that must be satisfied in order for a deduction to be claimed. Also, some jurisdictions will not allow a deduction even if a chargeback is implemented.
The following examples provide insight into the many issues that a US multinational will need to consider in determining whether or not a DTA can be established for an international grant and how prior grants are treated for purposes of establishing the Hypothetical APIC Pool.
Australia: Where an actual financial cost is borne by the Australian entity with respect to the award, a corporate income tax deduction is generally available. However, even if there is a chargeback, the Australian tax authorities generally will not recognize a deductible cost if the shares used to satisfy the award are newly issued shares. Accordingly, in order for a DTA to be established for an Australian grant, the methodologies for securing a deduction (inter-company chargeback arrangements and the use of treasury shares to satisfy an award) need to be in place at the date of grant. Note, these requirements relating to the use of treasury shares in order to substantiate a deductible cost (in addition to a chargeback) generally also apply in France, Germany, Singapore and many other countries.
Brazil: A corporate income tax deduction is possible if a chargeback arrangement is implemented. However, such arrangements are generally not implemented due to the assessment of a withholding tax on any chargeback payment and due to exchange control requirements. Accordingly, DTAs generally are not available for Brazilian grants because chargebacks generally are not implemented due to these complications.
Canada: Canada does not allow a corporate income tax deduction related to payments made in shares. Accordingly, DTAs generally cannot be expected to be established for grants to employees of Canadian affiliates.
United Kingdom: A corporate income tax deduction is generally available by statute (various requirements must be satisfied-such as the stock must be ordinary shares, fully paid-up and non-redeemable, the stock must be publicly traded or the company must satisfy certain additional conditions, and the employee is or would be subject to income tax if resident and employed in the UK)) where the taxable event of the award occurs in company accounting periods commencing on or after January 1, 2003. Chargebacks were generally required to secure deductions related to taxable events occurring prior to 2003. Accordingly, DTAs can likely be established on a prospective basis for new grants.
Other Corporate Tax Benefits Related to Global Equity Compensation
The primary benefit that a US multinational will recognize from implementing a chargeback strategy is the tax-free repatriation of cash pursuant to Treasury Regulation 1.1032-3. The tax-free repatriation of cash is a very significant benefit to the US parent company. Also, if these chargeback arrangements are structured correctly, the payment of the invoice by the foreign affiliate is generally, with very few exceptions, not subject to local withholding taxes.
Historically, repatriating foreign income that has previously been permanently reinvested has had a negative impact on the company's effective tax rate. Accordingly, companies generally took the position under APB 23 that low-cost off-shore income was permanently reinvested (for example, foreign earnings from operations in Hong Kong or Ireland have historically been treated as permanently reinvested under APB 23). Recent incentives, in the form of a 5.25% US income tax rate on the repatriation of certain income, have been introduced in order to promote the idea of repatriating these earnings to the US.
Pursuant to Regulation Section 1.1032-3, if the parent charges the foreign subsidiary for the compensation costs related to a stock option or other stock award, then the foreign subsidiary is deemed to purchase the shares from the parent at fair market value with cash contributed by the parent and then immediately transfer the shares to the employee. Any amount that the US parent receives in payment for the stock, be it in the form of the exercise price paid by an employee or the payment of an inter-company invoice by the subsidiary in connection with the chargeback, reduces the amount of cash deemed to be contributed by the parent to the subsidiary. Therefore, the payment of the invoice by the foreign subsidiary is treated as purchase price for the stock, and the cash payment is repatriated tax-free to the US.
Another issue related to international grants that is frequently missed by US multinationals is the available basis adjustment in the parent's holdings of the foreign subsidiary. Controlled foreign corporations (generally, a foreign corporation where US shareholders own, on any day of the taxable year of the foreign corporation, more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation) are treated as US corporations for purposes of the calculation of earnings and profits ("E&P"). Regulation Section 1.83-6(d), relating to a US company's deduction for compensation expense related to most forms of equity compensation does not differentiate between foreign and domestic corporations. Accordingly, for the purposes of earnings and profits, the deduction for equity compensation follows the US timing, so the foreign rules on the timing of the taxable event are not applicable for these purposes. Therefore, at the time of the taxable event under US tax law (e.g., the exercise of a nonqualified stock option), the US parent receives a basis adjustment in the foreign subsidiary's stock (equal to the option spread for an exercise of a nonqualified stock option or the full fair market value of the stock at vesting of restricted stock). It is important to note that because the timing of this adjustment relates to the timing of the taxable event and available deduction under US tax principles, this basis adjustment applies even if the US parent has not implemented a chargeback arrangement. The tracking of mobile employees does remain an issue for these purposes, however, since each affiliate has its own E&P-where the E&P deduction lies can impact the effective tax rate of the foreign affiliate.
The implementation of a chargeback arrangement can provide many benefits to the US parent. However, careful planning must be performed in order to achieve the desired results and to ensure that unanticipated complications are not triggered by the chargeback. It is therefore generally recommended that a company implement a foreign corporate income tax deduction strategy only after careful analysis of the company's foreign tax credit positions, the structure of the foreign affiliates (branch or subsidiary of the parent, existence of cost-plus arrangements), transfer pricing issues, and the overall impact the strategy may have on the company's effective tax rate.
The implementation of a corporate income tax deduction strategy may also trigger unanticipated payroll compliance requirements. In many countries, equity compensation earned by an employee from a plan of a foreign parent company is not subject to income tax withholding and/or local social taxes. However, the implementation of a chargeback arrangement between the US parent and local employer can create such requirements. For example, if an employee of a US parent company's Mexican subsidiary exercises a stock option in the parent, the exercise spread is generally not subject to income tax withholding or social tax contributions. However, when the parent charges the Mexican affiliate for the compensation costs related to the exercise, income tax withholding and social taxes (to the extent the employee's other compensation does not exceed applicable wage limits) become due. Accordingly, careful due diligence should be undertaken to ensure that the US parent understands the additional compliance requirements that may arise due to the implementation of a corporate income tax deduction strategy.
The expensing of equity awards under FAS 123R is leading many companies to re-evaluate their cross-border tax planning. Companies that have not historically sought a foreign tax deduction for equity compensation may now desire to implement corporate income tax deduction strategies to achieve a deduction. Various incentives, such as the tax-free repatriation of cash exist for a company to implement a foreign corporate income tax deduction strategy. However, it is imperative that appropriate due diligence be performed so that the strategy achieves the desired results without triggering unanticipated results such as additional corporate costs related to payroll obligations. We generally recommend that the due diligence process include the performance of a cost/benefit analysis.
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