Complying with the global payroll reporting and withholding obligations on equity awards can often result in the employee owing the company on the tax equalization unless specific measures are taken to avoid this situation.

Why is this important? For an employee that is tax equalized, having a large tax equalization settlement due to the company can lead to many challenging situations including:

  • A large write-off for the company if they are unable to collect from the mobile employee. This often occurs if the employee leaves the company before the annual tax equalization calculation is prepared.
  • Awkwardness within the organization while the HR, payroll, and business units wait for the employee to repay the company.
  • The tax issues for a mobile employee are often quite confusing even in the best of circumstances, so owing a large amount to the company, (either as an out-of-pocket payment or with actual tax refunds) can be alarming and frustrating.

To illustrate the issue and possible solutions, we will use a fact pattern that is common for many US employees that go on assignment and are tax equalized.

Fact Pattern

  • US employee
  • On 3 year assignment in UK
  • On US actual payroll
  • On UK shadow payroll
  • Tax equalized, and company agrees to fund all UK taxes
  • Married
  • Base salary of $250,000, bonus of $150,000 and spouse has wages of $100,000
  • Equity income is sourced 100% to the UK
  • Employee has a single RSU vesting event that generates $1,000,000 of compensation income
  • Employee’s UK marginal tax rate is 45%
  • Employee’s US hypothetical marginal rate is 40%
  • Employer’s equity policy requires mandatory net settlement of the award (i.e., withholding shares to cover the taxes due)
  • Employer uses the “flat” rate (i.e., supplemental rate) withholding method on equity awards

Issue

Based on the facts above, the common approach would be to withhold US federal tax at a rate of only 25%. However, this would result in the following issues when the tax return and tax equalization are prepared:

  1. The employee would receive a US federal tax refund of $250,000 because claiming a foreign tax credit would eliminate all US tax on the equity income.
  2. The employee would owe $400,000 to the company on the tax equalization calculation. This is comprised of:
    1. The $250,000 federal refund that belongs back to the company (since the company paid the UK taxes that generated this refund).
    2. The $150,000 in under-withholding on the equity income, since the employee’s incremental tax rate is 40%.

In summary, the employee would need to have funds available to pay the employer for the $150,000 tax equalization settlement, as well as pass along the federal refund of $250,000 to the employer. To avoid the challenges noted above, the company should avoid having an employee owe it $400,000.

Potential Solutions:

Remove tax equalized employees from the net settlement requirement; instead, allow them to “sell to cover”

Industry data consistently shows that net settlement is – by far – the most popular tax settlement methodology for full-value awards, such as RSUs. This should come as no surprise since finance teams tend to prefer the anti-dilutive impact of this approach.

However, this favorable balance sheet result comes at a cost – i.e., reduced flexibility when selecting your tax rate. Specifically, the US Generally Accepted Accounting Principles (GAAP) governing net settlement (ASC 718 – and its latest guidance under ASU 2016-09) state that “good” accounting (i.e., fixed accounting) is preserved for a net settled award if withholding occurs at a rate that’s less than or equal to the maximum statutory rate. Stated another way, you trigger “bad” accounting (i.e., liability accounting) and its market-to-market requirement if you withhold at a rate that exceeds the maximum statutory rate.

Though withholding at the hypothetical rate would give us a good tax answer (since we would have a close approximation of the mobile employee’s actual tax liability) doing so via share withholding runs the risk of triggering liability accounting. The US Financial Accounting Standards Board (FASB) has, on multiple occasions, considered and rejected a specific exemption for hypothetical tax. Thus, we must assume the risk is real.

A straightforward solution to this problem exists if your plan allows participants to sell shares to cover the taxes due (i.e., “sell to cover”). This is because market-based transactions such as “sell to cover” are not subject to the same maximum statutory rate requirement. Rather, the accounting guidance places no rate setting restrictions on these market-based tax settlement transactions. If no restrictions exist, you can choose the rate that provides you the best estimate of the actual tax liability, generates cash at the point of transaction, and sends the payment directly to the employer.

If you are considering switching from net settlement to sell to cover, we recommend you consult with three critical stakeholders:

  • Your legal team to ensure this tax settlement method is permitted under your plan
  • Your finance team to ensure they’re comfortable with the less desirable dilution impact
  • Your plan administrator / broker to ensure “sell to cover” functionality can be supported

Continue to net settle, but do so based on the maximum host country rates

If the employee is subject to mandatory foreign withholding on the equity income, the company can withhold tax at rates up to the maximum applicable foreign tax-withholding rate. This option is a new alternative that has emerged pursuant to ASU 2016-09. Previously, withholding of shares to cover tax obligations at a rate above the minimum statutory tax rate generally resulted in liability accounting. However, where the US GAAP-imposed ceiling was once a country’s minimum statutory rate, it is now that country’s maximum rate.

In addition, since the equity income is subject to mandatory foreign withholding, the company is not required to withhold US federal income tax (although the wages would be reportable for federal tax purposes and subject to Medicare tax withholding).

To implement this solution, the company should consider having the employee sign a statement indicating that under IRC 3401, any items of income that are subject to mandatory withholding are exempt from US federal income tax withholding (even if the wages are supplemental wages that exceed $1,000,000). Even if the employee has not signed such a statement, if the company can ensure that there will be tax withholding in another country on that income, then the income can be exempt from US federal income tax withholding.

The process might look like the following on an equity transaction:

  • Amount withheld from employee at a rate of 45% (i.e., maximum tax rate in the UK) and reported as “hypothetical tax”.
  • Actual UK tax withholding required for UK payroll reporting is 40%, which company will pay via a gross-up from the funds withheld from the employee in step 1.
  • For the employee’s taxable income purposes, the amount in Step 1 and 2 are netted, resulting a net decrease to taxable compensation of 5% of the equity transaction.

Reduce US federal withholding, and collect hypothetical taxes as a separate transaction

To illustrate this solution, we will use the same facts as above, but assume that the employee has been on assignment to Japan, not the UK, and is therefore not subject to mandatory withholding on the equity income (as Japan does not typically require mandatory withholding for employees working on assignment in Japan). For this scenario, the solution to avoid a large balance due to the company on the tax equalization would be the following:

  1. Have the payroll department utilize the aggregate withholding method, rather than the supplemental withholding method.
  2. Have the employee complete a W-4 with hundreds or even thousands of withholding exemptions to ensure no federal tax withheld on the equity income.
  3. After the employee receives equity income, request that the employee write a separate check to the company to pay hypothetical tax. Note that in this scenario, the hypothetical tax rate could be any rate the company would like, since it is a separate transaction.

Other Related Issues

Issue: Equity income is not 100% foreign source

In the original fact pattern above, we assumed that the equity income was 100% UK source. In many cases, the equity income for a mobile employee is considered earned in multiple countries. In scenarios like this, then Solutions 1 through 3 can still be implemented, but only on the portion of income that is foreign sourced.

For the US source income, there is still an obligation to withhold US actual tax. If the company uses the flat withholding method, there is still the issue that the US sourced income may have taxes withheld at less than the employee’s incremental tax rate (refer to Myth 1 above). Therefore, the company may want to implement a different approach that is similar to Solution 3, using the aggregate withholding method (explained below).

Solution: Withhold actual US tax on US source income using the aggregate withholding method

For employees that have US source equity income that would be subject to 25% federal tax withholding under the flat withholding method, the company might want to consider implementing the aggregate withholding method.

However, instead of completing a W-4 with a large amount of withholding allowances as described in Solution 3, the employee would instead complete the W-4 with the “Single” status and claim zero exemptions. The result of this action is that the actual US tax withholding would quickly rise to the highest marginal tax rate, which would help to minimize the chance that the employee would owe additional tax later when the tax return and tax equalizations are prepared.

Issue: State income tax

If the employee has broken state residence, then the company cannot withhold hypothetical state tax on equity income not sourced to a state (if withholding of shares to cover tax), since there is no minimum required state withholding.

Solution 1 is generally the preferred method, as that type of structure would allow the company to withhold hypothetical state taxes as needed. The format for Solution 3 could also be beneficial, in that the company could request that the employee send a check for the hypothetical state tax withholding on the non-state source income.

However, if the company is utilizing Solution 2 for federal taxes, then a modified approach could apply for state taxes.

Solution: Withhold hypothetical tax at a higher rate than hypothetical federal rate and apply to state taxes

If the foreign maximum rate is higher than the US hypothetical rate, the excess above the US hypothetical rate could be considered hypothetical state tax. For example, based on the facts above, the UK marginal rate is 45%. Therefore, the employer could withhold hypothetical tax at 45%, of which 40% would be for federal hypothetical tax, and 5% would be for state hypothetical tax.

If the approach above does not result in withholding of actual US tax and hypothetical tax at the employee’s incremental hypothetical tax rate, then Solution 3 could be applied on the remaining tax due (i.e., having the employee write a check to the company for the under-withheld amount).

Summary

As explained above, there are potential solutions for avoiding large tax equalization settlements from mobile employees. Although it will require some work to implement these solutions, the payoff from not having to collect from mobile employees may well be worth the effort.

If you have any questions regarding the topics above, or if you would like to discuss which solution might be best for your company, please feel free to contact Brett Sipes at bsipes@gtn.com or +1.619.758.4083.

Updated: August 2017