Aug 23, 2005
In This Issue
Australia – Confirmation of Stock Option Taxation for Mobile Employees
The Australian tax authority has confirmed that it will not impose an exit tax on mobile employees with stock awards when they depart from Australia. For stock awards granted to the mobile employees while working in Australia, a prorated portion of the gain at exercise based on the time spent in Australia during the vesting period will be subject to Australian income tax. Stock awards granted to mobile employees based on work performed with a non-Australian employer will not be subject to Australian income tax.
Brazil – Removal of Exchange Control Restrictions
The Central Bank has removed exchange control restrictions that had significantly limited the exercise of stock awards by employees in Brazil. Under the new exchange control legislation, approval from the Central Bank is no longer necessary for the transfer of funds outside of Brazil to exercise a stock award. In addition, Brazilian employees are no longer required to transfer to Brazil the proceeds from the sale of shares received under an employee stock plan. With the liberalized exchange control legislation, foreign companies may reconsider offering stock purchase plans and stock awards to employees in Brazil.
China – New Income Tax Guidance
The Chinese tax authorities have issued Circular 35 concerning the award of stock options to Chinese employees. Two important issues are raised through Circular 35: (i) the confirmation of income tax withholding and reporting requirements; and (ii) the obligation to register stock option plans and award agreements with the regional tax authorities.
With regard to the withholding and reporting requirements, the Chinese tax authorities have confirmed that the local employer must withhold and report both income tax and social insurance at the time of exercise. The taxable amount is the difference between the closing price of the shares on the date of exercise and the exercise price. The method for determining the closing price and the taxable gain from a cashless exercise should be confirmed with the regional tax authorities.
In addition to the withholding and reporting requirements, a foreign issuer that offers stock options in China must now register the plan and award agreements with the tax authorities in the region where the employees are located. The foreign issuers must comply with the registration requirements for awards offered or exercised after July 1, 2005. At this time, it is unclear whether each of the regional tax authorities has implemented a process for the plan and award agreement registration. We recommend that the local subsidiary contact the regional tax authorities to confirm the registration requirements.
U.S. - Corporate Income Tax Implications of FAS 123r
On December 16, 2004, the Financial Accounting Standards Board adopted Financial Accounting Standard No. 123 (revised 2004) (“FAS 123r”). For publicly traded companies, FAS 123r becomes effective in fiscal years beginning after June 15, 2005, and requires companies to recognize compensation expense for all equity compensation awards, including “at-the-money” employee stock options. Prior to FAS 123r, most companies followed APB 25. Under this standard, employee stock option awards generally do not result in any compensation expense as long as the exercise price is equal to the fair market value of the underlying stock on the date of grant. FAS 123r, on the other hand, requires companies to estimate the “fair value” of all employee stock option awards using a valuation model (e.g., Black-Scholes) and amortize the estimated value as compensation expense over the vesting/service period.
As the FAS 123r effective date draws near, many companies are struggling with the estimation of “fair value,” which valuation model is most appropriate to use, and how the required assumptions should be determined. Most companies are focused on minimizing the compensation expense resulting from their option plans, and as a result are looking for ways to support assumptions that may be considered aggressive. Very few companies, however, have thought about an additional hit to earnings that under FAS 123r may arise when actual tax deductions are less than the compensation expense that was recognized for financial statement purposes on the date of grant. To spotlight this important area of FAS 123r, this article provides a brief overview on how tax deductions are reconciled with FAS 123r expenses and describes the potential pitfalls.
As previously stated, under FAS 123r a company must recognize compensation expense in its Income Statement equal to the fair value of the award at the time it was granted. Based on the amount that is recognized, the company usually recognizes a corresponding tax benefit which results in a reduction in Tax Expense. However, in nearly all cases, the actual tax deduction differs from the expense that was recognized on the date of grant as a result of “book-to-tax” timing differences. For example, in the case of nonqualified employee stock options, the financial statement compensation expense is based on the fair value on the date of grant, while the tax deduction is determined under IRC Section 83 on the exercise date and is based on the difference between the fair market value of the underlying stock and the exercise price. With regard to restricted stock, the financial statement compensation expense is based on the fair value of the shares on the grant date, whereas the tax deduction is determined on the vesting date, unless the recipient makes an 83(b) election.
Eventually, the company must reconcile in its financial statements the differences between the tax benefits reflected in Tax Expense with the actual tax benefit that was recognized. To illustrate, assume the following:
Under FAS 123r, XYZ Company will recognize $600 in compensation expense in the financial statements corresponding to the grant date. In the same financial reporting period, the provision for income taxes (i.e., Tax Expense) will be reduced by $210 ($600 x 35%), which represents the tax benefit from the $600 in compensation expense. Now assume that the option is exercised in full when the stock is trading at $14 per share, which results in a corporate tax deduction of $400 [($14 - $10) x 100] and a tax benefit of $140 ($400 x 35%), which is $70 ($210 - $140) less than the tax benefit that was previously recognized in the financial statements. Since tax benefits reduce income taxes and increase earnings, the $70 difference could be viewed as an overstatement of Net Earnings. As a result, XYZ Company must reconcile the $210 tax benefit that was incorporated into Tax Expense with the actual $140 tax benefit. Under FAS 123r, the $70 difference can be reconciled in a subsequent reporting period by either: (1) increasing Tax Expense (thus reducing net earnings), or (2) reducing Paid-in-Capital. Since an increase in Tax Expense results in a reduction in Net Earnings, most companies will opt for reducing Paid-in-Capital. However, there must be sufficient reserves in the Paid-in-Capital account; otherwise the reconciliation must be made by increasing Tax Expense in a later period.
Determining FAS 123r Paid-in-Capital Reserves
Paid-in-Capital reserves generally result from stock option exercises that occurred in prior reporting periods under accounting standard APB 25.1 When stock options are accounted for under APB 25, there is no compensation expense when certain requirements are met, one being that the exercise price must not be less than the fair market value on the date of grant. APB 25 and FAS 109 do not allow companies to recognize a tax benefit when no corresponding compensation expense is recognized. Instead, the tax benefit is credited to Paid-in-Capital, which increases the amount available to offset future tax deficiencies. The accumulated balance of these tax benefits represents the FAS 123r Paid-in-Capital reserve. To the extent these reserves exist, companies can reconcile short falls between actual tax deductions and the corresponding FAS 123r expenses by reducing Paid-in-Capital, instead of increasing Tax Expense which decreases Net Earnings.
1 The tax deduction could also be greater than the financial statement compensation expense that was previously recognized if there is sufficient growth in the underlying stock. In this case, the company is required to credit the additional tax benefit to Paid-in-Capital because no corresponding expense was recognized on the Income Statement. This also results in an increase to the Paid-in-Capital, which may be used to offset future tax deficiencies.
U.S. – Definition of Grant Date Under FAS 123r
The FASB staff has recently confirmed the definition of grant date for stock awards under FAS 123r. The definition of the grant date is important because it is the valuation date for share-based compensation. The grant date is the date that the material terms of the stock award are communicated to the recipient. The current practice of setting the grant date as the date that the board of directors or appointed committee approves the stock awards is no longer valid unless the material terms of the stock award are also communicated to the employee on that date.
U.S. – IRS Revenue Ruling 2005-48 on Nonstatutory Stock Options
The IRS has issued guidance concerning the tax treatment of nonstatutory stock options under IRC Section 83. Through Revenue Ruling 2005-48, the IRS has clarified the taxable event for nonstatutory stock options when the sale of the shares is restricted under Rule 10b-5 of the Securities Exchange Act of 1934. The IRS has taken the position that an employee will be subject to tax at the time of exercise, regardless of whether his or her opportunity to sell the shares is restricted by the insider trading rules of Rule 10b-5 or other share lock-up requiremen ts . The IRS commented that the restrictions on sale and the potential liability for insider trading or other share lock-up requirements are not considered a substantial risk of forfeiture under IRS Section 83; and do not result in deferred taxation.
U.S. - Net Share Issuances of Employee Stock Options
Although FAS 123r imposes significant exposure for financial statement purposes, there are some advantages to accounting for stock options under these guidelines. One particular advantage is that companies can settle “cashless” exercises of stock options via a net share issuance without being subject to “variable” accounting, whereas under APB 25, the net issuance of shares results in a compensation charge and possibly subjects the entire plan to variable accounting. Settlement of stock option exercises by means of a net share issuance significantly reduces shareholder dilution because only the shares representing the value of the net gain are issued. Under the cashless exercise method of payment, all shares under the option are issued to the employee and the broker immediately sells a sufficient number of shares to settle the exercise price and tax withholding. To illustrate this point, consider the following example:
Value of 100 Shares at Exercise
Gain at Exercise
Net Gain at Exercise
Shares Issued at Exercise
26 (i.e., $650/$25)
Shares Immediately Sold to Settle Exercise Price and Tax Withholding
Shares Retained by Employee
The above example illustrates that a net issuance of shares in lieu of the traditional cashless exercise reduces shareholder dilution by nearly 75% (26 vs. 100 additional shares outstanding), with no impact on the value transferred to the employee. In either case, the net gain at exercise is $650 and the employee retains 26 shares. Under the net share issuance method, instead of issuing the entire 100 shares and immediately selling 74 shares in the open market, the company issues only 26 shares directly to the employee.
In the above example under either method the employee recognizes $1,000 of compensation income and the company recognizes a corporate tax deduction for the same amount. However, there is a difference with respect to the mechanics of tax withholding and remittance. In the case of a net share issuance, the company funds the tax withholding through its cash reserves, and makes payment directly to the tax authorities on behalf of the employee. Under the cashless exercise method, shares are sold in the public market and the proceeds from sale are remitted to the tax authorities to satisfy the company’s tax withholding obligation.
Under FAS 123r, there are no adverse accounting consequences resulting from the net issuance of shares. Whether the shares are issued via the cashless exercise method or through a net share issuance, the fair value of the award is estimated on the date of grant and amortized over the vesting period. There are, however, negative accounting consequences under APB 25. Although a cashless exercise of a stock option generally does not result in an accounting charge under APB 25, a net share issuance of shares under this standard is tantamount to a cash settlement, which requires the company to recognize compensation expense equal to the value of the shares issued. Additionally, APB 25 requires the company to apply variable accounting to all outstanding options if the company routinely settles options through the net issuance of shares.
John J. Heber
Craig P. Tanner
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