Everything you need to know about the taxation of options for employees

The increase in the percentage of employees in the hi-tech industry brings with it a discussion about granting stock options to employees. However, for every option and every consideration, there is taxation. Employee stock options raise many questions about the tax implications. Here is everything you need to know about options and taxation.

The rationale behind providing stock options to employees is the recognition that employees are stakeholders in the economic venture and share common interests with both the employees and the company. In the case of granting options to employees, there are various taxation methods outlined in Section 102 of the Income Tax Ordinance. This section allows for taxation at a capital gain rate in some cases. However, if options are granted to service providers to the company without formal employee-employer relationships, Section 102 of the ordinance does not apply, and Section 3(9) regarding taxation at progressive rates comes into effect.

Below is an overview of the aspects and taxation possibilities for the option recipient under Section 102 of the Income Tax Ordinance.

Employee Stock Options in Private Companies – Taxation

Taxation of Allocation of Options to Employees through a Trustee in the Capital Gain Route in a Private Company (Section 102(b)(2)):

By this route, as long as the employee waits for the vesting period to end (24 months), they will be taxed at a rate of 25% on the capital gain. If the employee does not wait for the vesting period to end in this route, the tax rate at the time of exercise will be according to the individual tax bracket they fall into. This way the company will not withhold any value from the options, whether the employee waits for the vesting period to end or not.

• Advantages: Assuming the employee waits for the vesting period, the tax rate applied to the employee is lower than their individual tax bracket.
• Disadvantages: The vesting period is longer, lasting 24 months, and the company cannot deduct expenses for granting the options to the employee. It should be noted that if employees believe there is a possibility that they will not wait for the vesting period to end, it is recommended not to choose this route. This is because the employee’s tax rate in the case of early exercise will be based on their individual tax bracket, and the company will not be able to deduct expenses for granting the options.

Allocation through a trustee in the employment income route (Section 102(b)(1)):

In the event that the company chooses this route, the employee will be subject to tax at the ordinary income tax rate upon the completion of the vesting period (12 months). In addition, National Insurance and additional tax will apply. The less the employee is willing to wait for the end of the vesting period to exercise the option, the more the employee will pay for the benefit at the higher tax rate between the grant date and the exercise date. In any case, the employee will have deductions for actual expenses incurred (payment to the trustee, additional cost for the option, etc.). For this purpose, exercising implies the early date between the grant of the option/share to the employee or the sale of the option/share by the trustee. From the company’s perspective, it is more beneficial to classify the value of granting the options to the employee as salary.

• Advantages: The vesting period is short, lasting only 12 months, and the company can deduct the benefit value as employment income.
• Disadvantages: The employee’s tax rate will be based on their individual tax bracket.

Allocation without a trustee for non-traded options (Section 102(c)(1)):

 In this route, the company directly transfers the options or shares to the employee without using a trustee and without a vesting period. The benefit value will be subject to tax at the employee’s individual tax rate at the time of allocation. This is because the options or shares are considered clear substitutes for salary.

• Advantages: In this case, there is no vesting period, and the company can deduct the allocation of options as salary expenses.
• Disadvantages: In this option, the employee pays a tax at the moment of allocation based on their individual tax bracket.

Allocation through a trustee for options in a public company (Section 102(b)(3)):

According to this route, the benefit value must be calculated at the exercise date. When calculating an average net adjusted value from the benefit, a component of the value will be taxed at the marginal tax rate, and the remaining portion, if any, will be taxed at a rate of 25%. The net adjusted average value will be calculated as follows: the value of the shares at the grant date (calculated based on the average of the 30 days preceding the grant date). If the company is registered for trading within 90 days from the grant date, then the average of the first 30 trading days will be considered. The value should be adjusted for the exercise date (by multiplying it by the partial exercise index divided by the grant index). Any expenses incurred by the employee should be deducted from the presented value, adjusted to the exercise date. For the company, the expense will be recognized as the employee’s income under Section 2(1) or 2(2) as applicable, meaning, as the amount of the net adjusted average value from the benefit. The vesting period in this route is 24 months.

• Advantages: On the one hand, it allows the allocation of the employee’s benefit to be partially recognized as capital gain, and on the other hand, it acknowledges a partial expense for the company.
• Disadvantages: Both the expense for the company and the income for the employee are not fully recognized as capital gain. Additionally, there is a relatively long vesting period (24 months), and in cases where the option is exercised before the vesting period, the employee will be subject to marginal tax on the entire amount, while the company will not incur expenses beyond those allowed when the employee did not exercise the option before the vesting period.

Allocation through a trustee in the employment income route (Section 102(b)(1)):

This is applicable to private companies: for this route, if the company chooses it, the employee will be subject to tax at the end of the vesting period (12 months) at the marginal tax rate, in addition to National Insurance and supplementary tax. If the employee does not want to wait until the end of the vesting period to exercise the option, they will pay tax on the benefit value at a higher rate between the allocation date and the exercise date. In any case, the employee will also be subject to withholding for actual expenses incurred (payment to the trustee, additional cost for the option, etc.). For this purpose, exercising means the earliest date between transferring the option/stock to the employee or selling the option/stock by the trustee. From the company’s perspective, it is more favorable to recognize the value of the options as employment income.

• Advantages: The vesting period is short, lasting only 12 months, and the company is allowed to recognize the value of the benefit as employment income.
• Disadvantages: The tax rate applied to the employee will be according to their individual marginal tax rate.

Rules regarding the application of Section 102

All the regulations presented above do not apply to a substantial shareholder, even if the shareholder also acts as an employee of the company. In order for the allocation to be classified as “allocation of shares through a trustee,” as defined in Section 102 of the Ordinance, there is a requirement to deposit the beneficial owner’s shares in the hands of the trustee – both at the time of the allocation and up to 45 days thereafter. As mentioned, service providers cannot be included under Section 102, as it applies exclusively to employees and is subject to Section 3(t) of the Ordinance – taxation according to tax brackets. In Decision 1138/18, the Tax Authority clarified the essence and broadened the definition of the employer in Section 102 of the Ordinance. According to the Ordinance’s definition, the employer must be a company. In this decision, they treated partnerships as if they were companies. The Tax Authority confirmed that the allocation of options to partnership rights falls under the provisions of Section 102 of the Ordinance.

Termination of Employee Relationship – Employer and Tax Aspects of Employee Options

According to the Tax Authority, if a salaried employee becomes a shareholder and provides their services through the company, options cannot be granted under the provisions of Section 102 of the Ordinance. This is because the Tax Authority views this as a termination of the employee-employer relationship, and after such a change in employment status, the provisions of Section 3(t) of the Ordinance will apply.

In Taxation Decision 5236/14, a case of a company seeking approval from the Tax Authority for an allocation under the capital gains route to a former employee was discussed. This was because the additional allocation of options resulted from the company’s commitment to an allocation that was granted to the former employee during their employment with the company.

After legal discussions between the company and the former employee regarding their entitlement to options, the Tax Authority determined that the allocation of options to the former employee should be subject to Section 3(t) rather than Section 102. Therefore, the tax event will occur at the time of converting the options into company shares, and the former employee’s income will be classified as employment income.

This decision was made for the following reasons:

1. Section 102 of the Ordinance applies to grants from an employer to an employee, and the examination of the employee-employer relationship is on the day of the grant of the options.
2. The purpose of Section 102 is to strengthen the relationship between the employee and the company. It aims to encourage the employee to participate in the company’s success by granting them a share of the company’s capital, motivating them to promote the company. This purpose is not achieved when options are granted to a former employee who is not actively involved in the company’s activities. Additionally, Section 102 is not intended to serve as an alternative to retirement payments or retirement arrangements for employees, which are dealt with under Section 9(7) of the Ordinance.
3. A legal commitment that arose while the employee-employer relationship was still in place but was not implemented in the form of option grants does not constitute an allocation for the purposes of Section 102 and must be accompanied by a deposit with a trustee.
4. An employer who did not see fit to include its commitment to grant options to the employee during the employment period does not fulfill the provisions of Section 102 of the Ordinance, and at the same time, the employee cannot fall within the framework of Section 102 (unless approved by the company).

In cases where Section 102 can be applied despite the absence of formal employment relationships between the option recipient and the granting company, there are certain conditions to consider:

• The option recipient can also be an employee of the company that grants the options if the company granting the options has control over the recipient company.
• The option recipient can be an employee of a company that has control over the company granting the options.
• Even in the absence of formal employment relationships, criteria based on labor law principles can be recognized as employee-employer relationships. These criteria may include tests such as the test of subordination and supervision, as well as the test of integration.
• The option recipient can hold a position in the company that is not considered an employee (e.g., a director or CEO). However, the definition of an officeholder in the Income Tax Circular 3/03 has been narrowed to include only those who serve as directors, CEOs, or those directly subordinate to the CEO.

These conditions allow for the application of Section 102 in situations where there may not be formal employment relationships but where certain criteria or control relationships exist between the option recipient and the granting company.

From this, it can be inferred that individuals who meet the defined criteria, such as senior executives in a company who do not have formal employer-employee relationships, can independently provide management services (through invoicing) and still benefit from the favorable tax provisions offered by Section 102 of the Income Tax Ordinance.

In certain cases, the tax authority regards individuals who provide services under the guise of an officeholder as service providers in disguise of officeholders.

In many cases, service providers may prefer to avoid taxation according to the marginal tax rates set in Section 3(t) of the Income Tax Ordinance and may request to apply Section 102 instead. The tax authority takes into consideration situations of service providers operating under the guise of officeholders, and we must take this into account:

A service provider employed as an independent contractor (through invoicing) will not be eligible for the grant of options under Section 102 of the Income Tax Ordinance, unless all the mentioned conditions are met:

• The individual is a director of the company
• The individual is a permanent employee of the company who invests most of their effort and time in the company
• The service provider is not an employee or partner in a consulting firm, law firm, etc.

In any tax-related process or inquiry, it is important to consult with a tax professional – contact us today!