How to Grant Stock Options to Foreign Employees
Need help onboarding international talent?
Employee stock options are one of the most effective ways for startups and high-growth companies to attract and retain top talent. With the rise of remote and distributed work, those options are still viable but they become more legally complex to execute, especially when it comes to international tax compliance.
This short guide on incentive stock options suggests mechanisms to reward your most committed international employees with equity without accidentally breaching tax law.
What are stock options?
Stock options are a common form of equity compensation. In 2019, there were over 6,200 unique companies offering employee stock options, allowing them to acquire shares of a company at a fixed price after a fixed amount of time.
Companies can offer stock options to their local employees and independent contractors, as well as international employees and contractors. However, stock options become more legally complex to perform for remote, foreign employees, especially when it comes to international tax compliance.
Fortunately, you can choose between multiple stock option plans— each of which stands out depending on your company’s equity structure, who you want to award equity to, and where they live.
Types of stock option plans
You can offer company equity as remuneration to any international worker, whether they’re employed under a local subsidiary or hired through a third party like an employer of record (EOR).
There are several plans to choose from:
1. Incentive stock options (ISOs)
Incentive stock options (ISOs) are stock options structured in a way that qualifies them under a special section of tax law in the United States (Section 422, to be specific).
This tax law gives ISO holders — your employees — a tax break if they meet certain conditions, which makes this a popular form of compensation. But this only applies to employees under the US tax system. Foreign tax systems won’t recognize this tax advantage.
Furthermore, you can only grant ISOs to employees. Independent contractors don’t qualify. So international employees miss out on this tax structure, and contractors everywhere are not eligible. For this reason, it’s generally easier to go with a different stock option structure unless you have exclusive full-time, American employees.
Why it’s unique: ISOs gives US employees a tax break, but they don’t offer many advantages to international workers.
Some companies have post-termination exercise clauses, which give employees a short period (typically, though not always, 90 days) to exercise the option after leaving the country. Without a post-termination exercise clause, ISOs expire 10 years after the grant date. Also, they only apply while an employee works for a company and 90 days after the employment relationship is terminated.
2. Non-qualified stock options (NSOs)
Non-qualified stock options (NSOs) do not meet the conditions for special tax treatment under US tax law. But you can grant NSOs to anyone, including foreign employees and non-employees, like freelancers and independent contractors.
NSOs generally receive the same tax treatment around the world. NSOs are taxed at ordinary income tax rates (without any special tax breaks) two times:
- At the time of exercise of the option;
- At the time of selling the shares.
Why it’s unique: NSOs don’t require an employment relationship between the company and the person who’s granted the stocks. Contractors, advisors, board members, and consultants are all eligible to receive NSOs.
Restricted stock options (RSUs)
Restricted stock units (RSUs) are not technically stock options, they are actual shares provided to workers gradually. Employees with RSUs receive shares through a vesting plan after completing agreed milestones, usually related to performance or time spent with the organization.
The vesting period, or the time it takes to gain access to the shares, is usually four years. Under most plans, the RSU-holder cannot access their shares until the “cliff,” or one year after the grant date. They can sell or hold 25% of the shares after the first year, 50% after the second year, and so on, until the vesting period is completed.
As soon as the stock units vest, they become active at a fair market value, and the employee pays income tax for the value at a standard tax rate. RSUs can be granted to non-employees like independent contractors.
Why it’s unique: RSUs can be granted to non-employees, who can sell them at their discretion upon vesting. RSUs don’t have to purchase their stocks, as is the case with ISOs and NSOs. Instead, they receive stocks gradually throughout the vesting period.
Employee stock ownership plans (ESOPs)
Employee stock ownership plans (ESOPs) refer to qualified benefit plans that grant employees company stock. Employees can choose when to buy shares, usually at a predetermined price; purchasing shares makes the employee a partial owner, or shareholder, of the company. US-based and foreign employees are eligible to participate in an ESOP.
ESOPs also often have vesting plans, incentivizing employees to stay with the company. Shares acquired through an ESOP are taxed as perquisite at the date of exercise, or when the employee exercises the share.
ESOPs are often a part of total employee compensation and represent trust funds with several ways of financing: through self-funding (contributing shares to the ESOP), bank loans, or indirect loans (where the company borrows money and gives it to the ESOP).
Why it’s unique: ESOPs help corporations to align their employees’ and shareholders’ interests as employees themselves become shareholders and are incentivized to do what’s best for the company.
Employee stock purchase plans
Employee stock purchase plans are company equity plans where employees can buy shares at a discounted price by contributing with payroll deductions.
The ESPP provides a discount (typically 15%) on the fair market value of the stock. The fair market value is generally what the stock trades at on the public market, which is why this plan is more common with public companies. Some ESPPs can offer special tax treatment if they follow certain requirements (Section 423); otherwise, ESPPs are taxed like regular taxable income, once when you purchase and again when you sell.
All employees, even international employees, are eligible for ESPPs.
Qualified vs. non-qualified ESPP
Qualified ESPP frees the employees from paying the taxes on the discount they received at the time of buying the stocks. Non-qualified ESPP doesn’t provide such benefits: the employees need to pay the taxes on the discount as if it were regular income.
Why it’s unique: Unlike the RSUs, ESPPs aren’t granted to employees. The employees get an opportunity to purchase options of company shares.
Stock Appreciation Rights (SARs)
Stock Appreciation Rights (SARs) depend on the company’s stock price and allow employees to receive, either in cash or in stock, the sum by which the company stock value increased during a specified period of time.
In this arrangement, an employee or a contractor doesn’t actually own any shares. They get the difference in value of the shares when it increases–companies typically pay SARs in cash.
Why it’s unique: SARs let holders benefit from increases in stock value without having to purchase any.
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Why is granting stock options to international workers difficult?
International workers need to pay income tax in their country of residence when they receive money from stock options, even by a US company.
Countries define stock options in different ways, taxing them at different rates. Consult a local CPA, tax professional, or employer of record to understand the legal and tax implications.
Foreign employees could be taxed differently
Some countries don't impose any taxes on awarded stock options before vesting or exercising. Others treat a stock option grant as an employee benefit and require tax withholding as soon as the grant is awarded. Foreign workers with stock options like RSUs may be responsible for calculating the withholding tax on their own.
In the US, workers can take advantage of tax laws that reduce their tax liability. For example, holding stock for a longer period of time allows them to qualify for a reduced long-term capital gains tax rate, which is usually 15%, but may drop to 0% if you meet specific conditions.
These tax reliefs and advantages may not be available in every foreign country.
Residency in the US can complicate tax obligations
If an international worker has ever resided in the US while working, US income taxes come into play. The worker may need to pay income tax to the IRS on the spread—the difference between the stock’s market price on the exercise date and the exercise price.
Based on the number of workdays the employee was in the US during their vesting period, the spread will be split into US-sourced and foreign-sourced income. If the foreign worker was granted NSOs, the US-sourced portion of the spread is taxable and subject to wage withholding.
If the non-resident never worked in the US, they aren’t subject to US income tax (unless they’re a US citizen—US citizens are taxed by the US no matter where they live and work).
Foreign workers may not be able to accept stock options
The securities laws in the country your employee lives in may have restrictions or exemptions related to stock options.
In Canada, for example, there are no restrictions. But in Argentina, the offer must be limited to employees only and the stocks can’t be traded in Argentina.
Foreign workers may have additional reporting requirements
Your foreign employees may have foreign exchange control laws requiring them to report ownerships of shares in foreign companies. Option grants may be exempt from this rule in some locations, but it’s an important compliance consideration.
Option expiration may be different abroad
Labor laws may affect how stock options expire. In the US, unvested stock options generally expire on the resignation or termination date. However, some countries consider the options to be part of the severance package of the worker, meaning they retain options even after termination.
Stock options may affect the contractor-client working relationship
Granting stock options to a contractor increases the direct relationship between contractor and client. This adds an additional risk to worker misclassification or permanent establishment. Companies should weigh the benefits of a competitive compensation offer against the risk of compliance issues.
Questions to consider while choosing your equity compensation strategy
Figuring out equity compensation is a worthwhile investment for many companies wishing to reward and retain their international talent.
Consider the following situational questions to guide your compensation strategy:
Are you a startup or a publicly traded company?
Publicly traded companies may sometimes offer ESOPs, if they’re able to afford them, since ESOPs may cost hundreds of thousands of dollars to set up. Publicly traded companies also use ESPPs because the payroll deductions simplify distribution of stocks to large workforces.
Most startups offer NSOs, ISOs, and RSUs, as they are more affordable and can serve as a great incentive to keep the key employees while the company begins its journey (and hopefully gets big). Facebook is a good example of how an employee can earn a substantial amount of money by owning shares in a promising startup.
Do you have international contractors to award?
If so, consider using NSOs. NSOs are very flexible and are available to both employees and independent contractors. Both of these stock options can be granted to foreign individuals and employees of a foreign subsidiary.
Is your international employee employed through an employer of record?
Most companies employ international employees through an employer of record. The employer of record, such as Deel, serves as the employee’s direct employer. But Deel can’t issue equity belonging to other companies—only Deel equity. To issue equity to an EOR employee, the company needs to establish a “side agreement” on their own with the worker.
Is the international employee employed through a subsidiary?
Awarding options through a foreign subsidiary may have tax implications for the US parent company.
For instance, in Belgium, tax withholding is required for the employer if the subsidiary is involved in the delivery of underlying shares or awards or plan administration. In the Czech Republic, the employer needs to withhold and report the cost of the option benefits, but if the subsidiary reimburses the parent company these expenses, it’s allowed a tax deduction.
If this sounds confusing, that’s okay. These examples demonstrate how quickly complicated stock options grants to foreign employees can become. Don’t get intimidated though; reach out to a tax professional or global hiring expert to make sense of your options.
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Disclaimer: The material and information available in this article is provided for general informational purposes and should not be treated as legal and/or accounting advice; consequently, you should not rely upon this material for making any business decision. You should seek professional advice.