5 April, 2019
In order to retain talents and maintain their competitiveness, companies in the technology industries often grant employees stock options, making them shareholders of the companys and allowing them to enjoy the benefits of the increase of the stock value.
In an administrative interpretative letter, the Ministry of Finance (“MOF”) discussed the income taxation on the exercising stock option by an employee, indicating that the employee’s income upon exercising the option should be the “difference between the market price of the shares on the exercising date and the exercising price of the option”
However, if an employee is also an insider of the company (e.g., directors or managers of the company), the employee may not sell the shares acquired through exercising stock options during the six months lock-up period’. If the insider employee violates the restriction, the transfer of the shares would be deemed a “short term trading” under the Securities and Exchanges Act (the “SEA”), and the company may collect the profits of such transaction from the insiders as a punishment (disgorgement). It is a stark contrast compared to an employee without insider status, who may freely sell the shares after exercising the stock options. The market price of the shares on the exercising date, on which the above-mentioned MOF interpretative letter based to calculate income, is unrelated to the profits an insider could enjoy. Using the market price on the exercising date to calculate the insider’s profits could result in unfair consequences if the share price drops significantly after the exercising of the option. In such a scenario, the “taxable income” could be higher than the “actual income”, and even a “negative taxable income” could appear.
Lets use an example to show the problem. If a company grants an insider employee an option to buy 100,000 shares of the company stock at $30 per share when the market price of the stock is $20 per share, and the employee later exercises the option to acquire the shares when the market price of the stock increased to $100 per share. Assuming that when the six month lock-up period expires, the market price drops to $50 per share. If the employee now sells the shares, the taxable income would be $700,000 (=($100-$30)x100,000), but the actual income is only $200,000 (=($50-$30)x100,000). If the applicable income tax rate is 40%, the tax payable would be $280,000 (=$700,000×0.4), which is higher than the actual income ($200,000).
We think that a more reasonable way to recognize income for an insider exercising stock options is using the difference between “the market price at the disposable date” (i.e., the date immediately following the expiration date of the six month lock-up period), when the employee may dispose of the shares, and the “exercise price”. Our reasons are as follows:
The principle of ability to pay and the principle of substance over form: During the six month lock-up period, employee is unable to enjoy the increase of the share prices; therefore there exists no justifiable reason to recognize income for that period. Instead, the date immediately following the expiration date of the six month lock-up period should be a more appropriate point of time to recognize income.
The hierarchy of tax laws: Tax laws should respect the disgorgement mechanism under the SEA, assist taxpayers to perform their obligations under the SEA, and protect people’s property right from being violated.
The principle of equality: When respect to the calculation of income derived from the “restricted stock units” under the Company Act, the MOF interpreted that income is the difference between the market price of the shares on the “disposable date” and the exercise price. If, as such, the “disposable date” is already used as the benchmark date for calculating income under tax law in the “restriction of transfer by contract” situation, it should be more fair and sensible to use the “disposable date” as the benchmark date for recognizing income for tax purpose in a “restriction of transfer by law” situation.
Balancing the legislative intent of “employee stock option” and “disgorgement”: Using the date immediate following the expiration of the lock-up period as the benchmark date for recognizing income is not only consistent with the prohibition on short term trading, but also in line with the legislative intent of retaining talents and maintaining international competitiveness through employee stock options. It would be an all-win situation for the government, the general public and the investors.
The MOF should review the soundness of its interpretation concerning the taxation over the exercising of stock options by insider employees. Using the difference between the market price on the “disposable date”, namely, the date immediately following the expiration date of the six month period after the employee exercises the stock option to acquire the shares, and the exercise price to calculate the insider’s income for tax purpose is a more appropriate approach by virtue of the tax laws and various legal principles.
For further information, please contact:
Yvonne Liu, Partner, Tsar & Tsai Law Firm
yvonneliu@TsarTsai.com.tw
