Switzerland Update: Employee Participation Plan (Part 1)

Are the incentives set correctly? Employee Ownership Choice Is Critical to Your Company’s Success – Part 1

The following two-part article is intended to provide an overview of the most important forms of employee participation programs that can be considered for Swiss growth companies. Primarily tax law and social security law aspects are examined. This two-part article is designed to help you choose the alternative that best suits the needs of your company, employees, and other stakeholders.

While the first part deals with the motives for employee participation schemes, the types of employee participation schemes commonly used in Switzerland and their Swiss tax consequences, in the second part we will discuss the treatment of employee participation schemes in Swiss social insurance schemes and give tips on how to design employee participation schemes.

Why employee shareholdings?

Young, fast-growing companies (growth companies) and start-ups are in competition with established large companies. Due to their lower financial resources, it is often not possible for these companies to pay their employees the same high wages as their powerful competitors. However, growth companies usually offer employees a great deal of room for manoeuvre and often have great potential – but they also play poker very highly. In many cases, the goal of growth companies is a so-called exit, i.e. a sale or IPO of the company. Therefore, if a growth company becomes successful, the shareholders realize a significant increase in the value of their shares.

Successful growth companies therefore need outstanding and motivated employees who are willing to share the corporate risk to a certain extent and to work for the company’s success not only as employees, but also as entrepreneurs. Employee participation helps to find such employees and supports the motivation to achieve a defined, long-term goal together.

There is no such thing as the ideal employee participation

Compensation models are dominated by four key parameters:(1)

• fixed vs. variable;
• short-term vs. long-term;
• cash vs. participation (direct or indirect);
• individual vs. company-wide target achievement.

The choice of the form and design of employee participation along these parameters depends on the company, its owners, the employees and the goals that are to be achieved with the employee participation schemes.

Typically, the following questions need to be considered:

Company: Is the company a startup with a clear exit strategy, a successful private company with a growth strategy, or a listed company that wants to use employee ownership to retain employees?

Owners: Genuine employee shareholdings, such as shares, lead to the shares of the previous shareholders being diluted. So your share in the company is decreasing. The participation of employees in the company by means of share securities such as shares also means that the previous shareholders can no longer make decisions on their own, but that the employees also have a certain say. Are the owners willing to share capital and influence with their employees?

Employees: Are the company’s employees rather young and willing to take risks, or are they not in the economic or personal position to take risks? What do employees mean by fair remuneration?

Other stakeholders: How is the employee participation program perceived externally, for example by (future) investors? Do investors accept that employees are involved in the company as small shareholders or that if the company is sold due to the employee shareholdings, there may be an outflow of money to the employees (cash out)?

What types of employee participation schemes are common in Switzerland?

In our practice, we see in particular the following forms of employee shareholdings, whereby the acquisition of these employee shareholdings is usually made dependent on conditions, e.g. minimum duration of employment:

Employee options: An employee option is the right, usually granted to an employee on preferential terms, to acquire an employer’s equity securities (shares, participation certificates, ordinary shares) within a defined period of time (exercise period) at a certain price (exercise price) in order to participate in the company and its success.

Free genuine employee shareholdings: Free genuine employee shareholdings are shares, ordinary shares, participation certificates of the employer or related parties that are transferred to employees by the employer on the basis of an employment relationship, usually on preferential terms. While shares and ordinary shares give the holder a say in corporate decisions, as well as allowing them to participate in the share capital and profits, participation certificates only grant a participation in the share capital – and profit without a say. After receiving the employee share, the employee can freely dispose of it, i.e. sell it or give it away.

Blocked genuine employee shareholdings: In contrast to free employee shareholdings, the employee can only freely dispose of the shares, ordinary shares or participation certificates after a predefined lock-up period has expired. If the employee leaves the company before the expiry of the blocking period, the company usually has the right to buy back the employee shareholdings at market value or a lower value, e.g.dem the original purchase price. Blocked employee shareholdings therefore show a lower value (discount) compared to freely tradable employee shareholdings.

Restricted Stock Units: Entitlements to employee shares offer employees the prospect of being able to acquire or receive a certain number of genuine employee shareholdings at a later date, either free of charge or on preferential terms. Like employee options, entitlements represent compensation for future benefits.

Fake employee shares: In the case of fake employee shares, employees never receive real equity securities, but only cash payments. Fake employee shareholdings are, for example, virtual shares (phantom stocks) or stock appreciation rights (SAR). Phantom stocks are fictitious equity securities that reflect the value of a particular share and put their holders on an equal footing with shareholders in terms of ownership rights, but not in terms of co-determination. Accordingly, the holders usually receive payments that correspond in amount to the dividend distributions or the capital gain from the sale of the shares. Stock appreciation rights entitle employees to receive the increase in value of a certain underlying security, often shares, in cash from the employer at a future date. In contrast to phantom stocks, there are no payments that correspond to the respective dividends in terms of amount – the payments are limited to the increase in value of the underlying security.

Cash bonus: Cash bonuses, colloquially known simply as bonuses, are cash payments to employees for achieving agreed individual or company-wide goals. These goals are usually defined annually with the employee as part of the appraisal interview. Bonus payments are to be distinguished from gratuities. While in the case of bonus payments, employees are entitled to payment of the bonus when the agreed goals are achieved, bonuses are voluntary special payments made by the company to employees. Bonuses are often paid out on special occasions, e.g. company anniversary or exceptionally good financial year, etc. However, the decision on the payment of a bonus is at the discretion of the company.

Important terms related to employee ownership

Employee participation schemes originally come from the Anglo-American region. Therefore, the English names are often used instead of the German ones. The most important terms are the following:

Grant Date and Vesting Period: The time at which employee participation is granted is the grant date. At this point, however, the company often only gives employees a written promise (grant notice) that the employee will receive employee participation over a certain period of time (vesting period), e.g. 4 years, if certain conditions (vesting conditions), e.g. unterminated employment with the company, are met during this time. If this condition occurs, the employees receive a fundamentally irrevocable right to the promised number of employee shareholdings at this time (vesting date). Often, the employee shareholdings “vest” quarterly over the entire vesting period, e.g. in the case of 4 years over 16 quarters.

Exercise Price: If options are issued as employee shareholdings and these options have vested, the employee can decide for himself or herself whether and when (exercise date) the option should be exercised and thus the employee shareholding, e.g. a share, should be acquired. The price to be paid for the purchase of the employee participation is called the exercise price. Usually, the exercise price is below the market value – often at the nominal value of the shares – of the employee participation in order to compensate employees for past work performance. The company is free to set the exercise price.

Blocking Period: Period of time during which the employee participation cannot be freely disposed of or the company has the right to buy back the employee participation at a predefined price.

Market value or formula value: If an employee share, e.g. share, is traded on a stock exchange or if a significant share of shares in the company has recently been sold between independent third parties, an objective market value of the employee participation is available. However, startups often lack such market value. In this case, it is necessary to determine the value of employee participation using a formula. The value determined in this way is then called the formula value. In principle, the employer, i.e. the company, is free to decide which formula should be used to evaluate employee participation. However, it must be a method that is suitable for the employer and a generally accepted method. In practice, we often see that companies use the asset tax value of employee ownership as a formula value, since this value is accepted by the tax authorities and calculated annually by them. However, the use of the tax value is sometimes not optimal in terms of the tax consequences for employees – we will discuss this in the second part of our article.

What are the tax consequences of employee shareholdings?

The profit that accrues to employees from the receipt of employee participation generally represents wages, i.e. income from employment. If the employee is resident in Switzerland, this income is taxable in Switzerland and is subject to Swiss social insurance.

When this income or non-cash benefit accrues to the employee and is thus taxed depends on the type of employee participation (see table). However, if, for example, employees receive shares in a start-up that is not yet listed on a stock exchange, they may even have to pay taxes on the value of these shares, even though they cannot sell these shares at all (so-called “dry income”).

Nevertheless, it may make sense to exercise options early and pay taxes on the value of the shares received (in the case of options: minus the strike price). Since Switzerland does not tax private capital gains, this gives you the opportunity to make a tax-free capital gain in the event of a later sale – but of course it can also lead to a non-tax-deductible capital loss. However, this only applies if, at the time of receipt of the shares, the market value of these shares was known and thus the market value of the shares was used to determine taxable income.

In the case of companies that are not listed on a stock exchange, there is often no market value. The value of the shares must then be determined by the company itself, whereby the company is basically free to choose this formula value, as mentioned. However, the cantonal tax administrations do not accept valuation methods with a future hypothesis, such as discounted cash flow valuations and similar methods. It is required that the chosen method has a capitalized earnings component. The net asset value of the company forms the lower valuation limit.

If there is no market value and the shares have been valued at a formula value at the time of allocation, the shares must be held for at least five years before the sale so that the capital gain on sale is fully tax-free. In addition, there must have been no change from the formula value valuation to the market value valuation during these five years, i.e. the company must not have gone public during these five years, for example (depending on cantonal practice). If the shares are sold within five years, the formula value is determined at the time of sale. Only the increase in the value of the formula value is tax-free. The excess profit, i.e. the difference between the selling price and the formula value at the time of sale, is taxed.

We recommend obtaining a ruling from the competent cantonal tax administration to confirm the applicable formula value and the expected tax consequences. In certain cantons, a market value can also be confirmed for companies that are not listed on the stock exchange if a valuation recognised by the tax administration is available from an experienced valuation company. It should be noted that in order to confirm the tax consequences for profit taxes, the ruling must always be obtained from the cantonal tax administration of the canton in which the company is domiciled, while for the purposes of income taxes of employees, a ruling must be obtained from the respective tax administration of the canton of residence. If an employee is resident in a canton other than the canton in which the company is based, two tax rulings must be obtained. The reason for this is that the tax administrations of the cantons are not bound by a tax ruling of the tax administration of another canton.

The treatment for wealth tax differs depending on the type of employee participation. For example, options have no wealth tax value – unless they are tradable on the stock exchange.

In order for the tax administration to be able to verify the correct tax treatment of employee shareholdings by the company, the company must document the information required for taxation on the employee’s salary statement or on an additional sheet thereto.

Employee participation is therefore a salary component. Usually, employees therefore hold the employee shareholdings they receive as private assets.

Recommendation

There is no such thing as “the” best way to involve employees in the success of the company. It is important that the type of employee participation is in line with the corporate culture and attracts the employees that the company needs for its further development. The four parameters for remuneration models must be taken into account.

It makes sense to take your time with the preparation of the employee participation plan. In Switzerland, many types of employee participation schemes are possible. An off-the-shelf employee stock ownership program is typically the wrong choice. The employee participation program, plan and form of employee participation must be adapted to the company’s strategy and objectives, taking into account the specific tax and social security circumstances of the company and its employees. If employees receive shares in the company, it is also worthwhile to draw up a shareholders’ agreement tailored to the employee participation program.

As soon as the value of the shares, ordinary shares or participation certificates sold to employees cannot be based on a stock exchange price and the formula value is not to be determined on the basis of the tax value, it is worthwhile to obtain a tax ruling to confirm the formula value or a market value of these employee shareholdings.

(1) Cf. Matthias Staehelin, Driving Performance: Incentive Structures from an Entrepreneurial and Legal Perspective, in: A wonderful world: New Opportunities, New Law, New Challenges by Dieter Gericke, Conference Proceedings 2022 of the 8th Conference on Private Equity, p. 82 f.

By Vischer, Switzerland, a Transatlantic Law International Affiliated Firm.

For further information or for any assistance please contact switzerland@transatlanticlaw.com

Disclaimer: Transatlantic Law International Limited is a UK registered limited liability company providing international business and legal solutions through its own resources and the expertise of over 105 affiliated independent law firms in over 95 countries worldwide. This article is for background information only and provided in the context of the applicable law when published and does not constitute legal advice and cannot be relied on as such for any matter. Legal advice may be provided subject to the retention of Transatlantic Law International Limited’s services and its governing terms and conditions of service. Transatlantic Law International Limited, based at 42 Brook Street, London W1K 5DB, United Kingdom, is registered with Companies House, Reg Nr. 361484, with its registered address at 83 Cambridge Street, London SW1V 4PS, United Kingdom.