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Equity-based incentives

Share options What are the most common types of share option plan in your jurisdiction? Please outline the rules relating to each scheme.

There are two main types of share option:

  • incentive stock options (ISOs); and
  • non-qualified stock options (NQSOs).

ISOs must meet the requirements of Section 422 of the Internal Revenue Code, which are as follows:

  • ISOs can be granted only by a corporation to employees of the corporation or employees of a subsidiary or parent corporation.
  • The exercise price cannot be less than the fair market value of the underlying shares on the date of grant.
  • The option must be granted under a plan that was approved by the shareholders of the corporation. The plan must set out the number of shares that may be granted as ISOs and have a term not greater than 10 years from the date on which it was adopted.
  • The term of the ISO grant cannot be greater than 10 years from the date of grant and, if an employee terminates employment for any reason other than death or disability, the ISO can be exercised as an ISO only within 90 days following the termination of employment (the 90-day period may be up to one year if the termination is on account of disability).
  • The ISO cannot be transferable, other than on account of death.
  • The grantee of the ISO cannot own stock possessing more than 10% of the voting power of the corporation or its parent or subsidiary (if the grantee meets this requirement, the ISO must have an exercise price not less than 110% of the fair market value of the underlying stock on the date of grant and the term of the ISO cannot be longer than five years from the date of grant).
  • No more than $100,000 of the ISO can first become exercisable in any one calendar year.

NQSOs may be granted to employees, non-employee directors; consultants and advisers. NQSOs are not subject to the ISO rules described above. However, an NQSO must be granted with an exercise price of not less than the fair market value of the underlying stock on the date of grant and the stock must constitute ‘service recipient stock’ under Section 409A of the Internal Revenue Code (which is generally common stock of the company), otherwise the NQSO will be considered a deferred compensation arrangement subject to the requirements of Section 409A of the Internal Revenue Code (which could result in significant adverse tax consequences to the grantee if the NQSO is not structured in a compliant manner at the time of grant). In addition, if a public company wants to provide for the grant of NQSOs, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ) both require that the shareholders approve the plan pursuant to which the NQSO will be granted, with certain limited exceptions.

What are the tax considerations for share option plans?

ISOs are not taxable at grant or at exercise – although, for purposes of calculating alternative minimum tax for the employee in the year of exercise, the appreciation in the ISO at the time of exercise (ie, the difference between exercise price paid and fair market value of the shares on the date of exercise) is counted toward the alternative minimum tax calculation for such employee. If the employee does not sell the shares acquired through the exercise of the ISO until the later of two years from the date of grant or one year from the date of exercise, the entire appreciation (the difference between the exercise price paid and the sale price of the shares) is taxed as capital gains to the employee.

If the employee does not satisfy the holding period for the ISO, when the shares are sold, the employee recognises ordinary income equal to the difference between the exercise price paid for the shares subject to the ISO and the fair market value of the shares on the date of exercise and capital gains tax (short or long-term, depending on the period of time the shares were held from the date of exercise) on the difference between the fair market value on the date of exercise and the sale price received for the shares.

NQSOs are not taxable at grant, but are taxed as ordinary income at exercise equal to the difference between the exercise price paid for the shares subject to the NQSO and the fair market value of the shares on the date of exercise. When the shares are sold, the individual will recognise capital gains tax (short or long-term, depending on the period of time the shares were held from the date of exercise) on the NQSO on the difference between the fair market value on the date of exercise and the sale price received for the shares.

Share acquisition and purchase plans What are the most common types of share acquisition and purchase plan in your jurisdiction? Please outline the rules relating to each scheme.

The most common type of share acquisition arrangement are restricted stock awards and restricted stock unit awards. Restricted stock awards provide that the participant will become vested in shares if he or she meets certain vesting requirements tied to the restricted stock award. Vesting may be tied to continued employment or performance goals. Restricted stock awards may be granted or purchased for consideration or no consideration. If a public company wishes to provide for the grant of restricted stock, the NYSE and NASDAQ both require that the shareholders approve the plan pursuant to which the restricted stock will be granted, with certain limited exceptions.

Restricted stock units are equivalent in value to a corresponding number of shares of stock. Restricted stock units are typically structured with a vesting schedule and a date following the vesting date on which the restricted stock units convert to an equivalent number of shares of stock or the cash equivalent. 

The most common type of share purchase plan is an employee stock purchase plan (ESPP), intended to meet the requirements of Section 423 of the Internal Revenue Code. The requirements of an ESPP include the following:

  • Options can be granted only by a corporation to employees of the corporation or employees of a subsidiary or parent corporation.
  • The exercise price per share of an option can be the lesser of 85% of the fair market value of the underlying shares on the first day of the purchase period or 85% of the fair market value of the shares on the last day of the purchase period.
  • The ESPP must be approved by the shareholders of the corporation.
  • With certain limited exceptions, all employees of the corporation must be eligible to participate in the ESPP to purchase shares, with the same rights and privileges.
  • The option period cannot be longer than 27 months if the option price is not determinable until the purchase date or five years if the exercise price is not less than 85% of the fair market value of the underlying stock on the last day of the purchase period.
  • An employee cannot participate in the ESPP if he or she owns stock possessing 5% or more of the voting power of the corporation or its parent or subsidiary.
  • Under the ESPP, no employee can purchase more than $25,000 of the fair market value of the corporation’s stock in any calendar year in which the option is outstanding. 

The most common type of share acquisition arrangement are restricted stock awards and restricted stock unit awards. Restricted stock awards provide that the participant will become vested in shares if he or she meets certain vesting requirements tied to the restricted stock award. Vesting may be tied to continued employment or performance goals. Restricted stock awards may be granted or purchased for consideration or no consideration. If a public company wishes to provide for the grant of restricted stock, the NYSE and NASDAQ both require that the shareholders approve the plan pursuant to which the restricted stock will be granted, with certain limited exceptions.

Restricted stock units are equivalent in value to a corresponding number of shares of stock. Restricted stock units are typically structured with a vesting schedule and a date following the vesting date on which the restricted stock units convert to an equivalent number of shares of stock or the cash equivalent. 

The most common type of share purchase plan is an employee stock purchase plan (ESPP), intended to meet the requirements of Section 423 of the Internal Revenue Code. The requirements of an ESPP include the following:

  • Options can be granted only by a corporation to employees of the corporation or employees of a subsidiary or parent corporation.
  • The exercise price per share of an option can be the lesser of 85% of the fair market value of the underlying shares on the first day of the purchase period or 85% of the fair market value of the shares on the last day of the purchase period.
  • The ESPP must be approved by the shareholders of the corporation.
  • With certain limited exceptions, all employees of the corporation must be eligible to participate in the ESPP to purchase shares, with the same rights and privileges.
  • The option period cannot be longer than 27 months if the option price is not determinable until the purchase date or five years if the exercise price is not less than 85% of the fair market value of the underlying stock on the last day of the purchase period.
  • An employee cannot participate in the ESPP if he or she owns stock possessing 5% or more of the voting power of the corporation or its parent or subsidiary.
  • Under the ESPP, no employee can purchase more than $25,000 of the fair market value of the corporation’s stock in any calendar year in which the option is outstanding.
  • Options under the ESPP cannot be transferable, except in the event of death.

What are the tax considerations for share acquisition and purchase plans?

Restricted stock awards are not taxed at grant if they are subject to a substantial risk of forfeiture and are not transferable at the time of grant. When the restrictions lapse, the participant will recognise ordinary income equal to the difference between the amount paid for the restricted stock and the then fair market value of the shares.

When the shares are subsequently sold, the participant will recognise capital gain (short or long-term, depending on the period the shares were held from the date of vesting) on the vested shares equal to the difference between the fair market value on the date of vesting and the sale price received for the shares.

A participant who is granted a restricted stock award may make a so-called ‘83(b) election’, which is a filing with the Internal Revenue Service to recognise in income the fair market value of the restricted stock award at the time of grant (as opposed to the value of the shares at the time of vesting), provided that the 83(b) election is made within 30 days following the date of grant. If an 83(b) election is made, when the restricted stock vests, there will be no tax consequence to the participant.

When the shares are subsequently sold, the participant will recognise capital gain (short or long-term, depending on the period the shares were held from the date of grant) on the shares equal to the difference between the fair market value on the date of grant and the sale price received for the shares.

There is no tax to the employee in an ESPP at the time of grant of the option or exercise of the option under an ESPP that satisfies the requirements of Section 423 of the Internal Revenue Code. If the employee does not sell the shares purchased under the ESPP until the later of two years from the date of grant of the option or one year from the date of exercise, then the employee will recognise ordinary income equal to the difference between the fair market value of the underlying shares on the date of grant of the option and the exercise price of the option (or, if lower, the difference between the fair market value of the stock on the date of sale and the amount paid for the shares). 

Any additional amount between the exercise price of the option and the fair market value of the shares on the date of the sale will be taxed as long-term capital gain to the employee. If the employee sells the shares purchased under the ESPP before satisfying the holding period, the employee will recognise ordinary income equal to the difference between the exercise price paid and the fair market value of the shares on the date of exercise and capital gain (short or long-term, depending on the period the shares were held from the date of exercise) on the shares purchased under the ESPP on the difference between the fair market value on the date of exercise and the sale price received for the shares.

Phantom (ie, cash-settled) share plans What are the most common types of phantom share plan used in your jurisdiction? Please outline the rules relating to each scheme.

The most common type of phantom share are restricted stock units. Restricted stock units are equivalent in value to a corresponding number of shares of stock. Restricted stock units are typically structured with a vesting schedule and a date following the vesting date on which the restricted stock units convert to an equivalent number of shares of stock or the cash equivalent. If the restricted stock units convert to stock at the same time as the restricted stock units vest, the restricted stock units are generally not subject to Section 409A of the Internal Revenue Code. 

However, if the restricted stock units vest and are converted to stock in a different tax year, the requirements of Section 409A must be met with respect to the restricted stock units. If a public company wishes to provide for the grant of restricted stock units that are convertible into stock, the NYSE and NASDAQ both require that the shareholders approve the plan pursuant to which the restricted stock units will be granted, with certain limited exceptions.

What are the tax considerations for phantom share plans?

Restricted stock units are not taxed at grant or at vesting. Although, for employment tax purposes, the fair market value of the restricted stock units are subject to employment taxes in the year of vesting. 

When restricted stock units are converted to stock or cash, the participant is taxed equal to the then fair market value of the shares of stock received or cash paid. A participant may not make an 83(b) election on restricted stock units.

Consultation Are companies required to consult with employee unions or representative bodies before launching an employee share plan?

Companies are not required to receive the consent of a union or representative body before adopting an employee equity plan. However, to the extent to which employees covered by a collective bargaining agreement may receive grants, the grants generally must be negotiated with the union before grant, as the grant would be viewed as additional compensation subject to bargaining.

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