The rules relating to the US taxation of equity awards in an international context are often complex and sometimes uncertain. This On the Subject explores how COVID-19-related travel restrictions affect the US taxation of certain equity awards for employees transferred to and from US-based employers.
The US tax rules governing the taxation of equity awards for globally mobile employees are complex and in some cases, uncertain. Among other things, employers must consider the type of award, grant and vesting dates, and sourcing rules to ensure proper reporting and withholding for non-US employees that have worked in the United States. The global Coronavirus (COVID-19) pandemic and its attendant travel restrictions have triggered a panoply of income tax consequences for employers, from simple extensions of filing deadlines to complex considerations such as permanent establishment risk and withholding tax obligations. In addition, the restrictions have caused US multinational businesses to review their existing processes for how they compute and report taxable income for non-US employees working in the United States. This On the Subject addresses an unintended tax consequence important not only for tax executives, but also for corporate human resource and payroll departments: the effect of travel restrictions on the US taxation of equity awards for employees transferred to and from a US-based employer.
Restricted Stock Units and Performance Stock Units
Restricted stock units (RSUs) and performance stock units (PSUs) are commonly used as long-term incentive compensation for executives and key employees. An RSU is an agreement by the employer to issue shares of its stock at certain specified times in the future after the employee has met designated vesting requirements based on continued employment (e.g., 100% vesting upon completing three years of service). A closely related form of grant is a performance stock unit or PSU, which is an agreement to issue shares at certain specified times in the future after meeting specified performance conditions (e.g., attaining a designated level of earnings per share). RSUs and PSUs can be attractive to employers because they reduce the amount of cash employers must pay out in the form of compensation while providing a long-term incentive. These type of awards also avoid income taxation to the employee until shares are received, which can be long after the employee has met all vesting conditions. In the current COVID-19 environment, businesses have been considering issuing additional RSUs and PSUs tied to operational objectives as a way to conserve cash in order to weather the economic storm.
For US citizens performing services in the United States, the rules are relatively straightforward. Structured properly, RSUs and PSUs are not subject to income tax until shares are delivered to the holder. In effect, these awards are an unfunded, unsecured promise to pay compensation, and employees are subject to tax upon receipt of the shares. Unlike shares that are issued up front as restricted stock, RSUs and PSUs are not eligible for an 83(b) election. In addition, depending upon when shares are issued in relation to when the awards vest, there may be restrictions on when the shares may be issued which, if violated, result in federal income tax on vesting, a 20% addition to tax and interest.
The rules relating to the US taxation of RSUs and PSUs (and certain other nonqualified deferred compensation arrangements) in an international context are often complex, daunting and, in some cases, uncertain. During the vesting period, holders of RSUs and PSUs do not have voting rights, nor are they entitled to receive dividends (although dividend equivalent payments are present in some RSU/PSU plans), as the holders do not yet hold actual shares of the company. Depending on each company and the respective plan documents, an employee may receive the net shares or the cash equivalent value of the shares.
RSUs, PSUs and Inbound Assignments
It is common for US multinational corporations to host employees from overseas affiliates for short- to long-term assignments, and such employees may have received RSU or PSU grants before their US assignment began. Identifying the appropriate US taxation of RSUs and PSUs for employees who are not US citizens, lawful permanent residents (i.e., green card holders) or otherwise US income tax residents (i.e., nonresident aliens (NRAs)) requires careful analysis of US sourcing rules. “Multi-year compensation arrangements” can complicate an employer’s US withholding obligations with respect to RSUs and PSUs issued to NRAs. “Multi-year compensation” refers to compensation that is included in the income of an individual in one taxable year but which is attributable to a period that includes two or more taxable years. NRAs may be subject to US income tax on portions of their RSU and PSU income even if they are not considered US income tax residents.
To the extent an NRA physically works in the United States between the date RSU/PSUs were granted and the date they vest, a portion of the value of the RSU/PSUs will be sourced to the United States and therefore be subject to US income taxation. That portion is typically calculated by summing the total number of days the employee provided services in the United States for the employer during the period between the grant date and the vesting date, divided by the total number of days between the grant and the vest date. For example, suppose an NRA employee is granted PSUs on January 1, 2020, with a single vesting date for the entire award on January 1, 2023. The PSUs are worth $100 upon vesting. If the NRA employee works for the employer in the United States during all of 2020 and thereafter provides services in Ireland (from 2022 through December 31, 2023), one-third of the $100 (i.e., $33) upon vesting would be sourced to the United States and therefore be subject to US income tax. To the extent that there are multiple vesting dates under an award, there are often complicated allocation issues, particularly when considered in light of accounting treatment under ASC Topic 718 (Compensation – Stock Compensation).
In some cases, the complex sourcing rules associated with multi-year compensation arrangements lead to employers over-reporting taxable compensation on an employee’s Form W-2 by including foreign source income. In such cases, employees have been successful filing refund claims with the IRS.
Social security withholding is another important consideration for NRA employees who receive multi-year compensatory equity awards. Generally, and with certain exceptions, in the absence of a social security totalization agreement between the United States and the non-US employee’s home country, Federal Insurance Contributions Act (FICA) taxes will apply to the RSU/PSU. Where an NRA is from a totalization agreement country (with the exception of Italy) and is transferred to the United States for a period of five years or less, FICA taxes generally will not apply, provided the foreigner obtains a “certificate of coverage” from her home country and provides it to her US employer. A certificate of coverage confirms that the NRA employee remains subject to her home country’s social security system.
RSUs, PSUs and Outbound Assignments
US tax resident employees who participate in outbound assignments (i.e., transfer to a foreign affiliate of the US corporation) face their own set of unique tax issues regarding RSUs and PSUs. The outbound employees may become tax resident of the country to which they are transferred, and in the absence of an exclusion or exception, US federal income tax income and wage withholding and reporting obligations will remain applicable for the entire award, as the US taxes its citizens and resident aliens on worldwide income.
Limited exclusions exist from US withholding for US citizen and resident employees who work outside the United States on an international assignment. One such exclusion is the US foreign earned income exclusion, which generally permits a US taxpayer to exclude a certain amount of foreign earned income, including RSU/PSU income (for 2020, the amount is $107,600). For a US employer to rely on the foreign income exclusion with respect to withholding on income relating to RSUs and PSUs, the employer must have a reasonable belief that the employee is a qualified individual who is permitted to exclude the equity income from his gross income. A second exception that may be useful for RSU and PSU income applies if a US citizen’s (the exception does not apply to other US income tax residents, including green card holders) income is subject to mandatory non-US tax withholding in the country in which she is employed. Third, a US employer may not be required to withhold on RSU/PSU income to the extent the transferred employee has indicated eligibility for a US foreign tax credit. Finally, if an individual employee is subject to double tax on RSU/PSU income, relief may be available under the terms of an applicable tax treaty. Notwithstanding the applicability of an exclusion, the US employer is required to report the entire amount of the employee’s RSU/PSU income on the employee’s Form W-2 for the applicable tax year.
With regard to FICA withholding, in the absence of a totalization agreement, where a US citizen or permanent resident is employed outside the United States by a US employer (e.g., a branch of a US corporation), US FICA taxes apply and must be withheld from the individual’s income, including RSU/PSU income. If a totalization agreement applies and an individual’s RSU/PSU income would otherwise be subject to non-US social security taxes, US FICA taxes are generally inapplicable if the transfer is for more than five years. Unlike the federal income tax regulations, the FICA regulations provide no basis for apportionment of multi-year compensation such as equity award income.
The use of tax equalization agreements is a common method that seeks to manage adverse income tax implications that may arise to globally mobile employees. The primary objective of a tax equalization agreement is to ensure that international assignees are no better or worse off as a result of their home and host country taxes. For example, permanent and temporary income tax distortions may occur as a result of differing income tax rates, income realization and recognition rules, etc. between the home and host country. Some multinational corporations apply tax equalization to all international assignees, while others negotiate tax equalization on a case-by-case basis, typically with executives. To the extent possible, it behooves an employer to project future equalization payments, if any, before sending an employee on an international assignment to avoid future surprises of substantial equalization payments. Moreover, employers that have tax equalization agreements with their employees should consider how their employees’ income tax situations may change because of the inability to travel and how that might impact the size of potential equalization payments.
Introducing COVID-19 into the Mix of Tax Ramifications
Because an employer’s US income and wage withholding obligations on internationally mobile employees generally turns on where the employees provide services, employers should review their existing processes and procedures for computing the US taxable income of non-US employees. In turn, and in the absence of IRS guidance on the issue, employers should consider the effect of COVID-19 travel restrictions on their reporting and withholding obligations, including with regard to RSU/PSU income, if their mobile employees are “stuck” in the United States but continue to work for the company. For example, a foreign employee who intended to leave the United States for his home country (or another non-US host country) but who is unable to leave the United States will require the US company to review and adjust his US withholding obligations to account for the apportionment of additional US source income to that employee when the RSU/PSUs vest. Additionally, employers should review their existing tax processes with respect to option plans that are governed by similar tax rules that govern RSU/PSUs. Accordingly, in light of the current travel restrictions, employers should examine any outstanding and anticipated RSU/PSU vesting and revisit their withholding requirements in advance of RSU/PSUs vesting.