“Share-based payments: Compensation or fringe benefit?” by Ruben R. Rubio (November 27, 2009)
SUITS THE C-SUITE By Ruben R. Rubio
Business World (11/27/2009)
Taxation of employee stock options is an area that still lacks clarity
Incentive schemes and share-based payments are becoming prevalent in the corporate world, as publicly listed companies move to broaden their ownership base, encouraging their employees to directly participate in company affairs.
Most common of these are the stock option (SO) plans, restricted stock unit (RSU) plans, employee stock purchase plans (ESPP), and long-term investment plans (LTIPs). These plans start on a grant date.
SO plans give the right to purchase a certain number of company shares. The purchase price (also known as grant or exercise price) is determined on the grant date, which is when an employee becomes a participant to the plan.
There is also a so-called vesting period — a period of time that must pass before the participants can purchase the shares. During this period, the share value is expected to appreciate, so that by the time the participant purchases the shares, the grant price could be lower than the shares’ prevailing fair market value (FMV). The purchase of the shares is also known as “exercise.”
ESPPs allow participants to set aside a portion of their salary to purchase shares at a discount, after the lapse of the vesting period. These salary deductions are placed in a trust account which may or may not earn interest. Upon vesting, the participant is allowed to use, either fully or partially, the accumulated savings to purchase shares.
RSU plans grant participants ownership of a certain number of stocks without the participant having to pay anything for it. There is also a vesting period, during which the participant is not yet considered as the owner of the shares, or his or her rights as an owner are restricted, including the right to dispose of the shares, receive dividends and/or vote as a shareholder. Upon vesting, these restrictions are lifted, and the shares are delivered to the participants.
The LTIPs generally grant interest-free loans that enable participants to buy stocks. The loans are payable within a certain period of time, using the declared dividends. The participant uses the proceeds from the sale of stocks to settle the loan, or pays through cash. Some plans allow the surrender of shares to settle the obligation in full, regardless of the prevailing FMV at the time of the loan settlement.
Generally, the right to avail of the benefits of the plan depends on the existence of an employee-employer relationship between the participant and the company during the vesting period. If employment during the vesting period ceases, the right to own the shares will depend on the reason for termination of employment.
Thus, if the employment ceases for reasons beyond the employee’s control (such as death, retirement or disability), the company can grant him or her, or his or her heirs, the right to exercise, receive the delivered shares, or purchase the shares pursuant to the plan.
In case an employee left under bad circumstances (such as termination for valid causes), the company can revoke the privileges.
For LTIPs, the cessation of the employer-employee relationship between the participant and the company can render the obligation due and demandable, or cause the surrender of the shares to the company.
These schemes have some other peculiarities that set them apart from regular company benefits.
For one, its recipients could be all of the employees or a certain group of employees only. If granted to a particular class, these could be enjoyed by everyone in that class, such as all those occupying managerial levels; or by some selected people only, such as those holding key positions in the management, or only those who belong to certain level of income.
The purpose for their grant is worth noting. While some plans are meant to compensate the participants for their services to the company, others are designed as perks for certain individuals.
Given the increasing practice of companies to grant share schemes, the Bureau of Internal Revenue (BIR) had occasion to rule on the taxation of the income derived from these plans, and the rulings vary.
Historically, the BIR has treated share-based payments as compensation income. In recent years, it has ruled that stock options granted only to selected top level executives are fringe benefit. It has made a similar pronouncement on RSUs. While the rulings are specific to stock options and RSUs, the BIR is expected to apply them to other share schemes.
The rulings, however, show a notable distinction in the facts. When the income is treated as compensation, the plan appears to be issued to all employees. When declared as fringe benefit, the recipients are selected key personnel only.
While this may be the case, we believe that the BIR could also consider the nature of the payment. Thus, when the participation in the plan is performance-based, it may treat the income as compensation, though received by a select group of individuals only, since it is more of a payment for services rendered. If given as a perk to the participant, then it may rightfully be treated as fringe benefit.
We have plans that are granted to non-employees, such as consultants and members of the board of directors. As employer-employee relationship does not exist in this situation, the income is neither compensation nor fringe benefit, but a business income which the recipient must declare for income tax purposes.
One must look carefully at the classification of income — whether this is compensation or fringe benefit — to determine certain obligations. If the income is treated as compensation, it is the participant that has the obligation to report it, and pay the tax. If it is otherwise a fringe benefit, the company must report the income and pay the tax.
These are just the most immediate concerns, and there are others such as the company’s withholding obligation, liability for social security contribution, and deductibility of expenses.
Moreover, there are issues around the taxation of dividends declared during the vesting period of RSUs, the interest-free loans under the LTIP, gains from the sale of the shares, and the surrender of the shares in satisfaction of the loans. These matters should also be given attention and studied further from the standpoint of income taxation.
(Ruben R. Rubio is a Tax partner of SGV & Co.)
This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.