Tax

Taxation may not be the most exciting topic to explore, but it can be even more frustrating when it comes as a surprise. It is crucial to have a basic understanding of when and what will be taxed when setting up an incentive plan.

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Tax laws vary across different countries, so understanding tax implications internationally, especially when employees work abroad or move between countries, is of particular importance. However, the good news is that some fundamental principles apply similarly worldwide.

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Several countries offer tax advantages for employee incentive plans. Find out what the conditions are and take them into account when setting up your own plan. In countries where there are no tax advantages available, alternatives such as phantom equity, also known as a virtual stock option plan (VSOP) might be a better solution.

Tax aspects to consider

• Tax residency. Ensure you know the tax residencies of the employees and other participants in your equity plan. If a participant has doubts in regards to their tax residency, they can turn to the tax authorities, who should be able to issue a tax residence certificate if such confirmation is needed.
• Country of employment. If the participant's country of residence differs from where they work, familiarise yourself with the tax rules of their country of employment. The country of employment is where income from employment-related incentive plans is taxed.
• Requirements for tax relief. Find out if the country of employment offers any tax advantages for employee stock option plans. There are usually several requirements that the stock option plan and participants have to meet in order to get favourable tax treatment.
• Employees vs other contributors. It is common that favourable tax treatment is offered to employees and less often to freelancers, contractors, or other participants who are not employees. Sometimes, non-employees are explicitly excluded, and sometimes, the tax laws should be read in a certain way to understand their tax treatment. If you want to include non-employees in your plan, check whether they can be covered by the same tax treatment as employees.
• Taxable events. Be aware of the most common taxable events that can trigger taxation in most countries - grant, vesting, exercise, and sale.

When should taxes be paid?

1. Grant of stock options can be considered as the starting point for taxing them. This is because the employees are receiving something valuable. While some countries delay the taxation until the employees actually buy the stocks using the options, there are still a few countries that haven't clearly explained how they tax the stock options. Such lack of clarity creates a risk of different interpretations of the rules and the need for help from local tax authorities or advisors.
2. Vesting of stock options can also be seen as a taxable event. Unlike the initial granting of options, which is simply a promise outlined in a signed agreement, the first vested options can actually become tangible assets, especially if the conditions allow them to be traded. In some countries, these valuable assets can be treated as taxable income if there are no specific rules in place to postpone taxation until a later stage.
3. The exercise of stock options is the most common taxable event for stock options. In many countries, income tax is imposed on the benefit that employees receive when they exchange their options for company stocks. This taxable benefit is calculated by determining the difference between the market price of the stocks and the price the employee pays to acquire them. In simpler terms, payroll taxes are typically applied to the discount that employees receive when purchasing the stocks, as compared to someone else who would pay the full market price.
4. The sale of stocks is the second most common taxable event in stock option plans. In most countries, with only a few exceptions, the gains from the sale of stocks are subject to taxation. Typically, income tax must be paid at two different points: the exercise of the options and the subsequent sale of stocks. Sound tax systems aim to avoid double taxation that may occur due to these two taxing points. However, the best tax systems are those that allow taxation only at the point of sale, when the stocks are actually sold and the monetary profit from the transaction is realised. These countries help prevent the taxation of "dry income," which is a common result of taxing at the exercise stage where no actual monetary gain is received.

Which kind of taxes must be paid?

The taxes that must be paid depend on the country and its tax system. Different countries may have different names for similar taxes. However, the most common taxes associated with stock options are income tax and social security contributions.

[fs-toc-h2]Income tax

There are usually two types of income tax related to stock options:

1. Income tax on the benefit. Employees typically pay income tax on the benefits they receive from their employer. In most countries, any form of monetary or non-monetary compensation from the employer is treated similarly to a regular salary. Therefore, if options or stocks are provided for free or at a discounted price compared to their market value, they are usually considered as a bonus and taxed accordingly, using the same income tax rates as regular salary.
2. Income tax on the profit from the sale of stocks. In some countries, this tax is referred to as capital gains tax, but the idea is the same - to tax the profit obtained from the disposal of (e.g. selling) stocks. The taxable amount is calculated by deducting the purchase price from the sales price. If the stocks were acquired without an exercise price, the entire gain is typically subject to taxation. In many countries, the tax rates for employment income and capital gains differ. A few countries either do not tax capital gains from the sale of stocks or apply tax depending on the duration or amount of the stock ownership.

[fs-toc-h2]Social security contributions

Payments of various social security contributions are usually applicable to active income like salaries or wages. Thus, similarly to the income tax described above, social security contributions are often levied on additional benefits from employers to employees. Social security payments are more common in Europe, where numerous types of contributions are collected to fund welfare, health or medical care, pensions, and support for the unemployed and disabled, among other purposes.

[fs-toc-h2]Other taxes

There are additional taxes that may be imposed, such as taxes on wealth, property, or financial transactions. Also, there may be some taxes that depend on the personal circumstances of the participant, such as municipal income taxes or, for instance, a church tax. However, these types of taxes are less frequently levied, and the tax rates are typically much lower than the average income taxes or social security contributions.

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Some countries may also levy an “exit tax”. This tax applies when someone gives up their tax residency and takes their assets out of that country. Stocks or options can be included among such assets and taxed on their market value.

Who is responsible for paying the tax?

Different taxes have different responsibilities assigned to either the employee or the employer. Additionally, there are some taxes where the employer withholds the tax on behalf of the employee, even though the ultimate responsibility lies with the employee.

• The personal income tax is ultimately the responsibility of the employee. However, in many cases, the employer collects the income tax by withholding it from the employee's salary at the time of payment. This withholding tax is not a separate tax but rather a more efficient method of tax collection.
• The responsibility for paying income tax or capital gains tax on profits from the sale of stocks often falls solely on the employee. Exceptions to this rule exist, but the seller of the stocks typically possesses the most accurate information about the details of the stock transaction, such as the price and the time of transaction.
• Social security payments are often divided between the employer and the employee. The employee part of the contributions is usually withheld similarly to income tax, and the employer pays its part directly to the tax authority. Sometimes the social security payments can be deducted from the individual's income, thereby reducing the amount of income tax. In some rare cases, the social security payments are the sole responsibility of the employer.
• The employee is usually obligated or advised to submit an annual tax return to the tax authority, allowing for final adjustments in the income tax calculation based on individual circumstances. This ensures the payment of the precise and correct amount of income tax as required by tax laws.
• Attention should be paid to the provisions in the grant agreements since it is pretty common to include a clause that allows the employer to deduct all the taxes from the employee’s remuneration, even if the tax is actually the responsibility of the employer. Some countries allow such taxes to be deducted as expenses before income taxation, but this should be checked with the local tax authorities or advisors.

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