In line with the models applied in the English-speaking world, the granting of a stock option to a company’s manager, or to the members of its management team, is becoming increasingly widespread in Hungary too. A stock option not only gives the manager an incentive to increase the value of the company, but after exercising the option it also creates an opportunity for him or her to have a say in shareholder decisions. The regulations related to stock options in Hungary, however, carry a good deal of tax-related pitfalls. It pays to be aware of these when devising your stock option plan.

Granting the option

A stock option gives the manager an opportunity to acquire a stake in the company (shares or another form of ownership interest) at a future point in time, and at a predetermined price. The option is a right that has a determinable value, and as such, its acquisition could, in principle, be classified as income under the rules on personal income tax. However, for as long as the option’s beneficiary has no right of disposal over it (for example, if they cannot transfer it to another person), the acquisition of the option is not classified as income. Accordingly it incurs no tax liability.

Exercising the option

When the option is exercised, the beneficiary acquires a stake in the company, often at a nominal purchase price or one that is lower than its actual value. In this case, from a tax perspective, the exercise of the option is treated as if the private individual purchased a corporate shareholding below the market value at the moment of exercising the option. Accordingly, the difference between the option price and the market value of the share is classed as income for the beneficiary. The tax liability on this income depends on who the beneficiary received the income from. If it is the employer who grants options to its employees, then, when they are exercised, the income is taxed as salary. This means that personal income tax (15%), social contribution tax (19.5%) and social insurance (18.5%) is payable on it. The situation is slightly more favourable if the option is granted not by the employer, but by its parent company (or any other member of its corporate group). In this case, the employer’s contribution payable on the income can be avoided.

However, the overall tax liability is reduced by an extremely important rule of the Personal Income Tax Act. Accordingly, unless the taxpayer proves otherwise, the market value is defined as the value of equity as stated in the company’s last financial statements. And the equity value (especially if it reflects the situation a year previously) often considerably understates the true market value of the company. This can significantly reduce the income determined at the time of exercising the option, and – consequently – the amount of tax payable on it.

Exercising an option linked to an exit

In many cases the managers may exercise, or be entitled to exercise, their options concurrently with the main owner’s exit from the company. In this event, the managers can equally sell their shares, acquired by exercising the options, to the buyer of the company. Technically, therefore, this kind of arrangement involves two effectively simultaneous share transactions: the members of the management exercise their options, and then immediately they sell their shares acquired to the buyer. Here, the managers’ gain consists of the difference between the option price and the sale price. As, however, the management members often don’t have the funds to exercise the option prior to the time of the exit, a common feature of this kind of arrangement is that the obligor of the option lends the purchase price of the option to the management. In this way, the management – without any other money transfer – only receives the difference between the option price and the sale price; that is, the net gain realised on the sale of the shareholding. Do such type of arrangement carry any tax risk?

In principle, if the strike price matches the market value of the shares, then the difference should logically be taxed as a capital gain, and on this amount – apart from a minimal social contribution tax liability – only the 15% personal income tax obligation is incurred. However, in reality, the situation is not quite that simple. If the management members essentially run no financial risk, do not pay an option fee for the acquisition of the option, and do not even finance the purchase price, and if, in addition, only a minimal period of time passes between the exercise of the option and the sale, then the gain realized by the management members could easily be reclassified as income from work. Effectively, this would be treated as if the management had received a bonus tied to the value of the company. The tax on income of this kind, deriving from an employment relationship, is obviously far higher than it would be if the income were taxed as a capital gain. In these cases, therefore, it is only possible to safely argue that the management has actually received a capital gain if the option structure really does contain the features and risks of a proper option contract.

So is there a rationale for using stock options?

The domestic rules on the taxation of options are clearly not market-friendly. For a start, they don’t take into account the element of luck and the uncertainty that an option entails under true business conditions. Consequently, unlike many of the regulatory systems in other countries, they offer no incentive whatsoever for the parties involved to create such structures.

If a market actor nevertheless takes the decision to establish an option structure, there is a way to avoid, or at least reduce, the tax liability. Firstly, the exercise of the option will not result in a significant tax liability at a company where the company’s true market value is not reflected in the profit and assets stated in the balance sheet. Another tax saving can be made if the option is provided not by the employer, but by its owner. And finally, to cut down on the risk of the option structure being reclassified as salary income, it’s important to ensure that any elements associated with an employment relationship have the lowest possible weight within the transaction, while the option features that are customarily applied between independent parties should dominate.