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By Thomas Z. Reicher, Robert H. Miller and Thomas S. Welk
Cooley Godward Kronish LLP, San Francisco, San Diego, and Palo Alto, CA
As companies in the United States increasingly expand their operations abroad, the need to "export" equity compensation programs to foreign locations will grow. One such exportable program is an employee stock purchase plan ("ESPP") under §423 of the Internal Revenue Code. Although some employers seek to achieve international uniformity of their ESPPs, many employers recognize that variations among business models, local business conditions, foreign law requirements, local HR practices, and the needs of each workforce will dictate that an ESPP be tailored to take account of such variations. Fortunately, the final Treasury regulations under §423, issued in November 2009, have provided clear guidance on how to achieve such result, unlike the proposed Treasury regulations under §423 that were issued in July 2008.
The final Treasury regulations under §423 take an offering-by-offering approach to an ESPP's compliance with §423, allowing a multi-national employer to adopt a single ESPP with multiple offerings, one for U.S.-based employees and one or more for employees based outside of the U.S. For example, assume that ABC Corp. has a wholly-owned foreign subsidiary ("FS") and provides for a separate U.S. offering ("US Offering") and foreign offering ("FS Offering") under the ABC Corp. ESPP. For reasons of local HR practices, the terms of the FS Offering limit eligibility to employees at the manager level and above, which clearly does not comply with the eligibility requirements of §423. Under the offering-by-offering approach, the US and FS Offerings under the ABC Corp. ESPP are analyzed separately from a §423 qualification perspective, and the non-compliant FS Offering will not endanger the compliant status of the US Offering. Because employees in foreign jurisdictions generally will not care about the U.S. tax attributes of a §423 compliant offering, the offering-by-offering approach gives a multi-national employer a relatively free hand in designing its foreign offerings. The offering-by-offering approach also permits the multi-national employer to pick and choose among foreign entities that it will and will not cover under its ESPP.
For corporations with multi-national operations and employees, care must be taken to correctly classify all foreign entities for U.S. tax purposes. In particular, employees of foreign branch offices of a U.S. corporation and employees of foreign entities owned by a U.S. corporation that are disregarded for U.S. income tax purposes are treated, respectively, as employed by the U.S. corporation of which the foreign office is a branch or as employed by the U.S. parent corporation of the disregarded entity. This will mean that an ESPP offering of the U.S. corporation will have to include the branch and disregarded entity employees, subject to the narrow permitted exclusions from such offering under §423 that can only be applied uniformly to all employees (discussed below), and the failure to do so will cause disqualification of the U.S. offering, with undesirable tax consequences for participating U.S. employees.
The narrow permitted exclusions from an ESPP offering allow the offering to exclude citizens or residents of foreign jurisdictions if the grant of ESPP purchase rights is prohibited under the laws of the foreign jurisdiction or if compliance with the laws of the foreign jurisdiction would cause the plan or offering to violate the requirements of §423. Moreover, the general requirement of equal rights and privileges under ESPP purchase rights contains an exception that allows purchase rights to be granted on less favorable (but not more favorable) terms to citizens or residents of foreign jurisdictions. These exceptions for citizens and residents of foreign jurisdictions are helpful, to a degree, in designing a single worldwide ESPP offering that covers U.S. and foreign employees (or in maintaining the qualification of a U.S. offering that should have been extended to cover employees of a branch office or disregarded entity), but the requirements of a foreign law prohibition, resulting §423 non-compliance, or less favorable terms for foreign citizens and residents are insufficiently flexible to allow a practical adaptation of a U.S. offering to foreign needs and conditions. In the example above, the terms of the FS Offering could not have been made part of a single worldwide offering, and the multiple offering approach permitted under the final §423 Treasury regulations, therefore, is crucial.
Finally, the issue of foreign currency conversion should be addressed in connection with offerings under an ESPP that are extended to foreign employees. If foreign employees are participating in an offering that includes U.S. employees, it is particularly important that the conversion between foreign currency and U.S. dollars not result in a purchase price that is less than what is permitted by §423(b)(6), which sets the minimum price at the lesser of 85% of the fair market value of a share on the grant date of the purchase right and 85% of the fair market value of a share on the purchase date. Private letter ruling guidance from the IRS suggests that, under such a lesser of pricing formula, converting the U.S. dollar prices to local currency as of the purchase date and then determining the number of shares purchasable with accumulated local currency payroll deductions should be a reasonable method that will not violate §423(b)(6). Converting local currency payroll deductions to U.S. dollars on the purchase date for purposes of determining the number of shares purchasable under a lesser of pricing formula would also be consistent with such guidance, and this appears to be the approach taken by a number of U.S. companies with ESPPs that cover foreign employees. Even with a separate ESPP offering for foreign employees (which will insulate the U.S. offering from any §423 compliance concerns posed by foreign issues like currency conversion), it still will be important, as a matter of good plan administration, to establish the method by which foreign currency will be valued under the offering's pricing formula.
For more information, in the Tax Management Portfolios, see Reicher, Miller and Welk, 381 T.M., Statutory Stock Options, and in Tax Practice Series, see ¶5830, Employee Stock Purchase Plans.
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