Employers in Latvia have three innovative tools for motivating personnel: employee stocks, employee shares, and employee stock options. Each business can choose the option that best aligns with its goals and needs. These instruments not only enhance employee engagement but also offer flexibility to cater to diverse company strategies.
Pressure On Employers on Rising Workforce Costs
During the last years in Latvia there has been a continuous pressure on the employers as of the remuneration of employees. Namely, the numbers of available workforce are decreasing for several reasons, and this pushes the employers to compete for the best part of employees.
Therefore, salaries are increasing rapidly, different kind of new bonus schemes and benefits are invented to keep the employees.
The problem here is that most of the significant bonuses (money payments for performance etc.) and benefits (company car etc.) involve tax consequences for the employer – in a form of personal income tax (PIT), social security contributions, company car tax, and finally even a company income tax (CIT). This makes the pressure on the employers even harder, especially, if we realize that these benefits and bonuses do not create lasting ties between employees and the company.
There has always been a possibility for the owners of the company to confer some company shares to the best employees or to allow them to buy them. However, these options involve high costs, in the first case for the employer, because from the value of such shares PIT and social contributions shall be paid, in the second case – for the employee, because the value of such shares can be so high that they cannot afford to acquire relevant amount of shares to have any economic rationale behind that (to receive dividends or to gain income from the increase in value). Furthermore, ordinary shares allow the holder not only receive dividends but also to participate in the administration of the company and in case of a very fragmented ownership structure the management of the company can be negatively affected.
Employee Stocks
It has been already a long time (in the current form since July 2017) possibility for joint-stock companies (corporations) to confer employee stocks to its employees, members of the board and supervisory council (or to such persons within one group of companies), but there are also significant limitations involved as of these.
Namely, employee stocks can be issued only by joint-stock companies, and they by law may not be alienated. In case of employment termination or death of a stockholder, the employee stocks are transferred back to the company by law. Articles of association of the company may stipulate provisions, which differ from the foregoing. If employee stocks were granted for a fee, the company shall pay a compensation to the person or the heir respectively in the amount of which must be equal to the sum which the stockholder would acquire by dividing the property of the company in case of liquidation.
As it was already mentioned above, employee stocks may be allocated free of charge or for a fee. If employee stocks are allocated free of charge, the stocks shall be issued on the account of the undistributed profit of the company. The total nominal value of outstanding employee stocks may not exceed 10 per cent of the equity capital of the company.
The company may issue employee stocks of different categories. Employee stocks shall give at least the right to receive dividends and, if the stocks are allocated for a fee, the right to the liquidation quota. The articles of association of a company can stipulate that employee stocks give also the right to vote and other rights a shareholder may have.
Three main issues could cause tax consequences for employee stocks. First, the moment when employee stocks are conferred upon the employees. Since by law the employee stocks are not alienable and at the termination of employment they are to be transferred back to the company, this should not be considered an employee benefit to which PIT and social security contributions have to be applied. That would change, if the stocks are alienable – a person could get not only dividends but also earn on the increase in price of the stock.
The second tax implication is when the dividends are paid out. Distributed profits in Latvia are subject to 20% CIT (however, before applying the rate, the tax base shall be divided by a coefficient of 0,8). If 20% CIT from the profits of the company has been paid, the dividends paid to stockholders – Latvian residents – are exempt from PIT. The situation of non-residents receiving dividends from a Latvian company depends on their domestic tax law and bilateral treaties concluded with Latvia.
The third implication might be when the stocks are transferred back to the company. This is the moment when PIT from a capital gain could be established. If the stocks were conferred upon free of charge, they are also transferred back to the company without compensation, and therefore no capital gain can be established. In case the stocks were conferred upon for a fee, the positive difference between the sum of this fee and the compensation gained is taxable by 20% PIT.* The same applies if the stocks are alienable and the person sells them. The only issue there would be the value of the stocks at the moment of granting if they are granted for free – should one take into account the nominal value or the value that corresponds to the possible liquidation quota at that moment? The latter one should be more favourable since it is closer to the real value of the stock.
However, since the tax implications described above (especially the first one) are not clearly regulated by the law, it is highly advisable to elaborate on the intended scheme of employee stocks and ask for a binding legal opinion from the tax authority as of the tax consequences which would be incurred if the scheme in question would be executed.
Employee Stock Options
There is no definition of employee stock options given by the law, but they can be described as a right to acquire stocks in the future for a price, which was stipulated at the time when these rights were granted. It is important to note that stock options can be issued only by a joint-stock company.
Law defines the circle of persons, to whom stock options can be granted – the company’s employees, members of the board, and supervisory council (or to such persons within one group of companies).
Employee stock options may not be alienated unless the articles of association or regulations for issuing employee stock options provide otherwise.
Employee stock options are granted free of charge. If stocks thereafter are also acquired free of charge by using these employee stock options or for a fee that is lower than the nominal value of the stock at the time of the use of the employee stock option, the company shall issue stocks on account of the undistributed profit of the company or the payment for them shall be made from specially formed reserves.
The company board shall maintain the records of issued stock options in the same way as it is prescribed for convertible debentures. The process of issue is also similar to the one designed for convertible debentures.
As for the tax consequences the general rule of law is that the income gained from the execution of rights stemming from the employee stock options is taxable under the 20% PIT rate.* The income gained from the execution of rights stemming from the employee stock options is tax exempt if the following circumstances simultaneously occur:
- the minimum holding period of employee stock options (the period from the date of granting to the day when the person is entitled to start to execute the options) is not less than 12 months;
- during the minimum holding period of the stock options the employee has an employment relationship with a company that has granted the stock options or with a company that is related to the first company;
- the employer has submitted to the tax authority the set of rules by which the emission of the employee stock options is regulated;
- the options are executed not later than within six months from the day when the employment relationship between the person and the employer (or its related entity) is terminated;
- the company that has granted the employee stock options to the person, or an entity related to it, has not granted the person a loan that has not been repaid until the moment of execution of options (loans granted by credit institutions, national financial development institution and non-credit institutions providing consumer loans are excluded from this provision).
If these provisions are not met, the question arises what would be the tax base to which 20% PIT* would be applied? The person surely would argue that the tax base should be the nominal value of the stocks acquired, while the tax authority would like to stick with the real value of the stocks, which is not so easy to determine without proper due diligence. Another option for the tax authority would be the liquidation quota, which can be calculated from the information available to the public.
Employee (Personnel) Shares
Employee shares are to some extent similar to employee stocks described above. The most significant difference here is that employee shares can be issued by a limited liability company (LLC – SIA in Latvian).
This is a really recent development – the corresponding amendments to the Commercial law entered into force only in January 2021. However, the law regulates these in a very general way – there is quite a room given for one’s discretion.
Namely, now the law allows for a limited liability company to issue shares of different categories. The only limitation is that each category of shares shall differ from other categories by the set of rights stemming from these shares and each category shall have its own name. For instance, a limited liability company can issue three different categories of shares – ordinary shares and employee A and employee B shares, where employee A and employee B shares differ by the amount of dividend they are entitled to – B shares with a coefficient of 0.8, where A shares with a coefficient of 1.
What is important, along the share categories also the exception from the principle of proportionality was introduced – now the profit can be divided not proportionally to each share – that can differ by each category of share. This means that, for instance, 50% of shares can be actually entitled to 75% of the profits, etc.
Tax implications related to employee shares are similar to those of employee stocks. However, since the PIT law does not regulate employee shares at all, tax risks are involved in every step here. The moment when employee stocks are conferred upon employees – if the articles of association of the company say that employee shares can be alienated and they are conferred upon free of charge, this can be considered an employee benefit to which PIT and social security contributions must be applied. On the opposite – if the articles of association of the company say that employee shares cannot be alienated, cannot be subject to inheritance, and after termination of employment they are transferred back to the company, there would be no ground to apply PIT and social security contributions.
The easiest part here is the moment when profits are distributed – to the distributable profits 20% CIT is applied (before applying the rate, the tax base shall be divided by a coefficient of 0,8), and if 20% CIT from the profits of the company has been paid, the dividends paid to stockholders – Latvian residents – are exempt from PIT. The situation of non-residents receiving dividends from a Latvian company depends on their domestic tax law and bilateral treaties concluded with Latvia.
When the employee shares are transferred back to the company or alienated (if allowed by articles of association of a company), it is the moment when the possible capital gain shall be established. The potential tax base would be the difference between the value of the employee shares when they were granted (if conferred upon free of charge) or the cost of the acquisition of employee shares (if they were bought) and the compensation received from the company (if any) or the purchase price received from a third person. Taking into account the many possibilities available and the number of potential different compositions of these possibilities, also the tax consequences might differ accordingly. For instance, if an employee was granted free of charge 100 shares with a total nominal value of 100 EUR, and after 2 years the person terminates the employment, these 100 shares are transferred back to the company (articles of association stipulate so) without compensation, there would be no capital gain from which 20% PIT* should be paid. Another situation would be, if these shares were bought for 100 EUR and after the termination of employment the company would pay a compensation which corresponded to the liquidation quota of EUR 700. In this case the capital gain would be EUR 700 – EUR 100 = EUR 600, from which 20% PIT* shall be paid.
Taking into account the complexity of possible tax issues arising from employee share plans, it is necessary to elaborate the intended scheme of employee shares and request a binding legal opinion from tax authority about the tax consequences that would be incurred if the scheme in question were executed. Otherwise, all the good intentions of the employer could be ruined because of sudden tax implications.
Conclusions
Taking the above into account, it is evident that all three instruments offer employers the opportunity to provide benefits to employees with reduced tax liabilities compared to traditional benefits and bonus schemes. Moreover, these instruments create stronger relationships with employees encouraging them to work for the employer for a significantly longer period than might be expected in the respective business sector.
* Latvian government has announced that PIT rate applicable to capital gains and income from capital will be 25.5% as of 1st January 2025, and while you are reading this, respective amendments in law might be already adopted by the parliament and published.
