Regulatory obstacles #5: Warrants – paperwork overload and taxation
ESOPs are an important part of a startup’s journey, important in funding rounds and not least important for the warrant holders. In Denmark, many companies consider the required paperwork to be overwhelming, and the taxation is, at best, complicated. Therefore, we need a more attractive tax scheme for Danish warrant holders (both in Danish and foreign companies) and less time-consuming paperwork for Danish companies.
In this article, I’ll share my insights and highlight some of the regulatory obstacles that employees and fund managers meet when setting up warrant programs.
Paperwork overload
The implementation process for warrant programs requires the following:
- EGM with adoption of an authorization to the board of directors (which is the common and what I will be focusing on here) or a direct allocation, both to be adopted in the articles of associations and registered with the Danish Business Authority.
- A warrant program containing the terms of the warrants (e.g. vesting, leaver terms, exercise period and exit scenarios).
- A warrant agreement with the employee.
- An employer statement being an addendum to the employment contract.
- Minutes of a board meeting adopting the issuance of warrants to be adopted in the articles of associations and registered with the Danish Business Authority.
- Minutes of a board meeting adopting any exercise of warrants to be adopted in the articles of associations and registered with the Danish Business Authority.
- A warrant register.
The overload of paperwork has several consequences. The warrant allocation processes become more complicated, for warrant holders it becomes less transparent, we often see misalignment between the cap table and the different documents, and it makes warrant processes more expensive.
Hence, there is a great need to make the warrant processes easier to administer for companies which, in my view, would be in everyone’s interest. The following should suffice to protect all interests:
- Authorization to the board of directors in the articles of association
- Warrant agreement with the employee containing the terms
- Warrant register
- Board meeting with allocations (which would not go into the articles of associations)
Taxation
As for taxation, there are currently two possible tax regimes for employees: Section 28 of the Danish Tax Assessment Act, and Section 7P of the Danish Tax Assessment Act.
- Section 28 of the Danish Tax Assessment Act:
The starting point for employees is section 28 of the Danish Tax Assessment Act, according to which the difference between the exercise price and the market value of the shares at the time of exercise is taxable as personal income of the participant, including labour market contribution, at exercise of the warrants (up to approximately 56 percent). In addition, any gains on the shares compared to the market value of the shares at the time of exercise of the warrants will be taxed when the shares are sold, and then as share income at a rate of up to 42 percent.
- Section 7P of the Danish Tax Assessment Act:
As an exception to the above, section 7P of the Danish Tax Assessment Act provides for a more beneficial taxation of the participants according to which the participants will not be taxed at the time when warrants are exercised. Instead, any gains on the shares compared to the exercise price paid for the shares will be taxed when the shares are sold as share income at a rate of up to 42 percent. Under section 7P of the Danish Tax Assessment Act each participant may receive warrants with a value at the time of grant of up to 10 percent of his or her annual salary or up to 20 percent if the company offers warrants on the same terms to at least 80 percent of its employees. An option to increase the cap to 50 percent might also be available in case certain extra requirements are met. If it is decided to issue warrants under section 7P of the Danish Tax Assessment Act a valuation of the Company and the warrants must be obtained prior to the grant of warrants with the purpose of establishing the number of warrants that each participant may receive under the scheme. In this context the exercise price will substantially impact the value of the warrants and hence the number of warrants that may be issued under section 7P of the Danish Tax Assessment Act. Whether section 7P of the Danish Tax Assessment Act can be applied must be assessed upon consultation with a tax advisor. Please note that section 7P cannot be applied with respect to issue of warrants to board members, who will instead be subject to taxation under section 28 of the Danish Tax Assessment Act.
As for the taxation of warrants issued to others, e.g. investors, section 16 of the Danish Tax Assessment Act will apply, according to which taxation will take place upon obtaining right to the warrant.
The overarching problem with taxation of warrants in Denmark relate to the fact that employees risk being taxed of unrealized value (and value they may never receive). There are multiple scenarios where this situation is likely to occur, e.g. if time of exercise and time of sale are not identical in a section 28 scheme, if the warrant program is changed, if the company makes an IPO and the shares issued upon exercise of warrants are subject to lock-up or in foreign warrants schemes (e.g. US RSU or stock options programs).
Good news: There is currently a lot of focus on changing these rules to make them more transparent (and incentivizing for employees, which – after all – is the main purpose) and this is something that will be reviewed in the autumn of 2025.
More good news: We already have the solution in 7P we just need to get the restrictions and constraints out of 7P so it applies automatically to all employees issued to employees.
