Employee Stock Option Plans ("ESOPs") have become a significant tool for startups and companies aiming to attract and retain talent. ESOPs allow employees to become shareholders or benefit from the financial rights associated with company shares. This alignment of employee and shareholder interests contributes to the company's overall success and long-term sustainability.
On August 2, 2024 'wage exemption in benefits provided to service personnel through the issuance of share certificates,' was added to the Income Tax Law No. 193 (“ITL”) ("Amendment"). This Amendment introduced an exemption from income tax liability for the shares acquired by employees under ESOPs.
In this article, we will (i) briefly explain the concept of ESOPs and examine the key aspects to consider under Turkish Law. (ii) Then, we will explain the significance of the exemption introduced under the ITL.
What is an ESOP?
An ESOP enables employees to participate in the company's success without making a financial contribution. It can take several forms under Turkish law:
Direct Share Transfer
In this structure, shares are transferred to employees free of charge, often based on a vesting schedule tied to time, performance, or both. Upon meeting the vesting conditions, employees receive ownership of the shares. The value of the shares transferred to the employee constitutes the employee's income.
Stock Options
Employees are granted the option to purchase shares at a future date at a predetermined price. This right is often contingent upon meeting specific vesting criteria. Once these criteria are met, employees can acquire shares by exercising their options. The difference between the amount paid by the employee for the shares and the value of the shares at the time of transfer constitutes the employee's income.
Phantom Shares
Also known as "shadow shares," these do not provide actual share ownership. With this program, which has the nature of providing bonuses to employees, the employee benefits from cash payments derived from shares without becoming a shareholder in the company. Due to their nature, phantom stocks offer employees’ rights related to shares, rather than a physical acquisition of shares as seen in other ESOP programs. They provide a financial benefit in addition to salary payments.[1]
ESOPs Under Turkish Law
While ESOPs were not explicitly regulated in Turkish law before the tax exemption introduced by the Amendment, they can be implemented under the principles of contractual freedom and general legal provisions. Therefore, ESOPs should be structured and implemented in accordance with general legislation.
Despite the lack of a comprehensive legal framework, ESOPs are effectively used in the startup ecosystem to motivate employees and support the long-term success of companies.
1. ESOPs Under Turkish Company Law
Ownership Limit: According to Article 379 of the Turkish Commercial Code No. 6102 (“TCC”), companies are restricted from acquiring their own shares beyond 10% of their capital. This restriction also applies to shares intended for distribution through ESOPs. If the shares to be distributed exceed this limit, they must be held by the founders or issued through a conditional capital increase.
Operational Cost: According to TCC, companies not registered in the registered capital system must hold a general assembly with the participation of a ministry representative to increase their capital.[2] The advantage of startups over larger corporate structures is their ability to move and make decisions quickly. However, startups may have complex ownership structures. The disadvantage of implementing ESOPs through conditional capital increases is the potential for notary and registration costs, operational burden and time consumption.
Imposition on Share Transfers: Additionally, TCC Article 493 regulates the applicable transfer restrictions on shares distributed under an ESOP, which can be critical in retaining key employees and maintaining the stability of the company's ownership structure. Defining the legal methods for providing employee share options within the shareholders agreement and articles of incorporation will help prevent future disputes among shareholders and employees.
2. ESOPs Under Turkish Employment Law
Under Article 32 of the Turkish Labor Law, wages must be paid in cash. Therefore, ESOPs cannot constitute an employee's basic wage but can be provided as an additional benefit. Such benefits could include bonuses or other incentives that are not tied to the employee's base salary but are instead linked to the company’s performance or other criteria.
The right to acquire shares granted to employees may reflect the characteristics of a bonus or incentive, depending on the situation. If the company promises to provide shares to the employee free of charge or at a discount upon meeting certain success criteria, the share acquisition right can be considered a bonus. Conversely, if the right to acquire shares is provided free of charge or at a discount without any performance condition to show appreciation or strengthen employee loyalty, it can be considered an incentive. It may be more appropriate to regard the right to acquire shares at their real value as a different fringe benefit rather than a bonus or incentive. Fringe benefits are generally considered additional payments or advantages that increase the employee's total income and improve working conditions.
3. ESOPs Under Turkish Tax Law and the New Tax Exemption
a. The Tax Aspects of ESOPs
The nature of the disbursement is defined as 'wages' under Article 61 of the ITC. Wages are the monetary and non-monetary benefits provided to employees in return for their services, which are associated with a specific workplace under the authority of the employer and can be represented in monetary terms. In this context, shares provided to employees free of charge or at a discount are also considered wages, and such disbursements are included in the payroll and taxed through withholding. The taxation of these economic benefits occurs when the shares are legally or economically transferred to the employees. In other words, the share options granted to employees are taxed not at the time the option is granted but when the shares are actually transferred to the employee.[3]
b. Taxation of Real Share Transfers and the New Tax Exemption
Shares provided to employees are considered a form of wage paid for their labor and were previously taxed under Article 61 of the ITC. However, the Amendment stipulates that shares granted under an ESOP will be exempt from income tax. To qualify for this exemption, the following conditions must be met:
- The company must be classified as a technology venture according to the criteria set by the Ministry of Industry and Technology.
- The actual value of the shares at the time of transfer to the employee must not exceed the employee’s gross wage for that year.[4]
If these conditions are met, the employee will be subject to the following taxation on the shares from the date of acquisition:
- 100% of the exempted tax for shares disposed of within 3 years.
- 75% of the exempted tax for shares disposed of between 4 and 6 years.
- 25% of the exempted tax for shares disposed of between 7 and 12 years.
The tax, along with delay interest but without a tax loss penalty, shall be paid by the company.
If employees hold the shares for more than two years and then sell them, no capital gains tax will be applied according to Recurrent Article 80/1(1) of the ITC. Therefore, it is crucial to issue the share certificates as soon as possible for employees to benefit from this exemption. However, this exemption is only valid for shares of fully taxable companies. Shares of foreign companies that are not fully taxable cannot benefit from this exemption, even if held for two years, and will be subject to capital gains tax.[5]
Taxation of Phantom Stocks
In this case, the economic benefit obtained by the employee must be taxed according to the principles related to employee wages and included in the payroll.[6]
The Current Landscape and Future Trends of ESOPs in Türkiye
Globally, the adoption of ESOPs is on the rise, with significant growth observed in technology hubs like Silicon Valley. In Turkey, while ESOP implementation is still in its early stages, the trend is gaining momentum, particularly among startups striving to attract and retain top talent. With the ongoing development of legal frameworks and tax incentives, ESOPs are expected to become a more widespread and integral part of the Turkish corporate landscape.
Looking ahead, the evolution of ESOPs could be influenced by technological advancements, such as blockchain, which promises to enhance the transparency and security of ESOP transactions. As the Turkish startup ecosystem continues to grow, so too will the use of ESOPs, offering mutual benefits to both employees and companies in the pursuit of sustainable success.
[1] Aydın, S. (2022, April 13). Startup Hukuku - Çalışanlara Gölge Pay Opsiyonu Sağlanması – Phantom Stock. Startup Hukuku. https://startuphukuku.com/calisanlara-golge-pay-opsiyonu-saglanmasi_sh_/.
[2] In accordance with Article 32/2 of the Regulation on the Procedures and Principles of General Assembly Meetings of Joint Stock Companies and the Presence of Ministry Representatives at These Meetings, the participation of a ministry representative is not mandatory in the general assembly of single-shareholder companies.
[3] Dr. Öğr. Üyesi Kadir Baş, Çalışanların Pay Sahipliği Yoluyla Anonim Şirketlere Katılımı, pg. 376
[4] The excess amount will be subject to income tax.
[5] Dr. Öğr. Üyesi Kadir Baş, Çalışanların Pay Sahipliği Yoluyla Anonim Şirketlere Katılımı, pg. 377
[6] Dr. Öğr. Üyesi Kadir Baş, Çalışanların Pay Sahipliği Yoluyla Anonim Şirketlere Katılımı, pg. 378