Foreign Taxes May Reduce Stock Option Benefits

As U.S. companies expand into overseas markets and consider stock option plans for employees of their foreign subsidiaries, they should take into account "social taxes" imposed by foreign countries on noncash compensation. A misconception that other countries follow U.S. tax policy on the treatment of stock options could prove costly.

U.K.

Last year, the U.K. promulgated regulations that impose the National Insurance Contributions (NIC) tax on the exercise of certain stock options granted after April 5, 1999 through "unapproved plans." U.S.-style plans generally have unapproved status, unless approval is sought. Further, approval can cover only options worth up to U.K. 30,000; any remaining uncovered options are unapproved.

Much like the U.S. FICA tax rules, the U.K. rules require that both the employer and employee contribute to NIC tax. On behalf of an employee, an employer must withhold NIC tax on the exercise of stock options. This latter requirement generally is not burdensome in practice, as the employee's wage base on which NIC tax is assessed is limited to U.K. 26,000 per year. However, the employer's liability for NIC is 12.2%, and is not phased out. Some U.S. corporations have not anticipated the significant cost of the NIC tax.

Under the 1999 rules, NIC tax liability is a function of an employee's residency on the date of grant; liability accrues for employees who were "resident and ordinarily resident" in the U.K. on that date. Thus, NIC tax may be payable for a portion of options exercised even if the employee leaves the U.K., presenting an administrative challenge to employers.

Hardly any guidance exists to date describing who is "resident and ordinarily resident." An employee is deemed "resident" in the U.K. if he is physically present for more than 183 days during the year, with the number of days determined on a cumulative basis. An employee is deemed "ordinarily resident" if he is resident in the U.K. year after year. As a rule, an employee who is resident in the U.K. for more than three years is treated as ordinarily resident.

Failure to remit NIC tax may result in interest and penalties for an employer. Ignoring the requirement simply would postpone the problem, as the Inland Revenue cross-checks the returns of individuals who report option exercises against the returns of their employers to determine whether the employer complied with the 1999 rules.

Other Countries

Similar problems exist in other countries. For example, Sweden now imposes social taxes on stock options. Under Swedish law, a social tax is due on exercise of options vesting after July 1, 1998. Employees pay a 6.95% social tax; employers pay approximately 33.06%. An employee contributes social tax on income as high as SEK 299,800, while there is no cap on an employer's contributions. Thus, the employer has significant social tax liability for any outstanding stock options in Sweden.

From James Clancy, J.D., Joanne Fay, J.D., and Christopher McGowan, CPA, McLean, VA