Author: Fırat Coskun
A "Stock Option Plan" ("SOP") is an extremely popular method of attracting, motivating and retaining mostly the key employees, particularly when the company is unable to pay high salaries. This method is often used in the United States and European countries. Due to legal restrictions and lack of legislative background regarding SOPs, such option plans have yet to develop in Turkey. Upon the entry into force of the recent Turkish Commercial Code, SOPs did become exercisable in Turkey, however, and frequently preferred in publicly traded companies.
A SOP gives a company the flexibility to award stock options to employees, officers, directors, advisors and consultants, allowing them to buy stock in the company when they exercise the option. Most companies, both at home and abroad, are utilizing this scheme as an essential tool to reward and retain their employees. Currently, this form of restructuring is most prevalent in start-up companies and in IT companies where manpower is the main asset.
SOPs permit employees to share in the company's success without requiring a startup business to spend precious cash. In fact, SOPs can actually contribute capital to a company as employees pay the exercise price for their options. The resulting economic wealth of employees who have held stock options have made SOPs a powerful motivational tool for employees to work for the company's long-term success.
Actually, SOPs have been used as a way for companies to reward top management and "key" employees, and to link their interests with those of the company and other shareholders. More and more companies, however, now consider all of their employees as "key." Since the late 80s, the number of employees who hold stock options has increased about ten-fold. While options are the most prominent form of individual equity compensation, restricted stock, phantom stock, and stock appreciation rights have grown in popularity, and are worth considering, as well.
The dilutive effect of options, even when granted to most employees, is typically very small, and can be offset by their potential productivity and employee retention benefits. Options are not, however, a mechanism for existing owners to sell shares, and are usually inappropriate for companies whose future growth is uncertain. They can also be less appealing in small, closely held companies that do not want to go public or be sold because they may find it difficult to create a market for the shares.
Downsides of SOPs
Although there are dozens of advantages of SOPs, the downsides of SOPs should also be noted. In this context, most often the employees have to pay cash to exercise the SOPs. At the time of exercising SOPs, a tax may be incurred depending on the jurisdiction and type of the SOPs. When you exercise the SOPs, you will receive stock that will not be easily saleable if the company is still privately held or is subject to substantial transfer restrictions.
The value of the stock could go below the exercise price you have paid for the stock, and for this reason, many option holders wait until a liquidity event to exercise options. The main disadvantage of SOPs for a company is the possible dilution of other shareholders' equity when the employees exercise their stock options. From the point of view of the employees, the main disadvantage of SOPs in a private company, compared to bonuses or higher compensation amounts, is the lack of liquidity. Unless the company creates a public market for its stock or is acquired, the SOPs will not be the equivalent of cash benefits. And, if the company does not grow, and its stock does not become more valuable, the options may ultimately prove worthless.
Stages of a Standard SOP
A standard SOP has three stages. The first stage is granting. The date of granting a right to a determined employee group by a company with respect to having the company shares for a strike price, or for free of charge, in the event of fulfillment of the determined terms and conditions.
The second stage is vesting. At this stage, vesting occurs upon the right of a stock option as a result of fulfillment of the terms and conditions determined in the agreement (i.e., continuation of the employment in the company for a determined period of time, fulfillment of the determined performance criteria).
The third stage is exercising. Upon the achievement of the terms and conditions determined in the option plan, acquiring company shares through exercising the rights vested by the employees who are included to the share option plan.
SOPs in Turkey
SOPs are relatively new to the Turkish employment market and are, therefore, uncommon. However, with the increasing level of foreign investments and market entries into Turkey, SOPs are likely to become more common in the near future. Due to the disadvantages explained, above, and other legal restrictions, such options are more likely to be preferred by foreign companies that are conducting their business in Turkey.
As per Art. 15(c) of Decree No. 32 on the Protection of the Value of Turkish Currency ("Currency Law"), a foreign parent company can offer foreign securities and capital market instruments to the employees of a subsidiary in Turkey. This type of share sale is subject to Turkish capital markets legislation, and requires application to the Capital Markets Board of Turkey ("CMB"), unless all of the following apply (Communiqué on Foreign Capital Market Instruments, Depository Receipts and Foreign Investment Funds (VII-128.4)) (Foreign Capital Markets Law):
- The sale does not take place in Turkey;
- No transaction that can be defined as a public offering is conducted;
- The information provided to the employees does not contain any statements that give the impression of a public offering;
In Turkey, there are no specific rules or regulations with respect to SOPs. However, there are references to share plans in other pieces of Turkish legislation. In addition to the Currency Law and the Foreign Capital Markets Law, the following rules are likely to apply to SOPs in Turkey:
- Pursuant to Art. 403 of the Turkish Code of Obligations, even though not specifically referring to the ownership of shares by employees, this provision states that employees can be granted additional interests and benefits aside from their remuneration.
- Most of the provisions related with SOPs are regulated under Turkish Commercial Code numbered 6102 ("TCC"). According to Art(s). 522 and 523 of the TCC, companies are allowed to establish trusts, co-operatives and charity funds for its employees. Under this structure, trusts founded by employee contributions can become shareholders in the parent company, allowing the employees to indirectly own certain portions of a parent company's shares.
- Moreover, pursuant to Art. 463 of the TCC introduces the possibility of conditional capital increases, and makes direct reference to SOPs that are executed by companies for the benefit of their employees. In this structure, companies can enter into a capital increase on the condition that the newly issued shares will be granted to the employees.
- Furthermore, as per Art. 379 of the TCC, companies are allowed to acquire their own shares (up to 10% of the share capital). Accordingly, companies can subscribe to the shares, pay their value and transfer them to their employees as a bonus or premium.
- Also, as per Art. 380 of the TCC, a company can provide financial assistance to its employees to enable them to acquire its shares.
In Turkey, there are no established share option plans since such plans are relatively new in the market. In parallel with the current legislation, Turkish companies can use one of three general structures to offer shares to their employees:
Capital Increase and Issuing New Shares: Shares are granted to employees following a capital increase. The pre-emptive rights of current shareholders are restricted, and the employees subscribe to the newly issued shares derived from the capital increase;
Share Buyback and Reissuance: The company acquires its own shares, subject to the TCC and related CMB regulations for public companies, and then transfers the shares to its employees under a plan;
Option Agreement: This method is the combination of the above-explained two methods. In this structure, the company and the employee enter into an option agreement. The company grants the employee the right to acquire a certain amount of shares for a fixed range of amounts within a prescribed period. New shares are created through a capital increase, or issued shares are repurchased by the company, and then transferred to the employee under the terms of the option agreement. The financing for the shares is provided by the company or employee.
Other SOPs in Turkey
Other plans apart from SOPs in Turkey that are presented as a part of salary package for local and foreign employees who work in Turkish companies, and who are particularly part of the management staff, as there is a field of application for multinational companies within the scope of global politics are, generally:
- Employee Stock Purchase Plans
- Phantom Shares, Stock Bonuses
- Stock Appreciation Rights
- Restricted Stock Units
Taxation of the SOPs
Taxation is perhaps the most important issue in the exercise of SOPs both for company and employee. In this respect, firstly, it should be determined as to how the taxation rules apply to the granting and sales of the SOPs. Art. 61 of the Income Tax Law describes employment income as benefits paid in cash, in-kind, or through other means, represented by money for services rendered, to persons employed by an employer, and working at a certain workplace. This definition includes all non-cash benefits provided, and payments made (including allowance, compensation, cash indemnity, funds, increase, advance, dues, attendance fee, premium, bonus, and reimbursement or under any other names). Payment as a certain percentage of earnings (provided it is not related to an ownership of a company and related to the employment of the concerned personnel) must also be included under this definition and considered as employment income.
The taxable event for employment income is triggered once the employee legally and economically has the right to dispose of the benefit or to receive payment. Income tax is imposed upon the exercise on any "spread" on the shares, which is the excess of the fair market value of the shares on the exercise date, over the aggregate exercise price paid. According to Art. 94 of the Income Tax Law, the benefit, which is described as the difference between the shares' price at granting, and value at vesting, is subject to withholding taxes, and must be declared by the Turkish resident company in the withholding tax return. The income tax rate is applied at progressive rates ranging between 15% and 35% depending on the total amount of the benefit.
Under the definition in Article 80 of the Income Tax Law, capital gains exemptions apply in the event of (i) gains derived from the disposal of (Turkish-resident legal entities' shares that are held for more than two years and (ii) gains derived from a sale of shares listed on the Istanbul Stock Exchange and retained for more than one year are not subject to withholding tax.
In addition to the above, Art. 80 of the Income Tax Law provides an income tax exemption for up to TRY11.600 (for 2017) of capital gains derived in a calendar year, unless derived from the disposal of marketable securities and other capital market instruments, including listed shares. Since this exemption does not apply to a sale of marketable securities, the whole amount of gains derived from the sale of marketable securities is taxed as capital gains, regardless of whether they belong to a Turkish resident or non-resident entity.
It is also worth mentioning that the CMB Communiqué on Corporate Governance (numbered II-17.1) regulates the principles of corporate governance, which is applicable to publicly held corporations and listed corporations. The employees are among the stakeholders of these corporations. The Communiqué brings high-level principles for all stakeholders, including employees (for example, the rule of equal treatment and prohibition of discrimination among employees). The Communiqué also provides that these corporations can arrange employee stock ownership plans.
Element of Foreignness in Taxation
In the event of providing such interests to a foreign employee by a company that is resident in Turkey, in case there is a Double Taxation Agreement ("DTA") between the resident country of the employee and Turkey, taxation will be subject to the relevant provisions of the DTA. Otherwise, local legislation will apply.
In the event that taxation is subject to the DTA, the approach of the OECD (Organization for Economic Co-operation and Development) becomes highly important. Accordingly, the interest that is granted by the employees by exercising vested rights through acquiring shares of the company shall be taxed as remuneration, and the income arising from the sales of the acquired shares shall be taxed as increment value income.
In brief, there may be three types of income applicable: (i) employment income, (ii) capital gains, (iii) and dividend income if any dividend is obtained by the employee following the delivery of the shares. For the income of non-resident real persons to be subject to Turkish income tax, they must be deemed as "Turkish sourced". For example:
- For non-resident real persons, employment income is deemed to be sourced (taxable) in Turkey if the employment is exercised or benefitted from in Turkey;
- For non-resident real persons, capital gains is deemed to be sourced (taxable) in Turkey if the transaction is exercised or benefitted from in Turkey;
- For dividend income if the capital is invested in Turkey.
The term "benefitted from," in relation to employment income and capital gains, refers to when the activity or transaction generating the income is performed or accounted for in Turkey. "Accounted for" means that a payment is made in Turkey, or if the payment is made abroad, it is recorded in the books in Turkey, or is made from the profits of the payer or the person on whose behalf the payment is made in Turkey.
