It is very common for U.S. parent companies to include key non-resident alien employees of their foreign subsidiaries in their stock option plans. What happens when the non-resident exercises the options or sells the options? Is the non-resident subject to withholding tax? Is there a U.S. tax filing requirement?
As with any tax question, the answer is “It depends.” It depends on whether the non-resident employee worked in the U.S. If the employee never worked in the U.S., the exercise of the option will not give rise to U.S. taxable income. The grant or exercise of an option may result in taxation in the resident country, according to their local tax laws.
If the non-resident employee worked in the U.S., then he could be subject to U.S. income tax on part or all of the “spread.” Spread is the excess of market price of the stock at date of exercise over the option price. The key is to determine whether the spread is U.S. source or foreign source. Spread will be considered U.S. source based on the number of work days spent in the U.S. during the vesting period.
If the non-resident employee is granted “non-qualified stock options” (NSO’s), the U.S. source portion of the spread will be subject to wage withholding and will be taxable. If the non-resident employee receives incentive stock options (ISO’s), there is generally no U.S. tax implication on exercise. If there is a disqualifying disposition i.e., the ISO is sold within two years after the ISO is granted or one year after the ISO is exercised, then the employee realizes ordinary income on the “spread.” Determination needs to be made if the “spread” is U.S. source or foreign source as mentioned above. If there is no disqualifying disposition and the employee is a non-resident alien at the time of the sale then he will usually be exempt from U.S. capital gains tax on the entire gain.
A popular alternative to stock options is a restricted stock unit (RSU) plan. Under an RSU plan the employee receives a legally binding right to receive stock in the future. The employee is generally required to satisfy a vesting requirement to receive the stock. The employee recognizes ordinary income equal to the fair market value of the stock when distributed, less the amount, if any, that the employee pays for the stock. If the employee is a non-resident alien and worked in the U.S., then the income will be considered U.S. source compensation income based on the number of work days spent in U.S. during the vesting period. Double taxation may occur depending on the laws of the local country.
Under the tax laws of most foreign countries the receipt of stock is subject to immediate income tax notwithstanding the restrictions attached to the stock. Tax treaties play a vital role in many cases as they can help to eliminate cross-border income tax issues and mitigate double taxation of income obtained through stock-options.