You can eat cash, but not share options

The extent of share ownership in the Republic increased dramatically with the Eircom privatisation last year. It is said that an "equity culture" is taking hold. While it is true that more people than ever hold shares, the cutting edge of the equity culture and of an enterprise economy is those who take equity risks instead of stable and high cash salaries.

Last week, the Minister for Finance introduced an amendment to the Finance Bill to change the taxation of share options. Currently, share options are taxed as income when they are exercised. For many, though not all, option holders, this means tax at the highest personal income tax rate, rather than the capital gains rate of 20 per cent. At present, because they are taxed when exercised, the person holding them faces a substantial tax bill even if he or she holds on to the shares in the company. The amendment would tax them as income when the shares are sold. The Irish Software Association (ISA) has lobbied for a change, to make share options taxable as capital gains. In the run-up to the Budget the now well-known Tax Strategy Group considered an official paper analysing the proposal from the ISA.

The tax analyst easily picked holes in the ISA's proposal. It should never have asked for the change in tax to be confined to the software sector, as the analyst reports. However, a fundamental omission the Tax Strategy Group analyst made was not to comment on the claim by the Software Association that the "income" arising through the exercise of share options is a capital gain rather than income as such. This wasn't even addressed, let alone accepted.

The analysis, therefore couldn't have been complete and was, understandably in the circumstances, confined to questioning how exactly the tax change sought would address the Irish skills shortages.

The fundamental point about how to tax equity rewards must be addressed. Share options are not income. They are contingent rewards on the basis of the value created in the company. Cash is risk-free. Not to be deprecating you can eat cash, but not options.

The gains arising from share options are based on a market's perception of value in a company. This is also very different from profits. AIB's #761 million profits reported last year did nothing much for AIB's share price. For any employees at AIB rewarded on profit-sharing, it was a great event. For those rewarded by shares or share options, it was a terrible pity the market did not value earnings.

Equity is one step further, in terms of risk, from profit sharing.

The taxation of share options as they should be, as capital gains, is now held up by considerations of wider issues of taxation of profit sharing, gain sharing and employee save-as-you-earn schemes by a committee under the partnership arrangement. Social partnership was meant to help, not to delay progress.

The grounds for introducing the correct taxation of equity rewards as capital gains are not that it would deal with a skills shortage in the Irish software industry. It is a matter of principle, and not just for that industry. Besides, the skills shortage in software, advanced technology and investment management is worldwide, as these are globally integrated industries. The Republic will have to compete for the limited skills that are available globally, and quickly, if we want high value creation to take place in our economy.

Sure, we can wring our hands about distributional balances and we can tie up the issue in unrelated, albeit meritorious, arrangements like gain-sharing. But while we do so, value-creation and risk-taking will not wait for the Republic. It will simply happen elsewhere and we will have missed an opportunity to embed higher value-adding activities in the Republic. We cannot have high value-adding companies and industries without accepting two things: first, that the global capital market will make the valuations and, second, that some people living among us will own the value added, that is, get rich. The Government or the State does not reward risk-takers and entrepreneurs, as the argument goes. They reward themselves. The Government only takes away a certain amount of that reward. They create value, not the Government. Properly used, share options are a vehicle for that value creation.

Of course, there are issues relating to accounting for stock options as a cost to investors, and not rewarding general market gains, rather than company-specific value creation. All these can be dealt with; they are actually investors' concerns, rather than the State's. For its part, a state that wants high value industries to embed themselves here should tax risky equity rewards as capital gains rather than risk-free income, and soon.

Oliver O'Connor is editor of the monthly publication, Finance. E-mail: ooconnor@indigo.ie