Successful entrepreneurs have always known that increasing employee motivation leads to increased efficiency and improved economic performance. One good way to do this is to make employees owners of the company, which can be done via the use of share options.
It is often used, for example, in the startup sector, when at the beginning the company does not have the money to pay bonuses to the employee and the immediate bonus is replaced by share options that can be exercised in the future, when they may be worth tens if not hundreds of times more.
No less important is the possibility of linking employees to the company for a longer period of time, as well-skilled people are the greatest assets of companies.
Share options in the Estonian legal system
Granting share options to an employee is treated in Estonia as remuneration in kind. The Income Tax Act treats a share option as a derivative contract entered into with an employer, which gives the employee the right, not the obligation, to buy the option from the issuer or sell the option to the issuer at a fixed price and within a fixed term.
It is a contractual promise to give the employee the status of a company owner in order to link key employees to the employer for a longer period of time and to enable them to benefit from the company’s well-being. The status of the owner can be given directly in the employer but also in a company belonging to the same group as the employer. The share option can be granted to employees free of charge or for a specific fee, ie grant price. In principle, the exercise period of the options is not limited, but it is important for tax purposes.
The option to exercise the share option can also be linked to the performance of the company, the performance of the employee, or even the sale of the company. In practice, share in foreign employer share programs (RSU, PSU, ESPP) is also equated with the share option, but it is important that such assets do not have the typical owner’s rights, like dividend and voting rights.
In Estonia, share options are defined by their properties, if the assets treated as a share option abroad meet the definition of Estonian share options in terms of properties, then they can also be considered as share options in Estonia.
Taxation of share options in Estonia
The granting of a share option is not taxed in Estonia. If there is at least 3 years between the grant and exercise of the share option (acquisition of the share), the acquisition of the share by the employee is also not taxed. Thus, if the share option agreement is entered into on 02.01.2021 and the employee becomes a share owner after 02.01.2024, the employer does not incur a tax liability.
In such a case, the only tax obligation would rise from the employee and now the owner of shares selling the shares. The costs of acquiring the shares can also be taken into account, only the profit from the sales will be taxed.
If the 3-year deadline is not met or if the employee sells a share option, the share options are taxed as a fringe benefit. This means that the company is obliged to pay both income tax and social tax according to the market value of the share option. The obligation to reimburse the resulting fringe benefit taxes can be included in share option agreements.
This means that the employer is obliged to pay taxes, but the employer can recover the costs incurred by the employee. The obligation to pay taxes cannot be transferred to the employee.
Share options are taxable in the same country where the employee’s salary. Thus, in the case of a person living and working in Estonia, share options received from any company in the world are subject to taxation according to Estonian rules.
For example, in a situation where employee income tax is paid in one country and social tax in another, parts of fringe benefit taxes must also be paid in different countries.
Cash compensation for share options
The question often arises as to whether the share option can also be compensated to the employee in cash, can the employee be obliged to sell the shares back to the company, etc. In principle, it is not prohibited to enter such restrictions in a share option contract or share option program. However, these restrictions may affect taxation.
If it is known in advance when the share option is granted that employees cannot acquire the share but they are reimbursed for the value of the share in cash, ie the phantom stock situation arises, then the payment made to reimburse the share options is taxed in the same way as a regular bonus with income and social tax, even if the holding period of the share options has been more than 3 years.
If the employee acquires the shares and sells them back to the employer the next day, then all the conditions are formally met and the acquisition of the shares is tax-free. In this case, the consequent sale of the shares is taxable according to the rules of the ordinary sale of assets, among other things, the expenses incurred in the exercise of options can be taken into account.
The law provides for an exception in case of a full exit (100% of the shares) before the options are exercised. In this case, compensation of the options to the employees in cash is allowed, but the 3-year proportion of holding the options must be taken into account.
For example, if the full exit occurs 2 years after the option is granted, then the employee receives 2/3 of the money tax-free and the amount of the value of the unvested share option for the last year is subject to taxation as a bonus.
Granting share options to foreign employees
In practice, companies granting options often also have employees abroad. More typical examples in the case of Estonia are, for example, the UK, Ukraine, Latvia, and Lithuania. An Estonian company may enter into its option agreements in accordance with Estonian rules, but if the obligation to tax employees’ salaries is in their country of residence, the rules of the country of residence must also be taken into account when calculating the tax burden on share options.
For example, Latvia recently shortened the holding period of share options, which is a prerequisite for the tax exemption, so it is possible for a person living and working in Latvia to receive a share option tax-free after one year. There may be other restrictions in foreign countries, for example, in the case of Ukraine, an employee may need to apply for a permit to own investments abroad due to currency control rules.
Receipt of free shares is also taxable in Ukraine, and in some cases, the acquisition of restricted shares (RSU) may be taxable as a fringe benefit. It is therefore important to be aware of the rules of the specific countries of residence of employees.
Granting share options to companies
The taxation of share options is explicitly regulated by law only when giving share options to employees. If a company wishes to pay for a service to another company with share options (sweat equity shares), it can not be done using the rules discussed previously.
In intercompany accounting, it is important that the value received for the sweat equity shares corresponds to the market price, otherwise, the grant of the share options may be treated as a gift or a non-business expense and taxed accordingly.
Another important point arises with the issue of VAT. If the service provider is a taxable person, he must in any case issue an invoice, declare and also pay the VAT according to the content of the service. Non-monetary means, such as sweat equity shares, are suitable for paying the bill.
Receiving a fee in share options can cause a liquidity problem because the money with which to pay the VAT has not been received from the buyer and the Estonian Tax and Customs Board does not accept share options as a means of payment. To avoid problems and surprises, it is always necessary to consult experts for such transactions.
Involve an advisor when planning
In Estonia, the treatment of transactions with share options in law is rather general and superficial. In many ways, the rules have developed through practice, they can be found in the instructions of the Tax and Customs Board and binding preliminary rulings.
For example, more complex issues may arise with respect to changes in the underlying assets, as well as with the inclusion of employees in foreign option programs. However, as details are always the basis of taxation, it is worth using the help of a tax advisor to make sure you are making the right choices.
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