One of the most efficient ways to motivate employees is to make them owners. In Hungary, however, plenty of legal and tax obstacles have restricted the introduction of such incentive so far. Changes made to the legal and tax environment in the recent years may yet boost the spread of employee stock programmes in the future.
The past: neither share, nor option
The most straightforward way to involve employees into the company’s ownership is to provide them with business quotas or shares directly. This raises, however, several complications. Upon the receipt of a share the employee also receives the right to participate in the decision-making procedure of the company, which is not always a desirable outcome. Furthermore, unfavourable tax consequences may come up: the unpaid part of the fair market value of the share is taxed at the same way as if salary was paid to the employee. This makes such type of incentive rather unattractive.
An employee incentive stock programme can also be introduced in the form of an option structure: the employee receives the right to purchase the company’s shares at a discounted price upon the occurrence of a vesting event. This kind of incentive can ensure that, up to the time the employee exercises his option, he will not participate in the decision-making procedure of the company and will not become owner. He will though be interested in increasing the company’s market value. Several legal and tax barriers have, nevertheless, hindered the spread of option structures in the past. On one hand, the Old Civil Code restricted the duration, the offering and the transfer of such options. On the other hand, the tax laws treat the exercise of the option as if the company granted the underlying shares for free or at a discounted price to the employee at the time of the exercise. Consequently, the amount of the unpaid market value of the share is fully taxable upon exercise, i.e. the legislation does not recognize the uncertainty embedded in an option.
A new era is coming
New Civil Code
The New Civil Code entering into force in 2014 has introduced certain flexible rules that offer solutions to many of the above problems. The possibility to issue non-regulated classes of shares opened the door to such shares grants, where the participation of the employee in the decision-making procedure may be limited or even excluded. It is also worth mentioning that the New Civil Code fundamentally changed the regulatory framework of call options, among others, cancelling the 5-year restriction on the duration of such options.
Tax rules on the valuation of shares
Although the general tax legislation on employee stock programmes did not change, an important rule was introduced into the personal income tax regime a few years ago. Accordingly, upon the calculation of the fair market value of the received shares (and thus the tax base) the employees can refer to the proportional equity value of the company. Due to the fact that the proportional equity value is usually significantly lower than the actual fair market value, the taxation of employee stock programmes became much more favourable.
The special share class of “employee shares” (dolgozói részvény) has long been one of the most beloved employee incentive. Contrary to the general tax burden on other employee incentives, no tax liability arises if the company grants employee shares to its employees for free or under their fair market value. In addition, in case of withdrawal of such shares, only 50% of the earned income is taxable. Albeit the rigid provisions of the old rules impeded the extensive spread of the employee shares, the New Civil Code has changed this attitude. For instance, it abolished the restriction on the maximum amount of employee shares a company can issue. It also abolished the prohibition that the employee shares may not confer dividend preference at the same time. Surely, this will make the use of employee shares much more attractive.
Employee Stock Ownership Programme
The latest development in this area is the re-defined Employee Stock Ownership Programme (ESOP). The ESOP is based on a company jointly established by the employer and the employees, which acquires the shares in the issuer. As a result, the employees become indirect owners of the shares. The greatest benefit of ESOPs is its flexibility: companies can tailor ESOPs to their own needs. The re-introduction of ESOPs is also accompanied by tax incentives: income earned through an ESOP is taxed as capital gain and not as salary, i.e. in a much more favourable way. It would not be surprising if, in the forthcoming years, ESOP became one of the most widespread way of employee incentives.
The decision, whether to motivate employees through an employee stock programme, is a strategic one. If such decision is made, each company should find the most suitable incentive for its own needs and purposes. Fortunately, as a result of the changes in the relating legal and tax environment in the recent years, a wide range of instruments are now available.