Employee Share Options: foreign tax credit relief to an Australian resident taxpayer where an employee share option benefit is taxed by the United States

Is Australia obliged to provide credit relief pursuant to Article 22 of the tax treaty between Australia and the United States of America (US Convention) contained in Schedule 2 to the International Tax Agreements Act 1953 (Agreements Act) to an Australian resident taxpayer where: • a gain is made by the taxpayer on the exercise of employee share options • such gain is taxed by the United States (US) on the basis that it relates to options granted as a reward for past employment exercised by the taxpayer in the US, and • Australia taxes at least part of the gain under its capital gains tax provisions?

Yes. Australia is required to provide credit relief in accordance with Article 22 of the US Convention as the employee share option gain relates to a period of employment exercised wholly within the US and the US is entitled to tax the whole of the employee share option gain under Article 15 of the US Convention.

While the taxpayer was a resident of the US, the taxpayer was granted employee share options in a US public company.

The taxpayer subsequently relocated to Australia and became an Australian resident.

The taxpayer continued to work for an associate of the US Company in Australia until they exercised the options. The shares acquired as a result of the options were disposed of immediately.

The employee share options were granted in January of each year based on the employee's performance over the prior financial year.

While the options required a three year holding period prior to vesting, there were no other conditions attached to the employee share options. Accordingly, it is accepted that the employee share options were granted as a reward for past service which was exercised entirely in the US.

Article 15 of the US Convention provides that salaries, wages and other similar remuneration derived by a resident of Australia in respect of an employment shall be taxed only in Australia unless the employment is exercised in the US. If the employment is exercised in the US, such remuneration may be taxed in the US. The employee share options fall within the definition of 'salaries, wages or other similar remuneration' for the purposes of Article 15 of the US Convention. This view is consistent with paragraph 2.1 of the Commentary on Article 15 of the OECD Model Tax Convention on Income and on Capital (OECD Commentary).

The OECD Commentary further explains at paragraph 12.2 on Article 15 that taxing rights under that Article can be exercised by the source country in respect of an employee share option gain up to the time of exercise of the option. As the US has sought to tax only that part of the employee share option gain up to the time of exercise, the extent of its taxing rights under the treaty is governed by Article 15.

The OECD Commentary also provides guidance on the extent to which source country taxing rights can be exercised pursuant to Article 15. It states at paragraph 12.6 that: The determination of whether and to what extent an employee stock-option is derived from employment exercised in a particular State must be done in each case on the basis of all the relevant facts and circumstances, including the contractual conditions associated with that option ...

Paragraph 12.11 of the OECD Commentary further explains that options should only be considered to relate to services rendered before the time when it is granted to the extent that such grant is intended to reward the provision of services for a specific period. As the options were awarded on the basis of the taxpayer's prior service, it is considered that the period of employment for which the option relates occurred solely in the US, notwithstanding that the options were exercised in Australia.

Accordingly, as the whole employment period is in the US, the US has source country taxing rights under Article 15 of the US Convention in respect of the employee share option gain up to the time of exercise.

As the source country taxing rights in respect of the gain on the employee share option has been correctly exercised in accordance with the US Convention, Australia, as the country of residence of the taxpayer, is required to provide credit relief in accordance with Article 22 of the US Convention.

Article 22(2) of the US Convention provides that a credit (in accordance with Australian tax law) against Australian tax payable in respect of income derived by a resident taxpayer shall be allowed where such income is derived from sources in the US and has been taxed under US law and in accordance with the US Convention.

As the gain on the employee share option has been correctly taxed by the US under the US Convention, and Australia has also taxed the gain under the capital gains tax provisions, the taxpayer is entitled to relief under Article 22 of the US Convention. Note: Provisions relating to the employee share options and change of residence of employees were amended by the New International Tax Arrangements (Foreign-owned Branches and Other Measures) Act 2005 (No. 64 of 2005).