Framework Legislation for Stock Option Plans
There are various reasons why companies increasingly use mechanisms to engage and retain employees that are tied to the company's growth in value in the medium and long term: fluctuations in the economic scenario and the need to control cashflow, increased competition, with fewer physical barriers to hiring post-pandemic, and the need to engage newer generations by sharing profit and inspiring a sense of ownership.
The fact is that the use of long-term incentives programs based on companies' growth and market appreciation is becoming common, and companies that don't offer such a long-term incentive program run the risk of becoming less attractive and less able to retain talent. The law and the courts in Brazil, however, have not kept pace with this evolution in corporate relations.
The legal nature of one of the most well-known long-term incentives programs, stock option plans (SOPs), has long been a matter of debate. Where taxation is concerned, decisions by the administrative authorities are plentiful, and unfavorable to taxpayers.[1] In the courts, however, the decisions are mostly favorable[2] in finding that at least some SOPs are mercantile in nature, although the courts have not yet reached a well-settled position on the tax aspects of SOPs.
The courts tend to find that SOPs are mercantile in nature when the plans are voluntary, participants are required to pay for the options, and the element of risk is involved, since in such cases it can be argued that the legal relationship established by the plan is dissociated from an employment relationship, in which any payments or advantages made by employer in favor of employees are remuneration for services.
Bill PL 146/2019, better known as the Startups Framework Law, put regulation of SOPs, and especially their tax treatment, into the spotlight. As drafted, the Bill treated as remuneration from employment only the fair market value of the options granted under article 168§3 of the Brazilian Corporations Law, drawing on accounting rules and the single legal provision found in Law 12.973/2014. To a certain extent, the Bill attempted to balance the tax effects for the party granting the options (deductibility and payment of social security contributions) and the party receiving the option (payment of personal income tax). When the Bill became law, however, the provisions on SOPs were excluded, on the grounds that the subject required broader regulations which were "not restricted to startups". The promise of broader regulation for SOPs was kept with Bill PL 2724/2022 (the "SOP Framework Law"): it is much wider in scope and unlike the earlier bill, which treated the fair value of options as remuneration from employment, the new Bill establishes the characteristics that SOPs must have in order to be considered "mercantile" in nature.
According to the SOP Framework Law, the essential elements of a SOP are: a grant of options, a vesting period of at least 12 months, and payment of an exercise price. The Bill also highlights some features that can be added to SOPs without affecting their mercantile character, such as a minimum period of service with the company, the inclusion of targets, and restrictions on transferring options. In addition, the draft legislation allows SOPs to provide for valuing options, updating values, forms of payment of the exercise price, and repurchase of shares by the company.
In practice, the points dealt with in the draft SOP Framework Law constitute the pillars of stock option plans. To address specific situations driven by their particularities and different economic realities, however, companies need flexibility to establish SOPs.
In general, we see minimum waiting periods before beneficiaries can exercise their options (e.g. four years with partial vesting each year), which may or may not provide for cliff and lock-up periods for shares acquired with the options as well. Still, some plans do not have cliff, and vesting and lock-up periods are less than a year, if the plan is designed for a certain purpose, such as contracting a C-suite executive by offering incentives and short-term liquidity to make the company's proposal more attractive. Is it reasonable to say that such a SOP ceases to be "mercantile" because it provides for vesting in less than 12 months?
On the other hand, the draft SOP Framework Law does allow plans to grant options carrying an exercise price lower than market value, which is a point that gives rise to a lot of disputes in the tax precedents, and which is certainly essential to making SOPs an effective instrument for attracting and retaining talent.
Given the importance of SOPs, Brazil needs legislation that not only provides tax certainty, but also reflects the country's economic realities.
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[1] 58% of the decisions by the Administrative Tax Appeals Council (CARF) were unfavorable to the taxpayer, and of the favorable decisions, 30% were based on the nullity of the plan.
[2] 73% of the court decisions were favorable to the taxpayer in finding that the SOP was mercentile in nature.
