ESOP: New rules for the taxation of employee stock and options to purchase stock in a business corporation

On 15 November 2023, the Chamber of Deputies held the 3rd reading of the government’s bill amending certain laws in connection with the development of the financial market and the promotion of retirement security, along with Amendment No. 3452, which makes changes to the Income Tax Act (ITA) concerning the taxation of employee stock. Since the relevant bill has been fairly clearly adopted and is heading to the Senate, we would like to elaborate on how this regulation should practically translate into the taxation of non-cash income of employees related to the acquisition of stock (or certain other securities) in the business corporation under employee stock ownership plans (ESOPs).

As we have previously reported, the new regulation is expected to be effective as early as 1 January 2024. The proposed regime is intended to defer the time of taxation on the acquisition of stock or option to purchase stock under the ESOP until, ideally, the employee sells the acquired stock and realises cash from which the employee can pay related tax (and, if applicable, mandatory insurance contributions). Taxation would be deferred until the first of the following times occur after the stock or option is acquired:

a) the time when the employee terminates the related employment relationship;

b) the time when the liquidation of the relevant employer takes place;

c) the time when the relevant employer or employee ceases to be a tax resident of the Czech Republic;

d) the time of transfer or withdrawal (e.g. sale or gift) of such stock or option;

e) the time of exercise of the option;

f) the time of exchange of the interest where the total nominal value of the employee’s stock changes; and

g) the time of expiry of 10 years from the date of acquisition of the stock or option.

It is clear from the above-stated list of defined times at which the time of taxation is deferred that some employees acquiring such interests or options will have to tax the relevant income before they sell the stock and receive cash incomes from which they could pay relevant tax (and where applicable, mandatory insurance contributions).

This deferral of taxation of income from employee stock plans should apply to cases in which the employee acquires the stock or option to acquire that stock in the business corporation that is the employee’s employer for which the employee is engaged in an activity or that is a parent or subsidiary of that employer or an entity related by capital to that employer. For the application of the deferral of the tax liability, it will not be relevant from which of these entities the employee acquires the stock, but in order to qualify for the deferral of taxation, the employee has to conduct activities for the employer or its successor in title or for a parent, subsidiary, or a capital-related entity of that employer at the time of the acquisition of the stock or option.

With respect to the options referred to in (e) above, the Explanatory Memorandum and unofficial statements of the officials of the Ministry of Finance indicate that options for the purposes of the proposed regulation are only transferable option rights/transferable securities, not non-transferable option rights/non-transferable promise of the employer. It is our understanding that such non-transferable option rights, previously addressed by Decree of General Financial Directorate (GFD) No. D-59 to Section 6 (3) of the ITA and taxable at the time of their exercise, would be tax deferred under the new regulations until the first time that occurs after the exercise of the option right, i.e. from the acquisition of the related stock.

The taxable income in the case of the deferred taxation would be, as before, the difference between the price actually paid by the employee for the stock or option to purchase the stock and its normal (fair market) value at the time of acquisition of such stock or option. However, the bill introduces the possibility of reducing taxable income when the value of such stock or option falls between the time of acquisition and the time of deferred taxation. In such a case, however, any profit shares paid in the meantime or other benefits arising from the holding of stock as defined in the bill must be considered at the time of deferred taxation.

In relation to point (c) above, in our opinion, it is not entirely clear whether the employee who is the tax non-resident of the Czech Republic (for example, the resident of the Slovak Republic who lives with his family in Slovakia and commutes to Brno for work because he is employed at a start-up based there), would not lose any possibility of deferring the moment of taxation because at the time of the acquisition of the share, the employee is not the tax resident of the Czech Republic. The question is therefore whether this preferential tax regime should not apply only to tax residents. This point adds further complexity to the whole matter, and we hope that a literal interpretation of the wording of this point will eventually prevail as opposed to an interpretation based on the related Explanatory Memorandum.

In relation to point (d) above, the regulation introduces an obligation for employees to inform their employer of the sale/transfer of the stock or option by the end of the month in which it occurs. Such an employer will then provide details of such income on the employee’s pay slip. This obligation is relevant only in cases where the employer is in the position of the payer of tax on earned income.

Unfortunately, however, the relevant bill does not contain any transitional provision specifying whether the possibility to defer taxation will apply only to stock and option acquired after 1 January 2024 and whether, for example, the occurrence of some of the problematic times stated above will be monitored only after a transitional period in which the interpretation of the provisions in question could be clarified. In view of the many uncertainties, it would be useful if the relevant points of contention were clarified, for example, by a Decree of the GFD.

It is clear from the above that the proposed regulation will help some employees and employers by allowing them to defer taxation of the relevant income. However, we understand from the reactions, particularly from the startup scene, that the new regulation does not really address their situation, and there will continue to be efforts to put pressure on government officials to make further modifications in the future, for example providing that the relevant income would be taxed as capital gain (instead of employment income), as is the case in some other countries. Of course, this bill does not change the fact that potential capital gain on the increase in value of the stock in the period between its acquisition and its sale is taxed as “other income” (not as employment income) and is eligible for, among other things, a time test (exemption after 3 years/5 years from its acquisition).

In this context, we would like to draw attention to an existing bill, submitted by the Minister of Science, Research, and Innovations, which is currently under a comment process, which would allow, subject to certain conditions, the full exemption of income derived by an employee from the acquisition of the stock in the business corporation that is their employer, based on the exercise of an option held by the employee for more than 2 years.

We would also like to point out that the deferral of taxation of the relevant income from employment also brings some uncertainty. This is because it could be the case that tax (and where applicable, mandatory insurance contributions) rates would change/increase significantly between the time the relevant stock or option is acquired and the relevant first time defined.

To conclude, please note that the above-stated brief overview does not touch on the implications of this regulation in terms of international taxation and avoidance of double taxation of the relevant income if it is subject to taxation in different countries. The proposed regulation partly moves the Czech Republic halfway from the group of countries where income is taxed on the acquisition of the stock to the group of countries where income is taxed on the sale of the stock. In this respect, it is certainly even more true than before that employees who have the relevant income to be taxed not only in the Czech Republic should prefer to use the services of a tax advisor who has experience in the taxation of such income and who can, if necessary, arrange for services of a tax advisor in other countries relevant to such an employee.

We will continue to monitor this area for you and keep you informed in other articles on our blog or on our webcasts. You can also find more information on our website where we cover the topic of ESOP in detail.

Chamber of Deputies Document No. 474, which amends the laws in connection with the development of the financial market, is available on the website of the Chamber of Deputies.
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