As a result of foreign ownership, it's common for U.S. employees to receive stock options from foreign parents that are subject to taxation in the United States.
To comply with the Internal Revenue Code, stock options granted to U.S. employees must be granted at fair market value, as of the date of grant. An option that is granted with an exercise price that is less than the FMV on the date of grant, known as a "discounted" stock option, is considered to be a form of nonqualified deferred compensation. When a discounted stock option vests, there are penalties under Section 409A of the Code, unless the discounted stock option formally complies with Section 409A.
The primary issue for all employers granting foreign stock options to U.S. employees is whether the options are granted at FMV on the date of grant. It's common for option plans in foreign countries to grant options based upon FMV over a period of time, such as a 30-day period of time prior to grant. Under Section 409A, where a stock is readily tradable on an established securities market, an average selling price may be used if certain conditions are met. The primary condition is that the averaging period occur within the 30-day period before, or the 30-day period after, the grant date. Where the stock is not readily tradable on an established securities market, a reasonable valuation method may be used to determine fair market value.
For example, let's assume the FMV of ABC Ltd. stock on the date of grant is $10. An option is issued under the ABC option plan from a foreign parent with an option price of $9 on the date of grant. If this option vests when the FMV of ABC Ltd. stock has increased to $15, $6 will be subject to Section 409A, resulting in immediate income tax upon vesting (even if the option is not exercised), a 20% excise tax and an additional tax based on an underpayment of tax interest penalty.
Assuming that the ABC Ltd. options may be granted with an exercise price that is less than FMV on the date of grant, the U.S. affiliate should either: determine if the exercise price constitutes FMV on the grant date under the Section 409A regulations; amend the ABC Ltd. option plan to provide that options for U.S. employees must be granted at fair market value on the date of grant; or limit the employee's ability to exercise the options only upon a permissible distribution event under Section 409A (e.g., upon a separation from service or a change in control event), which may not be practical.
If U.S. employees exercise options and retain stock in a foreign country, U.S. employees will need to report the existence of such foreign bank accounts if over $10,000 is in such an account at any time during a calendar year. This reporting is required under the Foreign Bank and Financial Account rules.
It's important to note that if ABC Ltd. is publicly traded on an established securities market, certain "specified employees" may not receive payments from a nonqualified deferred compensation plan upon a separation from service until six months after leaving. For example, let's say a specified employee has their employment terminated, and is entitled to a severance benefit equal to two years base salary in a single lump sum payment. Under Section 409A, the severance benefit must generally be delayed for a period of six months. However, under a Section 409A exception, an amount equal to $500,000 may be paid in 2012 before the end of the six-month period if the payment is in connection with an involuntary severance pay agreement.
Since foreign parents or affiliates may be unfamiliar with unique U.S. tax laws, it's prudent for U.S. companies with foreign affiliates or parents to review all employee benefit plans, programs and agreements granted in a foreign country that might include deferred compensation for U.S. employees.
Contributing Editor Frank Palmieri, CPA, JD, LL.M (Taxation) is a partner with the law firm of Palmieri & Eisenberg, with offices in Princeton, N.J., and Alexandria, Va.
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