Taxation of employee share plans

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If an employer gives an employee a share in the employer’s business or a company in the same group as the employer’s business at a discounted price or for free, this constitutes a fringe benefit.

Although a fringe benefit is intrinsically employee income, the tax obligation in Estonia for a fringe benefit falls on the employer, who must pay corporate income tax and social tax. The employer’s tax expense on a fringe benefit is 66.25% of the value of the benefit. Fringe benefits are not personalized and are not linked to a specific employee for the purpose of tax declaration.

Under the Income Tax Act, share options have a tax exemption on certain conditions, on the basis of which options with an exercise time of at least three years are not considered fringe benefits. That means there must be at least three years between granting the option and acquisition of the assets underlying the option.

In practice, employees frequently are offered – as a part of the benefits package – an opportunity to join the group’s share option plan, which generally does not take into account the specifics of the Estonian tax system or potential tax incentives. Acquisition of a holding can take place periodically (e.g. once a year over four years), which incurs a fringe benefit tax obligation for Estonian employers. Another situation that incurs a tax obligation is when shares have been transferred to employee ownership before three years have passed, but their use is restricted (e.g. the employee cannot sell the shares before four years have passed but does earn dividends on them).

A process called sell-to-cover is often applied, for the purpose of covering the employee’s income tax obligation on share income, not taking into account the fact that shares received as employee remuneration are not taxed, but solely capital gains from selling or trading the shares. The benefit arising at the moment of receiving the shares is taxed at the employer level. When they sell the shares, the employees can take into consideration as the expense or acquisition cost the amount taxed as a fringe benefit by the employer.

The employee and employer may reach mutual agreement on how the tax burden of the fringe benefit is to be shared or agree that the employee compensates the employer for the taxes assessed. If this is the case, it should be remembered that the declared value of the fringe benefit decreases according to the expense borne by the employee and ultimately it might happen that the employee transfers to the employer a larger tax amount than the employer is obliged to transfer to the tax authority.

For this reason, we recommend for any share option plan offered to employees to discuss taxation aspects with a local tax advisory, since the Estonian tax system is different from most systems and every plan has its own nuances that can change the approach to taxation.

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