Equity-based Compensation: The Basics for Australian Expats – Stock Options

Introduction

The United States and the broader Asia-Pacific (APAC) region acts as a beacon of opportunity for Australian Expats looking to accelerate their careers in industries such as Computer Software, Information Technology, Mining, Law Practice, and many more. With this opportunity, Australian Expats are commonly presented with unique compensation packages that include equity in the employer company, supplementing their ordinary wage income.

Some common examples of equity-based compensation include:

-        Restricted Stock Units (RSU)

-        Stock Options

-        Employee Stock Purchase Plans (ESPP)

This 3-part Article series will look to discuss the unique aspects of receiving different types of equity-based compensation and explain how Australian Expats can best manage them from a sound financial planning standpoint.

What are Stock Options?

Stock Options are another form of equity-based compensation that allows employers to offer their employees shares in the company, or rather, the right to buy shares in the company. Stock Options are offered in a similar manner to Restricted Stock Units (RSUs) in that they are initially granted to the employee and subject to a vesting schedule before the employee can exercise them for an economic value. A stock option gives the optionee the right, but not the obligation, to purchase shares at the exercise price. An important contrast with receiving Stock Options over RSUs is that the value of the Option can be zero at the time they vest. Here’s how.

A stock option is a type of derivative security, meaning the value of the Option contract is derived by the current market price of the company share (in the case of public companies). At the time of vesting, the recipient will be entitled to buy shares in the company at the “exercise price” set out in the employees' grant agreement when initially granted. Where the exercise price of the stock option (also known as the strike price) is below the prevailing market price of the share, the employee can buy the shares at the exercise price and then sell them on the secondary market at a profit. However, if the share price has fallen and is now trading below the exercise price in the option contract, the employee would be wise not to exercise the option and let it expire, as they could instead buy the shares on the secondary market for less. The exercise price tends to be the market price of the share at the time of grant. There is generally an expiry term or “exercise window” that the options must be exercised by otherwise they will expire. This can be 7 to 10 years from when the Options were initially granted to the employee.

An employer can offer a range of different Stock option types to their employees including:

-        Incentive Stock Options (ISO)

-        Non-qualified Stock Options (NSO)

-        Stock Appreciation Rights (SAR)

The operational features of each Stock Option type are similar; however, the differences can be seen when looking at the tax treatment at the time of exercising each option type. This will also vary depending on your country of tax residence. It’s important to note that although some of the rules that regulate stock options are imposed by tax and securities laws, other rules are at the company's discretion.

Incentive Stock Options (ISOs) are the more favourable option type as they can qualify for special tax treatment. They are generally not subject to tax at the time of grant, vest, or exercise, rather, taxation occurs at the time those shares are subsequently sold. The extent to which taxation occurs depends on the period of time those shares were held from the date of exercise. If the shares were held for more than two years from the grant date, and at least one year from the date of exercise, the difference between the exercise price and the sale price is subject to more favourable long-term capital gains tax rules. Where the above holding periods are not met, the difference between the exercise price and the market price at the time of exercise is subject to ordinary income tax rules, and the difference between the market price at the time of exercise and the sale price will be subject to the Capital gains tax rules. Where this is the case, the exercise price generally becomes the cost basis for CGT purposes.

Non-qualified Stock Options (NSOs) tend to be the least favourable option type offering fewer tax concessions. Where an employee receives NSOs, they are generally taxed at the time the option is exercised, and the spread between the exercise price and the current market price is treated as ordinary income. Should the employee then decide to sell the share on the secondary market, whether immediately or after holding them, they are generally subject to the capital gains tax rules on the difference between the market price at time of exercise and the sale price.

Stock Appreciation Rights (SARs) are not quite a stock option in the traditional sense, but we will discuss them here as they are a type of derivative security offered by employers relating to equity compensation. SARs are different to NSOs and ISOs in that they are commonly settled in Cash, and employees don’t have to physically receive stock in the company when exercising the contract right. Instead, at the time of exercise, employees can receive the sum of the increase between the exercise price and market price as cash compensation and do not have to pay the exercise price. The key benefit of SARs is that employees can receive proceeds from stock price increases without having to buy the stock. Similarly to NSOs, withholding tax is usually withheld by the company at time of exercise, and the difference between the exercise price and market price at time of exercise is considered ordinary income.

Financial Planning Risk and Opportunities

There are certainly more nuances associated when looking at Stock Options compared with RSUs. This is because the employee must make two decisions before they yield a cash value return. The first decision is when to exercise the Stock Option, and the second decision is when to sell the shares they have received. This can cause many employees to overanalyze the stock price outlook and inertia sets in, and the employee makes no decision at all.

Similarly to the discussion on RSUs above, an employee needs to be careful not to accumulate such a substantial options position, and introduce a plan to reallocate the funds based on their broader situation and financial objectives. Consideration as to when the options will expire should also be paid attention to.

Employees should also familiarize themselves with their equity grant agreement before making any decisions or taking any action with their stock options. For those Australian Expats that are residing in Singapore, while there is no capital gains tax on shares, you can be subject to a tax at the time of ceasing employment or departing Singapore on any unvested RSUs or unexercised options as part of the IRAS deemed exercise rules. The tax is also generally required to be paid within 1 month of ceasing employment. Careful planning and advice should be sought to best mitigate this.

Conclusion

In summary, while being afforded such compensation can be advantageous, and even lucrative at times, Australian Expats should take due care to manage this supplementary income from a tax planning and long-term risk mitigation outlook, especially in the face of heightened share market volatility. Partnering with a Financial adviser can help put you on a path to making the best use of this income to achieve your financial goals. Stay tuned for Part 3 of this 3-part Article series where I will discuss Employee share purchase plans (ESPPs).

General Advice Disclaimer: The information contained herein is of a general nature only and does not constitute personal advice. You should not act on any recommendation without considering your personal needs, circumstances, and objectives. We recommend you obtain professional financial advice specific to your circumstances.