Synthetic options – an advance tax ruling from the Norwegian directorate of taxes

Incentive schemes are an important tool for several employers. Synthetic shares and options provide employers greater flexibility compared to the subscription or acquisition of ordinary shares with associated organisational rights.

In cases where an employer wishes to offer employees the opportunity to co-invest in the company in the form of synthetic shares or options, the question arises as to whether the income should be classified as either employment income or capital income. The classification is significant as employment income is taxed at a marginal rate of 47.4%, and employer`s national insurance contributions must be reported and paid by the employer, which means that the maximum effective tax rate can be 55.8%. On the other hand, capital income is taxed at 22%, income on shares are for private persons taxable with 37.84%, and for employees with holding companies, taxation of certain incomes may also be covered by the Norwegian exemption method (Nw. fritaksmetoden) and thus be postponed until distribution from the holding company.

There is no definition of synthetic shares or synthetic options, but the financial instruments can be characterised as follows:

• A synthetic share derive its economic effects from an actual share in a company as an underlying object but does not give the holder any rights as a shareholder such as voting rights at the general meeting.
   
• A synthetic option can be characterised as a financial instrument giving the holder the right to a cash payment equivalent to any increase in the value of an underlying share from the time the option is subscribed until it is exercised. Synthetic options, unlike regular share options, do not give the right to actually acquire shares as prescribed by the rule on employment income in Section 5-14 of the Norwegian Tax Act.

In the binding advance ruling, a company wanted to launch an incentive scheme where employees were offered to subscribe synthetic options which upon redemption or sale gave the employee the right to a cash payment based on the market development of the shares in the employment company. The employees were to pay a market-based consideration for each instrument subscribed, valued by a third party based on the Black & Scholes model. The instrument would give the employee the right, at a future date, to receive the cash payment corresponding to the market value of the shares at the date of realization, less 140% of the market value of the shares at the subscription date. The employees could only achieve a maximum of 385% of the market value calculated from the subscription date. The employees would essentially risk losing the entire consideration for the option if the market value of the company's shares at redemption or sale was lower than 140% of the value at the subscription date.

If the employment relationship were to be terminated before the date of realization, the company would have the right to purchase the employees' financial instruments at a market-based consideration. The employees would be allowed to sell the instruments to external third parties, but in such cases, the company would have a pre-emptive right.

The Directorate states that financial instruments, such as synthetic options, fall outside the scope of Section 5-14 of the Tax Act regarding taxation of options in employment relationships as employment income. This is because Section 5-14 only regulates cases where the holder of the option also becomes entitled to the share itself. The Directorate nonetheless believed it was not decisive that Section 5-14 did not apply, as the general rule in Section 5-1 of the Tax Act could result in gains from synthetic options being classified as employment income. The crucial factor would be whether the employment relationship had caused the benefit and whether there was such a close connection between the gain and the employment relationship.

The Directorate addresses whether the subscription of synthetic options will involve an economic risk for the employees. The Directorate states that these synthetic options will have the same effect as ordinary share options and assumes that the instruments will have the same risk of loss. On this basis, the Directorate considers how the Norwegian legislature has justified Section 5-14 of the Tax Act regarding ordinary share options. When designing Section 5-14, one of the reasons for classifying options as employment income was that the holder of an option position, unlike a shareholder position, generally has not invested that much capital and has almost only the prospect of gain, without significant risk of loss.

Although the employees were to pay market value for the synthetic options upon subscription, this was not given significant weight. The Directorate was of the opinion that the consideration of equal treatment indicated that the legislature's assessment and emphasis on economic risk related to options in employment relationships under Section 5-14 also should apply to instruments with the same or nearly the same risk of loss.

After assessing and weighing the economic risk of the incentive scheme, the Directorate evaluated the terms of the option agreement with the employees. The question was whether the agreement was made on market terms. The Directorate points out that the incentive scheme was only offered to selected employees in the group and that the company could purchase the instrument at market value if the employment relationship ended. With regards to options traded on the ordinary market, it is not usual for the issuer of the option to have the right to have a pre-emptive right to purchase the option back before the date of realization. These conditions represented, in the Directorate's opinion, deviations from market terms for options and similar benefits. Overall, the Directorate considered that there was such a close connection between any gain and the employment relationship that these synthetic options had to be classified as employment income pursuant to Section 5-1 of the Tax Act.

Furthermore, the company then would be obliged to pay employer`s national insurance contributions on the taxable benefit the employees receive upon realization of the synthetic options. 

The Directorate's statement shows that the tax classification of incentive schemes is subject to a specific assessment where several factors must be considered and weighed. The choice of incentive scheme can have different tax implications and should be evaluated from a cost and risk perspective. It is therefore necessary to make thorough assessments when implementing such incentive programs, and it is recommendable to discuss with a legal advisor which incentive scheme is appropriate for your company.