An Introduction To Australian Management Equity Plans In A Private Equity Context - Capital Gains Tax

Private capital continues to experience a meteoric rise, with the Australian Investment Committee reporting assets under management at a record high of $118 billion as of September 2022. With the Australian market continuing to attract a larger proportion of domestic and foreign investors, a core consideration for any private equity acquirer is ensuring that key management personnel, whether existing or new, of a portfolio company are sufficiently incentivised and aligned with the commercial objective of the private equity house to generate superior returns on exit. The most common tool to increase alignment of interests would be implementation of management equity plans (typically referred to as MEPs).

MEPs come in many different forms and generally fall within the following broad categories:

Employee share schemes (ESS) that are subject to the ESS Rules under Division 83A of the Income Tax Assessment Act 1997 (Cth)
Loan-backed share plans (LBSP)
Loan-backed option plans (LBOP)
Phantom equity schemes (PES)
Cash bonuses

In determining the most appropriate MEP for a particular investment, private equity houses typically consider a number of factors including:

The correct KPIs to be implemented (which could be as simple as achieving a certain IRR or MoM on exit) which will drive the correct behaviours
Aligning desired business objectives with outcomes from the plan through appropriate vesting conditions or triggers for economic rewards; for example, tranches could be implemented which vest upon certain milestones
Who the participants in the MEP will be; for example, would it be more senior management only or would it also extend to broader management?
Management's preferred tax outcomes to incentivise participation in the MEP (and therefore the business)
Management of participants, good leavers and bad leavers
Whether the plan will be a simpler "one size fits all" or more bespoke, particularly where management are located in different jurisdictions with differing tax and legal outcomes

Below, we explore the common MEP structures in the Australian landscape as well as some initial key tax considerations.

Employee share schemes (ESS)

Key features

Employees receive interests (such as shares or options) at a discounted value or for no value. There are other variants on this structure including adoption of employee share trusts or zero priced options, which we would be happy to discuss in further detail with you. ESS can also incentivise a large pool of participants using a single set of documentation rather than individualised documentation per participant.

Example

Consider a company with ordinary shares with market value of $100 each. An offer is made to a manager to issue an ordinary share for a discounted value, say $80. Under certain events, such as the company's acquisition, the executive may cash out their shares or convert them into shares of the acquiring company.

Advantages of an ESS

ESS are simple to implement and may be more appropriate for larger pools of participants as a "one size fits all" plan which requires less documentation per person. As such, we typically see ESS adopted by listed companies where a company prefers to incentivise a larger pool of middle management participants or in an early state or start-up context where founders may wish to provide equity exposure for key employees at a lower cost in addition to access to certain favourable tax concessions.

Disadvantages of an ESS

There are a number of disadvantages associated with ESS structures discussed in further detail below, being:

Upfront taxation for managers (though this can be deferred)
Certain adverse employment tax outcomes could arise if not properly managed, payroll tax in particular

Upfront taxation

The default tax position under the ESS rules is that any discount to market value provided to the employee under the ESS will be taxed at the employee's marginal tax rate in the year of issuance (i.e., upfront taxation). However, certain concessions exist in the ESS rules to defer payment of tax to a later point in time (for example, when a liquidity event occurs). If this is the case, then tax is levied on the delta between the issue price and the market value at the time of the taxing point, that is, whilst tax is deferred, any growth in value in the discounted security is subject to additional taxation. Access to such concessions require specific features to be attached to the plan, such as performance hurdles and disposal restrictions.

There may also be other potential income tax concessions available under the ESS rules which include:

Start-up tax concessions for certain share and option arrangements by eligible start-up companies: A tax exemption of $1,000 per year on the market value of shares for employees with a taxable income of less than $180,000
Tax deferral for salary sacrifice arrangements of up to $5,000 per year

In the hands of the employee, ESS interests (i.e., the discounted shares or options) are considered a capital asset but are held on revenue account until tax is paid on the "discount." Upon the payment of this tax under the ESS rules, the asset is then held on capital account. This means any future disposal could be subject to a 50 percent capital gains tax (CGT) discount if the interest is held for more than 12 months.

Employment tax outcomes

Where an ESS interest is issued, the value of the ESS interest may be subject to upfront payroll tax, depending on the relevant state or territory in which the manager provides services. There are a number of rules relating to determination of taxable value for payroll tax purposes depending on jurisdiction, and in most cases, the employer can choose to defer this payroll tax liability until a future event.

It is worth noting that in a deals context, particularly for growth deals or in the start-up space, confirmation of whether payroll tax has been appropriately paid on ESS interests at the time of grant issued to key personnel is a key diligence point. Where the acquisition itself deals with such interests, this may trigger a payroll tax liability upon completion. Alternatively, if the ESS interests are not dealt with at the time of entry, then a private equity acquirer would need to accept the presence of a latent payroll tax liability which will crystalise at a later point.

Whilst typically fringe benefits tax (FBT) would not apply on ESS interests, there are certain circumstances where the ATO may seek to apply FBT. Tailored tax advice should be taken upon implementation to confirm FBT applicability (or lack thereof).

Further, certain reporting requirements would exist under the ESS rules.

Loan-backed share plans (LBSPs)

Key features

LBSPs involve the company making a loan to the manager to facilitate the acquisition of shares (whether it be ordinary or a special class, discussed further below) at market value. The loan is typically structured as a limited recourse interest-free loan. This means to the extent the underlying shares are exited at a loss to entry price, then the company has no further recourse against any other personal assets of the manager (i.e., the manager suffers no loss in a downside scenario). Additional complexities and structuring considerations may arise if the manager wishes to hold the underlying shares in another vehicle rather than on their own personal basis.

Loan-backed share plans may use ordinary shares as the underlying equity, or use a separate special class of shares with bespoke rights and conditions which could reflect:

Vesting conditions, whether it be over time or upon certain economic hurdles or milestones being met
Good leaver and bad leaver provisions and management of such through buy-backs/cancellations
Inclusion or removal of voting or other shareholder rights

Other, more exotic variations of the LBSP in the market include either:

"Flowering shares" or "ratcheting shares" where a fixed pool of shares are issued with no rights and no value. Upon certain economic hurdles or milestones being met, then a certain proportion of these shares would have rights switched on (say, to be the equivalent of an ordinary share or through a variation into an ordinary share) and therefore have value attributed to them.
"Withering shares" where a fixed pool of shares are issued with full rights and value. Upon certain economic hurdles or milestones occurring, then a certain proportion of these shares would have their rights switched off and become valueless. This would be the inverse structure of a flowering or ratcheting share.

LBSPs are one of the two most popular structures typically favoured by private equity investors, who enjoy the flexibility that they offer in structuring and features.

Example

Advantages of LBSPs

Given the loan-backed shares are acquired at market value:

No upfront taxation applies for the manager with tax payable only on exit.
Shares are held on capital account by the manager and therefore subject to a potential 50 percent CGT discount if held for more than 12 months.
The tax implications for the company should be much more straightforward with certain rules and reporting obligations not applying.
The loan can be interest-free due to the application of certain tax rules.

Usage of a special class of shares also allows for bespoke features to be built within the share terms, including tailored vesting conditions, inclusion or non-inclusion of certain shareholder rights, and mechanisms to deal with the shares upon certain events occurring. This is an attractive proposition for private equity investors who may wish to incentivise management toward certain desired behaviours.

Disadvantages of LBSPs

As the loan-backed shares must be acquired at market value in order for the ESS rules to not apply, it is critical that the shares are acquired at market value to prevent any upfront taxation from arising. Additional action and cost may be required to support a market valuation, such as engaging an external third-party valuer to value the underlying ordinary shares and, in particular, where a special class of share is used.

Given a loan is made to MEP participants to facilitate the acquisition of shares, Division 7A (which deems such loans to be an unfranked dividend and therefore assessable income for managers) will need to be appropriately managed. As such, this structure may not be appropriate for participants who are pre-existing shareholders (whether it be through co-investment alongside of a private equity fund, rolling over their equity ownership or are already MEP participants). This reduces the ability for LBSPs to contain "top up" features though this can still be implemented (albeit with certain adverse tax consequences).

Loan-backed option plans (LBOPs)

Key Features

LBOPs operate similarly to LBSPs, although interest-bearing limited recourse loans are instead used to fund options being issued to managers at market value. Market valuation of the options can be determined by reference to certain safe harbour tax rules rather than through usage of an external third-party valuer.

The options would allow the participant to purchase ordinary shares in the company at a set exercise price. Upon an exit, the options can be dealt with either through (1) a buy-back/cancellation by the company, (2) acquisition by a purchaser or (3) exercised and the underlying shares sold. Typically we would expect (1) or (2) to occur as (3) may preclude access to the CGT discount where the shares are sold within 12 months of exercise. This is discussed further below.

The loan made to managers will be subject to interest at FBT benchmark rates and would not be interest-free.

Similar to LBSPs, vesting conditions and certain terms can be built into the option terms including:

Vesting conditions, whether it be over time or upon certain economic hurdles or milestones being met
Good leaver and bad leaver provisions and management of such through buy-backs/cancellations
Inclusion or removal of voting or other shareholder rights

Again, LBOPs are one of the two most popular structures typically favoured by private equity investors, who enjoy the flexibility that they offer in terms of structuring and features as well as tax certainty on valuation (discussed further below).

Example

Under the same example above (where market value of each ordinary share is $100), an executive receives a $1,000 interest-free limited recourse loan from the company. The loan is then applied by the manager to acquire 20 options with a market value of, say, $50/option. Upon exit, these options can be bought back by the company or sold to a third party acquirer, or the manager may exercise the options and sell the shares.

Advantages of LBOPs

The advantages of LBOPs are similar to LBSPs (with the exception of access to interest-free loans) with the following incremental advantages:

Market valuation certainty and simplicity through safe harbour tax valuation rules. This reduces cost and complexity in terms of supporting a market valuation and potential engagement of an external valuer.
The safe harbour tax valuation rules are very concessional and may provide additional economic upside for managers.
Issued options do not dilute the current equity interests of the business, which may be crucial for businesses seeking to manage ownership percentages.

Disadvantages of LBOPs

Whilst LBOPs take away the main disadvantage of LBSPs (being valuation support and management), limited recourse loans made under this structure would need to be subject to interest equal to at least the FBT benchmark rate (currently 7.77 percent for year ending 31 March 2024). If an interest-free loan is desired, then additional complex structuring solutions will need to be implemented.

The other disadvantage of LBOPs would be exit management. The option asset and the exercised shares are separate CGT assets and, accordingly, any exercise of the option resets the 12 month clock for potential access to the CGT discount provisions.

Similar Division 7A considerations to LBSPs would also apply. Given a loan is made to MEP participants to facilitate the acquisition of shares, Division 7A (which deems such loans to be an unfranked dividend and therefore assessable income for managers) will need to be appropriately managed. As such, this structure may not be appropriate for participants who are pre-existing shareholders (whether it be through co-investment alongside of a private equity fund, rolling over their equity ownership or are already MEP participants). This reduces the ability for LBOPs to contain "top up" features, though this can still be implemented (albeit with certain adverse tax consequences).

Phantom equity scheme and cash bonuses

Key Features

Unlike the above arrangements, phantom schemes do not actually provide the relevant employee with any equity within the business, but rather provide a cash bonus that is calculated with reference to the value of the underlying equity that the employee would notionally be entitled to under the arrangement. Phantom equity schemes are more commonly utilised by businesses with ownership restrictions or where the current controllers are seeking to minimise any dilution of the company's equity.

Example

A participant is entitled to receive 10 units of phantom equity stock, subject to meeting certain EBITDA growth hurdles. The phantom equity stock is valued at $5 each at the time of the creation of the phantom equity right, totalling $50. At the time the growth hurdles are met and the cash bonus is paid, the phantom stock is valued at $150 each. Depending on the form of phantom equity arrangement, the participant may receive a cash bonus of $50 (i.e., the value of the phantom stock at issuance), $100 (i.e., the value of the stock growth) or $150 (i.e., the value of the phantom stock at payment).

Advantages of phantom equity schemes and cash bonuses

Cash bonuses and phantom equity schemes are the simplest and most straightforward mechanisms to reward relevant employees or managers. Minimal paperwork and legal requirements need to be satisfied. As discussed above, there is also no dilution of equity ownership.

Disadvantages

Payments made under a phantom equity scheme are treated as ordinary income and would accordingly be subject to the employee's marginal tax rate. Further, the lump sum payment should be considered as wages and will accordingly be subject to standard payroll tax, Pay As You Go withholding and superannuation requirements, but not fringe benefits tax.

Another disadvantage is that payments to employees are run through the relevant payroll systems which may trigger confidentiality concerns around visibility over exit bonuses issued to various different managers.

How can A&M help?

As private capital continues to grow and MEPs grow in popularity, it is becoming increasingly more important for companies to understand the current MEP rules to ensure desired results for both companies and employees. Our A&M Tax Team has significant experience in advising the tax implications of MEPs and can provide expert guidance and support on MEPs, including assisting with the structuring of MEPs, considering alternative structures and helping navigate through the applicable tax regimes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.