Tax Articles

Equity-Based Compensation

By Atty. Fulvio D. Dawilan

Fulvio D. Dawilan Managing Partner   +632 8403 2001 loc.310 This email address is being protected from spambots. You need JavaScript enabled to view it. View Profile

Other than the reforms introduced by RA No. 12214 (Capital Markets Efficiency Promotion Act or CEMEPA) on the taxation of capital markets and related products, included in the law are other changes that have nothing to do with the taxation of the capital markets. One of these is the inclusion of the equity-based compensation (such as stock options, restricted stock units, and stock appreciation rights) as among those considered as “compensation for services” constituting gross income under Section 32 of the Tax Code. This addition also clarified that equity-based compensation shall be included in the gross income at the time of exercise.

Is this a new rule that should be given fresh consideration? It appears to be new, but it’s actually not. While this is a new insertion in the provision of the Tax Code, the taxation of equity-based compensation is not a new concept. In the past, however, because of the absence of a specific provision in the Tax Code, the rules were dictated by the revenue issuances promulgated by the tax authorities. But these issuances had not been consistent. These inconsistences in the rules had also led to confusion and uncertainty in the implementation and compliance.

Equity-based compensation had always been treated for tax purposes as part of compensation of the employees, and therefore included in the compensation income subject to the usual withholding tax. But others considered this benefit as fringe benefit subject to both the fringe benefits tax and to the tax on compensation – depending on the status of the employee who avails of the benefit.

This difference in the tax treatment of equity-based compensation was a result of confusions brought by the revenue issuances themselves. While these are supposed to be part of the compensation package of employees and should be taxed as such, there were rulings and even revenue memorandum circulars issued by the tax authorities where the tax treatment of stock options and other option plans deviated from this rule. Based on these issuances, the taxability of equity-based compensation would depend on the position of the employee - whether or not the employee occupies a managerial or supervisory position. Benefits derived by supervisory and managerial employees from equity-based compensation were considered fringe benefits subject to the fringe benefits tax. However, benefits derived by rank-and-file employees from the same type of compensation package were treated as compensation. In effect, taxes on the equity-based compensation of supervisory and managerial employees were shouldered by the employer while the same type of benefit derived by rank-and-file employees were borne by the employees themselves.

The rules were again modified with the issuance of Revenue Regulations No. 13-2022 (RR 13-22) in 2022. As so provided in this regulations, the equity grants to be awarded to the employees are for the services being rendered by the said employees. Consequently, the equity grants under the equity plans, once exercised or availed of by the grantee-employee, is considered compensation to be taxed as such under Section 32 of the Tax Code. And this rule is applied regardless of the employment status of the grantee-employee who could be rank-and-file or occupying a supervisory or managerial position. The reason is that Section 32 of the 1997 Tax Code does not make a distinction for purposes of applying the tax implication on all forms of compensation, including equity-based compensation. And perhaps realizing the erroneous interpretations in the past, this RR also made it clear that it was revoking or repealing previously issued inconsistent regulations, rulings, orders or circulars.

Clarifying this further under RMC 143-2022, the circular specifically declared that the difference between the book value or the fair market value of the shares, whichever is higher, at the time of the exercise of the equity-based compensation, and the price fixed on the grant date, shall be considered as additional compensation subject to income tax and to withholding tax on compensation.

But even with those clarifications on the taxation of equity-based compensation, the rule remained uncertain. Thanks to the passage of CMEPA, this uncertainty no longer exists. By specifically including equity-based compensation in Section 32 of the Tax Code, CMEPA made the tax treatment of equity-based compensation permanent. Any implementing rule should be consistent with this tax treatment. And such rule could not be simply changed by a revenue issuance.

As to when the tax accrues, the law had also made it clear that the income should be included in gross income at the time of exercise. For some types of equity-based compensation, they undergo a number of stages before the benefit is realized by the employee. Regardless of these various stages, it is only the exercise that triggers the accrual of tax. 

For as long as the equity - equity issued by the employer or other entity - is granted as part of the payment for the services rendered under and employer-employee relationship, the same should form part of the compensation and taxed as such. The same should be taxed when the employee realizes the benefit – at the time of the exercise.