Traditionally, US companies focused their attention on the tax treatment of US shareholders and employees holding equity compensation awards in corporate transactions. However, as more and more transactions contain international components, US companies have been necessarily forced to place greater consideration on the tax implications corporate transactions will have on foreign shareholders and employees holding equity compensation awards. The US has a developed system of federal tax laws that, for the most part, clearly address the tax treatment of certain corporate transactions and the impact on US shareholders and employees holding equity awards. The same cannot be said for many other countries. Many foreign countries will tax shareholders and employees in connection with a corporate transaction even though it is considered tax neutral in the US, especially for employees holding tax-qualified equity awards. This column uses one example to highlight some of the international issues a US company should consider when undertaking a global corporate transaction. More specifically, it addresses the differences between the tax treatment of US employees and shareholders in a spinoff and the tax treatment of Israeli employees and shareholders in a spinoff where the company that is spun off assumes the equity compensation awards held by employees of the spun-off company.

What is a spinoff?

In a spinoff, a company (RemainCo) transfers a business segment to one of its wholly owned subsidiaries (the New Company). Often, the transfer of the business segment is completed through a series of asset and share deals as part of an internal reorganization. Upon completion of the internal reorganization, RemainCo will distribute all of the issued and outstanding shares of the New Company to RemainCo shareholders (the Distribution).1 Immediately after the spinoff, RemainCo shareholders will hold a combination of RemainCo shares and New Company shares. The New Company may then list its shares on a US stock exchange, or it may acquire or be acquired by another corporation.

Equity compensation basics

Most US publicly traded companies grant equity awards to employees of their worldwide subsidiaries in order to attract and retain talent. Common types of equity awards granted include restricted stock units (RSUs) and stock options.

An RSU is an unsecured, unfunded promise to issue company shares to the award recipient at a future date, provided that certain time or performance-based conditions are met. The award recipient does not have to pay any consideration to acquire the company shares underlying the RSUs on the vesting date. In the US, the award recipient will typically be subject to tax on the fair market value of the company shares issued on the vesting date. The taxable amount will be classified as additional employment income and will be subject to US federal income taxes, social security contributions (i.e., FICA, to the extent the applicable contribution ceiling has not been reached), and the Medicare tax.

A stock option is a right to buy company shares in the future at an exercise price typically equal to the fair market value of the company shares on the stock option grant date. In the US, the award recipient will typically be subject to tax when the stock options are exercised. The award recipient will be subject to tax on the fair market value of the company shares at exercise less the exercise price paid. The taxable amount will be classified as additional employment income and will be subject to US federal income taxes, social security contributions (i.e., FICA, to the extent the applicable contribution ceiling has not been reached), and the Medicare tax.

Equity treatment in a spinoff

In a spinoff, some employees will remain employees of RemainCo and its subsidiaries (RemainCo Employees) while others will be transferred to the New Company and its subsidiaries (New Company Employees). Typically, the treatment of equity compensation awards held by New Company Employees will be addressed in the separation and distribution agreement governing the spinoff and the related employee matters agreement, which will address the HR aspects of the spinoff (collectively, the Agreements). The Agreements may specify that these equity awards are cashed out, cancelled, assumed for equity, or assumed for a combination of equity and cash consideration. Here, we assume the New Company will assume the equity compensation awards held by New Company Employees, but it is important to confirm that the terms and conditions of the employee share plan and award agreement that govern the equity awards allow for the prescribed treatment in the Agreements.

Basket method or concentrated method

In the context of a spinoff, companies can handle outstanding equity awards in one of two ways. Under both methods, RemainCo Employees and New Company Employees will have their outstanding equity awards adjusted to maintain their pre-spinoff intrinsic value and the outstanding equity awards will generally retain the same terms and conditions. Under one approach, commonly referred to as the "basket method," RemainCo Employees and New Company Employees will hold outstanding equity awards over both RemainCo shares and New Company shares following the spinoff.

Under the other approach, commonly referred to as the "concentrated method," RemainCo Employees will hold outstanding equity awards only over RemainCo shares and New Company Employees will hold outstanding equity awards only over New Company shares. The following discussion addresses the concentrated method.

Adjustment of outstanding equity awards held by RemainCo Employees

Under the concentrated method, RemainCo Employees will hold outstanding equity awards only over RemainCo shares after the spinoff. The outstanding equity awards will be adjusted to maintain their pre-spinoff intrinsic value.

To ensure that the value of outstanding equity awards remains the same, RemainCo typically will apply an "adjustment ratio" to outstanding equity awards to preserve the intrinsic value held by RemainCo Employees. The adjustment ratio generally will equal the closing price of RemainCo shares immediately prior to the spinoff divided by the opening price of RemainCo shares immediately after the spinoff.2

Example: Assume Employee A holds 1,000 RSUs over RemainCo shares prior to the spinoff. The intrinsic value of the RSUs prior to the spinoff is USD 100,000 (1,000 shares × $100 closing price of RemainCo shares immediately prior to the spinoff). The adjustment ratio of two is multiplied by 1,000 (the number of RSUs held over RemainCo shares). After the spinoff, Employee A will hold 2,000 RSUs over RemainCo shares. The intrinsic value of the RSUs immediately after the spinoff is USD 100,000 (2,000 shares × USD 50 opening price of RemainCo shares immediately after the spinoff). Accordingly, the pre-spinoff intrinsic value of outstanding RSUs held by RemainCo Employees is maintained by virtue of the adjustment factor.3

The adjustment of outstanding equity awards to maintain their pre-transaction intrinsic value is not a taxable event for US federal income tax purposes.

Conversion of outstanding equity awards held by New Company Employees

Under the concentrated method, New Company Employees will hold outstanding equity awards only over New Company shares after the spinoff. The outstanding equity awards will be adjusted to maintain their pre-spinoff intrinsic value.

Again, to ensure the equality of the value of the employee's awards, New Company typically will apply a "conversion ratio" to outstanding equity awards. The conversion ratio generally will equal the closing price of RemainCo shares immediately prior to the spinoff divided by the opening price of New Company shares immediately after the spinoff.4

Example: Assume Employee A (employed by the New Company) holds 1,000 RSUs over RemainCo shares prior to the spinoff. The intrinsic value of the RSUs prior to the spinoff is USD 100,000 (1,000 shares × USD 100 closing price of RemainCo shares immediately prior to the spinoff). The conversion ratio of 0.5 is multiplied by 1,000 (the number of RSUs held over RemainCo shares). After the spinoff, Employee A will hold 500 RSUs over New Company shares. The intrinsic value of the RSUs immediately after the spinoff is USD 100,000 (500 shares × USD 200 opening price of New Company shares immediately after the spinoff). Accordingly, the pre-spinoff intrinsic value of the outstanding RSUs held by New Company Employees is maintained by virtue of the conversion factor.5

The adjustment to maintain the outstanding equity award's pre-transaction intrinsic value and the conversion of outstanding equity awards to equity awards over New Company shares are not taxable events for US federal income tax purposes.

US tax treatment of Distribution

For US federal income tax purposes, the Distribution often will be tax free to RemainCo, the New Company, and their respective shareholders, except to the extent that cash is paid in lieu of fractional shares of New Company. For example, if, pursuant to the Distribution, a RemainCo shareholder is entitled to 5.5 New Company shares, the RemainCo shareholder may receive five New Company shares and cash consideration equal to 0.5 of a New Company share. In the US, the distribution of the five New Company shares will be done on a tax-free basis and the cash consideration representing the fractional shares will be taxable to the RemainCo shareholder.

Israeli tax treatment of a spinoff

US multinationals with local subsidiaries in Israel typically will grant equity compensation awards to Israeli employees via one of the tax preferential tracks permitted under the Israeli Tax Ordinance (the Ordinance). In this regard, the following discussion summarizes the permissible tracks, the requirements under each track, and the benefits to award recipients.

 


1 Instead of a distribution, the spinoff can be completed by way of an exchange offer. In an exchange offer, RemainCo shareholders may exchange their RemainCo shares for New Company shares. If all of the New Company shares are not distributed in the exchange, a "clean up" action can be used to distribute the remaining New Company shares to RemainCo shareholders on a pro rata basis.
2 The adjustment ratio does not have to be the closing price of RemainCo shares immediately prior to the spinoff divided by the opening price of RemainCo shares immediately after the spinoff. The adjustment ratio should just be a formula that ensures the intrinsic value of the outstanding equity awards is maintained. The parties should have justification for why a certain adjustment ratio was chosen.
3 The same calculation is applied to determine how many stock options the RemainCo Employee will hold after the spinoff. Also, in the stock option analysis, the "adjustment ratio" is multiplied by the exercise price to determine the new exercise price of the stock options after the spinoff.
4 See note 2, supra.
5 The same calculation is applied to determine how many stock options the New Company Employee will hold after the spinoff. Also, in the stock option analysis, the conversion ratio is multiplied by the exercise price to determine the new exercise price after the spinoff.
6 Before granting equity awards in Israel, a company should determine if there are any securities requirements. To avoid publishing a prospectus in Israel, a company must obtain a securities exemption from the Israeli Securities Authority if it anticipates granting equity awards to more than 35 Israeli employees within a consecutive 12-month period. The securities exemption should be obtained in advance of the grant of these equity awards. Securities laws and other issues are beyond the scope of this article.
7 Equity awards granted under section 102 of the Ordinance may only be settled in shares and cannot be made to an employee or officer that is a 10% shareholder of the company.
8 Certain documents must be filed with the Israeli Tax Authority ("ITA") in advance of the grant of equity awards under a trustee track.
9 Assuming the local subsidiary reimburses the issuer for the cost of the awards, the local subsidiary is entitled to certain tax deductions under the capital gains trustee track and the ordinary income trustee track. There is no tax benefit to the employee or local subsidiary under the non-trustee track (although there is no lock-up period for the employee).
10 If the company is publicly traded, it can obtain a Supervisory Trustee Ruling issued by the ITA. The Supervisory Trustee Ruling allows for the trustee to be informed about the Trustee Track Awards without actually being registered as the owner and without receiving the board resolutions approving the grants. The trustee is also responsible for withholding applicable taxes in connection with the Trustee Track Awards.
11 In Israel, the fair market value when calculating ordinary income is equal to the 30-day average closing price of company shares before the date of grant for public companies, or the 30-day average closing price of company shares after the shares are listed, if the shares are listed within 90 days of grant.
12 An employee share purchase plan is a plan in which employees make contributions during an offering period and at the end of the offering period shares of the company are bought on behalf of the employee at a discount (generally ranging from 5% to 15%).
13 Israel taxes Israeli residents on their worldwide income and nonresidents on their Israeli-sourced income.
14 RemainCo should consider the time and cost of obtaining a tax ruling from the ITA. The process from start to finish can be expensive and may not be worth the cost if few employees hold outstanding capital gains trustee track awards, or shares issued pursuant to capital gains trustee track awards. From start to finish, the tax ruling process can take six months, depending on the resources available to the RemainCo. The ITA also requires RemainCo Employees and New Company Employees to consent in writing to the provisions of the tax ruling if they wish to have the tax ruling apply to them. This includes former RemainCo Employees who receive New Company shares in the Distribution as a result of the settlement of capital gains trustee track awards. It can be administratively difficult to obtain the consents, as former employees can be difficult to track down and communicating the benefits of consenting to the ruling to the employees and former employees can be difficult.
15 For example, assume Employee A held one RemainCo share prior to the spinoff. The fair market value of the RemainCo share prior to the spinoff was USD 500 and Employee A's basis in the RemainCo share was USD 100 (i.e., USD 400 of built-in-gain). RemainCo then distributes all issued and outstanding New Company shares pro rata. Assume Employee A now holds one RemainCo share and one New Company share. After the spinoff, the fair market value of the RemainCo share is USD 250 and Employee A's basis in the RemainCo share is USD 50. The fair market value of the New Company share is USD 250 and Employee A's basis in the New Company share is USD 50. By making a pro rata adjustment to the basis of the shares, the built-in-gain is preserved after the spinoff.

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