Mandatory Cashless Exercise
Pursuant to the current statutory regime, employees can choose to apply either (i) the customary regime of taxation upon vesting (and exercise if that takes place within three years after grant), or (ii) taxation upon exercise (regardless of the time at which that exercise takes place) to option grants. The applicability of the second option can be effected by making an explicit choice for postponement of taxation, based on the law.
In practice, many employees indicate that they prefer not have to pay tax until the options are exercised, since this avoids risk and advance financing. In order to effect taxation upon exercise, the employee must specifically choose this. However, the disadvantage of this alternative is that the total gain upon exercise (if any) is taxed (ie, there is no chance for a tax-free capital gain).
The choice for postponement of taxation until the time of exercise of the options could lead to a significant practical problem with respect to the possible intrinsic value. This relates to the intrinsic value that could arise during the period between setting the exercise price (eg, during the board meeting of the employer) and acceptance of the grant by the individual employee. That intrinsic value is not eligible for postponement and is always taxed when the options become unconditionally exercisable (ie, vest). Upon subsequent exercise, the intrinsic value that was already taxed may be deducted, but this deduction will not lead to a tax refund. Thus there is an extra administrative burden for the employer and a price risk for the employee.
In order to avoid this problem, 'pre-acceptance' can be used. This is where the employee accepts the option grant in advance. In that event, if the employer actually realizes the option grant there will never be an interval of time between the grant and acceptance of the options. As a result, there will never be any intrinsic value upon acceptance of the options, provided that the exercise price is set at the value of the stock on the date of grant. The actual option contract (together with the form in which a choice is made) must be signed in the customary manner. Thus, the employee will have to sign the following documents:
- the pre-acceptance agreement;
- the option contract; and
- the form in which a choice for postponement of taxation is made.
If this regime is used the employer will be obliged to withhold wage tax (and possibly social security contributions) until the options are actually exercised. In order to avoid a grossing up, the employer will have to recover from the employee the tax (and contributions) that are due. The basis for that recovery can be the regular net monthly wages or the proceeds of sale realized upon exercise of the option.
In spite of the advantages there are three practical obstacles with respect to the proposed regime in which the employee can choose postponement of taxation.
Effect of pre-acceptance
If the pre-acceptance agreement is signed immediately after the employer sets the exercise price of the options, there is still a risk with respect to the intrinsic value that could arise during the intervening period. This can be avoided by having the pre-acceptance take place before the employer sets the exercise price. However, there are disadvantages in that (i) the tax authorities could take the position that there still is not a sufficiently determinable grant (and thus that the pre-acceptance has no effect) and (ii) expectations are created for the employee before the employer has officially resolved to grant options.
In order to avoid an intrinsic value upon acceptance and ensure taxation upon exercise, both the pre-acceptance agreement and the form in which a choice is made must be signed. This creates certain administrative burdens and implementation risks (eg, if the employee is unable to sign due to holiday or sickness).
Deductibility of costs
Employers may only deduct as labour costs the amount taken into consideration as wages for the employees with respect to the options at the first taxation moment (ie, upon vesting). Employers are not allowed to deduct the employees' amount taxed at the second taxable moment from their profit as labour costs (Article 9(3) of the Dutch 1969 Corporate Income Tax Act).
Pursuant to the law (Article 9(3) of the Dutch 1969 Corporate Income Tax Act), even if an employee opts for postponement of taxation, the amount that would have been taken into consideration as taxable wages if he or she had not opted for postponement of taxation will be deductible. Consequently, the choice in favour of postponement of taxation will lead to additional administrative expenses for employers, as a fictitious calculation of wages will have to be made when the options become unconditional, in order to determine the amount of the deductible costs.
In order to meet the preference for taxation upon exercise, it could be decided to limit the right arising from the option for the Dutch employees (ie, by implementing the condition upon grant that all stock that is acquired upon exercise of the option be immediately sold for the employee's account). This would occur in practice, since the employees exercise the options only in order to realize the potential financial profit (rather than to become shareholders). Through this obligation after exercising the options the employee would only be paid the net difference in cash between the price of the stock and the exercise price of the option, and therefore would acquire no stock.
As a result of the employee's obligation to sell, the option would in fact no longer entitle the employee to retain the stock that was acquired upon exercise. In that case, the options will not qualify as an option right for Dutch tax purposes, but rather as a stock appreciation right, (ie, the right to a cash bonus, the amount of which will depend on the price of the underlying stock). This means that the bonus (ie, the difference between the price of the stock at the time of exercise of the options minus the exercise price of the options and any costs related to the sale of the stock) constitutes taxable salary at the time at which it is paid.
The practical advantages of this alternative are as follows:
- From a Dutch tax perspective the option no longer qualifies as such. As a result, pre-acceptance is no longer necessary in order to avoid any intrinsic value;
- The entire bonus ('spread' upon exercise) constitutes a deductible cost for the Dutch employer;
- From a US perspective, the option will probably continue to qualify as such, since the entitlement to stock will continue to exist. It is unlikely that the obligation to sell that stock immediately will affect that qualification. However, this should be verified with a US accounting firm.
A 'mandatory cashless exercise alternative' addendum can be used to ensure that the option is converted into a quasi-stock appreciation right (for Dutch tax purposes). Ideally this will already be implemented in the actual stock option agreement for Dutch employees, and thus only this document must be signed.
For further information on this topic please contact Jan-Willem de Tombeor or Patrick Rietbroek at Baker & McKenzie, Amsterdam by telephone (+31 20 551 75 55) or by fax (+31 20 626 79 49) or by e-mail ([email protected] or [email protected]).
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