Article 3.2.2 of the OECD Model Rules include an election (the ‘stock-based compensation election’) to replace the deductible amount of stock-based compensation in the financial accounts of the constituent entity with the amount deductible in its corporate income tax return. This applies to shares/stock and options and warrants related to them.
As with a lot of the Pillar Two GloBE adjustments, the intention here is to replicate the tax treatment under domestic tax in many jurisdictions.
For financial accounting purposes, companies generally account for stock-based compensation based on the present value of the stock option at the time of issue and amortize that amount over the vesting period.
However, for tax purposes, companies generally deduct the value of stock-based compensation based on the market value of the stock.
Eg a company may be able to deduct the present value of the stock option at the time of issue over the term of the option, and then the difference between the present value at the time of issue and the ultimate market value when the option is exercised by the employee.
If the market value of the stock increases over the life of the option, as it frequently does, the tax deduction for the company will be higher than the financial accounting expense. This isn’t a temporary difference and therefore won’t be picked up in the deferred tax calculation. This would then result in a lower Pillar Two GloBE effective tax rate (ETR).
This election, therefore, looks to replicate domestic tax laws that allow a tax deduction based on the value of stock at the exercise date. If the election is made and a tax deduction is taken on the issue of the option (as permitted under the domestic law) but it is not subsequently exercised, the amount taken as a deduction for Pillar Two GloBE income is treated as additional Pillar Two GloBE income.
The election is a 5-year election on a jurisdictional basis (ie it applies to all constituent entities in the jurisdiction).
Stock-Based Compensation Election – Example
Whilst the treatment for both financial accounting purposes and domestic tax treatment can vary, depending on the GAAP and domestic tax regime, this simple example illustrates the key principles.
MNECo1 is part of an MNE group subject to the Pillar Two GloBE rules.
In year 1 it issued 1.2 million stock options to employees with an exercise price of 20 euros per share. The current share price is 20 euros per share.
The fair value of each stock option is 10 euros per share.
The stock options vest over a 3 year period.
For accounting purposes, there will be an expense in the financial accounts in years 1-3 of 4,000,000 euros (400,000 shares * 10 euro/share). The accounting entry each year is:
Dr P&L – Stock-based compensation expense 4,000,000
Cr Balance sheet – Additional Paid in Capital (APIC) 4,000,000
In year 4 the stock options vest. All of the employees exercise their options. The share price is 40 euros per share.
The accounting entry is:
Dr Cash 48,000,000
Dr Additional Paid in Capital 12,000,000
Cr Common Stock & APIC* in Shareholders Equity 60,000,000
*Additional Paid-In Capital (APIC)
In this case, the APIC account is reversed when the options are exercised. Note when the stock options are exercised there is no impact on the P&L as the entries go to the balance sheet. Therefore, the company effectively gets a deductible expense for financial accounting purposes of 4,000,000 euros per year for the 3-year period.
For tax purposes, in MNECo1 jurisdiction, the company gets a tax deduction equal to the value of the shares received by the employee at the date of exercise, less any amount paid for those shares by the employee ie 24,000,000 euros.
In this case, there would be a choice between using the accounting treatment and taking a 4,000,000 euros deduction to reduce profits for the 3 years or the tax treatment and a 24,000,000 deduction in year 4.
This is actually not the end of the matter though as there is also a deferred tax implication due to the timing difference between the recognition of the tax expense and the financial accounting expense.
Let’s assume the tax rate in MNECo1’s jurisdiction is 20%.
In each of the 3 years deferred tax would be provided for as:
Dr Deferred Tax Asset (Balance Sheet) 800,000 (4,000,000 * 20%)
Cr Deferred Tax Expense 800,000
After the three years when the tax deduction is obtained, the deferred tax asset is released. In this case, this would be:
Dr Deferred Tax P&L 2,400,000
Cr Deferred Tax Asset 2,400,000
Therefore the 800,000 euro credit to the P&L for deferred tax would decrease the ETR which would offset the expense in the P&L for share-based compensation.
Similarly, the release of the deferred tax asset would increase covered taxes and increase the ETR.
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