European Expansion: The Consultant Trap

European ExpansionBy Sian Story

Sian Story – Osborne Clarke – Palo Alto, CA– Sian is a UK qualified lawyer, advising US clients on UK and European employment and stock options matters, and is based in California.

We all know that fast growing technology based businesses don’t just grow quickly within the US any more. Falling into overseas markets is increasingly common.  Plus, global domination is the ultimate goal. But expansion outside of the known territory is complicated, full of regulatory landmines and not something that can be achieved overnight.

As a result, companies frequently engage consultants when venturing to Europe for the first time, perceiving consultancy as a low-cost, easy option avoiding the need to establish formal operations, tax registrations and payroll overseas (not to mention avoiding the challenging employment laws found throughout Europe). Care should be taken though: consultancy arrangements are often not as straightforward as they appear.

Here are a few things to think about as you venture forward:

The Pseudo-Employee

Of course, the biggest challenge with engaging consultants the world over is that in many cases they look more like employees (thanks to the full time role they personally fulfill, the company’s reporting structures and processes, the company cell phone, laptop and business cards they are supplied with). The same is true in Europe: the test will vary from country to country but the existence of a test does not.

Advice should always be sought to confirm that the proposed consultancy agreements clearly reflect consultancy in the country in which they are to be applied. Even more importantly the relationship should be managed in line with that agreement as irrespective of what the contract says, the actual performance of the relationship will determine its status. In some cases that may simply not be possible (because the individual is being engaged as the General Manager, or because their work needs to be controlled by someone in the US) and then a risk analysis may be required.

What’s the worst that can happen? 

Where the relationship is deemed to reflect employment, the local tax authorities claim unpaid income taxes, social security contributions and state pension contributions, together with penalties and interest, from the company for the life of the relationship as these will not have been withheld as they should have been.

How would they find out? 

In most cases, this results from a claim by the individual consultant that they are actually an employee (often in the event of termination), enabling them to benefit from the employment laws and protections, which the company had hoped to avoid. This can result in the company facing substantial claims for breaches of employment laws as well as unpaid taxes.

Contracting with the consultant through a personal services company may help with the analysis, but is not necessarily conclusive, so taking time to get the agreement and arrangements right is still recommended. Obtaining advice from a lawyer in the particular jurisdiction is always recommended.

The Commercial Agent

A potential trap for companies engaging a consultant in a sales role within Europe is that the individual could be considered to be a commercial agent, and then benefit from the protections of the Commercial Agency Regulations (CARs) in the EU. The CARs apply to all agreements appointing a self-employed intermediary who has continuing authority to negotiate the sale or purchase of goods (but not of services) on behalf of his principal.

The CARs can afford consultants a range of benefits, some of which cannot be contracted out by the company. Those include rights to a specified period of notice on termination, the right to be paid commission including post-termination, and the right to receive a lump sum payment on termination (which if not specified in the agreement may be determined on a “compensation basis” more favourable to the consultant).

Care should therefore be taken to ensure that the relationship is structured in such a way that these can be minimized and/or avoided, or at the very least that the company can obtain as much protection in the contract as possible where rights can be contracted out. Again, obtaining the advice of counsel is critical in avoiding these potential liabilities.

The IP Risk

In Europe there is no concept of “works for hire”. However, as in the US, whilst IP created by an employee during the course of employment will be deemed to be owned by the company, works created by a consultant will be owned by the consultant unless specifically agreed to the contrary. Therefore companies using consultants as developers outside of the US should take care to ensure that the IP created is assigned to the company by contractual agreement, which is binding and enforceable in the relevant country. Given that a designation as “works for hire” will not be recognized in Europe, companies cannot assume that standard US IP protection agreements will protect their IP outside of the US.  Failure to localize properly could leave the company exposed, so tailoring agreements for the relevant country is essential to minimize the risks.

The Permanent Establishment Issue

It is easy to assume that when a company doesn’t have a subsidiary or registered branch office in a particular country, and doesn’t have any employees there, that there is no permanent establishment for tax purposes. The analysis is not quite so simple – a consultant can constitute a permanent establishment in most countries in the same way as an employee would – particularly likely if the consultant has the ability to negotiate or sign agreements on behalf of the company. Whilst the risk may remain low with just one consultant, it should always be considered so that a tax presence is not triggered unexpectedly. Tax advisors should always be consulted.

The Cost of Stock Options

Granting stock options to a genuine consultant is possible, but unusual in Europe. As a result, the grant of stock options is often seen as an indicator of an employment relationship if the consultant falls into the all-too-common grey area between employment and consultancy. Equally, where consultants are granted options those grants will not fall within the employee exemptions from regulations around financial promotion prohibitions, or prospectus requirements.  Where a deduction or expense against corporation tax may be available in respect of options granted to employees that may not apply where grants are made to consultants.

Furthermore, employment income arising on exercise of an option can be subject to withholding of tax and social security contributions in the same way as for ordinary employment income, and can include a liability for the company, where a consultant is later judged to actually be an employee. This may not be adequately provided for in the documentation and can unexpectedly increase potential liabilities, so companies should again ensure that they are aware of risks before they grant.  Again, counsel with professionals is always desirable.

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Stock Option Exercise Tax Math

Stock Option Exercise Tax MathExercising a stock option is not always as straight forward as you might expect. The reason? Taxes.

How to Calculate the Tax on the Exercise of an NQO

“Spread” means the positive difference between the fair market value of the stock underlying the option and the strike price.

Let’s do a math example. Suppose you have a nonqualified stock option to purchase 50,000 shares at a strike price of $0.05 per share. The current fair market value of the common stock is $3.75, according to the company’s latest Section 409A calculation. Meaning, the spread is $3.70 a share.
If you exercise your option in full, you will have to write a check for 50,000 x $0.05, for the strike price – for a total of $2,500.

However, when you exercise a nonqualified stock option, not only do you have to pay your employer the exercise price per share, but you also have to pay your employer the employee tax withholding due. This includes your income tax withholding and employee side FICA.

Thus, you will also have to pay the company an amount equal to the income tax and employee‑side FICA tax withholding on the spread. The “spread” here is 50,000 shares x (3.75 – 0.05), or 3.70 per share x 50,000, or $185,000. Income and employee‑side FICA on $185,000, assuming you are over the FICA cap, is going to be approximately $48,932.50. (This according to Randy Harris, payroll consultant (@getthepayroll). Thank you, Randy!, calculated as follows:

    $185,000 x 25% (supplemental withholding rate for pay under $1 million) = $46,250
    $185,000 x 1.45% (Medicare tax) = $2,682.50
    $46,250 + $2,682.50 = $48,932.50

But watch out, annual earnings over $113,700 will be exempt from the Social Security Tax of 6.2% BUT due to the Affordable Care Act, as of January 1, 2013, income over $200,000 will require an additional 0.9% Medicare Tax Withholding.

In addition, please see the attached link for a breakdown of tax rates applicable to other situations, and be sure to consult your accountant/advisor for specifics:  2013 Fast Wage & Tax Facts.

Finally, also be aware that this tax withholding satisfies the employer’s obligations, but may not satisfy the employee’s tax obligations in full. That depends on the employee’s other tax items. The employee may need to make additional tax deposits to avoid an underpayment penalty. The optionee should consult with his or her own tax advisor on this issue.

State Income Tax Consequences

This blog post doesn’t address potential state income tax withholding issues.

Conclusion

When you are planning to exercise, consult your company’s chief financial person. He or she can help you work through the tax math of the exercise.

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Social Purpose Corporations: Reports

Social purpose corporationIf you are a social purpose corporation, don’t forget about your annual social purpose report.  Under RCW 23B.25.150, social purpose corporations have to file a report annually, reporting on how they are doing.

The Social Purpose Corporation Statute, RCW 23B.25.150 (the “SPC Statute”), provides as follows:

“The board of directors of a social purpose corporation shall cause a social purpose report to be furnished to the shareholders by making such report publicly accessible, free of charge, at the corporation’s principal internet web address, not later than four months after the close of the corporation’s fiscal year, and such reports shall remain available on that web site through the end of the corporation’s fiscal year.”

Timing

For companies whose fiscal years are the calendar year, reports should go up no later than April 30.

Contents

The social purpose report is required to include a narrative discussion concerning the social purpose or purposes of the company, including the company’s efforts intended to promote its social purpose or purposes.  It may include the following:

  1. Identification and discussion of the short-term and long-term objectives of the company relating to its social purpose or purposes;
  2. Identification and discussion of the material actions taken by the company during the fiscal year to achieve its social purpose or purposes;
  3. Identification of material actions that the company expects to take in the future with respect to achievement of its social purpose or purposes; and
  4. A description of the financial, operating, or other measures used by the company during the fiscal year for evaluating its performance in achieving its social purpose or purposes.

No Need to Measure and Report Performance Against Third Party Standard

The Washington legislature, when it adopted the SPC statute, expressly chose a permissive and flexible model rather than a prescriptive one.  Thus, SPC shareholders have the choice whether to include in the SPC’s articles of incorporation that the corporation must furnish an annual assessment of the overall performance of the corporation with respect to the achievement of its social purposes, measured against a third-party standard.  This is an example of the flexibility that the SPC statute affords, ranging from certified “B Corps” that measure the SPC’s performance against a third party standard like the standard established B Lab, the sponsor of the certified B Corp, to those that desire a different model.In other words, in Washington, SPCs may, but are not required to, measure their annual performance against a third party standard.  The statute says:

“the articles of incorporation of a social purpose corporation may contain … [a] provision requiring the corporation to furnish to the shareholders an assessment of the overall performance of the corporation with respect to its social purpose or purposes, prepared in accordance with a third-party standard;”

Theory Behind the Social Purpose Report

The theory behind the annual social purpose report is that, through posting on the SPC’s website, the report will provide a meaningful measure of transparency and communication to the SPC’s shareholders and other stakeholders with respect to the decision-making and actions of directors and officers.  The report must include a narrative discussion concerning the social purpose, including the corporation’s efforts intended to promote its social purposes.  If the corporate has adopted a third party standard against which its performance must be assessed, the corporation may include the annual assessment in the report.

Failure to Perform

The failure to furnish shareholders a social purpose report does not affect the validity of any corporate action.

Conclusion

Companies should take care and time to prepare their annual reports, especially since they are going to have to post these reports on their web sites.

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Commercial Coventures: Making a Difference while Making a Profit

Commercial Coventures

By David Lawson

Many entrepreneurs want to use their businesses to make a difference in their communities, but don’t necessarily want to start nonprofits or dedicate themselves only to charitable causes.  One of the most common tools entrepreneurs use to make a difference is a type of promotion where a percentage of the receipts (or the profits) from sales of a for-profit company’s goods and services go to one or more charitable organizations.  A famous example is the ubiquitous pink yogurt lids that benefit breast cancer research.  These promotions can bring terrific results for both for-profit sellers and charities alike, but there are a few potential hurdles that sellers should be aware of before setting one up.

First, there is a wide variety of state laws that regulate these promotions, which are known in many states as “commercial coventures.”  In most cases, both the seller and the charity are subject to state laws in each state where the seller takes active steps to sell the goods and services involved.  This includes a physical presence in the state; advertising targeted to the state; and phone calls or email to potential buyers that the seller has reason to know are located in the state.  Approximately 45 states require the charity to register to solicit charitable funds, although most major charities will probably already be registered.  Approximately 22 states (not including Washington, but including both Oregon and California) also have laws governing the conduct of the for-profit seller – the “commercial coventurer,” in state law terms.  The seller will generally be required to have a written agreement with the charity that specifies the exact percentage or amount the charity will receive and the terms of payment.  In just a few states (Massachusetts, Maine, and Alabama), the seller is obligated to register with the state as a commercial coventurer, and post a surety bond.  In general, compliance must be achieved before the promotion starts; in a couple of states, the agreement must be filed with the state two weeks in advance.

Second, both state and federal consumer protection laws may apply to any claims made in advertising.  In general, sellers should be precise in advertising, to avoid any potential deceptive claims.  For example, it is fine to say “20 percent of sales from this product go to charity” (provided that is true, as set forth in a written agreement with the charity) but it is generally not OK to say, without more information, “This product helps charity” or “This product helps end cancer.”  A few states also regulate claims in advertising as part of their commercial coventurer statutes.

Finally, if a for-profit seller engages in other types of fundraising efforts for charity beyond the type of promotion described above, the for-profit seller will want to avoid retaining any commission or percentage of the funds raised.  Retaining a percentage of charitable funds subjects the fundraiser to “professional fundraiser” statutes in almost every state, which impose a substantial and expensive regulatory burden.  Fundraising efforts that are not through a sales promotion should be structured so that all of the funds raised go to charity.

Raising funds for charity is a fantastic way to harness the power of your business to do good in your community.  But it is worthwhile to consult an attorney knowledgeable in the nonprofit or charitable area before starting a charitable promotion or fundraising effort, to avoid any regulatory surprises.

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Comment Letter On Venture Fund Investment Adviser Registration Rules

If you are interested in following the debate about the proposed new rules in Washington State that would regulate venture fund managers, and require them in many instances to register as investment advisers, you might find the attached letter a good read.

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