Proposals on How to Handle Options
By FLOYD NORRIS
Published: September 6, 2004
PARIS
ACCOUNTING for stock options has become an international battleground, but those wars may be nearing an end as major industrial countries move toward rules that force companies to deduct the value of options from their earnings.
New battles may be brewing in a different but related area: taxation of the profits derived from exercising stock options. If a worker for an international company is granted an option while working in France, has it vest while working in Australia and exercises it while working in Japan, how will those profits be taxed, and by which country? What if the worker moves to the United States and then sells the shares purchased with the options?
Another issue, perhaps more important to countries worried about corporate tax receipts, concerns the arcane matter of transfer pricing between a parent company that grants options and a subsidiary for whom the executive receiving the options works. Companies can normally deduct the value of a stock option from their taxable income, but in which country should the deduction be taken? And when?
The Organization for Economic Cooperation and Development, whose 30 members include the major industrialized countries, released two reports yesterday recommending how countries should handle the issues. The proposals, which are not binding on countries but can be influential, are intended to avoid both double taxation and allowing a worker to escape all taxation by moving from country to country.
In general, the group recommended that workers should be taxed by the countries in which they performed the labor for which the option was rewarded. In most cases, it said, that would be work performed between the time the option was granted and the time it vested, even if the actual exercise of the option was several years later, with the income split among countries based on the amount of time worked in each country. But it said that minor differences in the provisions of the options could lead to changes in recommended taxation.
On transfer pricing, the organization shied clear of prescribing specific rules, saying that it might not always be clear whether the cost of an option on stock of a parent company, given to an employee of a subsidiary, should be borne by the parent or the subsidiary. But it said that whatever arrangements there are should be worked out in advance, and that they should be subject to the same principles as other transactions between affiliated companies, in which terms should be the same as would be negotiated in an arms-length transaction.
That issue could be important to countries because companies may seek to have the expense - and the accompanying tax deduction - go to the parent or subsidiary in the country where the deduction would save the most taxes.
The issue is complicated because tax rules on options vary, and it is expected to get even more complicated because the terms of options are likely to become more diversified when accounting rules change.
Currently, the United States and some other countries tax employees on the profits from an option when it is exercised. At the same time, the issuing company receives an identical tax deduction.
But the O.E.C.D., without giving information on specific countries, noted that they followed widely varying tax regimes. Depending on the country, an option might be taxed when it is granted, when the employee is allowed to exercise it, when the shares acquired are actually sold or even if it is not exercised at all.
Without coordination among countries, that could lead to employees paying no tax or facing double taxation depending on which countries they were living in when the options were issued or exercised.
The O.E.C.D. recommended that countries deal with the issue in tax treaties but left open several possible treatments. It said one principle should be that profits realized by the employee after the option is exercised - that is, on gains in the stock price after the employee acquires the shares and has the legal right to sell them - should be viewed as capital gains, not compensation income.
Under American accounting rules, most companies do not report options as an expense on the financial statements they send to shareholders so long as the options meet certain requirements, like being exercisable at the market price that prevailed when the option was issued.
But the rules are likely to change, perhaps as early as next year, requiring the value of all options to be treated as an expense. The Financial Accounting Standards Board said it planned to impose the rule, and while a bill to block it had passed the House of Representatives, it appeared unlikely to be approved by the Senate. A similar rule is scheduled to go into effect next year in countries that follow rules laid down by the International Accounting Standards Board, including those in the European Union.
One result of that change is that companies are expected to begin to alter the terms of options. Critics of corporate governance have pushed for such changes to make it more likely that the options will pay off only if the company does well, not if it benefits from an overall increase in the stock market.
But it is possible that companies will change terms for one of two other reasons: either to reduce the reported expense or to seek tax advantages depending on the details of tax statutes in countries in which they operate. That may make options a fertile area for tax strategies by both companies and countries.
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