Non-US employees and equity compensation taxation

Equity compensation is a vital aspect of an employee’s work life. Thus, getting a grip on its mechanisms and technicalities becomes highly significant. Employees who receive equity-based compensation can find it to be one of the most useful yet one of the most perplexing benefits provided by their employer, especially since equity compensation taxation includes way many layers for non-U.S. employees. We are here to guide you through this journey with this article.

Equity compensation taxation and non-US employees

Equity compensation enables cash-strapped businesses to get highly qualified people to join their staff and board of directors. With increasing globalization, migration to more developed countries, particularly the U.S., has increased tremendously in the past few decades (Although the pandemic has affected this recently, the preferences are intact). As a result, foreign nationals who are not U.S. citizens relocate there and become U.S. tax residents when their equity-based grants, which were made years before they came, vest or become eligible for the exercise.

Equity compensation overview

Non-cash compensation offered to the employees of a company is known as equity compensation. Options, restricted stock, and performance shares are included in equity compensation; they all give employees ownership of the company.

If there are vesting restrictions, equity compensation can help retain staff by allowing them to participate in the company’s earnings through appreciation.

Equity pay has historically been utilized by technology companies to compensate employees, whether they are in the start-up stage or are more established businesses. A CEO of one of the 50 largest companies in the United States received an average compensation of $1.2M between 1970 and 1979, of which 11.2% came through stock options. The same figures had increased to $9.2M and 37% by 2000-2005, respectively.

Types of equity compensations

Depending on the sort of business and the goals of its founders, an employer may offer various equity compensation options. Common types of equity compensation are as follows:

• Stock options – The most popular type of equity compensation is a stock option. It’s a legal agreement that grants the holder the right, but not the duty, to purchase or sell shares of a specific stock within a set time frame and at a fixed price. This price is known as the exercise price. Workers that are granted this option are not stockholders, but they do have the option to purchase or sell stocks in the future. The option expires and is no longer valid after that time.
• Non-Qualified stock options – The most straightforward employee stock option plans are non-qualified stock options (NSOs). Since they are not eligible for special tax treatment, they are also known as non-statutory options. Instead, employees must pay taxes when they exercise their stock options or obtain NSO shares. They might also be eligible for the capital gains tax rate if they keep their shares for a year before selling them.
• Restricted stock units – Another popular kind of equity compensation is restricted stock or restricted stock units (RSUs), which includes issuing firm shares to an employee subject to vesting over a certain period of time and attaining defined performance targets. This indicates that the stock is subject to sales restrictions for a set time during which the holder is not permitted to transfer the shares.
• Employee stock purchase plan – Employees can acquire company stock shares at a discount through payroll deductions under an employee stock purchase plan (ESPP). In this case, the business purchases the stock using their salary on the employee’s behalf. The cost to the employees is the stock’s current market value, less any tax savings since they buy shares on an after-tax basis.
• Performance shares – Another form of equity compensation that links employee pay to their company’s financial performance is performance shares. Awards, sometimes known as shares or units, are distributed in accordance with performance shares. They depend on achieving certain financial goals, such as return on equity or earnings per share (EPS) (ROE).

Pros and cons of offering equity to non-U.S. employees

Before granting equity or stock options to non-U.S. employees, a company should know the pros and cons of offering equity to non-U.S. employees.

Pros

Let’s look at the advantages of granting equity to non-U.S. employees below.:

• Adding the top global talents to your team – Which business doesn’t want to hire top talent from around the globe? Granting equity to foreign employees ensures the diversity of talent in your team.
• Improve Workplace Engagement – When a distribution event happens (usually at exercise for stock options and at vest for RSUs/PSUs), the bonus for the employee is frequently higher when the company performs better during the vesting period. Employees are more cooperative and devoted over the long term if an award’s vesting conditions are closely related to company performance.

Cons

Below are some disadvantages that businesses face while granting equity to non-U.S. employees:

• Acquiring Knowledge of All Equity Compensation Options – Since different equity grants generate different results for the business, knowing the best option for your company becomes essential. Thus, it might become a hassle to keep tabs on all kinds of equity grants and their implications on the company.
• Risks of Tax and Employment Compliance – There are about 200 nations in the world, and each has its unique set of tax rules and regulations. If your multinational stock equity plans are not adaptable enough, they can lead to undesirable outcomes, hamper business growth, and discourage staff involvement. If tax-equalization policy exclusions are not designed to offer suitable solutions for both parties, unexpected outcomes could hurt the employee or employer.

Understand equity compensation taxation

If you’re earning equity, you need to know what kinds of taxes you’ll owe and when to pay them. Let’s understand equity compensation taxation and how they matter to non-U.S. employees.

How equity is taxed for non-US employees

Non-U.S. employees who receive remuneration from sources in the United States are liable to graduated rates of net income taxation in the United States as effectively connected income (subject to modification by treaty). The income will be taxed as “effectively connected income” (ECI) under Section 871(b), which means that it is effectively connected with the operation of a trade or business in the United States or as “fixed, determined, annual or periodic” (FDAP) income under Section 871(a)(1) (A).

The non-U.S. employee typically only needs to file a U.S. federal tax return if they have additional U.S. income or investments. FDAP income is taxed at a flat rate of 30% and is withheld. However, it is subject to graduated rates of U.S. taxation. The employee is required to file an annual U.S. federal tax return on Form 1040NR. Any withholding at source and estimated tax payments at this point are to be paid by the employee with his final federal tax liability for the year.

Foreign tax considerations

A non-U.S. employee who works in a U.S. corporation is likely to be completely subject to taxation in their home country on any pay they receive. However, there may be exceptions, especially if the employee is not a resident of one of the 67 nations having a tax treaty with the U.S. In most cases, employees should be able to reduce any double taxation by claiming a foreign tax credit or tax deduction in their home country for the U.S. taxes paid. In some circumstances, the U.S. corporation hiring a non-U.S. employee has tax duties of its own in the employee’s home nation.

Tax compliance for non us employee

Paying your taxes on time ensures a strong credit profile and tax history. Tax compliance for non-U.S. employees is a strict adherence. Generally, you won’t have to pay U.S. capital gains tax on your investment earnings if you’re a nonresident alien. Nonresident aliens are only required to submit tax returns to the United States (Form 1040-NR, U.S. Nonresident Alien Income Tax Return) if they receive taxable income from sources such as wages, tips, dividends, grants, and other sources that qualify.

The U.S. firm hiring the non-U.S. employee is typically required to deduct 30% of the income paid to the non-resident employee as U.S. federal tax. The withholding may be reduced, but it is advised to be compliant in this arena as the withholding is a Tier 1 compliance issue under Section 1441 by the Internal Revenue Service.

Importance of understanding local tax laws and regulations

Understanding local tax laws and regulation is crucial for non-U.S. employees. You can reduce your tax liability by making wise judgments by comprehending tax regulations.

Being familiar with tax rules is also vital for avoiding legal issues. You can make well-informed judgments that are in your best interests if you are aware of the tax repercussions of various financial actions. Equity compensation taxation becomes a lot more manageable if you are familiar with the minute details of laws and regulations.

Challenges of managing equity compensation in different currencies

A currency’s fluctuations are determined by supply and demand factors. A currency will strengthen in relation to other currencies when its demand increases among investors. The opposite is accurate when there is an abundance of supply. A significant equity market can affect currency markets; thus, dealing with different currencies poses challenges when managing equity compensation.

If a foreign currency plays a significant role, the company’s earnings will frequently differ from analyst expectations. Investors can then evaluate the management’s comments regarding the prognosis for currency changes in the future. Any hints that a corporation will implement future hedging tactics are things to watch out for.

How to structure equity compensation for non-U.S. employees

To guarantee that the standard equity compensation package is effective and suitable in light of foreign tax rules, it is crucial to structure it properly so that it is beneficial to your company.

• Global PEO – An international employer of record, often known as a global PEO (Professional Employer Organization), hires workers on behalf of a client company operating in a different nation. While granting stock options to non-U.S. employees, it should be done in accordance with Form S-8 (for publicly listed stock) or Rule 701 of the Securities Act of 1983 (for privately owned shares).
• Outsourcing Payroll and Benefits Administration – Giving stock options to foreign workers through a PEO or employer of record may occasionally be a compliance concern. Nonetheless, there is frequently a workaround that is effective. PEO contracts between international PEOs and client companies are adaptable legal arrangements. The client company can often continue acting as the employees’ legal employer while outsourcing the payroll processing, withholding of employee taxes, and management of stock options and other benefits.
• Understand tax equalization policy for non-U.S. employees – Tax equalization is utilized to offset the impact of a global assignment on an assignee’s individual tax liability. It is a method for determining the total amount of taxes owed by a non-U.S. employee while on an international assignment (in the U.S.) and determining how much of those taxes should be paid by the employee and how much by the company. On revenue from company sources, the Company will cover the assignee’s actual home and host country taxes. In return, the assignee will have to pay a “hypothetical tax” on income from the Company that is sourced in their home country.

Importance of seeking expert help to reduce tax liability for non us employees

Working in a foreign nation is a vast mountain itself. The sense of non-belonging on one side and all the complicated taxation laws on the other might make a non-U.S. employee feel alienated and later affect his performance. Several elements of a person’s pay structure can aid in lowering their tax obligation. One can significantly reduce their tax obligation if one can make the best use of all the allowances one receives as compensation and claim all the appropriate deductions when completing their ITR (Income Tax Return). To deal with such legalities and finances, you will need expert assistance to execute an accurate equity compensation taxation and to get your boat sailing smoothly.

Equity compensation taxation reporting requirements

Equity compensation taxation reporting requirements state that Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding) must be used to report any payments subject to withholding under Section 1441 and any taxes withheld throughout the relevant year as required by Section 1461. Also, Form 1042 of the American corporation must provide information about the payments made to the non-U.S. employee (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons). If no tax was deducted from the income paid, Form 1042 reporting is still necessary.

Manage your equity compensation with Eqvista!

With this, you will know that equity compensation taxation is a very technical task requiring strong financial expertise and experience. With Eqvista’s advanced cap table software and leading valuation services, equity management and taxation will become much more accessible and more beneficial for your company. Contact us now and seek experts’ help in complying with equity compensation taxation.