Written by Joel Roy C. Navarro, 22 March 2007
To encourage loyalty and continued tenure for key talents within the organisation, multinational companies provide a wide array of monetary and non-monetary incentives to their employees. One such special incentive, known as the “stock-based compensation”, gave employees the opportunity to become part-owners of the company.
Stock-based compensation allows employees, by way of stock options, to purchase their corporate employer’s or its affiliate’s shares of stock at a lower than market price (“exercise price”). The employee enjoys the incentive upon exercising the options since the employer or its affiliate bears the cost of the difference between the market and the exercise price of the shares.
In 2005, a new accounting treatment has been adopted on stock-based compensation involving shares of a parent company. Under Philippine Financial Reporting Standards (PFRS) No. 2, if the employees of a Philippine subsidiary/employer are granted stock options to purchase shares of their employer’s parent company, said employer should recognize in its books the fair value of the options/incentive by recording an employee expense and an equity account. Hence, the parent company initially bears the cost of the incentive on behalf of its Philippine subsidiary and it is up to the parent whether it will recharge the cost to the subsidiary or not.
Regardless of a recharge or not, PFRS 2 already construes the transaction as if the parent company passes on the expense to the subsidiary and makes additional capital contribution to the affiliates to subsidise the expense. These accounting entries are required in the subsidiary’s books despite the absence of formal documents to support the actual recharge and capital contribution.
On the other hand, the employer wonders if the recognition of employee expense and equity accounts in its books will give rise to a taxable event. Can they deduct the employee expense for income tax purposes or will it be subject to withholding tax on compensation? Incidentally, the Bureau of Internal Revenue (BIR) has not yet issued formal guidelines on the taxation of this employee incentive. However, it has issued certain rulings on how to tax similar transactions. Hence, it is worth discussing the issues in line with these rulings.
On the deductibility of the employee expense, the rules is, for an expense to be deductible, it should be ordinary and necessary and incurred in connection with the taxpayer’s trade or business. Following this rule, can the subsidiary construe the employee expense as realized or incurred upon initial recording of the transaction?
Based on past rulings, the BIR has been consistent in allowing said “incentive” as a deductible expense of the subsidiary once the employees exercise the options and that the subsidiary will reimburse its parent company on the difference between the market and exercise price of the shares (BIR Ruling Nos. DA 181-01; 135-97; 27-95).
Therefore, the employee expense becomes deductible when it is realised or when it becomes an actual expense of the subsidiary. For this purpose, it is at the time when the parent recharges the cost to its subsidiary and not when the expense is recorded in the subsidiary’s books that such expense becomes deductible. Similarly, for the equity to be treated as an actual addition to capital, the subsidiary should issue shares or charge the same to additional paid-in capital. In both cases, proper documentation should be in place to support the capital contribution and the actual recharge of the expense.
On the issue of withholding tax, the above-cited rulings also explained that in case of a recharge, the incentive shall be subject to withholding tax on compensation since it is considered an additional compensation to employees. However, a BIR ruling relieved the subsidiary from withholding tax since it is not “in control” of the purchase of the parent company’s shares but the employees who exercised the options (DA ITAD BIR Ruling No. 20-06). Also, the BIR ruled that an entity is not required to withhold tax from the options exercised by retired/resigned employees because of the difficulty or impossibility of monitoring the purchase of shares. The BIR, however, still requires information on the income earned by the employees out of the exercise of the options to check if it is declared in their individual income tax returns (BIR Ruling No. 27-95).
Assuming that employees deal directly with the parent company and that the subsidiary has no information on when the employees will exercise the options, will this be sufficient ground for the non-withholding of tax on the part of the subsidiary as mentioned in the BIR rulings? This is a valid concern that should be addressed by tax authorities since the withholding tax requirement on this scenario will entail a huge administrative burden on the employer. Moreover, taxpayers are advised to get their own BIR ruling before they decide not to withhold tax on this transaction.
Given the potential tax risks on this incentive, employers may opt for other methods of rewarding employees that are less onerous in terms of taxes and administration. For those paying purely compensation income to employees, this issue may not be a concern though there is always room to improve the benefit packages for high-performing employees. After all, the key in maintaining a great organization is to retain its best people.
