U.S. Taxation of ISOs and NQSOs Held in Foreign Retirement Plans

With globalization, more and more Americans are working abroad and participating in foreign stock option plans. Americans are taxed on their worldwide income and as a result, Americans participating in foreign stock option plans are subject to U.S. federal income tax on any stock gains. Foreign stock options often create unexpected tax traps due to mismatched timing and anti-deferral rules. This article discusses how foreign stock options are taxed in the U.S.

Stock Option Plans Held Retirement Plans

Many foreign stock options are held in retirement plans. Since stock options are often held in plans, the tax consequences foreign retirement plans must be considered. Under U.S. tax law, a retirement plan can be classified as a “qualified plan” or Non qualified” or “nonexempt retirement plan.”

Section 401 of the Internal Revenue Code provides that a “qualified” pension must be created or organized in the United States and must be for the exclusive benefit of employees or their beneficiaries. In addition, the pension or retirement trust must satisfy a myriad of other requirements, e.g., it must meet the minimum participation standards of Section 401, must not discriminate in contributions or benefits in favor of highly compensated employees, must meet minimum vesting standards of Section 401, must comply with the limitations on contributions and benefits set forth in Section 415, must prohibit assignment or alienation of benefits, and satisfy minimum standards of Section 412.

If a plan is qualified, then the plan, the employer, and the employees all receive favorable tax treatment with respect to their plan-related income or expenses. To be qualified under U.S. tax law, a plan must comply with an elaborate set of standards. A plan will not be a qualified plan under Section 401(a) of the Internal Revenue Code unless its participation, vesting, and accrual standards meet the requirements of Title 1 of ERISA. Title 1 covers only plans established or maintained by: employers engaged in commerce or whose industry or activity affects commerce; unions representing employees engaged in commerce or in any industry or activity affecting commerce. The most important rule for a plan to be classified as a qualified pension plan is the nondiscriminatory rules. These rules prohibit a plan from favoring highly paid employees and insiders of the business with respect to coverage and benefits.

Under these rules, the minimum coverage standards limit discrimination in favor of highly compensated employees or, correlatively, against nonhighly compensated employees. The concept of a highly compensated employee is a fundamental one for the nondiscriminatory rules. In general, an employee is highly compensated for any given year (the determination year) if he or she: (A) was a 5-percent owner in that year or the preceding one; or (B) in the preceding year received compensation from the employer in excess of a sum indexed for inflation and, if the employer elects, was in the top-paid group of employees for that year.

A 5-percent owner of a corporation in a given year is a person who at any time in the year owns more than 5% of the outstanding stock or stock possessing more than 5% of the combined voting power. A 5 percent owner of a non-corporate employer in a given year is a person who at any time in the year owns more than 5% of the capital or profit interest. Ownership includes constructive ownership. Generally, a foreign pension plan will not satisfy the Section 401(a) qualification rules because these types of pensions must be created or organized in the United States. Thus, the vast majority of foreign pension plans cannot be taxed as a “qualified plan” for U.S. tax purposes. If a foreign pension plan could be taxed as a qualified plan, the employer’s contribution to the plan would be deductible, up to specified limits. The deduction is limited to the amount necessary to fund the plan properly under actuarial method and assumptions used. The income of the pension plan or trust would be tax-exempt pursuant to Section 501(a) of the Internal Revenue Code. Investments in the pension plan would accumulate free of any tax. The participant would only be taxed when he or she received distributions from the pension plan. Premature distributions would be subject to a 10% federal penalty.

As a general rule, in order for a retirement plan to be treated as a qualified plan, the plan must be created in the United States. Since a retirement plan must generally be established in the United States in order for it to be classified as a qualified plan, a foreign retirement plan typically cannot be classified as a qualified retirement plan.

U.S. Tax Concepts Applied to the U.S. Taxation of Foreign Pension Plans Tax as a Nonexempt Employee Trust Under Section 402(b)

As discussed above, most foreign pension plans cannot be classified as a qualified plan. Although the vast majority of foreign pension plans cannot be characterized as qualified plans for U.S. tax purposes, some foreign pension plans can be classified as nonexempt plans under Section 402(b) of the Internal Revenue Code.

Section 402(b) governs the taxation of funded employee benefit trusts that are not exempt from tax under Section 501(a), which exempts trusts that satisfy the requirements of Section 401. Section 402(b) typically applies to funded nonqualified deferred compensation arrangements. Section 402(b)(1) provides that employer contributions to a nonexempt employees’ trust are included in an employee’s gross income in accordance with Section 83 of the Internal Revenue Code, except that the value of the employee’s interest is substituted for the property’s fair market value in the first year in which the contributions are transferable or no longer subject to substantial risk of forfeiture. The presence of a substantial risk of forfeiture is determined under Section 83 and its regulations.

Internal Revenue Code Section 402(a)(1) specifies that distributions from a qualified plan (other than rollovers and certain lump sum distributions) are taxable in the year in which they are made, in accordance with Section 72 of the Internal Revenue Code. Section 72 deals with the taxation of annuities, including annuities from plans. Its basic rule is that amounts received in the form of annuity is that amounts are taxed as ordinary income. See IRC Section 72(a). Section 402(b)(2) provides that amounts held in a Section 402(b) trust are not taxed until they are distributed or more available to the individual and taxed under Section 72, with the exception that distributions of income before the annuity starting date (as defined in Section 72) are included in the individual’s gross income without regard to Section 72(e)(5) (relating to special rules for amounts not received as annuities). This means that the amounts are taxed as an annuity; i.e., a portion of the amounts is treated as nontaxable basis recovery, and the remainder is treated as taxable income.

U.S. taxation under Section 402(b) depends on whether the nonexempt trust is discriminatory. A Section 402(b) trust is considered discriminatory if one of the reasons it is not an exempt trust under Section 501(a) is the plan’s failure to satisfy the requirements of either Section 401(a)(26) (participation requirement for qualified defined benefit plans) or Section 410(b) (coverage requirements for qualified defined contribution and defined benefit plans). If the Section 402(b) trust is not discriminatory, employees who participate in the underlying plan are taxed under Sections 402(b)(1) and (2). In contrast, if the trust is discriminatory, highly compensated employees (as described in Section 414(q) are taxed under Section 402(b)(4), which provides that they are taxed each year on the employee’s vested accrued benefits as of the close of the trust’s tax year, less the employee’s investment in the contract.

The concept of “highly compensated employee” is a fundamental one for the nondiscrimination rules. In general, an employee is highly compensated for a given year (the determination year) if he: (A) was a 5-percent owner in that year or the preceding one; or (B) in the preceding year received compensation from the employer in excess of a sum indexed for inflation ($160,000 in 2026) and, if the employer elects, was in the top-paid group of employees for that year. See IRC Section 72(a). A 5-percent owner of a corporation in a given year is a person who at any time in the year owns more than 5% of the outstanding stock or stocks possessing more than 5% of the combined voting power. A 5-percent owner of a non-corporate employer in a given year is a person who at any time in the year owns more than 5% of the capital or profit interest. Ownership includes constructive ownership. Section 318 is one of several sets of constructive ownership rules in the Internal Revenue Code. Its principal role is to treat a taxpayer as “owning” stock that is actually owned by various related parties. The attribution rules in Section 318 fall into the following four categories:

Family Attribution. An individual is considered as owning stock owned by his or her spouse, children, grandchildren, and parents. See IRC Section 318(a)(1).

Entity to Beneficiary Attribution. Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in proportion to their beneficial interests. IRC Section 318(a)(2)(A). Stock owned by a corporation is considered owned proportionately (comparing the value of the shareholder’s stock to the value of all stock) by a shareholder who owns, directly or through the attribution rules, 50 percent or more in value of that corporation’s stock. IRC Section 318(a)(2)(C).

Compensation includes not only wages, salary, commission, and other items includable in gross income, but as well elective deferrals and elective contributions to other deferred compensation plans. A top-paid employee for a year is an employee in the top 20% for that year, ranked by compensation. IORC Section 414(q)(3). In determining the number of employees equal to 20%, the following employees are not counted: those who normally work less than 17 ½ hours per week; those who normally work no more than 6 months during any year; those younger than 21; certain employees covered by a collective bargaining agreement; and certain nonresident aliens. IRC Section 414(q)(5) & (8). An employer may elect less stringent exclusions. Or none at all. Then, the so-called “top 20%” may consist of fewer than 20% of all employees. The exclusions just described are only for purposes of determining the size of the top 20%, not its membership. A top-paid employee may, for example, have completed only 3 months of service. Section 414(q)(6) states that “A former employee shall be treated as a highly compensated employee if he or she separated from service before the determination year and was a highly compensated employee either for the year of separation or any year after he or she reached 55. IRC Section 414(q)(6). After the determinations are made regarding whether or not the plan is discriminatory and whether or not the participant is highly compensated the tax treatment can be narrowed based on: (1) plans that are not discriminatory, or plans that are discriminatory but the participant is not highly compensated, and (2) plans that are discriminatory and the participant is highly compensated.

Taxation of Foreign Pension Under Section 402(b) If the Plan is Not Discriminatory

If a U.S. taxpayer is fully vested (The term “vesting” in a retirement plan means ownership) in a foreign pension plan that is not discriminatory, the amount contributed to the plan is included in U.S. taxable income. IRC Section 402(b)(1). However, plan earnings are not included in U.S. taxable income until the funds are distributed or made available to the U.S. participant under Section 72. IRC Section 402(b)(2). Section 72 deals with the taxation of annuities, including annuities from plans. Section 72 is complex. Its complexities, though, result mainly from the need to exclude portions of annuity payments on which the participant has already been taxed- for example, portions attributable to her own after-tax contributions. Of course, where only non-taxable employer contributions were made on behalf of the participant, the rule is very simple: the annuity payments are taxable in full.

The basic exclusion rule of Section 72 deals with amounts received as an annuity. An annuity payment are defined as amounts payable at regular intervals, over a period of more than one full year from the annuity starting date, for which the total amount payable can be determined as the annuity starting date, either from the terms of the annuity contract or from actuarial tables. Treas. Reg. Section 1.72-4(b)(1). For amounts received as an annuity, the following proportion- the exclusion ratio – is excluded from gross income: investment in the contract as of the annuity starting date/expected return under the contract as of that date. IRC Section 72(b)(1). Thus, if an annuity pays $500 per month, and the exclusion ratio is 10%, $50 of each monthly payment is excluded from U.S. gross income.

The investment in the contract is the total of the participant’s after-tax considerations plus any amount of the participant’s contributions that were includible in the participant’s gross income, less the amount received to date under the annuity contract to the extent it was excludible from gross income. IRC Section 72(c)(1) & (f). It is essentially the undistributed amount that has already been taxed. The expected return is the total amount expected to be received under the annuity contract, either as fixed by the terms of the contract or from actuarial tables. IRC Section 72(c)(3). The exclusion continues until the participant’s investment in the contract has been distributed to her. IRC Section 72(c)(3). After that time, the entire amount of the annuity payment is subject to U.S. tax.  As a result, the amount ultimately excluded from taxable income for U.S. tax purposes will be equal to the taxpayer’s investment in the contract. The U.S. participant’s investment in the contract or foreign pension plan will generally include contributions and earnings that were previously included in the participant’s U.S. taxable income, as well as amounts that were previously included in the participant’s non-U.S. taxable income during a period when the taxpayer was a nonresident alien of the U.S.

If contributions to a U.S. participant’s foreign pension that is treated as a non-exempt trust, the contributions for U.S. purposes because these amounts are non-vested (i.e., the participant has a substantial risk of forfeiture pursuant to Section 83), but such amounts become vested in a later period, then the vested amount is included in the

taxpayer’s taxable income pursuant to the rules of Treas. Reg. Section 1.402(b)-1(b). For purposes of Section 83, a substantial risk of forfeiture exists when the employee’s right to property or compensation is contingent upon the performance of substantial services or the occurrence of other significant conditions, and there is a real risk of losing those benefits if the conditions are not met.

An example of a foreign pension taxed under Section 402(b)(1) is a Singaporean Central Provident Fund. As per IRS Memorandum PMTA 2007-00173, for an employee who is taxed under the rules of Section 402(b)(1), contributions paid by the employer to the Fund are taxable pursuant to Section 402(b)(1). This is because non-elective contributions are withheld from an employee’s salary without the consent of the employee. Because contributions to the pension are withheld without consent of the employee, the contributions to the plan are not constructively received by the employee for U.S. tax purposes and as a result, these contributions are considered employer contributions and are taxed under Section 401(b)(1).

It is often very difficult to determine if a foreign pension plan is discriminatory. Since it is often difficult to determine if a foreign pension plan is discriminatory, foreign retirement plans are often presumed to be discriminatory for U.S. tax purposes.

Taxation of Foreign Pensions if Plan is Discriminary or if Plan is Not Discriminatory, but the Participant is Highly Compensated

If a U.S. taxpayer is fully vested in a foreign pension plan that is discriminatory, the amount contributed to the plan is included in U.S. taxable income the amount to be reported as income in a given year is equal to the vested accrued benefit, less the taxpayer’s investment in the contract (i.e., amounts previously included in income). The net effect of these provisions is that the taxpayer essentially marks the foreign pension to market each year and includes the net vested increase in value in income. In the event the value of the foreign pension decreases for a given year (e.g., the decrease

in value for the year exceeds any current year contributions) the taxpayer would not be entitled to a current deduction, but the taxpayer’s investment in the contract would exceed the vested accrued benefit and additional income would not be reportable until such time as the vested accrued benefit exceeded the investment in the contract.

Assuming the U.S. participant is fully vested in the plan, current earnings are effectively included in U.S. taxable income since current earnings would factor into the taxpayer’s vested accrued benefit. Distributions are taxed in the year distributed or made available to the taxpayer in accordance with the rules for taxation of annuities pursuant to Internal Revenue Code Section 72. As a result, the amount ultimately excluded from taxable income for U.S. tax purposes will be equal to the taxpayer’s investment in the contract. The U.S. participant’s investment in the contract will generally include contributions and earnings that were previously included in the participant’s U.S. taxable income, as well as amounts that were previously included in the participant’s contributions before the individual became a U.S. resident for income tax purposes under Section 7701(b) of the Internal Revenue Code.

If a foreign pension plan participant is not highly compensated (regardless of whether the plan is discriminatory), the U.S. tax implications of fully vested contributions are included in U.S. gross income. However, non-elective contributions to the foreign pension are not included in U.S. gross income for income tax purposes. Foreign pension plan earnings are not subject to U.S. income tax until distributed. Distributions from the foreign pension plan are taxed under the annuity rules of Section 72 of the Internal Revenue Code.

If the participant of a foreign pension plan is highly compensated (and the plan is discriminatory), the U.S. participant includes in U.S. gross income the “vested accrued benefit” for the applicable year. A vested accrued benefit is the portion of a retirement benefit that a participant owns and has a non-forfeitable right to, even if they leave the company before they retire. It represents the portion of the retirement benefit that has been earned and is guaranteed.  The participant’s vested accrued benefit may be expressed in the form of an annual benefit payable at normal retirement age. Mathematically, a participant’s accrued benefit is multiplied by the applicable vesting percentage (based on the plan’s vesting schedule). The plan’s vesting schedule should be at least as favorable as one of the vesting schedules identified in Section 411(a)(2) and 416(b). A participant’s vested accrued benefits are typically expressed as annual (or monthly) benefits payable over the life of the participant (life annuity), payable at normal retirement age. As a result, the U.S. participant “mark-to-mark,” effectively including contributions and earnings in the taxable year on a current basis. If contributions to the foreign pension plan are not taxable in the year of contribution because such amounts are non-vested (i.e., the taxpayer has a substantial risk of forfeiture pursuant to Internal Revenue Code Section 83), but such amounts become vested in a later period, then the vested amount is included in the U.S. participant’s U.S. taxable income.

Foreign stock options are often held in plans treated as discriminatory plans for U.S. tax purposes. It is not uncommon for these plans to have vesting schedules. If a foreign stock option plan contains a vesting schedule, under Section 401(b)(4), the U.S. participant is each year on the participant’s vested accrued benefit as of the close of the trust’s tax year, less the employee’s investment in the contract. The participant is not taxed on the year he or she receives a distribution from the plan. This may come as a surprise to many participants in foreign retirement plans that stock options. In certain cases, participants of foreign stock option plans can take a tax treaty position and defer the tax consequences of a vesting schedule. Some tax treaties abrogate this general rule. For example, Paragraph 7 of Article 13 of the U.S.-Canada Income Tax Treaty provides a rule with respect to the taxation of natural persons on income accrued in a pension or employee benefit plan in the other Contracting State. Thus, paragraph 7 of Article 13 applies where an individual is a citizen or resident of a Contracting State and is a beneficiary of a trust, company, organization, or other arrangement that is a resident of the other Contracting State, where such trust, company, organization, or other arrangement is generally exempt from income taxation in that other State, and is operated exclusively to provide pension, or employee benefits. In such cases, the beneficiary may elect to defer taxation in her State of residence on income accrued in the plan until it is distributed from the plan.

The U.S. Tax Consequences of Gains

Now since we determine the timing of a stock option for U.S. tax consequences, we must discuss the general tax consequence of stock gains. Typically, stock options are either taxed as an Incentive Stock Option (“ISO”) or Non-Qualified Stock Option (“NQSO”). ISOs offer special tax benefits because there is no regular income tax due at the time of exercise. Instead, taxes are delayed until the stocks are sold. A foreign company typically cannot issue an ISOs under U.S. tax law. Thus, ISOs are typically not a consideration for U.S. participants of a foreign stock option plan. Foreign stock option plans are typically taxed as NQSOs for U.S. tax purposes. If a foreign stock option is treated as a NQSO, the distribution from the plan will be taxed as ordinary income at the time of exercise (on the spread between the fair market value and the strike price), rather than a sale which is taxed at a favorable capital gain rate.

Anytime a U.S. investor receives stock in a foreign corporation, a consideration must be given to the Passive Foreign Investment Company (“PFIC”) tax regime. Although an NQSO itself is not a corporation and cannot be a PFIC, the underlying foreign corporate stock held by the U.S. investor or right to purchase such a share can be classified as a PFIC. The objective of the PFIC provisions of the Internal Revenue Code is to deprive a U.S. taxpayer of the economic benefit of deferral of U.S. tax on a taxpayer’s share of the undistributed income of a foreign investment company that has predominantly passive income. Although the PFIC provisions were aimed at U.S. persons holding stock in foreign investment funds, the PFIC provisions have a much broader impact. The next subsection of this article will discuss the U.S. tax consequences if an a foreign stock is classified as a PFIC.

Definition of PFIC

A foreign corporation is a PFIC if it satisfies either an income or asset test. Under the income test, a foreign corporation is a PFIC if 75% or more of the corporation’s gross income for the taxable year is defined as “foreign personal holding company” for purposes of Subpart F provisions of the Internal Revenue Code, with certain adjustments. Internal Revenue Code Section 954(c) defines “foreign personal holding company income” to include most types of passive income, such as interest, dividends, rents, annuities, royalties and gains from the sale of stock, securities or other property that produces interest, dividends, rents, annuities or royalties. See IRC Section 954(c)(1)(A) and (c)(1)(B)(i). The adjustments include exclusions for income derived from the active conduct of a banking, insurance, or securities business, as well as any interest, dividends, rents, and royalties received from a related person to the extent such income is properly allocable to nonpassive income of the related person. A “related person” is defined in Internal Revenue Code Section 954(d)(3). An individual, corporation, partnership, trust or estate that controls or is controlled by a controlled foreign corporation (“CFC”) is a “related person.” Control means, in the case of a corporation, direct or indirect ownership of more than 50 percent of the total voting power or value of the stock of the corporation.

For purposes of the income test, passive income is subject to four exceptions. The first two exceptions relate to income from the active conduct of a banking or insurance business. See IRC Section 1297(b)(2)(A) and (B). The third covers interest, dividend, rent or royalty income received from a related person to the extent that such income is properly allocated to income of such related person that is not passive income. See IRC Section 1297(b)(2)(C). The fourth covers certain foreign trade income subject to special treatment under two preferential tax regimes for export sales.

Under the asset test, a foreign corporation is a PFIC if the average market value of the corporation’s passive assets during the taxable year is 50% or more of the corporation’s total assets. An asset is characterized as passive if it has generated (or is reasonably expected to generate) passive income in the hands of the foreign corporation. See IRC Section 1297. Assets that generate both passive and nonpassive income in a tax year are treated as partly passive and partly nonpassive to the proportion to the relative amounts of the two types of income generated by those assets in that year. See IRC Notice 88-22.

Anytime a U.S. individual has an option to acquire stock in a foreign corporation, it should be determined if the stock can be characterized as a PFIC for U.S. tax consequences. The acquisition of foreign stock classified as a PFIC can have serious negative U.S. tax consequences and trigger a number of filing obligations with the IRS.

Taxation of a PFIC

A shareholder of a PFIC is subject to the Section 1291 excess distribution rules in which shareholders must allocate excess distributions and gains realized upon the sale of their PFIC shares pro rata to their holding period. See IRC Section 1291(a)(1)(A).

An excess distribution includes the following:

1. A gain realized on the sale of PFIC stock, and
2. Any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer for the year exceeds 125 percent of the average actual distribution received by the taxpayer in the preceding three taxable years. The amount of an excess distribution is treated as if it had been realized pro rata over the holding period of the foreign share and, therefore, the tax due on an excess distribution is the sum of the deferred yearly tax amounts. This is computed by using the highest tax rate in effect in the years the income was accumulated, plus interest. Any actual distributions that fall below the 125 percent threshold are treated as dividends. This assumes they represent a distribution of earnings and profits, which are taxable in the year of receipt and are not subject to the special interest charge.

Interest charges are assessed on taxes deemed owed on excess distributions allocated to tax years prior to the tax year in which the excess distribution was received. All capital gains from the sale of PFIC shares are treated as ordinary income for federal tax purposes and thus are not taxed at favorable long-term capital gains rates. See IRC Section 1291(a)(1)(B). In addition, the Proposed Regulations state that shareholders cannot claim capital losses upon the disposition of PFIC shares. See Prop. Regs. Section 1.1291-6(b)(3).

Below, please see Illustration 1. and Illustration 2. which demonstrates a typical sale of PFIC stock.

Illustration 1.

Jim is an engineer and a citizen of Germany. Jim moved to California and became a U.S. green card holder. Jim likes to invest in foreign mutual funds. On the advice of his German broker, on January 1, 2016, Jim buys 1 percent of FORmut, a mutual fund incorporated in a foreign country for $1. FORmut is a PFIC. During the 2016, 2017, and 2018 calendar years, FORmut accumulated earnings and profits. On December 31, 2018, Jim sold his interest in FORmut for $300,001. To determine the PFIC excess distribution, Jim must throw the entire $300,000 gain received over the entire period that he owned the FORmut shares – $100,000 to 2016, $100,000 to 2017, and $100,000 to 2018. For each of those years, Jim will pay tax on the throw-back gain at the highest rate in effect that year with interest.

It is easy to envision significantly more complex scenarios. Such a scenario is described in Illustration 2 which is based on an example in Staff of Joint Comm. On Tax’n, 100 Cong., 1st Sess., General Explanation of Tax Reform of 1986, at 1027-28(1987).

Illustration 2.

On January 1 of year 1, Samatha, a U.S citizen, acquired 1,000 shares in FC, a foreign corporation that is a PFIC. She acquired another 1,000 shares of FC stock on January 1 of year 2. During years 1 through 5, Samatha receives the following dividend distribution from FC:

Date of Distribution                                               Amount of Distribution

Dec. 31 of year 1                                                     $500
Dec. 31 of year 2                                                     $1,000
Dec. 31 of year 3                                                     $1,000
Dec. 31 of year 4                                                     $1,000
Apr. 1 of year 5                                                         $1,500
Oct. 1 of year 5                                                         $500

Under Internal Revenue Code Section 1291, none of the distributions received before year 5, are excess distributions since the amount of each distribution with respect to a share is 50 cents. However, with respect to distributions during year 5, the total distribution to each share is 37.5 cents ($1 minus 62.5 cents (1.25 times 50 cents)).

Accordingly, the total excess distribution for FC’s tax year ending December 31 of year 5 is $750 (37.5 per share times 2,000 shares). This excess distribution must be allocated ratably between the two distributions during year 5. Thus, $562.50 (75 percent of the excess distribution, i.e., $750 times $1,500/$2,000) is allocated to the April 1 distribution and $187.50 (the remaining 25 percent of the excess distribution, i.e. $750 $500/$2,000) is allocated to the October 1 distribution. These amounts are then ratably allocated to each block of stock outstanding on the relevant distribution date. For the distribution on April 1 of year 5, $281.25 of the excess distribution is allocated to the block of stock acquired on January 1 of year 1 and $281.25 is allocated to the block of stock acquired on January 1 of year 2 and $281.25 is allocated to the block of stock acquired on January 1 of year 3. The $187.50 excess distribution on October 1 of year 5 is also allocated evenly between the two blocks of stock outstanding on the date of the distribution. Finally, the excess distribution for each block of stock is in accordance with Internal Revenue Code Section 1291(a)(1).

The federal tax due in the year of disposition (or year of receipt of an excess distribution) is the sum of 1) U.S. tax computed using the highest rate of U.S. tax for the shareholder (without regard to other income or expenses the shareholder may have) on income attributed to prior years (called “the aggregate increase in taxes” in Section 1291(c)(1)), plus 2) U.S. tax on the gain attributed to the year of disposition (or year of receipt of the distribution) and to years in which the foreign corporation was not a PFIC (for which no interest is due). Items (1) and (2) together are called the “deferred tax amount” in Section 1291. Item (2), the interest charge on the deferred tax, is computed for the period starting on the due date for the prior year to which the gain on distribution or disposition is attributed and ending on the due date for the current year in which the distribution or disposition occurs.

Conclusion

When a U.S. person participates in a foreign corporation’s stock option plan, the U.S. participant must consider the U.S. tax consequences of the option plan, the timing of the U.S. tax, if a tax treaty may be utilized to mitigate the U.S. tax consequences of the stock option, and the PFIC tax regime. Obviously, this is a very complex area of tax law.
U.S. participants in a foreign stock option plan should consult with a skilled international tax attorney they are considering participating in a foreign stock option plan.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.