In an era when attracting and retaining employees through various benefits is no longer sufficient, especially in sectors with a significant labor shortage such as ICT, employers are increasingly turning to giving equity in the company to their employees. Some of the larger Croatian companies listed on the Zagreb Stock Exchange, such as Kraša, AD Plastika, and Podravka, have already implemented the so-called ESOP program (employee stock ownership), and there are also examples of smaller companies, joint-stock companies, that have decided to take such a step. For instance, Infobip has implemented an ESOP program, the software company Bornfight recently also gave equity to all employees, as well as the most recent example Determ (formerly Mediatoolkit), despite legal issues as introducing employee shareholding in Croatia is not straightforward.
Maja Milas, the finance manager at Determ, who was responsible for implementing the project, emphasizes that there are legal issues, but implementation is not impossible. They are currently in the final phase and preparing documentation for all employees to whom they will give equity in the company. Since they recently had a rebranding and changed the company name from Mediatoolkit to Determ, they have slightly postponed the legal part of the implementation.
– Croatian laws are not ‘intentionally’ restrictive towards such initiatives, but they are simply not sufficiently adapted to some new market needs. The paperwork and administration are extensive, and on top of that, you have to explain a lot of legal terms to employees who are not familiar with these terms. We have been preparing the project for a long time, consulting on multiple fronts because it was important to align everything from a legal and tax perspective and ensure that everything is in accordance with the law – explains Milas.
Unfavorable Tax Treatment
The concept of giving equity in company ownership has long existed abroad, but in Croatia, it has not been tax-efficient, emphasizes Petra Megla, Associate Partner in the Tax Department of KPMG in Croatia. Only in the last few years has this idea taken root in our business circles, adds Megla, likely due to the shortage of qualified workers, ‘but also due to changes in tax laws that have simplified and reduced the tax burden for certain categories of companies.’
– At one point in the past, the effective tax rate on the allocation of shares in Croatia exceeded 170 percent, so it is no surprise that companies were not inclined towards such plans. Fortunately, through a general reduction in tax rates and significant changes in tax regulations in the area of option compensation, the tax rate has now dropped to a much more reasonable 30 percent, however, only for those companies listed on the stock exchange. For example, the same treatment cannot be applied to limited liability companies, of which statistically more than 98 percent exist in Croatia, thus the majority. It is positive that this topic is being discussed and awareness is being raised about the importance of the same treatment for all, so we are optimistic and hope that this problem will also be resolved in the near future – says Megla.
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That joint-stock companies have a more favorable tax treatment in Croatia is confirmed by Katarina Pavlović, director in Deloitte’s tax department, and Ivan Zornada, a lawyer at the law firm Krehić and partners, who collaborates with Deloitte. The allocation of shares in limited liability companies, say Pavlović and Zornada, is considered income from dependent work, or salary, for tax purposes.
– Income from the allocation or option purchase of own shares given to employees and/or managers is considered income from capital and is taxable at a rate of 20 percent plus local surtax. It is important to note that the market value of shares allocated to employees is considered net benefit in kind which for tax purposes is increased by 20 percent income tax and surtax, if applicable, leading to an effective tax burden of approximately 25 percent, or 31 percent for someone paying surtax in Zagreb.
Thus, the employer pays an effective tax of up to 31 percent to the state on the market value of each share given to the employee free of charge or below market value at the moment of transferring legal ownership of the same to the employee – explain Pavlović and Zornada.
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They also note that the currently applicable provisions of the Income Tax Act prescribe this tax treatment for the allocation and option purchase of own shares.
– From this, it could be concluded that the more favorable tax treatment (20 percent + surtax) can only be applied by joint-stock companies, while the allocation or option purchase of own shares in a limited liability company would be considered income from dependent work, or salary, for tax purposes. However, we assume that the legislator’s intention was to apply the preferential tax treatment (capital income compared to salaries) to the allocation and option purchase of own shares in a limited liability company as well. As far as we know, the Tax Administration has not officially stated whether the relevant provisions of the Income Tax Act apply to limited liability companies, however, we hope that this will be clarified in the near future to resolve any doubts and legal uncertainty regarding the tax treatment – add Pavlović and Zornada.
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Implementing an ESOP, therefore, costs, and Megla adds that employers, in addition to investing their capital, i.e., shares, must also account for the costs of realizing this plan.
– In terms of additional costs in the actual realization, the good news is that if it is a plan that falls into the category of capital income, neither the employer nor the employee pays contributions, and the tax rate is nominally 20 percent, while the actual rate can rise to effective around 30 percent due to certain legal requirements that require recalculation of the rate. However, not every plan automatically falls into this category, so it is essential to thoroughly examine the tax treatment already in the preparation phase, because if the plan does not qualify for more favorable taxation, the actual tax rate can be much higher than the mentioned 30 percent, making the whole thing unprofitable – warns Megla.
Legal Undertaking
Deloitte advises that employers view the implementation of the ESOP as a legal-tax undertaking and engage legal and tax advisors for this purpose. They note that the concept of employee shareholding is not specifically regulated by the laws governing the operation of commercial companies.
– In this sense, the actual allocation is not legally demanding, and in the case of the allocation of business shares, it will take place through the conclusion of a simple sales contract and the transfer of business shares, or the re-registration of shares to the employee in the system of the Central Clearing and Depository Company, if shares are involved – say Pavlović and Zornada, who also advise that the ESOP be implemented in accordance with the company’s objectives.
– Small and medium-sized entrepreneurs will generally opt for the ‘simpler’ option of allocating business shares to employees, with or without compensation, while larger companies will often, especially if they plan to list on the stock exchange or seek other forms of investment, choose more complex ESOP structures, such as option agreements. In such cases, the country of ESOP implementation will often not be Croatia but another, for example, the United Kingdom – say Pavlović and Zornada.
Megla, on the other hand, emphasizes that good preparation and thorough familiarization with legal possibilities are key. There are many challenges in the process of planning and implementing an ESOP, adds Megla, but they are not insurmountable. However, tax inefficiencies, especially for limited liability companies, are often the reason why employers abandon the idea of giving equity to their employees.
– They are simply too expensive and do not provide the desired financial effect for the worker, so it is cheaper for the employer to pay a regular cash bonus. However, with that, they lose the greatest advantage of the option plan, which is retaining employees for a longer period and motivating them, which is currently essential for many employers to achieve their strategic goals – explains Megla, but adds that in some industries, companies are willing to go for the less favorable, i.e., more expensive option just to retain employees.
This, Megla believes, can ensure business stability with much greater certainty in the long run.
