ESOP (Employee Share Ownership Programme) entities have been springing up like mushrooms in Hungary since last year, and the acronym itself has become something of a buzzword. And this is hardly surprising, as ESOP entities can be a tax efficient vehicle for paying out work incomes. Caution is advised, however: alongside the many advantages, the regulations also conceal a number of pitfalls.

What is an ESOP?

An ESOP is an entity created by an employer to hold securities issued by it or by its parent company, for the benefit of employees. So rather than awarding shares directly to employees, the employer or its owner sets up an ESOP entity, and transfers the shares to that entity instead. The company’s employees each receive a membership share in the ESOP entity, and in this way they gain access to the yield on the securities transferred to the ESOP.

Although the employees become owners of the ESOP entity, their shares only entitle them to receive payments through the entity; they have no voting rights or any influence in the running of the ESOP entity or, through it, in the running of the employer.

The biggest advantage of ESOPs lies in their taxation: income received by employees through the ESOP is taxed as capital income (that is, at a rate of 15%), and as such the award is not liable for the employer’s and the employee’s social security contributions. Another important element of the favourable tax regime is the exemption from tax on the acquisition, by employees, of their shares in the ESOP entity: if the employer were to award securities directly to the employees for free or at a discount, this benefit would be liable for tax, and what is more, this tax would be payable at the high rates applicable to salaries.

A wide range of opportunities

Under the classic type of scheme, the ESOP entity holds a proportion of the employer’s shares for the benefit of the employees, and the profit deriving from the dividend earned on the shares is distributed among the employees, also as dividend. The wording of the law, however, allows significantly greater freedom than this in terms of how ESOPs can be used.

There is no prohibition on the ESOP entity holding bonds or other securities issued by the employer, instead of shares, and distributing the yield on these among the employees. There is also no restriction on paying out to the employees the capital gain from the sale or redemption of the security itself. It is also possible to set up facilities where the payments are only partially dependent, or not dependent at all, on the yield of the security.

The system also allows flexibility as, in addition to the employer’s securities, the securities of its parent company can also be included in the ESOP scheme. This way, even companies operating as limited liability companies (kft) can enjoy the benefits of an ESOP. If the employer itself is unable to create an ESOP entity (because an equity share in a kft. is not classified as a security) but its parent company is a private company limited by shares (zrt), or if a holding company operating as a zrt. is established as the employer’s owner specifically for the purpose of creating an ESOP entity, then the shares of that holding company can be held by the ESOP entity.

What do you need to watch out for?

There are several things to bear in mind when setting up an ESOP, however. The basic document regulating payments to employees is the remuneration policy, which specifies the extent of each employee’s entitlement to the income generated in the ESOP. The law, however, imposes several conditions that must be taken into consideration when drawing up the remuneration policy. For example, the remuneration policy must be carefully phrased to ensure that it contains no unwarranted discrimination between employees, and care must be taken to comply with the statutory requirement imposing that payments must be contingent on the predetermined improvement in the company’s operating profit or on other performance ratios.

Maintaining control, as owner, of the employer’s company is a similarly thorny issue. The appropriate structure and system of contracts need to be elaborated, so as to ensure that the transfer of some of the employer’s shares to the ESOP does not, under any circumstances, result in a curtailing of the owner’s decision-making rights.

And finally, it is important to understand that the ESOP is not suitable, either technically or in terms of its intended purpose, as an alternative channel for regular salary payments. The ESOP is, principally, a vehicle for the payment of bonuses and other performance-based awards.