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21 September 2007
A foreign individual settles in the United States, works for a US employer and earns options under his or her employer's stock option plan. He or she leaves the country, loses resident status and then exercises the US stock options. When does the United States tax the employee - and on what?
This tax issue occurs at the junction of international, corporate and employee benefits taxation. As it does not fall squarely within a single specialty, few practitioners could answer the question offhand. Moreover, articles dealing with the issue have tended to group it together with other tax problems that occur at the nexus of equity-based compensation and international tax law. As a result, some of the details specific to US tax treatment are considered only briefly. For example, an excellent article by Thomas Bissell and Alfred Giardina summarizes the issue as follows:
If the interaction of international, corporate, employee benefits and withholding rules was complicated before 2005, their interaction with the new Internal Revenue Code Section 409A is even more so. In addition to considering domestic and international taxation, tax treaties and the subset of laws specific to expatriating former citizens and residents, practitioners must contemplate the new deferred compensation rules and a draconian new penalty regime. The likelihood of missing a significant issue has risen with the stakes.
This update provides a detailed but manageable analysis of all of the US tax issues which this scenario might produce. It begins by discussing employee stock options in a purely domestic context, examining the types of options, how they are taxed and the various withholding obligations to which employers are subject. It proceeds to discuss the complexities which an international framework introduces.
Grant, vesting, exercise and sale
When an employer grants stock options to an employee, there are four events that could, in theory, trigger an employee's tax liability: the grant of the option, the vesting of the option, the exercise of the option and the employee's sale of the stock underlying the option.
When an employee is granted an option, he or she receives the right to purchase a certain amount of stock at a certain price (termed the 'option price') on or after a future date.
When the employee can first buy and keep the underlying stock at the agreed price, the stock option is said to vest. Usually, the option holder must continue to work for the employer until the option vests. An employee who leaves his or her employer before the option vests may forfeit it, but after the option vests, the employee holds it unconditionally - he or she can exercise it even if he or she retires, is fired or goes to work for another employer. After an option vests, it is exercisable, but it may be exercisable only for a limited period, after which the option expires and the employee loses the right to buy the stock at the option price.
When the employee acquires the underlying stock at the agreed price, he or she is said to have exercised the option. The employee may or may not subsequently sell the underlying stock.
General principles of stock option taxation
Section 83(a) of the code provides that an employee who receives property in exchange for services must recognize income equal to the excess of the property's fair market value over the acquisition price (ie, the amount the employee paid for the property) when the employee's rights to the property vest. Under this general rule, an employee is taxed on a stock option as soon as it vests. However, Congress and the Treasury determined that this rule would be difficult to apply to employee stock options, as there is often no ready market for them. Accordingly, the applicable Treasury regulations provide that employee stock options are taxed either on their exercise date (ie, the date on which the employee exercises the option) or sometime after the exercise date when the employee sells the stock underlying the option. The tax timing depends on the type of stock option the employee holds.
There are two kinds of employee stock option: non-statutory (or non-qualified) options and statutory (or qualified) options. The former are ordinary, run-of-the-mill options. The employer gives the employee the right to buy a certain amount of stock on or after a certain date for a certain price. Non-statutory options are taxed under Section 83 and associated regulations. The latter provide more tax deferral than non-qualified options and permit the taxpayer to treat all income associated with the options as long-term capital gain. However, in order to enjoy such benefits, employees must satisfy certain requirements. Statutory options are taxed under Section 422 and associated regulations.
Non-statutory stock options
Taxation of non-statutory stock options
Because employee stock options cannot be reliably valued on their grant or vesting date, they are generally taxed when exercised.(2) An employee exercises an option by purchasing the underlying stock at the agreed price (ie, the option price). If the employee were to sell the stock immediately after exercise, he or she would realize the difference between his or her option price and the stock's fair market value - this is termed the 'spread'. Accordingly, Section 83 treats an employee exercising a stock option as if he or she had made a discount purchase of stock: the employee is taxed on the spread.
As Section 83 treats the spread as compensation, the spread is characterized as ordinary income rather than capital gain; as the employee option holder has paid tax on the spread, he or she holds the stock with a higher basis that includes the spread.(3) Thus, an employee who sold the stock immediately after exercising it would recognize no capital gain on the transaction, even though the stock's sale price may have greatly exceeded the price the employee paid to acquire it (in this case, the option price). In other words, when the employee exercises the option and pays income tax on the spread, he or she takes the stock with an adjusted basis equal to the fair market value (the option price plus the spread on tax has just been paid). The option price may be his or her acquisition price, but because he or she pays income tax on the spread, the fair market value on exercise is the adjusted basis. Having exercised the option, the employee holds the underlying stock with this basis and without regard for the stock's origins in a non-statutory stock option - the compensatory aspect is closed.(4) Henceforth, the employee holds the stock purely as an investor.
Withholding on non-statutory stock options
Employers have Section 3402 wage withholding obligations with respect to non-statutory employee stock options. The option spread on a non-statutory stock option is included in gross income as wages and, as such, is subject to wage withholding under Section 3402.(5) In general, withholding requirements arising pursuant to non-cash compensation are identical to those arising pursuant to cash compensation.(6) This is the case even though, in the strict sense of the term, cash cannot be 'withheld' from a non-cash payment. Accordingly, the Internal Revenue Service (IRS) provides that the employer must "make necessary arrangements to insure that the amount of the tax required to be withheld is available for payment in money".(7) In order to make such arrangements, the employer may simply withhold the tax from the employee's cash compensation, but this method may cause financial hardship for some employees. The IRS allows employers to mitigate this potential hardship by timing the withholding so as to minimize any ill effects.(8) However, this flexibility is limited to specific contexts that do not include the exercise of employee stock options. Instead, the IRS permits 'cashless exercise', whereby the employee exercising the option pays the option price by selling some of the stock back to the corporation. Thus, the employee receives sufficient cash to pay the option price and any withholding taxes.(9)
Impact of Section 409A
The taxation of employer stock options changed dramatically in 2004 when Congress introduced a new statute to govern non-qualified deferred compensation (ie, deferred compensation not covered under the Employee Retirement Income Security Act).(10) Non-qualified deferred compensation becomes subject to the new Section 409A when an employee has a legally enforceable right to it, and compensation subject to 409A becomes taxable when no longer subject to a substantial risk of forfeiture. Section 409A imposes strict requirements on deferred compensation and draconian penalties for non-compliance.
As compensatory stock options delay realization of option income, some stock options may fall within the scope of Section 409A, which could result in the acceleration or increase (or both) of the employee's tax burden. An employee with a vested right to deferred compensation that does not comply with the requirements of Section 409A is immediately subject to tax on the deferred compensation. The employee is also subject to a 20% penalty and interest running from the year of vesting.(11)
Exception to Section 409A for equity-based compensation
In general, Section 409A does not apply to non-qualified stock options, provided that the exercise price is not lower than the fair market value on the grant date. However, Treasury regulations provide additional criteria that a stock option plan must meet in order to qualify for the exception. For example, the requirement that the underlying stock be service-recipient stock restricts options to common stock issued by the employer or corporations in an upward chain of owners with a controlling interest (usually 50% ownership) in the corporation below.(12) Under this rule, any grant of stock options in stock with a dividend preference or stock of a subsidiary corporation would be subject to Section 409A.
Anti-modification provisions further restrict the exemption of stock option plans from Section 409A. A reduction in the exercise price is treated as the grant of a new option.(13) In order to be exempt from Section 409A, this 'new' option must meet the same criteria as the original option, including the requirement of an exercise price greater than or equal to the fair market value on the grant date. An 'underwater' option (ie, an option in stock with a value less than the exercise price) will satisfy this requirement. However, if the stock has increased in value, the deemed new option will necessarily fail the test on the new, deemed grant date and will therefore be subject to Section 409A.
An option that falls outside the exemption from Section 409A will almost invariably violate it because payment of the deferred option income occurs upon an impermissible trigger. Section 409A limits the permissible events that can trigger a distribution of deferred compensation.(14) Permissible distribution events include separation from service, disability, death, fixed schedule, change in control and unforeseeable emergencies.(15) Exercise is not one of the permissible distribution events. Thus, modifying an option that is not underwater triggers taxation and the imposition of penalties under Section 409A, payable (with accruing interest) from the moment the option vests.
The regulations also prohibit extensions of the exercise period after either the last possible expiration date under the original grant or a date 10 years after the original grant, whichever is earlier.(16) An option extended in this manner is treated as having had an additional deferral feature from the original grant date. Thus, the stock option is deemed to have violated Section 409A from the grant date and interest runs accordingly.
Timing of Section 409A violations
The taxable consequences of a Section 409A violation depend on two factors: the timing of the violation and the amount of compensation at issue. Regardless of the timing of the violation, no compensation is vested and therefore no tax is due until the substantial risk of forfeiture has lapsed.(17) However, the compensation must be included in income the moment it vests.
If the option remains subject to a substantial risk of forfeiture on the date of the violation, the tax does not fall due until the risk of forfeiture lapses. For example, many stock options require the recipient to continue to provide services until a certain date, at which time the employee's right to the options will vest. As long as the employment-related condition has not been met, the options are subject to a substantial risk of forfeiture and Section 409A violations will not trigger taxation. Thus, an option with an exercise price below the fair market value of the stock on the grant date and exercisable after four years of service represents an immediate violation of Section 409A, but no tax falls due and therfore no interest begins accumulating until four years of service have elapsed.
When Section 409A violations occur before exercise
Taxation before exercise, as required in the example above, may require the resolution of significant valuation problems. In the event that taxation is accelerated under Section 409A such that the option-holder is taxed before exercise, the taxable compensation is the value of the option itself. This includes the 'option privilege' as defined in Reg Section 1.83-7(b)(3). However, the compensatory aspect of the option remains open and Section 409A remains applicable until exercise.(18) Thus, the option holder may realize additional income and incur additional penalties when the option is exercised.
Statutory stock options
Taxation of statutory stock options
Statutory stock options are a special class of employee stock options and are not taxed on exercise.(19) The holder of a statutory option does not recognize income until he or she disposes of the underlying stock, at which time he or she recognizes income in an amount equal to the difference between the sale price and his or her basis in the stock.(20) However, the employee holds the stock with an option-price basis, rather than with a basis equal to fair market value on exercise (as would be the case for a non-statutory option), because he or she did not pay tax on the spread at exercise.
After exercise the employee holds the underlying stock as an investor. The subsequent sale of the underlying stock is taxed as the straightforward sale of a capital asset without regard for the stock's origin as a statutory option. Thus, it is taxed as long-term capital gain, not ordinary income. The holder of a statutory option not only defers taxation until he or she sells the stock, but also ensures that all income associated with the transaction is taxed as capital gain.
In order to enjoy these benefits of deferral and recharacterization, the employee must meet a number of requirements, including holding period requirements. The latter requirements consist of two independent prescriptions: the employee must avoid disposing of the stock until two years after the grant date or one year after the date of transfer of the share itself (ie, the exercise date), whichever is earlier.(21) In other words, both periods must elapse before the employee can sell his or her shares without falling out of the statutory stock option regime. An employee who disposes of his or her stock before both periods have elapsed engages in a disqualifying disposition; when there has been a disqualifying disposition, the option holder recognizes both ordinary income and the capital gain on the transaction.
An employee who disposes of stock in a disqualifying disposition recognizes income in the tax year of the disposition.(22) The employee recognizes as ordinary income the excess (if any) of the stock's fair market value on exercise over the option price.(23) Additional gain realized on disposition is treated as capital gain. This tax treatment reflects that of non-statutory stock options - ordinary income on the spread, capital gain on the underlying stock's subsequent increase in value. A disqualified statutory option provides one advantage over a non-statutory option: the employee defers tax on the spread until he or she disposes of the stock. However, because a disqualifying disposition takes place at a maximum of two years after the exercise date, the available deferral is minimal.
If the employee sells the stock for less than its value on exercise and the transaction is such that a loss is recognized (ie, it is not a gift or a sale between related persons), special rules apply. The employee does not determine tax liability by treating the two transactions seriatim (ie, in series), recognizing first ordinary income (ie, value on exercise over option price), then a capital loss (ie, sale price over value on exercise). Instead, the exercise of the option and the sale of the underlying stock are integrated and the employee recognizes as ordinary income the excess of the sale price over the option price.(24) Consequently, the value on exercise becomes irrelevant to the calculation; the employee simply recognizes ordinary income to the extent that the sale price exceeds the option price.
Withholding on statutory stock options
Withholding poses no problem in the non-statutory context, for as the employer's withholding obligation arises in the year of exercise, the employer knows that the obligation exists and knows the correct amount to withhold. In contrast, withholding in the statutory context poses significant practical difficulties: it requires the employer to withhold on a transaction that takes place between a person who may no longer be an employee and a third party which is likely unknown to the employer. The employer may not even know that the transaction has occurred. Furthermore, if the employee no longer works for the employer, the employer may not have payment obligations to the former employee from which such tax may be withheld. This problem was addressed by Congress in the American Jobs Creation Act of 2004, which provides that Section 3402 withholding does not apply to statutory options.(25) When an employee exercises a statutory stock option and subsequently engages in a disqualifying disposition, the employer has no withholding obligation with respect to the compensatory income attributable to the transaction.
Solving the administrative problem in this way effectively eliminated oversight by the only repeat players in the stock option context: namely, the employers. Employers are in a better position to learn the complicated tax regime and keep records that will enable them to track employees' time abroad. If the employer lacks an incentive to learn the tax regime and keep the necessary records, the employee alone must learn the correct tax treatment of the stock option and make a relatively complicated disaggregation of the income attributable to the stock sale. The extent to which employees and former employees have accurately reported the income attributable to the disqualifying disposition of statutory stock options is beyond the scope of this update; however, it seems likely that it is relatively low.
A better solution consists of a withholding obligation triggered on exercise. The employer would be obliged to withhold on the option spread under Section 3402, regardless of whether the option was statutory or non-statutory. Once the holding period had elapsed, an employee who held a statutory option and had not engaged in a disqualifying disposition could file for a refund. Alternatively, the amounts withheld could simply be escrowed by the employer until the holding period has elapsed. Either method would ensure that all taxes were paid in a timely fashion and, just as importantly, would help to ensure consistent compliance with the holding period requirements of statutory stock options.
Impact of Section 409A on statutory options
Section 409A provides a much wider exception for statutory options, which are generally deemed not to constitute deferrals of compensation. However, the anti-modification provisions can still cause difficulties. If a modification results in the new option's failing to meet the statutory option requirements, Section 409A applies to the option retroactively to the grant date and the modification has the same effect as the modification of a non-statutory option.(26)
The taxation of stock options exercised by non-resident aliens introduces an additional issue: how does the income attributable to the option fit within the general rules governing the taxation of foreign persons? Two independent inquiries are necessary in order to determine the extent of taxable income and the correct rate and manner of tax.
Characterizing the compensation income
First, the character of the income must be determined in order to determine both the rate and manner of tax. If the character is fixed and determinable, it is taxed at the flat 30% rate under Section 871(a)(1); if effectively connected to the taxpayer's trade or business within the United States, it is taxed at the graduated rates described in Sections 1 and 55 of Section 871(b)(1) - income thus earned is identified by the acronym 'ETBUS', derived from the term 'engaged in trade or business within the United States'.
The performance of personal services within the United States constitutes a trade or business within the United States(27) and income received for such services is considered both US source income and ETBUS income.(28) Thus, if the non-resident alien's option income arises from personal services performed in the United States, it should be treated as ETBUS income and taxed at graduated rates.
Allocating compensation income from non-statutory stock options
When an employee exercises a non-statutory stock option, he or she recognizes ordinary income on the option spread. As the ordinary income constitutes compensation for personal services for tax purposes, the treatment of the income depends on where the employee did the work to which the income is attributable. Work performed in the United States produces US source income which is taxable as ETBUS income.(29) Work performed abroad produces foreign source income which is taxable for a resident alien, but not for a non-resident alien.(30) Thus, the employee is taxed on the income attributable to services performed in the United States. This rule seems simple, but it is almost impossible to apply in the context of stock options.
A number of years will usually elapse between the grant date and the vesting date, and additional time may elapse between the vesting date and the exercise date. Between the grant date and the vesting date, the employee may work for the employer in the United States, work abroad or both. After the vesting date, the employee may or may not remain with the employer. If the employee remains, he or she may remain for some or all of that time and may work in a variety of locations.
The regulations under Section 861 provide a sourcing rule for such scenarios, whereby income received in one tax year is attributable to services provided in two or more other tax years. These are called multi-year compensation arrangements. The percentage of time for which the employee worked in the United States during the applicable period determines the percentage of income from a US source,(31) and the regulations provide that, for stock options, the applicable period is the period between the grant date and the vesting date (ie, the date on which all employment-related conditions for their exercise have been satisfied).(32) Thus, when an employee works both in and outside the United States during the vesting period, the option spread is sourced based on the percentage of time spent working in each location.(33)
Although the exercise of the option constitutes a realization event and triggers the analysis, the applicable period ends on the vesting date, not the exercise date. Thus, an employee can defer realization of income attributable to the stock options by delaying exercise, but he or she cannot alter the manner in which that income will be sourced. The percentage sourced to the United States is fixed and immutable from the day on which the option vests.
The regulations cited above were issued in 2004 and took effect in 2005. Before this, Revenue Ruling 69-118 provided the sourcing rules for employee stock options. The ruling sources ordinary income arising from the exercise of stock options based on hours worked in the United States between the grant date and the exercise date. Therefore, employees exercising before 2005 could minimize the percentage of income attributable to US sources by delaying exercise and spending work time abroad.
Statutory stock options
To the extent that a non-resident alien realizes ordinary income on the option, the income receives the same tax treatment whether the option is statutory or non-statutory. The income is sourced under the applicable multi-year compensation rules and characterized as ETBUS income; only the withholding requirements differ.
Effectively connected income
Since the performance of personal services in the United States constitutes a 'trade or business' and all income from work performed in the United States is US source income which is deemed to be 'effectively connected' to that trade or business, all ordinary income attributable to the employee's stock option should be taxable under Section 871(b). However, the deferral provided by employee stock options raises a potential complication: if an employee who is a non-resident alien recognizes the option income in a tax year during which he or she has no other contact with the United States, is the employee engaged in trade or business effectively connected with the United States during the relevant tax year? Should a non-resident alien recognize as effectively connected the deferred wage income realized in a tax year during which he or she has no ETBUS activities?
Section 864(c)(6) provides that, when income is thus deferred, the relevant tax years for the purposes of the ETBUS analysis are those to which the income is attributable, not the year in which it is recognized. It states:
"[I]n the case of any income or gain of a non-resident alien individual or a foreign corporation which is taken into account for any taxable year, but is attributable to a sale or exchange of property or the performance of services (or any other transaction) in any other taxable year, the determination of whether such income or gain is taxable under Section 871(b)... shall be made as if such income or gain were taken into account in such other taxable year [ie, the year to which it is attributable]."(34)
The characterization of deferred income thus mirrors the sourcing under the multi-year compensation rules. Just as delayed recognition does not affect the percentage of the income attributable to foreign sources, delayed recognition does not affect its treatment as ETBUS income.
The look-back rule introduces an additional complication: if the non-resident alien was a US resident during the year in which he or she performed the personal services (ie, during the look-back year), is it proper to characterize income attributable to that year as ETBUS income, a category associated only with non-resident aliens?
The IRS considers that a taxpayer need not be a non-resident alien in the look-back year in order to recognize subsequent ETBUS income attributable to that year's activities. Field Service Advice 200128037 suggests that if an employee provides services within the United States as a resident alien and receives deferred compensation in a subsequent tax year during which he or she is a non-resident alien, the Section 864(c)(6) look-back rule applies. Technically, this should not be the case. The look-back rule should determine only whether income is taxable under Section 871(b) - and a resident alien's income is never taxable under Section 871(b).
As the field service advice addresses deferred compensation attributable to services performed in the United States by individuals who were resident aliens during the look-back year, it opens up an additional issue: does Section 864(c)(6) extend to foreign source income as well as US source income? Resident aliens are taxable on their worldwide income, not just their US source income. If the look-back rule applies to both resident aliens and foreign source income, an option holder who was a US resident in the look-back year would be taxed differently from an option holder who was a non-resident alien with ETBUS income in the look-back year - the former would be taxed on his or her entire option spread, whereas the latter would be taxed only on the US portion of the option spread.
A purely formal analysis of the statutory language suggests that Section 864(c)(6) does not reach this far. The look-back rule determines not whether income is taxable, but whether it is taxable under Section 871(b). Foreign source income not effectively connected with the United States is not taxable under Section 871(b), and there the analysis ends. However, this is the very logic that the IRS rejects in the field service advice to apply the look-back rule to an individual who was a resident alien during the look-back year. Formally, the income of a resident alien is not taxable under Section 871(b), but the field service advice nonetheless applies Section 864(c)(6). Since the look-back rule applies - againts formal logic - to a resident alien, there is no purely logical reason to limit its application to that resident alien's US source income. Strictly speaking, neither is taxable under Section 871(b).
The IRS has never addressed this issue directly, but it does not appear to adopt the position that Section 864(c)(6) gives it retroactive authority to tax the deferred worldwide income of former resident aliens. For example, PLR 8904035 addresses the position of German residents who received distributions from Section 401(k) accounts attributable to employment in the United States. The IRS ruled that all such individuals were taxable under Section 864(c)(6) and Section 871(b). It did not attempt to disaggregate those who had been resident aliens during their periods of US service or to suggest that they should be taxed differently from those who had been non-resident aliens.
Other indirect statements suggest that the IRS would limit the reach of Section 864(c)(6) to US source income. For example, it describes Section 864(c)(6) as governing "the character of income".(35) If limited to a determination of income's character rather than the authority of the United States to tax the income at all, then Section 864(c)(6) would not reach the former resident's foreign source income.
In short, non-resident aliens who receive compensatory income from the exercise of United States stock options are taxable, at graduated rates, to the extent that the income is attributable to services provided in the United States. This look-back rule applies regardless of whether the non-resident alien was a former resident of the United States - at least, that is the IRS's position. The look-back rule does not retroactively subject former residents to tax on their worldwide income.
Withholding under Section 1441
Non-statutory stock options
An employer whose employee exercises a non-statutory stock option withholds under Section 3402. The employer need not withhold under Section 1441, because the regulations exclude from Section 1441 withholding any ETBUS income subject to withholding under Section 3402.(36) Withholding on a non-resident alien's wage income is nonetheless more complicated than withholding on the wage income of a US citizen or resident. Theoretically, the employer should withhold only on US source compensation, but an employer which must withhold from non-resident alien employees may not know how much of the employees' income is attributable to US sources. Employers may not always track their employee's US and non-US business days in each pay period. Regulations applicable to Section 1441 withholding provide that when a payer "does not know at the time of payment the amount that is subject to withholding because the determination of the source of the income" depends on unknown facts, the employer must withhold on the entire amount.(37) This rule is generally applicable to wage withholding as well. Thus, an employer facing this conundrum is permitted to withhold on the entire amount, leaving the non-resident alien employee to claim a refund.(38)
Ordinary income attributable to the disqualifying disposition of stock underlying a statutory stock option is not subject to withholding under Section 3402: "No amount shall be required to be deducted and withheld under Chapter 24 with respect to any increase in income attributable to a [disqualifying] disposition described."(39) The same administrative convenience reasons exist to exclude disqualifying disposition income from Section 1441 withholding that helped lead to its exclusion under Section 3402. However, the phrasing of the American Jobs Creation Act's exclusion opens the door to an equally troublesome withholding requirement under Section 1441. As Section 1441 withholding is not a Chapter 24 requirement, the exclusion as written does not reach Section 1441 withholding. The general exclusion of wages from Section 1441, which eliminates Section 1441 withholding in the non-statutory context, is limited to income subject to withholding under Section 3402.(40) The act eliminated the Section 3402 withholding requirement and with it the exception from Section 1441 withholding. This means that the income arising from a disqualifying disposition is subject to Section 1441 withholding requirements in part because Congress excluded it from the wage withholding requirements.
There is a further exclusion from Section 1441 withholding for ETBUS income that would be subject to withholding under Section 3402 but for the fact that it is excluded from the definition of 'wages' in Section 3401(a).(41) However, this regulatory exception does not apply because Section 3401(a) does not contain an exception for a non-resident alien's ordinary income attributable to a disqualifying disposition of the stock underlying a statutory stock option. The legislative history of the act suggests that Congress regards statutory stock options as a tool of employee ownership, not compensation.(42) However, the Section 1441 regulatory exclusion specifies that a payment must be excluded from wages under Section 3401(a). Neither Congress's statement that the payments have a non-compensatory purpose nor Treasury's interpretation that they do not constitute wages suffices to bring a disqualifying disposition under the exclusion because neither is expressed in Section 3401(a).
Arguably, the spread on statutory options should be exempt from Section 1441 withholding for practical reasons, since an employer which does not participate in the disqualifying transaction cannot withhold on its proceeds. However, this solution would merely extend the problem created by the exemption under the act - that is, the lack of oversight for a complex and potentially confusing tax regime. Moreover, the problem is magnified for non-resident aliens. If the average employee is unlikely to learn the correct tax treatment of the stock option and make a relatively sophisticated analysis of the income attributable to the stock sale, a non-resident alien is even less likely to do so. A non-resident alien has less familiarity with the US tax system and, living outside the jurisdiction of US courts, has less motivation to determine the correct tax treatment of the transaction. As the suspension of the withholding obligation would introduce enforcement and oversight problems, universal withholding (or escrow) upon exercise provides a preferable solution.
In general, capital gain from the sale of securities by a non-resident alien is foreign source income;(43) as such, it is not taxable to a non-resident alien as either "fixed and determinable" income under Section 871(a) or ETBUS income under Section 871(b). Therefore, if the non-resident alien realizes capital gain by selling the stock underlying the option (as opposed to income from the exercise of the option), the capital gain is foreign source income and non-taxable.
If the non-resident alien was a long-term resident of the United States before leaving the country, he or she may fall foul of the expatriation rules of Section 877.(44) If so, the non-resident alien's capital gains taxation is affected and he or she may be taxed on capital gains associated with the ultimate disposition of the stock as if he or she were a US citizen. In order to trigger the expatriation rules, the employee must have been a long-term resident of the United States.(45) A 'long-term resident' is defined as an individual who was taxed as a lawful and permanent US resident (ie, a green card holder) for at least eight years of the 15 years immediately preceding expatriation.(46)
In order to become subject to Section 877, the employee must also meet either the income tax liability or the net worth test under Sections 877(a)(2)(A) and (B). An individual meets the income tax liability requirement if he or she has an average net US income tax liability of over $124,000 a year for the five years immediately preceding expatriation.(47) This figure is indexed for years after 2004; for expatriations occurring in 2007, the threshold is $136,000. The employee meets the net worth requirement if he or she has a net worth of $2 million or more.(48) The net worth threshold is not indexed for inflation.
If the employee was a long-term resident and meets either the income tax liability or net worth test, the alternative tax regime described in Section 877(b) applies for 10 years after expatriation.(49) During this period the employee is subject to taxation under either Section 871 (applicable to normal non-resident aliens) or Sections 1 and 55 (applicable to US citizens and residents), whichever generates the larger tax burden. However, the taxable amounts are limited to items of US source income as defined specially for the purposes of Section 877. If, without the operation of Section 877, the non-resident alien would have avoided a tax burden on US source income by leaving the United States, the special sourcing rules of Section 877 may deny him or her the benefits of that advantage.
US source income arising from the exercise of stock options (or a disqualifying disposition of the underlying stock) is taxed to a non-resident alien at the graduated rates applicable to ordinary income, regardless of Section 877(b). Stock option income is personal services income, which is considered to be effectively connected to the conduct of a US trade or business.(50) A non-resident alien's effectively connected income is taxed at the graduated rates under Section 871(b), even if the individual is no longer considered to be engaged in a US trade or business in the year of receipt.(51) Thus, the operation of Section 877 does not affect the tax treatment of ordinary income that arises either from the exercise of stock options or from a disqualifying disposition of statutory stock options.
By contrast, the operation of Section 877 has a significant effect on the taxation of capital gains income associated with the disposition of the underlying stock. Under Section 877, all gains on the disposition of stock in US corporations are characterized as US source income.(52) Thus, if the employee's total tax burden is such that the tax regime described in Section 877(b) applies, and if the stock underlying the employee's option is stock in a US corporation, the employee will be subject to US tax on capital gains associated with dispositions of stock that occur within 10 years of expatriation. For this reason, a well-advised employee who has fallen foul of the expatriation rules will, if possible, delay disposing of underlying stock in a US corporation until the 10-year deadline has passed.
As a practical matter, tax treaties will not alter the US tax treatment of stock options of alien employees who were employed by US employers or lived in the United States for at least 184 days during the period in which the services were performed. Under most treaties, such options are fully taxable in the United States and are therefore governed exclusively by US tax rules.
If a non-resident alien employee fails to satisfy the presence test during a year of employment and works for a foreign employer (although not for a US branch of the foreign employer), a treaty may deny the United States the authority to tax some of the ordinary income attributable to the employee's option. Such an employee would be exempt from US taxation of option income attributable to that year, even if the income were directly attributable to work performed in the United States.
General rule for resident employers and/or resident employees
Under the US Model Treaty, the United States is authorized to tax remuneration for work performed in the United States if such remuneration is provided either by a US employer or to a worker who was sufficiently present in the United States during the period of service. The treaty provides that personal services income is taxable by the country in which the services are provided and that the same treatment applies to employment-related benefits, such as stock options. The treaty states that:
"[S]alaries, wages and other similar remuneration derived by a resident of a contracting state in respect of... employment shall be taxable only in that contracting state, unless the employment is exercised in the other contracting state. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other state."(53)
In the technical explanation to the model treaty, the Treasury explicitly applies this rule to the exercise of stock options, stating that:
Noting that a stock option may be "considered to be derived from employment exercised in more than one state", the Technical Explanation to the Organization for Economic Cooperation and Development (OECD) Model Treaty specifically outlines the current US rule for multi-year compensation arrangements as the effective source rule.(55)
A number of treaties adopt this model language and associated explanations. Treaties with the United Kingdom (in 2001) and Japan (in 2003), for example, reflect this understanding of options and the multi-year compensation rules. The respective technical explanations also use identical language to express the tax allocation involved.(56)
Thus, the US Code generally governs the tax treatment of ordinary income arising from the exercise of employee stock options, at least to the extent that the income is sourced as US income under domestic US tax rules. However, this treatment does not apply to some options that foreign employers may provide.
Foreign employers of non-resident aliens
Article 14(2) of the treaty restricts the rule described above. The treaty denies the United States authority to tax the option income paid by a non-resident employer to an employee who is present in the United States for 183 days or less during any 12-month period that begins or ends during the relevant taxable year. (The Treasury Technical Explanation provides that 'presence' is determined under the 'days of physical presence' method, with days counted as set forth in Revenue Ruling 56-24.) In order to qualify for the exception, the compensation paid by the non-resident employer must not be deductible by a permanent establishment that the employer maintains in the United States. This restriction prevents an employer from deducting compensation that is not ultimately taxable to the employee.(57) Under these rules, ordinary income from the exercise of a foreign employer's stock option is not taxable in the United States.
This exclusion interacts with the multi-year compensation rules. For employees not subject to the exclusion of Article 14(2), the taxable percentage of option income tracks the percentage of days worked in the United States during the entire applicable period.(58) However, an employee subject to the exclusion is taxable only on US source income attributable to periods in which he or she spent sufficient time in the United States. Thus, the effective taxable percentage of the option income tracks the percentage of days worked in the United States during taxable periods within the applicable period. For employees who consistently maintain a presence in the United States at or near the 183-day threshold, this exclusion can create significant tax savings.
In general, stock options are taxed on or after exercise. However, the new rules under Section 409A may alter the timing of recognition if the stock option plan is not drafted and administered so as to take advantage of the exception for equity-based compensation. In addition, tax treaties may exclude option income attributable to work performed for some non-resident employers.
Ordinary income that arises from the exercise of a stock option is sourced according to the multi-year compensation arrangement rules. This is the case whether the income is recognized on the exercise date or, pursuant to the operation of Section 421(b), in the year of a disqualifying disposition of the underlying stock.
An employer has Section 3402 withholding obligations with respect to its employee's exercise of a non-statutory option. There are no withholding obligations associated with the exercise or disposition of statutory stock options by a US person. However, there appears to be a Section 1441 withholding obligation associated with a non-resident alien's disqualifying disposition of stock underlying a statutory stock option.
Capital gains arising from the disposition of underlying stock by a non-resident alien have a foreign source. As such, they are not generally taxable to the non-resident alien. However, if the stock underlying the option is the stock of a US corporation and if the employee has fallen foul of the expatriation rules, the employee is also taxable on the capital gains.
For further information on this topic please contact Dana Goldblatt or Stafford Smiley at Caplin & Drysdale by telephone (+1 202 862 5000) or by fax (+1 202 429 3301) or by email (email@example.com or firstname.lastname@example.org).
(1) Thomas Bissel and Alfred Giardina, "International Aspects of US Retirement Plans, Deferred Compensation and Equity-Based Compensation Plans: An Overview" in Tax Management International Journal, Issue 25, pages 275 and 288.
(2) See IRC Sections 83(a)(1) (taxing compensatory property on the date of transfer or vesting) and 83(e)(3) (exempting employee stock options from the general Section 83 inclusion regime), and Reg Section 1.83-7(a) (taxing non-qualified employee stock options upon exercise).
(5) Revenue Ruling 67-257. The ruling further provides for treatment of the spread as a supplemental wage payment. (For the methods of calculating the correct withholding percentage of a supplement wage payment, see Reg Sections 31.3402(g)-1(a)(2), (6) and (7)).
(9) See, for example, Private Letter Ruling 200550007, which rules that the implementation of a cashless exercise feature did not alter the material terms of the option programme within the meaning of Reg Section 1.162-27(e)(4)(vi).
(21) IRC Section 422(a)(1) and Reg Section 1.422(a)(1)(i). Although technically involving a disposition of the underlying stock, cashless exercise of a statutory stock option (in which the option holder uses some of the stock to pay the exercise price) is not considered a violation of the holding period requirements (Reg Section 1.422-5(b)(1)). Cashless exercise of statutory options is not necessary to pay applicable taxes, since there are no taxes due on the exercise of a statutory stock option. However, because cashless exercise obviates the need to liquidate additional capital to finance exercise, it can nonetheless be a significant feature of statutory options.
(42) Comm Rep 4211.00099 (American Jobs Creation Act, PL 108-357, October 22 2004). See also Reg Section 31.3402(8)-1(a)(1)(iii) (income from the disqualifying dispositions of shares of stock acquired pursuant to the exercise of statutory stock options, as described in Section 421(b), is not included in regular wages or supplemental wages).
(54) Treasury Technical Explanation to the Model Convention. See also the OECD Treasury Technical Explanation (2005 Income Tax Treaty) Section 12.2 (applying the rules to any benefit derived from the option itself until it has been exercised).
(56) For the United Kingdom, see the Treasury's technical explanation issued on March 5 2003 (Income Tax Treaty 2001), Article 14(1); for Japan, see the technical explanation issued on February 25 2005 (Income Tax Treaty 2003), Article 14(1). This rule is not absolute; treaties may vary.
An earlier version of this update was published in Corporate Taxation.
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