Employee Stock Options

In economically strong countries options have been known for several decades, but in Lithuania, they have become more widely used only recently, with the change in the Law of the Republic of Lithuania on Personal Income Tax (hereinafter – Law on PIT) which introduced the relief from the personal income tax (hereinafter- PIT) to employee stock options granted after 1 February 2020.

Pursuant to item 58 of Paragraph 1 of Article 17 of the Law on PIT, as tax-exempt income considered “the benefit of an employee under options from the employer or a person related to the employee, that the employee received after the acquisition of shares free of charge or at a reduced price if the shares are acquired not earlier than 3 years after the right to an option was granted”. A similar incentive in respect to social insurance contributions (“Sodra”): fringe benefits from share options are exempt from contributions if the shares are acquired by an employee (the share option is exercised) not earlier than 3 years from the grant of the option (see Item 25, Paragraph 1 of Article 11 of Law on State Social Insurance).

The essence of the incentives is that if the mandatory requirements are met, the benefits received by the employee under the Option agreement are not subject to either PIT or  “Sodra” contributions (social insurance contributions).

It should be noted that, from the perspective of PIT, the exemption will only apply to options entered info after 2020, therefore, the PIT incentive can be actually exploited only in 2023, i.e. 3 years after the signing of the option contract.

What are employee stock options?

An employee stock option is a motivation tool for employees manifested in an agreement between the employee and the employer that entitles the employee to acquire or receive shares in the company in which he or she works at a reduced price or free of charge at some point in the future.

The definition discussed above describes “classic” option contracts. In practice, a wider range of arrangements can be classified as options: the employer may grant shares in an associated company rather than in the company where an employee works, option agreement may be concluded with investors, board members, etc. In this context, it should be noted that both above-mention tax incentives are linked to “classic” options (there are some exemptions when shares can be granted in the associated company), therefore, “classic” options will be discussed further.

By concluding an option agreement, the employer and the employee agree on the conditions under which the employee will be able to purchase shares at a reduced price/free of charge in the future.

The content of an option is individualized according to the employee’s occupation, as the contract assigns the employee individual results that reflect his occupation, for example, when an option contract is entered into with a director, the success of his job is usually measured by the financial performance of the company.

Pros and cons of employee stock options

The benefits of the employee stock options can be briefly described as follows (see table below):

EMPLOYER BENEFITS EMPLOYEE BENEFITS
“Golden handcuffs” for an employee Possibility to receive company shares at a discounted price or free of charge
Increased employee involvement, motivation, and responsibility Greater “attachment” to the company
Opportunity to improve the company’s performance The “good feeling” of becoming a business owner (even if it means being a minority shareholder)
Funds are not needed (or less needed) to promote employees through bonuses, “welfare” packages, etc. neither „today“ nor „tomorrow“
Smaller companies have a greater competitive opportunity to attract “hard-to-afford” employees, while larger companies – retain existing employees, who create high added value for the company. 

 

The negative side of the options is related to the changes in the shareholder structure and the possible influence on the shareholders’ decisions. In many cases, existing shareholders do not usually lose a controlling share package because the employee is given an insignificant number of shares, but each case is individual.

Are employee stock options for everyone?

When assessing the possibility of granting an option, the economic (business) logic of such a transaction must first be taken into account: can an employee be granted such an option with such content?

While assessing the most common cases of granting an option in practice, from the point of view of economic (business) logic, the options can be divided into two categories:

  • Start-up options. Newly established companies are generally unable to offer competitive, market-based salaries, so options are used as a tool for motivation and “salary supplement”.
  • Options for long-term companies facing difficulties in retaining a certain category of employees. In these cases, options are used to prevent a “brain drain” and to slow down the processes of change in value-added employees.

Article 47-1 of the Law on Companies of the Republic of Lithuania provides for an exception where options cannot be granted- shares may not be granted to a person who is a shareholder of the company, parent company, or subsidiary and to whom the shares owned give at least 1/20  of all votes. Thus, in cases where the employee already has 5 percent of an employer’s (or its associated company’s) share capital, a stock option agreement cannot be entered into with such an employee.

Tax-perfect “sandwich”

A list of prerequisites for the options not to be taxed would look like this:

  • Agreement between the employee and the employer. The option agreement must be in writing, contain clear provisions.
  • The economic logic of the transaction. The company must be able to justify why an option has been offered to a particular employee and provide reasoning for its content.
  • Option exercise date. The exercise date of the option must not be earlier than provided by law, i.e. at least 3 years must have elapsed since the signing of the option agreement.
  • The employee becomes a real shareholder. This condition means that the legal objectives of this institute, i.e. the employee has in fact become a shareholder with all the legal consequences that flow from it (the employee can vote, is free to decide whether he wants to remain a shareholder or not, and with whom and when he wants to conclude a share transfer transaction in the future, etc.). If at the exercise date of the option, cash compensation is offered to the employee in lieu of shares, the cash benefit would not meet the required tax incentive terms.
  • The employer or a person related to him does not repurchase the shares. If the employer or a person related to him repurchases the shares within a relatively short period of time, there is a risk that the tax administrator may consider that the real purpose of the option was not to grant shares to the employee but to pay monetary compensation.

Timeline

Three events are important for tax purposes:

  • Granting an option;
  • Option exercise;
  • Sale of shares

A statutory period of 3 years must be maintained between the first and second events.

There are no restrictions between the second and third events on how long an employee can realize the acquired shares, but if the shares are transferred within a relatively short time to an employer or a person related to the employer, there is a risk that the tax incentive will be challenged.

Exercise scenarios for employee stock options 

There are 3 possible alternatives:

  • An allotment of shares;
  • The Company’s existing shareholders transfer part of their shares to the employee;
  • The Company repurchases part of the shares from the existing shareholders and transfers them to the employee.

What does this look like in practice?

A practical example of option application: an employer with director signs an option agreement in 2021 that upon achievement of certain results in 2022-2024 the director will be able to buy 100 units (3%) of shares for the price of 15 Eur / unit. In 2024 the director buys shares for the discounted price, i.e. buys 100 units (3%) of shares for 15 Eur / unit, although at the time of the transaction the market price has changed – is 100 Eur / unit. As the director was able to acquire the shares at a reduced price, the director received a benefit of EUR 8,500 and this benefit is not subject to PIT or social contributions (“Sodra”). If the director decided to sell the shares at market price, he could earn a profit of EUR 8,500, which then would be subject to PIT.

According to item 10 of Resolutions No. 133 “On approval to the Rules for Determining the Acquisition Price of Non-Individual Activity Property of a Resident” adopted by the Government of the Republic of Lithuania: when the employee acquires shares under employee stock options from the employer (or a person related to him) not earlier than 3 years after the right to the option is granted free of charge, the acquisition price of these shares is NIL or the actual amount paid for the shares.

This means that all profits earned by the employee (the difference between the sale price and the amount actually paid to the employer for the option) at the time of the share transfer would be subject to PIT, therefore, the PIT incentive should be considered as a deferral of PIT obligations but not as a full relief from PIT obligations.

High risk scenarios

The following high-risk options can be identified:

  • The Company (employer) or a person related to them buys (repurchases) shares from the employee within a relatively short period of time;
  • Lack of business economic logic;
  • The employee’s rights are restricted in such a way that the employee does not actually become a “de facto” shareholder and is only a “formal” shareholder.

 

Summary

In summary, the following key aspects related to options can be identified:

  • Employee stock options – an attractive tool to attract and/or retain high-value-added employees without the necessity to invest a large amount of money.
  • “Sodra” (social contribution) incentive – a “real” tax incentive at all stages.
  • PIT incentive – only deferral of PIT until the shares are sold.
  • At the employer level, options are attractive because there are no taxes – the burden of PIT falls on the employee at a later stage when he will sell the shares sometime in the future.