British Companies Protest Paying Tax on Employee Stock Options

LONDON -- Sometimes the trouble is taxation with representation.

Thanks to a wrinkle that holds British companies liable for the gain on stock options issued to their employees, Internet companies based in the U.K. stand to owe the government millions. Moreover, a volatile stock market for most of these companies makes estimating the liability extremely difficult.

Known as the National Insurance tax, the government is entitled to 12.2% on the difference between the exercise price of an option and the market value at the time of exercise. This tax is similar to the alternative minimum tax in the U.S., except for one big difference. In the States, it's the employees receiving stock options who must pay the government, whereas in the U.K., it's the corporations issuing the options that must ante up.

Until recently, the tax was just another in a laborious code. It goes to pay things such as state pensions, with its most similar counterpart in the U.S. being Social Security. Because the use of stock options in any sizable quantity is a relatively new phenomenon here, and because most Old Economy companies saw their stocks rise only marginally in a year, the tax never caused much fuss. But the growth of Internet companies that issue tons of options and have highflying and volatile stocks adds a whole new level of risk to the equation. Although that risk is somewhat less than it was several months ago, before Internet shares collapsed, it remains considerable because the strike price for most options can be as low as pence.

"It's very significant for e-commerce companies," says Paul Wigham, a tax partner with Deloitte & Touche in London.

Take the case of QXL (QXLC Quote - Cramer on QXLC - Stock Picks). In its most recent financial year, ended March 31, the online auction site had to set aside 11.6 million pounds ($17.3 million) as a reserve against this tax. That's almost double its annual sales.

The reserve is an estimation of the tax bill if all the employees who are eligible to exercise options do so. In reality, the charge doesn't hit the bottom line until 14 days after the end of the month in which the options are exercised.

"It has never been a cash charge for us yet, but there will be some impact when people come out of lockups and start exercising shares," says Robert Dighero, QXL's chief executive.

Those agreements, which, in addition to the normal six-month lockup include more stringent requirements, will begin expiring when the company files results for the three months ending Sept. 30.

Just how large an impact is anyone's guess because the tax is based on the price of QXL's stock when the options are exercised. With the shares swinging widely since the company went public in October, from a high of 117 3/8 to a low of 4 21/32, estimating the charge is like playing darts blindfolded. On Thursday, QXL shares changed hands at 10 15/16.

QXL isn't alone in this matter. Many British Internet and technology companies, including Freeserve (FREE Quote - Cramer on FREE - Stock Picks) and 365 Corporation, are facing a similar dilemma.

"If you're going to own any technology shares in the U.K., you should be concerned about this," says Peter Misek, an analyst with Chase H&Q.

Taking a cue from the Americans, British companies have launched their own Boston Tea Party of sorts in opposition to the tax. The result of heavy lobbying is new legislation that will allow corporations to enter into voluntary agreements with their employees, who agree to shoulder the burden. The key word here is voluntary.

"There's no way an employee will say, 'Sure, I'll pay the tax for you,'" Dighero says.

As a result, the tax burden of options already in issue likely will remain with the company. The new legislation, however, does give corporations some leverage when issuing options in the future. For instance, companies can make the award of new options contingent upon employees agreeing to pay the tax.

"Going forward, we'll use the legislation," Dighero says. "The alternative is totally unacceptable. But historically [options already in issue], there remains a liability."

Other options are open to companies wishing to mitigate their risks. For instance, some companies are embedding the cost of this tax in the strike price of options, Wigham notes. Companies also can choose to use option plans that are approved by the Inland Revenue Service, but under these plans, no individual can be granted options in excess of 30,000 pounds. That's unacceptable to most companies considering the going package for top Internet executive these days is in the millions.

So too, it seems, is the amount British Internet companies are going to have to fork over to the government.