Incentive compensation programs create real compliance challenges for companies with mobile employees. They can also create unexpected tax costs, resulting in significant impact to your business. Managing these tax costs is vital to the financial health of your organization.
Companies will often provide tax equalization or tax protection so that employees are not worse off from a tax perspective as a result of their move. But this resulting tax reimbursement becomes an additional cost of the assignment. Ensuring all costs are considered and planned for is essential for any company looking to keep its budget under control.
Standard Approach and the Pitfalls
It is standard practice for companies to prepare detailed tax cost projections for budgeting and accruing assignment tax costs. However, incentive compensation (e.g., restricted stock units, stock options) is often overlooked in the tax cost projections. Or, at best, included based on straight line apportionment of a target percentage of salary. This doesn’t consider the employee’s outstanding awards and the specific tax rules of the home and the host countries.
Another common mistake is that companies try to simplify the process and do not refresh accruals on a frequent basis. This practice will not save companies from surprises in the future, when the actual tax bill arrives to the relevant entity, as the final calculation will not be accurate.
One example comes to mind of an executive moving from Switzerland to the US. The executive paid tax at grant in Switzerland on his restricted stock. After he moved to the US, the restricted stock vested and became taxable in the US. As he was tax equalized, the company paid the applicable US taxes. The tax bill was significant and had a huge impact on the profit of the small US business unit, risking bonuses for other employees. Had the company properly accrued for the estimated tax costs, they could have appropriately planned for the costs, mitigating the impact to the business and the other employees.
As incentive compensation continues to become a more important and larger part of employees’ total compensation, incorrectly assessing assignment costs can significantly impact business budgets and add constraints to the assignment. Further, incentive compensation may also affect the accuracy of a company’s earnings forecast if it is not accrued properly in the books. This may naturally generate cash flow issues and may mislead investors in the future.
According to the International Financial Reporting Standards (IFRS) and Financial Accounting Standards Board (FASB), companies should provide prudent information in their financial reporting to help investors and others assess the amount and timing of prospective cash flows. In extreme situations, companies may risk misreporting, which in short term may disturb managers’ budgets, but in long term may have colossal consequences to the business.
As you can see, the preparation of accurate tax cost projections, taking into account tax costs related to incentive compensation, is critical when planning for expatriate assignments and can help mitigate costs and surprises. Best practice would be to prepare accurate tax cost projections at the beginning of an assignment, based on the employees outstanding incentive compensation as well as other specific facts and circumstances. Further tax cost projections should be updated annually or when a significant event occurs that impacts the projection (e.g., large fluctuation in stock price).
How KPMG can help you
- Enabling business units to budget effectively
- Understanding future tax reimbursement costs
- Updating financial books quickly and easily on a regular basis
- Avoiding imbalance in the books