Whilst New Zealand is underway with revamping its tax rules around employee share schemes, the United States has a well-defined framework for the tax treatment of such schemes, including stock options.
US rules
Employee stock options in the United States fall into two categories:
- statutory stock options, and
- non-statutory stock options.
The tax implications are determined by whether a fair market value can be established for the stock option or not. In other words, a ‘readily determined fair market value’.
If the option is not actively traded on a market, by way of which a ‘readily determined fair market value’ can be obtained, it may still be deemed to have a ‘readily determined fair market value’ if:
- the option can be transferred,
- it can be exercised immediately,
- no conditions exist which could significantly affect the fair market value of the option price, and;
- the fair market value of the option privilege can be established.
If no ‘readily determined fair market value’ can be established:
- No taxable event arises upon granting of the option.
- Restricted property rules apply at the time of exercising or transferring the option.
- Taxable income arises upon exercising the option only if the property is substantially vested at the time.
- If the property is not substantially vested at the time of exercise, recognition of income is deferred until the property is substantially vested.
Restricted property rules require that the fair market value (FMV) of property only becomes taxable at the time that it is substantially vested.
Property is deemed to be ‘substantially vested’ when it is transferable or there is not a good chance of forfeiture.
If there is a readily determinable fair market value:
- Non-statutory stock options are treated as compensation.
- The timing of recognition of income is governed by the restricted property rules.
- There is no taxable event upon exercise or transfer.
Statutory stock options
This category covers stock options which meet the following criteria:
- The options are issued under a plan, either an Incentive stock option plan (ISO) or an Employee stock purchase plan.
- The option holder must have been an employee of the company or a related company from the date that the option was granted until three months before the date of exercising the option.
- The option is transferable only upon death.
Statutory stock option plans are not taxable until the stock is sold. That is, the granting of, or exercising of a stock option is not a taxable event.
The manner in which statutory stock option plans are taxable depends on whether the plan is an ISO or an employee stock purchase plan, and whether the following holding period is met or not.
The holding period is the end of the later of:
- the one year period after exercising the option and stock being issued, and;
- the two year period after the option was granted.
If the holding period is met and it is an ISO, the gain or loss is capital in nature, being the difference between the price paid for the stock and the sale price.
If the holding period is met and it is an employee share purchase plan the income is ordinary income, being the difference between the exercise price and the sale price.
If the holding period is not met and it is an ISO:
- The difference between the FMV at the time of exercising the option and the exercise price is ordinary income and
- The difference between the FMV at the time of exercising the option and the sale price is capital gain.
Any loss on sale is a capital loss with no ordinary income.
If the holding period is not met and it is an Employee Share Purchase Plan:
- The difference between the FMV at the time of exercising the option and the exercise price is ordinary income.
- The basis is increased by the amount of ordinary income, and the difference between the basis and the sale price is a capital gain.
US tax rules around employee stock options are complex and include many rules for various scenarios such as options issued at a discount, non-arms’-length transactions. In addition, Alternative Minimum Tax implications arise upon the exercise of ISO plans.
New Zealand rules
It is interesting to observe New Zealand’s rules in comparison to the United States rules.
New Zealand is moving towards taxing an employee at the time that all conditions related to the issue of shares and share options are satisfied.
In the United States, this is covered under the ‘substantial risk of forfeiture’ provisions.
If we make the assumption that a share price is increasing, currently New Zealand employee share schemes with conditions are more favourable to an employee than the US model.
Not only does New Zealand tax conditional employee share schemes at exercise, but there is also no capital gains tax due upon sale – as is the case with the United States employee share schemes.
Double taxation
The current mismatches between the New Zealand tax treatment, and the United States tax treatment often result in double taxation arising out of a timing difference, as well as the manner in which income is taxed. For example, statutory stock options in the United States are not taxable upon exercise, however, these are under New Zealand income tax legislation, yet ensuing gains upon sale are taxable in the United States but not in New Zealand.
There is no relief available under the income tax treaty in force between New Zealand and the United States.
This article provides general information, current at the time of publication. The information contained in this article does not constitute advice and should not be relied upon as such. Professional advice should be sought prior to actions being taken based on the information contained in this article.
NZ US Tax Specialists Ltd disclaims all responsibility and liability (including, without limitation, for any direct or indirect consequential costs, loss or damage or loss of profits) arising from anything done or omitted to be done by any party in reliance, whether wholly or partially, on any of the information. Any party that relies on the information does so at its own risk.