03/09/2004 - As part of a drive to help governments rationalise their tax policies, the OECD has issued a series of recommendations designed to achieve a common interpretation of how tax treaties apply with respect to employees or directors who receive stock-options as part of their remuneration.
 
Over recent years, stock-options have come to account for an increasing share of executive pay packages. This has given rise to lively debate regarding their effect on incentives, risk taking and corporate governance.

The use of stock-options is influenced by different countries’ treatment of various forms of remuneration, raising a number of tax policy issues that have been a subject of study by the OECD over the last three years. Specific issues include:

• cross-border income tax issues and the need to clarify tax treaties to avoid both double taxation and double non-taxation of income obtained through exercising stock-options ;
• transfer pricing issues raised by the use of employee stock-options as elements of remuneration packages within multinational enterprises ;
• the treatment of stock-options under national tax systems, in comparison with the treatment applied to other forms of employee remuneration.

The OECD’s recommendations on the interpretation of tax treaties and its analysis of transfer pricing issues are contained in two reports now published on the OECD’s web site and are summarised below. Comments on national taxation issues will be contained in a study on domestic tax issues to be released, along with the first two studies, in an OECD publication later this year.

Tax treaty issues

As a first step, following discussions in its Committee on Fiscal Affairs, the OECD is making changes to the Commentary on its Model Tax Convention, the basic document for the negotiation, application and interpretation of the global network of bilateral tax treaties that govern taxation of cross-border income and capital. The Commentary is not binding, but it gives guidance to governments on how to interpret and implement the provisions of the Model Tax Convention. 
 
Under the revised Commentary, the OECD’s main proposals are as follows: 

• relief from double taxation should be granted by the residence country even if it taxes the employment benefit derived from stock-options in a year that is different from the source country ;
• the moment of exercise of an employee stock-option should constitute the dividing line between the employment benefit and any capital gain related to the stock-option ;
• the employment services to which a stock-option relates should be determined on the basis of the facts and circumstances of each case, in line with specified guidelines ;
• when employment services are provided in more than one State, the employment benefit derived from a specific country should be determined on the basis of the number of days during which employment has been exercised in that country ;
• the above rules should also generally apply to stock-options granted to members of a board of directors.

Transfer pricing issues

In addressing the transfer pricing issues that may arise between associated  parties of a multinational enterprise as a result of the use of employee stock-options, the OECD bases its approach on the so-called arm’s length principle, whereby  the conditions of commercial or financial relations between associated enterprises should be comparable to those which would have taken place between independent parties.

The OECD analysis focuses on three main areas:

• The granting of stock-options to employees of an associated enterprise resident in another tax jurisdiction: where this should give rise to a charge by the issuing (parent) company on the employers of the beneficiaries, three possible approaches to measuring the charge are identified.
• The impact of provision of a stock-options plan on other intra-group transactions where the transfer pricing method to be applied to these other transactions is sensitive to employee remuneration, and the impact of stock-options on comparability where employee remuneration of either the taxpayer or third party comparables is materially impacted by stock-options.
• The impact of employee stock-options on Cost Contribution Arrangements within a multinational enterprise: based on an example, the study contains a discussion of whether and under what circumstances employee stock-options must be taken into account in the valuation of the participants’ contributions to a CCA, as well as a discussion of the valuation principles that may be applicable and circumstances in which employee stock-options may be omitted from the determination.

Because of the complexity of the issues and the range of different circumstances to which they can apply, the OECD does not prescribe any single specific response. It does, however, stress the importance of intra-group documentation to support the intent of the parties at the time that a stock-option plan is set up: e.g. risk allocation between the company issuing the plan and the affiliates employing the beneficiaries of the plan, inter-company charging policy, etc. It also highlights the importance of ensuring that intra-group arrangements achieve an arm’s length allocation of the risks inherent to the stock-option plan among the parties concerned, in order to ensure a consistent application of the arm’s length principle.

The full texts of the published reports are available below or at www.oecd.org/daf/ctpa.  For further information, journalists are invited to contact Nicholas Bray in the OECD’s Media Relations Division (Tel: (33) 1 45 24 80 90).