With the new year and tax reforms that came into effect on January 1, there has been a simplification in the taxation of share allocations in companies (d.o.o.). Until now, only joint-stock companies could provide shares in the company as a benefit to employees in Croatia, while limited liability companies had to pay a tax of 125.43%, which was not profitable for many employers. Some entrepreneurs circumvented this problem by registering companies in, for example, the USA, UK, Ireland, or Estonia, where taxes on share allocations are lower. However, this will no longer be necessary as this tax has been reduced to 31.58%, making it much more favorable and less risky.
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—– Before the legal change, the effective tax burden for limited liability companies was 125.43% when allocating shares in the employer, which was treated as income from dependent work, or 71.79% when allocating shares in the employer’s group company, which was treated as other income. Now, after the legal changes, the tax rate is 24% and there are no contributions, but the share income is considered a net taxable income that needs to be recalculated to gross for tax purposes, so the current effective tax rate is 31.58%, not 24% as one might initially conclude – explained Kristina Grbavac, a partner at the consulting firm KPMG, during a recently held workshop on ESOP.
Most Common in Startups
ESOP as a type of employee reward is particularly popular among startups and IT companies that strive to retain experts in this way. Therefore, the workshop was organized by the Croatian association Cro Startup together with the association of software exporters CISEx, and the workshop was led by Grbavac and Goran Križanac, a senior manager at KPMG.
– The usual way of rewarding employees for good results is through bonuses, but it comes with a high tax burden. Unlike bonuses, rewarding through the ESOP plan is much less tax-burdened as it is not subject to mandatory contributions, and it is also possible that it will be burdened with a lower tax rate, which depends on the case – emphasized Križanac.
In a small environment like startups, employees directly participate in the development of the company, and for that, they deserve to be rewarded. Startups and IT companies employ people in high-paying positions, which are the most heavily taxed, so the allocation of shares (now also tax-relieved) is an attractive benefit. However, as Grbavac and Križanac pointed out at the workshop, it is important to understand that ESOP is only an opportunity given to employees to acquire shares one day when they meet the conditions set by the employer. These conditions may include, for example, a certain period spent working for the company, working on a project, or achieving some specific, measurable goal.
The Importance of Legal Support
If the implementation of ESOP is not well planned, it may happen that the employer pays more tax than they would give to the employee as a bonus, so it is necessary to consider tax regulations, but also to have legal support from lawyers when negotiating all the conditions for introducing ESOP. Likewise, the employer must define all elements based on which they will determine the price of the share, who will be able to receive shares and how many, under what conditions (for example, lower-ranked employees receive less), and it would be advisable to define the price at which the employee will be able to sell the share. There are many factors to consider, but perhaps the most important thing for employers is to clearly inform their employees about all decisions, opportunities, and responsibilities related to ESOP. Employees need to know exactly what benefits they will receive, under what conditions and rules. Also, to avoid potential negative consequences, the employee can agree in advance with a notary whether the share in the company will be part of the marital property or not.
Exiting ESOP
But what happens when an employee wants to sell their share or, for example, is terminated from the company in which they have a share? The basic way of ‘exiting ESOP’ is actually the realization of rights from the option plan, explains Grbavac.
– After employees meet all the conditions prescribed by the plan (whether it is a time condition, achieving some goal, or some other event), plan participants, i.e., employees become formal owners of shares in the company. In that case, ESOP as such or at least one of its cycles, depending on how ESOP is set up, ceases to exist. Of course, the company always has the option to initiate a new ESOP plan or a new cycle of the existing ESOP plan. However, sometimes in certain circumstances, such as termination of employment and the like, a person exits ESOP even before the end of the plan or cycle. What will happen to the rights to shares for such employees depends on the rules of the plan. Combinations can vary and largely depend on the reasons for leaving the plan. ESOP plans usually already recognize the reasons for leaving ESOP and classify them as leaving under so-called ‘bad’ and ‘good’ circumstances. An example of ‘bad’ circumstances would be termination of the employment contract due to employee misconduct, and in such cases, ESOP usually anticipates that employees will not acquire the right to a share in the company/share. In contrast, an employee who leaves the company under so-called ‘good’ circumstances (for example, retirement) usually has the right to a proportional part of the shares proportional to the years they participated in the plan – explains Grbavac.
Possible Sale of Shares
On the other hand, when employees leave the company, and if they have previously acquired a share in it, it means they have become formal and actual co-owners of the company, says Grbavac, which means they can freely dispose of their shares, including selling them. However, the company may set certain rules or restrictions regarding the sale in advance.
– Namely, many companies do not want to introduce other persons into the ownership structure besides existing shareholders and employees, so in that case, they introduce certain conditions regarding the disposal of acquired shares. One possible condition is that an employee leaving the company must sell their shares back to the company or that the company has a right of first refusal. Sometimes employees acquire and sell shares simultaneously, which we often see in startups that set the sale of the company to a third party as a condition for the realization of the ESOP plan – says Križanac.
