Great review of Proposed new ESPP Regulations from Baker and McKenzie

IRS Issues Proposed Regulations for ESPPs

On
July 29, 2008, the IRS issued a comprehensive set of proposed
regulations under Section 423 of the Code, which contain major
revisions to the regulations dealing with tax-qualified Employee Stock
Purchase Plans ("ESPPs").

Although
in many respects these new proposed regulations restate or merely
update the rules currently in effect, several significant changes are
proposed that are worthy of note.  They are as follows: 

Exclusion of Employees

As you know, Section 423 permits exclusion of employees:

(1)         who have been employed less than two years,

(2)         who customarily work 20 hours or less per week,

(3)         who customarily work not more than five months in any calendar year; and

(4)         who are highly compensated employees (under the tax-qualified plan definition in Section 414(q) of the Code).

In
these proposed regulations, the IRS permits an employer to exclude a
narrower subset of employees than the categories of excludable
employees specified in the statute.  Thus, a plan may
exclude employees who have completed a shorter period of service or
whose customary employment is for fewer hours per week or fewer months
in a calendar year than is specified in the statute.  However,
the proposed regulations then take the rather surprising position that,
although a company may exclude a narrower subset of employees in any of
these excludable categories, it must do so in an identical manner
relative to all employees of every corporation whose employees are
granted options under the ESPP.  This is surprisingly
restrictive, given that past practice has been for a company to exclude
all employees of less than two years employment in the parent, for
example, but exclude only those with less than one year in a particular
subsidiary, or to exclude all highly compensated employees who are
officers of the parent only, without excluding officers of other
corporations even if they are highly compensated employees.  Moreover,
selective exclusion within a permissibly excludable class of employees
is permitted in tax-qualified plans governed by Section 401(a) of the
Code, so it is difficult to understand why the IRS is being so
restrictive here.

This new rule is particularly problematic for ESPPs that wish to exclude part-time employees in the U.S. (e.g.,
less than 20 hours per week), but to include them for European
subsidiaries in order to comply with nondiscrimination requirements in
Europe relating to part-time employees.

As
noted in the Preamble to the proposed regulations, the IRS rejected a
request to permit exclusion of collectively-bargained employees, as
well as non-resident aliens who have no U.S.-source earned income.  The
IRS reasoned that, although these categories may be excluded under
Section 401(a) tax-qualified plans, there is no equivalent statutory
basis in Section 423 to support this exclusion.  The
proposed regulations do provide, however, that employees who are
citizens or residents of a foreign country may be excluded if (1) the
grant of an option to them under the Plan would be prohibited
under the applicable foreign law or (2) compliance with the laws of the
foreign jurisdiction would cause the ESPP to violate Section 423.  This rule may not prove very useful in practice, since very few countries actually prohibit
the grant of an option to a local resident, but the securities or
exchange control laws in that country may make the grant highly
impractical or expensive.  Of course, since the
"excludable employees" portion of the Section 423 rules operate on a
corporation-by-corporation basis, it is still possible to exclude all employees employed by any separate corporation which is treated as a corporation for U.S. income tax purposes (e.g.,
all employees employed by a subsidiary based in Vietnam) and still have
the ESPP be in compliance with the proposed regulations.

If
a company has inadvertently excluded some employees from an ESPP plan,
we had hoped that the IRS might both acknowledge that such an error
would not disqualify the plan and also provide for a corrections
program to allow the excluded employees to participate in past
offerings.  The IRS has not adopted either such hoped-for
rule, but the Preamble to these proposed regulations invites comments
on whether, and how, such a corrections program might be designed.

Equal Rights and Privileges

Code
Section 423(b)(5) requires, subject to limited exceptions, that an ESPP
provide that all employees granted options under the Plan have the same
rights and privileges.  In response to a request that the
ESPP be permitted to vary terms designed to avoid adverse consequences
for an employee under foreign law, the proposed regulations provide a
limited exception to the equal rights and privileges requirement to
permit certain terms to be less favorable with respect to foreign employees in order to comply with the laws of a foreign jurisdiction.

This
limited provision is not likely to be very helpful in most situations
involving foreign employees, however, in that often the local variation
is not required in order to comply with the foreign law, but rather to avoid some expensive or burdensome local regulatory filing or tax issue.  Also, in some cases, local law imposes a requirement that is more favorable than in the U.S., such as payment of interest on payroll deductions.  Accordingly, in such cases the local variation would not be permitted under the proposed regulations.

The proposed regulations make it clear that the method of payment (e.g., payroll deductions versus direct payment by the employee) is one of the rights and privileges that must be equal.  Hence,
if direct payment is permitted in Hong Kong because payroll deductions
are problematic, then it appears that all participants in the ESPP may
need to be permitted to make direct payments.  This result applies even if the employees in Hong Kong are employed by a separate corporate entity (e.g., a subsidiary of the U.S. issuer).[1]  Carryover
of unused amounts as of any purchase date, other than amounts
representing fractional shares, also is a covered right, so that if
some participants as permitted carryovers of unused amounts, any other
participants, even if they would otherwise not have funds to be carried
over, or who are newly eligible, must be able to make a direct payment
in an amount equivalent to the maximum amount carried over by any other
participant.  The limited exception to the equal rights
and privileges requirement and the view that certain features, such as
method of payment, are rights and privileges, are likely to give rise
to significant additional administrative burdens and design headaches
for sponsors of global ESPPs.[2]  In
many cases, employers will be forced to choose between (1) a
tail-wagging-the-dog exercise of making global modifications to plan
design and/or administration in order to comply with the peculiar
requirements of one country and (2) excluding employees of that
subsidiary from participating in the ESPP.  Further,
where employees in a "problematic" country are not all employed by a
separate corporation, excluding all employees in that country may not
be an option.

It
is interesting to note that the proposed regulations do not expand at
all on the statutory exception to the equal rights and privileges
requirement permitting ESPP contributions to be based on a uniform
relationship to total compensation, or to the basic or regular rate of
compensation.  In the past, the IRS has been rather liberal in allowing flexibility and variation in determining eligible compensation.[3]  It
is not clear at this stage whether the tightening of the equal rights
and privileges requirement generally in the proposed regulations will
result in a more restrictive approach to determining eligible
compensation in future rulings. 

Date of Grant

The proposed regulations now make it clear that the beginning of an offering period may be treated as the date of grant.  The
date of grant is critical in determining the one‑year/two-year holding
period for disqualifying dispositions, the date for determining fair
market value for the $25,000 limit and the permissible look-back price
in a look-back plan (where the purchase price is a discount (typically
15%) of the lower of the price on the first day of the offering period
and the purchase date) even though the minimum option price is not
fixed or determinable at that time.  It is still important
to ensure that the Plan provide either a limit on the number of shares
a single employee can purchase for any offering, or a formula to
determine, on the first date of the offering period, the maximum number
of shares the employee can purchase for that offering.

Annual $25,000 limit

Section 423(b)(8)
sets out the $25,000 limit, namely that an ESPP may not grant an
employee an option to purchase stock under the Plan which accrues at a
rate exceeding $25,000 of fair market value of shares (determined as of
the grant date) for each calendar year the option is outstanding.  In
a new interpretation of the statutory language, the proposed
regulations now provide that the $25,000 annual amount can accumulate
not over each year the option is outstanding, as provided in the
statute, but only over years in which the option is both outstanding and exercisable.  In
essentially every ESPP, the option is exercisable only as of the
purchase date, so in an offering period that overlaps a calendar year,
this new interpretation will further limit the amount of shares that
can be purchased.  This is a dramatic change from the
current rule in existing regulations, and evidently resulted from a
desire to calculate this limitation in a manner consistent with the
manner in which the $100,000 limitation under the ISO rules is
determined.[4]  A new example in the proposed regulations illustrates this:

"Corporation FF maintains an employee stock purchase plan and Employee Q is employed by FF.  On
September 1, 2010, FF grants Q an option under the Plan that will be
automatically exercised on August 31, 2011 and August 31, 2012.  On
August 31, 2011, Q may purchase under the option an amount of FF stock
equal to $25,000 in fair market value of FF stock (determined at the
time the option was granted).  On August 31, 2012, Q may
purchase under the option an amount of FF stock equal to the difference
between $50,000 in fair market value of Q stock (determined at the time
the option was granted) and the fair market value of Q stock
(determined at the time of grant of the option) purchased during 2011."

Under
the current regulations, and what seems clear under the statute, Q
could have purchased stock equal to $50,000 in fair market value on
August 31, 2011 and up to $75,000 on August 31, 2012 (less prior
purchases).

If
this rule is not changed in the final regulations, then this change
will affect all ESPPs with offering periods that overlap the calendar
year.  We, and no doubt others, plan to comment on this aspect of the proposed regulations.

Shareholder Approval Requirements for Subsidiary's Option Grants

These
proposed regulations liberalize a restrictive rule that was adopted in
2004 under the final ISO regulations, identifying "granting
corporation" whose shareholders must approve an ESPP plan, when options
are granted by a subsidiary on a parent corporation's stock.  Those
final ISO regulations provide that although a parent corporation can
approve an ISO plan adopted by a subsidiary to grant options on that
subsidiary's stock, if the subsidiary wants the options to be granted
with respect to the parent's stock, the parent's shareholders must
approve the plan.[5]  These
proposed regulations reverse that rule, permitting the parent
corporation to approve a subsidiary's grant of options on the parent
corporation's stock.  Comments are invited on this
proposed change (which, as proposed, would affect both the ESPP
regulations and the ISO regulations).[6]

Effective Date

These
regulations are proposed to apply as of January 1, 2010 to any option
under an ESPP granted on or after that date, although the taxpayer may
rely on them with respect to any option granted after July 29, 2008.

Final Thoughts

These proposed regulations present a "good news - bad news" scenario.  First, while they do permit some leeway to accommodate variations for foreign employees, they do not go far enough.  Second,
the proposed regulations do not give ESPP sponsors the ability to
selectively use the employee exclusions or to comply with the equal
rights and privileges requirement on a corporation-by-corporation basis.  Third, they otherwise take a strict view of the equal rights and privileges provision.  Fourth,
they impose a more restrictive interpretation of the $25,000 annual
limit as applied to offering periods that overlap a calendar year than
under the statute and existing regulations.  Finally, they
liberalize the shareholder approval rules governing grants by
subsidiaries of both ESPP options and incentive stock options on parent
stock, but do not make all the apparently required conforming changes
to deal with corporate acquisitions.

Because
a company is free to exclude employees of any given corporation in the
corporate group altogether, it would be both logical and consistent to
permit differing rules to apply among different corporations, so long
as the Section 423 rules are satisfied in each case looking at any
particular corporation.  At a minimum, the IRS should permit selective use of the excludable employee categories.

Unless
these regulations are liberalized considerably, it will still be
necessary, in many cases, to have an omnibus or umbrella plan
permitting both Section 423 options and non-Section 423 options to be
granted (similar to an omnibus option plan permitting ISOs and
non-qualified options).  In that way, variations necessary for non-U.S. locations can be made by designating specified corporate subsidiaries, e.g., the U.K. subsidiary, as participating in the non-Section 423 component of the Plan.  This
approach would permit, for example, the inclusion of part-time U.K.
employees (required by U.K. law) even if part-time employees are
excluded for U.S. employees employed by the parent company. 

We look forward to discussing these proposed regulations with our clients and obtaining your views.