The Taxation Of Share Options: Internationally Mobile Employees: An Update.

Share options

Share incentives available to internationally mobile employees can take various forms. This article is about share and stock options and updates previous guidance given in TB55 in the light of international consensus reached at the Organisation for Economic Co-operation and Development (OECD). This article supersedes Tax Bulletin 55 and also incorporates the relevant parts of Tax Bulletin 60. In particular, this Article explains how gains arising from the exercise of options are to be sourced on the employment exercised between grant and vest when considering a Double Taxation Agreement (DTA) (except for the US) on a workdays basis. This article will also appear as Tax Bulletin 76 and will be published by the end of April 2005.

Employees can be granted options to acquire shares in their employing company or a company in the same group. Typically the employee is granted options to acquire a specified number of shares at a price fixed at grant - the “option price”. This may be set at the market value of the shares at the date of grant or at a lower figure. The option will then be exercised some time later, when the employee buys shares at the option price. The shares then belong to the employee and can usually be immediately sold.

Domestic legislation

The UK tax treatment of such options in the hands of the employee depends on factors such as:

  • Whether or not it was granted under a plan providing income tax advantages - the Inland Revenue approved Company Share Option Plan, a SAYE share option plan or an Enterprise Management Incentive (EMI) option.
  • The employee’s residence status at the dates of grant and exercise.
  • The period over which the option can be exercised.
  • Whether the option was granted at a price below the market value of the shares at the time of grant.

This article is concerned only with options granted under an unapproved share option plan and non-qualifying exercises of options granted under an Inland Revenue approved plan. A “non-qualifying” exercise here means one where the conditions for income tax relief have not been followed so that there is an income tax charge. An EMI also provides income tax exemption on the exercise of certain share options but income tax may be due if the options were issued at a discount to the share price or there has been a disqualifying event. To the extent that gains on such options remain in charge to income tax, this article applies to them in the same way as to unapproved share options.

Further information on approved plans and EMI can be found at Share Schemes.

There will normally be UK income tax implications only if the individual was resident in the UK at the date of grant or the option was granted in respect of duties carried out in the UK. As the option over the shares is acquired by reason of employment an income tax charge may arise at:

  • the date the option was granted
  • the date the option was exercised or
  • the date the shares acquired at exercise are disposed of. (This generally relates to options granted to individuals who are not ordinarily resident in the UK at the date of grant – see Example 4).

Capital gains tax may be due where gains on the disposal of shares are greater than the gain chargeable to income tax under the Income Tax Earnings and Pensions Act (ITEPA). Examples are where:

  • the sale price exceeds the exercise price, or
  • the individual was not resident in the UK at the date of grant.

Capital gains tax may arise where individuals are either resident or ordinarily resident in the UK at the date of disposal or if they are within the scope of the temporary non-residents rules contained in Section 10A, Taxation of Chargeable Gains Act (TCGA ) 1992. There are special rules for the tax year of commencement or cessation of residence and for non-UK domiciled individuals.

A UK tax charge may be triggered by other events, such as the assignment or release of an option to acquire shares or the conversion of shares acquired by reason of employment from one class of share into another class of share. This article cannot cover every possible situation but guidance about circumstances not dealt with here is available from the contacts listed at the end.

Interaction with Double Taxation Agreements

If the employee moves between countries a tax charge may also arise in another country when the option is exercised, assigned or released. This article sets out the Revenue’s practice from April 2005 for dealing with possible double taxation in the most common scenarios.

The UK has been actively involved with work at the OECD to reach a common international consensus on the treatment of share option gains. Discussion papers have been published as that work progressed and on 3rd September 2004 the OECD announced that additional guidance would be incorporated in the next update of the OECD Model Taxation Agreement (the “Model”) and Commentary scheduled for 2005.

If there is no Double Taxation Agreement (DTA) with the other country then both countries are free to tax income in accordance with their domestic laws. In accordance with its normal rules the United Kingdom will grant its residents unilateral relief in respect of foreign tax suffered on income that arises in another country but is taxed in the UK on the basis of residence.

If a comprehensive DTA exists it will normally have an employment income Article along the lines of Article 15 of the OECD Model Tax Convention. Gains realised from the exercise of options granted to an employee fall within the provisions of this Article rather than those Articles that deal with other income or capital gains.

Article 15(1) provides that if a resident of one country performs the duties of his employment in the other country, then the latter country retains any domestic rights to taxation of remuneration and benefits from that portion of the employment. The OECD has now considered in detail how this applies to share options, where the entitlement to benefit from them accrues over a period of time when work may have been carried out in more than one country.

The OECD identifies two main sorts: American- and European-style options. In the UK virtually all the options we have seen follow the American pattern. These are granted with a future period of service required in order to qualify for exercise. The first date that they can be exercised is also known as the vesting date and the actual date of exercise may be then or afterwards.

The OECD concluded that:

  • up to the point that an option is exercised the gain derives from employment and is governed by the Income from Employment Article in a typical double taxation treaty
  • at that point the employee makes an investor decision to use his or her own money to exercise and decisions from then, to sell or hold onto the shares, are those of a normal investor. So from that date the gain is a capital gain and within the Capital Gains Article if the relevant treaty has one
  • the period of employment on which exercise is contingent will run only to the date that exercise can first take place – the vesting date;
  • The correct method of allocating taxing rights is by straight-line time apportionment, as the right to exercise is based itself on time spent in employment
  • whether the gain on a share option is charged at grant, vesting, exercise or on sale of the shares acquired it should be regarded as the same source and credit available accordingly.

The new UK/Australia DTA has an Exchange of Notes that follows these lines.

Our existing guidance was set out in Tax Bulletins 55 and 60. This stated that where an employee:

  • was granted a share option in the UK during the course of an employment
  • exercised that employment in the other country during the period between the grant and exercise of the option
  • remains in that employment at the date of the exercise and
  • would be taxed by both of them in respect of the option gain and
  • is not resident in the UK at the date of exercise

then the UK would give relief in calculating the tax charge for the proportion of the option gain which relates to the period or periods between the grant and exercise of the option during which the employee exercised the employment in the other country. This was also the line followed in the new UK/USA DTA. (The 5 factors above are those referred to in Frequently Asked Question 1 later in this article).

The Revenue has reviewed this existing practice in the light of the OECD’s published document. Whilst the OECD accepts that countries may, in their bilateral agreements, opt to apportion up to the date of exercise, the OECD recommendation is that the apportionment should be based on the period of grant to vesting. The UK seeks, as far as possible, to interpret its DTA in accordance with the OECD Commentary. With effect from 6 April 2005, for options exercised on or after that date, the UK will base any apportionment on the period of employment up to the vesting date unless the DTA in question specifies another treatment (e.g. the UK/US Treaty). This will apply even when an option could have been exercised before 6th April but was not.

Where an option is exercised prior to 6 April 2005, the UK will continue to give relief for periods of employment in the other country up to the date of exercise. However when a taxpayer considers that it would be to their advantage to take the date of vesting, in accordance with the OECD recommendation, the UK will do so, unless the other country involved is the USA. Where the other country is the USA, apportionment of the gain between grant and exercise must continue as we have a specific Exchange of Notes in the new UK/USA double taxation agreement to that effect.

The OECD Report draws a distinction between “vesting” and “irrevocable vesting”. The Revenue has been asked to comment on these terms. Examples to demonstrate the concept of “irrevocable vesting” are not readily available. The OECD refers to there being “a condition that is applicable after the option becomes exercisable and under which the option will be lost if employment is terminated before the option is exercised.” Suppose an option is exercisable after 3 years employment but that the individual also has to be an employee at the date of exercise. The option vests at the 3 year point as this is when the individual becomes entitled to exercise the option. However, the option will only irrevocably vest when the individual actually exercises the option as at that point the final condition (of being employed at the date of exercise) disappears. References to the vesting date in this article refer to the time of “vesting” and not “irrevocable vesting”.

The gain will be time-apportioned on a straight-line basis by reference to workdays in the period of grant to vesting (or grant to exercise if the Treaty involved is the US/UK Treaty). OECD suggests a typical year can be taken as 260 workdays once, say, weekends and leave are excluded. We would expect to use the same measure of workdays for calculating relative periods in each country. Periods not in that particular employment are left out of account so that the apportionment is still made on the basis of relative periods of employment in each country. The OECD work produced no justification for using any other basis.

Where the individual is resident for tax purposes in the UK at the date of the taxable event then credit relief may be appropriate. In accordance with the normal rules for credit, the amount due will be that relating to relevant periods of employment overseas. Any excess should be reclaimed from the other tax authority.

In the following examples:

  • all the share option plans are unapproved so that tax is due under UK domestic rules
  • all references are to the ITEPA unless otherwise stated
  • there is a comprehensive DTA with the overseas country containing a provision along the lines of Article 15 of the OECD Model (but the country is not the USA)
  • all the options are American-style ones.

Example 1

Mr. A is resident and ordinarily resident in the UK and working here on 1 January 2001. On that day he is granted an option to purchase 1,000 shares in the company in four years’ time at the 1 January 2001 market price of £1. On 1 January 2004 he is moved to another country and is still in the employment there when the option is exercised on 1 January 2006. At that date the shares are worth £5 each. The first date on which he could have exercised the option was 1st January 2005.

A is resident and ordinarily resident in the UK at the date of grant and is therefore liable to income tax under Part 7 of ITEPA on any gain realised at exercise. The gain is calculated as the difference between (a) the value of the shares at the date of exercise and (b) the option price paid plus any consideration given for the option itself; in this case the gain is 1,000 x £4 = £4,000. This amount is classified as specific employment income under ITEPA and is therefore taxed without regard to the individual’s residence status at the date of exercise.

Between the date of grant and the date of vesting (1 January 2005) the employment has been performed in the UK for 3 years and in the other country for one year. 75% of the gain (£3,000) will therefore be assessed in the UK and 25% (£1,000) will be regarded as attributable to the other country.

The exercise of the option will be within the scope of PAYE by virtue of Section 696 if the shares are readily convertible assets (see IR’s Employment Income Manual EIM 12400). Under Section 696(2) the amount on which PAYE should be operated is the amount which, on the basis of the best estimate that can reasonably be made, is the amount of income likely to be chargeable to UK income tax. So if the employer has sufficiently accurate information on periods of employment spent abroad they may be able to operate PAYE for the non-resident employee only on the UK proportion.

Example 2

The facts are the same as for example 1 except that A takes the whole of 2002 as a sabbatical year when he does not exercise his employment anywhere.

Three years have been spent in employment over the period between the grant and vesting of the option. The total gain in value of £4,000 is apportioned 67% to the UK and 33% to the other country.

Example 3

Mr. B is resident and ordinarily resident in the UK and working here on 1 December 1999 when he is granted a share option. He works overseas during 2000. He returns to the UK on 1 January 2001 and is still in the employment here when the option vests and he exercises that option on 1 January 2005.

As B is not resident in the other country either when the option is granted or when it is exercised it is unlikely that any tax would be charged there in respect of the share option. As he is resident in the UK at both grant and exercise, the UK will tax the whole gain. If any tax has been paid in respect of the option in the other country for the year spent working there then the UK will give credit for this against the domestic income tax charge.

Example 4

Mrs C is resident but not ordinarily resident in the UK when an option is granted. She is still resident in the UK when she exercises the option and sells the shares. The charge on exercising options in Chapter 5 of Part 7 is predicated on the employee being resident and ordinarily resident in the UK at the time of grant so within the general charge under section 15 (Chapter 4 of Part 2) or section 21 (Chapter 5 of Part 2). Instead, Mrs C will be liable to UK income tax under Chapter 3C of Part 7 at the time of disposal of the shares as well as a possible annual charge under the benefits legislation. The charge is on the difference between the market value of the shares at the time of exercise less any amounts paid. This is treated as a notional loan written off within Section 446U and is taxed as specific employment income.

If an individual is resident in the UK at both the date of grant and the date of exercise the UK will have primary taxing rights even where a treaty partner country wishes to tax the gain under its own domestic legislation. A claim under the DTA for credit relief may be relevant if the duties of the employment have been carried out in the other country during the period between grant and vesting of the option and double taxation has occurred. Currently, where an option is granted to an employee resident but not ordinarily resident in the UK who performs the duties of the employment both in and outside the UK, the Revenue treats a proportion of any gain on exercise of the option as relating to an employment not within the charge to UK tax. This calculation is based on the proportion of workdays in the period between grant and vesting (or grant and exercise if considering the US) that are outside the UK. This apportionment would not include any part of the period after the employee becomes resident and ordinarily resident.

C may be liable to UK capital gains tax on any gain she makes on selling the shares acquired by exercising the option. Her allowable cost will be the total of the amounts she paid for the option and shares together with any amount charged to UK income tax other than the annual benefits charge. There are special capital gains rules for non-UK domiciled individuals at Section 12, TCGA 1992.

Example 5

Mrs. D is not resident and not ordinarily resident in the UK when her employer grants her an option to purchase shares. At some time before exercise she moves to the UK and performs the duties of the employment there. She exercises the option when working in the UK and sells the shares.

D will not be liable to UK income tax on any gain realised at exercise, unless the grant of the option is clearly related to duties performed in the UK. In this case there could be a liability under Chapter 3C although all relevant facts and circumstances would need to be considered before determining whether or not a liability arises.

She may, however, be liable to UK capital gains tax on any gain realised as a result of selling the shares acquired following the exercise of the option. This would be so if she is either resident or ordinarily resident in the UK at the date of disposal or if she is within the scope of the temporary non-residents rules contained in Section 10A, TCGA 1992. There are special capital gains rules for the tax year she commences UK residence and for the case where she is a non-UK domiciliary. D’s allowable capital gains cost would be the total of her payments for the option and shares together with any amount charged to UK income tax.

Even though exercise will not normally trigger a UK income tax liability in this case, it may well give rise to a tax charge in another country. Where tax has been paid in a treaty partner country, the OECD view now is that the part of the gain up to the date of exercise should be treated as falling within the provisions of the employment income Article of the relevant double taxation agreement, regardless of the eventual type of tax levied in each country under their domestic rules. The UK will therefore allow the relevant proportion of the foreign tax paid as a credit against the UK capital gains tax:

  • if the options are exercised and the shares sold on the same day, the whole gain is treated as falling within the provisions of the employment income Article of the relevant DTA
  • if the shares are disposed of at a later date, part of the gain may be treated as falling within the employment income Article of the agreement. The appropriate calculation of relief will be straight-line time apportionment in line with OECD views.

Frequently asked questions

Some FAQs on this topic were discussed in Tax Bulletin 60. We have also updated these.

Q1 Is relief by allocation of taxing rights only available if the five factors detailed in TB55 and above are present?

We are able to give certainty in the most common situation where double taxation arises, which is when all five factors are present (NB the second factor should now be read as ‘exercised that employment in the other country during the period between grant and vesting of the option’). There are other situations in which some relief by allocation of taxing rights may be appropriate, for example if the employment ceased shortly before the options were exercised. However there are many permutations possible and it is not possible to deal with all of these in that article. Cases that do not fall within the circumstances described will continue to be considered on their own facts and in the light of the new OECD guidance.

Q2 Does an employment 'continue' if the employee changes contractual employer on being relocated?

If the employers were in the same group of companies and the change did not affect the employee’s stock option rights, then the UK would normally regard it as one employment for the purposes of apportioning the option gain attributable to the UK.

Q3 Previously it has been possible to use methods of apportionment other than the straight-line time method. TB55 endorsed this 'very occasionally'.

The Inland Revenue has always maintained that time-apportionment should be the expectation and in practice few cases have been seen claiming another basis – a handful only in the last 3 years. And in some of those the other country involved agreed to accept straight-line time apportionment after discussions. In the light of the new OECD guidance and international consensus we would not expect to agree cases using any other method of apportionment.

Q4 Is it necessary for the country of residence to actually tax the gain?

The normal expectation would be that tax would actually be levied. Exchange of information powers may be used to ensure the other country is aware of the option gain so can tax it if their domestic legislation permits.

Q5 If the employee is resident and ordinarily resident in the UK both when the option is granted and when it is exercised, can the gain ever be time-apportioned in the UK? Example 4 of TB55 implied that it can.

The statement that “a claim may be relevant under the employment income Article….” does not mean that relief would be due by leaving out of account a part of the gain that related to overseas employment. It was meant to reflect that relief by means of credit might be available if the UK recognised that another country had a valid claim to tax part of the gain because it could be said to be derived from employment performed there. We have reworded Example 4 in this article to make the position clearer.

Q6 Does it matter whether the option is over shares in an overseas or a UK company?

In general, no. The source for double taxation treaty purposes will be the employment, and where it is carried on.

Q7 Is any relief due on an option gain if an employee were resident in the UK at the date of grant but resident in a non-treaty country at the date of exercise?

Assuming the individual is also ordinarily resident at the date of grant, the whole gain is taxable in the UK under ITEPA. If there were overseas tax payable on any part of the share option gain, the UK would consider unilateral relief on a claim. However, unilateral relief is only available to credit overseas tax paid by a UK resident, or a person who is treated as such by section 794 of the Income and Corporation Taxes Act 1988, not by taking any amount out of account by time-apportioning a gain. The amount of unilateral relief may never exceed what would be available if a double taxation treaty with the country existed.

Q8 Is it possible to provide guidance on some other important issues, such as periods of residence in a third country, or short-term business visitors now that work at OECD has been completed?

Example 8A

Mr. E is granted share options on 1st January 2000 when he is resident and ordinarily resident in the UK and working here. He goes to country A on 1st January 2001 for a year then to country B on 1st January 2002. He is still living there on 1st January 2005 when the options vest and he exercises immediately. By then he is tax resident in Country B.

If Country B taxes option gains on exercise it will have the full right to tax Mr. E as he is resident there at that time. If a claim is made under the DTA between the UK and Country B, then the UK will regard one year’s worth of the option gain as derived from UK employment so, in accordance with Article 15(1) of the OECD Model will restrict taxation to 1/5 of the gain as this is the proportion that is sourced here.

Example 8B

Mrs. F is granted share options on 1st January 2000 when she is resident and ordinarily resident in the UK and working here. She spends 5 months from 1st January 2001 working in country A for her UK employer so that no tax is due in Country A and she remains resident for tax purposes in the UK. She then moves to Country B to work, becomes tax resident there and is still in Country B when the options vest and are exercised on 1st January 2005.

When the options are exercised the UK is not the country of residence so would confine taxation to the fraction of the gain that is derived from employment in the UK, i.e. one year’s worth out of the five.

Example 8C

Mr G is awarded restricted shares on 1st January 2000 as part of the bonus scheme for 1999. He immediately goes to work in Country A and becomes tax resident there. The restrictions will not lift until 1st January 2005, when he can sell the shares freely. UK IT is due at that date. He claims that the gain should be wholly apportioned to Country A under the relevant DTA.

Although the same principles will apply to other forms of share-based earnings besides options, the underlying facts may mean the result is different. Here the share award derives wholly from employment up to 1st January 2000. The period when restrictions on sale are imposed is merely a blocking period. The whole gain on sale therefore derives from UK employment and no reduction in UK taxing rights is made under the DTA.

Q9: What if the individual is a director?

Article 16 in the OECD Model DTA provides special rules for directors and takes precedence over Article 15. The Commentary to this will be expanded to make clear that share options are also within these special rules to the extent that they were granted to a person in their capacity as a member of a Board of Directors.

Q10: I work for a European multi-national and think therefore that the options I have been granted whilst working in the UK are not American-style ones.

This will be a question of fact. European-style options are usually a reward for past service and vest on the day they are awarded even though they cannot be exercised for a given period. In such a case time apportionment will not be appropriate unless work was carried out in another country before the date that the options were granted.

Q11: How will apportioning UK workdays operate in practice?

Employee is resident and ordinarily resident and working in the UK on 1 January 2003. He’s granted an option to purchase shares at a price of £1 conditional on remaining in that employment until at least 1 January 2006. On 31 December 2004, he moves to work in Country B where he becomes resident. He exercises the option on 1 July 2006 and sells the shares immediately. The benefit should be regarded as income from employment covered by Article 15.

The UK may tax the part of the stock option benefit that was derived from employment carried on in the UK, on the proportion of those days that were relevant for the stock option plan. If each year has 260 workdays then the days relevant to the stock option plan are 3x260 = 780. The UK may tax 520 (2x260) days of this and B may tax 260 days. The remaining days of employment between vesting (1 January 2006) and exercise (1 July 2006) are not relevant to the stock option plan so are ignored.

Further advice

Tax Bulletin 56 deals with National Insurance Contributions and other issues around share incentives for internationally mobile employees are covered in Tax Bulletin 60. Updated guidance on National Insurance Contributions will be issued shortly.

For further advice on domestic legislation governing the charge to tax on share options, contact:

Mike Staples
Revenue Policy
Savings, Pensions and Share Schemes
Room G48
1 Parliament Street
London
SW1A 2BQ

Tel: 020 7147 2865

e-mail:

For further advice on the PAYE treatment of share options, contact:

Peter Walker
Personal Tax (Solihull)
550 Streetsbrook Road
Solihull
West Midlands
B91 1QU

Tel: 0121 713 4602

e-mail:

And for further advice on international aspects, contact:

Jane Truelove
Revenue Policy International
Fitz Roy House
Castle Meadow Road
Nottingham
Nottinghamshire
NG2 1BD Tel: 0115 974 2003

E-mail:

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