Having heard the word ‘executive’, most people associate the term with managing directors, CEOs and other people involved in the senior management of a company, regardless of the company’s legal form. However, from a labour law perspective these persons shall be only considered as executives if they work within the framework of an employment agreement. In this case the provisions of the Labour Code applies to their legal relationship with certain alterations from the rules applicable to the regular employment relationships.
Another group of employees also form part of the executives, on the basis of the nature of their position and upon the parties’ agreement included in their employment agreement.
As these positions are particularly important from the employer’s point of view, the related rules grant to the contracting parties a greater freedom in defining the terms of their agreement. However, regarding the rules related to remuneration, the two groups mentioned above must be examined differently, as the levels of protection differ from each other.
Apart from the salary prescribed by the labour law, the employer may decide to introduce different types of allowances and compensate the executives’ work, loyalty and motivate their productivity by other means (e.g., bonuses, ensuring the possibility of taking part in employee share schemes). These allowances are usually incorporated in a detailed internal policy, by taking into account the potential ways of amendment and its difficulties, which is the most economic solution to ensure adequate protection of the employer’s interests.
Collective agreements do not apply to the executives.
i Income tax for employees
Personal income tax consequences of executive compensation
The rules applicable to personal income tax are set out in the Act of CXVII of 1995 on Personal Income Tax (Act on PIT). Any consideration received by a private individual in any way or form – in cash or in non-cash assets – can qualify as income for the purposes of the Act on PIT. If the executive’s income becomes taxable in Hungary, the employment income will be subject to 15 per cent personal income tax (PIT) in 2017.
In general, Hungarian tax residents are subject to PIT on their worldwide income, regardless of whether the funds are transferred to Hungary. Non-residents are taxed on income from Hungarian sources only. Therefore, the tax residency of the executive has to be determined in order to ascertain whether and to what extent Hungarian PIT liability arises concerning his income.
Hungarian tax resident status
According to Section 3 of the Act on PIT, the following should be regarded as being resident for PIT purposes in Hungary:
- a Hungarian citizens;
- b EEA nationals who spend at least 183 days per calendar year (including the day of entry and the day of exit) in Hungary; and
- c third-country nationals who have a permanent residence permit or stateless status in Hungary.
Also, individuals qualify as being resident in Hungary for PIT purposes if:
- a their only permanent home is in Hungary;
- b their centre of vital interests is in Hungary if there is no permanent home in Hungary or if Hungary is not the only country where they have a permanent home; or
- c their habitual abode is in the domestic territory if there is no permanent home in Hungary, or if Hungary is not the only country where they have a permanent home and if their centre of vital interests is unknown.
For the purpose of a permanent home, any form of dwelling may be taken into account (e.g., a house or apartment belonging to or rented by the individual, or a rented furnished room). However, the permanence of the home is essential; this means that the individual has arranged to have a dwelling available to him or her at all times continuously, and not occasionally for the purpose of a stay, which is necessarily of a short duration (e.g., business travel, educational travel). To substantiate that the individual has a permanent home in Hungary the requirement is usually to have at least a rented flat for which he or she is paying public utility, telephone and internet bills.
As regards the notion of centre of vital interest, the Hungarian public guideline largely follows the OECD Commentary and claims that the centre of vital interest is the country with which the personal and economic relations of the individual are closer. Thus, his or her family and social relations, occupation, political, cultural and other activities, place of business and the place from which he or she administers his or her properties should be considered. The circumstances must be examined as a whole, but considerations based on the personal circumstances of the individual (e.g., close family relatives living in the same household) must receive special attention.
Avoidance of double taxation
It may occur that an executive not qualifying as a Hungarian tax-resident derives remuneration in respect of an employment exercised in Hungary. If there is a double tax treaty in force between Hungary and the other jurisdiction concerned, the relevant double tax treaty rules will apply to eliminate double taxation.
The double tax conventions (DTC) concluded by Hungary usually follow the OECD Model Convention on the Avoidance of Double Taxation in eliminating the double taxation
of income from employment. Therefore, the remuneration of an executive would be taxable in Hungary unless:
- a he or she stays no more than a total period or periods of 183 days in Hungary in the relevant fiscal year;
- b the remuneration is paid by or paid on behalf of an employer that is not resident in Hungary; and
- c the remuneration is not borne by a permanent establishment located in Hungary.
Under Hungarian law, granting stock option to the employees should not be taxable in itself. Employees will only recognise taxable income upon the exercise of the option in an amount equal to the difference between the fair market value of the shares on the date of exercise and the amount of purchase price, acquisition and transaction costs, if any. The income of a Hungarian resident private individual arising upon exercising the options would be subject to PIT at 15 per cent in Hungary.
The dividend income from the shares of a Hungarian resident private individual is subject to PIT at a rate of 15 per cent. Capital gains realised by a Hungarian resident private individual on the sale of the shares is subject to PIT at a rate of 15 per cent.
The Act on PIT incentivises retirement planning by providing preferential tax treatment for pension insurance contracts and for placing assets in voluntary mutual pension insurance funds and in retirement accounts. Such incentives are not restricted to executives, but they can also apply to other employees.
ii Social taxes for employees
If the executive becomes subject to the Hungarian Social Security, the employment income will be subject to 10 per cent pension contribution, 7 per cent health insurance contribution and 1.5 per cent labour force contribution payable by the employee.
According to the Act of LXXX of 1997 on Social Security (Act on Social Security), the employee can become subject to the Hungarian social security system if his employment relationship is governed by Hungarian law or the employee carries out his activities in Hungary or in another Member State of the European Union to which Regulation (EC) No. 883/2004 of the European Parliament and of the Council of 29 April 2004 on the coordination of social security systems (Social Security Regulation) applies. The Social Security Regulation has precedence over the Act on Social Security when ascertaining whether the executive is subject to the Hungarian Social Security.
The dividend income of a Hungarian-resident private individual is subject to health tax at a rate of 14 per cent capped at 450,000 forints per annum in 2017. Dividend payments distributed by or on behalf of a legal person or other organisation seated in a low tax jurisdiction are subject to health tax at 22 per cent payable by the recipient, in addition to the PIT.
Capital gains realised by a Hungarian-resident private individual will be subject to health tax at a rate of 14 per cent capped at 450,000 forints per annum in 2017. Capital gains arising from the sale of shares in a legal person or other organisation seated in a low tax jurisdiction would be subject to health tax at 22 per cent.
iii Tax deductibility for employers
The executive’s remuneration, the social tax, the training fund contribution and the health tax can be accounted for as employment expenses. These expenses also reduce the corporate income tax base of the employer.
The Act on PIT defines ‘certain specified allowances’ including services in connection with business trips, life, accident or health insurances concluded by the employer to the benefit of its employee. Such allowances and the PIT due on them payable by the employer also qualify as employment expenses, therefore, they reduce the corporate income tax base of the employer.
III Tax planning and other considerations
i Tax planning
If the taxes on the remuneration of the executive payable in the country of residence exceed the amount of taxes that should be paid if the income were taxable in Hungary, the lower Hungarian tax rates and the exemption method under the applicable DTC can result in significant tax savings when posting the executive to Hungary. This posting structure is demonstrated in the following example (note: the tax rate applicable in the foreign jurisdiction of the example is fictional).
Posting an employee to Hungary in order to act as an executive in a Hungarian entity would require that the Hungarian entity and the foreign entity posting the employee conclude a management service agreement under which the foreign entity would provide management services to the Hungarian entity via its employee. Based on the management services agreement, the foreign entity should be compensated on an arm’s-length basis that usually means that such compensation should cover its expenses and some margin.
The annual salary of an employee posted to Hungary payable by the employer, the foreign entity would be €200,000. That would be the amount of salary expenses at the foreign entity.
The amount of the management services fee would be the sum of the above-mentioned salary expenses of €200,000 and of a margin of €5,000, that is €205,000.
In case of a favourable DTC between Hungary and the jurisdiction of the foreign entity, the salary income would be taxable in Hungary. Personal income tax payable in Hungary is €30,000 (€200,000 x 15 per cent). This income should be fully exempted from taxation in the jurisdiction of the foreign entity, that would otherwise be €60,000 by applying the 30 per cent PIT rate. Therefore, the tax savings on the personal income tax would be €30,000 per year.
Based on the above, depending on the corporate income tax positions of the group companies and the social taxes payable in each country, it can be established that due to the difference between the personal income tax burdens in Hungary and the jurisdiction of the foreign entity, significant tax savings can be achieved if the income for the foreign employee is channelled through a Hungarian entity.
ii Other considerations
Certain benefits provided by the employer are exempt from PIT. Among such exemptions, the employer can provide non-repayable housing allowance to the employee up to 30 per cent of the purchase price or the total cost of construction in the maximum amount of €16,400 over a five-year period.
The accommodation allowance provided by the employer to the employee is also exempt from PIT up to a monthly amount of €210 over the first 24 months of the employment relationship.
The reimbursement by the employer of nursery and kindergarten fees or a part thereof to the employee based on an invoice issued to the name of the employer is also exempt from PIT.
IV Employment law
i Special agreement
By underlying the special nature of this type of relationship, the related rules are to be found between the special rules of the Labour Code.
Assuming that the executives’ position does not require the same level of protection, the legislator grants to the parties a greater flexibility and freedom in defining the content of the employment agreement. Accordingly, the executive’s employment agreement can deviate from most of the general rules of the Labour Code.
The possibility of application of these rules (i.e., the conclusion of this type of agreement is limited to certain cases).
Executive means the director of the employer, and any other person under his or her direct supervision and authorised – in part or in whole – to act as the directors deputy. These are typically the managing directors, CEOs and other employees filling such a position, but if the preconditions are met, a procurist may also belong to this group. In these cases it is not a matter of choice that the employee is an executive if he or she performs his or her work within the framework of an employment agreement.
The term of the employment agreement shall be in line with the term of appointment for the position indicated in the company register.
The parties can also agree to invoke the provisions on executives if the employee fills a position considered to be of considerable importance from the point of view of the employer’s operations (e.g., CFO, HR director) or a post of trust (chief accountant, IT manager), provided that his or her salary reaches seven times the mandatory minimum wage, which is approximately €2,900.
iii Rules of termination
In the event that the employment agreement has been concluded for an indefinite term, neither the employee nor the employer has to justify the termination. This solution creates a more favourable situation on the employer’s side; however, the termination cannot violate the prohibition of abuse of rights. The principle of equal treatment shall be also respected. Despite the fact that there is no obligation of justification, the employee has the right to sue the employer; however, it is more difficult for him or her to determine the truth.
In the case of employees participating in the management of the company, and who are typically appointed for a definite term, the lawful termination needs justification from both sides. The fixed-term employment relationship may be terminated only in limited, defined cases, detailed in the Labour Code.
Accordingly, the employer may terminate the employment relationship concluded for a fixed term exclusively during the liquidation or bankruptcy procedure against the employer, for reasons connected to the employee’s abilities, or if maintaining the employment becomes impossible due to unavoidable external reasons.
The employee may terminate the employment relationship only on the basis of such reasons, which would make it impossible for him or her to maintain the employment or which would cause disproportionate harm to him or her considering his or her circumstances.
Breaching these rules may imply an obligation to pay compensation for damages resulting from the breach of the agreement.
iv Allowances due to the employee upon termination
Upon termination the employer and the employee shall account with each other, including the return of equipment provided by the employer having regard to the employment relationship.
Based on the Labour Code – unless otherwise agreed by the parties – the employee may be entitled to the following types of allowances.
If it is the employer who decided to terminate the employment relationship, the employee may be entitled to severance payment. The entitlement depends on the length of service, except if the employee is recognised as a pensioner at the time when the notice of dismissal is delivered or when the employer is terminated without succession, or he is dismissed for reasons in connection with his or her behaviour in relation to the employment relationship or on grounds other than health reasons.
The severance payment equals the sum of absentee pay due for one month in case of an employment relationship for up to three years, which shall be increased gradually up to six months after at least 25 years of service.
Also the employee would be entitled to compensation for unused holidays, regardless of which party terminated the employment. This is the only case when compensation may be paid in lieu of allocation and ordering the use of holiday.
The Labour Code takes into account the employer’s possibly difficult financial situation at the time of termination. Thus, should the notice of termination be delivered after the opening of bankruptcy or liquidation proceedings, the employer is obliged to pay only an amount up to six months’ absentee pay due to the employee. The remaining part of the amount otherwise due shall be payable upon the conclusion or termination of bankruptcy proceedings, or upon the conclusion of liquidation proceedings.
The Labour Code creates the option for the employer to protect its rightful economic interests even after that the employment relationship is finished, by extending the employee’s obligation in this respect by means of a non-competition agreement to a definite term. The non-solicitation obligation makes part of this commitment under Hungarian law, thus every activity which may violate the employer’s legal economic interest can be restricted.
We note that the obligation of confidentiality after termination, which binds the employee without a time limitation, is for the same purpose, but the difference is that the confidentiality obligation does not require the parties’ agreement, and while the obligation of confidentiality does not require compensation, the non-competition agreement cannot be validly concluded without adequate compensation. The two obligations are frequently confused; their boundaries are blurred. The basis of the confidentiality obligation’s mandatory and unlimited nature in time is the common interpretation of the Labour Code and the Competition Act.
The aim of the non-competition agreement is the protection of the employer’s lawful economic interests. However, in accordance with the principle of purpose limitation, the lawful economic interest serving as a legal basis for the non-competition shall be significant and measurable.
It’s also the employer’s economic interest that limits the scope of restrictions, as the obligations undertaken by the employee need to be tailored to the purpose. It means that in order not to make it impossible to the employee to find another job, the territorial scope and the type of activity to be avoided shall be defined in the agreement by taking into account the potential threat to the employer.
The necessity of the non-competition agreement depends on the position of the employee filled at the employer’s organisation, the knowledge and expertise gained at this position, the term of the employment relationship and the employer’s position on the market, so it shall be decided on a case-by-case basis.
The rules related to the conclusion of a non-competition agreement are particularly strict, and the breach of these rules may result in the invalidity of the non-competition agreement.
An employee is entitled to adequate compensation in exchange for his or her undertaking. The minimum amount for the term of the non-competition agreement is defined in the Labour Code, which may not be less than one-third of the employee’s base wage due for the same period. However, the amount of adequate compensation shall be determined on the basis of the degree of impediment the agreement has on the employee’s ability to engage in employment relationship elsewhere, also taking into account his education and experience, which requires the complete evaluation of all these facts. Accordingly, the non-competition agreement shall be always customised to the employee in question, by taking into account the economic and market conditions.
The payment scheduling entirely depends on the parties’ agreement. It may be paid in one single amount during or after the employment relationship, or after that the whole non-competition period successfully elapsed. Also, the parties can agree that the compensation will be paid in monthly instalments during the employment or the non-competition period. However, payment in advance during the employment deserves special attention, as it could happen that the overall amount of monthly instalments provided exceeds the amount otherwise due to the employee. In this case the employer is not entitled to claim back the undue amounts, which may create a financial disadvantage on the employer’s part. Another problem can be if the employment agreement terminates before the employee received the full amount of the compensation. In such a case, if adjustment has not been included in the non-competition agreement, it would be invalid, as this amount cannot be replaced afterwards.
However, the parties’ agreement may grant to the employer the possibility of withdrawal before the non-competition agreement enters into effect. Accordingly, if during the employment it became clear that the entry into force of the non-competition agreement does not serve the employer’s interest, the employer can decide not to pay the compensation and the employee won’t be bound by his or her undertakings after termination to the employment relationship.
In the event that the parties expressly included in the non-competition agreement that the employee shall be accountable for the amounts paid in advance during the employment relationship, the employer can reclaim these amounts upon withdrawal.
Another optional provision ensuring safeguard and flat-rate compensation for damage for the employer in case of breach of contract is the penalty, which requires a written form. The rate of the penalty may also be defined as a percentage of the compensation. In case of an excessive penalty the court can reduce this amount upon the employee’s request. In addition to a penalty, the employer is entitled to demand payment for damages not covered by the penalty, which shall be also included in the non-competition agreement.
One of the core issues is that the non-competition agreement shall be concluded before the termination of the employment. In the case the parties do not conclude this agreement at the beginning of the employment they can conclude it at any time until the termination of the employment agreement, but the bargaining power of the employer may be weaker.
V securities law
Pursuant to applicable Hungarian laws, in the case of a company limited by shares (both private and public companies), a special type of shares (employee shares) may be issued to employees either for a special price (which is usually less than the face value of the shares) or without consideration.
The value of these employee shares is also limited; they may only be issued simultaneously with the increase of the respective company’s share capital, not exceeding 15 per cent of the amount of the so increased share capital.
Such employee shares may only be transferred or sold effectively to another employee of the given company or to former employees of such company, provided that the deed of foundation expressly allows such transfer or sale. If the employee ceases to be employed by the company in which it owned employee shares, the former employee shall transfer such employee shares in accordance with the above rules. Consequently, employee shares cannot be sold on the market.
In the case of employee shares of a private company limited by shares, the issuance of the employee shares only needs to be notified to the Hungarian financial regulator (being the National Bank of Hungary). If a public company limited by shares intends to issue employee shares, registration of such employee shares with the Hungarian financial regulator is required, although no prospectus and announcement shall be published with respect of such employee shares.
VI Specialised Regulatory Regimes
In line with EU regulations, special remuneration policies are to be mandatorily applied to certain employees in the financial and investment sector.
i Remuneration policy in the financial sector
The remuneration policy is applicable to the executive officers of a financial institution as well as to other employees of the given financial institution who have material impact on the financial institution’s risk profile.
The supervisory body shall adopt and periodically review the general principles of the remuneration policy and the management body shall be responsible for the implementation and the execution thereof. The remuneration policy shall be reviewed by the internal control department at least annually.
Financial institutions with a market share of at least five per cent in respect of their balance sheet total are required to establish a remuneration committee, which is responsible for reviewing the remuneration of the senior officers of risk management and compliance as well as for the preparation of decisions regarding remuneration. The chairman and the members of such remuneration committee shall be those members of the management body of the financial institution who are not engaged under an employment contract with the financial institution concerned.
Financial institutions shall distinguish between basic remuneration and variable remuneration, and shall fix in their internal policy the ratio that basic remuneration represent within the total remuneration, where the variable component shall not exceed hundred per cent of the basic remuneration for each senior executive. In certain cases financial institutions may provide variable remuneration up to 200 per cent of the basic remuneration.
At least 40 per cent – or at least 60 per cent in the case of a variable remuneration component of an amount exceeding the limit specified in the internal policy – of the variable remuneration component shall be deferred (aligned with the nature of the business, its risks and the activities of the senior executive) and paid over a period between three and five years.
Senior executives and employees of a financial institution are not allowed to undertake hedging strategies to mitigate the risk alignment effects embedded in their remuneration arrangements.
ii Remuneration policy in the investment sector
The remuneration policy is applicable to the executive officers of an investment company as well as to other employees of the given investment company whose task is risk management and control activity.
The supervisory body shall adopt and periodically review the general principles of the remuneration policy and the management body shall be responsible for the implementation and the execution thereof. The remuneration policy shall be reviewed by the internal control department at least annually.
If the investment firm has a balance sheet total exceeding 200 billion forints, it is required to establish a remuneration committee, which is responsible for reviewing the remuneration of the senior officers of risk management and compliance as well as for the preparation of decisions regarding remuneration. The chairman and the members of such remuneration committee shall be those members of the management body of the investment firm who are not engaged under an employment contract with the investment firm concerned.
Investment firms shall distinguish between basic remuneration and variable remuneration, and shall fix in their internal policy the ratio that basic remuneration represent within the total remuneration, where the variable component shall not exceed hundred per cent of the basic remuneration. In certain cases investment firms may provide variable remuneration up to 200 per cent of the basic remuneration.
At least 40 per cent – or at least 60 per cent in the case of a variable remuneration component of an amount exceeding the limit specified in the internal policy – of the variable remuneration component shall be deferred (aligned with the nature of the business, its risks and the activities of the senior executive) and paid over a period that is between three and five years.
Senior executives and employees of an investment firm are not allowed to undertake entering into hedging strategies to mitigate the risk alignment effects embedded in their remuneration arrangements.
VII Developments and conclusions
The rules related to the executives are not dynamically changing parts of the related acts, these are well crystallised part of the Labour Code and practice.
However, owing to the entry into force of the new Civil Code in 2014, issues were raised in connection with the relation of the liability regime under the Labour and the Civil Code.
The question is whether or not these are the liability rules of the Labour Code that shall be applied in case of damage caused by the employee to the employer.
We can state that in case if the executive perform his or her tasks within the framework of an employment agreement, and he or she breached his obligations stemming from the employment relationship by failure to act as it might normally be expected in the given circumstances, the executive’s liability towards the employer shall be governed by the rules of the Labour Code.
In this case the burden of proof to verify the circumstances mentioned above, the occurrence of loss, as well as the causal link, lies with the employer.
The executive is also subject to full liability for damages caused by negligence. The executive is not liable, though, for any damage unforeseeable at the time of the breach or that resulted from the employer’s wrongful conduct, or that was incurred owing to the employer’s failure to perform its obligations to mitigate the damage.
However, if the breach is not related to the executive’s obligations related to his or her employment, his or her liability shall be governed by the Civil Code.
The question of liability shall be examined on a case-by-case basis.
1 Barnabás Buzási, Melinda Pelikán and János Pásztor are senior associates, and Alexandra Tóth and Eszter Bohati are associates at Wolf Theiss.