International employee stock plans: Part 1

Speedread

International employee stock plans (ESPs) are becoming increasingly popular as more and more companies extend their operations beyond their home country. Partly as a result of the rapid growth of high tech and internet companies, which often begin operations in several different countries simultaneously and which in many cases have a different approach to remuneration package design from old economy companies, the number of international plans has mushroomed over the past few years.

The drive to globalise ESPs was initiated mainly by companies headquartered in the US and UK and reflects the importance placed on stock based remuneration in those jurisdictions over the past 10 to 20 years. However, the newer international ESPs are often for companies headquartered in countries which, historically, have not had a culture of employee share ownership or which have operated plans only for the benefit of employees in the headquarter country, such as Israel, and Scandinavian and Asian Pacific countries.

The big picture

An ESP is a stock option or other stock acquisition plan that allow employees to acquire shares or other forms of equity interest or securities. An international ESP is any stock based plan that operates for the benefit of employees in more than one location, normally over shares in the parent company of the relevant group. An international ESP will tend to be structured in one of the following ways:

• Employees participate in a single plan which is rolled out with no local country variations (this has historically been the US approach).
• As a series of locally designed plans within a broad framework specified for the group (more prevalent as an approach within some parts of continental Europe).
• There is a single plan with local variations for some countries, but only where there is a clear corporate or employee advantage in doing so (this is an approach often used by UK groups and one which is generally becoming more popular).

In considering whether to introduce an ESP, and, if so, what structure to use, it is important to spend time thinking about certain key issues:

• What are the main objectives of the ESP and how do the objectives influence plan design?
• What regulatory, securities law and shareholder issues is the company likely to face in implementing the plan?
• What are the accounting and cost implications?
• What communication plans does the company need to implement?

Objectives and design

It is essential at the outset to establish the overall objectives of the international ESP and determine how it is intended to "fit" within existing human resources (HR) policies and remuneration package design on both a group wide and local level. Wherever the parent company is based and whatever the relevant locations of the employees, the overall objectives are likely to be based on the answers to the following questions:

• Is the intention that the plan will "glue" the group together, i.e. provide a benefit geared ultimately to the performance of the whole group, rather than purely locally based remuneration and incentives?
• Alternatively, should the stock awards be linked to local operations or individual lines of business?
• Is the plan intended to put the group ahead of its competitors or to maintain comparable levels of benefit?
• Is the plan to encourage recruitment more than retention, or vice versa?
• Is the plan to be an opportunity to mitigate the cost of cash compensation?
• Is incentivisation the key objective?
• Is the plan a response to market or employee expectation?
• Is the intention to align rewards with value created for other shareholders/ owners?
• Are the objectives a combination of some or all of the above?

Once the primary objectives are established, the company should spend time considering various possible structures. While the objectives of the plan will be based primarily on the HR criteria mentioned above, the design aspects of the plan itself will raise a range of issues, including legal, regulatory, cost, tax, social security and treasury matters. Companies therefore generally find it helpful if, from the very outset, the ESP project team includes personnel from HR, tax, finance, treasury and internal legal/ company secretarial functions both at parent company level and, where appropriate, from local country operations.

The questions the team will have to address at this stage include the following:

• Who is to participate? Is the plan is to be geared to director level, key executives and managers only or to be more broadly based?
• What is an appropriate type of plan? Should the plan be a stock option plan or another form of plan, such as restricted stock, performance stock or other type of stock acquisition plan? (see box "Deciding on the type of plan").
• Bearing in mind the nature of the plan, relevant local practice and the "fit" of the stock awards within the overall remuneration policy, what is an appropriate level of award for the selected participants?
• Are new or existing shares to be used and what are the relative cost implications of the various options (see below "Accounting and cost issues")?
• When should employees become entitled to exercise stock options or to receive the stock (vesting)?
• Should vesting be conditional on performance conditions such as earnings or total shareholder return (a combination of share price and dividend) targets being achieved?

The answers to the vesting questions are likely to be driven by a number of factors, depending on the location of the parent company. With the exception of plans introduced by UK headquartered groups, most international ESPs do not make vesting of stock options dependent on performance conditions. The reason for this is partly cultural (other than in the UK there appears to be little shareholder impetus for performance conditions to be imposed) and partly influenced by financial accounting considerations. For companies that account under US GAAP, for example, stock awards which have vesting performance conditions will make an ESP a "variable" plan. This means that upwards movement in the stock price over the relevant performance period will need to be reflected in the companies' financial statements as a compensation cost.

At the end of the design and planning stage:

• The team should have considered all of the issues in the design planning grid (see box "Design planning grid").
• It should be the case that the majority of the questions raised in the HR design questionnaire can be answered in the affirmative (see box "HR design questionnaire").

Regulatory, securities law and shareholder issues

The majority of the above issues are not, however, particularly country specific. Once they have been resolved, the rather more detailed analysis of particular country and cost issues comes to the fore, the most significant of which are the regulatory/securities law requirements. Certain fundamental questions need to be answered on a location by location basis, such as:

• Is it lawful to offer participation in an ESP in that location?
• Is it lawful for residents to purchase and/or hold shares in an overseas parent and, if so, does it make a difference if those shares are listed on a recognised stock or investment exchange?

If these preliminary questions do not indicate any significant difficulty and/or a prohibition on the proposed ESP, then ask the secondary questions, such as:

• Is there an exemption from the requirement to issue a prospectus on an issue of this type?
• What (if any) regulatory consents or filings need to be completed?
• By when?
• In the context of any form of stock purchase plan (including stock option plans), is it permissible under local exchange control regulations for employees to send the purchase money from their country? If yes, what, if any, local consents are needed to do so?

The answers to all these questions will differ substantially from location to location and may also be affected by the aggregate value of the offering and/or the numbers participating in a particular location and the status of the issuer (see box "Country by country").

For countries where employee stock participation has been relatively common on a local basis there will often be specific exemptions from normal securities laws and/or prospectus requirements. For example, the UK has a wide range of prospectus exemptions and exemptions from investor protection legislation for employees share plans. Similar (although not identical) exemptions or partial exemptions apply in a number of other European jurisdictions.

Limited exemptions from US Federal Securities laws may apply to some employee stock plans operated by non-US issuing companies, but the main exemptions are subject to stringent requirements relating to:

• The value of the offering.
• The number of individuals to whom the offer is made.
• The information which needs to be given to those individuals.

In the US it is also necessary to consider state "blue sky" laws, i.e. State requirements in relation to the offering of stock/stock options. In some States there are no additional requirements for employee stock offerings beyond those required for Federal purposes (for example Florida, Massachusetts and others). However some States have additional requirements, ranging from a simple notification/registration procedure (for example New York, Oregon and others) through to very specific requirements relating to the terms on which the stock is offered (California, for example, has specific vesting requirements as well as relatively onerous filing requirements).

In addition to the requirements on making the offer, there may also be additional corporate or individual requirements which need to be met on vesting and/or purchase or retention of the stock. These might relate to, for example, obtaining local National Bank consent to acquire and/or retain the stock and/or corporate or individual reporting and registration requirements. Whether these types of requirements exist will depend on the location, value, and the nature of the plan. In some locations, in particular those in Eastern Europe and in parts of Asia, the relevant requirements tend to change relatively frequently. For this reason it is important to check the position not only on grant but also shortly before vesting and/or purchase or exercise.

It is often the case in practice that the majority of a particular group's employees will be employed in a minority of the locations concerned. From a cost/benefit point of view, many companies focus at least initially on their major locations, that is, normally, those with the most employees, to ensure that their desired ESP can be operated lawfully and without excessive compliance cost in those locations.

If countries with smaller numbers of employees are likely to cause particular compliance difficulties and/or obtaining appropriate consents in those countries is difficult:

• It might be appropriate to operate a tandem cash based Stock Appreciation Rights Plan. This would, for example, give employees in the selected locations an award which gives them a right to a cash bonus equal to the increase in a specified number of notional shares in the company over a pre-set period. For a plan which is stock based, for example a restricted stock or performance share plan, rather than an option plan, a mirror phantom plan over notional shares designed to deliver cash equal to the value of the notional shares might be introduced in some locations. The purpose of plans of this kind is to produce broadly similar gross economic benefits to employees but in the form of cash. Cash based plans will, normally, be treated differently from an accounting and cash perspective than a plan designed ultimately to deliver real stock.
• Alternatively there may be relatively minor modifications which can be made on a local basis which will avoid or reduce the identified local difficulties and yet remain within the broad framework of the intended ESP operated elsewhere. For example, changes to the vesting schedule in California to meet blue sky requirements, or in Australia granting options over new shares rather than, for example, shares sourced via a trust or special purpose vehicle (see below "Source of shares").

In addition to the regulatory/security compliance issues arising in the non-parent company locations, it is also necessary to ensure that the ESP is implemented and operated correctly at parent company level:

• Depending on the parent company location and the status of the company, it may be necessary to obtain the consent of the shareholders to the introduction of the plan. For example in the UK it will be necessary in the context of a listed company to obtain shareholder consent to a plan if shares can be issued under it and/or directors are to participate. In contrast, in the US and some continental European countries the power to adopt may be conferred on the Board (or, in some cases, the Supervisory Board), rather than shareholders.
• If the ESP is to be sourced using purchased shares, then consideration will need to be given in many locations as to whether company-provided financial assistance for the acquisition of the shares is lawful or whether there is legislation prohibiting share support arrangements which might prevent or restrict the ability to provide such funding.
• In some jurisdictions, if the local company bears a cost in relation to the plan, (for example if a charge is made by the parent company to the local company in respect of the participation of employees of that local company) this may also have an effect on the requirement of the company to withhold employee taxation and/or on the incidence of social security.

Accounting and cost issues

The cost of implementing and operating an international ESP should not be underestimated. Surprisingly, at the outset many companies only focus on the initial cost of designing the plan, preparing the rules and dealing with initial compliance issues. This can give a misleading picture: the actual cost of an international ESP is made up of a number of elements, including:

• The cost, direct or indirect, of providing shares for use in the plan.
• The accounting cost of operating the plan, for example the cost which, under some accounting standards, will need to be reflected as a charge against earnings even if there is no actual cash cost.
• The related payroll costs for the group in operating the plan, in particular employer social security costs.
• The ongoing compliance cost in, for example, reviewing and updating regulatory and securities law consents and related disclosures, dealing with appropriate local reporting and withholding for income tax, and communicating with employees. These elements of cost can be very substantial, particularly for groups that have employees who move from location to location between award and vesting or exercise. In such circumstances, tax and social security issues may arise in several jurisdictions in relation to the same individual and an effective employee tracking mechanism is needed.

Source of shares. For some companies the preferred route is to operate a plan using new issue shares. It is important in this scenario to take account of the long term cost of providing these shares. Failure to do so can give a false view of the true total cost, because it ignores shareholder dilution. Even though dilution might not be reflected directly as a cost in a profit and loss account, it is nonetheless a cost and has an impact on financial measures such as earnings per share, as well as, in the longer term, on cash. There is again a cultural divide in the approach to this cost - in the US dilution cost appears not to be a particularly sensitive issue, whereas in continental Europe and, increasingly, in the UK, there is a greater awareness of it.

As a result, the approach to the sourcing of shares for use in ESPs may well be different depending upon the location of the issuer. For US companies and in those parts of Asia Pacific where ESPs are becoming more common (in particular Australia) the vast majority of ESPs operate over new issue shares or shares held in treasury. Within Europe there is an increasing tendency for ESPs to operate over shares which are purchased in the market through some form of special purpose vehicle or derivatives, even though this then results in an actual cash cost. At the very least the question of how the shares are sourced should be considered at the design stage (see above "Objectives and design").

Accounting standards. Given the range of different accounting standards operating worldwide, methods of accounting for ESPs can vary enormously. Accounting for ESPs under US GAAP is different, for example, from accounting under UK or International GAAP and the latter two standards are themselves different. For larger international groups that prepare their annual financial statements on more than one basis it is important to understand these differences, bearing in mind the very different bottom line result which might arise under each approach.

Accounting for ESPs is a very live question much under debate, in particular as a result of the publication of the UK "G4 + 1 Discussion Paper" issued in July 2000 raising a number of points for debate in the context of the G4 +1 countries (Australia, Canada, New Zealand, the United Kingdom and the US) (for background see "Accounting for business combinations" GC, 1999, IV(5), 76 ). The decisions emanating from that discussion process are likely to have a material impact on the method of accounting for ESPs in the future and therefore potentially on the number of new ESPs.

Payroll. Social security and associated payroll costs should be considered at the design and implementation stage. In the case of some countries, mainly within Europe, these costs can be huge. In France, for example, the employer rate (uncapped in each case) is approximately 45%, in Sweden 32.82%, Belgium 35% and the UK 11.9%. In the context of an ESP where the ultimate benefit to be provided is geared to share value and is therefore unquantifiable at grant, this gives rise to an unknown, contingent cost which will need to be provided for over the life of an award. In some locations, for example, France, Italy, the UK and some others, it is possible, within certain limits and parameters to have a stock option plan which has some form of tax and/or social security favoured status via locally approved or qualified sub-plans. These are potentially valuable and may well give rise to a decision to have some local variations in those countries in order to meet the conditions for approval/qualification whilst remaining within the framework of an umbrella plan. The impact of social security cost is, however, also sometimes a reason why a group may simply decide not to operate the international ESP in a particular location.

Ongoing compliance. Related to payroll cost is compliance cost - the cost of ensuring that internal systems and personnel can cope with the requirements of tracking employees and dealing with appropriate annual reporting and, for tax and social security, withholding where required. This is an area to which many groups have paid insufficient attention in the past and, with the increase in the number of international ESPs, is something that local tax and other authorities are becoming increasingly aware of.

The cost of "getting it wrong" can be very significant. One multinational recently had to find US$25 million (EUR 29 million) in respect of income tax payable for its employees based in Japan because of failures to report and account for stock option income. The compliance burden, particularly for groups with large numbers of mobile employees who might be liable (subject to double tax relief where relevant) to tax and social security in more than one country by reference to the same stock award is therefore considerable and relatively costly (see box "Country by country").

Companies also need to consider the extent to which, if at all, it may be possible for amounts equivalent to the employees' gain to be deductible for corporate income tax. The benefit of such a deduction can help offset the costs of running an international ESP and it is normally worth spending some time exploring this for each location. Whether a deduction is available will depend on a range of factors, including, for example:

• The relevant location.
• Whether new issue shares are used.
• Whether there is an accounting cost.
• How the stock awards are treated for employee taxation purposes.

The easiest location in this respect is probably the US. Unless the ESP is a US qualified incentive stock option or qualified stock purchase plan, a corporate deduction will be available to the extent that employees receive compensation subject to income tax at normal income rates. This US treatment obviously gives rise to a question of whether the group should adopt a US qualifying plan for its US based employees (thus conferring the potential for them to make gains within lower longer term rates of tax) and forfeit the potentially valuable corporate deduction, or vice versa. For other countries the ability to achieve a deduction is likely to involve some specific structuring and/or potentially a specific approach to the sourcing of shares and the charging of cost to the relevant employing companies in the relevant locations. For example in some locations a corporate deduction will not be allowed if new issue shares are used in the plan. For some countries however, a deduction will not be allowed regardless of the structure.

Employee communication

Effective communication of an ESP, both initially and on an ongoing basis, is key to the success of a plan. Thought and effort put into the explanation of what is, for many employees a complex benefit, will greatly enhance their understanding and perception of the value of the plan to them. In an ideal world a detailed communication plan will be designed with the help of head office and local HR and rolled out on a staged basis. Matters to be considered include:

• The style and content of explanatory booklets.
• Whether communication should be paper based or web based.
• The languages to be used in the process.
• Whether for consistency purposes and to reinforce the group wide message, something such as a video explaining the ESP, its objectives and features should be used.

When considering a communication plan it is also important to agree the approach to be taken should there be a dip in the share price and/or if any performance related aspects or conditions relating to the ESP are not on course to be achieved.

The second part of this article, to appear in the July/August issue of Global Counsel, will focus on how to avoid potential pitfalls when implementing an ESP.