Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
From a tax perspective, it is important whether, upon the investment by the management members, economic ownership in the shares (or other instruments) actually transfers. In relation to shares this mainly depends on the management members’ entitlement to dividends (if any), voting rights and the applicability of transfer restrictions. Management incentive packages are typically structured to ensure such transfer. Otherwise, the full return received at exit may be subject to taxation as (employment) income.
Where economic ownership of the benefit concerned passes for arm’s-length consideration (usually management is asked to invest up to one year’s salary), there is no taxation of the grant (for Austrian tax residents). If there is no arm’s-length consideration, the grant is taxed as employment income.
In the case of stock options, non-transferable stock options are not taxed at the time of the grant, but upon exercise of the option based on the difference between the (discounted) acquisition cost and the fair market value of the shares received based on the option. In contrast, transferable stock options are considered an asset for tax purposes and, consequently, are already taxed at the time of the grant.
Income from shares received by individuals resident in Austria is taxed at 27.5 per cent. Such income includes dividends as well as capital gains. Former models that granted shares to the management relied on an exemption for capital gains (if the percentage of the shareholding in the Austrian company was below 1 per cent and was held for more than one year) are no longer applicable as realised capital gains are generally subject to tax. However, in the case of non-resident individuals, capital gains are only subject to tax in Austria at a rate of 27.5 per cent if the percentage of the employee’s (weighted) shareholding in the Austrian company amounts to at least 1 per cent during the previous five years. Double taxation treaties, however, usually restrict Austria’s right to tax such capital gains (article 13, paragraph 5 of the OECD Model Tax Convention on Income and on Capital), whereas dividends are subject to withholding tax at a rate of 27.5 per cent (which is usually reduced by double taxation treaty).
Recurring income from profit participation rights that classify as equity at the level of the company is taxed similar to income from dividends, at a rate of 27.5 per cent. If, owing to its features, profit participation rights qualify as debt at the level of the company, income is taxed similar to interest at a rate of 27.5 per cent. Regarding the exit, profit participation rights generally give more room for a tax-optimised structuring than other incentives, such as stock options or restricted stock.
Income from phantom stock (not qualifying as profit participation rights) is generally taxed similar to ordinary income from employment at the progressive income tax rate.
There are no specific tax rules applicable to management rollovers (e.g., tax-free rollovers) or parachute payments (e.g., prohibition of deduction for such payments and imposition of excise taxes on such payments) in Japan.
With respect to stock options, certain “qualified” options that meet specific criteria will be classified as “qualified stock options” that will be subject to tax at capital gains rates (about 20%) when the underlying shares are sold. In contrast, holders of non-qualified stock options are first taxed based on the economic gain reflected in the difference in the value of the shares underlying such options compared to the exercise price of the options at the time of exercise of the options; and such gain is taxed as salary income (which would usually subject such holder to a higher progressive tax rate as compared to tax at the capital gains rates). Such holders are taxed a second time at the time of sale of the shares underlying such options; and the applicable tax is a capital gains rate tax on any increase in the value of the shares since the exercise of the options.
Under Mauritius law, all the benefits associated with the employment of the employee will be counted in the remuneration and form part of the taxable income.
Generally, management investors should be treated as investors and will need to take on genuine risk as holders of equity instruments (i.e. no downside protection should exist and the invested amount should be meaningful) to mitigate the risk of any reclassification of capital gains to salary payments. Thus, the terms of the management investment plan should be tailored to meet the financial investors' commercial terms and the managements' expectations with respect to tax treatment.
The management's investments should be made at fair market value as any discount will be considered salary payments for Norwegian tax purposes taxable currently at a marginal rate of 46.6% and employer's national insurance contributions.
Management will normally invest through investment vehicles (private companies) to benefit from Norwegian participation exemption and facilitate potential roll-over transactions in connection with a future exit.
There are no specific Norwegian tax relieves available, except certain exemptions provided for roll-over transactions and options.
Taxes can be triggered upon entry or exit of the managers. Generally, managers will invest at fair market terms based on the purchase price of the financial sponsor and should not suffer a tax at entry. Certain discounts for blocking periods are accepted under Swiss tax law. The decisive question is whether the participation qualifies as "ordinary" investment (which should be the case of a strip investment) or as co-investment or entails salary components. Capital gains on privately held shares are generally tax exempt for Swiss resident shareholders. For management participations, however, the qualification as co-investment would result in the full difference between exit price and acquisition costs being treated as taxable salary (also subject to social security charges on employer level) or the application of a so-called formula value which applies at entry and exit, resulting in the excess of the exit price above the application of the formula upon exit being taxable salary (depending on the canton only during a five year period or unlimited). The treatment is generally subject to a tax ruling in order to obtain certainty.
For Dutch tax purposes, the sweet equity may be classified as a ‘lucrative interest’. In such case the income and gains derived from the sweet equity will in principle be taxed as ordinary income (box 1 income - tax rate up to 51.95%). However, if the sweet equity is held indirectly through a separate management vehicle or holding vehicle, it may be possible to structure the sweet equity in such a way that the proceeds are taxed as capital income (box 2 – flat 25% rate).
Another important matter in the structuring of a management incentive scheme for Dutch managers is the acquisition price of the shares. If the acquisition price for the managers is too low, management realizes a taxable benefit that is treated as employment income upon closing, i.e. the managers will be taxed upfront, at closing, on the expectation value of the sweet equity (box 1 – tax rate up to 51.95%). This may typically be the case if (i) the fixed yield on the preference shares and/or shareholder loans is not in line with the expected IRR upon exit and (ii) management participates relatively for a higher percentage in the ordinary share capital (the sweet) than the private equity investor (the strip).
UK tax law has a specific set of rules governing the tax treatment of equity incentive awards. One of the key principles is that the relevant individual should subscribe for his equity at the unrestricted fair market value of the equity at the time of subscription. Valuations are undertaken to provide supporting evidence of this.
Stock options receive a beneficial tax treatment, with an upfront taxation on the lump sum value of the options and in principle no taxation at exercise. In addition, stock options for employees are exempt from social security contributions. This is a double advantage: no employer contributions (+/- 30% uncapped) nor employee contributions (13,07% uncapped) need to be paid with respect to this type of management incentive plans.
This is different for free shares, restricted stock (units) or phantom shares, for which taxation occurs at the actual acquisition of the shares or the payment of an equivalent cash amount. Taxes are in this case due on the actual share value at the moment of acquisition.
Furthermore, unlike stock options, these incentive schemes are not exempt from social security contributions.
In principle, no personal income tax is due on capital gains on shares held by Belgian-resident individuals, while dividends and interest received is taxed at a flat 30% rate.
This depends on the tax residence of the managers.
For Polish resident managers, in order to ensure that the tax of 19% will be paid not upon receiving the securities in the incentive scheme but upon the final sale of the received securities numerous conditions have to be met, in particular the incentive scheme has to be established upon decision of the general meeting by the joint-stock company which is employing or cooperating upon a civil contract with the beneficiaries of the securities or by a joint-stock company which is a parent to the company employing or cooperating with these beneficiaries and the beneficiaries have to actually take up or acquire the securities (i.e. cannot receive only financial equivalent due to the participation in a program).
Additionally, securities have to be received from companies with their seat within the EU or EEA or with their seat in a country with which Poland entered into a treaty for avoidance of double taxation.
Additionally, any revenues received gratuitously in the management’s incentive schemes other than revenues from shares, transferable securities or financial derivatives cannot be taxed as revenues from the capital gains (i.e. it is impossible to apply flat tax rate of 19%).
The relatively high “top bracket” income tax rates on employment income in Portugal coupled with the taxation regime applicable to this type of income and, in particular, stock options, have provided an additional incentive for such stock option plans to be implemented. Through these plans: (i) taxation is deferred until the exercisable moment of the option; (ii) tax shall be paid only on the difference between the price paid (if any) and the market value of the physical / “virtual” shares upon the exercisable moment.
With regards to carried interest in private equity funds, there is still uncertainty as to how to qualify this type of income tax-wise (as business income, ultimately subject to the progressive rates of personal income tax, or as capital gains, which can be taxed at a final withholding tax rate of 10%). Some commentators argue that there may be reasons to sustain that “capital gains” treatment should apply to this income, as the absence of specific rules, namely treating the carried interest as business income, points to the need to promote and develop the private equity industry in Portugal and compete with other locations for the attraction of capital.
A specific set of Chinese tax laws and implementation rules promulgated by the State Administration of Taxation govern the tax treatment of equity and non-equity incentive awards. In general, equity incentive awards (e.g. stock options) are taxed at the time of exercise (which typically are treated as ordinary incomes subject to progressive individual income tax rates) and at the time of sale (gains generated from which are subject to capital gains taxes at a lower rate), and non-equity incentive awards are often treated as ordinary income (subject to progressive individual income tax rates) at the time of payment.
Management’s incentive schemes are to a large extent driven by tax rules. The main difference in share issues as opposed to share options is often not the tax category, as such, but the timing of taxation. With regard to share issues, if the subscription price management pays is lower than the fair market value of the shares, the difference is taxed as earned income upfront. In the rare instances where share options are used as part the management’s incentive scheme, the realised option benefit (i.e. the difference between the fair value of the shares and the exercise price), is taxed as earned income, but only upon the exercise thereof. Moreover, while dividends are normally capital income and taxed accordingly, dividend on management shares that is directly or indirectly conditional on work performance is taxed as earned income rather than capital income, i.e. often at a higher rate, which limits the use of such incentives. Further, the Finnish tax administration tends to put emphasis on the overall consideration of the contractual arrangements in the incentive scheme. Accordingly, tax rules allow the tax authorities in Finland to consider a range of arrangements as share options from a tax perspective. For instance, if certain conditions are met, incentive schemes based on management holding companies could be viewed and taxed as share options.
Gains realized by French resident managers investing in shares should in principle be eligible to the capital gain tax regime. As highlighted by recent tax case law, such investment should notably be substantial, at risk (i.e. no minimal return guaranteed) and priced at arm’s length in order to mitigate the risk of reclassification as salaries from a tax standpoint. Capital gain tax regime generally results in a 30% taxation (including social security contributions), whereas salary payments are taxed pursuant to the progressive income tax scale (i.e. up to 45%), plus social security charges.
Other equity schemes can benefit from specific favorable regimes, such as free shares plans, provided that they are attributed in compliance with the conditions set forth by the French commercial code and the Tax Authorities guidelines.
It is worth noting that management schemes are subject to increasing scrutiny from the French tax administration. In addition, from a French social security standpoint, the Paris court of appeal has recently considered that gains realized by managers should be considered as salaries because the instruments at stake (warrants) only benefited to the managers and were closely linked with their employment contracts. This decision has been criticized and an appeal is pending before the Supreme Court.
If the management incentive scheme provides for a subscription by management to equity (or equity-like) instruments, beneficial capital gains tax treatment for income deriving from such instruments can be achieved under German tax law, if the individual has acquired beneficial ownership in the shares (e.g. participation in profits and losses; full administrative rights (esp. voting rights); notwithstanding vesting, ownership in the underlying assets cannot be arbitrarily withdrawn by sponsor etc.). The current capital gains tax rate is approx. 26.375 % (plus church tax if applicable) if a manager holds less than 1 % in equity or approx. 28.5 % (plus church tax if applicable) if the manager holds at least 1 % in equity. No capital gains tax treatment can be achieved if a program merely ‘mimics’ an equity participation (such as a phantom share program) or where share options are issued. Income from such programs would be usually qualified as wage income, subject to wage tax withholding, i.e. personal tax rate, which is currently up to approx. 47.5 % (plus church tax if applicable).
Bonuses are taxed as normal employment income. The new income tax code introduced in Greece in 2014 confirmed that stock options to employees constitute a taxable benefit in kind and are also taxed as normal employment income. The time at which the option is exercised or transferred is defined as the time at which the benefit is taxed. The tax base is determined using the market price of the stock reduced by the cost of the option.
Benefits obtained by the employee are generally subject income tax, social security and the universal social charge at a marginal rate of 52%. The timing of the tax charge will depend on the duration of the share option.
Approved Share Option Schemes
Income tax relief will be available where a right to acquire shares in the company is granted to its employees or directors and exercised in accordance with a share option scheme that has been approved by the Revenue Commissioners. A three-year claw back provision applies. In order to qualify for approval, the scheme must be made available to all employees and directors at the same time subject to a maximum service requirement of three years. There is scope to include a “key employee” element to an approved share option scheme but the scheme cannot be limited to key employees only. The total number of shares granted to key employees or key directors cannot exceed 30% of the total number of shares in respect of which rights have been granted to all employees and directors under the scheme. Where a share option scheme has not been approved by Revenue, income tax, PRSI, USC and CGT at the normal rate will apply. However, unapproved share option schemes generally provide more flexibility for companies and any associated tax cost is the responsibility of the employee and not the company. Unapproved share option schemes are more common in practice.
Entrepreneur relief is much more limited than in the UK. It will apply to the liability to CGT where the individual disposing of the shares holds at least 5% of the company’s ordinary share capital, and if applicable, CGT will be chargeable at 10% on the first €1,000,000 of gain (over a lifetime) with the balance taxed at the standard rate of capital gains tax of 33%.
Key Employee Engagement Programme
A new initiative was introduced in 2017 in respected gains arising on the exercise of qualifying share options acquired in SME companies. An SME is a company which employs fewer than 250 people and has an annual turnover not exceeding €50 million and/or an annual balance sheet total not exceeding €43 million.
The regime exempts any gains realised on the exercise of qualifying share options granted between 1 January 2018 and 31 December 2023 from income tax, social security and the Universal Social Charge. However, the gain remains chargeable to CGT on future disposals on the shares. To qualify the share option must be held for at least 12 months, and be exercised within 10 years. The Minister of Finance announced improvements to the initiative in Budget 2019. The changes will see an increase the earnings threshold to 100% of salary (currently 50%), replace the three-year limit with a lifetime limit and increase the quantum of share options that can be granted under the scheme from €250,000 to €300,000.
Where the employees receive shares, which qualify as "restricted shares" (essentially restricts the employees ability to dispose of shares within a specified period), it may be possible to restrict the taxable value of the shares by up to 60% where the specified period is more than 5 years.
"Growth shares " or "flowering shares" are becoming increasingly common. Typically, these operate as a separate class of shares which allow an employee benefit from the future value of the shares with no entitlement to the current value of the business and are subject to performance targets. The company is responsible for operating PAYE, PRSI and USC on the difference between the acquisition price paid by the employee and fair market value of the shares on acquisition.
Debt is commonly used in acquisition financing in Ireland. However, it is important to consider whether interest on the borrowings is tax deductible and the rules can be complex.
Tax deduction against trading income
The general principle is that where interest is incurred wholly and exclusively for the purpose of a trade carried on by the company in the period in which the interest is accrued, it is allowable as a trading expense.
Tax deduction against rental income
In general interest on money borrowed to purchase, improve or repair a rented property is allowed as a deduction against the related rental income in arriving at the taxable rental income.
With effect from 1 January 2019, a 100 % deduction will be available for interest on loans for the purchase, improvement or repair of residential rental property, including foreign property loans (this is currently restricted to 85%). The deduction is unrestricted for rented commercial property.
Interest as a charge on total income (for companies and individuals)
Subject to a number of conditions being met, interest relief is available on acquisition debt used to buy the shares and can be treated as a ‘‘charge”. This means that it can be off-set against the company’s total profits or, in the case of an individual, against the income for the year of assessment in which the interest is paid. The charge can also be used against profits in other group companies subject to certain conditions. It should be noted that this is a complex area which is subject to a number of detailed anti-avoidance provisions.
Such interest is deductible against the total profits of the company. However, to the extent that there is excess interest, such current-year interest can be surrendered within a corporation tax group (i.e. a 75% group). The interest surrendered can be off-set against the other company’s total profits, minimising its tax.
Carried interest tax regime
The Luxembourg income tax law distinguishes between two categories of carried interest income earned by the employees of alternative investment fund managers (AIFMs) or management companies of alternative investment funds (AIFs):
(i) carried interest not structured under units, shares or representation issued by an AIF; and
(ii) carried interest structured under units, shares or securities issued by an AIF.
The return on the first type of carried interest arrangement is taxed at the progressive income tax rate up to 45.78%. Capital gains on the second type of carried interest realised are subject to the same progressive income tax rate. However, if the gain is realised after a period of six months it is not subject to taxation, unless the carried interest represents a substantial stake in a tax-opaque AIF. Such a substantial stake is generally present if the carried interest directly or indirectly represents more than 10% of the AIF's capital. In this case, gains are taxed at half the progressive income tax rate (maximum tax rate of 22.89%). To ensure that the income paid under the second type of carried interest arrangement benefits from this exemption, the carried interest-holder should dispose of its carried interest, which would generally entail a buy-back of carried units by the AIF.
Circular letter on stock-options
Based on the 29 November 2017 circular letter, Circular L.I.R. n°104/21 on stock options, transferable options are subject to taxation at the granting date whereas individual/virtual options are taxed at the date of exercise. For transferable options granted on or after 1 January 2018 which are not listed nor are valued in line with a recognised financial method, the benefit is determined at 30% of the value of the underlying shares. In addition, all stock-options granted as of 1 January 2018 have to be notified to the Luxembourg tax authorities at each granting date of the stock-options.
For Luxembourg social security purposes, contributions are due on the granting of options. However, where the annual remuneration of the employee already exceeds the Luxembourg annual social security ceiling (EUR 122,912.52 for the year 2018), no additional Luxembourg social security contributions would be due.
The new circular L.I.R. n°104/2 has replaced the circular letter issued on 20 December 2012 and the one issued on 28 December 2015, as well as the service notes L.I.R./N.S. 104/3 of 22 May 2013 and 104/4 of 12 January 2015.
Under U.S. tax law, a key principle for profits interest and stock options are for those awards not to have any built-in value at the time of grant. Valuations are undertaken to provide supporting evidence of this.
There are no specific tax rules other than the tax rules for capital gains. Management incentive schemes based on shares or options set up for Swedish resident managers by Swedish companies generally allow for capital gains taxation at a tax rate of 30%. Management incentive schemes taxed at the progressive tax rates for employment income, e.g. traditional employee share option schemes, are unusual due to high marginal tax rates (up to ~58%) and the cost of employer social security charges (the general uncapped rate is 31.42%).
The terms and conditions governing the management incentive scheme have to be structured in such way that the instruments are deemed to be actual securities. Far-reaching transfer restrictions and lockups or terms such as that the managers are not allowed to vote for their shares or they are not allowed to be registered as owners in the share register, may determine at which rate any gain is taxed.
Employee Share Option Programmes should be carefully structured under the relevant Maltese tax rules and the fringe benefit rules. However, the applicability of Maltese tax rules will very much depend on whether or not the individuals involved in the management of the target company effectively establish their ordinary residence in Malta.
There are specific tax rules which govern the taxation of employee stock options, wherein the value of the employee stock option less the amount paid by the employees is regarded as a “perquisite” and taxed under the head “salary” in the hands of the employees at the time of exercising the stock option. The Employer is obligated to withhold taxes at the time of exercise of the options. Capital gains shall be levied on the employee on sale of shares allotted pursuant to the stock option scheme.