Acquisition of Shares in Finnish Startups
Tax issues for founders and investors
Startup enterprises, often originally established in a simple form, regularly need to adapt their shareholder structure: Persons that can contribute important know-how acquire shares as well as investors of venture capital.
In Finland, startups are usually incorporated as private limited companies (Oy). New partners are brought in by way of transfer from the founding shareholders, or by the company issuing new shares.
Persons that are of key importance for the emerging enterprise are usually awarded shares in the start-up company without any significant capital contribution or purchase price. When entering into such arrangements, it is good to take the tax effects into account.
Acquisition of shares as a taxable “gift”
If a key person of the enterprise acquires shares without consideration or against a merely nominal purchase price or capital contribution, then the transaction may become subject to gift taxes to be paid by the acquirer.
In Finland, gift tax is applicable not only in the case of gifts in the legal-technical meaning of the term but more generally in the case of any forms of property transfer for which the transferee does not pay a market price – at least if the price is below 75% of the market value.
Therefore, gift tax can be incurred in the sale of shares as well as when subscribing newly issued shares. The tax allowances for gifts in Finland are next to non-existing. Only gifts with a value of less than 5,000.00 Euros are free of taxes.
Transfers of shares to important cooperation partners in start-up companies can remain below the allowance in the early days of the startup in which the company does not yet have any equity capital to speak of. However, the market value of the company and its shares increases as soon as the start-up activities create value and profit expectations for the enterprise.
Third-party investment as value indicator
This increase in value becomes apparent at the latest when the company succeeds in attracting investors of venture capital.
Example: The start-up enterprise Start Oy has found an investor who is willing to invest a sum of 500,000 Euros into the company in return for 10% of the shares in the company. At the same time, a consultant has established valuable business contacts for the enterprise; in order to tie the consultant to the company also for the future, she shall receive a share of 10% in the company as well. For these shares, the consultant shall pay only the nominal value of 250 Euros.
If the two transactions described in the example are executed at about the same time, then the acquisition of the consultant will lead to her obligation to pay gift tax. It will not be possible to convince the tax authorities that the same shares for which the investor is ready to pay a substantial price are of any less value in relation to the consultant. The difference between the market value (as represented by the price paid by the investor) and the nominal price paid by the consultant will be regarded as a gift. The gift tax in this case would amount to 146,357 Euros.
In the case of a foreign transferee, it will depend on the tax laws of his or her home country and on possible tax treaties with that country whether or not there will be additional tax liabilities in the home country.
Fees and bonuses as alternative solution?
Gift taxation as such is certainly avoided is the transferee of shares pays the full market price for the acquisition. It is generally possible for the company to pay to this person an agreed sum of money as a fee for his or her services for the company. Such payment can be made at the same time with the purchase of the shares and can be used for paying the purchase price. In order for such arrangement to be accepted by the tax authorities, the payment must be economically reasonable.
In any case, the payment of such fee to the new shareholder is income for the latter and is subject to income taxation. If the recipient of the fee is not a resident of Finland and has performed the respective services outside of Finland, then income taxation is generally governed by the tax laws in the shareholder’s home country. Depending on the circumstances, such arrangement may or may not be preferable as compared to Finnish gift taxation.
Long-term arrangements and options
In order to make it possible for key persons to be bound to the company without the described tax effects, the share transactions must be undertaken as early as possible. The earliest possible and therefore most beneficial point of time for this is the formation of the company. The subscription of shares in the formation process against payment of the nominal share value is not subject to any taxation.
The acquisition of shares can be possible in a tax-neutral way also in the time immediately following establishment before any measurable business value has been created. As time passes, depending on the progress of the startup and the addition of new investors, share transfers for nominal consideration become increasingly difficult to defend against taxation.
If a key person shall be included in the structure of the enterprise without the parties concerned wanting to transfer shares in such early stage, a possible alternative is to grant the respective person an option to acquire shares at a later point of time. When assessing the tax consequences of an acquisition based on an option, the option price is compared with the market value of the shares at the point when the option was granted, not the point of time of its execution.
Often, the shares do not yet have a significant value when the option is granted. In such cases, gift taxes do not have to be paid even if the market value of the shares exceeds the option price considerably at the time when the option is exercised.
Special case: employee options
The option arrangement must, however, be seen in an entirely different light if the holder of the option is (also) an employee of the company. For stock options granted to employees of an enterprise, Finnish tax law provides that the full advantage taken from the option, i.e. the difference between the option price and the market value when the option is exercised, is regarded as taxable work income.
It is not always easy to draw the line between an employee and an entrepreneur in a startup, particularly in hindsight. As usual, timely planning and stringent documentation are of the essence.