Private equity funds and strategic industrial acquirers often implement incentive schemes for key personnel. This article written by Hans Kristian Nygaard discusses the use of synthetic shares in such employee incentive programs.

Private equity funds and strategic industrial buyers planning to establish share-based incentive schemes for key employees should consider utilizing synthetic shares instead.

Upon acquiring a Norwegian company, it is common to establish a share-based incentive scheme for key employees. The advantage of share-based incentive schemes lies in their triggering lower tax implications compared to derivative-based incentive schemes such as options, subscription rights, warrants, etc. However, the advantage of derivative-based incentive schemes is their simplicity in establishment, as there is no need to issue actual shares. As an alternative to shares and derivatives, applying synthetic shares in the incentive scheme provides both tax efficiency and avoids the issuance of actual shares. Such an incentive scheme would thus also be beneficial for companies where the owners wish to avoid dilution of ownership or an increased number of shareholders.

The Norwegian Directorate of Taxes recently released a statement that confirms beneficial tax treatment at the use of synthetic shares in incentive schemes. The statement clarified three Norwegian tax issues:

• Profit from the sale of synthetic shares held by an employee's private holding company is tax-exempt, as synthetic shares are classified as a financial instrument under the Norwegian participation exemption rule.
• Profit from the sale of synthetic shares owned directly by the key employee is taxed as capital income at 22%, without a gross-up by a factor of 1.72, as is the case with other share income (2023 and 2024). However, there is no shielding deduction (Nw.: Skjermingsfradrag) for gains on synthetic shares.
• Loans from the employer to partially finance the acquisition of synthetic shares do not incur income tax or employer's contribution if the loans interest rate corresponds to the official interest rate for tax purposes (Nw.: Normrenten) set by the Norwegian Directorate of Taxes.

An incentive scheme is established by having the key employee or his or her holding company to purchase synthetic shares without the transfer of physically issued shares. The synthetic shares must be purchased at market value, taking into account vesting, lock-up, etc. Financing of the purchase is facilitated by the employer providing a loan covering a material part of the purchase price, with the agreed interest rate matching the official interest rate for tax purposes set by the Norwegian Directorate of Taxes.

A dividend distribution to ordinary shares is replicated towards the owner of the synthetic shares by accumulating an equal value-add payable at redemption of the synthetic shares, or by a gain on a sale of a relative part of the synthetic shares.

The incentive scheme is wound up by the employer redeeming or buying the synthetic shares and the key employee or his / her holding company repaying the loan.

If the synthetic shares are owned by a holding company, the gain will be tax-free under the participation exemption method. However, when the employee receives the profit at a subsequent distribution from the holding company, the dividend is taxable at a rate of 37.86% on the hands of the employee. If the synthetic shares are owned directly by the employee, the gain is finally taxed as capital income at 22%, without a gross-up and a shielding deduction. A direct holding by the employee will thus be tax beneficial when synthetic shares yield profits.

It is important to note that if there is a loss on the synthetic shares, an employee's holding company will not be able to claim a deduction due to the participation exemption method. Loss on synthetic shares held directly by the employee is deductible for tax purposes. The employer would not be able to deduct the payment on the redemption of the synthetic shares due to the participation exemption. On the other hand, there will be no payroll taxes or holiday payment cost related to such payment.

Further, note that if the employer forgives part of the loan in a loss situation for the employee, the employee will be subject to salary income tax on such benefit, even if the loan is granted to the holding company, and the waiver will also trigger payroll taxes for the employer.

For those considering establishing an incentive scheme with synthetic shares, Aabø-Evensen can provide legal and tax assistance in this regard.

Link to the statement in Norwegian: https://www.skatteetaten.no/rettskilder/type/uttalelser/bfu/syntetiske-aksjer--fritaksmetoden-og-aksjonarmodellen/