I am a corporate tax lawyer in a firm without a share scheme specialist. We have several UK company clients with businesses in the US, with employees sometimes moving between countries. They also grant share options. I am aware that the tax treatment of options has changed where they are granted to UK residents who are non-domiciled or not ordinarily resident in the UK (R/NOR). It sounds horribly complicated but I am sure I will be asked about it soon. In particular, I expect to be asked about PAYE (www.practicallaw.com/4-200-3405) and national insurance contributions (NICs) (www.practicallaw.com/8-201-8297) and I am dreading it! Is there a simple explanation of the new position?
It is horribly complicated. However, the taxation of share incentives granted to internationally mobile employees was already complicated and the old rules have not been completely swept away.
There have been two main changes:
Previously, some of the share incentive tax charging provisions applied only if incentives were acquired by an employee who was both resident and ordinarily resident (R/OR). This did not always mean that other employees' incentives went untaxed - instead they were taxed in a different way:
someone who was R/OR when they were granted a share option would not be taxed on grant, but would be liable to a charge under Chapter 5 of Part 7 of the Income Tax (Earnings and Pensions) Act 2003 (ITEPA 2003) on exercise; but
someone who was R/NOR when granted an option might be liable to a money's worth charge on the value of the option at grant and would then be liable to tax after exercise under Chapter 3C of Part 7 of ITEPA 2003 (the "notional loan" provisions).
From 6 April 2008, options granted to both R/OR and R/NOR employees will be taxable under Chapter 5 in the same way, so you could say there has been a little bit of simplification.
There is a new remittance basis of taxation for resident/non-domiciled and R/NOR taxpayers. If that applies, in some circumstances some or all of any employment income from share incentives can be treated as relating to foreign duties and taxable only if "remitted" to the UK. The detailed rules for this apportionment of income between UK and foreign duties are different for different types of share incentive (and for resident/non-domiciled compared to R/NOR taxpayers). In this answer, we are going to consider only share options granted to R/NOR employees.
There is an important caveat - shares in a UK company and share options granted by a UK resident person will be remitted to the UK when received by an employee. (This is because legally they are always located in the UK so must be received and used here. For more on this, see Practice note, Remittance of securities and options income to the UK and the treatment of UK shares (www.practicallaw.com/7-382-7749).) However, if the employee has non-UK duties the apportionment rules will still be relevant:
on any exercise of a UK share option, for determining the amount of tax due immediately under PAYE, even though all of the "foreign" option income may eventually be taxable in the UK (under self-assessment) because the option is automatically remitted; and
on a surrender of a UK share option for a payment at least equal to its market value, if that payment is made and kept outside the UK (and so not remitted). This is very important, because it may be the easiest way for a UK company to allow an R/NOR option holder to reduce their UK tax burden in line with their non-UK duties.
The best way to explain the new position is probably by means of an example:
In our example, the employer is a UK company with US businesses. Its shares are traded on AIM (www.practicallaw.com/8-107-6392), so they are readily convertible assets (www.practicallaw.com/5-107-7109) and PAYE will apply when tax becomes due on any share incentives awarded to its employees and directors.
A USA-based executive is seconded to the UK for a short period and has both UK and US duties during that time. She is R/NOR throughout her residence in the UK (she has not lived or worked in the UK before). She has substantial non-UK investment income and gains in every year of her UK residence.
The executive is granted a typical executive option (by the UK company itself) over the UK company's shares, just after coming to live and work in the UK. (She is also non-domiciled in the UK, as she was born in the USA to US-domiciled parents and intends to return to the USA as her long term country of residence. However, this is not relevant, as the rules for R/NOR employees apply regardless of domicile.)
The option can be exercised three years after grant.
In fact, the option is exercised four years after grant.
For the first two years after grant the executive is R/NOR with both UK and US work. After that, she returns to the USA, becomes non-resident in the UK and has no further UK duties.
The company will need to know various facts to be able to calculate UK tax arising from the share option:
The employer needs to know that the option holder is R/NOR and so can claim the remittance basis of taxation. This is very likely to be the case in the circumstances set out in the example, with a US resident seconded to the UK for the first time and for a short period. In these circumstances, the employer is likely to realise that the remittance basis is an issue. However, it may not always be so clear. For more on this, see Practice note, Non-domiciled tax reforms: impact on share incentive taxation from 6 April 2008: What does "not ordinarily resident" mean? (www.practicallaw.com/7-380-8717)
The employer needs to know:
The date the option was granted.
The statutory "vesting" date. This is the first date on which the executive can exercise the option.
These dates respectively define the start and the end of the statutory "relevant period" that will normally apply for the new apportionment mechanism.
If a taxable event occurs before the option is capable of exercise, the relevant period will end instead with the date of the taxable event. (This is not too likely, but might happen, eg, if the option was surrendered for a payment before it vested.)
Because the statute says the period begins "with" the grant date and ends "with" the vesting date, even options which are already capable of exercise when granted will have a relevant period of one day.
Remittance basis apportionment of a share option gain is available only:
If the remittance basis applies for at least one tax year, or part of a tax year, falling within the relevant period. In the case of an option, this means that apportionment cannot apply if the remittance basis is not claimed during any part of the period from grant to vesting, even if it is claimed for other parts of the period from grant to exercise. The statutory mechanism for just and reasonable adjustment cannot help with this problem should it arise. This may be a particular issue for options with a short vesting period; and
For those parts of the relevant period to which the remittance basis applies.
As a result, the company needs to know if and when the remittance basis applies during the relevant period. This is up to the individual taxpayer to decide, by making a claim for each tax year (at least in the circumstances of our example). Employers should therefore discuss taxation issues with any R/NOR option holders and ask them to be as clear as possible about whether they will claim the remittance basis for each relevant tax year. Not all R/NOR taxpayers will find it worthwhile to make a claim and some may make a claim for some tax years and not others.
There are two significant disincentives to making a claim for the remittance basis:
The taxpayer will lose their personal allowance and capital gains tax annual exempt amount for the tax year.
Long term residents must pay £30,000 per tax year to make a claim. However, many R/NOR taxpayers (including the executive in our example) will not have to pay this charge, as they will not have been UK resident for long enough.
As our executive has substantial non-UK investment income and gains (and would not want these to be subject to UK taxation), she would probably decide to claim the remittance basis for all tax years in which she is UK resident, even though she will pay more income tax on her UK earnings as a result of the loss of her personal allowance.
Note that the option in our example is a UK asset and will be treated as remitted to the UK on grant. As a result, this executive would not be likely to claim the remittance basis just because doing so would shelter part of her option income from UK tax, unless she knew that the taxable event for the option would be a surrender for market value consideration which could be paid and kept offshore. However, if she has substantial duties outside the UK, it might be worth claiming the remittance basis to avoid paying UK tax on her salary and any cash bonus for non-UK duties, if these can be paid outside the UK.
In our example, we will assume that the executive will:
Claim the remittance basis throughout her UK residence.
Tell the company she plans to do so.
Assuming the executive's duties within and outside the UK are of equivalent "value", the employer also needs to know the number of days the executive spends:
Working in the UK; and
Working outside the UK,
in each tax year or part of a tax year within the relevant period.
The legislation requires apportionment to be based on the duties in the different countries. Normally this will be done purely on the basis of the days worked in each. If duties are genuinely different in the two countries, it might be possible to agree with HMRC (or HMRC may require) that one set of duties should be given more weight than the other.
Someone who is R/NOR in the UK and has duties in both the UK and another country in a particular tax year is likely to pay tax on their employment income in both countries. If so:
The way the employment income, including any share option gain, will be taxed will probably be specified in a double taxation agreement (DTA) (www.practicallaw.com/8-107-6151) between those two countries (the UK has DTAs with many countries and there is some variation between their terms); and
The treatment specified in the DTA will take priority over the UK remittance basis apportionment rules, if there is any difference between the two and both apply.
If the provisions of a DTA differ substantially from the UK remittance basis apportionment mechanism, the application of the DTA could substantially change the tax treatment. That will be so where:
The UK/USA DTA applies;
The taxable event is an exercise of the option some time after it vests; and
The split of workdays over the period to exercise is substantially different from the split over the vesting period.
(All of these conditions are met in our example.)
This is because the UK/USA DTA apportions option gains on the basis of workdays in the UK and US between grant and exercise, rather than grant and vesting. As a result:
If (as in our example), the option holder is resident in the USA, and not in the UK, when the charge arises, the UK will tax only a portion of the option gain equal to the fraction of total workdays worked in the UK during the period from grant to exercise. The USA will give tax relief for the UK tax paid. In that case, the portion of the gain which is foreign under the UK remittance basis apportionment mechanism will not be taxable in the UK, even if, as in this example, it is remitted here.
Strictly, the taxpayer should make a claim under the DTA for HMRC to agree to this treatment. But they say they are prepared to do so for share options (but not other incentive charges) without a claim, as there is broad international agreement that this is how share options should be taxed.
The same treatment would apply if the option holder were tax resident in both countries for the year of the charge, but treated as resident in the USA under the DTA. Residence under a DTA ("treaty residence") is different from residence status under UK law. Each individual should be treaty resident in only one of the two countries under a DTA, but may be tax resident under the domestic law of both countries.
If instead this option holder were UK resident (or treaty resident in the UK) when the charge arose, the USA would be limited under the DTA to taxing only a portion of the option gain equal to the fraction of total workdays in the USA during the period from grant to exercise. The UK would give tax relief for the US tax paid against UK tax on the US portion of the gain. The US portion would also be taxable in the UK, since this option is a UK asset and therefore automatically remitted.
For an option which is not a UK asset, the US portion of the gain on exercise would probably not be taxable in the UK, as a non-UK option would generally not be capable of remittance (see Practice note, Remittance of securities and options income to the UK and the treatment of UK shares: Share options granted by non-UK residents (www.practicallaw.com/7-382-7749)). As the US portion of the gain would not be remitted, then the US portion would not be taxed in the UK. As a result, there would be no UK tax relief for the US tax paid on the unremitted amount.
Many other DTAs specify an approach which is essentially similar to the UK remittance basis apportionment mechanism. We consider the effect of DTAs of this type in more detail in another "Ask the Team" (see "Ask the Team": The new tax regime for expatriate employees' share options where an OECD-style DTA applies (www.practicallaw.com/9-383-4466)).
One general point is worth making. If there will be time-based apportionment of option income under a DTA that is likely to be at least as beneficial as the new remittance basis apportionment, the apportionment of any potential option gain may not be relevant to a taxpayer when deciding whether or not to claim the remittance basis. It is also possible (as in our example) that the application of a DTA might prevent the automatic remittance of UK options or shares being a disadvantage to an R/NOR option holder who has non-UK duties and claims the remittance basis.
Under the apportionment mechanism, if the taxpayer is not resident for a tax year within the relevant period, apportionment works on the basis that the taxpayer is R/NOR and claiming the remittance basis in that year. This is relevant to our example because the option holder returns to the USA more than one whole tax year before the option vests.
Let's say our executive starts work in the UK on 8 April 2008 and is granted an option on 15 April 2008.
The option vests on 15 April 2011. The relevant period is therefore 15 April 2008 to 15 April 2011.
The executive has 240 working days in a full year, so there will be 239 falling within both the tax year 2008/2009 and the relevant period. In that year, she works 57 days in the USA and 182 in the UK.
In the tax year 2009/2010, she works 152 days in the UK and 87 days in the USA. She also leaves the UK and returns to the USA on 1 March 2010.
In the tax year 2010/2011, she works all 240 days in the USA and is UK non-resident.
In the tax year 2011/2012, she again spends all her 240 work days in the USA and is non-resident. She exercises the option on 6 April 2012.
As a remittance basis claim is made (or treated as made) in our example in all the relevant tax years, we can just use the whole relevant period to calculate the proportions of UK and foreign income from the option exercise.
If the remittance basis did not apply in any period, you would not apportion the part of the option gain equal to the workdays in that period as a proportion of the workdays in the whole relevant period. All of that part of the option gain would be treated (under the remittance basis) as taxable in the UK.
We will assume that the company knows everything it needs to in order to make the remittance basis calculation fairly exactly.
239 + 240 + 240 + 8 = 727
total workdays over the relevant period.
Of these, the UK workdays total:
182 + 152 = 334.
So, the US workdays total:
727 - 334 = 393.
As a result, the UK portion of the option gain on exercise is:
334/727 x 100 = 45.9%.
The US portion of the gain (which the statute calls "foreign securities income" or "FSI") is therefore:
100 - 45.94 = 54.1%.
239 + 240 + 240 + 240 = 959
total workdays in the period from grant to exercise.
Of these, the same number as before (334) are UK workdays, so the US workdays total:
959 - 334 = 625.
As a result, the UK taxable portion of the option gain on exercise (which is also taxable in the USA, but with foreign tax credit for UK tax paid) is:
334/959 x 100 = 34.8%.
The portion of the gain taxable only in the USA is therefore:
100 - 34.83 = 65.2%.
When the option is exercised, the company will need to account for PAYE. In doing so:
If remittance basis apportionment applies, the company should account for PAYE income tax only on its best estimate of the part of the option gain that is not foreign securities income.
This is so even when the option is a UK asset and is therefore remitted to the UK when granted, so that the whole option gain will be potentially taxable in the UK.
However, if the option holder is not resident in the UK at the time the charge arises and time-based apportionment under a DTA applies, the company should account for PAYE income tax on its best estimate of the actual UK tax liability.
HMRC expect companies to apply remittance basis apportionment, or DTA time-based apportionment, when operating PAYE if this is appropriate and they have enough information to do so. Their guidance states (in the updated HMRC Employment-Related Securities Manual (www.practicallaw.com/5-362-6964), at ERSM161030):
"This means that, if the employer has sufficient information to calculate the amount of employment income which is foreign securities income ..... then it is the net amount of employment income after deduction of the foreign securities income on which PAYE should be operated. Where the employer does not have sufficient information to calculate, using the best estimate that can reasonably be made, the amount of foreign securities income, then PAYE should be operated on the full amount of the employment income, subject to any apportionment the employer has sufficient information to make in respect of treaty exemption.
An example where an employer could make a reasonable estimate of an employee’s foreign securities income would be where the employer knows that the employee is resident and not ordinarily resident for the year and has evidence, such as an assurance from the employee, that a claim to the remittance basis will be made. If the employee’s overseas duties are fairly regular from year to year, and/or the expected balance of his or her UK and overseas duties for the current year is known, then the employer could reasonably estimate the FSI on the basis of its expectation for the current year."
In our example, the company's estimate of PAYE under UK remittance basis apportionment would be 45.9% of the taxable gain on exercise. (The gain will equal the market value of the shares acquired on exercise less the exercise price and also less any amount paid by the option holder for the option.)
However, the company also knows that the UK/USA DTA applies and gives a lesser estimate of the UK income tax liability - only 34.8%. Therefore, PAYE income tax should be accounted for on this percentage of the total option gain.
The adjustment of the income tax and PAYE legislation to reflect remittance basis apportionment does not affect NICs on share option gains. (In HMRC's view, it also does not affect any other share incentive NICs computation, but this is somewhat controversial. For more on this, see Practice note, Remittance of securities income by R/NOR taxpayers: NICs and apportionment of securities income (www.practicallaw.com/0-383-0081))
If the option holder in the example:
Instead, exercised her option when still resident and employed in the UK (but with a similar split of workdays throughout the relevant period); and
She was contributing to/covered by the UK social security system when her option was granted (see below),
NICs would be due on the full amount of the option gain on exercise, even though apportionment would apply when calculating the PAYE income tax due at the same time.
NICs are not affected by the application of any DTA, but, like tax, they may be the subject of agreements between the UK and other states. There is a UK/USA Reciprocal Agreement concerning social security. Where an employee moves to work in another state on secondment, it may be possible for them to:
Remain covered by their home state's social security system under a social security agreement between the states.
Not become liable to make social security contributions in the state to which they are seconded.
This can affect the liability to pay NICs in respect of share incentives. There are also special rules about NICs liabilities arising after leaving the UK, even if special arrangements for staying outside the UK's social security system while working here do not apply. As a result, whether NICs liabilities arise on the exercise of options after leaving the UK is a complicated issue.
However, if the executive in our example has not arranged to remain within the US social security system at the time the option was granted, NICs would probably be due on the full amount of the option gain on exercise. We will examine this subject in more detail in future publications.
Companies will find any difference between amounts subject to PAYE income tax and those subject to NICs on a single chargeable event particularly confusing. But this is not something newly imposed by the remittance basis changes.
There is a detailed remittance basis apportionment mechanism set out in the new legislation. However, the legislation also includes a provision for some other, more appropriate basis to be used to apportion share incentive income if the normal basis would produce a result that is not "just and reasonable". The application of this just and reasonable override (JRO) could be used either to:
Benefit the taxpayer; or
Increase the tax liability when HMRC feel that the normal rules produce an unreasonably small amount of UK tax.
HMRC's guidance specifies that any use of the JRO by a taxpayer or employer will be subject to specialist scrutiny at HMRC if they become aware of it. The guidance also sets out several examples of reasons why HMRC might apply the JRO to increase UK tax. For this reason, you may want to discuss any possible application of the JRO with HMRC's Employee Shares and Securities Unit in advance.
We briefly consider two possible reasons to apply the JRO to a share option in another "Ask the Team" (see "Ask the Team": Just and reasonable override of statutory UK/foreign split for share option tax (www.practicallaw.com/2-383-4177)). However, there will be other circumstances that may call for the JRO to be used, so employers and advisers will have to stay alert to this possibility.
We discuss the new taxation regime for share incentives granted to non-domiciled and R/NOR taxpayers in more detail in:
HMRC published a short note on the effect of the remittance basis changes on share incentives in August - see Update, HMRC guidance on impact of "non-dom" reforms on securities and options taxation (www.practicallaw.com/9-382-7630).
HMRC have also now revised their main guidance on international mobility and share incentives to take account of the changes - see Update to main HMRC guidance on share incentives for internationally mobile employees (www.practicallaw.com/3-383-2309).
Another important HMRC announcement in this field confirmed the continuing availability of an important extra statutory concession - see Update, HMRC announcement about ESC A11: Split-year treatment and tax on employment-related securities and securities options (www.practicallaw.com/6-382-4299).
HMRC have also published some useful guidance on the OECD's approach to the double tax treatment of share options. (This guidance was published in April 2005 in HMRC's Tax Bulletin 76.)
On the subject of NICs, the existing HMRC guidance on NICs, share incentives and international mobility is now a little out of date. This is because of the changes in the specific taxing provisions which apply to incentives granted to R/NOR employees. However, it is still useful in explaining the international NICs issues, but when reading it you need to keep in mind that some of the examples are no longer current. (For example, some scenarios refer to the application of Chapter 3C of Part 7 of ITEPA 2003 in circumstances where Chapter 5 would now apply instead.) This guidance was published in an April 2005 special edition of HMRC's Tax Bulletin.
This is a newly revised and complicated area of law and tax/NICs practice. So we are particularly keen to receive any comments or criticisms about this note and our analysis. Suggestions for future "Ask the Teams" on this topic are also welcome. Please e-mail us at firstname.lastname@example.org.