Equity-based compensation plans for multinationals: compensation in a worldwide environment.

• Author: Dunn, Bill

Introduction

In the past, entities viewed global expansion as a natural progression of a domestically mature business. Now, competitive pressures prompt many companies to enter the international arena at early stages in their corporate existence. As a consequence. there has been a surge in the number of companies dealing with human resource responsibilities in multiple jurisdictions.

Logically, the addition of foreign affiliates raises local legal issues relating to compensation since each jurisdiction imposes its own unique set of income, payroll, social security and other taxes. Thus, pay plans are generally tailored to each taxing regime to ensure compliance with local law. Many compensation arrangements, however, do not originate locally. One of the consequences of the great strides that companies have taken in enhancing interaffiliate communications is that employees are no longer content to be compensated in a vacuum. If the top domestic sales managers for a U.S.-based multinational are participants in a stock option plan the top manager for its Belgian subsidiary will expect the same.

Therefore, even companies that are generally familiar with U.S. law in this area now face with the daunting task of linking compensation pay practices among multiple legal jurisdictions in an attempt to maximize the benefits of incentive compensation. Unfortunately, although the initial objective of companies seeking to export their equity-based compensation plans is simplicity and uniformity, the tax law elsewhere in the world may produce unexpected consequences. As a result, this project requires active involvement by the tax professional.

This article discusses the most frequent tax issues disrupting simplification and unification, while keeping in mind the need to balance human resource objectives with the employer's cost and potential tax benefits. While the law in certain countries is discussed to illustrate these issues, this article is not intended to provide a comprehensive discussion of all the laws imposed by our major trading partners.

The State of the Law

With few exceptions, U.S. income tax law in this area is significantly more advanced that that of our trading partners. Thus, the certainty that we enjoy in the United States is lacking elsewhere. A number of factors contribute to this variance. First, the notion of granting individuals an ownership interest in their employer is an alien concept in many countries, where the employee reward philosophy does not embrace the idea of proletarian ownership. The limited statutory and administrative guidance in these countries is often the progeny of plans put in place by multinationals that do not share this view.

Further, many countries that have now become common trading partners were, for many years, governed by totalitarian regimes. In the past, these governments imposed severe exchange control restrictions on the citizens of these countries, where the ownership of foreign currency and stock was prohibited. In other words, private ownership of stock is a new legal concept in such countries, flowing both from the recent wave of privatization of state-owned enterprises and from the entry of multinationals into the local commercial environment.

Roadblocks, however, continue to exist. For example, many former Eastern Block countries continue to require central bank approval before its citizens are permitted to own stock offered by foreign companies. In Russia, central bank approval is still required by Russian nationals who wish to own stock of foreign companies. The application process is time consuming and approval for an individual to own shares in a non-Russian company is often denied.(1*)

Finally, other actions may be taken by certain countries that interfere with the exportation of compensation plans. For example, under a Belgian Royal Decree of December 1993 which remains in effect, it is illegal to introduce new employee compensation plans in Belgium unless they are a replacement plan providing essentially the same benefits as under an employee compensation plan in existence in December 1993.(2) Thus, unwitting multinationals that have introduced their plans to foreign subsidiaries may have committed a criminal violation to the extent they have a Belgian presence.

Equity Plans in General

Before addressing specific foreign tax concerns, it is best to summarize the most commonly used equity-based incentive compensation plans that are familiar to U.S. corporations. Equity-based plans can be grouped into two general categories: those that provide employees with actual stock, and those that provide employees with cash rewards based upon the performance of stock or other performance-like measures. These two groups can be broken down into the following subsets which are presented in the context of U.S. law and practice.

* Stock Options

[] Nonqualified

[] Qualified

* Incentive Stock Options

* Employee Stock Purchase Plans * Direct Stock Grants

[] Restricted

[] Unrestricted

* Other Equity-Based Plans

[] Phantom Stock

[] Stock Appreciation Rights

[] Performance Plans

1. Nonqualified Stock Options

   Stock options are contractual rights granted by the employer to the employee that allow the employee to take possession of actual stock if they satisfy the terms of the option (typically to pay a fixed price per share of stock to be received). Generally, these rights have a fixed exercise period expressed in a term of years.

   Under section 83 of the Internal Revenue Code, an employee is taxed only if he or she receives property. Under IRS regulations, the receipt of a contractual right that promises to pay property or money is not itself a transfer of property.(3) Thus, the grant of a stock option to an employee is generally treated as a non-event for tax purposes.(4) As a result, the employee does not incur a tax liability at grant. Rather, the bargain element is treated as wages to the executive upon exercise, at which time the company receives a tax deduction equal to the amount the employee takes into income. This compensation is subject to Social Security tax as well as income tax withholding. Future appreciation is treated as capital gain at sale.

2. Incentive Stock Options

   Like nonqualified stock options, Incentive Stock Options (ISOs) are contractual promises that permit an employee to acquire stock from the employer at a future date under established terms. Because ISOs meet stringent restrictions and conditions, they are not taxable for regular tax purposes at either grant or exercise.(5) Instead, if the stock received as a result of the exercise is held at least two years from the date of grant and one year from the date of exercise, the employee will recognize capital gain when the stock is sold in an amount equal to the excess of the stock's selling price over the exercise price.

3. Employee Stock Purchase Plans (ESPPs)

   ESPPs are plans that allow employees to purchase shares at a discount on a tax deferred basis. The purchase price may not be less than the lesser of 85 percent of the fair market value of the stock at the time the option is granted, or 85 percent of the fair market value of the stock at the time the option is exercised. These purchase opportunities are generally available via payroll deductions and are subject to rigid requirements regarding participation, stock holding periods, and administration.(5)

4. Stock Grants

   These plans involve a direct award of actual stock to the employee, and may impose conditions on the employee's rights to such stock. Such conditions may have tax importance under the Internal Revenue Code. Specifically, an employee is taxed on the compensatory receipt of stock unless the stock is transferred subject to a "substantial risk of forfeiture."(7) The most common example of a substantial risk of forfeiture is a service term, i.e., the employee will forfeit the property unless he or she completes a specified employment period.(8) The risk of forfeiture provides an incentive to the employee, for if he or she does not satisfy the condition, the property must be returned to the employer. In these situations, taxation is deferred until the restrictions lapse, at which time the employee will recognize compensation income equal to the value at that point.(9)

5. Other Equity-Based Plans

   "Phantom stock," "stock appreciation rights," and...