“It’s such a good deal that it won’t last for long”, cried hundreds of business owners in response to the suggestions of setting up an ESOP. However, a bill recently adopted by the Parliament suggests that if a company uses this type of employee benefits scheme for its intended purpose, they should be able to count on it in the long term as well.
What’s an ESOP, and what’s it good for?
The Employee Share Option Programme (or ESOP for short), introduced three years ago, represents an effective and versatile alternative means of remuneration. Through the ESOP, the company’s employees acquire a share in their employer indirectly: the employee transfers some of its own shares to the ESOP entity set up for this purpose, while the employees are awarded a membership share in the latter. In this way, the employees do not become owners of their employer individually, but do so collectively, under the umbrella of the ESOP entity. Individual employees do not have any voting rights in the ESOP entity, so despite ostensibly being owners of the company, they have no say in the running of the business. Their shares only entitle them to receive remuneration through the entity.
The biggest advantage of ESOPs lies in their taxation. Rather than receiving a salary that is subject to an overall tax burden of 45%, through the ESOP the employees can receive a part of their income as capital income, which is taxed at a rate of 15%.
Games without frontiers
While the basic concept of the ESOP is to allow indirect acquisition of ownership by employees, and to use this as a vehicle for the payment of dividends, the wording of the law actually allows a far broader scope of application for ESOPs. This is because the law permits not only shares, but other securities – including bonds issued by the employer – to be transferred to the ESOP entity. Until now the law does not prevent, either, the distribution of the purely theoretical capital gain realised on the difference of the value of the securities between the time of their granting and repurchase. This has made it possible to set up structures where the payments are only partially dependent, or perhaps not dependent at all, on the yield of the security. Besides this, the law in effect does not specify the minimum holding period during which the securities have to be owned by the ESOP entity. Making use of these legal loopholes, many companies have essentially introduced, under the umbrella of ESOP, a tax efficient bonus payment system without establishing a genuine ownership relationship, where the securities were held by the ESOP entity for a matter of days only.
Like all tax structures that seem excessively favourable, this one also gave rise to uncertainty: if the ESOP is such a good thing, then surely it won’t be sustainable over the long term. For this reason, many businesses didn’t embark on the introduction of a programme of this kind, despite the substantial tax savings that it promised.
Less cake from 2019
Under the bill that has just been passed, with effect from 2019, only the employer’s ordinary shares, or other, publicly issued securities that embody a similar investment risk, will be transferable to the ESOP entity. This change will eliminate the corporate bond programmes – which often had no genuine economic substance – from the ESOP system, because the bonds in question were typically issued privately. Another important change will be that the period for the assessment of the company’s performance, serving as the basis for payments, need to last at least 1 year in 2019, 2 years and from 2020 onwards. In other words, the securities will also have to be owned by the ESOP entity, and through it by the employees, for at least this length of time. This change could put a stop to the ESOP structures in which the employer, contrary to the original intentions of the legislator, transferred the securities to the ESOP entity for a brief period only.
The approved bill does not, however, prevent many other techniques that are currently used when planning ESOPs. For example, it still does not limit the opportunities for a parent company, created – possibly for this specific purpose – as a privately held joint-stock company (Zrt.), to set up an ESOP for the benefit of the employees of a subsidiary operating in the form of a private limited company (Kft.). The bill also does not prevent the transfer of share options, rather than the shares themselves, to the ESOP entity. And, under the bill, it would also remain possible for the capital gain realised on the sale of the shares to be distributed among the employees, rather than their yield.
So should we rejoice or mourn?
Although the legislature is essentially closing some of the most obvious loopholes, this is also a sign that it plans to maintain support for ESOPs in the long term. Therefore, all companies planning to establish an ESOP entity in keeping with the spirit of the law can feel more secure about doing it, as the costs of creating and establishing the ESOP entity will probably – over a period of many years – be far exceeded by the tax benefits that it brings. The importance of ESOPs could also get a boost from next year due to the fact that other tax-saving employee benefit systems – especially the cafeteria scheme – are now clearly in their final death throes.