Irish executives working for U.S. multinationals need to be on alert for a wind of change may be about to blow through the financial markets. For years investment managers have been extolling the benefits of share buy-backs for shareholders in public companies and for years the boards of many public companies have been happy to oblige. But recently analysts have begun to notice that buy-backs do not bring about the reduction in issued shares that they were expecting.
Take Microsoft. The Financial Times has reported that the company recently returned almost $17bn to shareholders by buying back 150m shares. By reducing the number of shares in issue, the company’s earnings per share should have increased. But the increase was nothing like what it might have been.
The reason was that at the same time the company issued 116m new shares to its employees on foot of the exercise of share options or the vesting of Restricted Stock Units, usually known as RSUs. Microsoft’s employees paid about $1.1bn for this privilege but the company had spent $17bn on the buy-back. The discrepancy did not go unnoticed in the U.S. investor community. What added fuel to investors’ ire is that Microsoft is far from alone in carrying on this practice.
So, what’s the story behind stock options and RSUs?
A generation ago Warren Buffett railed against the grant of stock options to the executives of public companies. He argued that options give executives a one-way bet so that can’t lose even if the company’s share price declines and in this way do not have the same stake as shareholders.
Criticism like this led to changes in reporting rules with the result that grants had to be expensed on a company’s income statement instead of merely appearing as a footnote. More unpopularity came with the recession of 2008/09 when stock markets crashed, and many executives found that their options became worthless.
Cue the rise of the RSU, essentially a promise to an executive that, on completion of a ‘vesting period’, he or she will receive a number of shares. This technique attracted its fair share of criticism too because all an executive had to do to earn RSUs was to remain in his or her job until the vesting period had expired.
To avoid this, PSUs or performance stock units came to be used. With these shares could only be issued if the company met a pre-defined performance test.
The first rule for executives
Many Irish executives in public companies enjoy share options, RSUs and PSUs. What lessons can they take from all this?
The first and most obvious lesson is, Don’t Lose It, in other words, do nothing that may jeopardise the inherent value in share options, RSUs and similar financial instruments that have been received or are yet to be received. Quitting the job is one way of spoiling the party.
And the second rule
The second rule is not to ignore the tax rules that apply to these awards. Operating the rules correctly will prevent the value of the awards from being dissipated by arrears of tax, interest and, possibly, penalties.
Take share options that are granted by an employer as an example. An option is just a right that the employer has granted the executive to acquire shares in the company. Income tax is payable on any gain from the exercise, assignment or release of a share option. But tax may also be payable on the value of the grant itself if the option can be exercised more than 7 years after the date of grant. It pays to check.
The tax complications don’t end there. Having acquired shares through the exercise of an option, the executive may decide to sell some or all of them. If he or she already holds shares that will give rise to a taxable gain when sold, a Capital Gains Tax trap awaits the unwary executive. This is because the cost of shares that are sold is arrived at by applying the first-in-first-out rules. So, it’s possible for a sale after the exercise of the option to be matched with a low, historic cost, and in this way for a taxable gain to arise.
Luckily the executive has an important choice. His or her potential tax cost can be avoided by taking care to sell the new shares within the time limit that overcomes the first-in-first-out rule.
As for RSUs and PSUs, executives usually do not run into income tax problems with shares that are acquired under RSU and PSU rules, since the employer is obliged to deduct PAYE/PRSI/USC at the point that the executive acquires the shares. Capital Gains Tax is another matter and will normally be a more relevant consideration. Here, the same timing rule as was mentioned above will also apply. In this way the executive can avoid the first-in-first-out rule and avoid the tax cost that would otherwise arise.