Share-based compensation: understanding the tax accounting

2 December 2014

In brief

As multinational companies (MNCs) seek to incentivise high performance among employees, the popularity of share-based compensation and equity incentive plans continues to increase. Mobility of global workforces and evolving global tax and regulatory compliance requirements raise significant challenges in administering global equity incentive plans. In addition, tax accounting for equity incentive plans remains a complex area for many MNCs due to the uniqueness of the accounting principles coupled with diverse local territory tax laws.

Many questions must often be addressed in the process of accounting for the tax consequences of these arrangements.

To assist MNCs with addressing these questions we provide a refresher of the tax accounting guidance for share-based compensation under US GAAP and IFRS and highlight similarities and differences between the two accounting standards.

In detail

Differences between US GAAP and IFRS

US GAAP

For awards that are expected to result in a tax deduction under existing tax law, the general principle is that a deferred tax asset is established as the entity recognises compensation cost for book purposes. The measurement of the deferred tax asset related to share-based compensation is based on an estimate at the grant date of the future tax deduction for the settlement of the share-based award considering the appropriate enacted tax rate and recognised over the service period.

Changes in the estimated future tax deduction during the vesting period caused by changes in the fair value of the shares do not impact the measurement of the deferred tax asset or result in any adjustments prior to settlement or expiration. Nor is the current fair value of the shares or changes in anticipated forfeitures of awards considered when determining whether a valuation allowance is needed for a deferred tax asset related to share-based compensation. The assessment of the need for a valuation allowance should be based solely on the ability of a company to generate future taxable income sufficient to realise the deferred tax asset. If a company expects that pending deferred tax write-offs upon settlement due to an anticipated shortfall will be material, it should consider disclosing this expectation. However, the deferred tax asset should not be adjusted before settlement of the award in anticipation of a shortfall.

Windfall tax benefits realised upon settlement of an award are recorded in equity. Shortfalls are recorded as a reduction of equity to the extent the company has accumulated windfalls in its historical pool of windfall tax benefits. If the company does not have a sufficient accumulated windfall tax pool, shortfalls are recorded in tax expense.

In instances when the settlement of an award results in a loss carryforward or increases a loss carryforward (i.e., the settlement will generate a tax deduction before the realisation of the tax benefit from that tax deduction), the excess tax benefit and the credit to equity for the windfall should not be recorded until the deduction reduces income taxes payable. The loss carryforwards related to windfall tax benefits should be tracked separately and disclosed in the financial statement tax footnotes. This accounting should be applied only to the windfall portion of the deduction.

Accounting for share-based compensation is currently on the radar of the Financial Accounting Standards Board (FASB). It recently added the following topics to its Simplification agenda:

The FASB's consideration of these topics is expected to result in an exposure draft that will be issued to solicit broad stakeholder input.

IFRS

A deferred tax asset recorded for share-based compensation is measured based on the estimated future tax deduction at the reporting date using an intrinsic value approach (i.e., considering current share price valuations, expected forfeiture rates, etc.).

To illustrate this difference in tax accounting models, consider stock option awards which are expected to result in a tax benefit upon settlement. Under both US GAAP and IFRS, compensation expense is recorded based on the fair value of the awards on the grant date recognised over the vesting period. Under US GAAP, the deferred tax asset is generally measured applying the applicable tax rate to the pre-tax compensation expense recorded in the reporting period. However, under IFRS, the tax benefit is measured based on the estimated future tax deduction inherent in the awards at the reporting date (i.e., the value of the underlying shares in excess of the exercise price at the reporting date). If at the end of the reporting period the underlying share value is equal to (or less than) the exercise price, no tax benefit is recorded under IFRS even though pre-tax compensation expense is recognised. When the adjusted estimated tax deduction exceeds the cumulative book expense, the excess tax benefit is recorded in equity. IFRS does not include a requirement that taxes payable be reduced before a benefit is recorded in equity. When the adjusted estimated tax deduction is less than the cumulative book expense, the entire adjustment to the deferred tax asset is recorded in tax expense. IFRS does not include the concept of a pool of windfall tax benefits to offset shortfalls. A shortfall may be offset by a windfall benefit previously recorded in equity if it relates to the same award. This necessitates tracking windfalls and shortfalls on an award by award basis.

Comparison between US GAAP and IFRS

The following table summarises some of the differences and similarities in tax accounting guidance for share-based compensation under the two accounting standards.

US GAAP IFRS
Deferred taxes upon grant Deferred tax asset is measured based on an estimate made at the grant date of the future tax deductible amount of compensation expense that will be recognised for book purposes. Deferred tax asset is measured based on an estimate of the future tax deduction of the award at the reporting date.
Deferred taxes during vesting period

Deferred tax assets follow book compensation and are not adjusted for changes in estimated future tax deductions due to fluctuations in share value or expected forfeitures during the vesting period. In other words, any anticipated shortfalls are ignored until settlement.

Recoverability of deferred tax assets related to share-based compensation is evaluated on the basis of future taxable income sufficient to realise the deferred tax asset.

Deferred tax assets are recorded based on an estimate of the future tax deductions inherent at each reporting date, considering fluctuations in share value, expected forfeitures, etc., pro rata over the vesting period.

  • adjustments that reduce the value of deferred tax assets for a cumulative shortfall are recorded in tax expense
  • adjustments that reflect a future tax benefit in excess of the cumulative book compensation expense for that award are recorded in equity. Adjustments that reduce prior cumulative windfalls are also recorded in equity

Recognition of deferred tax assets related to share-based compensation is evaluated on the basis of future taxable income sufficient to realise the deferred tax asset.

Realised tax benefit upon settlement

Tax benefits realised in excess of deferred tax assets previously recorded – windfalls – are recorded in equity; shortfalls are recorded in tax expense unless accumulated windfall tax benefits are sufficient to offset the shortfall.

Windfall benefits are only recorded in equity when the deduction reduces income taxes payable.

IFRS does not include a concept of a pool of windfall tax benefits to offset shortfalls. Cumulative windfall benefits from an award are recorded in equity and cumulative shortfalls from an award are recorded in tax expense.

A reduction in income taxes payable is not required before recording a windfall benefit in equity.

Recharge arrangements

In order to be eligible for a local corporate tax deduction, often foreign subsidiaries of MNCs must bear the cost of a share-based compensation award. To achieve this, a cash charge is commonly made to the foreign subsidiary for the cost of the share-based compensation.

Among MNCs, recharge arrangements are as varied as MNCs' human capital strategies and global tax profiles. Recharge arrangements are commonly an element of a MNC's global transfer pricing and profits repatriation policies. Accordingly, recharge arrangements should be crafted with careful consideration to local tax jurisdiction rules around chargeback deductibility, tax compliance requirements and global transfer pricing policies. The recharge arrangement should have a clear link to the global equity compensation plan (i.e., distinguished from a general management fee recharge).

The takeaway

The increased prevalence of share-based compensation and use of recharge arrangements around the world presents complex tax accounting issues.

This is particularly true in the case of MNCs that have to navigate tax laws and regulations in multiple jurisdictions as well as report the tax accounting under both local FRS and US GAAP or IFRS. An added layer of complexity is the fact that individual share-based compensation plans vary significantly. The diversity of accounting standards and tax law requires careful monitoring of awards and the expected tax benefits to be realised, as well as tracking of potential accounting adjustments between US GAAP/IFRS and local GAAP.

Additionally, share price volatility in the current economic environment may potentially amplify the materiality and scrutiny of issues related to share based compensation. Notwithstanding these challenges, organisations can effectively navigate the tax accounting issues presented by global equity compensation plans.

Through an understanding of the appropriate tax accounting framework and careful planning and coordination with the other compliance functions for the global equity compensation plans, the risks of improper accounting can be mitigated.

Let's talk

For a deeper discussion of tax accounting for share based compensation, please contact:

Tax Accounting Services

Andrew Wiggins
+44-(121)-232-2065
andrew.wiggins@uk.pwc.com
Edward Abahoonie
+1-(973)-236-4448
edward.abahoonie@us.pwc.com
Tim Hale
+1-(312)-298-5399
timothy.hale@us.pwc.com
Katya Umanskaya
+1-(312)-298-3013
ekaterina.umanskaya@us.pwc.com
Gary Jones
+1-(617)-530-5663
gary.f.jones@us.pwc.com