Cross-Border Tax Notes #2 - Equity Compensation Earned in Multiple Countries
Updated: Sep 15
For the second topic, I wanted to focus on equity compensation in the context of cross-border situations, because, frankly, this is the topic that I find the most compelling at the moment, and now that it's tax season again, it's heavily on my mind.
The crux of the problem with equity compensation in cross-border situations is that not all countries 1) characterize the type of income in the same way (compensation, or ordinary income, vs. capital gains, or passive income), and/or 2) tax the income at the same time. For example, with respect to ISOs (Incentive Stock Options) in particular – these are a type of stock options specific to US tax law. Other countries may tax them at grant or at vest, and may or may not tax the resulting capital gain (because some countries just don't tax capital gains). For example, an ISO will be taxed in many countries at exercise as compensation, but in the US as capital gain upon sale – so your client would have a mismatch in both the timing and type of the foreign taxes paid, thereby affecting the ability to use the two primary methods for mitigating double taxation: the Foreign Earned Income Exclusion (FEIE) and foreign tax credits. Because the US segregates foreign tax credits according to type of income – i.e. foreign taxes paid on capital gains would not be creditable against US taxes on compensation – this could lead to double taxation, i.e. paying taxes in full to both the US and a foreign country on the same income – a situation no client would like to face.
But, taking a step back, the first issue to be dealt with is determining the sourcing of the compensation. Under US tax law – and again, this is another potential area where different jurisdictions could disagree – equity compensation is generally sourced to the country(ies) where the client worked between the dates of grant and vest. This is important because it determines the amount of compensation considered foreign source, and therefore the amount of compensation eligible for the both the FEIE and/or foreign tax credits.
For example, if a client moves to France halfway between the grant and vest dates for a particular Non-Qualified Stock Option grant, then 50% would be considered US source, and 50% would be considered foreign source from the perspective of US tax law. However, if France considers the sourcing to be between grant and exercise, then it might treat 25% as US source and 75% as French source, based on the relative days worked during that period between the two countries. In this scenario, if there was $20,000 of income, and France taxed $15,000 (75%) at 45% tax rate, your client would pay almost $6,800 in taxes to France. At the same time, your client might pay $6,400 (32%) tax in the US on that income – as you are probably well aware, US citizens and green card holders are generally taxed on their worldwide income, regardless of residency. Combined, this is over $13,000 in taxes – on $20,000 of income!
This is where the magic of foreign tax credits come in. In a perfect world, 100% of the French taxes would offset your client's US tax liability, so there would be no double taxation, but this is not the case. Your client's foreign tax credit is subject to two limitations here: 1) foreign source income, and 2) at the US effective tax rate. In the scenario above, where only 50% would be considered foreign source income from the US perspective, and the US effective tax rate is 32%, the foreign tax credit would be limited to $20,000 x 50% x 32% = $3,200 – that is the amount of US tax that would be eliminated by virtue of the $6,800 taxes paid to France. So we have reduced the global taxes from $13,000 down to $9,800, with a carryforward (or back) of the unused French taxes paid of $3,600 ($6,800 less the $3,200 used).
Another significant challenge with equity compensation earned over multiple jurisdictions – or simply earned while resident of one jurisdiction and paid while resident of a second jurisdiction – relates to sorting out where and how the income should be reported and subject to tax. For example, I recently had one client whose RSU income – while earned 100% in Hong Kong and reported on a final payslip, with the appropriate Hong Kong taxes withheld – was also reported on his payslip from his new job in Ireland because the income from the RSUs was paid after he'd relocated to Ireland through his company. Determining that there was double reporting of almost $100,000 of RSU income saved him thousands of dollars in US taxes, and led to a question about whether his Irish tax return should be amended to include a credit for the Hong Kong taxes paid on that same income, thereby also resulting in an additional Irish income tax refund.
In order to effectively advise clients with equity compensation in cross-border situations, it helps to understand the taxation and reporting requirements not only in the US, but also in the foreign country you are dealing with. Hopefully, the examples I've only touched upon above have helped to give you a sense of the complexity of these types of situations.
While you yourself are unlikely to be preparing any of the tax returns, it could be an extremely valuable service for you to be aware of some of these potential pitfalls so that you can bring them to your clients’ attention. At the very least, make sure that they have competent tax advisors on their team who are addressing these types of questions, but if you are doing any tax or cash flow planning for your client, it would be very helpful for you to understand some of the mechanics and drivers, as well.
Additional information: if you are a member of CIGA Network, I gave an hour-long “Roundtable” presentation in July 2022 which outlined some of these areas, but in much greater depth.
"Handling Equity Compensation in Cross-Border Situations," July 28, 2022
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