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Equity Compensation & Employee Mobility

I. The Issues

The compensation of employees with equity has become a critical tool for the recruitment, retention and motivation of executives at all levels. The popularity of equity compensation (and the requirement to expense awards) has created a great deal of complexity for operations, controllers, human resources, tax and financial reporting. This paper explores the impact of employee mobility on equity compensation issues across all departments.

 

Employee mobility refers to the movement of employees across business units, legal entities, departments, physical locations, employee grades, countries, states and any other category of interest to the business.

 

For example, an employee who takes a transfer to another department triggers a new allocation of compensation expense for budgetary and accounting purposes. If the employee moves to a different state or country, the tax department needs to know the duration of the transfer in order to claim the deduction in the correct jurisdiction. If the employee takes a promotion, human resources will want to see the effect of the change on pay grade statistics and withholding taxes. The roll-up of these changes will affect the footnote disclosure compiled by the financial reporting group.

 

Employee mobility will impact the systems of each of department. The accountants will prepare new journal entries to the general ledger that reflect the split of time between departments. The tax people will need to update their tax accounting and return software for the correct deduction. Human resources will supply new feeds to payroll and their own internal compensation systems. This raises a number of integration issues which are addressed in greater detail below.

 

Employee mobility also creates a number of audit issues. External auditors are interested in verifying both locations and allocations that impact the financial statements, such as the disclosure of separate income statements for business units or markets. Boards are interested in performance, dilution and accountability, all of which are affected by mobility. The IRS will often demand a reconciliation between the employee’s W-2 and the deduction claimed on the corporate return as well as an understanding of the benefit generated by the employee in the U.S. State tax auditors have started looking into the location of employees during the vesting period in order to allocate a higher amount of the gain to their states. Tax inspectors outside the U.S. have always questioned the validity of intercompany charges, and will only grant a deduction for time spent in country. The documentation required to satisfy all of these constituents can be daunting, particularly as each is driven by a unique view of employee movements.

 

Employee movements are nothing new; however, equity compensation is. The requirement to expense grants of equity to employees has only been around since 2006 and many of the computations remain off-line, usually on spreadsheets. Linking these spreadsheets to employee movements can be challenging, particularly when each department is interested in a different type of movement.

 

II. The Way Forward

So what to do? The first step is to obtain a clear view of time spent by all employees in each category. In a perfect world, this is a single file that contains the entire history of the time spent by every employee in each category that is of interest to the company. In a less than perfect world, this information is scattered across many departments and is difficult to gather and normalize. Like any journey, the collection of this data begins with a single step in the right direction, in this case, a place to store the data. With proper storage in a system designed for this purpose, the mobility file can be built out as it is uncovered. Structured files can be mass-loaded. Web screens can be used to gather information from off-line sources, which are then memorialized in the database. This approach, while gradual, ensures that each piece of data represents a permanent part of the mobility file.

 

The second step is to understand the rules that drive the calculation and allocation of data for each purpose. For example, a withholding tax allocation will require a different set of rules than a journal entry that splits compensation expense between departments. In looking at these rules, there is a bright line that separates two types of equity compensation calculations. On one side of the line are calculations that need to memorialize the vesting schedule of grants; on the other side are calculations that do not. This is important because linking employee mobility with a vesting schedule adds a level of complexity to the exercise.

 

The chart below set forth several common needs and outlines whether or not a vesting schedule is required:

The vesting schedule is not required for the allocation of compensation expense used in departmental journal entries, budgets or salary analytics. This is due to the fact that the vesting schedule is already “baked into” the calculation; i.e. it is not possible to create compensation expense without reference to the vesting schedule, which is then simply allocated in real time to various reporting periods. In effect, compensation expense is, for these purposes, allocated based on days spent in each category during the reporting period.

 

Compare this to the allocation of compensation expense for deferred taxes. Here, the addback of compensation expense for tax purposes creates a deferred tax asset. A question arises where the deduction will ultimately be claimed, which in turn depends upon where the employee has been resident during the vesting period. An employee who is resident in a single country for the entire vesting period will likely be taxed in that country upon exercise, which can help the company justify a deduction in that country. An employee who is resident in different countries during the vesting period may require a proration of the gain upon exercise (or the application of rules contained in the appropriate tax treaty). This will also support the company’s claim for a deduction in the appropriate country.

 

The final step is to create a permanent process improvement, a consistent practice that delivers the correct data to all departments in a systematic and, hopefully, automated manner. Since the requirement to expense equity compensation is relatively new, most of the calculations and allocations remain offline, usually on spreadsheets. Over-reliance on spreadsheets creates the following issues:

 

  • Increased likelihood of error,
  • Unstable source of data to defend the company against future audits,
  • Minimal opportunities to integrate with other systems of the company.

 

It is difficult to integrate spreadsheets with existing systems because spreadsheets are unstructured and data points can change from one reporting period to the next. This means that points of integration can move, forcing a change in the process.

 

A structured database under company control reduces issues around the accuracy and retrieval of data. It also lays the groundwork for integration with the following systems within the company:

 

  • General ledger
  • Budgets
  • Payroll
  • Human Resource Analytics and Planning
  • Tax Provision
  • Tax Return

 

Integration can be defined many ways, depending upon the company’s appetite for automation. However, in all cases, a structured database is a good start and can usually be expanded to meet a company’s changing needs.

 

III. Comprehensive Example

What follows is a comprehensive example that illustrates many of these concepts. Company X is interested in analyzing equity compensation for departmental budgets (which are also tracked in the general ledger), payroll and income tax.

 

Company X has managed to obtain a history of time spent by employees in department, country and state over the relevant time period.

 

Employee A has the following profile:

 

A grant for restricted shares was issued on January 1, 2009 with a 3 year vesting period for 10,000 shares at a market price of 33.34 per share, yielding the following amortization of compensation expense, assuming a 10 percent forfeiture rate. Company X uses a graded amortization method.

This amortization schedule makes a simplifying assumption that the 10 percent forfeiture rate will apply throughout the entire amortization period for this employee, even though he does not actually forfeit any shares. A more realistic assumption would show the 10 percent forfeiture rate declining to zero at the end of the vesting period for Employee A.

 

Employee A vests all 10,000 shares at $ 40 per share on December 31, 2011. This is also a simplifying assumption as it is common for employees to vest their shares at the end of each year.

 

The combination of employee A’s mobility and this amortization schedule leads to the following allocations of compensation expense for budgetary and general ledger purposes.

The build of the deferred tax asset follows the same allocation methodology using jurisdictions and adding tax rates.

In 2011, after the final vesting and release at $ 40 per share, Company x will be entitled to a tax deduction. We have assumed that Employee A earns the rights to the shares at the same time they are amortized; i.e. consistent with the graded vesting schedule, and that the corporate deduction will be allowed where the income is taxed to Employee A. We have also assumed that all tax regimes will accept their prorated share of the corporate deduction.

 

Tax deduction in each tranche: 400,000/3 = 133,333

The tax deduction is allocated based on the number of days in country to the total number of days in the tranche. So the deduction for the 3,333 shares in tranche 1 are allocated over 365 days, the 3,333 shares in tranche 2 are allocated over 730 days and the shares in tranche 3 are allocated over 1095 days.

 

The same methodology is used for the excess tax benefit/detriment needed to true up the deferred tax asset (or tax payable) and update the APIC pool.

 

Excess tax benefit net of forfeiture: 10,000 x (40 – (30.006) = 99,940/3 = 33,313

 

As a simplifying assumption, forfeitures have been left in the 30.006 price used to set up the deferred tax asset. In reality, the unforfeited shares of Employee A would increase the compensation expense, thereby reducing the excess tax benefit and the APIC adjustment.

A rollforward of the deferred tax assets in each jurisdiction shows how the balances zero out at the release date:

 

IV. Summary

The movement of employees across borders and company classifications creates a number of challenges for equity compensation professionals. As employees move, they create computational and allocation issues for operations, human resources, accounting, tax and financial reporting.

 

This paper presented a three step approach to deal with these issues:

 

  • Creation and maintenance of a single file that contains a history of all relevant employee movements,
  • Rules that articulate the computational needs of various constituents within the company, with and without the need to memorialize the vesting schedules.
  • Need for permanent process improvements that provide ownership of data, audit trails and opportunities for integration.

 

About the Author

Kevin Brady is the CEO and Founder of ARMtech. He is the lead director of Annaly (NLY), currently traded on the New York Stock Exchange with a market capitalization of $ 10 billion, and has served as the chair of the audit committee for 12 years. Previously, Kevin was the CEO and founder of TaxStream, which was sold to Thomson Reuters in 2008. He can be reached at (201) 238-2900 x 0237 or kbrady@armtechnology.com.


 
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