U.S. Tax Obligations for the Company
On the tax side, most companies are aware that compensation paid to non-U.S. directors (including equity awards) is usually subject to a flat U.S. withholding tax of 30%.
However, companies will first need to verify that the director is not a U.S. tax resident before withholding tax. This means he or she cannot be a U.S. citizen or permanent resident (green card holder) or spend 183 days or more in the U.S. in any tax year (or as determined under a special three-year look-back formula).
Furthermore, companies will need to check if an exemption from U.S. tax withholding exists under a tax treaty with the director's country of residence. Most tax treaties no longer include such an exemption, but there are notable exceptions, such as the U.S.-Canada Tax Treaty, which provides for an exemption from U.S. taxation unless the director has a fixed base or other permanent establishment (e.g., a physical office) in the U.S. If the exemption applies (because the director does not have a fixed base in the U.S.), the director will need to complete a Form 8233 on an annual basis to claim the treaty exemption and the company will need to file a copy of the form with the IRS.
Assuming the director is not a U.S. tax resident and no treaty exemption applies, U.S. federal tax withholding at a flat rate of 30% is required on any U.S.-source compensation paid to the non-U.S. director. U.S.-source compensation is compensation that is earned based on services provided in the U.S. If all of the Board meetings take place in the U.S., it is common for companies to take the position that all compensation is U.S.-source income and, accordingly, withhold U.S. tax on the full amount of the compensation. If, however, some Board meetings are held outside the U.S. or if the company believes it is reasonable to assume that the director prepared for the Board meetings while being outside the U.S., pro-ration of the compensation can be appropriate. Companies should develop a clear policy in this regard and apply it consistently.
If U.S. tax withholding is required, companies will also have to report the income paid to the director on an annual basis on Form 1042-S and file a tax return on Form 1042. A copy of the Form 1042-S has to be provided to the director. The forms have to be filed by March 15 of the year following the year in which the compensation was paid. Furthermore, to avoid that companies are subject to a back-up withholding obligation with regard to the compensation, they should obtain a Form W-8BEN from the director every three years. (There are situations where a Form W-8BEN may not be required to avoid back-up withholding, but we believe it is easier and safer to request the form from the director.)
Aside from the U.S. federal tax obligations, companies will also need to assess if they have any state tax obligations in the states in which the director provides services (i.e., typically the state(s) in which Board meetings are held). As an example, in California, companies arguably are not required to withhold California tax on compensation paid to a nonresident director. However, reporting is required, but it should be acceptable to take the position that the federal reporting (i.e., on Form 1042) will satisfy the reporting obligation in California, such that no additional tax report will need to be filed for California.
Lastly, but perhaps most surprisingly, companies may have tax withholding and/or reporting obligations in the director's country of residence. In many countries, because the director is not an employee of the U.S. parent or any of its subsidiaries, no such obligations will exist. However, there are several exceptions to this rule. In Canada, for example, the director will be viewed as an employee and the U.S. company will be required to withhold tax from the director's compensation and report it annually to the Canada Revenue Agency. This means that the U.S. company will in most cases need to obtain a Canadian Business Number to be able to discharge these obligations.
Director’s Tax Obligations
Of course, companies should firstly be concerned about their tax obligations, but many will also want to provide at least some information to the director regarding his or her personal tax treatment. Companies should be careful in this regard because conflicts of interest can ensue between the tax position the company may want to take and the director's tax position. Therefore, it usually is a better idea to advise the director to engage a U.S. and local tax advisor to determine his or her personal tax obligations with regard to the compensation paid by the company.
In general terms, however, it is likely that the director will be required to file a personal tax return in the U.S. (on Form 1040-NR). The 30% tax withheld by the company can be applied against the director's personal federal tax liability, but in certain cases, the director may owe additional tax and may be required to make estimated tax payments on a quarterly basis. Similarly, if services are provided in states with state income tax, the director may be subject to state income tax on the director's compensation and required to file a personal tax return at the state level.
In addition, the director usually will be subject to tax in his or her country of residence, which leads to double taxation. Tax treaties can provide relief from such double taxation and the director generally should be able to claim a foreign tax credit for the U.S. tax withheld.
Special Considerations for Equity Awards
When granting equity awards to a non-U.S. director, much like for grants to employees, companies will need to assess any regulatory issues in the director's country of residence. Depending on the type of award, exemptions may be available. However, just because the company grants the same type of award to employees in the respective country and can rely on an exemption, it should not assume that the exemption is also available for the grant to a director, because some exemptions are limited to employees (e.g., in the United Kingdom). Therefore, additional exemption filings may be required or, in extreme cases, stock-settled awards may not be a granted.
Finally, on the tax side, we see that many companies allow directors to defer the receipt of the shares (and/or their cash compensation). If properly structured under Section 409A of the Internal Revenue Code, U.S. directors can defer taxation accordingly. However, outside the U.S., this will not always be the case for voluntary deferrals. Consequently, companies should review the tax consequences for deferred awards in the director's country of residence to decide whether offering such an award makes sense from a tax perspective.
Non-U.S. directors are becoming a reality for many U.S. companies. Because of the heightened visibility of such individuals, companies are well-advised to thoroughly vet the tax and regulatory issues for compensation paid to such directors, both in the U.S. and in the director's country of residence. This analysis should be reviewed on a regular basis (e.g., annually).
If you are looking for more detailed information, I can highly recommend an article on this topic written by my colleague Sinead Kelly.