The Norwegian Directorate of Taxes (No. “Skattedirektoratet”) recently published an advance tax ruling clarifying a number of questions regarding the tax treatment of synthetic shares issued to employees. Following the clarifications, synthetic shares emerge as an interesting instrument when structuring management incentive schemes.
Synthetic instruments are financial instruments that are engineered to simulate other financial instruments, but with deviations. Synthetic shares often provide the holder a right to sell the instrument at a pre-determined future date against a purchase price equal to the fair market value of an underlying share, without actually owning the underlying share. The synthetic shares thus derive its economic effects from the underlying shares, but without giving the holder any other rights as a shareholder. The Norwegian tax treatment of synthetic shares acquired by employees have been somewhat uncertain, and the advance tax ruling provides clarity on several questions.
In the case considered by the Directorate, the synthetic shares would be offered to employees at fair market value of the underlying shares, adjusted for the value reduction due to the agreed vesting schedule. The employees would pay 50% of the fair value of the synthetic shares in cash, while the remaining 50% would be financed through an interest-bearing seller's credit from the parent company.
The Directorate was requested to consider three questions regarding the tax treatment of synthetic shares:
Firstly, the taxpayer wanted clarification on whether the synthetic shares, if acquired by a holding company owned by the employee, would qualify for participation exemption. The Directorate concluded positively. The decisive factor for the outcome was whether the synthetic shares are independent objects to be taxed separately from the underlying instruments – which was the case in this matter as the synthetic shares would be synthetic without granting the holder a right to receive the underlying shares. As a result, capital gains on the synthetic shares will be fully exempt from taxation for the employees' holding companies when selling the synthetic shares.
In the extension of the first question, the Directorate considered whether the value adjustments due to dividend distributions from the subsidiaries could lead to taxation, as participation exemption on derivatives is limited to capital gains/losses. The Directorate concluded that the value addition due to dividend distributions was to be regarded as an increase of the output value used in the gain/loss calculation when the synthetic shares are to be realised. Hence, the value adjustments due to dividend distributions on the underlying shares would not result in taxation.
Secondly, the taxpayer sought clarification as to whether personally owned synthetic shares would be covered by Section 10-31 of the Norwegian Tax Act, which specifies the deductible risk-free return (No. “skjermingsfradrag”) and gross up of gains/losses on shares. The gross-up would result in an increase of the effective taxation (disregarding deductible risk-free return) on the synthetic shares held personally, from 22% to 37.84%.
The Directorate concluded that it must have been a deliberate choice by the legislature that financial instruments are not explicitly mentioned in Section 10-31. Therefore, there is no basis for deductible risk-free return or gross up of gains/losses on the synthetic shares. The result was thus that any gains or losses on synthetic shares held personally by the employees will be subject to a flat tax rate of 22%.
Finally, the taxpayer wanted clarification as to whether the debt financing, being a seller`s credit from the parent company of up to 50% of the investment amount with an interest rate equal to the normal interest rate for the taxation of low-cost loans from an employer (No. “normrente for beskatning av rimelige lån hos arbeidsgiver”, would trigger employers´ national insurance contributions for the subsidiaries.
As a main principle, benefits earned from a low-interest loan granted under an employment relationship is taxable as employment income. However, there is a statutory exemption stating that benefits from a loan granted under an employment relationship is taxable only for the difference between the applied interest rate and the normal interest rate. The Directorate concluded that the normal interest rate also applies in situations where the ultimate parent company grants a loan to the holding company of an employee. It was then irrelevant whether the interest rate was below the market interest rate, as long as the interest rate was not below the normal interest rate.
It should be noted that the advance tax ruling relates to a specific fact pattern presented to the Directorate. Issuance and sale of synthetic shares that deviate from the fact presented to the Directorate can potentially be treated differently for tax purposes and should be considered by a tax practitioner.