Granting of stock options to employees is not new; it has been used for many decades around the world.
Until recently, however, the granting of stock options has not been directly regulated by company laws in Latvia, although the possibility of benefiting from an exercise of stock options was referred to in the country’s Law on Personal Income Tax. Nonetheless, the Latvian tax administration held that stock option income could only be earned if the options were granted by a company incorporated abroad, as local laws and regulations were silent about the exercise of stock options in Latvia.
Of course, stock options were granted anyway, but as part of a private-law process and on the basis of a mutual agreement. This procedure meant that the mechanism could only be implemented in a company with a small number of shareholders, all of whom, as a rule, needed to consent to avoid any difficulties related to the increase of the share capital that would result from an option exercise. Due to the absence of applicable regulations and uncertainty demonstrated by the tax administration, acquisition of shares at a price below their nominal value (or free) could trigger a tax risk.
This uncertainty was eliminated when the Commercial Law (the “Law”) was amended this summer and a new mechanism was introduced; namely, the granting of stock options to employees and management (defined in the Law as “employee stock options”).
With the new legal provisions in place, the burdensome nature of the process has been eliminated. The procedure for granting stock options can be implemented relatively easily with a single decision by the shareholders recorded in the Commercial Register as an increase of the share capital subject to condition. For the sake of accounting of employee stock options and their holders, the management board maintains an employee stock option register.
When the conditions specified in the terms for an increase of the share capital have been met, the option holders file an application with the company and pay up the shares, and the management board of the company issues the necessary number of shares. The supervisory board specifies the amount of the share capital and the increase of the share capital is registered with the Commercial Register Office.
“Dilution” – the possible weakening of existing shareholder influence – is considered one of the risks of the mechanism. The legislator has established certain limits, however, and the sum total of nominal values of shares to be obtained as a result of the exercise of employee stock options may not exceed 10% of the paid-up share capital of the company. It should be noted that business operators may, at their discretion, establish the stock purchase price or grant shares free of charge. In addition, shares may be granted with or without voting rights, and the shares granted may be limited to a certain class (namely, the owners of the company may retain their exclusive right to make decisions regarding a certain range of issues).
The current Law also stipulates that if shares are granted to employees at a value that is below their nominal value or free of charge, the increase of the share capital is paid up from retained earnings or reserves formed for such purpose. If the stock option scheme is correctly structured and the option granting and holding period is no less than 36 months, no payroll tax is applicable to granting of shares or their options. In such case, the company is obligated to provide statutory information to the State Revenue Service, including provision of information on criteria applicable to employees to become eligible for employee stock options and conditions to be met to exercise the employee stock option.
To date, according to the Law, only joint stock companies enjoy the right to grant employee stock options, so we cannot say that the new legal provisions of the Law have reached the entire target audience that could benefit most from the pattern (for instance, start-ups – which are usually limited liability companies – are left out). Still, there is hope that all companies could benefit from this mechanism, as working groups formed by SMEs in diverse economic sectors have become proactive, discussing and making proposals to the legislator aimed at improving the laws and regulations so that the advantages offered by the mechanism can reach the maximum scope of stakeholders.
By Zane Eglite-Fogele, Partner, Primus Attorneys at Law
This Article was originally published in Issue 4.12 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.