Translating your ESOP abroad.

Until now, the idea of starting an employee stock ownership plan for international divisions wasn't for the faint of heart. But the new international ESOP may just change all that.

If you have an employee stock ownership plan, you may have toyed with the idea of extending it to your non-U.S. employees. But until recently, the daunting challenges of adapting ESOPs to other countries have stymied all but the most determined. Faced with a bewildering array of foreign legal and regulatory hurdles, many corporations have abandoned the idea of establishing ESOPs for their international operations.

But a model for an international ESOP is beginning to emerge, holding out the promise of new corporate-finance and employee-benefits strategies. For financial executives long denied the opportunity to develop an ESOP for their worldwide work force, this new development is a good reason to revisit the issue. And for global managers who haven't yet contemplated this vehicle, now's a good time to think about it.

The goal of the international ESOP is to replicate the methodology and the tax benefits of the U.S. ESOP. Under a domestic ESOP, a company-established trust acquires employer shares and holds them until employees are ready to take their distributions, which usually occurs at retirement. Employers get a tax deduction for the costs of funding the plan. And because employees don't have free access to their shares, they can defer paying personal-income tax until they do receive them.

But until recently, corporations have often run into problems when trying to transplant their U.S. ESOPs into other countries. For example, many foreign countries require employees to pay taxes on shares once they become nonforfeitable. Because vesting normally occurs during employment (well before the company distributes the shares), this tax liability creates an employee funding problem. Employers often try to get around this rule by tailoring their tax-qualified schemes to each country's laws, but that increases professional fees, not to mention the costs of management time and administrative overhead. And while some countries have developed ESOP legislation of their own, most are "near ESOPs" that usually won't fill the bill.

These obstacles have driven some corporations to grant stock options to their employees instead, a move that presents its own set of difficulties. For one, stock options often fail to produce career-long employee stockholders. Plus, in most countries, exercising a stock option triggers local income-tax liability. In practice, this often means that employees must sell shares to pay the tax or that employers incur the extra cost of "grossing up" employees' pay to cover the expense. And because exercising a stock option involves an investment decision, local investor-protection laws often apply to these schemes.

ESCAPING THE LABYRINTH

The international ESOP bypasses this regulatory maze. It operates through an ESOP trust with an employer-appointed trustee, normally a professional corporate trustee in an offshore location, such as Jersey in the Channel Islands. Under this arrangement, the international ESOP can provide benefits comparable to those available domestically, and it can do so quickly and at a reasonable cost. (See the box for one company's thumbs-up vote.) The international ESOP receives contributions from locally established ESOPs funded by the company's non-U.S. divisions and subsidiaries. The plan uses those funds to acquire parent-company shares or to pay down debt incurred to acquire those shares.

Employees' accounts remain subject to possible forfeiture until their employment ends. This means they can defer vesting and taxability until they're entitled to a cash payment equal to the value of their accounts. The company often pays the distribution in local currency, providing the employees with the funds needed to pay the tax liability. The company can use share dividends to pay ESOP debt, or it can distribute the dividends or add them to the participants' accounts. The trustee can grant voting rights on all or certain issues to the participants.

In most industrialized countries, such as Japan, Germany, Hong Kong, France and the United Kingdom, the local ESOP's payments to the international ESOP qualify as a tax-deductible business expense, and the laws generally permit companies to repay ESOP loans from their pre-tax revenues. Special arrangements can lower the amount of withholding tax on dividends a U.S. corporation pays on ESOP-held shares. As with the U.S. ESOP, the company can allow employees to diversify their accounts as they approach retirement or some other goal.

Because participants receive cash rather than stock, local investor-protection or other securities laws normally don't apply. Instead of becoming registered shareholders, employees receive participation certificates and regular account statements.

Of course, you should remember that an international ESOP, like its domestic counterpart, can also be a corporate-finance technique. Companies use ESOPs to fund share repurchases, divest their divisions, refinance outstanding debt and so on. For example, when employees used ESOP financing to acquire Avis in 1986, they maintained the same level of pay and benefits they had before the acquisition, including a 3-percent-of-pay 401 (k) profit-sharing plan. The ESOP financing facilitated the buyout and provided an additional employee benefit in the form of shares.

In contrast, consider the more recent example of United Airlines, where employees are (at press time) in the process of negotiating an ESOP purchase of roughly 53 percent of the company's shares. At this writing, employees had agreed to concessions valued at $4.6 billion. In effect, the employees, aided by ESOP-financing tax incentives, are paying for their shares through wage and work-rule concessions.

ESOPs can also be a good tool for dealing with unionized, industry-wide "pattern bargaining." The United Steelworkers union began negotiating for ESOPs during the 1980s to save the jobs and pensions of an aging membership. Breaking with their traditional industry-wide bargaining strategy, local unions agreed to take less cash out of certain companies in return for shares, using ESOPs to gain equity stakes that were often 30 percent or more. More than 70,000 union members now participate in ESOPs via a bargaining strategy that helped maintain operations and jobs in 36 of the 39 companies that implemented the plans.

But the same circumstances don't necessarily apply to international ESOPs, which may run into local labor restrictions. For example, German law requires ESOPs to be approved by local works councils, statutory bodies that govern some labor and benefits issues for companies above a certain size. Other countries might view an ESOP as part of the terms and conditions of employment. In these cases, the plan may be subject to collective bargaining, although that's less likely if the funding derives solely from employer contributions, as is often the case.

PROCEED WITH CAUTION

In some countries, an international ESOP may have its drawbacks. Some countries' laws specify a minimum level of employee benefits, such as high social-security payments or mandatory profit-sharing, making an ESOP less attractive. Similarly, if the law precludes a tax deduction for plan-related funding costs (a rarity), an international ESOP may prove to be more costly for your subsidiary. In that case, the subsidiary may decide to fund it at a lower level.

Although no country has yet classed ESOPs as entitlements, beware of local interpretations of "acquired rights," which are restrictions on your ability to reduce or terminate future contributions. That danger can arise, for example, if a plan's funding formula is linked to profits (because employer contributions will vary from year to year), or if an employer intends to use an ESOP only to acquire a predetermined amount of shares.

Also, foreign-currency controls can limit a foreign subsidiary's ability to transmit funds to an offshore trustee to buy shares. In addition, dollar-denominated ESOP accounts subject employees to a dual risk: the fluctuations in the company's equity value and in the exchange rate, which occurs regardless of the company's fortunes. This is why employees typically prefer to receive their distributions in local currency rather than incurring currency-conversion costs or potentially running afoul of local restrictions on holding foreign currency. In the future, hedging strategies may emerge to help address these concerns.

You also should consider an international ESOP's potential impact on profits and earnings per share. In most countries, your ESOP plan expense qualifies for a local tax deduction, so the impact on profits will be the same as traditional employee-benefit expenses. Plus, establishing an ESOP can improve employee morale and thus productivity, and an ESOP may help restrain the growth of future compensation costs.

But the impact on earnings depends on the structure of the plan and the source of the shares. If your company sponsors an unleveraged plan to which it periodically contributes cash in lieu of other benefits to buy outstanding shares, the impact will be shareholder-neutral. But if you issue new shares simply to allow the plan to acquire them, you may dilute the value of the shares and trigger the pre-emptive rights of other shareholders to participate in this new issue.

The issues get more complex when you use an international ESOP as a financing technique. For example, if a leveraged ESOP borrows funds to buy a block of newly issued or treasury shares, the shares are typically held in "suspense" pending their allocation to employees' accounts. Accounting principles generally require all ESOP shares to be treated as outstanding when computing earnings per share, while the ESOP loan is carried as a balance-sheet liability, with a corresponding reduction in equity. Both are gradually reversed as the ESOP repays the loan.

Finally, ESOP loan payments are generally charged to compensation expense, while dividends paid on ESOP-held shares are charged to retained earnings. This is true whether you reinvest those dividends, use them to repay ESOP debt or pay them out to employees.

Clearly, an international ESOP isn't foolproof, nor is it the solution to every employee-morale woe to come down the pike. But for companies that want to give their foreign-subsidiary employees the same benefits as their U.S. counterparts, it's a welcome new development.

How One Firm's ESOP Builds Bridges Overseas

Can an international ESOP strengthen employee loyalty? H.B. Fuller, a Fortune 500 company, thinks it can. The company, which has 6,000 employees worldwide, implemented an international ESOP in 1992. The plan is part of its long-term strategy for building employee commitment, fostering a common corporate culture and encouraging cooperation among its far-flung operations. Originally, the plan covered employees in nine of the 35 countries in which the company operates. In 1993, the company extended the plan to four other countries, and it hopes to implement it in 10 or 12 more countries in 1994.

This St. Paul-based manufacturer of paints and chemicals is using its international ESOP to acquire approximately 0.5 percent of its outstanding equity each year, in addition to shares it acquires for its U.S. employees via a company-sponsored profit-sharing plan. About 4,100 employees participate, including 1,600 non-U.S. employees. The company anticipates that 1,000 more employees will become participants this year. The plan might eventually own as much as 20 percent to 30 percent of the company's shares. H.B. Fuller budgeted $400,000 for setup costs during the first three years of operation, including legal and trustee fees, administrative costs and employee-communication expenses.

The company's funding policy is performance based, which means that subsidiaries are obliged to contribute only after worldwide earnings exceed 2.7 percent of sales. All the plans are trusteed by a Jersey (Channel Island) trust company. Since the ESOP is unleveraged, each subsidiary contributes funds to the trust based on group profits. The trustee applies those contributions to buy outstanding shares, a strategy that prevents shareholder dilution. The ESOP uses any dividends to purchase additional shares.

All of the subsidiaries' plans are fundamentally the same, although certain countries, such as Canada and New Zealand, require legal documents tailored to comply with their laws. In certain locales, such as Honduras and Brazil, the ESOP may not become operable (or the country will delay its start-up) because of concerns about acquired rights or employees' rights to won shares offshore.

Instead of deferring the vesting of employees' accounts until distribution, which would also defer taxation, the company pays its annual profit-sharing bonus partly in shares and partly in cash. A portion of that cash is available to employees to pay taxes on their shares. The ESOP defers distributions until employees leave the company, although they have full voting rights on their shares. Employees can receive distributions either in U.S. dollars or in local currency.

DANGER AREAS FOR INTERNATIONAL ESOPs

If you're thinking about starting your own international ESOP, here's a quick checklist of some stumbling blocks you might run into.

BELGIUM

Tax relief for ESOP contributions may be challenged

FRANCE

High social-security contributions can raise costs

GERMANY

Risk that ESOP awards may become "customary" and therefore not easily withdrawn

HONGKONG

Companies Act provisions require a company to get an exemption permitting its ESOP to acquire its own shares

JAPAN

Securities laws may regulate the ESOP if it has more than 50 participants

SPAIN

Tax relief for ESOP contributions may be challenged

UNITED KINGDOM

Careful structuring required to ensure tax deferral of employee's accounts

Mr. Gates is an attorney and president of the Gates Group, an international consulting firm headquartered in Atlanta. Mr. Reid is a tax partner in the London office of Clifford Chance, a European law firm.