Chapter 8 — Employee Stock Purchase Plans

8.2 Noncompensatory Plans

ASC 718-50

General

25-1 An employee share purchase plan that satisfies all of the following criteria does not give rise to recognizable compensation cost (that is, the plan is noncompensatory):

The plan satisfies either of the following conditions:
1. The terms of the plan are no more favorable than those available to all holders of the same class of shares. Note that a transaction subject to an employee share purchase plan that involves a class of equity shares designed exclusively for and held only by current or former employees or their beneficiaries may be compensatory depending on the terms of the arrangement.
2. Any purchase discount from the market price does not exceed the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering. A purchase discount of 5 percent or less from the market price shall be considered to comply with this condition without further justification. A purchase discount greater than 5 percent that cannot be justified under this condition results in compensation cost for the entire amount of the discount. Note that an entity that justifies a purchase discount in excess of 5 percent shall reassess at least annually, and no later than the first share purchase offer during the fiscal year, whether it can continue to justify that discount pursuant to this paragraph.
Substantially all employees that meet limited employment qualifications may participate on an equitable basis.
The plan incorporates no option features, other than the following:
1. Employees are permitted a short period of time — not exceeding 31 days — after the purchase price has been fixed to enroll in the plan.
2. The purchase price is based solely on the market price of the shares at the date of purchase, and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid (such as those paid by payroll withholdings).

25-2 A plan provision that establishes the purchase price as an amount based on the lesser of the equity share’s market price at date of grant or its market price at date of purchase, commonly called a look-back plan, is an example of an option feature that causes the plan to be compensatory. Similarly, a plan in which the purchase price is based on the share’s market price at date of grant and that permits a participating employee to cancel participation before the purchase date and obtain a refund of amounts previously paid contains an option feature that causes the plan to be compensatory. Section 718-50-55 provides guidance on determining whether an employee share purchase plan satisfies the criteria necessary to be considered noncompensatory.

Unless it meets all three conditions in ASC 718-50-25-1, an ESPP is compensatory and therefore gives rise to the recognition of compensation cost.

8.2.1 First Condition in ASC 718-50-25-1

Under ASC 718-50-25-1(a), an ESPP must satisfy either of the following criteria:

“The terms of the plan are no more favorable than those available to all holders of the same class of shares.”

Meeting this criterion is uncommon because ESPPs often offer terms for the purchase of shares that are more favorable than the terms available to all shareholders. To prevent an entity from creating a separate class of shares solely to satisfy this condition, ASC 718-50-25-1(a)(1) contains an anti-abuse provision, which states that “a transaction subject to an employee share purchase plan that involves a class of equity shares designed exclusively for and held only by current or former employees or their beneficiaries may be compensatory depending on the terms of the arrangement.”
A purchase discount, if it is greater than 5 percent, does not exceed the per-share amount of share issuance costs that would be incurred to raise a significant amount of capital through a public offering.

A purchase discount of 5 percent or less from the market price of the entity’s shares is a safe harbor and does not result in a compensatory ESPP. Many IRC Section 423 plans, however, offer a purchase discount of 15 percent from the market price of the entity’s shares. If an entity can justify that the discount (e.g., the 15 percent discount permitted under IRC Section 423) is equivalent to the share issuance costs that the entity would have incurred to raise a significant amount of capital in a public offering, the ESPP may be considered noncompensatory (provided that the plan meets the remaining conditions discussed below). AICPA Technical Q&As Section 4110.01 provides guidance on what amounts should be considered for inclusion in the share issuance cost. It states, in part:
Such costs should be limited to the direct cost of issuing the security. Thus, there should be no allocation of officers’ salaries, and care should be taken that legal and accounting fees do not include any fees that would have been incurred in the absence of such issuance.

In addition, the entity must continue to justify the appropriateness of the discount percentage (if greater than 5 percent) at least annually and no later than when it makes the first share purchase offer during the fiscal year. If the entity is no longer able to justify a discount in excess of 5 percent, subsequent grants using that discount rate would be considered compensatory (unless the “terms of the plan are no more favorable than those available to all holders of the same class of shares” and the other conditions in ASC 718-50-25-1 are satisfied). The inability to justify a discount on a current offering would not affect the noncompensatory nature of previous offerings. That is, an entity would not record compensation cost for purchase offers made before the entity is unable to justify a discount in excess of 5 percent.

The application of the condition in ASC 718-50-25-1(a) is illustrated in the following implementation guidance:

ASC 718-50

55-35 Another criterion is that the terms are no more favorable than those available to all holders of the same class of shares. For example, Entity A offers all full-time employees and all nonemployee shareholders the right to purchase $10,000 of its common stock at a 5 percent discount from its market price at the date of purchase, which occurs in 1 month. The arrangement is not compensatory because its terms are no more favorable than those available to all holders of the same class of shares. In contrast, assume Entity B has a dividend reinvestment program that permits shareholders of its common stock the ability to reinvest dividends by purchasing shares of its common stock at a 10 percent discount from its market price on the date that dividends are distributed and Entity B offers all full-time employees the right to purchase annually up to $10,000 of its common stock at a 10 percent discount from its market price on the date of purchase. Entity B’s common stock is widely held; hence, many shareholders will not receive dividends totaling at least $10,000 during the annual period. Assuming that the 10 percent discount cannot be justified as the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering, the arrangement is compensatory because the number of shares available to shareholders at a discount is based on the quantity of shares held and the amounts of dividends declared. Whereas, the number of shares available to employees at a discount is not dependent on shares held or declared dividends; therefore, the terms of the employee share purchase plan are more favorable than the terms available to all holders of the same class of shares. Consequently, the entire 10 percent discount to employees is compensatory. If, on the other hand, the 10 percent discount can be justified as the per-share amount of share issuance costs that would have been incurred to raise a significant amount of capital by a public offering, then the entire 10 percent discount to employees is not compensatory. If an entity justifies a purchase discount in excess of 5 percent, it would be required to reassess that discount at least annually and no later than the first share purchase offer during the fiscal year. If upon reassessment that discount is not deemed justifiable, subsequent grants using that discount would be compensatory.

In the example in ASC 718-50-55-35 above, B offers its shareholders the ability to participate in a dividend reinvestment program (DRIP) and offers its employees a 10 percent discount on purchases of its common stock up to $10,000. Because the shareholders are not likely to receive dividends totaling $10,000, their participation in the DRIP will not be the same as that of employees in the ESPP. That is, while the terms of the ESPP (for employees) and the DRIP (for all other shareholders) are similar (i.e., B’s shares may be purchased at a 10 percent discount from the market price), employees can participate in the ESPP by contributing up to $10,000, whereas all other shareholders can participate in the DRIP by contributing only up to the amount of dividends they receive, which may not total $10,000. Accordingly, the terms available to employees under the ESPP may be more favorable.

The ESPP may still be noncompensatory with respect to the discounted shares offered to employees if B can justify that the discount does not exceed the share issuance costs that the entity would have incurred to raise a significant amount of capital in a public market (assuming the plan meets the remaining conditions in ASC 718-50-25-1). However, as discussed above, the entity must continue to assess the discount percentage at least annually, and no later than the first ESPP offer during the fiscal year, to justify continued use of the discount percentage on subsequent offerings.

Example 8-1

On January 1, 20X1, Entity A establishes an ESPP that permits employees to purchase A’s shares at a 7 percent discount. Entity A can justify that the 7 percent discount is not greater than the costs A would have incurred in a significant offering of A’s shares in a public market. Therefore, the ESPP is not considered compensatory (provided that all the other criteria in ASC 718-50-25-1 also have been met).

On July 1, 20X1, A makes a second offering under its ESPP, also with a 7 percent discount. Entity A is not required to reassess the 7 percent discount used in the second ESPP offering in 20X1. As long as all the other criteria in ASC 718-50-25-1 continue to be met, the plan is not considered compensatory.

On January 1, 20X2, A makes a third offering under its ESPP and again offers a 7 percent discount. In accordance with ASC 718-50-25-1(a)(2), A would have to justify that the 7 percent discount remains appropriate for this offering. If, for this offering, A can no longer justify the 7 percent discount, the plan is considered compensatory (unless the “terms of the plan are no more favorable than those available to all holders of the same class of shares” and the other conditions in ASC 718-50-25-1 have been met). Entity A’s inability to justify the discount on the current offering would not affect the noncompensatory nature of prior offerings. That is, A would record no compensation cost for purchase offers made before A is unable to justify the discount (i.e., for the January 1, 20X1, and the July 1, 20X1, offerings). Further, for the third offering, A must include the entire amount of the discount (i.e., 7 percent) in determining the amount of compensation cost over the requisite service period, not just the discount in excess of 5 percent.

8.2.2 Second Condition in ASC 718-50-25-1

Under ASC 718-50-25-1(b), the ESPP must allow substantially all employees that meet limited employment qualifications to participate on an equitable basis. ASC 718-50-55-34 provides examples of limited employment qualifications as follows:

ASC 718-50

Example 2: Limitations for Noncompensatory Treatment

55-34 Paragraph 718-50-25-1 stipulates the criteria that an employee share purchase plan must satisfy to be considered noncompensatory. One of those criteria specifies that substantially all employees that meet limited employment qualifications may participate on an equitable basis. Examples of limited employment qualifications might include customary employment of greater than 20 hours per week or completion of at least 6 months of service.

While an entity will assess whether it has satisfied this condition on the basis of its specific facts and circumstances, the underlying principle is that the ESPP should be nondiscriminatory. For example, participation could be limited to employees in a specific country and be considered nondiscriminatory. However, if participation is limited to executives (i.e., nonexecutives are not eligible to participate) the ESPP would not meet this condition.

8.2.3 Third Condition in ASC 718-50-25-1

Under ASC 718-50-25-1(c), an entity assesses whether the ESPP incorporates option features and, if so, whether they cause the plan to become compensatory. Except in the following two circumstances, an option feature renders a plan compensatory:

The option feature gives an employee “a short period of time — not exceeding 31 days — after the purchase price has been fixed to enroll in the plan.” However, an ESPP with such a feature may have an additional option feature that renders it compensatory. For example, an ESPP would be compensatory if (1) the purchase price is set on the date the employee begins to participate in the plan and is having money withheld to pay for the shares but (2) the plan allows the employee to cancel participation after enrollment and receive a refund of the amount previously withheld from the employee’s pay. This is because the employee begins to benefit from, or be adversely affected by, subsequent changes in the entity’s share price once the purchase price is set. Allowing cancellation of participation after enrollment would give the employee benefits similar to those of a stock option.
The “purchase price is based solely on the market price of the [entity’s] shares at the date of purchase, and employees are permitted to cancel participation before the purchase date and obtain a refund of amounts previously paid” (emphasis added). Unlike a scenario in which the employee can cancel participation in the plan after the purchase price has been set (and therefore after beginning to benefit from, or be adversely affected by, subsequent changes in the entity’s share price), such an option feature does not give the employee benefits similar to those of a stock option because the employee can only cancel participation before the purchase price is set.

Note that many existing ESPPs include a look-back feature that allows the purchase price to be set at the lower of (1) the market price of the entity’s shares on the date the employee begins participating in the plan and is having money withheld to pay for the shares or (2) the market price of the shares on the purchase date. A look-back feature is considered an option feature that results in a compensatory plan. See discussion in Section 8.9.

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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.