David Miranda, partner at Osborne Clarke, is a corporate lawyer campaigning for change to the country’s stock option system. But he isn’t optimistic.

What is the problem?

The main problem is the way stock options are taxed. It is really awful in Spain. Any remuneration from stock options is considered as ordinary income rather than capital income. In Spain that can mean tax at 48%.

“Stock options are taxes as ordinary income. And you get taxed twice.”

And you get taxed twice, when you exercise the option and when you later sell the shares. Tax is triggered when the options are exercised. The difference between the fair value of the stock and the strike price is considered ordinary income, but at this point you have only received shares with no market to sell them, so you are in a dry income situation, where you are required to pay taxes but you have no cash to pay them. Then you get taxed again on any gains you make when you sell the shares.

In the US, in contrast, employees may benefit from so-called incentive stock options where, subject to certain requirements, you are taxed only once, when you sell the shares, and the income qualifies as long term capital gains. Implementing something similar to ISOs or UK’s Enterprise Management Incentives would be a good start if we want to have more employee friendly stock option tax framework.

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But, further to the tax issue, there is also a problem with corporate law, which is usually overlooked. In Spain you have two types of companies, SAs and SLs. SAs are like public limited companies and typically bigger. Some 95% of companies created in Spain are SLs, however, which are like private limited companies.

Issuing stock options for SLs is complicated. When SLs were created in 1956 stock options were almost unheard of so corporate laws were not written to enable them to do this. All the references in Spanish law to shares are for SAs. In fact, SLs do not have authorised capital that can be allocated by the board of directors, for example, so every time they want to issue shares they need to get approval from the general shareholders meeting.

Besides, SLs, unlike SAs, are generally prevented from holing portfolio shares, which makes it almost impossible for an SL to have a pool of shares to be delivered to employees upon exercise of their options. As a result, a stock option plan would require a SL to hold periodical shareholders meetings to approve the corresponding share capital increases each time stock options are exercised, which is completely inefficient from a legal cost perspective. And the last thing a startup needs is to increase their legal costs because of an inefficient regulation.

 

Read more about the Europe’s stock option problem: 

 

In Spain, companies are using “phantom stock” to get around this because with these, the payment is triggered when the stock is sold and so then the employees have the money to pay the taxes. But phantom stock options means employees never really become shareholders and, for instance, in case of an IPO, the employee will lose the potential upside of remaining as a shareholder.

 

Is there a reason the stock option system is designed this way?

The existing framework is the result of a legal reform approved in 1999, following a controversy with stock options awarded to managers of certain formerly public companies that had been recently privatised. After that, stock options regulations were tightened and they became very unpopular.

(There is a good summary here

“It goes back to a stock option scandal with Telefonica in 1999…since then stock options have been unpopular.”

They started to become popular again in the last 10 years as startups started to become trendy. Before that, no one really knew what a startup was. Now there is more of an understanding that startups create jobs and boost the economy and that stock options are key to attract talented people, when you cannot pay market salaries.

 

Do we really need change?

There are some benefits to issuing phantom shares. Companies keep their cap table very manageable because people given phantom shares never become shareholders. But on the other hand, employees never become shareholders in the company and, therefore, they have no political rights and cannot benefit from shareholders distributions (such as dividends), which may also impact their economic rights.

Because phantom shares are so usual in Spain most of the people simply accept that this is how it is. But if they are hiring people from other countries this can be a problem because of tax inefficiencies.

“When Spanish companies start to expand they establish a holding company in London or in Delaware.”

You can see that some Spanish companies that start to expand overseas establish a holding company in Delaware or other jurisdictions (like the UK), where you have much more favourable stock option regimes.

I want to make clear that those jurisdictions are not tax shelters and that having a holding in Delaware or elsewhere does not mean that these companies do not pay taxes in Spain, which they all do as any other company operating in Spain. The basic reason for setting up a company in Delaware (or any other jurisdiction) is the investors’ willingness to be bound by a law they are familiar with.

However, creating these holding companies can involve extra cost for the companies and, from the perspective of the Spanish employees, it does not really solve the problem, since they will be taxed as Spanish residents and the mere exercise of their stock options will trigger the tax payment as ordinary income. Besides, holding shares in a non-Spanish company is subject to certain annual reporting requirements, which, if accidentally forgotten, can result in an unreasonable fines.

 

How likely is it that we will see reform?

The current socialist government started an internal consultation on creating a new startup law, but we don’t know what that will involve and whether there is any interest in addressing the stock option issue.

Now we are in the middle of an election and the initiative has been frozen. In relation to the reduction of the tax burden, which is the object of most of the criticism, I am pretty sceptical about the willingness of any of the political contenders to change the status quo. There may be tax cuts, depending on who wins, but no one seems to be willing to change the way stock options are taxed, from ordinary income to something more employee friendly.

The main problem with stock options is tax and the government has not been keen on reducing the tax bill. With the coming elections, no one really dares to tackle the problem.

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