Chapter 10 — Share-Based Payments
Chapter 10 — Share-Based Payments
10.7.1 Tax Effects of Replacement
Awards Issued in a Business Combination That Ordinarily
Would Result in a Tax Deduction
10.7.2 Tax Effects of Replacement
Awards Issued in a Business Combination That Would Not
Ordinarily Result in Tax Deductions
10.7.3 Exchange of Vested Acquiree
Employee Awards for Unvested Share Awards of Acquirer in a
Business Combination
10.1 Background and Scope
ASC 718-740
Overview and Background
05-1 Topic 740
addresses the majority of tax accounting issues and
differences between the financial reporting (or book) basis
and tax basis of assets and liabilities (basis
differences).
05-2 This
Subtopic addresses the accounting for current and deferred
income taxes that results from share-based payment
arrangements, including employee stock ownership plans.
05-3 This Subtopic specifically
addresses the accounting requirements that apply to the
following:
-
The determination of the basis differences which result from tax deductions arising in different amounts and in different periods from compensation cost recognized in financial statements
-
The recognition of tax benefits when tax deductions differ from recognized compensation cost
-
The presentation required for income tax benefits from share-based payment arrangements.
05-4 Income tax
regulations specify allowable tax deductions for instruments
issued under share-based payment arrangements in determining
an entity’s income tax liability. For example, under tax
law, allowable tax deductions may be measured as the
intrinsic value of an instrument on a specified date. The
time value component, if any, of the fair value of an
instrument generally may not be tax deductible. Therefore,
tax deductions may arise in different amounts and in
different periods from compensation cost recognized in
financial statements. Similarly, the amount of expense
reported for an employee stock ownership plan during a
period may differ from the amount of the related income tax
deduction prescribed by income tax rules and
regulations.
Scope and Scope Exceptions
15-1 This
Subtopic follows the same Scope and Scope Exceptions as
outlined in the Overall Subtopic, see Section 718-10-15,
with specific transaction qualifications noted below.
15-2 The guidance in this Subtopic
applies to share-based payment transactions.
Understanding the tax law relevant to share-based payment awards is critical to
understanding the proper accounting for the income tax effects of such awards. An
entity must carefully consider the specific facts and circumstances of its
share-based payment awards to determine the appropriate income tax treatment for
them, and consultation with the entity’s tax advisers is encouraged. Taxation of
transfers of property (including shares) to employees and vendors in connection with
performance of services and delivery of goods is generally governed by IRC Section
83. This chapter summarizes U.S. tax law related to share-based payment awards under
IRC Section 83.
10.1.1 Nonvested Shares
Under IRC Section 83, the grantee of a nonvested share award is
generally taxed on the date the grantee becomes substantially vested in the
share for income tax purposes (which may be different from the vesting date for
accounting purposes). The fair market value of the share on the income tax
vesting date is treated as ordinary income for the grantee, and the employer
generally will receive a corresponding tax deduction.
10.1.2 Share Options
For share options, taxation depends on whether the transfer of shares resulting
from exercise of the option is considered a qualifying transfer under IRC
Sections 421 and 422.
For the transfer of shares resulting from the exercise of an option to be
considered a qualifying transfer, the following must be true of the option and
option plan:
-
The option plan is approved by the stockholders of the company.
-
The option is granted within 10 years of adoption of the plan or, if earlier, the date on which the stockholders approve the plan.
-
The maximum term of the option is 10 years from the grant date. For employees who own more than 10 percent of the total combined voting power of the employer or of its parent or subsidiary corporation, the maximum term is 5 years.
-
The option price is not less than the fair market value of the stock at the time the option is granted. For employees who own more than 10 percent of the total combined voting power of the employer or of its parent or subsidiary, the option price must not be less than 110 percent of the fair market value.
-
The option is transferable only in the event of death.
-
The employee is employed by the employer (or its parent or subsidiary) for the entire period up to three months before the exercise date of the option.
Share options that meet these criteria are commonly referred to
as incentive stock options (ISOs) or statutory stock options, and shares
transferred or issued in connection with the exercise of such options are
referred to as statutory option stock. Options that do not meet these criteria
are commonly referred to as nonqualified stock options (NQSOs). ISOs may be
issued only to employees, whereas NQSOs may be issued to nonemployees.
To continue being considered as a qualifying transfer, the
transfer of shares resulting from the exercise of an option must meet the
criteria above, and the individual acquiring statutory option stock may not
dispose of it within two years of the grant date or within one year of the
exercise date. If these requirements are violated, a disqualifying disposition
occurs, and the transfer is no longer considered a qualifying transfer. Also,
the maximum amount of ISOs that may first become exercisable by an employee in a
calendar year is $100,000. That maximum is determined by reference to the fair
market value of the shares underlying the option on the grant date (i.e., the
fair value of the shares, not the fair value of the option, on the
grant date). Generally, options to acquire shares that exceed the annual maximum
should be treated as NQSOs.
10.1.2.1 Qualifying Transfers
Qualifying transfers receive favorable tax treatment from the perspective of
the employee. These transfers are not taxable to the employee (or former
employee) for “regular” tax purposes until the statutory option stock has
been disposed of (although there may be AMT consequences — see the next
paragraph). Upon disposition of the stock, the employee will be subject to
long-term capital gains tax for the difference between the proceeds received
upon disposal and the exercise price, as long as the employee has held the
stock for the required periods. If the employee holds the stock for the
required periods, the employer does not receive a tax deduction related to
the ISO.
Under the tax law, an individual must recognize a “tax
preference” item upon exercise of an ISO that is equal to the difference
between the exercise price and the fair market value of the underlying
shares on the exercise date. This tax preference item may cause the
individual to owe AMT. Generally, the AMT may be avoided by selling the ISO
shares in the same calendar year in which they were purchased (a
disqualifying disposition; the tax consequences are noted below). An
employer does not receive a tax deduction corresponding with an employee’s
AMT liability upon exercise of an ISO.
10.1.2.2 Nonqualifying Transfers
If the transfer is considered nonqualifying because the
terms of the award preclude it from being considered an ISO, the intrinsic
value of the option on the date of exercise is included in the employee’s
ordinary income and the employer receives a corresponding tax deduction.
If the transfer is considered nonqualifying because of a disqualifying
disposition, the lesser of (1) the excess of the fair market value of the
stock on the exercise date over the strike price or (2) the actual gain on
sale is included in the employee’s ordinary income as compensation in the
year of the disqualifying disposition. The employer receives a tax deduction
for the amount of income included by the employee.
10.1.3 Restricted Share Units and Share Appreciation Rights
Share-settled RSUs and share appreciation rights (SARs) are both
generally taxed when the shares are transferred in settlement of the award.
Taxation of share-settled RSUs is the same as that for deferred compensation,
resulting in ordinary income for the employee equal to the value of shares when
distributed and a corresponding tax deduction for the employer. RSUs are not
considered legally issued shares and therefore do not represent actual property
interests (e.g., equity in the company). Unlike nonvested shares, RSUs can be
structured to defer income beyond the vesting date.
Taxation of SARs is similar to that of NQSOs. Like NQSOs, SARs
result in income on “exercise” or settlement. The employee has ordinary income
on the basis of the fair value of the cash or shares transferred at settlement,
and the employer receives a corresponding tax deduction.
10.1.4 Employee Stock Purchase Plans
Employees may also have the option to acquire stock of their
employer in accordance with an employee stock purchase plan (ESPP). In a manner
similar to ISOs, the acquisition of stock in connection with an ESPP that meets
the criteria in IRC Section 423 also generally does not result in income to the
employee at the time the stock is purchased. Therefore, the employer would not
ordinarily receive a tax deduction related to shares purchased under an ESPP
unless a disqualifying disposition occurs. The maximum amount of stock that can
be purchased under an ESPP is $25,000 per year.
10.2 Deferred Tax Effects of Share-Based Payments
ASC 718-740
Determination of Temporary Differences
25-1 This guidance addresses how
temporary differences are recognized for share-based payment
arrangement awards that are classified either as equity or
as liabilities under the requirements of paragraphs
718-10-25-7 through 25-19A. Incremental guidance is also
provided for issues related to employee stock ownership
plans.
Instruments Classified as Equity
25-2 The
cumulative amount of compensation cost recognized for
instruments classified as equity that ordinarily would
result in a future tax deduction under existing tax law
shall be considered to be a deductible temporary difference
in applying the requirements of Subtopic 740-10. The
deductible temporary difference shall be based on the
compensation cost recognized for financial reporting
purposes. Compensation cost that is capitalized as part of
the cost of an asset, such as inventory, shall be considered
to be part of the tax basis of that asset for financial
reporting purposes.
25-3 Recognition of compensation
cost for instruments that ordinarily do not result in tax
deductions under existing tax law shall not be considered to
result in a deductible temporary difference. A future event
can give rise to a tax deduction for instruments that
ordinarily do not result in a tax deduction. The tax effects
of such an event shall be recognized only when it occurs. An
example of a future event that would be recognized only when
it occurs is an employee’s sale of shares obtained from an
award before meeting a tax law’s holding period requirement,
sometimes referred to as a disqualifying disposition, which
results in a tax deduction not ordinarily available for such
an award
Instruments Classified as Liabilities
25-4 The
cumulative amount of compensation cost recognized for
instruments classified as liabilities that ordinarily would
result in a future tax deduction under existing tax law also
shall be considered to be a deductible temporary difference.
The deductible temporary difference shall be based on the
compensation cost recognized for financial reporting
purposes.
Initial Measurement
30-1 The
deferred tax benefit (or expense) that results from
increases (or decreases) in the recognized share-based
payment temporary difference, for example, an increase that
results as additional service is rendered and the related
cost is recognized or a decrease that results from
forfeiture of an award, shall be recognized in the income
statement.
10.2.1 Equity-Classified Awards That Ordinarily Result in a Tax Deduction
ASC 718-740-25-2 indicates that the “cumulative amount of
compensation cost recognized for instruments classified as equity that ordinarily would result in a future tax deduction
under existing tax law shall be considered to be a deductible temporary
difference in applying [ASC 740]” (emphasis added). This represents the
first of two key exceptions to ASC 740’s balance sheet model contained in ASC
718 (see Section
10.2.10 for discussion of the second). Because the accounting for
an equity award under ASC 718 does not result in a difference in the basis of an
asset or liability recognized for income tax or financial reporting purposes
(i.e., because the offsetting entry to compensation cost is equity of the
issuer), no temporary basis difference would exist, and therefore no deferred
taxes would be recorded for such an award. ASC 718-740-25-2, however, requires
that the cumulative amount of compensation cost itself be considered a
deductible temporary difference for which a DTA is recorded. Likewise,
recognition of compensation cost for share-based payments that “ordinarily do
not result in tax deductions” do not give rise to deferred taxes, as
indicated in ASC 718-740-25-3, but the recognition of a DTA may be required if a
future event gives rise to a tax deduction that ordinarily would not be
available for such instruments. See Section 10.2.7 for additional
information.
As described in Section 10.1, examples of awards that
ordinarily would result in a future tax deduction under U.S. tax law include
nonvested shares, SARs, RSUs, and NQSOs.
The example below illustrates the basic deferred income tax
effects of deductible, equity-classified share-based payment awards in
situations in which the amount of cumulative compensation cost and the ultimate
amount of the associated tax deduction are equal.
Example 10-1
Assume the following:
-
Company A grants 100 equity-classified NQSOs on its $0.01 par value common stock to its employees in 20X1.
-
The strike price of the options is equal to the fair value of A’s common stock of $5 on the grant date. The fair value of the options on the grant date is $4.
-
The options vest at the end of the fourth year of service (cliff vesting).
-
The options are exercised immediately after the completion of the four-year vesting period, when the share price is $9, and A receives a tax deduction when the options are exercised.
-
Company A has a 21 percent tax rate in all years.
Because the $400 of compensation cost
(100 awards × $4 fair-value-based measure) that will
result in a future tax deduction is recognized over the
requisite service period, a temporary difference arises,
and A records a DTA in accordance with ASC 718-740. This
DTA is equal to the book compensation cost multiplied by
A’s applicable tax rate. The effect of forfeitures is
ignored for simplicity in this example. Therefore, the
following journal entries are made at the end of each
service year to recognize the compensation cost and tax
benefits associated with the options:
Journal Entries
(Years 1–4)
Upon exercise of the options, the fair
value of the company’s stock is $9, resulting in a tax
deduction1 of $400 for income tax purposes, or ($9 – $5) ×
100 option awards.
Journal Entry:
Pretax Entries Upon Exercise of Options
Journal Entries: Tax
Effects of Exercise of Options
Because the cumulative compensation cost
and the amount of the tax deduction upon exercise of the
options are equal, there is no net impact to income tax
expense or benefit as a result of the exercise.
10.2.2 Liability-Classified Awards That Ordinarily Result in a Tax Deduction
As indicated in ASC 718-740-25-4, the accounting for
liability-classified awards that would ordinarily result in a tax deduction is
the same as that for equity-classified awards. That is, the cumulative amount of
compensation cost recognized for financial reporting purposes represents a
deductible temporary difference for which a DTA is recorded. While ASC 718-740
does not make a distinction between equity and liability-classified awards
(e.g., a SAR that requires settlement in cash) for this purpose, the deferred
tax accounting for liability awards does not represent an exception to the
balance sheet model under ASC 740 because the cumulative amount of compensation
cost recorded for financial reporting purposes under ASC 718 does result
in a temporary difference (i.e., a liability recorded for financial reporting
purposes with no corresponding liability for tax purposes).
10.2.3 Determining Deductibility of Awards Under IRC Section 162(m)
IRC Section 162(m) may limit the deductibility of an ordinarily
deductible share-based payment award issued by an entity that is a “publicly
held corporation” under that section’s requirements. The definition of a
publicly held corporation includes entities that must register securities or
file reports under Sections 12 or 15(d), respectively, of the Securities
Exchange Act of 1934. IRC Section 162(m) specifically limits the deductibility
of compensation paid to a company’s CEO and CFO as well as its three other
highest paid officers (referred to collectively as “covered employees”). Under
IRC Section 162(m), only the first $1 million in compensation (whether cash or
share based renumeration) paid to a covered employee is deductible for tax
purposes in any given year. Once an individual becomes a covered employee, he or
she remains a covered employee in each taxable year during the period of
employment and thereafter, including after termination and death. Before the
enactment of the 2017 Act, compensation that was performance based was
generally not subject to this limitation, which lessened the impact of IRC
Section 162(m) on the deductibility of executive compensation given that
performance-based compensation is common for covered employees.
In addition, IRC Section 162(m) applies differently to (1)
compensation arrangements entered into before November 2, 2017 (that have not
been materially modified on or after that date2), and (2) compensation arrangements entered into on or after November 2,
2017. That is, only compensation stemming from a written, binding contract
entered into after November 2, 2017 (or a preexisting contract modified on or
after this date), is subject to the revised terms of IRC Section 162(m) as
amended by the 2017 Act. Compensation arrangements that were in place before
this date are effectively “grandfathered,” and the legacy requirements apply.
Therefore, it is important for an entity to consult with its tax advisers
regarding the deductibility of executive compensation for covered employees to
determine how the limitations in IRC Section 162(m) apply.
Because IRC Section 162(m) applies to all types of compensation
issued to covered employees, it may be difficult to determine the extent to
which the share-based component of the covered employees’ compensation is
limited by IRC Section 162(m). We are aware of three approaches that have been
commonly applied in practice both before and since enactment of the 2017 Act
regarding the accounting for deferred taxes in cases in which compensation is
expected to be limited by IRC Section 162(m). These approaches are as
follows:
-
Deductible compensation is allocated to cash compensation first — A DTA would not be recorded for share-based compensation if cash compensation is expected to exceed the limit.
-
Deductible compensation is allocated to earliest compensation recognized for financial statement purposes — Because stock-based compensation is typically expensed over a multiple-year vesting period but deductible when fully vested or exercised, and cash-based compensation is generally deductible in the period in which it is expensed for financial statement purposes, stock-based compensation is generally considered the earliest compensation recognized for financial statement purposes, and a DTA for share-based compensation would be recorded up to the deductible limit.
-
Limitation is allocated pro rata between stock-based compensation and cash compensation — A partial DTA may result on the basis of the expected ratio of share-based compensation to cash compensation.
The choice of which approach to apply is a policy election that should be applied
consistently.
See Section 10.3 for guidance on the
accounting for an award subject to IRC Section 162(m) that is determined not to
be deductible.
Changing Lanes
On March 11, 2021, President Biden signed into law the American Rescue
Plan Act of 2021, which expands the definition of “covered employee” in
IRC Section 162(m) for tax years after December 31, 2026. The Act
expands the definition to include not only the CEO, the CFO, and the
next three most highly compensated executive officers but also the next
five highest compensated individuals, and it does not limit covered
employees to officers. Further, such individuals do not automatically
retain covered employee status in each subsequent taxable year.
Accordingly, entities will need to establish policies to identify the
additional five highest compensated employees for each taxable year to
determine the qualifying compensation associated with each of them and
the related tax effects.
10.2.4 Excess Tax Benefits and Tax Deficiencies
ASC 718-740
Treatment of Tax Consequences When Actual Deductions
Differ From Recognized Compensation Cost
35-2 This Section addresses the
accounting required in a period when the deduction for
compensation expense to be recognized in a tax return
for share-based payment arrangements differs in amounts
and timing from the compensation cost recorded in the
financial statements. The tax effect of the difference,
if any, between the cumulative compensation cost of an
award recognized for financial reporting purposes and
the deduction for an award for tax purposes shall be
recognized as income tax expense or benefit in the
income statement. The tax effect shall be recognized in
the income statement in the period in which the amount
of the deduction is determined, which typically is when
an award is exercised or expires, in the case of share
options, or vests, in the case of nonvested stock
awards. The appropriate period depends on the type of
award and the incremental guidance under the
requirements of Subtopic 740-270 on income taxes —
interim reporting.
35-3
Paragraph superseded by Accounting Standards Update No.
2016-09.
35-4 See
Examples 1, Case A (paragraph 718-20-55-10); 8
(paragraph 718-20-55-71); 15, Case A (paragraph
718-20-55-123); and Example 1 (paragraph 718-30-55-1),
which provide illustrations of accounting for the income
tax effects of various awards.
The tax deduction that arises for an equity-classified
share-based payment award will frequently differ from the amount of compensation
cost recorded for financial reporting purposes. Such a difference is referred to
as an excess tax benefit (when the amount of the tax deduction is greater than
the compensation cost recognized for financial reporting purposes) or as a tax
deficiency (when the amount of the tax deduction is less than the compensation
cost recognized for financial reporting purposes). In accordance with ASC
718-740-35-2, the excess tax benefits and tax deficiencies are recognized as
decreases or increases to current tax expense in the income statement in the
period in which the excess tax benefits or tax deficiencies arise. This results
in a permanent difference between the amount of cumulative compensation for
financial reporting purposes and the tax deduction taken for income tax purposes
and has an impact on an entity’s ETR in the period in which the excess or
deficiency arises. The example below illustrates an excess tax benefit and a tax
deficiency for a deductible equity-classified award. See Section 10.3 for further
discussion of permanent differences associated with share-based payments.
Example 10-2
Assume the following:
-
Company A grants 100 NQSOs on its $0.01 par value common stock to its employees in 20X1.
-
The strike price of the options is equal to the fair value of A’s common stock of $5 on the grant date. The fair value of the options on the grant date is $4.
-
The options vest at the end of the fourth year of service (cliff vesting).
-
The options are exercised immediately after the completion of the four-year vesting period, when the share price is $10, and A receives a tax deduction when the options are exercised.
-
Company A has a 25 percent tax rate in all years.
Because the $400 of compensation cost
(100 awards × $4 fair-value-based measure) that will
result in a future tax deduction is recognized over the
requisite service period, a temporary difference arises,
and A records a DTA in accordance with ASC 740. This DTA
is equal to the book compensation cost multiplied by A’s
applicable tax rate. The effect of forfeitures is
ignored for simplicity in this example. Therefore, the
following journal entries are made at the end of each
service year to recognize the compensation cost and tax
benefits associated with the options:
Journal Entries
(Years 1–4)
Upon exercise of the options, the fair
value of the company’s stock is $10, resulting in a tax
deduction3 of $500 for income tax purposes, or ($10 – $5) ×
100 option awards.
Journal Entry:
Pretax Entries Upon Exercise of Options
Journal Entry: Tax
Effects of Exercise of Options
If the share price at the time of
exercise was instead $8, a tax deficiency would be
recognized as follows:
Journal Entry: Upon
Exercise of Options
10.2.4.1 Excess Tax Benefits and Tax Deficiencies in Interim Financial Statements
ASC 740-270-30-4, ASC 740-270-30-8, and ASC 740-270-30-12
require entities to account for excess tax benefits and tax deficiencies as
discrete items in the period in which they occur (i.e., entities should
exclude them from the AETR). Therefore, the effects of expected future
excesses and deficiencies should not be anticipated. However, the tax
effects of the expected compensation expense should be included in the AETR.
See Chapter 7
for further guidance on the accounting for income taxes associated with
share-based payments in interim financial statements.
10.2.4.2 Tax Deficiency Resulting From Expiration of an Award
When a fully vested NQSO award has expired unexercised, the tax effects are
accounted for as if the tax deduction taken is zero. Thus, the DTA recorded
in the financial statements would be reduced to zero through a charge to
deferred income tax expense. See ASC 718-20-55-23.
Example 10-3
A company grants 1,000 “at-the-money” fully vested
NQSOs, each of which has a grant-date
fair-value-based measure of $4. The company’s
applicable tax rate is 25 percent. Further assume
that no valuation allowance has been established for
the DTA and that the awards subsequently expire
unexercised. The company would record the following
journal entries:
Journal Entries: Upon Grant
Journal Entry: Upon Expiration
10.2.5 Deferred Tax Effects of a Change in Share Price on Equity-Classified Awards
The DTA associated with stock-based compensation is computed on
the basis of the cumulative amount of stock-based compensation cost recorded in
the financial statements and is not affected by the grantor’s current stock
price. Such DTAs should not be remeasured or written off because of a decline in
the grantor’s stock price, even if it has declined so significantly that (1) an
award’s exercise is unlikely to occur or (2) the intrinsic value on the exercise
date will most likely be less than the cumulative compensation cost recorded in
the financial statements (i.e., a tax deficiency exists).
10.2.6 Deferred Tax Effects of a Change in Share Price on Liability-Classified Awards
The primary difference between the deferred income tax
accounting for equity-classified awards and that for liability-classified awards
under ASC 718 is that the measurement of the DTA associated with
liability-classified awards inherently takes into account the grantor’s current
stock price in each period. This is because liability-classified awards are
remeasured to their fair-value-based amount each period until settlement. The
DTA (and corresponding deferred income tax benefit) is recognized in the same
manner as the compensation cost (i.e., either immediately or over the remaining
service period, depending on the vested status of the award). Because the DTA
and the associated compensation cost are remeasured in each reporting period,
the tax benefit of the liability-classified award will, upon settlement, equal
the DTA. Accordingly, the settlement of a liability-classified award generally
will not result in an excess tax benefit or a tax deficiency as described in
Section 10.2.4 for equity-classified
awards.
The example below illustrates the differences between the income
tax accounting for deductible equity-classified versus liability-classified
awards issued in the form of SARs (including an excess tax benefit).
Example 10-4
On January 1, 20X1, Company A grants 1,000 SARs to one
employee. The SARs vest at the end of the second year of
service (cliff vesting). The fair-value-based measures
of the SARs are as follows:
-
$10 on January 1, 20X1.
-
$15 on December 31, 20X1.
-
$14 on December 31, 20X2.
-
$18 on December 31, 20X3.
For simplicity, the effects of forfeitures have been
ignored. Company A’s applicable tax rate is 21 percent.
There are no interim reporting requirements. In Scenario
1 (see table below), A is required to settle the SARs
with shares (equity-classified award). Note that the
income tax accounting for an equity-classified SAR is
the same as the accounting for an equity-classified
NQSO. In Scenario 2 (see table below), A is required to
settle the SARs with cash (liability-classified award).
The award is settled on May 15, 20X4, and the value of
the shares (Scenario 1) and cash (Scenario 2) delivered
upon settlement is $16.
10.2.7 Deferred Tax Effects of a Change in Tax Status of an Award
If an entity has non-tax-deductible awards (e.g., ISOs) that are expected to be
subject to disqualifying dispositions, it should follow the guidance under ASC
718-740-25-3, which explains that an entity cannot record a tax benefit in the
income statement until the disqualifying disposition of an award occurs.
Therefore, no DTA and related tax benefit can be recognized in connection with
such an award until a disqualifying disposition occurs.
When a disqualifying disposition occurs, a tax deduction is
available to be taken in the employer’s tax return. The benefit of any tax
deduction resulting from the disqualifying disposition would be recorded as a
reduction of current-period tax expense in the income statement.
Example 10-5
A company grants a fully vested ISO with a grant-date
fair-value-based measure of $100, which is recorded in
the income statement as compensation cost. Since the
award is an ISO, no corresponding DTA or tax benefit is
recorded because the award does not ordinarily result in
a tax deduction for the company.
Assume that a disqualifying disposition
occurs and results in the company’s taking a tax
deduction of $120 in its tax return. If the company’s
applicable tax rate is 25 percent, the company would
record a $30 current income tax benefit in the income
statement ($120 tax deduction taken on the income tax
return × 25% tax rate).
Example 10-6
Assume the same facts as in the example
above except that the disqualifying disposition results
in a tax deduction of only $80. If the company’s
applicable tax rate is 25 percent, the company would
record a tax benefit of $20 as a reduction of current
income tax expense in the income statement ($80 tax
deduction taken on the income tax return × 25% tax
rate).
10.2.8 Deferred Tax Effects of Changes in Tax Rates
When enacted changes occur in the tax law that cause a change in
an entity’s tax rate, a DTA related to temporary differences arising from
tax-deductible share-based payment awards should be adjusted in the period in
which the change in the applicable tax rate is enacted into law. To determine
the amount of the new DTA, an entity should multiply the new tax rate by the
existing temporary difference for outstanding tax-deductible share-based payment
awards measured as of the enactment date of the rate change. The difference
between the new DTA and the existing DTA should be recorded as a deferred tax
benefit or expense and allocated to income from continuing operations
discretely. See Section
3.5.1 for a broader discussion of the accounting for deferred tax
effects of changes in rates.
10.2.9 Deferred Tax Effects of IRC Section 83(b) Elections and “Early” Exercises of NQSOs
The grantee of a nonvested share may, within 30 days of that
grant, make an election under IRC Section 83(b) to be taxed when the award is
granted (i.e., when the property is transferred for IRC Section 83 purposes)
rather than when it vests for tax purposes (commonly referred to as an 83(b)
election). In that case, the grantee will have ordinary income equal to the fair
market value of the stock on the date the award is granted and the employer will
receive a corresponding tax deduction. Any subsequent appreciation realized by
the employee upon sale of those shares is taxed at capital gains rates.4
Similarly, a grantee of an NQSO may be permitted to exercise the
option before it is vested (commonly referred to as an “early exercise”). The
stock received upon an early exercise represents a nonvested share for which the
grantee may make an 83(b) election. In this scenario, the grantee will have
ordinary income equal to the intrinsic value of the option on the date of the
early exercise (which, for options issued at the money, will be zero if early
exercised on the grant date) and the employer will receive a corresponding tax
deduction. Such awards often include an employer call feature that allows the
issuer to repurchase the option share if the employee leaves before the end of
the requisite service period.
When an employee makes an 83(b) election upon receipt of a
nonvested share, a DTL should be recorded for the amount of the tax benefit on
the basis of the tax deduction that the employer receives. For example, if an
employee receives an equity-classified nonvested share with a grant-date fair
value of $10 and makes an 83(b) election, the employee will be taxed on ordinary
income of $10 and the employer will receive a tax deduction of $10. Assuming a
tax rate of 21 percent, the employer would record a current tax benefit (and
reduced income tax payable) of $2.10 to account for the tax deduction. The
employer would also record a DTL and deferred tax expense of $2.10 in the period
of the grant. The DTL will then be reversed in proportion to the amount of
expense recorded over the requisite service period, resulting in a normal
rate.
10.2.10 Deferred Tax Effects When Compensation Cost Is Capitalized
Under U.S. GAAP, compensation cost may be capitalized for
employees who spend time on production of inventory or construction of fixed
assets. This results in an asset for financial reporting purposes with no
corresponding tax basis and, under ASC 740, would ordinarily represent a taxable
temporary difference and corresponding DTL. However, in accordance with ASC
718-740-25-2 (for instruments classified as equity) and ASC 718-740-25-4 (for
instruments classified as liabilities), the “cumulative amount of compensation
cost recognized for instruments . . . that ordinarily would result in a future
tax deduction under existing tax law shall be considered to be a deductible
temporary difference.” If the cost of an award that will ordinarily result in a
tax deduction for tax purposes is capitalized (e.g., as part of inventory or a
fixed asset), the capitalized cost also becomes part of the tax basis of the
asset. This represents the second of two key exceptions to ASC 740’s balance
sheet model contained in ASC 718 (see Section 10.2.1 for a discussion of the
first). As a result of this exception, the book and tax basis of the capitalized
compensation cost initially are considered to be equal and no DTL is recorded.
If depreciation is taken for financial reporting purposes before a tax deduction
(or capitalization) for income tax purposes, a temporary difference will arise.
Upon generating a tax deduction (or upon capitalization) for income tax
purposes, an entity should recognize any excess tax benefit or tax deficiency in
the income statement. Any capitalized cost of an award that would not ordinarily
result in a future tax deduction would not be treated as part of the tax basis
of the asset in accordance with ASC 718-740-25-3.
Example 10-7
In year 1, Company A grants fully vested NQSOs to the
employees involved in the construction of a fixed asset,
resulting in the capitalization of $1,500 of share-based
compensation cost. Other key facts include the following:
-
The asset is placed into service at the beginning of year 2 and has a 10-year life.
-
Awards are fully vested on the grant date.
-
Company A will receive a tax deduction for the intrinsic value of the option when it is exercised.
-
Company A’s tax rate is 25 percent.
-
The employees exercise the options with an intrinsic value of $4,000 at the end of year 3.
-
None of the compensation cost is capitalized for income tax purposes upon exercise.
Journal Entry: Grant Date in Year 1
On the grant date, the share-based compensation cost
related to the NQSOs increases the carrying amount of
A’s fixed asset under construction by $1,500. The
offsetting entry is a credit to APIC.
In year 2, A records $150 of
depreciation expense and has a $1,350 remaining book
basis in the portion of the equipment’s carrying amount
related to the share-based compensation cost. In
accordance with ASC 718-740-25-2, A’s corresponding tax
basis is presumed to be $1,500, which is not depreciated
for tax-return purposes. As a result, A recognizes a
$37.50 DTA: ($1,500 tax basis – $1,350 book basis) × 25%
tax rate.
Journal Entries: Year 2
Journal Entries: Year 3
Record Depreciation and DTA (Same as Year 2)
Record Exercise of Options
When accounting for the impact of
exercising the options, A must (1) record a reduction in
income taxes payable and corresponding reduction of
current tax expense of $1,000 resulting from the
exercise ($4,000 × 25%), (2) reverse the $75 DTA
generated in years 2 and 3, and (3) establish a DTL for
the basis difference resulting from the exercise:
($1,200 remaining book basis − $0 remaining tax basis) ×
25% tax rate = $300 DTL. Note that this results in the
entire excess tax benefit’s being recorded immediately
in the income statement upon exercise.
In years 4 through 11, A would continue
to record depreciation expense. In addition, A would
reduce the DTL and record a corresponding tax deduction
in the deferred tax expense over the same period.
Journal Entries: Years 4 Through 11
10.2.11 Deferred Tax Effects of Awards Issued to Employees of Consolidated Partnerships
When share-based payment awards of a public corporation (“PubCo”) are issued to the
employees of a consolidated operating partnership (“LLC”), compensation cost is
recognized in both the consolidated financial statements of PubCo and in the
stand-alone financial statements of LLC. The compensation cost is recognized for the
share-based payment awards as a debit-to-stock compensation expense and a credit to
equity (APIC) (i.e., a “net zero” impact on both consolidated and stand-alone equity
of the reporting entities).
Assuming that PubCo is entitled to a future tax deduction (as a result of its
attributable share of LLC’s tax deduction) when the options are exercised, PubCo
would recognize a DTA in accordance with ASC 718-740-25-2 for its portion of the
cumulative amount of compensation cost that would ordinarily result in future tax
deductions for PubCo under existing law. Such DTA would be recognized separately and
apart from any deferred taxes PubCo records for its outside basis difference in its
investment in LLC. See Section 3.4.15 for a
discussion of the two acceptable approaches for recording the deferred tax
consequences of an investment in a pass-through entity: the outside basis approach
and the look-through approach.
Footnotes
1
The tax deduction represents the
difference between the company’s share price on
the date of exercise and the exercise price stated
in the award multiplied by the number of options
awarded.
2
The 2017 Act contains explicit wording indicating that
material modifications made to a compensation agreement on or after
November 2, 2017, will cause the agreement to become subject to the
updated requirements of IRC Section 162(m). An analysis of applicable
laws is necessary in order to assess whether an arrangement constitutes
a written binding contract as of November 2, 2017. Judgment may be
required in the determination of whether a modification is material.
Further, if a modified compensation agreement is related to a
share-based payment award, companies will need to consider whether the
modification guidance in ASC 718-20 should be applied.
3
See footnote 1.
4
Because RSUs do not represent actual property interests
(e.g., equity in the company), an employee receiving RSUs does not have
an opportunity to make an IRC Section 83(b) election on the grant
date.
10.3 Permanent Differences Resulting From Share-Based Payment Awards
As indicated in ASC 718-740-25-3, recognition of compensation cost
for share-based payments that “ordinarily do not result in tax deductions” do not
give rise to deferred taxes for financial accounting purposes. In addition, excess
tax benefits and tax deficiencies result in permanent differences between the amount
of cumulative compensation cost recorded for equity-classified share-based payments
and the amount of the corresponding tax deduction taken for tax purposes as
discussed in Section
10.2.4.1. Other circumstances that result in permanent differences
are discussed in the next sections.
10.3.1 Equity- and Liability-Classified Awards That Do Not Ordinarily Result in a Tax Deduction
ASC 718-740-25-3 indicates that the cumulative amount of
compensation cost for awards that would not ordinarily result in a future tax
deduction under existing tax law does not represent a deductible temporary
difference. No deferred taxes would be recorded for these awards unless a change
in circumstances occurs. A common example of this type of an award is an ISO
(see Section 10.1).
When an entity issues an ISO, it will record compensation cost as the award is
earned but will not receive a tax deduction upon the holder’s exercise of the
award (i.e., a tax deduction will result only if the holder subsequently
disposes of the shares in a disqualifying disposition). Thus, the resulting book
expense is considered a permanent book-to-tax difference and will have the
effect of increasing the issuing entity’s ETR.
10.3.2 Tax Benefits of Dividends on Share-Based Payment Awards
ASC 718-740
Tax Benefits of
Dividends on Share-Based Payment Awards to
Employees
45-8 An income tax benefit from
dividends or dividend equivalents that are charged to
retained earnings and are paid to grantees for any of
the following equity classified awards shall be
recognized as income tax expense or benefit in the
income statement:
-
Nonvested equity shares
-
Nonvested equity share units
-
Outstanding equity share options.
As discussed further in Section 3.10 of Deloitte’s Roadmap
Share-Based Payment
Awards, the terms of some share-based payment awards
permit holders to receive a dividend during the vesting period and, in some
instances, to retain the dividend even if the award fails to vest. Such awards
are commonly referred to as “dividend-protected awards.” Dividend payments made
to grantees for dividend-protected awards should be charged to retained earnings
to the extent that the awards are expected to vest. If an employee is entitled
to retain dividends paid on shares that fail to vest, the dividend payment for
dividend-protected awards that are not expected to vest should be charged to
compensation cost.
For income tax purposes, dividends paid on such awards may
result in a tax deduction and corresponding income tax benefit. The income tax
benefit resulting from payment of dividends on (1) nonvested equity shares, (2)
nonvested equity share units, and (3) outstanding equity share options should be
recorded as an income tax benefit in the income statement. If the dividend is
charged against retained earnings for pretax accounting purposes, a permanent
difference will result.
10.4 “Recharge Payments” Made by Foreign Subsidiaries
Generally, a U.S. parent company is not entitled to a share-based compensation tax
deduction (in the United States) for awards granted by the parent to employees of a
foreign subsidiary. Likewise, in most jurisdictions, the foreign subsidiary that
does not bear the cost of the compensation (i.e., because the foreign parent who
issued the award to the foreign subsidiary’s employees is bearing the cost) will not
be able to deduct the award in the foreign jurisdiction. Accordingly, some
arrangements may specify that a foreign subsidiary will make a “recharge payment” to
the U.S. parent company that is equal to the intrinsic value of the stock option
upon its exercise so that the foreign subsidiary is entitled to take a local tax
deduction equal to the amount of the recharge payment. Under such an arrangement,
the U.S. parent company is not taxed on the payment made by the foreign subsidiary
with respect to the parent company’s stock.
At its July 21, 2005, meeting, the FASB Statement 123(R) Resource
Group agreed that in this case, the direct tax effects of share-based compensation
awards should be accounted for under the ASC 718 income tax accounting model.
Because the U.S. parent company does not receive a tax deduction on its U.S. tax
return for awards granted to employees of the foreign subsidiary, the foreign
subsidiary’s applicable tax rate is used to measure (1) DTAs and (2) excess tax
benefits and tax deficiencies recorded by the foreign subsidiary in accordance with
ASC 718. Any indirect effects of the recharge payment are not accounted for under
ASC 718. For example, if payment of the recharge results in an increase in an
outside basis deductible temporary difference or a reduction in an outside basis
taxable temporary difference, the corresponding deferred tax benefit will be
recognized in the income statement at the time the recharge payment is made and the
tax deduction actually occurs for income tax reporting purposes.
10.5 Cost-Sharing Arrangements
Related entities in different tax jurisdictions may enter into cost-sharing
agreements under which one party is reimbursed for a portion of certain costs it
incurred in undertaking shared development activities associated with intangible
property. A jurisdiction may permit or require the resident entity to include
stock-based compensation cost in the joint cost pool that is reimbursed (commonly
referred to as the all costs rule).
The guidance in this section is applicable for entities that are allocating
stock-based compensation to related parties under a qualified cost-sharing
arrangement. See Section 4.6.3 for a
discussion of uncertain tax positions associated with transfer pricing.
The issue of accounting for income taxes related to cost-sharing arrangements in the U.S. federal tax jurisdiction was discussed at the FASB Statement 123(R) Resource
Group’s July 21, 2005, meeting. The discussion document for the meeting states, in part:
Related companies that plan to share the cost of developing intangible
property may choose to enter into what is called a cost-sharing agreement
whereby one company bears certain expenses on behalf of another company and
is reimbursed for those expenses. U.S. tax regulations specify the expenses
that must be included in a pool of shared costs; such expenses include costs
related to stock-based compensation awards granted in tax years beginning
after August 26, 2003.
The tax regulations provide two methods for determining the amount and timing
of share-based compensation that is to be included in the pool of shared
costs: the “exercise method” and the “grant method.” Under the exercise
method, the timing and amount of the allocated expense is based on the
intrinsic value that the award has on the exercise date. Companies that
elect to follow the grant method use grant-date fair values that are
determined based on the amount of U.S. GAAP compensation costs that are to
be included in a pool of shared costs. Companies must include such costs in
U.S. taxable income regardless of whether the options are ultimately
exercised by the holder and result in an actual U.S. tax deduction.
The example below, adapted5 from the discussion document, illustrates the accounting for income taxes
associated with the allocation of share-based payment awards under a cost-sharing
arrangement in the U.S. federal tax jurisdiction.
Example 10-8
Company A, which is located in the United
States, enters into a cost-sharing arrangement with its
subsidiary, Company B, which is located in Switzerland.
Under the arrangement, the two companies share costs
associated with the R&D of certain technology. Company B
reimburses Company A for 30 percent of the R&D costs
incurred by Company A. The U.S. tax rate is 25 percent.
Cumulative book compensation for a fully vested option
issued to a U.S. employee is $100 for the year ending on
December 31, 20X6. The award is exercised during 20X7, when
the intrinsic value of the option is $150.
The tax accounting impact is as follows:
Exercise Method
On December 31, 20X6, Company A records $18
as the DTA related to the option (rounded for $100 book
compensation expense × 70% not subject to reimbursement ×
25% tax rate). When, in 20X7, the option is exercised, any
net tax benefit that exceeds the DTA is an excess tax
benefit and is recorded in the income statement. The company
is entitled to a U.S. tax deduction resulting in a benefit
(net of the inclusion) of $26 (rounded for $150 intrinsic
value when the option is exercised × 70% not reimbursed ×
25%). Accordingly, $8 ($26 – $18) would be recorded in the
income statement as an excess tax benefit.
Grant Method
The cost-sharing impact is an increase of
currently payable U.S. taxes each period; however, in
contrast to the exercise method, the cost-sharing method
should have no direct impact on the carrying amount of the
U.S. DTA related to share-based compensation. If there was
$100 of stock-based compensation during 20X6, the impact on
the December 31, 20X6, current tax provision would be $8
(rounded for $100 book compensation expense × 30% reimbursed
× 25%). If the stock-based charge under ASC 718 is
considered a deductible temporary difference, a DTA also
should be recorded in 20X6 for the financial statement
expense, in the amount of $25 ($100 book compensation
expense × 25%). The net impact on the 20X6 income statement
is a tax benefit of $17 ($25 – $8). At settlement, the
excess tax deduction of $13 would be recorded in the income
statement.
An entity should consider the impact of cost-sharing arrangements when measuring, on
the basis of the tax election it has made or plans to make, the initial and
subsequent deferred tax effects associated with its stock compensation costs. If
regulations in a particular jurisdiction vary significantly from those in the U.S.
federal tax jurisdiction described above, the entity should consult with its
accounting advisers regarding the appropriate accounting treatment.
Footnotes
5
The original example included in the discussion document for the FASB Statement 123(R) Resource Group’s July 21, 2005, meeting was
developed before the issuance of ASU 2016-09. The example has been modified
herein to reflect the guidance in ASC 718-740-35-2, as amended by ASU
2016-09, which indicates that all excess tax benefits and tax deficiencies
should be recorded in the income statement.
10.6 Accounting Considerations for Valuation Allowances Related to Share-Based Payment DTAs
ASC 718-740
30-2
Subtopic 740-10 requires a deferred tax asset to be
evaluated for future realization and to be reduced by a
valuation allowance if, based on the weight of the available
evidence, it is more likely than not that some portion or
all of the deferred tax asset will not be realized.
Differences between the deductible temporary difference
computed pursuant to paragraphs 718-740-25-2 through 25-3
and the tax deduction that would result based on the current
fair value of the entity’s shares shall not be considered in
measuring the gross deferred tax asset or determining the
need for a valuation allowance for a deferred tax asset
recognized under these requirements.
ASC 718-740-30-2 prohibits an entity from considering the current
price of the grantor’s stock in the measurement of the DTA and adjusting the gross
amount of the DTA to reflect the current price.
When an entity is evaluating the need for a valuation allowance, it
should apply the guidance in ASC 740-10-30-17 through 30-23. That is, whether the
entity needs to record a valuation allowance depends on whether it is more likely
than not that there will be sufficient taxable income to realize the DTA. See
Chapter 5 for a
broader discussion of valuation allowance considerations.
Therefore, even if the award is deep out-of-the-money to a degree
that its exercise is unlikely or the award’s intrinsic value on the exercise date is
most likely to be less than its grant-date fair value, the
entity should not record a valuation allowance unless and until it is more
likely than not that future taxable income will not be sufficient to realize the
related DTAs.
See Section 5.3.2.2.2 for a discussion of the
effects of excess tax deductions for equity-classified share-based payment awards on
the assessment of future taxable income.
Example 10-9
On January 1, 20X6, an entity grants 1,000 “at-the-money”
employee share options, each with a grant-date
fair-value-based measure of $7. The awards vest at the end
of the third year of service (cliff vesting), have an
exercise price of $23, and expire after the fifth year from
the grant date. The entity’s applicable tax rate is 25
percent. On December 31, 20Y0, the entity’s share price is
$5. The entity has generated taxable income in the past and
expects to continue to do so in the future.
In each reporting period, the entity would
record compensation cost on the basis of the number of
awards expected to vest, the grant-date fair-value-based
measure of the award, and the amount of services rendered.
Contemporaneously, a DTA would be recorded on the basis of
the amount of compensation cost recorded at the entity’s
applicable tax rate. On December 31, 20Y0, even though the
likelihood that the employee will exercise the award is
remote (i.e., the award is “deep out-of-the-money”) and the
DTA therefore will not be realized, the entity would not be
allowed to write off any part of the gross DTA or to provide
a valuation allowance against the DTA until the award
expires unexercised (January 1, 20Y1) assuming there is
sufficient future taxable income to realize that DTA on
December 31, 20Y0. The entity would be able to record a
valuation allowance against the DTA only when it is more
likely than not that the entity will not generate sufficient
taxable income to realize the DTA.
10.7 Deferred Tax Effects of Replacement Awards Issued in a Business Combination
See Sections 11.6.3 and
11.6.4 for a discussion of the accounting
for the deferred tax effects of replacement awards issued in a business combination.