U.S. Taxation of Stock-Based Compensation Received by Nonresident Aliens

The following is a general summary of the cross-border tax consequences associated with stock-based compensation. Stock-based compensation is a form of stock based compensation used to reward employees. Stock-based compensation vests at some point in the future. It is common for U.S. multinational corporations to assign U.S. employees to overseas affiliates for short or long term assignments. These employees may have received stock based-compensation grants before their foreign assignment began. This can trigger income and social security tax consequences related to stock-based compensation in multiple jurisdictions. The rules relating to the taxation of stock-based compensation in an international context are often complex and sometimes uncertain. This article provides a brief overview of the taxation of stock-based compensation in the international context.

U.S. Taxation of Stock-Based Compensation Received by Nonresident Aliens

U.S. citizens and resident alien individuals are taxed on their worldwide income regardless where the income is earned or sourced. However, nonresident aliens are taxed differently for U.S. income tax purposes. Nonresident aliens are taxed on a territorial basis. A nonresident is defined as any person that does not satisfy the “green card” or “substantial presence” test discussed in Section 7701(b) of the Internal Revenue Code. A nonresident alien is only taxed on income that is sourced to the United States and income that is effectively connected with a U.S. trade or business. Services performed in the United States are generally considered U.S. source and services performed outside the United States are generally considered foreign source.

There are two categories of U.S. income that nonresident aliens are subject to U.S. tax. First, nonresident aliens are taxed U.S.-source income that is not effectively connected with a U.S. trade or business. U.S.-source income received by foreign persons that are not effectively connected with a U.S. trade or business is subject to a flat tax of 30 percent on the gross amount of the income received. Section 871(a) imposes a 30-percent tax on “interest * * * dividends, rents, salaries, wages, premiums, annuities, compensation, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.” The collection of such taxes is effected primarily through the imposition of an obligation on the person or entity making the payment to the foreign person to withhold the tax and pay it over to the Internal Revenue Service (“IRS”).

The second category of income is effectively connected with a U.S. trade or business. The term “trade or business within the United States” is not defined in the Internal Revenue Code, although certain statutory prescriptions apply in specific instances dealing with the performance of services. For example, Section 864(b) of the Internal Revenue Code provides that “the performance of personal services within the United States at any time within the taxable year” generally constitutes the conduct of a U.S. trade or business. There is, however, a de minimis exception for a nonresident alien who is present within the United States not more than 90 days during the tax year and receives no more than $3,000 as compensation for working in the United States for a foreign person, entity or office. See IRC Section 864(b)(1). Effectively connected income is taxed at U.S. graduated tax rates. In addition, deductions can be taken against this type of income.

Many companies provide stock-based compensation in lieu of cash. Compensation that is based on the equity of a corporation can take several forms. The most common types of equity compensation provided to nonresident alien individual recipients are Restricted Stock Units (“RSUs”) and Non-qualified Stock Options (“NSOs”). When a nonresident receives stock compensation, they should be prepared to identify the type of stock compensation received, when the income is recognized, the type of income it is, and a determination should be made if the equity compensation is U.S. source or foreign source income.

As discussed above, a nonresident alien is only taxed on compensation that is attributable to their personal services performed in the United States. If the nonresident alien did not perform services in the United States in connection with the equity compensation, the equity compensation is considered foreign source and likely exempt from U.S. taxation. If on the other hand the nonresident alien performs services both inside and outside of the United States, the equity compensation will need to be allocated between the United States and the foreign country on the basis that correctly reflects the sourcing of income for income tax purposes.

An RSU is a promise to transfer shares or make a payment at a future date. An RSU is not a taxable grant. Since an RSU is not a taxable grant, a recipient may defer compensation to a later date. The value of the stock transferred is includable in the income of the recipient upon the vesting of the RSU and it is taxed as ordinary income once the RSU vests and is assigned a value. Upon vesting, the fair market value of the RSU is includable on a Form W-2.

The other common form of equity compensation offered by corporations. A stock option gives the recipient the right to acquire a specific number of shares of company stock at a pre-set price. This is known as an exercise or strike price. Prior to a stock becoming exercisable by a recipient, the stock option is subject to a vesting period. There are two types of stock options: incentive stock options (“ISO”) and non-qualified stock options (“NSO”). ISOs are a type of stock option that can qualify for special treatment. Depending on when a recipient exercises his or her option and the spread at exercise (the difference between the fair market value and the purchase price), the alternative minimum tax (“AMT”) may be triggered. Individuals may be entitled to favorable capital gains treatment on gains if the recipient held the shares for: 1) two years from the date the ISO was granted and 2) one year from the date the shares were exercised. If both conditions are satisfied, the individual will pay favorable long-term capital-gains tax between the sale price and the price paid for the ISO.

An NSO plan is basically a legal agreement between an employer and an employee. The agreement states the terms under which the employer is willing to sell stock options to the employee or recipient. When the recipient is granted an option, they receive the right to purchase stock at a certain price, which is known as the exercise price. There is typically a vesting period before an employee can sell shares granted through a NSO plan. The strike price is typically the same as the market value of the shares when the company makes such options available, also known as the grant date.

The tax treatment of NSOs are governed by Internal Revenue Code Section 83 unless Section 409A applies. Section 409A generally provides that a NSO plan must comply with various rules regarding the timing of deferrals and distributions. Section 409A applies whenever there is a “deferral of compensation,” which occurs when an employee has a legally binding right during a tax year to compensation that is or may be payable in a later tax year. A company’s valuation determines the strike price of an opinion. Most NSOs do not have a readily ascertainable fair market value on the grant date. Thus, the taxable event occurs when the NSO is exercised. Thus, the employee would typically include in gross income the spread, the express of the fair market value of the option over the exercise price. Internal Revenue Code Section 83 treats the spread as compensation and the spread is classified as ordinary income for U.S. tax purposes. Consequently, the taxable event generally occurs when an NSO is exercised. The employee would include in gross income the spread, the excess of the fair market value of the option over the exercise price. The exercise of the NSO is income in the year of exercise and reported on the Form W-2 for employees and Form 1099 for consultants. Internal Revenue Code Section 83(1) permits employees of certain privately held companies to elect to defer payments of income up to five years.

As option income is considered compensation for personal services for tax purposes, the treatment of income for nonresident aliens depends on where the employee performs their services. As indicated above, services performed in the United States are U.S. source income that is effectively connected to a U.S. trade or business. Services performed outside of the United States is foreign source income, which is not taxable to nonresident aliens. Consequently, nonresident alien employees are only taxed on the income attributable to services performed in the United States. This allocation rule is often difficult to apply with respect to stock options for the following reasons: 1) usually several years have elapsed between the grant date of the option and the vesting date of the option; 2) additional time may occur between the vesting date of the option and the actual exercise date of the option; three, during the time period between the grant date and the vesting date, a nonresident alien may work for the employer only in the United States, only outside of the United States, or both inside and outside of the United States; and fourth, after the vesting date, the employer may or may not remain an employee of the employer that grants the options.

The regulations of Section 861 of the Internal Revenue Code provide a sourcing rule for the scenarios discussed above. The regulations provide for a percentage of time for which the employee worked in the United States during the applicable period determines the percentage of income that is U.S. source. As personal services are sourced to where they are performed, if personal services are performed both inside and outside of the United States during the vesting period of NSOs, an apportionment must be made. This apportionment is based on a time basis such as the number of days the nonresident alien is an employee in the U.S. See Treas. Reg. Section 1.861-4(b)(2)(i). The U.S. source compensation for employees from NSOs is generally computed by multiplying the option spread by a fraction that contains the total days of services that were performed in the U.S. as a numerator and the total days of services provided anywhere as the denominator during the vesting period.

After the nonresident alien exercises his or her NSOs, they will own stock classified as personal property for sourcing rule characterization purposes. Any subsequent disposition of the stock by a nonresident alien is characterized as capital gain or loss from the disposition of personal property and is generally considered foreign source under Internal Revenue Code Section 865 and is not taxable to nonresident aliens unless the disposition of the stock is considered to be effectively connected income with a U.S. trade or business under Section 871(b).

In regards to the reporting of RSUs and NSOs, the general rules are as follows:

For RSU income, employers generally will file a Form W-2 for the nonresident alien and include income on the Form W-2 at the fair market value of the RSU as of the date they vest. This fair market value will be shown in boxes 1, 3 and 5 of the Form W-2. Employers often include in box 14 of the W-2 the letters RSU and the value of the stock in Box 1 as wage income.

For NOSs, employers generally will file a Form W-2 for the nonresident alien in the year the NOS is exercised to report the taxable portion of the spread which is included as wage income on the Form W-2 in boxes 1,3, and 5. The spread will be shown in Box 12 with code V.

Nonresident aliens that perform services within the U.S. and outside the U.S. during the vesting period may not have the correct amount of taxable income reported on the Form W-2 filed with the IRS by the employer. This may be the result of the employer not having the sufficient information to calculate and report the U.S. source only income and instead report the entire spread amount on the Form W-2 as U.S. source taxable income. In such a case, the nonresident alien may attempt to have their employer file a corrected Form W-2 with the IRS. In the alternative, the nonresident alien may attach a statement to their tax return detailing why only a portion (or no portion) of the income reported on the Form W-2 is taxable. In such a case, it is imperative that the nonresident alien maintain proper travel and work records to properly compute the portion of the income that is attributable to U.S. sources over the vesting period.

Conclusion

U.S. employees who accept a transfer to a foreign affiliate of a U.S. corporation face unique tax issues in regards to stock options The same can be said for foreign employees that come to the U.S. for short or long term assignments that have been stock based compensation. These individuals may be subject to double tax on stock-based compensation income. In some cases, foreign earned income exclusions, tax treaties, and tax credits may mitigate these harsh tax consequences. Individuals receiving stock-based compensation who work in more than one country must also consider social security tax associated with stocks. Generally, in the absence of a social security totalization agreement between the U.S. and the relevant foreign country, a recipient may be required to pay social security taxes to the U.S. and a foreign taxing agency.

The United States has entered into agreements, called Totalization Agreements, with several nations for the purpose of avoiding double taxation of income with respect to social security taxes. These agreements must be considered when determining whether a recipient of stock-based compensation is subject to the U.S. Social Security/Medicare tax, or whether stock based compensation recipients are subject to the social security taxes of a foreign country.

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. 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.