Traditionally, US companies focused their attention on the tax treatment of US shareholders and employees holding equity compensation awards in corporate transactions. However, as more and more transactions contain international components, US companies have been necessarily forced to place greater consideration on the tax implications corporate transactions will have on foreign shareholders and employees holding equity compensation awards. The US has a developed system of federal tax laws that, for the most part, clearly address the tax treatment of certain corporate transactions and the impact on US shareholders and employees holding equity awards. The same cannot be said for many other countries. Many foreign countries will tax shareholders and employees in connection with a corporate transaction even though it is considered tax neutral in the US, especially for employees holding tax-qualified equity awards. This column uses one example to highlight some of the international issues a US company should consider when undertaking a global corporate transaction. More specifically, it addresses the differences between the tax treatment of US employees and shareholders in a spinoff and the tax treatment of Israeli employees and shareholders in a spinoff where the company that is spun off assumes the equity compensation awards held by employees of the spun-off company.

What is a spinoff?

In a spinoff, a company (RemainCo) transfers a business segment to one of its wholly owned subsidiaries (the New Company). Often, the transfer of the business segment is completed through a series of asset and share deals as part of an internal reorganization. Upon completion of the internal reorganization, RemainCo will distribute all of the issued and outstanding shares of the New Company to RemainCo shareholders (the Distribution).1 Immediately after the spinoff, RemainCo shareholders will hold a combination of RemainCo shares and New Company shares. The New Company may then list its shares on a US stock exchange, or it may acquire or be acquired by another corporation.

Equity compensation basics

Most US publicly traded companies grant equity awards to employees of their worldwide subsidiaries in order to attract and retain talent. Common types of equity awards granted include restricted stock units (RSUs) and stock options.

An RSU is an unsecured, unfunded promise to issue company shares to the award recipient at a future date, provided that certain time or performance-based conditions are met. The award recipient does not have to pay any consideration to acquire the company shares underlying the RSUs on the vesting date. In the US, the award recipient will typically be subject to tax on the fair market value of the company shares issued on the vesting date. The taxable amount will be classified as additional employment income and will be subject to US federal income taxes, social security contributions (i.e., FICA, to the extent the applicable contribution ceiling has not been reached), and the Medicare tax.

A stock option is a right to buy company shares in the future at an exercise price typically equal to the fair market value of the company shares on the stock option grant date. In the US, the award recipient will typically be subject to tax when the stock options are exercised. The award recipient will be subject to tax on the fair market value of the company shares at exercise less the exercise price paid. The taxable amount will be classified as additional employment income and will be subject to US federal income taxes, social security contributions (i.e., FICA, to the extent the applicable contribution ceiling has not been reached), and the Medicare tax.

Equity treatment in a spinoff

In a spinoff, some employees will remain employees of RemainCo and its subsidiaries (RemainCo Employees) while others will be transferred to the New Company and its subsidiaries (New Company Employees). Typically, the treatment of equity compensation awards held by New Company Employees will be addressed in the separation and distribution agreement governing the spinoff and the related employee matters agreement, which will address the HR aspects of the spinoff (collectively, the Agreements). The Agreements may specify that these equity awards are cashed out, cancelled, assumed for equity, or assumed for a combination of equity and cash consideration. Here, we assume the New Company will assume the equity compensation awards held by New Company Employees, but it is important to confirm that the terms and conditions of the employee share plan and award agreement that govern the equity awards allow for the prescribed treatment in the Agreements.

Basket method or concentrated method

In the context of a spinoff, companies can handle outstanding equity awards in one of two ways. Under both methods, RemainCo Employees and New Company Employees will have their outstanding equity awards adjusted to maintain their pre-spinoff intrinsic value and the outstanding equity awards will generally retain the same terms and conditions. Under one approach, commonly referred to as the "basket method," RemainCo Employees and New Company Employees will hold outstanding equity awards over both RemainCo shares and New Company shares following the spinoff.

Under the other approach, commonly referred to as the "concentrated method," RemainCo Employees will hold outstanding equity awards only over RemainCo shares and New Company Employees will hold outstanding equity awards only over New Company shares. The following discussion addresses the concentrated method.

Adjustment of outstanding equity awards held by RemainCo Employees

Under the concentrated method, RemainCo Employees will hold outstanding equity awards only over RemainCo shares after the spinoff. The outstanding equity awards will be adjusted to maintain their pre-spinoff intrinsic value.

To ensure that the value of outstanding equity awards remains the same, RemainCo typically will apply an "adjustment ratio" to outstanding equity awards to preserve the intrinsic value held by RemainCo Employees. The adjustment ratio generally will equal the closing price of RemainCo shares immediately prior to the spinoff divided by the opening price of RemainCo shares immediately after the spinoff.2

Example: Assume Employee A holds 1,000 RSUs over RemainCo shares prior to the spinoff. The intrinsic value of the RSUs prior to the spinoff is USD 100,000 (1,000 shares × $100 closing price of RemainCo shares immediately prior to the spinoff). The adjustment ratio of two is multiplied by 1,000 (the number of RSUs held over RemainCo shares). After the spinoff, Employee A will hold 2,000 RSUs over RemainCo shares. The intrinsic value of the RSUs immediately after the spinoff is USD 100,000 (2,000 shares × USD 50 opening price of RemainCo shares immediately after the spinoff). Accordingly, the pre-spinoff intrinsic value of outstanding RSUs held by RemainCo Employees is maintained by virtue of the adjustment factor.3

The adjustment of outstanding equity awards to maintain their pre-transaction intrinsic value is not a taxable event for US federal income tax purposes.

Conversion of outstanding equity awards held by New Company Employees

Under the concentrated method, New Company Employees will hold outstanding equity awards only over New Company shares after the spinoff. The outstanding equity awards will be adjusted to maintain their pre-spinoff intrinsic value.

Again, to ensure the equality of the value of the employee's awards, New Company typically will apply a "conversion ratio" to outstanding equity awards. The conversion ratio generally will equal the closing price of RemainCo shares immediately prior to the spinoff divided by the opening price of New Company shares immediately after the spinoff.4

Example: Assume Employee A (employed by the New Company) holds 1,000 RSUs over RemainCo shares prior to the spinoff. The intrinsic value of the RSUs prior to the spinoff is USD 100,000 (1,000 shares × USD 100 closing price of RemainCo shares immediately prior to the spinoff). The conversion ratio of 0.5 is multiplied by 1,000 (the number of RSUs held over RemainCo shares). After the spinoff, Employee A will hold 500 RSUs over New Company shares. The intrinsic value of the RSUs immediately after the spinoff is USD 100,000 (500 shares × USD 200 opening price of New Company shares immediately after the spinoff). Accordingly, the pre-spinoff intrinsic value of the outstanding RSUs held by New Company Employees is maintained by virtue of the conversion factor.5

The adjustment to maintain the outstanding equity award's pre-transaction intrinsic value and the conversion of outstanding equity awards to equity awards over New Company shares are not taxable events for US federal income tax purposes.

US tax treatment of Distribution

For US federal income tax purposes, the Distribution often will be tax free to RemainCo, the New Company, and their respective shareholders, except to the extent that cash is paid in lieu of fractional shares of New Company. For example, if, pursuant to the Distribution, a RemainCo shareholder is entitled to 5.5 New Company shares, the RemainCo shareholder may receive five New Company shares and cash consideration equal to 0.5 of a New Company share. In the US, the distribution of the five New Company shares will be done on a tax-free basis and the cash consideration representing the fractional shares will be taxable to the RemainCo shareholder.

Israeli tax treatment of a spinoff

US multinationals with local subsidiaries in Israel typically will grant equity compensation awards to Israeli employees via one of the tax preferential tracks permitted under the Israeli Tax Ordinance (the Ordinance). In this regard, the following discussion summarizes the permissible tracks, the requirements under each track, and the benefits to award recipients.