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Tax treaties and employee share options

Category Technical Articles
AuthorTechnical Department
Article by Jonathan Schwarz, barrister, practising at 3 Temple Gardens Tax Chambers. This article was published in the October 2002 issue of Tax Adviser. The increasing use of share options as part of employee remuneration packages and increasing mobility of employees has highlighted the previously obscure issue of the application of tax treaties to cross-border taxation of share options. The Organisation for Economic Cooperation and Development (OECD) Working Party No.1 on Tax Conventions and Related Questions is currently examining the topic. In a related study, the OECD is looking at the question of transfer pricing and cross-border group share schemes. The temperature of the debate has no doubt been raised by the ‘irrational exuberance’ of stock markets in the 1990s and some senior executives amassing vast personal fortunes via options at the expense of other employees and shareholders, and the companies themselves.

In the United Kingdom(UK), these issues have likewise come to prominence. The Inland Revenue's administrative practice was published in October 2001 (Inland Revenue Tax Bulletin Issue 55, p. 833). The Exchange of Notes to the new treaty with the United States (US) signed in July 2001 addresses the issue in a treaty for the first time in setting out an approach to share option gains under Article 14 of that treaty. The absence of judicial interpretation of treaty provisions dealing with cross-border share options and significant differences in policy between various countries in addressing the taxation of employee share options has made for considerable complexity. If that were not enough, the subject is made more complex by separate rules relating to National Insurance Contributions (NICs) and their foreign equivalents which operate in many circumstances under different policy and legal considerations.

A further factor has started to emerge recently. This is likely to have a significant impact, at least in the UK on this issue. It is the increasing move towards accounts-based taxation and potential changes in the accounting treatment of employee share options. Increasing pressure to deduct the cost of options in the profit and loss account of companies is likely to have a significant influence on cross-border taxation. This is optional under US generally accepted accounting principles (GAAP) and there is pressure in the US to make it mandatory. Similar pressure is building in the UK and internationally.

Treaty Provisions

Treaties patterned on the OECD model give primary taxing jurisdiction to the country of residence of an employee in relation to income from employment (OECD Model Art. 15(1)). The country in which employment is exercised is also permitted to tax income from employment under certain circumstances (Art. 15(2)). These are:


  • the remuneration must be in respect of an employment exercised in the other contracting state (the ‘Employment State’);
  • the recipient of the remuneration must be present in the employment state for a period or periods of at least 183 days in any 12-month period commencing or ending in the tax year concerned;
  • the remuneration must be paid by or on behalf of an employer who is a resident of the employment state; or
  • the remuneration must be borne by a permanent establishment which the employer has in the employment state.

Few would dispute that a share option provided as part of an employment package falls within the expression ‘salaries, wages and other similar remuneration’, so as to bring the treaty provisions relating to employment income into play. It is less clear whether the difference between the exercise price and market value at the time of exercise (the ‘option gain’) falls within those terms. The starting point of any UK analysis on this is the decision in the House of Lords of Abbott v Philbin [1960] 39 TC 82 in which it was held that the benefit of the option contract is a perquisite at the time of grant. Subsequent legislation on share options has aimed at determining the manner in which any option gain resulting from exercise is to be treated, depending upon which of the many different regimes for employee shares that have developed over time is applicable. Employee share options in a cross-border context may be solely within the capital gains regime from a UK perspective. A recent illustration may be seen in Mansworth v Jelley [2002] BTC 270, EWHC 442, All ER (D) 311 (Mar) . In that case, options granted while the employee was not resident in the UK were within the capital gains regime. This approach, however, is not adopted by all jurisdictions.

Determining which employment the option relates to

Where a foreign resident exercises employment in the UK (or a UK resident works overseas), it will be necessary to decide whether the options are in respect of an employment exercised in the UK (or in the other contracting state in the case of a UK resident working abroad). United Kingdom case law in this area has dealt with the apportionment of remuneration generally. In the leading case of Varnam v Deeble [1985] BTC 150, 58 TC 501, it was held that in the absence of a contractual allocation, emoluments must be calculated on a time apportionment basis. Time apportionment might provide a satisfactory method for allocating options granted in proportion to the amount of time worked in the respective jurisdiction, but it works best if the grant of the options are viewed as the taxable event from an employment perspective as was held to be the case in Abbott v Philbin. However, time apportionment itself does not fully identify the employment to which the options are linked. Thus, the OECD paper notes that options may be viewed as rewarding past performance or as an incentive for future performance. The OECD paper sets out helpful, but not uncontroversial ideas in addressing this. It suggests, for example, that options are for future performance where exercise is conditional on remaining in employment for a period subsequent to the grant. Putting the OECD proposals in the UK context, they would appear largely to be a matter of saying that the contractual terms of the options must be examined in addition to the employment contract, in order to displace or supplement time apportionment of the kind adopted in Varnam v Deeble.

Tax treatment of the employer in the employment state

Where options are allocated to the employment state, the right of that state to tax the employer is lost if:

(1) the remuneration is paid by or on behalf of an employer who is not a resident of that employment state; and
(2) the remuneration is not borne by a permanent establishment which the employer has in that state.

These rules provide that the right to tax share option gains of non-resident employees is dependent not only on the status of the employee and the employment to which the options relate, but also the tax position of the employer in the employing state. The UK follows the OECD in looking at who the economic employer is, in addition to the contractual position. The first consideration is whether there is an employer resident in the employing state who makes the payment or on whose behalf it is made. United Kingdom practitioners will also need to ask whether in the light of in MacNiven v Westmoreland Investments Limited [2001] BTC 44 (HL) and DTE Financial Services Limited v Wilson [2001] BTC 159 it is apt to say that remuneration is ‘paid’ in respect of the grant of an option. Even if the answer is yes, the same question must be asked as to whether the option gain, for example taxed under Income and Corporation Taxes Act 1988 (ICTA 1988), s. 135 is also remuneration paid in this sense.

Under the second consideration, a similar issue arises in relation to non-resident employers. The employee escapes taxation in the employment state, if the remuneration is not ‘borne by a permanent establishment’ which the employer has in the state of employment.

Conceptually both tests have a common base. If an employer in the employment state is entitled to relief in the form of a deduction in respect of remuneration, then this justifies taxing the employee in respect thereof. This symmetry is currently recognised in Revenue practice in relation to employment remuneration generally. The Revenue will not allow a deduction for remuneration paid by a UK company on behalf of an overseas employer, if the UK company has not been reimbursed for the expenditure. Likewise, the Revenue accept that a permanent establishment cannot be said to ‘bear the remuneration’ unless it is charged against its profits without a corresponding credit.

The effect of this analysis would be to exclude from the tax base share option gains in cases where there is no charge to the profit and loss account of a UK resident employer or permanent establishment. The result ought to be that unless there is a deduction available to the employer in the employment state, no liability should arise for the non-resident employee.

OECD paper and Revenue policy
The Revenue Tax Bulletin article and the OECD Discussion Paper both proceed on a somewhat different basis. There it is argued or assumed that the share option gain is or ought to be remuneration within Art. 15 generally. As a practical solution to the double taxation which would likely arise as a result, they suggest that the share option gain itself should be time apportioned as between periods of employment in the employment state and the residence state. While this approach will help alleviate double taxation in many cases, it will not eliminate it. Secondly (and somewhat inconsistently) – although in the OECD paper the share option gain is assumed to be remuneration within the article – the analysis becomes more questionable in determining whether it is deductible in the hands of a resident employer or permanent establishment. In the context of permanent establishments, they suggest that the Commentary to Art. 15 be ‘clarified’ so that remuneration in the form of share options must be considered to be borne by a permanent establishment even though a state takes the view that the issuing of shares pursuant to a share option does not involve deductible costs. Similarly, they take the view that a deduction for costs associated with the management of a share scheme should be sufficient justification to permit source state taxation of the option gains. This lack of symmetry undermines the argument and suggests that they are straining to find a basis for taxation in the state of employment.

Debate over these employer-related issues may become irrelevant as a result of change in accounting practice and the treatment of share options generally. In the UK in particular, as a result of Finance Act 2002 (FA 2002), s. 101, accounts are required to be prepared in accordance with UK GAAP. If employers become required to expense the share option gain in their profit and loss accounts and this is a permitted expenditure for tax purposes, then the position changes dramatically. Where companies are required to reflect these amounts in their accounts, and this is allowable for tax purposes, the requirements for taxation in the source state will be more easily met.

Transfer pricing in the context of employee share options is a related development which will impact on this.. It is also undergoing examination by the OECD. In the UK, the recent Special Commissioners decision in Waterloo Plc v IR Commrs [2002] Sp C 301, the Special Commissioners considered that the costs of administering and funding an offshore employee share ownership trust were required to be charged to foreign group members on an arm's length basis. The application of these rules, if extended to the share option gains (by a change in accounting practice), will also have a bearing on the employees' tax position. In this scenario, a proper application of transfer pricing rules related to both the options and the underlying role of cross-border employees will determine the scope for taxing option gains. Unless a common approach is taken to the deduction of share option costs, the effect of change in some countries will only heighten difficulties in this area.

The OECD Discussion Paper operates under certain policy assumptions. The general approach of the OECD Model Treaty to avoid or eliminate double taxation is to limit the taxing rights of countries of source in favour of countries of residence. The underlying assumption of the OECD paper is that source countries should not surrender taxing rights in favour of residence countries in respect of share option gains, but should rather be entitled to tax part of those gains. A more restricted approach to source taxation will produce simpler rules for cross-border employees and employers. On the other hand, it may permit more occasions when gains fall out of charge. An expansive assertion of source state taxation may mean that fewer amounts fall out of charge, but complexity will increase, as will double taxation. Present foreign tax credit rules do not always relieve this fully as recognised by the exchange of notes to the new United States Treaty which accepts that mutual agreement procedures may be necessary in some cases.

This paper is based on a presentation given to the Share Schemes Lawyers' Group in July 2002 and the author's book Tax Treaties: United Kingdom Law and Practice.

Technical Department
020 7235 9381

October 2002 by Jonathan Schwarz

 

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