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Taxes related to employee share and stock options

On 12 January 2021, amendments to the Latvian Commercial Law (CL) and the law “On Personal Income Tax” (PIT Law) entered into force. The new regulations will make the tool of issuing stock options and share options to employees as a more available and popular tool for motivating employees in Latvia. Until now, certain tax relief were available only for joint stock companies (akciju sabiedrība or AS), which had issued employee stock options or, in other words, granted the right to purchase stocks. The new amendments have enabled also limited liability companies (sabiedrība ar ierobežotu atbildību or SIA) to grant their employees right to purchase capital shares and to qualify for tax relief.

What is share and stock option?

By granting share or stock option an employer grants its employees the right to purchase after a certain period of time, at a fixed price (or free of charge), under specific conditions the capital shares or stocks (hereinafter both - stocks and capital shares referred together as - stocks) of the employer’s company or stocks of a company related to the employer. Granting of the stock options does not oblige employee in any way to exercise this granted right, meaning, that it is not mandatory for the employee to buy the company’s stocks offered by the employer. Thus, employees always have the freedom of choice whether to exercise the stock options or to refuse. In the result of exercising the stock options, an employee becomes an owner of the company’s stocks.

There are three key events in the process of granting stock options:

1. Granting of stock option - the company offers its employees the right to purchase stocks, for example, when starting the employment relations. At this moment the stock price is set (if they are not provided free of charge) at which the stocks will be made available for the employee to purchase after the expiry of the period of holding the stock options (also called the “vesting period”).

2. End of the period for holding the stock options – the end of a period specified by the employer (for example, 3 years from the day of granting of the stock options), after which the employee is entitled to exercise the stock options or, simply put, to buy the stocks. After this period, the employee may choose when to use the stock purchase option.

3. Exercising stock options - the employee purchases stocks at the price defined at the moment of granting the stock option, or free of charge, whenever the employee decides to exercise the stock options. After the end of the period of holding stock options, the employee may choose the most convenient and advantageous moment for exercising the stock options (for example, when the stock value is high).

Accordingly, issuing stock options for employees may serve as a long-term employees’ motivational tool, which can help to raise employees’ interest in the development of the company. Employees with stock options will have a direct interest in raising the company’s value, since the growth of the company will inevitably lead to the rise in the value of stocks, which employees will be able to purchase in the future. After purchasing the stocks, the employee can choose to keep or sell the stocks.

Issuing stock options for employees is a tool widely used by start-ups. Stock options can be used for attracting and retaining in long-term highly qualified employees. At the development stage a start-up might not be able to offer competitive salaries to such qualified employees. Therefore stock options that provide opportunity to obtain equity stake in the company serves as long-term motivation. When the start-up will be developed and increased its value, the employees will be able to exercise their stock options and choose to sell them if the company’s stocks or shares are purchased by investors.

What should be considered when issuing stock options?
There are several important aspects related to issuing employee stock options that must be considered.

Why to issue?
Employee stock options may be issued for several purposes:

  • as an additional remuneration and motivation for employees;
  • to keep highly-qualified specialists in the long run;
  • to engage employees in taking company-related decisions.

Depending on the reason, the company should define - which groups of employees will be eligible to receive stock options; the period of holding stock options (vesting period), and the amount of rights arising from stocks to be purchased by employees.

Whom to grant?
Stock option can be granted to members of board and council, employees (or employees of specific categories), employees and members of board and council of a company related to the employer.

How much to grant?
The company shall define how many stocks the employee shall be eligible to purchase as a result of exercising stock options.

In relation to joint-stock company, the total amount of nominal value of stocks that may be acquired by exercising the stock options shall not exceed 10% of the company’s paid-up capital at the moment when decision on issuing the stock options was made.

What rights to grant to employees?
A company may define various rights arising from stocks be purchased by employees in the articles of association. Both joint-stock companies and limited liability companies may have several categories of stock or share with different amount of rights. The rights arising from stocks or shares can be, inter alia, as follows:

  • rights to receive dividends;
  • voting rights in meetings of shareholders (stockholders);
  • rights to receive liquidation quota.

How long period the stock options shall be held?
The company shall establish the period of holding stock options (vesting period), i. e. a certain period starting from the moment when stock options are granted to an employee during which the employee must hold the stock options, and after the expiry of the period the employee shall have the right to exercise the stock option (to buy the stocks).

Employer can define one specific period of holding stock options after the expiry of which the employee will be eligible to exercise all granted stock options (“cliff vesting”). For example, an employee shall be entitled to exercise stock options to all 100% stocks granted to employee after 3 years as of the date of granting stock options. Or the employer may choose to establish that employee shall be eligible to exercise the stock option gradually (“graded vesting”). For example, 20% of the stock options can be exercise after 1 year, another 40% of the granted stock options may be exercised after 2 years, and so on.  

The minimum period of holding stock options, to qualify for tax relief, shall be 12 months.

What shall be the price of stocks?
When issuing the stock options, the company shall define whether the employee upon the expiry of the period of holding stock options, shall purchase the stocks at a set price or whether the stock will be free of charge.

If stocks are to be acquired free of charge or at a price that is less than the stock nominal value, the company shall issue the stocks at the expense of retained earnings or they shall be paid for from the company’s special reserves.

How are relations between shareholder regulated after the stocks are purchase?
The rights of company’s shareholders or stockholders can be regulated in shareholders’ (stockholders’) agreement that can specify, inter alia, various restrictions (regarding competition, for example), the company can also establish restrictions regarding handling of stocks, specify conditions for cases when employment relations are terminated with employee, and other provisions.

Furthermore, it is important to consider what will be the tax implications from issuing stock options to employees.

Tax implications

Acquiring stocks
The new amendments to the PIT Law expand the non-taxable income from exercising the stock options and establish a more favourable procedure for application of personal income tax (PIT).

In general, the PIT Law foresees that salary tax must be paid for the benefit granted to employee by an employer, including income obtained from the exercising of the stock options. The new wording of Section 8, Paragraph 25 specifies that income obtained from exercising of stock options, which has been granted to an employee, member of the council or board by the employer or company, which is a person related to the employer within the meaning of the law On Taxes and Duties, on the basis of employment relations shall also be considered as income for which the payroll tax must be paid.

It should be noted that within the meaning of Section 1, Paragraph 2 of the Corporate Income Tax Law, “stock” means also capital shares. Therefore, the new amendments also apply to exercising capital share options issued by a limited liability company.

At the same time, amendments to Section 9, Paragraph 1, Point 43 of the PIT Law specify the preconditions, which must be met in order to exempt the income obtained from exercising stock options from the payroll tax:

  • the minimum period of holding stock options (a period from the day of granting of the stock option until the date when an employee is entitled to exercise stock options) is not less than 12 months;
  • during the minimum period of holding stock options, the employee shall be in employment relations with a capital company which has granted the stock options to the payer or with a person related with which has granted the stock purchase option to the payer;
  • within two months after expiry of the time period during which employees could apply for the stock options, or stock option was granted (if the plan for exercising stock options does not provide for applying for the stock option), an employer has submitted to the State Revenue Service the information regarding the stock option plan;
  • stock options are exercised not later than within six months from the day when employment relations between the employee and employer are terminated;
  • the capital company has not issued the payer a loan that has not been repaid until the moment of exercising the stock options.

The amended provisions of PIT Law are more favourable for employees in relation to the minimum period of holding stock options, which used to be 36 months, but now not less than 12 months.

Additionally, a new norm forbidding debt obligations during the employment relations has been introduced.

 

Accordingly, if the above indicated conditions are met the payroll tax shall not be applied to an employee’s income obtained from exercising the stock options.

However, if the preconditions for applying the tax relief are not met, then the taxable income from exercising stock options shall be determined, in accordance with Section 1111, Paragraph 1 of the PIT Law. Namely, the taxable income shall be the difference between the stock market value on the day of exercising stock options and the stock purchase value. In addition, the method for establishing the stock market value depends on whether the stocks are traded publicly. According to Section 1111, Paragraph 2 of the PIT Law, the stock market value for publicly traded stocks is the average weighted price fixed on the day of exercising stock options.

It should be noted that a new norm has been introduced to the PIT law specifying that the stock market value for stocks not traded publicly is established in an independent written opinion that includes the methodology for the performance of assessment and that is provided by a person who in compliance with the Commercial Law has been included in the list of valuators of property contributions or who in accordance with the laws of the respective state is entitled to provide an independent opinion on the stock market value.

The mentioned opinion on stock value shall be valid 12 months from the day of drawing up thereof, unless significant circumstances have occurred after drawing up of the opinion due to which the option no longer reflects the true value of stocks.

It should be noted that the State Revenue Service must be informed (free format) about changes in the plan for the exercising of the stock options within two months from entry into force of such changes.

If stocks are alienated
If an employee decides to alienate the stocks that have been acquired by exercising the stock options, the income obtained will be regarded as income from the capital gains and taxable with PIT pursuant to Section 119 of the PIT Law. The stock purchase value is the stock market value on the day of exercising stock options if these stocks have been acquired by exercising stock options, and the income obtained on the day of exercising stock options is taxable pursuant to Section 8, Paragraph 25, and Section 11.11.

According to Section 15, Paragraph 5 of the PIT Law, PIT rate in the amount of 20% is applied to income from the capital including from the capital gains.

If dividends are disbursed
If an employee, in the result of acquiring stocks, is entitled to receive dividends, then the capital company pays the corporate income tax on this income at the moment of profit distribution and the PIT is exempted.

15.06.21


Author:   

Marta Tilhena

Legal Advisor

Mobile: +37123995389

Email: marta.tilhena(at)leinonen.lv

Līga Treilone

Senior Tax Advisor

Mobile: +37123995387

Email: liga.treilone(at)leinonen.lv

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