By: Chetana Kaasam, Mengxin Cui and Satya Yeruva
Companies that are headquartered in the US often want to provide stock options to their international subsidiaries as a way of building loyalty with employees. Luckily, this is possible and may carry tax benefits. We are going to examine the two most commonly-used stock options that may be issued to your employees of foreign subsidiary or parent companies – ISOs and NSOs – and their tax implications.
The Differences Between INcentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs)
Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs) give an employee the right to buy common stock on a future vesting date, at a discounted price.
An employee receives their stock options on a grant date. Typically, the grant date price is the fair market value of the shares on that date. The company can set a vesting period, which is generally two to four years from the grant date. Vesting periods can vary based on the employee’s time worked at the company or on their achievement of performance goals. The vesting period for ISOs cannot exceed 10 years, or five years for shareholders that hold 10% or more of the company. NSOs do not have a vesting period limitation.
When the vesting period is complete, employees can exercise, or purchase, their shares at their original grant date price. This incentivizes employees to increase the company’s worth – and stay with the company for longer – so that they can get more value from their stock options. The cost to the company is the stock’s price discount, or the difference between the grant date price and the fair market price when the employee exercises their stock.
If an employee leaves the company before the vesting period is over, the unvested stock is returned to the company. ISOs must be exercised within three months after an employee’s termination of employment in order to qualify for tax benefits. The exercise deadline is longer in the case of an employee’s disability (one year), or death (no deadline).
Normally, stock options cannot be transferred to other parties, so they do not have market value. However, if transfers are allowed, the company may reserve the right of first refusal on an employee’s ability to transfer vested stock.
Taxing Differences Between NSOs and ISOs
While ISOs are more difficult to administer than NSOs, the main difference between ISOs and NSOs is how they are taxed. NSOs are more attractive to employers, because they can take a tax deduction when the employee exercises their stock. However, NSOs are less advantageous to employees, since they are taxed twice: when they exercise the stock, and when they eventually sell it. NSOs are also taxed as ordinary income, which is usually a higher tax rate.
The reverse is true for ISOs. ISOs typically have a lower tax burden on employees, because they are mostly just subject to capital gains taxes when the stock is sold. However, employers typically cannot take tax deductions for ISOs. This makes ISOs more popular among start-ups, who do not yet have taxable income and whose value may increase significantly.
Issuing ISOs and NSOs to Foreign Subsidiaries
ISOs may be granted only to employees. NSOs are more flexible because they can be granted to non-employees, such as independent contractors and non-employee directors. In both cases, these definitions include employees and non-employees of a foreign subsidiary.
When a US parent corporation grants equity to the employees of a foreign subsidiary, the US parent is not entitled to a compensation deduction under US tax laws because it is not the service recipient.
Instead, the US parent company can enter into a recharge agreement with its foreign subsidiary. Under this agreement, the foreign subsidiary reimburses the US parent for the cost of the equity. The amount charged can vary based on local regulations, the stock cost accounting method used, and transfer pricing.
Recharge agreements may allow foreign subsidiaries to capture a deduction for the cost under applicable foreign laws. As another bonus, they allow the US parent to receive tax-free repayment for the stock options.
However, these agreements entail costs to the foreign subsidiary, and may lead to indirect tax considerations for the US parent company due to transfer pricing.
Stock options can provide a strong incentive to employees to stay with their employers and perform. US-based companies considering whether and how to offer stock options to employees of their foreign subsidiaries will have to examine the tax, cost, and transfer pricing considerations, among other things. Consult with an experienced Chugh CPA to ensure you structure your stock options beneficially.