Phantom shares and stock options are financial instruments that companies use as part of their compensation programmes to motivate employees and align their interests with those of the company. Both are designed to provide employees with the opportunity to benefit from the financial success of the company.
What are phantom shares?
We have already seen what phantom shares are and how they work in a previous blog post. To go even deeper, we can say that phantom shares are a special means of remuneration linked to the revaluation of the company’s shares/shareholdings, whose liquidity event or consideration occurs essentially in the event of a partial/total sale of the company’s share capital.
In this sense, phantom shares give the beneficiary of the Phantom Shares Plan economic rights but not political rights, i.e. they do not convert the beneficiaries into shareholders and therefore do not have voting rights.
It should be borne in mind that through the phantom share incentive system, employees do not have the possibility of acquiring the status of shareholder of the company; however, a percentage of the company’s share capital is conditional on the configuration of a Phantom Share Plan for certain employees.
In this sense, the remuneration that the beneficiaries of phantom share plans will receive would be calculated on the initial basis of the following scheme (transfer value – acquisition value). Although the acquisition value is zero since the phantoms are given free of charge, the value per share of the company at the time the phantoms were given must be taken into account when calculating the amount of phantom shares to be received as employment income.
Likewise, the shareholders must respect the percentage of share capital granted to the employees benefiting from phantom shares, thereby reducing the net amount to be received in the event of a liquidity event of the company.
The allocation of phantom shares to certain employees gives their beneficiaries economic rights similar but not identical to those of the company’s shareholders.
Phantom shares allow the loyalty and retention of key employees. In any case, phantom share allocations usually have a vesting period of three or four years and a cliff or vesting period of one year.
How are phantom shares taxed?
As far as the taxation of phantom shares is concerned, personal income tax (IRPF) is only required to be paid when a liquidity event occurs, usually in a majority sale of the Company’s share capital.
The income received by the beneficiary in the form of phantom shares is an income from work that is taxable for personal income tax purposes, and the company in turn must pay the corresponding withholdings.
In addition, Article 18.2 of the Personal Income Tax Law (LIRPF) establishes a reduction in the taxation of irregular income for personal income tax purposes, which is applicable in the case of phantom shares provided that certain requirements are met. These requirements include that these phantom shares have been allocated to the employee at least 2 years prior to the liquidity event, which generally refers to the sale of the company.
In such a scenario, the amounts received from the phantom shares would be subject to a 30% reduction in personal income tax. This means that an employee who receives income from phantom shares of up to EUR 300,000 could benefit from this 30% reduction in the taxation of that income.
In contrast, in case of granting Stock Options, the employee has to pay income tax at the time of exercising the option to purchase the shares.
On the other hand, according to the Corporate Income Tax Act, expenses related to employee remuneration through equity instruments are not deductible in the calculation of corporate income tax, whether paid in cash or equity instruments (Articles 14.3 and 6). If the transaction is in cash, the tax expense is recorded in the tax period in which the provision is applied for its purpose.
This instrument should be accounted for under the General Chart of Accounts as a potential liability, which is recognised at the time the liquidity event occurs that generates the payment obligation to the beneficiaries.
In short, the allocation of phantom shares to company employees allows them to participate in the success of the company by granting them economic rights linked to the value of the company’s shares/shares, which may be revalued over time.
What are stock options?
Stock options are a remuneration system consisting of the option of the right to purchase certain shares in a company if certain objectives are met by the beneficiary employees and they remain linked to the company, although there is freedom of agreement between the parties regarding the conditions and obligations to be established contractually.
Stock options grant the beneficiaries the future right to acquire shares in the company, subject to certain requirements and price.
Stock options are stock options that allow the recipient to acquire shares or units at a later date at a previously agreed price (known as the ‘strike price’). The exercise of these options is subject to certain conditions, such as the vesting period, the fulfilment of the good-bad leaver period, and other terms such as Cliff.
The system for exercising stock options involves a financial outlay by the employee in order to purchase these shares (even if the agreed valuation is below market value).
The delivery of stock options dilutes the percentage of share capital of other shareholders in the company, since the beneficiaries of stock options become shareholders of the company.
In this sense, when an employee exercises the option to acquire the shares, the difference between the market value of the share and what was paid for it must be declared as employment income, given that there has not been any remuneration in cash, but in kind (by means of the delivery of shares).
The delivery to active workers, free of charge or for a price lower than the normal market price, of shares or holdings in the company itself or in other companies in the group of companies, in the part that does not exceed, for the total of those delivered to each worker, 12,000 euros per year, provided that the offer is made under the same conditions for all the workers in the company, group or subgroups of companies.
The personal income tax exemption will be fifty thousand euros (€50,000) if it is a start-up company, in accordance with the provisions of Law 28/2022, of 21 December, on the promotion of the start-up ecosystem. The beneficiaries of the stock option plan who receive their options when the company is no longer considered an emerging company will not benefit from this tax incentive.
We have previously discussed in more detail how stock options are taxed in the income tax return. If the stock options are transferable, the employee must declare the employment income at the time of grant. In the event of a future sale of the shares and after having exercised the option to acquire these shares, a capital gain or loss would be generated.
In both cases, if the employee finally transfers the acquired shares, he/she will have to declare a capital gain, which will be included in the savings tax base.
At present, the personal income tax rates for capital gains are as follows:
The employer or payer can deduct the expense for corporate income tax purposes with the delivery of shares, but not with the provision. It must also make an interim payment on the non-exempt income, even if the parent company from which the stock options originate is foreign.
In summary, the new Startups Act maintains the requirements of the previous law on special remuneration plans, but includes some important new features for the beneficiaries of stock option plans:
- It extends from twelve thousand euros (€12,000) to fifty thousand euros (€50,000) per year the exempt limit (for which the employee will not be taxed) in the event that the company qualifies as a start-up and;
- It allows for the deferral of the imputation of income until the tax period in which certain circumstances occur, and in any case, within ten years of the delivery of the shares or holdings.
This system could generate some counterproductive effects, such as having to pay tax on income in kind when exercising the right to acquire shares, decapitalising the beneficiary as the case may be. Also, if the company is not sold or goes public, and the employee does not or cannot sell, he or she will be taxed without having obtained a return or capital gain;
Thus, the common scheme in internationalised start-ups are non-transferable stock options, which also manage to align the imputation of income and liquidity. In this case, options are delivered according to the established plan and vesting period, without tax consequences. When the call option is exercised, the difference between the market value of the share and the acquisition cost is considered as earned income. If the share is transferred, the difference between the transfer value and the fiscal cost of acquisition is considered as savings income. In addition, there is the possibility of being taxed as irregular income, which implies a reduction of thirty percent (30%) in the taxable base, up to a limit of three hundred thousand euros (€300,000).
In summary, both stock options and phantom options are compensation tools that offer different benefits and challenges. Ultimately, the choice between these options depends on the preferences and circumstances of both the company and its employees.
Article by:
Senior tax manager
jose.perezfuster@metricson.com
About Metricson
Metricson is a pioneering law firm providing legal services to innovative and technology companies. Since its inception in 2009, it has advised more than 1,400 companies from 14 different countries, including startups, investors, large corporations, universities, institutions and governments.
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