Stock-based compensations (SBCs) which can be simply described as a way of paying employees, executives, and directors of a company with shares in the company is on the rise, for obvious reasons, as it is not only an effective tool for the companies to recognise employees’ contribution to the company, but also to retain them by imbibing a sense of belonging and ownership. SBCs are even more relevant to start-ups who need a substantial amount of their working capital to invest in business growth or expansion, and do not have adequate cash to lure or retain talented employees.
SBCs can generally take two forms. The first form is employee stock options (ESOs) structure whereby an employee is granted the right to buy a specific number of shares of the company for a fixed price (exercise price) within a specific timeframe (exercise window) which would ordinarily be below the market price of such shares. The second form is restricted stock units (RSUs) structure, and this involves the granting of shares to the employees for free. Both ESOs and RSUs are always subject to performance and/or time-based vesting conditions. Further, they are not necessarily granted in relation to the direct employing entity but rather, by the ultimate parent company of the multinational group, especially if such parent company is a public company which makes it easier for employees to cash their shares would they so wish.
Despite the attractiveness of SBCs, compensating employees using stocks has various tax implications both on the side of the employee and the employer including whether and when the stocks acquired through any of SBC structures are taxed as employment income; whether and when the shares granted for free, or the discount granted on exercise of an ESO can be an allowable expense on the side of the employer; tax treatment of income derived from the shares acquired through SBC schemes such as dividends and capital gains; and whether it would make any difference if the shares were not granted in the directly employing entity. All these issues are considered in this article.
Employment income tax considerations
In terms of the Rwandan income tax law (2018), employment income includes all payments paid to an employee by his/her employer (whether in cash or in kind) in relation to the work performed including payments made in respect of previous, current or future employment. This clearly suggests that stock-based compensation constitutes a payment in kind, and therefore a taxable employment income.
What is not clear in the law is when an SBC can be taxed especially that it is in most of cases subject to time and performance based vesting conditions, and on this, one is of the view that an SBC can be taxed upon fulfilment of vesting conditions, and/or exercise of the option in case it is structured as an ESO. This view is based on fact that it is only upon satisfaction of the vesting conditions that an employee would be said to have full and unfettered right over an SBC
Another relevant feature of SBCs relates to the determination of the taxable value, and this should be the fair market value of the shares granted at the time of vesting or the difference between the fair market value and the strike price for an RSU or ESO structures respectively. When the employing and/or the issuing company are publicly traded, it would be a valid approach to consider the price at which the company’s shares are trading on the exchange as the fair market value of the shares for tax purposes. Where the employer or the issuing company is not listed, the employer would have to perform a valuation for it to be able to determine the fair market value of the shares for tax purposes.
Dividend and capital gain tax considerations
Shares acquired by employees by way of SBCs can generate income while they are still held by the employees (dividends) and/or at the time of their disposal (capital gain). While there should be dividend withholding tax (WHT) and capital gain tax (CGT) on these types of income, article 20 of the Rwandan income tax law (2018) exempts income "accruing (…) from employees’ shares scheme within [the employing] company” from income tax, and on the basis of this provision it can be fairly argued that dividends paid and/or capital gain arising from the disposal of shares held by employees in their employing companies are exempted from dividend WHT and CGT. It should be noted the Rwandan income tax law (2018) is in the process of being amended and among other changes proposed, include the exclusion of applicability of this exemption to employees holding shares representing more than 10% of the company’s share capital.
Expense deductibility issues
While the aspects considered above are more relevant to employees, employers would be more interested in whether they are entitled to claim (as expense) the value of shares freely issued to their employees or discount in case an ESO structure is adopted. The law is not prescriptive on this, but in the same way as cash benefits paid by the employer can be validly claimed as deductible expenses, the employer should also be entitled to claim the fair market value of the shares freely issued to the employee or the discount offered for an ESO structure, or in case the shares are issued by another group company, subject to transfer pricing requirements, expenses incurred by the employing entity in that regard.
SBCs equally (in one’s view) meet the deductibility criteria provided for under article 25 of the Income Tax Law (2018) namely being incurred for the direct purpose of the business and being directly chargeable to the income; corresponding to a real expense; leading to a decrease in the net assets of the business; and being used for activities related to the tax period in which it is incurred. Allowing SBCs as deductible expenses would also be in line with one of the principles underlying income taxation i.e. the matching principle whereby the tax treatment of a transaction for one taxpayer should be to a certain extent informed by tax treatment of such transaction on the side of another taxpayer. In this vein, since SBCs are taxed as an employment income in the hands of the employees it should also be recognized as an expense on the side of an employer. The aspect of timing is also relevant for deductibility of SBCs, and similarly to taxation, SBCs can be claimed as expense once the shares awarded are vested, and where an ESO structured is adopted, once the option is exercised.
On the whole, there are various legal and tax considerations associated with structuring SBCs and employers should seek professional advice in structuring their SBC schemes to avoid running afoul with tax laws. Further, given how SBCs are becoming a preferred way of attracting, motivating and retaining talents, certainty on tax treatment of SBCs and all aspects thereof is needed. The tax administration should issue a practice note on tax treatment of SBCs including valuation issues, deductibility, etc.
The views contained herein are those of the author.
The writer is a tax and corporate commercial lawyer, and Senior Associate at ENSafrica Rwanda.
Email: dnzafashwanayo@ensafrica.com