With management teams growing more international, it is common
for employees who have been tax resident in the U.K. for many years
to also become subject to taxation in another country. Home country
tax risks, however, are often overlooked and can create last minute
problems on a transaction.
Private equity firms frequently acquire businesses from other
financial institutions and/or founders. The target entity often
employs U.S. citizens who have resided in the U.K. for several
years. This has a number of tax implications since the U.S. taxes
its citizens on their worldwide income, even when the individual no
longer resides the U.S. To complicate matters, the U.S. has several
tax charges that can lead to a significant and unexpected tax
burden.
This article discusses three U.S. personal tax issues that can lead to additional tax liabilities for U.S. expats in the U.K.:
- Golden parachute payments;
- Deferred compensation; and
- Tax elections on receipt of restricted stock.
Golden parachute payments
Under Section 280G of the U.S. Internal Revenue Code, or IRC), an additional 20% tax (known as an excise tax) is levied where certain employees receive "excessive" payments as a result of a change of control of the business for which the employee works. The 20% tax is in addition to any regular taxes payable by the employees.
To be subject to these provisions, the employees need to be senior and the payments excessive. In broad terms:
An employee will be senior for these purposes if they are:
- Officers;
- Shareholders who own over 1% of the fair market value of all share classes; or
- Highly compensated individuals; i.e.:
- Those who have annual gross income of at least $155k; and
- Part of the highest paid 1% of employees or, if less, the highest paid 250 employees.
A payment is considered to be "excessive" if it is exceeds three times the individual's average taxable earnings over the five calendar years preceding the calendar year in which the transaction occurs.
Where a U.S. citizen holds incentive equity which is being sold as part of the M&A transaction, it is relatively easy for the excessive threshold to be exceeded, given potential significant gains being realised.
Fortunately, private companies can avoid the impact of section 280G by obtaining the approval of the target's shareholders for the compensation payments to be made to the impacted individuals prior to the sale. There are other methods that may also be implemented in the public company context (where shareholder approval is not available) to mitigate some of all of the impact of section 280G.
While shareholder approval is a fairly straightforward approach in private equity transactions, 280G presents significant issues for publicly traded companies. Undertaking the analysis (typically not straightforward given the need for historical earnings information) and drafting the necessary documentation needed to either obtain shareholder approval, or analysing and implementing other mitigation approaches where shareholder approval is not available, is time consuming, can impact the overall transaction timetable, and in some cases delay completion, especially if U.S. taxpayers are not identified early in the sale process.
Deferred compensation
A 20% excise tax (in addition to regular tax) arises in relation to certain deferred compensation arrangements (Section 409A of the U.S. Internal Revenue Code). Deferred compensation exists when an individual obtains a legally binding right to compensation in one taxable year, which is, or may be, payable in a subsequent taxable year. Deferred compensation is defined very broadly and can pick up elements of compensation that would usually not be viewed as deferred compensation (e.g., stock options and severance payments, based on the circumstances).
For U.S. citizens resident in the U.K. for many years, this excise tax typically arises is in the context of share option awards, which is a common element of compensation for many U.K.-based companies.
Share options are exempt from the deferred compensation rules if the exercise price is at least equal to the fair market value of the underlying shares on the grant date. However, identifying this exception can be problematic for U.K. businesses because the U.S. assessment of fair market value is prescriptive.
Therefore, whilst a U.K. business might intend to use current market value as the exercise price, and unless specific U.S. valuation advice is taken, for U.S. purposes it may well be below market value. Where this is the case, excise tax will apply at such time as the options vest, even if they remain unexercised.
Tax elections on receipt of restricted stock
It is common for employees to acquire shares to provide them with an equity incentive and align their interests with those of the shareholders. Such shares are typically subject to restrictions such as good/bad leaver provisions and/or limitations on transferability.
Under U.S. tax law, restricted shares are generally subject to tax when they become vested. However, recipients of restricted shares may make an election under section 83(b) of the IRC to be taxed on the fair market value of the shares at the time of receipt. In the event such an election is made, vesting will not be a taxable event, and all future gain above the amount recognised as income at the time of the election will be capital gain. The risk is that in the event the shares are subsequently forfeited, the recipient will not be able to take an income adjustment (other than a capital loss) or recover the tax previously paid.
Where an employee fails to file an election under section 83(b) relating to restricted stock acquired, the employee will be taxed at ordinary income rates (up to 37%) on the full value of the shares upon vesting. Had an election been made, the gain between grant and vesting would have been taxable as capital gain (capped at 20%, assuming the shares are held for at least one year).
If restricted stock has relatively low value on the grant date, and is expected to significantly appreciate in value between the grant date and vesting date, the employee who fails to make an election can be subjected to income tax at rates much higher than the rate that would have applied had the election under section 83(b) been made. The need for these elections is often overlooked where a U.S. citizen has resided in the U.K. for many years.
How can A&M help?
With professionals located both in the U.K. and the U.S., the A&M Tax team has considerable experience in assisting clients with the above issues, particularly in the context of a potential exit transaction. As part of our tax due diligence services, we identify whether any target group employees are subject to U.S. taxation and if so, whether any of the above matters needs to be considered in further depth.
At A&M Tax, we can assist with the following (but not limited to) U.S. tax issues:
- Determination of whether 280G applies to payments and if necessary, a review of the calculations and compliance with the administrative requirements;
- Review of stock option plans to determine whether 409A might apply and assistance with any post-close work in relation to correcting/dealing with non-exempt or noncompliant plans;
- Review of whether valid 83(b) elections have been made and filed within 30 days of acquisitions for direct acquisitions of restricted equity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
