Taxation on Phantom Shares and Restricted Stock Units

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Key Takeaways

  • Phantom shares and RSUs are alternative employee remuneration schemes (besides ESOPs) which help attract and retain talent.

  • Generally, taxation of RSUs follow the following formula: (# of shares received) ⨉ (OMP per share on date of lifting of selling restrictions).

  • Taxation of RSUs accrues in the year where the selling restrictions on employee’s shares are lifted.

  • On the other hand, taxation of phantom shares occur when they sell their phantom shares (possible only after the company is sold).

  • Each company should consult a legal expert for a more comprehensive understanding of the tax implications, deferments or reductions applicable in their respective jurisdictions.

Disclaimer: This blog is solely intended for general knowledge. Any opinions given in the post are based on the facts we are aware of and our own interpretation of it; we do not provide tax or legal advice. If you have any queries regarding your taxes, please contact a tax specialist.

Alternative employee remuneration schemes such as ESOPs, Restricted stock units (RSU) and phantom shares can help companies to attract and retain talent, while providing the right incentives for employees to work hard to grow their company. Employees and employers alike should know how RSUs and Phantom Shares work, and what their restrictions are, in order to correctly choose and maximise the benefits of these schemes.

What Are Restricted Stock Units (RSU)?

As its name suggests, employees on a RSU plan are directly granted company shares, subject to selling restrictions. In some cases, selling restrictions may be tied to RSU vesting, such as vesting period, schedule, or KPIs and milestones – companies can make it such that when RSUs are vested, selling restrictions are simultaneously lifted. Otherwise, selling restrictions can also correspond to trigger events, such as a company sale or IPOs – in this case, employees are unable to sell their shares directly upon vesting, but will need to wait for such triggers to occur.

In general, however, employees will have to stay with the company for a minimum period of time, and fulfil relevant criteria, before they are able to sell their share units – hence the name “restricted” stock units.

Once the relevant selling restrictions are lifted, RSU plans give the employee an ownership share within the company. The final number of RSUs received is typically agreed upon beforehand between the employee and company and granted at the start of employment – however, as suggested above, this may also depend on employee performance and their length of employment at their company.

RSUs entice employees to remain with the company for an extended period of time, hence serving as a form of talent retention. Because the stock units increase in value correspondingly with the value of the company, hence employees holding RSUs are motivated to do their best to better the company they work for, to maximise their gain when selling their share units.

What Are Phantom Shares?

Similar to RSUs, phantom shares are also an employee remuneration strategy. A phantom share plan is a contractual agreement between a company and an employee, whereby the latter is granted a cash benefit equivalent to the value of a fixed number of company shares. 

Phantom shares do not give the recipient any ownership or shareholder rights in the business, but can still be an effective talent attraction and retention mechanism, given how the cash payout value increases as the company’s share price increases. The value of phantom shares is ultimately realised when they are sold, which is possible once the company is sold or goes public. 

A Quick Note on Real vs. Phantom Shares

Real shares are issued and recorded on a company's register. They can be given to investors as part of an initial public offering (IPO), or they can be issued as part of subsequent financing rounds.

Phantom shares, on the other hand, are not "real" in that they aren't issued or recorded on a company's register. Instead, they are simply contractual records that show how much phantom stock has been allocated during each round of financing. Fundamentally, phantom shares are simply cash payouts corresponding to the value of the company’s shares – thus, in a sense, they “track” the value of company shares without being shares per se.

Also, as highlighted previously, phantom shares do not give investors any shareholder or voting rights in the company, unlike actual shares.

Check out our other article for information on tax implications regarding ESOP specifically

Taxation of RSU

When it comes to taxation, RSUs are taxed when the selling restriction(s) of the shares is/are lifted. Your taxable income is equal to the market value of the shares once the selling restriction(s) is/are lifted, as per the following formula:

(# of shares received) ⨉ (OMP per share on date of lifting of selling restrictions)

*OMP = Open Market Price

However, note that other tax fees may be applicable in addition to using the formula above. For instance, if the shares are held over time and pay dividends, certain jurisdictions may have dividend tax payable. Some jurisdictions also have capital gains taxes, for when shares are held and appreciate in value over time (typically over a period of 1 year or more) before being sold.

To illustrate this, let’s assume we have an employee named John working for a medium-sized enterprise. The RSUs that John’s company issues to him are configured to be flat-vested over 4 years, with the lifting of selling restrictions contingent on the company getting an IPO.

  • Assume that 4000 shares are vested – 1000 shares per year per shares
  • Assume that the company goes public at the start of Year 7, with the IPO price per share being $25
  • Assume John falls under a 10% tax bracket, based on his income
  • For the first 6 years, John does not have any tax which accrues to his RSUs, even though the shares have been vested
  • For Year 7, John has to pay taxes on his RSUs, regardless whether he sells them directly or keeps the shares for longer
  • Valuation of shares is 4000 ⨉ $25 = $100,000
  • The final sum John needs to pay, based on his income bracket, is 10% ⨉ $100,000 = $10,000
  • If the vested shares have paid dividends prior to selling, then the total amount of dividends received will be considered taxable in jurisdictions with dividend taxation as well
  • If John keeps his shares for more than a year after the lifting of selling restrictions, he may also be subjected to capital gains tax, depending on his jurisdiction

Taxation of Phantom Stocks

Phantom stocks are taxed in accordance to the total value of the cash benefit received. There are 2 main variants of phantom stock plans: Full Value and Appreciation-Only. A Full-Value plan involves a cash payout equal to the OMP of the company’s shares on date of receiving the payment, multiplied by the number of phantom shares granted. Appreciation-Only plans involve a cash payout equal to the full-value plan payout, minus the “base value” of the phantom shares. 

Taxation on phantom stock accrues in the year when the phantom stocks are sold – that is, the year in which the cash benefit is received.  Again, this typically occurs after the company is sold or goes public.  As for how much tax is levied, it also depends on the income bracket the employee falls under, which varies depending on the jurisdiction.

A noteworthy point is that, depending on whether your jurisdiction charges capital gains tax, the total amount of tax to be paid for phantom shares can be higher than RSUs.

  • Suppose a company’s shares are currently worth $35 per share, and that its jurisdiction does not have capital gains tax
  • Employee A has received 1,000 RSUs, worth $5 each at the lifting of selling restrictions, which he will sell at $35
  • Employee B has received phantom shares, which he/she will also sell at $35 per share
  • Assuming both employees pay 10% income tax, in the absences of capital gain tax
  • Employee A’s tax paid is 10% ⨉ 1,000 ⨉ $5 = $500
  • Employee B’s tax paid is 10% ⨉ 1,000 ⨉ $35 = $3,500

For a summary of the differences among RSUs, phantom stocks and ESOP, you may read this article on our website.

Implications and recommendations

Companies should consult their accountants or lawyers on whether there are any tax deferment or reduction schemes available in their corresponding jurisdiction. For instance, in Singapore, the QEEBR scheme allows eligible employees to defer their tax obligations on ESOP exercise for up to 5 years. The sub-optimal alternative to tax is that employees will need to sell a part of their RSUs for proceeds to pay for their taxes. However, in the case of phantom shares, the taxes will simply take a cut out of the financial benefit gained by the employee. 

Also, do take note of any special rules which apply to foreign employees – for instance, Singapore uses the Deemed Exercise Rule for (a) foreign employees who cease employment locally; (b) permanent residents who leave Singapore forever; (c) permanent residents posted to work overseas. Check out this other article for more specific details.

In a nutshell, when considering taxation for ESOPs, RSUs and phantom shares, it is important to know exactly what is taxed, when the tax accrues, and exactly how much tax will need to be paid. Understandably, there is no one-size-fit-all advice we can provide, because tax laws vary from jurisdiction to jurisdiction. Henceforth, the best strategy remains consulting a tax specialist, who would be well-versed and properly trained in these regulations, as well as how to manage them.

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