The Election Rests with the Employee, but Is the Right Choice Being Made?

by Daniel Hodgson and Ursula Dyer, KPMG, Sydney
(KPMG in Australia is a KPMG International member firm)

Over the past few years, the Australian government has made significant changes to the country's tax legislation aimed at removing some of the perceived financial barriers to moving to Australia in the hope of attracting more skilled professionals to the country.

For example, foreign nationals who have been residing in Australia temporarily may access their accumulated entitlement to Australian superannuation when returning home. Australia also continues to extend its network of double taxation treaties and social security totalization agreements. Such actions can make it easier for workers to come to (and return home from) Australia by making the burden of taxation less complicated and less onerous.

The government has also been progressively lowering income tax rates, while also increasing the thresholds where these rates apply, thus making the tax system more competitive.

In addition, legislation was passed not too long ago that enhanced Australia's potential appeal to foreign skilled professionals with, effectively, a reduction in the tax base for temporary residents by means of foreign income exemptions, whereby only Australian source income and income from employment is taxable in Australia (more on this below). Furthermore, recent statutory changes to the taxation of employee share schemes ushered in a tax regime for expatriates that is better aligned with other countries, and OECD recommendations (more on this below, also).

This article examines the current statutory environment in Australia and its effect, actual and potential, in particular, on employees who enter Australia on assignment holding unvested employee shares/options.

Temporary Residents

The Tax Laws Amendment (2006 Measures No. 1) Act 2006 introduced the temporary resident rules, thereby transforming taxation for individuals on international assignment in Australia.

As discussed in the Summer 2006 (2006-02) edition of The Expatriate Administrator, from 1 July 2006, temporary visa holders are generally only subject to tax on their income from employment and from Australian investments. For example, any income and gains from personal investments in the temporary visa holder's home country should be exempt from Australian tax. (Of course, this advantage only lasts until they are enticed to take up permanent residency and/or marry a local!)

Employee Share Scheme Income

Legislation has also been introduced to clarify the Australian tax treatment of income from employee share schemes where an employee relocates into, or out of, Australia during the vesting period.

New rules, in particular those introduced by the New International Tax Arrangements (Foreign-owned Branches and Other Measures) Act 2005 and the Tax Laws Amendment (2006 Measures No. 1) Act 2006, bring the Australian tax legislation that applies to employee share scheme income in line with OECD recommendations, such that only the proportion of employee share scheme income that can be attributable to the time spent working in Australia during the period from grant to vest is subject to tax.¹

Paying the Tax Man Upfront

Domestic taxpayers, in certain situations, may make an election to be taxed on the value of their employee shares/options in the year of grant, so that future appreciation may be taxed on capital account, thereby providing the opportunity to access the long-term capital gains tax discount.

Individuals who establish Australian tax residency holding unvested employee shares/options can make an election to be taxed on the employee shares/options in the year of arrival.

In this case, the value of the options/shares in the year of grant (calculated according to formulae in the tax legislation) attributable on a pro-rata basis to the time expected to be in Australia from grant to vest is subject to tax at marginal rates in the year of arrival.

It is important to note that in circumstances where an option is granted with an exercise price equal to the fair market value of the underlying share, the formulae attribute a value to the option. For example, where an option is granted in these circumstances with a 10-year life, the value calculated under the legislation is deemed to be approximately 18 percent of the value of the exercise price.

Interaction with the Temporary Resident Legislation

At first glance, making this election for a temporary resident may be an obvious decision, since it would bring future appreciation onto capital account, which might not be subject to Australian tax provided the individual remained a temporary resident.

However, this was anticipated at the time the temporary resident legislation was introduced. Where they make an election to be taxed on employee shares/options in the year of arrival, temporary residents will be subject to tax on a portion of the capital gains recognized from the sales of those shares.

How Should an Employee Decide Whether or Not To Make an Election?

Unfortunately, a one-size-fits-all approach in deciding whether to make such an election cannot be applied to every taxpayer.

Several variables come into play over which the taxpayer may have limited, or in certain circumstances no, control; and, in some scenarios, may lead to more tax being paid on the employee share scheme income when an election is made. For example, if there is significant share price appreciation between exercise and sale, making an election to be taxed in the year of arrival, and thereby bringing an element of the eventual capital gain into tax, may create a bigger overall tax bill than if no election had been made. Where no election is made, the post-exercise capital gain recognized by the temporary resident would be exempt from Australian tax.

Tax-Equalized Employees

Organizations should be reviewing the application of these rules to their tax equalization policies.

If stock option income is tax equalized, it can be difficult for employers to properly accrue for how much Australian tax will be due, and when it will become payable. Oftentimes, such costs can only be determined when the employee exercises his/her options, many years into, or even after, the assignment.

If the tax-equalized employee makes the election to be taxed in the year of arrival, a portion of the employer's tax costs are known and quantifiable in the first year of the assignment, making it easier to budget by removing the uncertainties described above.

Although a portion of the tax-equalized post-exercise capital gain made by temporary residents may remain subject to Australian capital gains tax, the present operation of some of Australia's tax treaties can potentially modify this. For example, if the shares acquired at exercise are sold after the Australian assignment when the individual is a U.S. tax resident, the treaty applies so that any gain is exempt from Australian tax.

U.S. Citizens and Greencard Holders

As we have discussed above, where no election is made in the year of arrival, the Australian tax liability is generally recognized in the year in which the option is exercised. However, the tax due does not become payable until the tax return is lodged, which, in some cases, may be almost two years later.

For example, options exercised in July 2008 should be reported on the employee's Australian income tax return for the year ended June 2009. If the employee is using a registered tax agent, the return may not need to be lodged, and the tax paid, until May 2010.

As a consequence, options exercised in the second half of the calendar year can present U.S. taxpayers with a mis-match between the time the income is recognized for U.S. tax purposes, and when a foreign tax credit can be claimed, even if the employee claims credits on the accrued basis. The foreign tax credit in this example will arise in a year subsequent to the U.S. tax event, which can present cash-flow problems and add administrative costs in amending prior returns to carry back the foreign tax credits.

Recognizing the Australian tax in the year of arrival will allow U.S. taxpayers to claim a foreign tax credit for the Australian tax due, which may be carried forward until the options are exercised and U.S. income recognized, thereby avoiding the need to amend prior returns to carry back foreign tax credits.

Other Issues

Other issues to consider include the possible additional administrative costs where an assignee pays tax on arrival, and subsequently forfeits the employee share options. In this situation, it would be necessary to claim back the tax paid in the year of arrival.

Similarly, if circumstances change such that the taxpayer is present in Australia for less time than was anticipated at the time of calculating the amount to include as assessable income under the election in the year of arrival, an amended return will need to be filed to claim back some of the taxes paid.

Concluding Thoughts: What Are Organizations Doing To Assist Their Expatriates with Making the "Right" Decision?

The ultimate decision on whether or not the election should be made rests with the employee; Australia's tax legislation does not require the employee to notify his or her employer if such an election is made. However, it is important to establish that the employee is aware of how, and when, the decision should be made, and is properly informed so that he or she can make an apt decision.

Fortunately, as the election does not need to be made until the tax return for the year of arrival is lodged, there is usually some "thinking time" available, which can also offer a degree of hindsight.

The key is communication. Where your assignees are provided with a tax briefing on arrival, it's helpful to put this topic on the agenda and adequately address it during the discussion.

Alternatively, we have observed some organizations provide their employees with a generic guide to the cross-border tax treatment of their employee shares/options; although everyone's facts and circumstances are different, this can form the basis on which advice specific to the taxpayer can be provided.

Where the income is covered by a tax equalization policy, some employers may consider encouraging the firm responsible for preparing the employees' Australian tax returns to discuss the upfront election with the assignees, and its potential impact on the employer.

Footnote:

1 For additional analysis of the statutory regime in this area, see Hayse, N., "Cross-Border Equity Compensation in Australia - Clarity at Last?" in The Expatriate Administrator, Spring 2006 (2006-01).

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.