Let’s talk tax! Taxes aren’t the most interesting of topics, but as a mass exodus from San Francisco begins in the wake of the COVID-19 pandemic, there are a whole bunch of people working at Silicon Valley tech companies who are going to have to start dealing with them in much more depth.
In general, people expect that taxes will be complicated in the year that they move. However, if you’re being granted equity, as most Silicon Valley employees are, you might be surprised to discover that they will be complicated for much longer.
If you choose to move internationally, rather than just interstate, this counts for double. My partner and I — neither of us US citizens — moved from San Francisco to Sydney three years ago, and have spent the last few years figuring out our tax situation. We struggled a lot to find good guidance on any of this online, so I’m going to take the time to document what we learned in a few posts, so that I can make the path more well-trodden for the next person.
Although I’ve spent a lot of time learning about this, I’m not a tax professional. If any of it sounds wrong to you, or if you have your own story to share, please reach out!
📆Trailing tax liabilities
Income taxes sound like they should be simple: at the end of a tax year, you pay a percentage of the amount that you earned that year to the relevant tax agency. In some countries, your employer collects these taxes as you earn them (PAYE/PAYG), and you need to think about them even less.
Equity complicates this situation. When you’re granted equity, you’re being promised something of value. There’s a problem though: that equity might not yet be liquid — it could have a vesting schedule, you might not have exercised it, it could be in a private company… and if it’s not liquid, you probably shouldn’t have to pay anything when it’s given to you. Many tax jurisdictions handle this by choosing to tax you at a later point: rather than when the equity is granted, instead taxing you when it vests, is exercised (in the case of options), or is sold.
However, imagine you move tax jurisdictions between the date where you’re given the equity, and the date on which you actually pay tax. The first jurisdiction now has a problem: in their eyes, you earned that equity while you lived there, and they only gave you a free pass on immediately paying tax on it through the goodness of their hearts. When you eventually pay tax in the second tax jurisdiction, they want a piece of that too.
This is a trailing tax liability.
Broadly speaking, any time that you’re granted equity in one jurisdiction, but only trigger a taxation event on it in another, the first jurisdiction is likely to say that they also have taxation rights.
That first jurisdiction is said to have “source” taxation rights, because that’s where the asset was sourced, while the second is said to have “residency” taxation rights, i.e. the right to tax you because you are presently a resident.
💰Apportioning income
Now presumably, if you worked in both jurisdictions between the point where you were given the equity, and the point at which you pay tax, there’s some percentage that each should be considered the source of.
Internationally, this apportionment is governed by pairwise tax treaties between countries. These are typically based on the OECD model tax convention, which helpfully has an in-depth commentary on this exact point (Commentary on Article 15, 12.14). In short, unless otherwise agreed between two countries, income is allocated based on the percentage of workdays spent in each jurisdiction, from the day the equity was granted, to the day that it vested. Note that this percentage will differ for each tranche, or part of a grant, that vests on a different day.
However, those treaties only apply at the country to country level, i.e. for taxes levied federally. In addition to imposing federal taxes, the US also has state taxes, and these are not governed by international tax treaties.
That allows states to take a different view of how to decide whether income belongs to them, and in fact, they do. For restricted stock, California takes the same view as the tax treaty, and considers the period from grant to vest. However, for someone granted options in California, who is a non-resident when they exercise those options, the source is calculated by the percentage of workdays spent in California from grant to exercise, rather than to vest (per the Equity-Based Compensation Guidelines).
🏠Residency taxation
But the tax doesn’t stop there! In addition to the source jurisdiction taxing you for the percentage they believe is theirs, the jurisdiction in which you are currently a resident will also want to tax you, typically on 100% of the income you earn from an asset. This can lead to double taxation: residency taxation means you need to pay tax on 100% of the income to your current tax jurisdiction, but you also need to pay tax on some percentage of the income (potentially up to 100% again) to the source jurisdiction.
Many tax agencies provide relief against this situation, in the form of tax credits: if you’ve already had to pay tax in one location for the same event, they won’t charge you again.
📔Worked example
That’s a lot to take in, so let’s work through an example:
Let’s assume you were granted 1,000 non-qualified stock options (NSOs) with a strike price of $1.00, on 2018-07-01, while a tax resident of California. The options vest once a year for the next four years, in four equal tranches of 250.
(If you’re not familiar with options, an NSO gives you the right to purchase a given company’s stock at a given price, regardless of its current market value. In this case, the option would be valuable if the company’s stock price rose above $1.00, because you could exercise your right to pay the company $1.00 for a share, and then immediately sell that share at its market value, taking the difference as a profit, and consequently, as income.)
About a year and a half later, on 2020-03-01, you move from California to Melbourne, Australia. We can figure out the source of each of those tranches like so:
| Tranche | Relevant work period | Total workdays | US workdays | AU workdays | US source % | AU source % |
|---|---|---|---|---|---|---|
| 2019-07-01 | 2018-07-01 – 2019-07-01 | 105 | 105 | 0 | 100% | 0% |
| 2020-07-01 | 2018-07-01 – 2020-07-01 | 209 | 174 | 35 | 83% | 17% |
| 2021-07-01 | 2018-07-01 – 2021-07-01 | 313 | 174 | 139 | 56% | 44% |
| 2022-07-01 | 2018-07-01 – 2022-07-01 | 417 | 174 | 243 | 42% | 58% |
Internationally, these percentages apply regardless of when you choose to exercise those options, provided you do so after the date you move to Australia. However, those options are also subject to taxation within California, and as we’ve mentioned, the tax agency there believes in a different source percentage scheme.
Let’s say that you don’t touch that equity until three years after your move, on 2023-03-01, when you choose to exercise it all.
| Tranche | Relevant work period | Total workdays | California workdays | California source % |
|---|---|---|---|---|
| 2019-07-01 | 2018-07-01 – 2023-03-01 | 487 | 174 | 36% |
| 2020-07-01 | 2018-07-01 – 2023-03-01 | 487 | 174 | 36% |
| 2021-07-01 | 2018-07-01 – 2023-03-01 | 487 | 174 | 36% |
| 2022-07-01 | 2018-07-01 – 2023-03-01 | 487 | 174 | 36% |
If we assume that once exercised, but not prior, your options become liquid shares, you’ll be taxed by each of the US federally, California, and Australia on the day you exercise. Taking just the 2020-07-01 tranche into consideration:
- you’ll be taxed on 83% of the income in the US,
- you’ll be taxed on 36% of the income in California, and
- you’ll be taxed on 100% of the income in Australia, which has residency taxation rights. However, you’ll be able to get tax credits for tax paid in the US federally on the 83% of the income considered to be foreign-sourced.
This means that despite having lived outside of the US and California for 3 years on the date of exercise, you’ll still need to declare US and Californian income, and pay tax in those jurisdictions. If you’d moved interstate within the US, you’d still be filing federal returns regardless, but you’d also be required to file a Californian return that year.
🔎Gotchas
Note that there’s a big gotcha in the worked example above: you only got to claim tax credits in Australia for the 83% income that the US taxed federally, but not for the 36% that California taxed.
That’s because, as previously mentioned, the tax treaties only operate between pairs of countries, not between one country and a state in the other. This means it’s quite possible that you won’t be able to get tax credits for taxes paid to a state of another country, and will end up double taxed on part of your income.
For the worked example, Australia specifically does consider Californian taxes to be a part of the US income tax system, so you would in actuality be allowed to claim credits for taxes paid there, though the same isn’t true in all other countries.
📈Investments
You might wonder what happens when you eventually sell the shares you get as a result of exercising – will those also be subject to US or Californian taxes? While I don’t have personal experience with this situation, the OECD tax treaty commentary clarifies this point in (Article 15, 12.2): only the income effectively connected to your employment is taxable in the source jurisdiction. Since exercising is considered to be an investment decision, any increase in value of the share resulting from the exercise of an option is considered to be a capital gain, and is therefore not taxable by the source jurisdiction. Helpfully, this is also California’s interpretation, giving us some much-needed consistency between what happens internationally and within California.
If instead you had chosen to exercise prior to moving, the OECD commentary states that when you moved the asset would be treated as being capital in nature, and so would only be taxable in your jurisdiction of residence at sale. However, several countries, including the US and Australia, impose capital gains taxes on citizens and permanent residents who move their residency to be in another country.
➡️ Different taxing points
Although it might seem complex, in our example above, it was fairly simple to reason about how tax credits would be applied, because the taxation events occurred at the same time in each of the different jurisdictions. However, this is far from a guarantee — different tax agencies can have different views of the point at which taxation should occur.
This complicates the discussion, because we end up needing to have three different views of the world: what happened according to each of the source jurisdiction, the residency jurisdiction, and the tax treaty.
These can get out of sync with one another! In order to understand how that happens, and talk about how to reconcile the inconsistencies, we’ll need a better understanding of how equity is taxed domestically in each jurisdiction.
In the next post, I’ll start with a deep dive into US equity taxation, then move onto Australian equity taxation (less broadly relevant, but we need a second country and it’s the one I’m most familiar with), then we’ll put what we’ve learned back together to see how many edge cases we can find.