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Unquoted US stock options-hidden perils

Posted on April 06, 2011

Quite a few of our UK clients have subsidiaries or operations in the US and offer stock options to their US employees to mirror the incentive arrangements they have in the UK. However companies considering the offer of stock options in unquoted shares should consider the risks carefully.

The problems arise from a worthy measure known as the Job Creation Act, introduced in 2004. No problem, you might think, in creating jobs. But during the passage of the Act through Congress, a piece of legislation was added that had nothing to do with job creation, but was instead designed to tax deferred remuneration: a measure with some similarities to the truly ghoulish legislation now being proposed by the UK government to attack remuneration by third parties (see Kafka lives in this month's newsletter).

Taxing deferred remuneration

The intention behind the US regulation is to impose a tax penalty in cases where companies and employees enter into arrangements where remuneration is declared but not paid until a later date. This arguably results in a delayed payment of tax. The most common example is a share option granted with an exercise price less than the fair value of the share. The discount is regarded as a gift of value but in normal circumstances would not be taxed until the option is exercised.

The Job Creation Act seeks to right this wrong by imposing a retrospective charge to income tax on the discount, plus interest, penalties and an additional tax of 20 per cent. Some states, for example California, impose a further 20 per cent. tax plus interest and penalties of their own. But in the case of an unquoted company, the question of what is fair value is a matter of judgment. Companies and their employees can therefore fall foul of the regulations inadvertently and the consequences of getting it wrong are severe.

Problems for ISOs

Further problems may arise if the option is intended to be a qualified option or Incentive Stock Option (ISO). Provided certain conditions are satisfied, the recipient of an ISO pays capital gains tax rather than income tax on the sale of shares acquired through exercise of the option. One of the conditions, however, is that the exercise price must not be less than fair value on the date of grant. If the US Internal Revenue Service (IRS) subsequently establish that the exercise price was less than fair value, the option will not qualify as an ISO. Accordingly, the tax on exercise will be higher to start with, even before the penalties and additional taxes are applied.

How can US employers avoid these perils? For quoted companies, there is usually no difficulty since reference can simply be made to the quoted price or an average of quoted prices over a period of time. But for unquoted companies the choice is stark take the risk, or commission a valuation of the shares which will satisfy the demanding criteria set out by the IRS.

IRS valuation requirements

In the UK, HM Revenue & Customs will often accept quite simplistic methods for valuing unquoted shares. Often, this amounts to nothing more than averaging profits over a number of years and applying a suitable price earnings ratio. The IRS, however, goes further. It requires that the following be included in any reasonable valuation method:

  • the present value of the company's future cash flows;the market value of equity interests in substantially similar businesses that can be determined readily by objective means;
  • the effects of any control premiums and/or marketability discounts;
  • recent arm's length transactions involving the sale or transfer of the stock or equity interests;
  • whether the proposed valuation method is used for other purposes that materially affect the company, its shareholders, or creditors;
  • other relevant factors such as control premiums or discounts for lack of marketability.

This requires a much more detailed level of analysis. To comply with IRS requirements the valuation should also be undertaken by a qualified valuer who should be a member of recognized professional appraiser organization or have recognised, relevant professional qualifications. A valuer who produces a report which the IRS considers to be grossly inaccurate also faces large fines under Sec. 6695A of the Internal Revenue Code and other penalties. For these reasons, the costs of commissioning a US valuation can run from $20,000 to $30,000 or more.

Some US advisers take the view that, for smaller unquoted companies, the chances are that the IRS will never look at the valuation issue. However, we would advise caution when granting US options in unquoted companies.

If you would like more information on any of the topics raised in this note, please call us on 020 8949 5522 and ask to speak to one of our advisers.

 
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