Did I just receive a benefit?
The first thing to keep in mind in taxation – any valuable thing or benefit you get from your employer is typically taxable income, except if the tax law says it is tax free. A reward that your employer gives you instead of money is called *fringe benefits* or *benefits in kind* and is usually taxed similarly to a salary, including income tax and social security contributions.
Still, it also depends on how a certain country defines income. In some countries, the definition is broad, covering every possible remuneration, while in others, only certain items listed in tax law are included.
Grant of options
Grant of a share option can be treated as you have received income, even if you haven’t received any monetary gain yet. However, few countries actually tax the grant of options, as it is rather difficult to determine the proper value of share options. Especially when the grant means just a signed agreement and the options haven’t started to vest.
Yet, in countries that do not have such rules and where taxable income is broadly defined, it is better to ensure in advance what is their tax treatment for share options. The chances are high that a grant of an option can be a taxable event or, worse - open to different interpretations.
Vesting of options
Vesting is another possible tax point as now the employee owns the share options (but not yet the shares).
Tradable share options might be treated as securities and, thus, taxed when received. Share options may come with conditions or restrictions to sell, so it is quite hard to determine what they would actually cost in the open market. So countries often don’t see much point in taxation of employee share options.
Therefore, most countries have set special tax rules to postpone taxation until options are exercised or shares are sold. Such rules typically have a number of requirements that ESOP has to meet (e.g. in Scandinavian countries).
Exercise of options
Exercise of options means getting real shares with more certain value compared to options, which is why this is the most common tax point in the tax laws of many countries.
The taxable amount depends on whether the exercise price is lower than the share's fair market value (FMV) at the time of the exercise. If the exercise price (i.e. strike price) is equal to the market value, there is no benefit and no taxes. If the strike price is lower than the market value, the discount is treated as a benefit from employer.
This benefit is often taxed as income from employment, i.e. salary, typically with income tax and social security contributions. The entire share value is considered taxable income if the employee does not pay any price for the shares at the exercise.
The problem with taxation at grant, vesting or exercise is that it creates the so-called “dry income”. Even if the employee receives a benefit in share options or shares, he or she might not have enough money to pay taxes on that benefit since there was no cash payment.
Besides, grant agreements often include a clause that allows the employer to deduct all the tax obligations from the employee’s remuneration, even if the tax laws have put these obligations on the employer (e.g. some social security payments). Therefore, all the wage tax obligations that come with the discounted share price might need to be paid from the employee’s own pocket.
So there is always a tradeoff where to set the strike price - if it is low, the employee might pay less for the shares but faces a higher tax bill. If the strike price is high, the tax bill can be avoided, but the employee needs more funds to exercise his options.
Thus, the best tax systems allow postponing taxation from exercise to sale in order to avoid the dry income issue (e.g. in the Baltic countries).
Sale of shares
The sale of shares is taxable in most countries, with only a few exceptions. However, the most common approach is that share options are taxed twice - at exercise and at sale.
Postponing the tax to the time of sale is actually a tax advantage. Thus, it usually comes with conditions. If the conditions are not met, the tax point cannot be shifted and it will still be at the exercise or grant.
Conditions also vary per country. Some are meant for a small group of entrepreneurs like start-ups or small entities, while other countries set requirements on the length of employment, the time between exercise and sale or the range of participants (often only employees are eligible).
The taxable amount then is the gain, i.e. the difference between the sales price and price you paid for the shares at the exercise. Usually only the income tax must be paid and no social security taxes.
Does two tax points mean double taxation?
Good tax rules avoid double taxation but it is not always the case.
If you paid income tax when you exercised your options, that amount of income tax is typically taken into account when the sale of shares is taxed.
Since each country has its own tax rules, it is always better to ask for more personal tax advice in cross-border situations. These tips will give you a good base to start from.
If you’re operating within one country, start by making clear whether there is a tax favourable treatment for share options and what the conditions are. If there are no such tax rules, ask the local tax authorities or advisors to clarify the tax treatment of share options, especially when the first taxing point is and what taxes are to be paid.
☝️ Pro tip: Paying your taxes correctly helps you sleep better! 😝
Check out our first in Europe Stock Option Tax calculator to understand tax costs of your stock option grant.