Considerations for Equity Grants to International PEO Workers

As companies expand into new jurisdictions, many are turning to third-party employment entities, particularly professional employer organizations ("PEOs"), to engage local workers. 

These PEO arrangements can offer a quick and cost-effective solution for workforce expansion.  However, they also can come with unexpected challenges and risks for the company's equity programs (and other areas[1]), which should be considered carefully on a country-by-country basis. 

What is a "PEO" worker?

A PEO (sometimes referred to as an employer of record or "EOR") is a form of third-party employer entity that hires individual workers as its direct employees while those individuals provide services to the company.  Although the engagement terms can vary, outside of the U.S., PEOs generally function as the legal employer - they enter into a direct employment relationship with the prospective worker, administer payroll, and provide local benefits.   The company retains responsibility for the direction and control of the worker, but generally does not have a direct contractual relationship with the worker.  

Companies often view these "PEO workers" as employees of the company and seek to offer them share plan benefits comparable to the benefits provided to direct employees of the same level.  However, this approach carries with it certain risks and complexities since the tax and legal considerations for granting equity to PEO workers are not always the same as for granting to direct employees or independent contractors. 

Companies preparing to grant equity in a new jurisdiction should confirm as part of their due diligence process whether the potential "employee" grantee is in fact a direct employee or a PEO worker since this can have a material impact on equity plan compliance as well as on the overall risk profile for the PEO arrangement.

What are the key tax and legal considerations for granting equity to PEO workers?

(1) Does the equity plan permit grants to PEO workers?

One threshold issue to consider before granting equity to PEO workers is whether the company’s equity plan permits such a grant.  

Most U.S.-style plans require that eligible grantees be either an employee or a consultant of the issuer or certain related entities.  On its face, this type of plan definition may not seem to allow for grants to PEO workers since these individuals are not traditional employees or consultants of the issuer or a related company.  However, depending on the facts and circumstances of the relationship between the worker and the company, it may be possible to take the position for purposes of the equity plan that the PEO worker can be classified as either a common law employee, a “de facto” employee or a consultant[2].   

For example, classifying the worker as a common law or “de facto” employee may seem appropriate where the worker is (a) providing services on an exclusive basis for the benefit of the issuer (or a related company); (b) working under the issuer's direction and control; (c) performing services traditionally performed by an employee; and (d) receiving compensation for such services that is the primary source of the individual's income.  

This analysis would need to look at the circumstances of the specific PEO arrangement as well as the equity plan terms. While many U.S. company plans are drafted broadly enough to allow for grants to PEO workers, some plans contain overly restrictive terms that may need to be amended.

In addition, some companies offer local tax-qualified plans or sub-plans (e.g., French-qualified restricted stock units or options under a UK Enterprise Management Incentive scheme).  Even if PEO workers are classified as employees for purposes of the company's omnibus equity plan, these tax-qualified plans/sub-plans may not be available for grants to PEO workers.

(2) What are the tax implications?

The tax treatment is one of the most complex and problematic areas for equity awards granted to PEO workers.  In most jurisdictions there is little specific guidance on how equity granted by a foreign issuer to a worker engaged under a PEO arrangement should be treated for tax purposes (although the landscape is rapidly changing).  The guiding principles generally are the tax rules applicable to employee grants, consultant grants, and any rules governing payments made by a third-party to an employee in connection with an individual's employment.  This means that that the tax implications often differ depending on whether the PEO employee is classified as an employee or a consultant for tax purposes.

For example, in some jurisdictions, equity awards granted to consultants will not trigger withholding/reporting obligations for the company, whereas if the workers are classified as employees, the company and/or the PEO may have tax withholding/reporting obligations (depending on the country).  Furthermore, a worker's classification as a consultant could impact the timing of the taxable event in certain jurisdictions. For example, in Canada and the UK, grants to consultants generally are taxed at the time of grant.

Where the proper classification is unclear, it may be most pragmatic to treat the PEO workers as employees for tax purposes since this is consistent with the way the individuals are generally viewed by the company and with how their salary is treated for tax purposes.  However, where this triggers a withholding/reporting obligation, companies will need to be prepared to (i) communicate to the PEO details about the awards, the taxable amount and taxable event, and/or (ii) transfer funds to the PEO for remittance of tax withholding amounts (assuming tax withholding obligations are satisfied by withholding/selling shares, rather than withholding from salary).  

One complicating factor is that many PEOs are not able/willing to discharge the tax withholding/reporting obligations for equity awards.  In this case, there may be additional exposure and practical issues for the company and/or the PEO worker.  Companies are well-served when first engaging a PEO to determine the PEO's withholding/reporting capabilities and to include these services in the service agreement with the PEO.

Finally, if the company subsequently converts the PEO workers into regular employees (as many do following rapid growth in a new jurisdiction), it cannot be assumed that the tax withholding/reporting obligations will automatically follow those for regular employees.  The impact of the conversion requires separate analysis.  Companies engaging PEO workers with the intent to convert them to regular employees should factor in the tax impact of the conversion in their decision on whether to defer an equity grant until the individual becomes a regular employee.

(3) What are the labor/employment law implications?

As discussed above, under the typical international PEO arrangement, the PEO functions as the legal employer and is responsible for compliance with local labor and employment laws in relation to the PEO workers.  However, these arrangements cannot fully insulate the company from potential labor/employment law claims, particularly if the company directs and controls the workers in practice, which generally is the case.  Accordingly, these PEO arrangements typically result in some level of joint employer risk for the company.  If the company is considering granting equity to a PEO worker, the grant could be a material factor in the overall joint employer risk analysis, which should be assessed on a case-by-case basis.  Further, the potential impact on the joint employer risk could be exacerbated if the company is taking the position for purposes of the equity award that the PEO worker is a common law or "de facto" employee of the company.

(4) Are there any regulatory issues?

The local securities and exchange control laws and other regulatory issues should be fully vetted before granting equity awards to PEO workers in any new jurisdiction.  Many securities law exemptions are predicated on an issuer granting equity awards to employees or certain other service providers. 

If PEO workers are classified as non-employees for securities law purposes (e.g., because their contractual employment relationship is with the PEO), then these securities law exemptions may be lost.  In this case, the company would need to rely on other exemptions (to the extent available, such as small-offering exemptions).  It is not safe to assume that the generally available employee share plan exemptions will apply for PEO workers.

Other regulatory restrictions also may prevent an issuer from granting equity to PEO workers.  In particular, the exchange control requirements in China under Circular 7 and in Vietnam under Circular 10 require offshore companies to obtain certain approvals before offering a share plan to individuals in these jurisdictions.   

Companies likely will have difficulty obtaining approvals in China or Vietnam to offer their share plans to individuals who are employed by an entity that is not part of the company group.

(5) What about ESPP?

While some companies may be inclined to offer ESPP to their international PEO workers, there are special practical and legal considerations that should be taken into account. 

First, all of the above considerations for equity grants to PEO workers apply equally to ESPP (in particular, whether PEO workers are eligible to participate under the provisions of the ESPP plan document).

Second, from a practical standpoint, the PEO may not be able to facilitate payroll deductions for ESPP contributions.  In this case, operation of the ESPP for PEO workers would not be feasible unless the ESPP rules allow for alternative contribution methods.  

Third, if the company is offering a U.S. Code Section 423 ESPP, it will need to carefully structure the offering so that it does not jeopardize the tax-qualified nature of the plan (e.g., by improperly including or excluding PEO workers in a particular jurisdiction).

Take-Aways

Given the time and cost-savings offered by the PEO model, it is not surprising that these arrangements are becoming increasingly prevalent for companies expanding globally (whether for business reasons or due to employee mobility/remote work).  

While it may be tempting to view PEO workers as "real" employees of the company, taking this view for equity award grants can be problematic.  As noted, the considerations for equity awards granted to PEO workers are different than for grants to employees or consultants.

To help manage the unique risks and practical considerations with granting equity to international PEO workers, companies should:

(1)   be able to identify and track which individuals are PEO workers and share this information with key stakeholders, including external advisors;

(2)   when engaging with a PEO, determine whether the PEO will be able to discharge applicable tax withholding/reporting obligations for equity awards outside the US, and if so, build this into the service agreement;

(3)   review equity plans to ensure that the eligibility criteria align with the company's intended grant population (whether this includes or excludes PEO workers);

(4)   assess the applicable tax, legal, and regulatory compliance issues before granting equity awards to PEO workers in a new jurisdiction (do not assume the rules are the same as for employees and/or consultants); and

(5)   where equity awards add risk or significant compliance burdens, consider (a) granting alternative vehicles (e.g., cash awards paid out by the PEO) or (b) delaying the grant (or vesting) until the individual is on-boarded as a direct employee of the company (or a related entity).