5.7 Exceptions to Liability Classification

5.7.1 Foreign Currency

ASC 718-10

25-14 For this purpose, an award of equity share options granted to a grantee of an entity’s foreign operation that provides for a fixed exercise price denominated either in the foreign operation’s functional currency or in the currency in which the foreign operation’s employee’s pay is denominated shall not be considered to contain a condition that is not a market, performance, or service condition. Therefore, such an award is not required to be classified as a liability if it otherwise qualifies as equity. For example, equity share options with an exercise price denominated in euros granted to employees or nonemployees of a U.S. entity’s foreign operation whose functional currency is the euro are not required to be classified as liabilities if those options otherwise qualify as equity. In addition, options granted to employees and nonemployees are not required to be classified as liabilities even if the functional currency of the foreign operation is the U.S. dollar, provided that the foreign operation’s employees are paid in euros.

25-14A For purposes of applying paragraph 718-10-25-13, a share-based payment award with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades shall not be considered to contain a condition that is not a market, performance, or service condition. Therefore, in accordance with that paragraph, such an award shall not be classified as a liability if it otherwise qualifies for equity classification. For example, a parent entity whose functional currency is the Canadian dollar grants equity share options with an exercise price denominated in U.S. dollars to grantees of a Canadian entity with the functional and payroll currency of the Canadian dollar. If a substantial portion of the parent entity’s equity securities trades on a U.S. dollar denominated exchange, the options are not precluded from equity classification.

Stock options may have an exercise price that is denominated in a foreign currency (i.e., a currency that is not the entity’s functional currency). While such foreign currency would not be a service, performance, or market condition (i.e., it is an “other” condition), indexation to the currency, by itself, would not result in liability classification of the stock options if:

A grantee of an entity’s foreign operation is awarded stock options with a fixed exercise price denominated in the foreign operation’s functional currency.
A grantee of an entity’s foreign operation is awarded stock options with a fixed exercise price denominated in the currency in which the employee’s pay is denominated.
A grantee is awarded stock options with an exercise price denominated in the currency of a market in which a substantial portion of the entity’s equity securities trades.

5.7.2 Statutory Tax Withholding Obligation

ASC 718-10

25-18 Similarly, a provision for either direct or indirect (through a net-settlement feature) repurchase of shares issued upon exercise of options (or the vesting of nonvested shares), with any payment due employees withheld to meet the employer’s statutory withholding requirements resulting from the exercise, does not, by itself, result in liability classification of instruments that otherwise would be classified as equity. However, if the amount that is withheld, or may be withheld at the employee’s discretion, is in excess of the maximum statutory tax rates in the employees’ applicable jurisdictions, the entire award shall be classified and accounted for as a liability. That is, to qualify for equity classification, the employer must have a statutory obligation to withhold taxes on the employee’s behalf, and the amount withheld cannot exceed the maximum statutory tax rates in the employees’ applicable jurisdictions. The maximum statutory tax rates are based on the applicable rates of the relevant tax authorities (for example, federal, state, and local), including the employee’s share of payroll or similar taxes, as provided in tax law, regulations, or the authority’s administrative practices, not to exceed the highest statutory rate in that jurisdiction, even if that rate exceeds the highest rate that may be applicable to the specific award grantee.

25-19 Paragraph superseded by Accounting Standards Update No. 2016-09.

25-19A Paragraph 230-10-45-15 provides guidance on the classification on the statement of cash flows for cash paid to a tax authority by an employer when withholding shares from an employee’s award for tax-withholding purposes.

In connection with an entity’s statutory tax withholding obligation, many share-based payment awards permit the entity to repurchase, either directly or indirectly through a net settlement feature, a portion of the shares that would otherwise be issued to employees (e.g., upon vesting of restricted stock or upon stock option exercise). ASC 718-10-25-18 contains an exception to liability classification for this share repurchase feature. Specifically, the net settlement of an award for statutory tax withholding purposes would not, by itself, result in liability classification of the award provided that (1) the entity has a statutory obligation to withhold taxes on the employees’ behalf and (2) the amount withheld for taxes does not exceed the maximum statutory tax rates in the employees’ relevant tax jurisdictions. The maximum statutory tax rate is based on the highest statutory tax rate in the employees’ jurisdictions (determined on a jurisdiction-by-jurisdiction basis), even if that rate is more than the highest rate applicable to a specific employee. If the amount withheld exceeds the maximum statutory tax rate, the entire award is classified as a liability.

If an entity issues an award to a grantee that meets the definition of an employee under ASC 718-10 (i.e., is a common law employee) but the entity does not have a statutory obligation to withhold taxes on behalf of the common law employee, the exception to liability accounting under ASC 718-10-25-18 does not apply.

5.7.2.1 Hypothetical Withholdings

If employees work in multiple jurisdictions (e.g., mobile employees) or are on international assignment (e.g., “ex-pat” employees), an entity may apply a “hypothetical” withholding rate to net settle their share-based payment awards. The hypothetical amount for an ex-pat employee, for example, might be based on the rate that would apply if the employee remained in the United States. To avoid liability classification, the entity must have a statutory obligation to withhold taxes on the employee’s behalf, and the amount withheld cannot exceed the maximum statutory tax rates in the employee’s relevant tax jurisdictions. If a third-party service provider is involved in administering a company’s stock plan, management should take steps to ensure that the service provider is (1) sufficiently conversant with the statutory tax withholding obligations in the applicable jurisdiction(s) and (2) has access to the necessary human resources and employment information needed to calculate the minimum withholding.

5.7.2.2 Cash Settlement of Fractional Shares

Because shares are typically withheld from employees in whole-number increments (the issuance of fractional shares is typically prohibited), the value of a fractional share may be paid in cash directly to the employee. For example, if 24.3 shares would be withheld to satisfy the entity’s statutory tax withholding obligation, the entity typically withholds 25 shares and pays the difference (the value of a fractional 0.7 share) in cash directly to the employee. ASC 718-10-25-18 does not appear to require liability classification of an award as a result of a policy in which fractional shares must be cash settled. Therefore, if the cash-settled portion is considered de minimis to the employee, it is not considered a violation of ASC 718-10-25-18 to round up shares to meet the entity’s statutory tax withholding obligation (up to the maximum statutory tax rate(s) in the employee’s applicable jurisdiction(s)). However, an entity should evaluate the facts and circumstances of each arrangement to ensure that (1) its substance does not create a liability and (2) the cash settlement of the fractional share is, in fact, de minimis to the employee.

An arrangement may be a liability in substance, though, if (1) there are multiple exercises in small increments (thereby increasing the number of fractional shares that are cash settled and thus the amount of cash paid to a single employee) and (2) the entity’s per-share stock price is so high that the cash paid for a fractional share could be significant.

5.7.2.3 Changes in the Amount Withheld

The classification of awards can be affected by the manner in which an entity remits tax savings to employees as a result of overpayments made during the year to tax authorities to meet the entity’s statutory tax withholding obligation. The example below illustrates how changes in the amount withheld to meet an entity’s statutory tax withholding obligation can affect an award’s classification.

Example 5-19

Entity A has a statutory tax withholding obligation for an employee’s restricted stock award. The tax authorities allow A to calculate the amount of taxes due on any date from the vesting date of an award to A’s year-end. For administrative ease, on the vesting date, A (1) withheld, on the basis of the fair value of the shares on that date, the amount of shares whose fair value is equal to the employee’s taxes by applying the maximum statutory tax rate in the employee’s jurisdiction and (2) remitted that amount to the tax authorities. At year-end, A decides to recalculate the tax withholding amount (also by applying the maximum statutory tax rate in the employee’s jurisdiction), which results in a decreased withholding because of a decrease in the fair value of the entity’s shares from the vesting date. The entity requests a refund from the tax authorities for the overpayment and then remits the overpayment to the employee.

Entity A’s classification of the award depends on how it remits the tax savings (i.e., refund of overpayment) to the employee. If the overpayment is remitted to the employee in cash, the transaction substantively represents the repurchase of shares for an amount in excess of the maximum statutory tax rate in the employee’s jurisdiction. As a result, in such circumstances, the entire award would have to be classified as a liability in accordance with ASC 718-10-25-18. Alternatively, if the tax savings are remitted to the employee in shares, A should, to avoid any adverse accounting consequences, determine the number of shares remitted to the employee by using the fair value of the shares on the vesting date. In essence, A would divide the employee’s tax withholding determined at year-end (on the basis of the maximum statutory tax rate in the employee’s jurisdiction and the fair value of the shares on that date) by the fair value of the shares as of the vesting date to determine the amount that would have been withheld as of the vesting date if A had known the employee’s year-end taxes (on the basis of the maximum statutory tax rate) as of the vesting date. The excess number of shares between the new calculation and initial calculation would then be remitted to the employee.

5.7.2.4 Nonemployee Director Tax Withholdings

While a nonemployee member of an entity’s board of directors may be treated similarly to an employee under ASC 718 (see Section 2.3), the director is not considered an employee under the IRS’s statutory withholding requirements. Because an entity does not have any statutory tax withholding requirements in the United States related to nonemployee directors, the entity would not qualify for the exception to liability classification in ASC 718-10-25-18. Thus, an entity’s practice of withholding shares to satisfy the director’s tax obligation would result in liability classification of the entire award. The same would be true for other nonemployee recipients of share-based payment awards for which statutory tax withholding requirements would not apply (e.g., partners of partnerships or limited liability companies).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.