Professional content

Is an abolishment of obligation taxable event?

6.5.2011 Andri Gunnarsson og Páll Jóhannesson

In judgment no. 626/2010, the Supreme Court addressed the matter whether an employee could be considered to have received taxable benefits from the employer because of a purchase agreement concerning purchase and sale of shares in the company. The Supreme Court rejected the Chief's of Internal Revenues interpretation of the reality principle and ruled that the wording of the contract must be examined in order to see whether it provided the employee taxable occupational benefits

Issues have arisen related to the precedence of Supreme Court judgment of 31 March no. 626/2010, which dealt with taxation of put option of a former bank employee. 

The said judgment dealt with the issue whether the employee could be considered to have received taxable benefits from his employer due to a purchase agreement between the employee and the employer concerning the employees right to purchase and sell shares in the latter. In assessing whether the taxable allowances were in place it is a significant matter whether the employee has enjoyed some kind of qualities that can be evaluated in monetary terms. 

The purchase agreement provided the employee with right to purchase shares in the employer with a loan for the purchase and right to sell (put option) the shares again later to the employer at original purchase price plus interests and levy. Thus, the employee was insured against loss if the shares dropped in price. In return, the employer had the right to buy (call option) the shares from the employee at the time the employee quits his job within a certain period of time. Furthermore, the employee was not permitted to sell the shares at that same time unless authorized by the employer. Thus, there was an obligation on the employee's shareholding beyond ordinary ownership of shares. 

Chief of Internal Revenue wanted to apply the so-called reality principle and look past the direct wording of the purchase agreement or the form of the transaction. He argued that it provided the employee with a call option and that the employee had not acquired the shares until it was clear whether the put option would be exercised. At that point, the employee would have decided whether he wanted to acquire the shares or return them by using his put option. Chief of Internal Revenue had therefore ruled that the difference between the market price and original purchase price at that point would be taxed as wages. The key issue would then be that the employee would be allowed to purchase the shares at a lower price than the market value because he was an employee at the company. 

The Supreme Court rejected this application of the reality principle and argued that it would not be able to ignore the purchase agreement as it was made. The employee had in fact acquired the shares immediately at the purchase and therefore it should be examined whether he had enjoyed any job-related benefits compared to the existing purchase agreement, namely: (i) whether the employee exercised the put option and thus gained profits or; (ii) whether the employee had taxable income from being released under the employers call option, i.e. that the employer could purchase the shares from the employee within a certain time for original purchase price if the employee quit.  

According to the Supreme Court judgment, the employee could not have benefitted in a financial way from the put option right other than not having to incur expenses in order to protect him in a similar way for a possible decrease of the share prices. The Supreme Court did not stipulate in a decisive manner whether the quality, which provided the employee with free derivative put option right that guaranteed against a decreased purchase price of the shares could be regarded as taxable benefits. 

Accordingly, the employee had not gained financial benefits from the put option, which he had undertaken, as he never exercised the right and thus got no value in return. This matter must be reviewed in context with the overall agreement.