Global Tax Alert - Sweden: Incentives in merger and acquisitions
The purpose of this article is to provide a general overview of the principles of taxation of Swedish incentive programmes and to connect these rules to various situations that often occur in M&A transactions.
The objective is to describe how the Swedish tax rules are applied in practice and to provide an insight into the country specific details that determine taxation in each situation.
Finally, we will take a closer look at the qualified employee stock options and describe how different Swedish incentives may be handled in an M&A transaction.
Legal classification of options
For Swedish tax purposes, options can be divided into two categories; securities and non-securities.
The taxable event can occur at three different stages: at grant, at vesting or at exercise.
- Grant is when the employee acquire the options.
- Vesting is when the employee has the first possibility to use the options.
- Exercise is when the employee actually use the options and purchase the shares or transfer the option.
It is the character of the option which determines at what stage taxation will occur.
Swedish law has not defined the term “security” (Sw. värdepapper). However, an option will generally be regarded as a security if:
- the option is freely tradable (an obligation to give the right of first refusal is possible);
- the right to realize the fair market value of the option is not dependent on continuous employment; and
- the option entails a future right to purchase a security.
- For an option, characterised as securities, the employee will be liable to tax at grant. The taxable value corresponds to the difference between the fair market value of the option (being a security) at grant and the purchase price. The benefit is regarded as ordinary salary and is taxed accordingly. The benefit also form basis for payment of social security charges, which currently are 31.42 percent (2022). The fair market value of the premium for the option is usually set by using the Black & Scholes formula.
On disposal of the option, any increase in the value of the option will be considered as a capital gain for which the employee will be taxed under the capital income category with a tax rate of 30 percent. Any decrease in the option value will result in a deductible capital loss.
On disposal of the shares, the employee will be liable to capital income tax, provided that the disposal resulted in a capital gain. The tax rate under income of capital is 30 percent for listed shares and generally 25 percent for unlisted shares. The taxable gain amounts to the sales price less the acquisition cost. The acquisition cost is the aggregate amount of the purchase price of the option at grant, an amount corresponding to the taxable value determined on grant and the purchase price of the shares paid at exercise.
It is possible to have certain bad leaver and good leaver clauses in the option agreement without the option being recharacterized into a non-security.
For options which are characterized as non-securities, Employee stock option (Sw. personaloption), the taxable event occurs on exercise or transfer of the options. The taxable value amounts to the difference between the fair market value of the shares and the exercise price. The benefit is regarded as ordinary salary (income from employment) and is taxed accordingly.
Furthermore, any amount that is deemed to be income from employment also forms the basis for social security charges (31.42 percent for 2022, not capped) payable by the employer.
The main pitfall with regards to the hard line that is drawn between securities and non-securities is the situation where a faulty assumption is made that options issued in an incentive scheme constitute securities and that market price is paid at grant. This will lead both the issuing entity and the employee into the belief that no taxable event will occur. Since non-securities are taxed at exercise1, the Swedish Tax Agency might make a reassessment at exercise with adverse tax implications. If the underlying shares have increased in value substantially since the grant of the options, which is very often the case with smaller businesses, a substantial spread might have occurred between grant and exercise that is fully taxable as salary and subject to social security contributions. If no disclosure of the options have been made in the tax return of the employee a tax surcharge of 40 percent of any unpaid tax can be levied by the Tax Agency. A 20 percent surcharge can be levied on unpaid social security charges for the employer.
Qualified Employee Stock Options
Special exemption provisions have been introduced for so called qualified employee stock options, (Sw. kvalificerade personaloptioner) which means that the benefit of an employee stock option shall not be taxed as salary income subject to certain conditions. The purpose of these tax breaks is to improve the ability of young, small businesses to recruit and retain key people. The rules were extended as of 1 January 2022.
For the favourable tax treatment to apply, the option must be exercised within three to ten years after the date of grant. The conditions relating to the target company group include not having carried on business for more than ten years, the shares not being listed, the company or group having fewer than 150 employees and net sales or assets of no more than SEK 280 million. Some businesses are excluded from the scheme, among them banking and finance management of real estate and consulting. An employee may not hold an option that is valued at more than SEK3 million and the total value of all the issued options shall not exceed SEK75 million. The employee shall on average work 30 hours a week and during a three-year vesting period receive salary and taxable benefits corresponding to 13 income base amounts (SEK920,000 for 2022).
If the conditions for the qualified employee stock options are fulfilled, the employees will not have to pay any tax when they are granted the employee stock options, when the option can be vested or when the option is exercised for shares. The taxation will instead take place when they sell the shares in the future or when they receive dividends on their shares.
Closely Held Company
If the company is a closely held company (Sw. fåmansföretag) special taxation rules on dividends and capital gains deriving from the company apply. A closely held company is a Swedish limited liability company where four or fewer individuals, directly or indirectly, holds at least 50 percent of the voting rights of the company. If the shares (or option) in the closely held company are deemed to be qualified (Sw. kvalificerad andel) the dividends and capital gains are taxed partly as employment income (with progressive tax rates up to a rate of approximately 58 percent depending on in which municipality the individual resides) and partly as capital income (at a flat tax rate of partly 20 percent and partly 30 percent).
The closely held company rules may be applicable on options which are regarded as securities from a tax perspective and also shares received from an option or employee stock options (regular employee stock options or qualified employee stock options.
It should be noted that passive owners, non-qualified owners, that hold at least 30 percent of the shares being entitled to dividend distributions may be regarded as an external owner (Sw. utomstående) under the Swedish closely held company tax rules. If so, the special rules do not apply. The external owner must under the main rule hold the shares for five whole calendar years for rendering the special rules inapplicable and subject to ordinary capital gains taxation.
Typical exit transaction with re-invest buy sellers
The picture below illustrates a typical Private Equity buying structure. The Private Equity buyer establish three tiers of buying entities. The Seller may either be a private individual or a legal entity. The Seller sells Target AB to Bid Co and receives a remuneration of cash and a receivable. The receivable can be exchanged into shares in the buying entity. In order for a roll-over tax relief for an individual Seller to apply it is necessary that the individual receive shares in the buying entity. i.e. Bid Co and not directly in Top Co. The following chapter will be written with reference to the picture.
Outstanding incentive programme at an exit
A Buyer of a Swedish target company group is in general not interested to take over an outstanding incentive programme. Therefore, an outstanding incentive programme in the Swedish target company may need to be accelerated into shares upon an exit. The Buyer may want to issue a new management incentive program (MIP) using a local Swedish Special Purpose Vehicle (SPV AB). The SPV AB functions as the Top Co in the illustration above, i.e. the MIP issues in Top Co. By using a debt financing in Top Co the fair market value of these shares may be pushed down and thereby making it easier for participants in the MIP to finance their acquisition of the securities. To avoid a taxable benefit upon grant of a security an employee needs to pay fair market value.
Outstanding incentive programmes with options which are regarded as securities from a tax perspective
A current option incentive programme in Target AB involving options which are treated as securities from a tax perspective may be accelerated into shares upon an exit. The benefit of this is that the applicable capital tax rate may be reduced from 30 percent to 25 percent for an individual holding incentive in Target AB.
Further, it is beneficial that an individual may perform a share-for-share exchange with shares and receive shares in the Buyer without any immediate tax effects. Generally, a share-for-share element of a disposal is treated as a "rollover" (i.e., the gain is "rolled" into the new shares). Key issues include a) that the total consideration shall be at arm's length (which might result in a focus on the market value of consideration other than shares or cash), b) any cash portion will be taxed upon disposal and c) that the acquiring entity shall, at the end of the financial year, hold shares representing more than 50 per cent of the total voting rights. A special calculation shall be made if the shares disposed of are qualified shares in a closely held company. The rollover gain is subject to tax upon the subsequent disposal.
A share-for-share exchange is not possible with an option in itself, i.e., the option first needs to be exercised into a share and thereafter apply the share-for-share exchange in the Buyer.
Employee stock option
If the options granted under a current incentive programme in Target AB are employee stock options and regarded as non-securities for Swedish tax purposes, the cancellation of the options upon an exit will not have any tax effects. The cancellation of the stock option programme will not in itself be regarded as a taxable event.
However, offering the holders of the options a cash amount will have tax consequences. Generally, all consideration, e.g., cash payments and benefits in kind, an individual receives due to his current or former employment is regarded as regular income from employment and is taxed accordingly. If the employee receives shares, the taxable value amounts to the fair market value of the shares less any purchase price.
Furthermore, any amount that is deemed to be income from employment also forms the basis for social security charges payable by the local Swedish employer.
Qualified Employee Stock Options (Sw. kvalificerad personaloption)
Cancellation - A cancellation of a qualified employee stock option due to an exit in Target AB will not have any tax effects. Any cash payment or bonus in equal value of the underlying shares will be regarded as income of employment and taxable with marginal tax rate for the individual. The same taxable value will also form basis for payment of social security charges.
IPO before end of qualification period – The qualified employee stock options are so called contractual options, meaning that the employee only has security based on the previous board or AGM mandate to issue options. Since an issue of actual shares requires a subsequent decision from an AGM, there is no guarantee that a post IPO AGM will allow for such an issue. It is thereby common that the option agreement for qualified employee stock options contains a right for the employee to sell back their options at market value if an IPO is imminent. Such remuneration will be taxable as salary payment and can be compared to a bonus payment. If the qualified employee stock option was subject to a premium payment at grant, the premium paid will reduce the taxable benefit.
Merger or demerger before end of qualification period – The Swedish rules regarding qualified employee stock options contains special rules concerning mergers and demergers. Subject to certain other factors in the legislation a premature exercise of the qualified employee stock options that is caused by an upcoming merger or demerger will not result in taxation for the employee or social security charges for the company.
In summary, different measures are necessary to handle outstanding incentive programmes in Target AB depending on the tax status of the programme. It may be beneficial in many cases to accelerate the outstanding options in Target AB into shares. The shares can thereafter be sold by the Seller tax free for a Seller suing a personal holding company. For an individual Seller the share-for-share exchange can be used and postpone payment of taxation until the shares in the Buyers structure is disposed of.
1 Options that at the sole discretion of the employer can be settled in cash and not in securities, are taxed at vesting.