Taxation of share options

A Client came in front of me when I was employed by a bank. This Client is an internationally known and respected Professor of Medicine.

A Client came in front of me when I was employed by a bank. This Client is an internationally known and respected Professor of Medicine. He and numerous university students and researchers as well as research groups had analysed and done research work on a certain factor causing cancer. The Professor presented to a lawyer of the Helsinki University the idea of assumed solution how to hinder cancer and the patent application was submitted by the university lawyer.  All of a sudden, the application process was dropped out by the university. The Professor bought the pendent patent to himself with 1 euro. After a while, B Corp. became interested in the idea and making this idea as a product. The Professor gave the right to possess the idea to B Corp. but the company did not want to pay any money – it was agreed that the Professor gets royalties from the sales of the product-to-be-created.

B Corp. acquired several patents eg. in Europe, Japan, USA, Mexico. At the same time researchers of the company continued to research and develop the idea. The business activities required a lot of funds and B Corp. could not pay any royalties for over 10 years. The idea had been published in an international Conference and research work related to the invented idea was done in several universities around the world.   

When B Corp. offered an option-plan to its employees, the Professor wanted to be paid. It was agreed that the company gives the Professor an individual option plan and the royalty agreement was wiped-off. Couple of years later the Professor subscribed shares and paid the subscription price. The company received about 1 million euro from subscriptions. When the Professor sold some shares of the company, he got profits and made some losses. The tax office regarded the profits to be taxable earned income to the Professor.  

The Income Tax Act (66 § 3 subsec.) governs the taxation of share option received on account of employment. The employment-based-share-options are given to employees to motivate and to reward them for their good work. The options give the employees the right to subscribe or to buy the shares of the company in the future for the value lower than the market value. The employees benefit from the increase in value of the company. This is the reason why the benefit received from options is taxed as earned income. This is a common tax praxis in various countries, also in the US. 

In Finland, the Supreme Administrative Court has given a judgement KHO 20.5.1997 T. 1221 according to which the Income Tax Act 66 § 3 subsec. is applied also to the option benefits received by the CEO and the Board Members of the company – even though their work is not based on employment contract.  

If the benefit has not been received because of an employment contract, it is not question of a employment-based-share-option according to the guideline given by the Tax Administration (20.9.2014 Dn:o A113/200/2013). The US Inland Revenue instructs that the issue must be rendered according to its actual character and intention which corresponds to the tax avoidance paragraph in the Finnish tax process law ex analog.

It is common opinion in Finland that the tax avoidance paragraph can be applied only in favour of the tax authorities.  If some circumstances or an action has been given such a legal as if the correct form had been used (tax avoidance paragraph). Nothing prohibits to apply this paragraph of the tax law in favour of the taxpayer. 

The benefit from option rights and share options can be based on something else than work done, and, in such a case, the employment-based-share-option-rule does not apply. The interpretation must be based on other legislative rules. The basis of a share option agreement could be an investment taking a financial risk in the company. The freedom of contract accepts various kind of agreements – whether they are good or bad.  

It the share option plan is based on a patented invention, the taxation of the person given up the patent is done according to the Income Tax Act 52 §: The compensation received on account of a patent is regarded taxable capital gains if the right to the patent has been acquired by succession, testament or by sales agreement; otherwise it is earned income. 

The guidelines of the tax authorities (taxation of inventors, 27.1.2009 D:ro 5/345/2009) include a statement: The inventors receive compensations for the immaterial rights created by them. The nature of these compensations may be various. According to the Income Tax Act 52§, the received income is always regarded to be earned income because the compensation is based on the work done and actions performed by the inventor himself.  

The legislation is old, and the legislator has not taken in account the altered society and its diversity. The roots of the Patent Law are in the time when the patents were products of engineering skills, different kinds of machinery, equipment and their parts. Nowadays the patented invention may be a solution in the field of medicine and a result of collaboration.

The income from capital is taxable as capital gains (Income Tax Act 32 §). In classical economics, the capital may be immaterial, intangible assets, intellectual capital.  Is the income from intellectual capital comparable with earned income based on work done if the income is not based on the work done by the person himself? 

The Income Tax Act 52 § makes no difference to the fact that the patent is often valueless idea and the monetary value (with regard to incomes) is obtained as a result after a long development work and marketing.  The financial investment required to make the patent valuable is often done by someone else than the inventor. In the Professor’s option case, the financial investment was made by B Corp – a company that bought the pendent patent and invested millions. 

In the civil law, the value of the object is determined by the value when the bargain was made. No one was willing to pay a monetary purchase price for a pendent patent application uncertain to be accepted. If the buyer company had went bankruptcy the Professor had lost it all. The Professor had taken a financial risk – does this point have any meaning in evaluating the case? 

The Administrative Court of Helsinki (21.3.2018) regarded that the tax praxis was established and clear (which it was not because the first option benefit was taxed as earned income and capital gains – double taxation). The Income Tax Act 52 § (work done by the taxpayer) and the Tax Procedure Act 26 § (decision in favour of the taxpayer in ambiguous cases) were applied by the Administrative Court. The decision was done by votes 2-1. The dissenting opinion was given by Judge Mika Hämäläinen. Judge Tero Särkikangas and referendary Elina Fasoúlas dismissed the Professor’s appeal.  

The Supreme Administrative Court (18.3.2019) did not grant a leave to appeal without any reasons. Judges Ranta-Lassila, Leena Äärilä and Vesa-Pekka Nuotio, referendary Katja Syväkangas adapted a paragraph of law that did not exist on the date when the application and appeal were submitted nor on the date when the decision was made (Act on Assessment Procedure 70 § 2 subsec.). The court was informed about this fact. 

A typing mistake or a mistake concerning the substance can be rectified ex officio if the decision is based on clearly false or defective evidence, obviously wrong interpretation of the law, or a procedural mistake has occurred whilst making the decision. If such an error has happened, it is a ground for demolition of the decision. When the highest administrative court realizes that an error has been made, the court ex officio should take the case into reconsideration.  It feels odd if it were true that the highest instance does not dare or want to deal cases that are significant societally or financially. Let it be clear that the matter cannot be so.  

The Professor did not want to submit any application to demolish the decision – he did not trust the court to make any other kind of decision than what had been made. It is common that no one wants to admit making a mistake, his point of view is understandable.

This article is based on a text written by Anne Nikula and published by on 7 January 2016, and the judgment given by the Supreme Administrative Court in 2019. 

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