Controversy about the tax treatment of stock option plans in Brazil
In the last few decades, stock option plans have consolidated in the US and Europe as a relevant instrument of long-term incentive for executive and employees.
Although the Brazilian corporate law that deals with this instrument dates back to 1976, stock options in the Brazilian business environment have only be seen in recent years. The tax law did not follow the stock options issue, so it lacks clear rules regarding the taxes levied on income related to it.
In this context, tax disputes involving stock options have arisen in recent years.
Remuneration arising from work or gains arising from a commercial contract
In general, disputes regarding stock options involve discussion on whether gains obtained by employees or managers are remuneration arising from work, or from a mere commercial agreement.
The reason for this lack of definition is simple: in the tax law, there is no express legal provision particularly related to stock option. Therefore, it is necessary to analyse the enforcement of generic rules to a specific case.
The Brazilian Federal Revenue Service understands that gains arising from stock options are an instrument to pay the participant for the work performed in favour of the company. From this view, the profit earned would be legally regarded as remuneration for the work.
From this premise, the tax authority argues that stock option taxation should occur in two different moments.
The first moment is upon the strike of the option by the employee. Income taxation, in the view of tax authorities, would be the potential difference between the strike price and the market value of the shares at the time of strike. The positive amount resulting would be taxed as remuneration due to work, subject to tax bracket between 7.5% and 27.5%.
Also, according to the Brazilian Federal Revenue Service, when the employee-participant sells the shares to a third party and there is a capital gain, this gain would be taxed again ranging between 15% and 22.5%.
In addition to the consequences related to the participant, tax authorities believe there are also tax burdens for the company. Considering that the income would be a sort of remuneration arising from the work at the strike (acquisition), the company should collect social security contributions (at a rate between 20% and 29%) and withhold income tax owed by the participant.
But from the taxpayers’ perspective, stock option gains should be taxed as they arise from commercial agreements. From this view, the gains arising from the difference between the strike price and the sale value of the shares to third parties (sale value) should be subject to income taxation.
In economic terms, the difference is extremely relevant. If the taxpayers' interpretation is accepted, stock options would be taxed, probably at 15% of the gains obtained in the transaction, which is much lower than the taxation levied if the gain is classified as remuneration form work, which would most probably will reach 27.5%. Also, if the gains are considered remuneration, the tax burden should comprise the aforementioned social security contributions.
Faced with the uncertain legislative scenario, discussions on the legal nature of stock options have intensified. In this sense, the Brazilian Federal Revenue Service used to focus only on assessing stock option plans with respect to companies, but it has recently also required income tax directly from the employee-participants.
Discussion of stock options in administrative and court proceedings
The Administrative Council of Tax Appeals (CARF) has settled its jurisprudence by declaring that the stock option plan, in theory, has a commercial nature. However, as a rule it has maintained the taxation on gains from stock option plans as if they were wages when analysing specific cases, considering particular conditions that would de-characterise stock option as a commercial contract.
With the consolidation of this understanding, the discussion began to be forwarded to the Judicial Courts, especially in the last months. The result has been mostly favourable to taxpayers, both in relation to social security contributions due by the company, and in relation to the income tax due by the participants.
This viewpoint concurs with the jurisprudence established by the Superior Labor Court (TST), which is the court responsible for standardising the interpretation of labour law. The TST understands that the stock option plan has the legal nature of a commercial agreement and, therefore, any gains arisen by employees in this context are not remuneration.
The controversy between the understanding of administrative tribunals and the judicial courts suggests that the issue should be taken directly to the judicial courts before initiating eventual administrative procedure for the tax collection by the tax authority.
When taxpayers file a lawsuits and obtain favourable decisions before any collection procedure, or when the judicial deposit of the disputed amount is made, their tax exposure can be drastically reduced as the Federal Revenue Service may not impose the severe penalties that would be applied in the case of tax inspection and assessment.
As a result, such initiatives may eliminate or mitigate unwanted risks for the registration of assets of participants and the employer, fiscal representation of the executives for criminal purposes and tax assessment, events that would be inconvenient for those in charge of running the company.
In contrast, in the most serious scenario in which the company and participant are assessed, the amounts that would be required by the Federal Revenue Service could easily exceed the 100% of the gains obtained with the stock option. This would certainly make this type of incentive instrument unfeasible.
This is because tax authority levies three different tax notices (social security contribution and penalty for absence of withholding income tax against the company, and tax on remuneration against the participant of the plan), which unduly camouflages the huge repercussion of the tax requirement. By charging three tax notices, the fiscal authorities impose three different penalties at a high rate, a procedure that raises relevantly the debt.
By obtaining a favourable judicial decision before fiscal inspection, company and participant can avoid these three different and relevant penalties. Also, going spontaneously into court might block the fiscal authorities’ initiative of diffuse tax collection, condensing the controversy in just one litigation procedure. Therefore, uniform decisions are ensured, preventing different outcomes to company and participants.
Stock options represent an important incentive for employees, especially when its institution is accompanied by judicial preventive measures, seeking to protect the company and participants from the high tax collection appetite of tax authorities.
On the other hand, the institution of stock options without a favourable court decision before possible fiscal inspection and tax assessment may represent high fiscal exposure for those involved, mainly due to three different penalties imposed by tax authorities.
In this regard, court decisions on the subject have been mostly favourable to taxpayers. Notwithstanding this initial positive signaling, the outcome of the discussion is still uncertain, considering that it is a controversy recently brought to judicial courts and not yet analysed by the higher courts in Brazil.
This article was prepared by Paulo Camargo Tedesco, partner at Mattos Filho, Veiga Filho, Marrey Jr e Quiroga Advogados.