Incentives – Using tax insurance to help attract and retain people during, and after, the pandemic
There are many ways to attract and retain people in the times of a pandemic, and one obvious way is to make sure you create the right monetary incentives for management and key employees. This can be done by simply paying a cash bonus, or by setting up a share based incentive program. Paying a bonus is usually not that complicated from a tax perspective, but that is not the case for share based incentive programs. Setting up a share based incentive program often entails navigating a complex set of rules and/or case law in order to achieve the right balance between risk and reward for the participants and the company alike without triggering adverse tax consequences. A way to mitigate the risk is to have it insured in order to focus on creating value for your business.
This bulletin provides a brief overview of the key tax issues related to incentive programs and how tax risk insurance may be a way to mitigate risks associated with such programs.
What are the risks?
There are essentially two tax related risks associated with incentive programs:
1. Income is taxed as salary (high tax rate) instead of capital income (generally lower tax rate) at the level of the individual and such re-characterization may also result in interest/penalties, and
2. Social security contributions or similar payments should likely be made in case of income re-characterization increasing tax costs and may also result in additional interest and/or penalties
The risk highlighted in bullet 1 is often subject to intense review by companies and their advisors. The reason for this risk materializing may differ depending on the jurisdiction and the type of securities offered but it usually relates to a company’s wish to retain individuals by creating lock-up mechanisms, e.g. by having the securities vest during a set period of time assuming continuous employment combined with a transfer restriction and/or an offer for first refusal for the company at a price below fair market value. This in turn creates a risk for re-characterization to salary income since securities and similar instruments generally need to be freely transferable and not linked to the employment.
The risk highlighted in bullet 2 above usually follows the re-characterization of the income and means that the employer providing the incentive will need to make an additional tax payment and may also run the risk of paying interest and/or penalties. Given the large number of variations in the type of securities and ways to structure incentive programs and related issues (e.g. valuation) it is usually very difficult to exclude risks and these consequently need to be dealt with somehow.
Can tax insurance be a solution?
Yes. If the risk is material in terms of amounts at stake and supported by an analysis from a well-reputed advisor, tax insurance may be a viable way forward. There are 10+ insurance companies focusing on tax risks so the capacity and risk appetite is there to ring fence the risk and help you to focus on your people and the business. A tax liability insurance policy will cover not only the additional tax but also interest and penalties (if any). Due to the growing market for tax insurance, the premium rates are now generally between 1.5-7% depending on, inter alia, the size and complexity of the risk.
Whether you are in the process of acquiring a company where a tax risk related to incentives have been identified or you are about to launch an incentive program for existing and/or new employees we are here to help you manage the risk. Our team comprises former tax-, corporate- and M&A lawyers with vast experience of incentive program risks and we are well-positioned to assist you in the tax insurance placement. We are always happy to have a conversation on how we can help you get a tailor-made tax insurance solution in place and if you are interested please contact your dedicated Marsh representative or: