Employee Share Options: taxation of a discount derived by a resident of the United States on the exercise of share options granted from previous employment in Australia

Does Article 15 of Schedule 2 to the International Tax Agreements Act 1953 (the US Convention) permit Australia to tax a discount on employee share options under subsection 139B(3) of the Income Tax Assessment Act 1936 (ITAA 1936) where the options were granted whilst the taxpayer was employed in Australia but were not exercised until the taxpayer became a resident of the United States?

Yes. Australia has a source country right under Article 15 of the US Convention to tax a relevant portion of the discount that relates to employment undertaken in Australia.

While the taxpayer was a resident of Australia, they were granted employee share options in a United States public company, the parent company of the Australian company with whom they were employed. The taxpayer did not make an election to be taxed on the options at the date of grant. The options vested proportionately every month over a four year period from the date of grant.

The taxpayer later departed Australia and relocated in the United States continuing their employment with the parent company. The taxpayer disregarded the capital gains tax event that occurred on the change of residency.

While resident of the United States the taxpayer exercised some of their options.

Article 15 of the US Convention broadly provides that salaries, wages and other similar remuneration derived by a resident of the United States in respect of employment shall be taxed only in the United States unless the employment is exercised in Australia.

As the employee share options were provided as part of the employee's remuneration package they are considered to form 'salary, wages and other similar remuneration' for the purposes of Article 15 of the US Convention. This view is consistent with the reasoning in an OECD discussion paper on tax treaty issues relating to the taxation of employee share options (see OECD, 'Cross-Border Income Tax Issues Arising from Employee Stock-Option Plans: Revised Public Discussion Draft' (21/07/2003) at http://www.oecd.org/dataoecd/46/34/4357310.pdf ).

The taxpayer exercised the options and derived the gain as a resident of the United States. However, as some of the employee share options relate to employment exercised in Australia, a portion of the discount derived from the exercise of those options may be taxed in Australia.

Under Article 15 of the US Convention, the State of source has the right to tax the part of the gain on the employee share options that constitutes employment income derived from services exercised in the State of source even if the State of source taxes the gain at a later time when the employee is no longer rendering services in that State.

Article 27(1)(a) of the US Convention provides that employment income which may be taxed in Australia, has an Australian source for both the purposes of the Convention and the income tax law of Australia.

Accordingly, as Australia is the State of source, it is permitted to tax a portion of the discount made by the taxpayer on the exercise of employee share options to the extent the options relate to employment exercised in Australia.

Subsection 139B(3) of the ITAA 1936 provides that where a taxpayer has not made an election in the year of income that a qualifying share or right was acquired, their assessable income includes the discount of the qualifying share or right in the year in which the cessation time occurs.

For the purposes of calculating the amount of the gain to be included under subsection 139B(3) of the ITAA 1936, the discount that is determined under either subsection 139CC(3) or subsection 139CC(4) of the ITAA 1936 needs to be apportioned for the period that is attributable to the employment exercised in Australia. The apportionment is calculated by the number of days that the taxpayer worked for their employer in Australia during the period between the grant of the option and the date of vesting of each option, to the total number of days employed between the grant of the options and the date of vesting of each option. This apportionment can be expressed as follows: Discount at exercise * (Days employed in Australia between grant and vesting / Total days employed between grant and vesting of the option)