Withholding Headaches in Sweden

Sweden has not been a country previously featured in this blog, but we have become aware that the Swedish Tax Agency (the “STA”) has contacted several local employers in recent months to seek clarification on the amounts withheld in relation to equity award income and correct the reporting where needed. We believe it is possible that many more companies could be audited with respect to their equity award tax withholding practices in 2019 and beyond.

The Issue

As of January 1, 2019, a new monthly Pay-As-You-Earn (“PAYE”) reporting system replaced the annual income statements that were previously required in Sweden. The monthly tax returns include separate line items for the different categories of income (i.e., salary, car benefit, fuel benefit and other benefits including equity income) and the tax withheld on the income for the applicable month.

Separately, it has always been the case that the amount of tax withheld in a particular month may not exceed the total amount of an employee’s gross monthly salary for the same month. If taxes due exceed the employee’s gross monthly salary, companies may withhold tax only up to the amount of monthly salary. The employee would then be required to pay any remaining tax when he/she files his/her annual tax return.[1] We understand that, in the past, withholding amounts could be spread over multiple pay periods to avoid this issue, but this is no longer the case.

Prior to implementation of the new PAYE system, taxes withheld on equity award income and other income were reported in an income statement at year-end, in which case it was nearly impossible for the STA to determine whether taxes withheld for purposes of equity award income in a particular month had exceeded an employee’s monthly gross salary for the same month. Under the new PAYE process, however, any time the withholding amount reported through PAYE for a particular month exceeds the employee’s monthly salary, the STA technically is being alerted to the infraction.

Especially in case of RSUs vesting or options being exercised and considering the high tax rates in Sweden, it can often be the case that the total tax due on RSU/option income (together with tax due on regular salary and other income) exceeds an employee’s monthly salary. It is irrelevant/not helpful that most companies either (i) sell a number of shares on behalf of the employee and use the sale proceeds to cover applicable withholding taxes, or (ii) withhold a number of shares and come up with the equivalent cash to cover applicable withholding taxes. Even though these processes mean companies are not actually withholding any tax due on the equity award income from the employee’s salary, the rule that the tax withheld as reported through the PAYE system cannot exceed the monthly gross salary still applies.

In this respect, it is also important to point out that companies arguably may withhold taxes only from salary (i.e., cash payments) so a sell-to-cover or share withholding method are not contemplated under Swedish tax law. [2]

As mentioned, we have already seen the STA approaching several companies to question why taxes withheld in a particular month exceeded an employee’s monthly gross salary. More concerning, the STA has suggested that, to the extent the tax withheld exceeds the monthly salary, such excess amount will be deemed additional taxable income on which income tax and employer social security contributions are due.

What Next?

In light of the above, companies should review their obligations both with respect to taxable events that have previously occurred in 2019 and on a going forward basis. To date, we have not seen the STA challenge years prior to 2019.

Prior Taxable Events

Companies should review their monthly individual income tax returns for 2019 to determine if there are instances where the tax withheld on equity award income (together with other tax withheld for the relevant month) exceeded the employee’s gross salary for the applicable month. If this were to be the case, it is possible to apply for a reassessment of the taxes due in the applicable month. This would entail effectively telling the STA that taxes were withheld from an amount other than salary and that taxes were overwithheld, so companies will need to carefully consider if this is the right strategy for them. Further, under Swedish tax law, a taxpayer generally can apply for reassessment only when there is an obvious mistake, such as transposing figures. However, we have seen reassessments being accepted by the STA for this purpose. If the STA accepts the reassessment, it will refund any tax withheld in excess of the monthly salary to the employee via the company (and the employee would then be required to pay the tax when he/she files his/her annual tax return).[3]

Going Forward

To avoid any issues going forward, we believe companies essentially have two alternatives:

1. Withhold from salary and let employees cover the remainder of the taxes due on their own
Under this approach, the company will withhold taxes from the employee’s salary up to the employee’s gross monthly salary and leave it up to the employee to come up with the cash to pay any remaining amounts.  Instead of selling/withholding any shares to cover taxes, the company would issue all of the shares to the employee.

This means: (a) the withholding could wipe out an employee’s entire pay check for one month and (b) employees will have to come up with the cash to cover the remainder of the tax obligation if/when it is due.  With respect to (b), employees can sell shares received from the equity awards (e.g., upon vesting of RSUs), but this could be problematic if the issuance occurs during a black-out (although we assume the employee could plan accordingly and enter into a 10b5-1 plan to sell shares).

2. Withholding from salary AND sell-to-cover/share withholding

    1. Step 1:  In the month of the taxable event, the local employer would withhold taxes from the employee’s salary up to the employee’s monthly salary and report only these withholdings through PAYE.
    2. Step 2:  The issuer would sell/withhold shares to cover the remaining taxes owed on the award income – these amounts would not be remitted or reported through PAYE. Instead, the issuer would either: (a) remit any remaining taxes to the employee’s tax account with the STA on behalf of the employee or (b) remit the amount of taxes to the employee for the employee to pay directly to the STA.

This alternative is more employee friendly as the employee can settle the tax liability immediately and will not have to worry about having to sell shares to cover the taxes due. However, it is more burdensome for the issuer from an administrative perspective.

Conclusion

As a first step, companies should check with their local payroll in Sweden to see if local payroll is aware of the issue and may have already been approached by the STA. As noted, it is recommended to review if the issue of withholding tax in excess of an employee’s monthly salary has already occurred in 2019 and, further, whether to file for a reassessment of taxes for the relevant month. Going forward, companies also need to make a decision on whether to change their withholding practices to follow one of the approaches outlined above. Most likely, communications to the affected employees will be required or at least highly advisable. Separately, some companies may decide to approach the STA to lobby for a change to the withholding rules for equity award income. We would be happy to assist with any of the above.

 

I would like to thank my colleagues Linnea Back (based in our Stockholm office) and Bianca Lansdown (based in our San Francisco office) for their help with drafting this post.

[1] If the total tax owed by an individual for the relevant tax year exceeds SEK 20,000, however, payment of the taxes must be made by February of the following year to avoid interest becoming due on the taxes owed.
[2] It is not entirely clear if the STA would be entitled to penalize companies for using these withholding methods. However, there is a chance an employee could claim to be entitled to the value of the shares sold/withheld (even though these amounts were used to settle taxes due by the employee).
[3] See FN 1.

Tax Deduction and Other Troubles in Israel

I hope most of you have seen our client alert on the recent Israeli Supreme Court ruling that confirmed that stock-based compensation has to be included in the cost base of Israeli subsidiaries of multinational companies.  As a result of the decision, we have already seen a flurry of activity as many companies are evaluating how to obtain a tax deduction for awards granted to Israeli employees.

As a reminder, for companies with a cost-plus arrangement with their Israeli subsidiary, the decision means that the income of the Israeli subsidiary is effectively increased by the amount of the stock-based compensation, plus the mark-up.  To mitigate the tax due on this increased income, it will be crucial for most companies to deduct at least a portion of the equity award income.

The problem is, however, that a tax deduction for equity award income is available in Israel generally only for awards granted under a trustee plan.  Many companies have already set up a trustee plan to grant awards in Israel because trustee awards can provide for beneficial tax treatment for the employees and, thus, most Israeli employees push hard to receive trustee awards.

So let’s look more closely at the requirements of a trustee plan and the corresponding tax benefits.

Trustee Plan Requirements

As the name indicates, a trustee plan has to be administered by an Israeli trustee which has to hold the awards and underlying shares for the duration of the holding period (more on this below), and which will satisfy the applicable tax withholding and reporting obligations.  Most companies enter into a “supervisorial” trust arrangement with the trustee, which means the awards and shares are not physically held by the trustee.  Instead, they are held by the existing broker (e.g., in the U.S.) and the Israeli trustee works with the broker to ensure the awards/shares are not sold before the holding period ends.

There are a number of companies in Israel which can act as a trustee for this purpose, and several are very familiar with U.S.-style equity plans and can work with the brokers that generally administer the plans.  The fees vary by trustee, and usually depend on the number of grantees in Israel and the number of transactions.

Further, to implement a trustee plan, an Israeli sub-plan to the parent plan will need to be adopted and filed for approval with the Israeli Tax Authority (“ITA”).

Once the initial filing has been made, companies must report each grant to the trustee within 45 days of the grant date.  This can be done by sending the trustee a copy of the board resolutions approving the grants.

There are two possible tracks for a trustee plan: the capital gains track and the ordinary income track.   Almost all companies we work with opt for the capital gains track because only this track also provides tax benefits for the employee.

Capital Gains Track

Under the capital gains track, employees will be taxed at sale on the sale proceeds minus any price paid by the employee to acquire the shares (i.e., exercise price for options, purchase price under an ESPP, nil for RSUs).  For public company awards, the tax treatment at sale is bifurcated: the value of the shares underlying the award at grant minus any price paid by the employee to acquire the shares is taxed as ordinary income at the employee’s marginal tax rate.  Any appreciation in value between grant and sale is taxed as capital gain at a rate of approximately 25%.

The employer will be able to claim a tax deduction for the ordinary income portion, provided the employer is charged for this cost.  The tax deduction can be claimed only once the shares have been sold.¹

To qualify for the capital gains track, the trustee must hold the shares for a minimum of 24 months from the date of grant for options and RSUs and 24 months from the purchase date for ESPP.

For RSUs, the ordinary income portion is equal to the value of the underlying shares at grant.  Because this typically will equal the amount that has to be included in the cost base, companies will be able to offset the additional tax burden with a corresponding tax deduction.  However, a timing issue remains because the tax deduction is available only in the year of sale, while the additional tax burden is created in the year of grant.

For options, given that the exercise price will in almost all cases be equal to the value of the shares at grant, there typically will not be any ordinary income portion at grant and, hence, no deductible amount.²

For ESPP, the ordinary income portion is equal to the value of the shares at grant minus the purchase price.  However, offering an ESPP under a trustee plan usually is not very beneficial to the employees.  Furthermore, because the 24-month holding period for an ESPP starts running on the purchase date, employees have to hold the shares for a longer period of time than the shares subject to options and RSUs.³

Ordinary Income Track

Under the ordinary income track, the entire gain at sale (i.e., sale proceeds minus any price paid by the employee to purchase the shares) will be taxed as ordinary income and, thus, deductible to the local entity, provided it is charged for this cost.4

To qualify for the income tax track, the trustee must hold the shares for a minimum of 12 months from the date of grant for options and RSUs and 12 months from the purchase date for ESPP.

Given the treatment of the entire gain as ordinary income and the 12-month holding period, this track is obviously not popular with employees and rarely implemented.

Conclusion

To maximize the tax benefits for both the company and the employee, granting RSUs under the capital gains track of a trustee plan is (and will be) the preferred approach for most companies that are interested in seeking a tax deduction.  As noted above, a timing issue still remains because the tax deduction cannot be taken until the shares are sold (even though the deductible amount will be limited to the value of the shares at grant).  In order to claim the tax deduction, the local entity has to be charged for the deductible amount pursuant to a written reimbursement agreement.

One additional wrinkle to consider for U.S. parent companies is that the amount that can be charged to local entities should not exceed the value of the shares at vesting.  Any amount charged in excess of this value could be considered as a taxable dividend under Section 1032 of the U.S. Internal Revenue Code.  Therefore, the charge-back amount should be limited to the lower of the value of the shares at grant and the value of the shares at vesting.  If the stock price drops between grant and vesting, this will reduce the value of the reimbursement amount and, thus, of the deductible amount in Israel.

 


1  For awards granted by a private company, the entire sale proceeds (minus any price paid for the shares) are treated as capital gain, which means no deduction is available.

2  Note that, to determine the value of the shares at grant under a trustee plan, companies will need to look to the prior 30-trading day average price of the shares.  Therefore, if the exercise price is determined based on the closing price on the grant date (or prior day closing price), a small discount could exist.

3  It used to be possible to obtain tax rulings for ESPP granted under a non-trustee plan in Israel whereby the ITA would agree to allow companies to treat the discount at purchase as ordinary income and take a tax deduction for this amount.  While it is still possible to get the ITA to agree that the discount at purchase should be treated as ordinary income, in recent years, the ITA has refused to allow a tax deduction for this amount.

4  It may be problematic for U.S. issuers to charge the local employer for an amount that is greater than the market value of the shares at vesting.

Oops, the French Did it Again……

Less than 18 months after the latest amendment to the regime for tax-qualified RSUs in France, another amendment became effective on December 30, 2016.  This amendment is the third amendment to the regime in five years, meaning that companies may (in theory) have to administer tax-qualified RSUs that are subject to three different income tax and social tax regimes.  The three different qualified RSU regimes are as follows:

  • French-qualified RSUs granted after September 28, 2012 (“Pre-Macron RSUs“)
  • French-qualified RSUs granted under a plan approved by shareholders after August 7, 2015 (“Macron RSUs“)
  • French-qualified RSUs granted under a plan approved by shareholders after December 30, 2016 (“Modified Macron RSUs“)

For companies that have granted tax-qualified RSUs in the past, the question is whether they will want to continue to grant qualified RSUs after the latest changes.  Similarly, companies that have granted non-qualified RSUs in France or that are starting to grant RSUs in France for the first time will want to evaluate whether they can and want to grant tax-qualified RSUs under the new regime.

Background

Granting equity awards to employees in France can be expensive because of the high employer social taxes.  In particular, any income realized from a non-qualified equity award (e.g., spread at option exercise, FMV of shares at vesting of RSUs) is subject to employer social taxes at a rate of up to 46%.  The 46% rate is comprised of different social insurance contributions, only some of which are subject to a cap.  This means that even awards granted to highly compensated employees will remain subject to employer social taxes at a rate of approx. 25%(while the employees will have reached the contribution ceilings for the other contributions with their other compensation).  If a company grants awards on a broad basis in France, makes large awards to some employees or if the stock price increases significantly after grant, accordingly, the French employer is looking at a big employer social tax liability.

Many companies have been trying to mitigate employer social taxes by granting tax-qualified awards.  Several years ago (before it was possible to grant French-qualified RSUs), no employer social taxes whatsoever applied to French-qualified options.  Recognizing the loss of significant tax revenue, the French government started to impose employer social taxes on tax-qualified awards, but the timing of the taxation and the tax rate have changed significantly over the years.  Some of the changes have made it very difficult for companies to determine whether granting tax-qualified awards is, indeed, beneficial for them.

Determining Which Tax Regime Applies

Before we look at the possible tax benefits of granting tax-qualified RSUs (versus non-qualified RSUs), let’s first discuss under which regime companies may be able to grant qualified RSUs.

Strangely, this depends on when the plan under which the RSUs are granted was last approved by shareholders.  If the plan was last approved on or before August 7, 2015, qualified RSUs can be granted only under the Pre-Macron Regime.  If the plan was last approved after August 7, 2015 and before or on December 30, 2016, qualified RSUs can be granted only under the Macron Regime.  If the plan was last approved after December 30, 2016, qualified RSUs can be granted only under the Modified Macron Regime.

Because it is unlikely that companies would take their plan to shareholders just to be able to grant qualified RSUs under a particular regime (or obtain approval just for a French sub-plan), the application of the different regimes is somewhat random*.

Employer Social Tax Treatment Under Different Regimes

As mentioned, the timing and rate of the employer social taxes varies significantly depending on the applicable regime and can be summarized as follows:

Non Qualified RSUs Pre-Macron RSUs Macron RSUs Modified Macron RSUs
Rate Up to 46% (same as for salary) 30% 20% 30%
Taxable event Vesting date Grant date Vesting date Vesting date
Taxable amount FMV of shares at vesting FMV of shares at grant or fair value as determined under IFRS 2 (at election of employer) FMV of shares at vesting FMV of shares at vesting

It is important to note that, if the employee forfeits the RSUs before vesting (typically because the employee terminates prior to vesting), no employer social taxes will be due under any of the regimes, except the Pre-Macron Regime.  For RSUs granted under the Pre-Macron Regime, the employer has not been entitled to a refund for the employer social taxes paid at grant (which has been one of the reasons why it has been so difficult to evaluate whether such RSUs can result in employer social tax savings when compared to non-qualified RSUs).  However, this might change due to a challenge that is currently pending with the French Constitutional Court.

If successful, employers will be able to apply for a refund (likely both for previously granted awards and for future awards).

Employee Tax Treatment Under Different Regimes

The employee tax treatment also varies quite a bit depending on the applicable regime, as follows:

Non Qualified RSUs Pre-Macron RSUs Macron RSUs Modified Macron RSUs
Annual vesting gain not exceeding €300,000 Portion of annual vesting gain exceeding €300,000
Taxable event / Taxable amount Vesting date/FMV of shares at vesting Sale of shares/Gain divided into Vesting Gain (FMV of shares at vesting) and Capital Gain (sale proceeds minus FMV of shares at vesting)
Income tax Taxation as a salary income

Taxed at progressive rates up to 45%

Taxation as sui generis gain

Taxed at progressive rates up to 45%

Taxation as a capital gain

Taxed at progressive rates up to 45%, but application of rebate on entire gain (i.e., vesting and capital gain) if shares held for certain period: 50% if shares held at least 2 years; 65% if held more than 8 years

Same as Macron RSUs Same as Pre-Macron RSUs
Social taxes Up to 23% (same as for salary) of which approx. 20% is tax deductible 8% of which approx. 5.1% is tax deductible + 10% specific social contribution 15.5% on entire gain of which 5.1% is tax deductible

The gist of the above is that RSUs granted under the Pre-Macron regime are not very beneficial to the employee, even compared to non-qualified RSUs.  For Macron RSUs (and for Modified Macron RSUs, provided the employee does not realize more than €300,000 in annual gains), the tax treatment can be dramatically better, but only if the employee holds the shares for at least two years after vesting.

Main Requirements under Different Regimes

Various requirements have to be met to qualify for the special tax treatment under any of the French-qualified RSU regimes.  The most significant ones are as follows:

Non Qualified RSUs Pre-Macron RSUs Macron RSUs Modified Macron RSUs
Minimum Vesting Period None Two years One year One year
Minimum Holding Period None Two years from relevant vesting date Two years from grant date Two years from grant date

For Pre-Macron RSUs, this means shares generally cannot be sold any earlier than after the fourth anniversary of the grant date, as opposed to two years under the Macron and Modified Macron Regimes (exceptions may apply in the case of death or disability).  This makes the Macron and Modified Macron Regimes a lot more attractive for employees.

However, several additional requirements apply that can be difficult to administer for the issuer (e.g., closed period restriction at sale, accelerated vesting at death).  These requirements are the same under all of the different qualified RSU regimes.

Conclusion

Given all of the complexities related to the tax treatment and the requirements of qualified RSUs, it is almost impossible to say whether it is a good idea to grant qualified RSUs in France.  So much depends on the company’s circumstances, not least on the regime under which the RSUs can be granted.

However, I would generally caution companies to grant qualified RSUs, unless they have a strong stock administration team that can properly administer these awards and keep track of the many changes that have occurred.  If qualified RSUs are granted, but then not correctly administered (e.g., holding periods are disregarded), companies risk disqualifying the RSUs which can have disastrous tax consequences for both the employer and the employees (and be way worse than if the company had granted non-qualified RSUs).  Companies should also consider that disqualification can occur if awards are adjusted due to corporate transactions, with the same negative tax consequences.

Furthermore, I am not convinced that we have seen the last of the changes to the qualified RSU regimes.  As France prepares to elect a new President and usher in a new government, it is very possible that more tax reforms are on the horizon (especially if Mr. Macron wins the election…..).

On the other hand, I recognize that some companies have granted qualified RSUs for years and that changing to non-qualified RSUs can be a difficult “sell” to employees (and maybe the French employer).  Similarly, companies that are fortunate enough to be able to grant Macron RSUs may be happy to shoulder the burden of administering French-qualified RSUs in return for a flat 20% employer social tax at vesting.

So, again, every company should carefully consider whether it makes sense to grant qualified RSUs.  And, in any event, we all must stay tuned for further changes!

*That said, we are aware of a few companies that have either timed their shareholder approval to be able to rely on a specific regime (typically only possible for private companies) or that have sought shareholder approval for a French sub-plan (even though no amendments were made to the general plan).

Brave New World: Withholding in Shares After Changes to ASC 718

brave-new-world

Many companies are considering changing their tax withholding practices after FASB modified the accounting rules for share-based awards (ASC 718). For most companies, the modified rules become mandatory for accounting periods starting after December 15, 2016, although companies are able to voluntarily implement the revised rules earlier.

The changes to ASC 718 were mainly intended to facilitate tax withholding for equity awards granted to employees outside the U.S., but have also raised questions for taxes withheld for U.S. executives. Continue reading

Welcome to The Equity Equation!

 

Welcome to my first blog on the fascinating topic of global equity and incentive awards. I am a partner with Baker & McKenzie (in our San Francisco office) and have focused on advising multinational companies on all aspects of their global equity and incentive programs for over 14 years. I will use the blog to share my thoughts on new (or not-so-new) developments that could affect your equity or incentive programs, best practices for these programs, as well as industry news and company trends.

I am always open to suggestions for my next topic, so if you have an idea for a blog-worthy post, please feel free to share it with me at barbara.klementz@bakermckenzie.com.