PRINT THIS PAGE

Taxing Stock Options

The EVCA has issued an update of its comparative paper on the taxation of both European and US stock options. SJ Berwin notes the EVCA found that stock options are still taxed in most countries as income when they are exercised, rather than on the subsequent sale of the underlying shares - a situation which is not proving helpful.

Late last year, the Tax and Legal Committee of the European Private Equity and Venture Capital Association (EVCA) issued an update of its comparative paper on the taxation of stock options, covering 17 European countries and the United States.

EVCA has found that stock options are still taxed in most countries as income when they are exercised, rather than on the subsequent sale of the underlying shares.

This is an unhelpful position, particularly for small and medium sized companies – some of whom are also having to come to terms with expensing share options in their profit and loss statements as a result of changes to international and domestic accounting standards.

Executives that join smaller companies are taking an entrepreneurial risk, so these companies typically offer equity incentives to managers. Share options are often the most practical and effective way to do this, especially as the shares in the company may become too expensive for the executives to acquire.

EVCA believes that executives should be taxed in a way that encourages them to remain as shareholders, aligning their interests with other investors. In EVCA’s view, this means delaying taxation of the options until the executive decides to sell the underlying shares.

Most countries surveyed in the paper do not impose a tax charge on either the grant of an option, or when the options vests. This makes sense: on the grant of an option no cash is received by the recipient to enable the tax liability to be met, and the option holder may not be in a position to realise any cash for a number of years, until the vesting period has expired.

Once the option has vested, a tax charge at this stage would encourage the executive to exercise the option and sell the shares immediately, rather than continue to hold the option or the shares.

However, EVCA’s survey demonstrates that stock options are usually subject to tax when an option is exercised. Many countries in Europe (including the UK in relation to unapproved options) impose an income tax charge on exercise (usually based on the difference between the market value of the share at the date of exercise and the exercise price). The US also imposes a tax charge on exercise of non-qualified stock options.

Often, the effect of this is that the executive has to sell shares as soon as they are acquired, in order to meet the tax liability. It may also be difficult for an executive to sell shares in an unquoted company, and the shares are difficult to value. There is also an adverse effect on the company itself, as a number of countries impose social security contributions at the time of exercise.

EVCA considers that the actual sale of the shares is the appropriate time to impose a tax charge. It argues that any profit made on the sale of the shares should be subject to tax as a capital gain (not income tax), under the normal rules for taxing gains on the sale of shares. However, only a small number of countries surveyed give this treatment, and even they have restrictions.

There is ample room for improvement, and the Italian rules stand out as an example to follow.

SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on its services to the private equity industry please contact Simon Witney in its London office +44 (0)20 7533 2222 or visit their website at www.sjberwin.com