When granting equity awards, one of the most important questions is the tax effect of such awards. Granting awards that have a negative tax impact on the employee or the company is counter-productive and should lead companies to consider other ways to incentivize their employees. On the other hand, should companies maximize the availability of favorable tax treatment for equity awards in certain countries? This is not an easy question to answer.
Favorable Tax Treatment – The Company vs. the Employee
When we talk about favorable tax treatment, it can mean different things depending on the country and the qualified-tax plan. The most basic distinction is whether the treatment is favorable for the employee, the company, or both.
- For employees, favorable treatment often means that taxation can be deferred (usually until the shares are sold), the taxable amount can be reduced or characterized more favorably (e.g., as capital gain, rather than employment income), social taxes can be mitigated or avoided, or a combination of the foregoing. For the company, favorable treatment usually means that employer social taxes can be reduced or avoided, tax withholding/reporting obligations can be eliminated, or a tax deduction becomes available.
- Companies will need to consider which of the above are most important to them. In my experience, it is usually a combination of employer social tax savings and employee tax savings that prompt companies to implement a tax-qualified plan.
The prime example for this is France, where a tax-qualified plan can reduce the very high employer social taxes (up to 46%) that are due on non-qualified awards, but also allow for a tax deferral and potential tax savings for employees. Of course, French-qualified awards are famously complex, due to the many changes the French legislator has adopted over the last few years (described in more detail in my prior blog post here).
By contrast, in Israel, a trustee plan (Israel’s version of a tax-qualified plan) benefits almost exclusively the employee, but has become so common that companies are almost forced to adopt one, due to competitive pressures. More recently, however, several of our clients have adopted trustee plans in Israel for the main reason of obtaining a local tax deduction, which has become more important in the wake of the Kontera decision, so there is now also a dual reason for such plans in Israel.
The Cost-Benefit Analysis
Before companies decide to implement a tax-qualified plan, they should undertake a careful cost-benefit analysis. In working with private companies, I have observed that they tend to almost reflexively adopt a tax-qualified option plan in the UK or a French-qualified plan. This is usually based on advice from local advisors who claim that these plans are common place for companies offering awards in their jurisdiction and that, to remain competitive, awards have to be granted under these plans.
While it is true that tax-qualified plans in these countries can be especially beneficial for private companies and their employees, this advice often omits the administrative burden and cost of maintaining such plans. Virtually all tax-qualified plans (with France and the UK being no exception) come with various special conditions (such as minimum vesting and holding period requirements) and ongoing filing obligations (such as special annual reporting requirements). And while the initial preparation and implementation of the tax-qualified plan can be handled by an outside advisor, ensuring that the special conditions are met and completing the ongoing filings typically falls on the company which, in the case of many private companies, may not have sufficient resources to deal with these issues.
Another important consideration is the treatment of qualified awards in a corporate transaction. This is again especially relevant for private companies which are more likely to be acquired before awards can first be exercised or vest. If an acquisition disqualifies the awards from the favorable treatment, the qualified plan essentially would have been implemented for naught.
Of course, companies don’t have a crystal ball and whether or not an award could be disqualified depends on the type of acquisition, the treatment of the awards in the acquisition, whether holding periods have been satisfied at the time of the acquisition and many other factors. Still, dealing with qualified awards in an acquisition is usually cumbersome and, in many cases, it will be necessary or advisable to obtain tax rulings to preserve the qualified status of awards. For example, in Israel, it seems that any modification of an existing award granted under a trustee plan requires the approval from the Israeli Tax Authority to maintain trustee plan status.
Embarking on a New Tax-Qualified Plan? Answer These Questions First!
As companies decide whether or not to implement a tax-qualified plan in a particular jurisdiction, they should ask themselves the following questions:
- What is the benefit of the tax-qualified plan? If the benefit is purely, or mostly, for the employee, how does this affect employees in other countries who may not be able to receive the same tax benefits? Are the employer social tax savings significant enough to warrant the implementation and maintenance cost of the plan, as well as the administrative burden?
- Has everyone weighed in on the decision to implement a tax-qualified plan? Operating a qualified plan will most likely have a significant effect on the stock plan administrator who will need to administer special terms, such as holding periods, and comply with ongoing requirements. It can also have corporate tax and accounting consequences which should be socialized with the right people within the organization.
- Who should pay for the implementation and maintenance of the plan? If the main benefit of the plan is employer social tax savings, perhaps it is appropriate to allocate the cost to the local entity.
- Do we have the administrative capacity to administer the qualified plan? In this respect, it is important to understand all of the requirements and any ongoing filing requirements. I would also consider creating a detailed checklist that can be used to track the requirements and obligations, which can be especially useful if there is turn-over at the company.
- What does the future hold? If a company is about to implement a new equity incentive plan, does it make sense to implement a qualified plan under the “old” plan, given that most qualified plans are tied to the parent plan and have to be re-done when a new plan is adopted? If a corporate transaction is probable, what is the impact of such a transaction on a qualified plan?
At the end of the day, as always seems to be the case with global equity awards, the answer of whether a tax-qualified plan should be implemented is highly fact-specific and depends on the particular circumstances of each company. The best advice is to not jump into implementation of a qualified plan, but carefully consider all of the benefits and requirements and seek input from multiple stakeholders.