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Everything you need to know about ESOP (Part 5) – Taxes and ESOPs in venture capital

Everything you need to know about ESOP (Part 5) – Taxes and ESOPs in venture capital

In respect of business and corporate structure, it is essential to constantly monitor and evaluate the impact of tax policy on the various aspects of corporate decision-making. One of the key tools that is gaining popularity in the Czech Republic is the ESOP system. Although ESOPs can provide many benefits in terms of employee motivation and retention, their tax implications can be complex and require careful analysis.

In this article, we briefly focus on tax issues related to ESOPs in the Czech Republic. We present the key tax considerations that companies should look out for when implementing and administering these plans, and outline the implications for individual participants. You will see that a proper understanding of the tax framework can make a significant difference in the success and effectiveness of an ESOP.

Taxes as the “hammer of ESOPs”?

Opinions resonate in the general public and venture capital community that the Czech legal system is not overly friendly to ESOPs and there is no legislation directly addressing their taxation. The absence of specific tax regulation is one of the most pressing issues related to ESOPs. The tax issue itself may be a key factor for a company in deciding whether or not to use an ESOP, as well as in deciding on the specific form of ESOP that the company will offer to its key employees and, where applicable, directors and officers (or other associates).

So let us take a look at these tax aspects in more detail, and we will answer the question of whether taxes are the “hammer of ESOPs” at the end of this blog.

Virtual ESOP

In the case of a virtual stock option plan, an ESOP can take two forms from a tax perspective. It will either involve a contractual bonus, or a dividend paid to the ESOP participant. In neither case is the participant a shareholder in the company.

In addition to what form the ESOP benefit will take, it will also always be important to consider whether the participant is an employee (who is covered by employment law, and from a tax perspective the benefit will always be considered income from dependent gainful activity) or an associate. In all cases, personal income tax (up to 23%) will need to be levied, and in some cases – depending on the specific situation – social security and health insurance premiums.

For the sake of completeness, the “acquisition” of a virtual share is not subject to any taxation, as it is essentially just a calculation formula for salary or remuneration. From a tax law perspective, only the actual pay-out of the bonus arising from the ESOP is relevant, whether it is a contractual bonus or a dividend, whilst dividend may paradoxically be strongly disadvantageous to the company from a tax perspective.

Equity ESOP

a) Acquisition of an ownership interest by transfer (or increase of the share capital)

In case the employee acquires a shareholding in the company, this will constitute taxable (and, as the case may be, insured) non-pecuniary income from employment to the extent of the difference between the acquisition price and the market price, and all the deductions will be paid/withheld by the employer.

In principle, the above does not apply in the case of associates (as there is no explicit provision for taxing the difference), but in this case the situation is questionable and if there is a significant difference between the acquisition price and the market price, taxation/insurance cannot be excluded (also in view of the risk of “concealed” employment, etc.).

b) Dividend

The dividend is subject to a 15% withholding tax by the company.

c) Sale of shares (exit)

If the ESOP is linked to the employee’s right to sell their shareholding in the company, e.g. in the event of a pre-agreed event (exit event), the difference between the acquisition price and the sale price is taxable on the sale. This income will be subject to up to 23% tax.

However, the sale proceeds are exempt if the time test is met, i.e. 3 years of holding for securities (excluding the membership certificate) or 5 years for ownership interests (including the membership certificate). This also constitutes a significant advantage of an equity ESOP over a virtual ESOP, where a similar exemption is not possible.

It should also be noted that the Czech Republic is one of the few jurisdictions that exempt income of natural persons from the sale of securities/shares and, therefore, an equity ESOP can be a very advantageous instrument from a tax perspective. (The government’s “recovery package” is supposed to limit this exemption to CZK 40 million per year from 1 January 2024 (or 2025); however, simply put, only for the increase in value after that date.)

What about the taxation of ESOPs in other countries?

Various abstracts and summaries of foreign legislation circulate within the professional community, where various tax (and often only purported) advantages of ESOPs are emphasised. A close look at the relevant legislation generally reveals that virtual ESOPs do not enjoy any advantages at all, and the only advantage of equity ESOPs is that in some jurisdictions the taxation of non-pecuniary income on the acquisition of securities or interests, as described above, is deferred until the sale (“liquidity event”). This particular possibility is currently being discussed in the Czech Republic. This deferral in foreign legislations is sometimes presented in a rather simplistic way as an “exemption”, and certain (usually capped) exemptions may indeed exist, but they exist in the Czech Republic as well, as explained above. There may also be exemptions from social security and health insurance contributions abroad, but again – these can be achieved in the Czech Republic in certain situations as well. In summary, we believe that the Czech tax regulations do not deviate in any way from the “standard” regulations “in the West”, and thanks to the exemption of income from sales, they are probably among the more advantageous ones.

So is there room for improvement?

It always is.

This could include the aforementioned deferral of the obligation to pay tax on non-pecuniary income (or advance tax withheld by the employer) in the case of equity ESOPs until the ESOP share is actually sold.

Another change in the case of equity ESOPs could be the recognition of a time test even for periods when the employee only held an option right on the basis of which they only subsequently acquired an interest in the company.

So are taxes the “hammer” of ESOPs?

As mentioned above, the tax environment in the Czech Republic is not perfect for ESOPs and employees, but it is among the more favourable ones by European standards.

From our perspective, many of the critical views on the Czech taxation of ESOPs and comparisons with one foreign jurisdiction or another, where the matter is “regulated very favourably”, arise from ignorance of tax issues, incomplete study of the relevant foreign regulations, etc.

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