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Room document 4 Statistics Directorate National Accounts Note on the treatment of employee stock options granted by non-resident corporations Paper prepared by theCentral Bureau of Statistics, Israel OECD MEETING OF NATIONAL ACCOUNTS EXPERTS Château de la Muette, Paris 8-11 October 2002 Beginning at 9:30 a.m. on the first day Note on the treatment of employee stock options granted by non-resident corporations Central Bureau of Statistics Israel The granting of stock options to employees of all levels has become common in recent years, especially in high-tech companies. The complicated issue of treatment of employee stock options has been analyzed by Eurostat and some NSO’s – a conclusion has yet to be reached, but it seems that there is an agreement to include such stock options in compensation of employees at the time the options are vested, even though this time does not coincide with the period that the labour input is made. Since data on employee stock options are often only available when they are included in wage data at the time they are exercised, it may also be difficult to estimate their size at the vesting date. However, the International Accounting Standards Board has recently decided to count stock options granted to employees as a cost of business, so that perhaps data will be more readily available in the future. There are however further complications to the issue, since in many cases the companies granting stock options are subsidiaries that grant stock options of parent companies abroad. In Israel no complete statistics on the stock options exist, but data collected for balance of payment purposes show that quite large amounts appear in financial reports of foreign owned companies. Since these transactions could not be ignored, we carried out an analysis of the problem. Below a proposed treatment and its implications are shown, through a numerical example. As is the case in other countries, the employee stock options have become more and more popular in Israel, since they tie the employees to their employers and also allow the firm to pay higher wages without lowering liquidity in the first years after a firm is established. Tax laws in Israel allow firms to choose two different paths of taxation of options given to employees: 1. The firm may choose to grant options without placing the options in trust. In that case the income from the options will be taxed up to 50%. 2. An alternative that may be chosen is to place the options in trust until they are sold. In that case the income from the options can be registered as expenditure on wages and taxed up to 50%, or as capital income and taxed up to 50% if the company is domestic, but only 35% if the company is a foreign one. Many foreign firms have affiliates in Israel and many originally domestic firms for various reasons also choose to register as foreign firms and place management abroad – according to experts from venture capital firms most new hi-tech companies established in Israel in recent years have chosen to register abroad and to place management abroad. This means that in many cases stock options are granted by foreign owned firms, and many will choose the second path of taxation. This also means that the problem how to register such transactions in the rest of the world account is quite an important one in Israel. Data on employee stock options granted by firms that chose the second tax alternative should be available from trust firms. Wage data from the National Insurance Institute will include all stock options granted to employees the moment they are taxed (when they are exercised). But such data 1 are not separated from other wage components and also are not included at the moment options are vested if not exercised. To get full coverage and separate data on employee stock options data will have to be collected in business surveys. On the other hand, as mentioned above the data will perhaps be more readily available from business reports in the future. In cases where firms grant stock options of foreign parent corporations the relevant data have to be collected. The fact that the transaction is to be registered at the vesting date may also complicate the compilation of the rest of the world accounts (and balance of payments), since it will not be sufficient to rely on banking transaction data. To analyze the transactions involved in the granting of options of a foreign owned company and the realization of gains by the unit receiving the options, we examined the following example of a domestic subsidiary of a foreign corporation. A numerical example The subsidiary of a foreign corporation offers stock options for 1,000 shares to its employees, to be issued by the parent corporation. The strike price is 100 units per share, equal to its market price, and the vesting date is the end of the next year The employees may exercise the option in any moment of the year following the vesting date. The option is not tradable and employees exercise it one year later. At the vesting date the market price of a share is 105. The value of the option will be registered as part of the subsidiary’s compensation of employees (CE) at the vesting date. Another possibility would have been to distribute the increase in the CE from the granting date to the vesting date, in order to have a better relation between the period employees services are provided and the CE paid for them (this could be done retroactively once the value of the option is known at the vesting date). Given that at the vesting date the market price is higher than the strike price, a liability for the parent corporation, adopting the form of a financial derivative, covers the value of the CE increase registered by the subsidiary. Its value per share is equal to the difference between the market and the strike price at the vesting date. Subsequent changes in the market price of the shares will be accounted as revaluation of the financial derivative. When the option is exercised, the financial derivative position is closed. A. Entries in the accounts at the vesting date It was assumed that the total value of the option is allocated to CE at the vesting date, consequently an increase of 5,000 in CE is registered in the generation of income account (5 monetary units per 1,000 shares). Since output, intermediate consumption and added value of the subsidiary do not change, its operating surplus (OS) should decrease in a value equal to the increase in CE. Being a subsidiary of a foreign parent corporation all its profits are shown as distributed abroad, in the national accounts and the balance of payments. These transactions are registered in the generation and allocation of income account. The undistributed profits are registered as reinvested through the financial account, affecting the net equity of the parent corporation on its subsidiary. But in fact the increase of CE is covered by a financial derivative that is a financial asset for the households and a liability for the parent corporation (that will have to sell the shares to the employees at the strike price, when the option is exercised after the vesting date). 2 Since the subsidiary acts as an intermediary between the parent company and the employees when granting the options, we propose to register the transfer of the financial derivative to the employees through the subsidiary. The subsidiary receives the derivative from the parent corporation which increases its net equity in the same amount of the decrease originated by a lower OS. The subsidiary subsequently pays CE using the financial derivative. As a result, the parent corporation maintains the same net equity on its subsidiary but has increased its liabilities with the subsidiary’s employees. In what follows the transactions are registered in the accounts without netting them. Entries in the accounts of the subsidiary: Subsidiary Generation of income account Uses D.1 B.2 Resources Compensation of employees Operating surplus +5,000 -5,000 Allocation of primary income account Uses Resources B.2 Operating surplus D.43 -5,000 Reinvested earnings on foreign direct investment -5,000 Financial account Changes in assets Changes in liabilities and net worth F.7 Financial derivative +5,000 (received from parent co.) F.5 Shares and net equity -5,000 (reinvested earnings on DFI) F.7 Financial derivative -5,000 (given to employees as CE) F.5 Shares and net equity +5,000 (the financial derivative received as a DFI of the parent corporation) Transactions to be registered by the Household sector: Households Allocation of primary income account Uses Resources D.1 Compensation of employees +5,000 Financial account 3 Changes in assets F.7 Financial derivative Changes in liabilities and net worth +5,000 The rest of the world accounts are also affected: Rest of the World Account of primary income and current transfers Uses Resources D.43 Reinvested earnings on direct foreign investment -5,000 Financial account of the rest of the world Changes in assets Changes in liabilities and net worth F.5 Shares and net equity -5,000 (reinvested earnings on DFI) F.5 Shares and net equity +5,000 (the financial derivative provided as a DFI of the parent company) F.7 Financial derivatives +5,000 As noted above, as a result of these transactions the parent corporation maintains the same net equity on its subsidiary, however it has increased its liabilities with the subsidiary’s employees. B. Exercise period The value of the option was already registered as a financial derivative asset/liability on the vesting date. Subsequent changes in its value will be registered in the revaluation account Assuming that at the end of the next period (the exercise date) the market price of the share has increased from 105 to 109 monetary units, the revaluation account will show the increase of the derivative value during this period (4 units per share for 1000 shares). The balance sheet will register the total liability of the foreign parent corporation in respect of this financial derivative as equal to 9,000 At the exercise date the parent corporation sells shares (with a market value of 109,000) to the employees (at the strike price value of 100,000). The difference between the market value of the shares and the cash payment received for them is registered as a transaction in financial derivatives, which corresponds to its new value after revaluation. When the option is exercised, the following additional transactions will be registered in the accounts: Assuming that the employees retain the shares bought at the strike price, the following transactions will appear in the Households accounts: 4 Households Financial account Changes in assets F.2 Currency and deposits F.5 Shares and other equity F.7 Financial derivatives Changes in liabilities and net worth -100,000 +109,000 -9,000 Revaluation account Changes in assets K.11 Nominal holding gains (+)/losses (-) F.7 Financial derivatives +4000 Changes in liabilities and net worth K.11 Nominal holding gains (-)/losses (+) Changes in balance sheet Assets AF.2 Currency and deposits AF.5 Shares and other equity AF.7 Financial derivatives Liabilities and net worth -100,000 +109,000 -5,000 B.10 Changes in net worth +4,000 Due to: B.10 Nominal holding gains/losses +4,000 Transactions registered in the Rest of the World accounts: Rest of the World Financial account Changes in assets Changes in liabilities and net worth F.5 Shares and other equity F.2 Currency and deposits +100,000 F.7 Financial derivatives +109,000 -9,000 Revaluation account Changes in assets K.11 Nominal holding gains (+)/losses (-) Changes in liabilities and net worth K.11 Nominal holding gains (-)/losses (+) F.7 Financial derivatives +4000 The following are the changes in the parent corporation’s balance sheet due to these transactions at the exercise date: Parent Corporation Changes in balance sheet Assets AF.2 Currency and deposits Liabilities and net worth +100,000 AF.5 Shares and other equity +109,000 5 AF.7 Financial derivatives Due to: -5,000 B.10 Changes in net worth -4,000 B.10 Nominal holding gains/losses -4,000 Conclusion The increasing globalization of production means that the issue of employee stock options is of importance not only in domestic sector accounts but also in the accounts for the rest of the world and the balance of payments. Subsidiaries of foreign corporations grant stock options of the parent corporations to employees. The rise in CE means that their OS and reinvested earnings on direct foreign investment fall. As a result, the net equity of the foreign parent corporations on their subsidies will be shown as decreasing. However, the increases in CE are really not paid for by the subsidiaries but covered directly by the parent corporations that issue the options. The proposed registration of the transfer of the financial derivative from the foreign parent company to the employees through the subsidiary as a direct investment maintains net equity of the parents corporations on their subsidiaries unchanged. A decision to register employee stock options at the vesting date, will also affect the timing of registration of these flows in the accounts of the rest of the world (and also in the balance of payments which should ideally be harmonized with the national accounts). 6