Australia: Improvements proposed to the taxation of employee share scheme provisions

Clayton Utz Insights
Last Updated: 11 February 2015
Article by Mark Friezer and Louisa Wu

Key Points:

If enacted in their current form, the amendments are intended to apply to ESS interests acquired on or after 1 July 2015.

The 2009 changes to the tax treatment of rights acquired through an employee share scheme (ESS) made it harder for Australian firms to attract and retain high quality employees – particularly for small start-up companies, which were effectively shut out from using ESS arrangements because of their likely tax consequences for employees.

Following on from the Government's announcement on 14 October 2014 that it will reform the rules, the exposure draft is designed to improve the taxation of ESS.

These changes are to be welcomed, and should increase the attractiveness of ESS as an effective way of attracting and retaining staff, and help innovative start-ups better compete in the labour market.

The problem with the current tax treatment of employee share schemes

Under the current ESS rules, employees are commonly taxed by the Government on the "discount" that they receive on their options at the time that the options can be exercised, instead of at the time that the employees actually exercise the options. This means that a tax liability may arise for an employee that is granted options at a time when the economic value of the options hasn't been realised – which, in the case of start-ups, could be some years away.

Reversing and improving certain parts of the 2009 reforms

Consistent with the Government's announcement, the exposure draft amends the rules to:

  • alter one of the taxing points for ESS interests that are rights, so that it applies not at the point at which a right can be exercised, but at the point at which it is exercised (subject to the share obtained by exercising the right not being further subject to a real risk of forfeiture or genuine restrictions on sale. Otherwise, in that situation, the deferral will continue to be at the time at which those risks and restrictions are lifted);
  • increase the maximum deferral period from seven to 15 years for ESS interests that are subject to deferred taxation, whether those interests are shares or rights;
  • allow certain ESS rights schemes that do not contain a real risk of forfeiture to access deferred taxation treatment if the ESS rights scheme genuinely restricts the employee immediately disposing of those rights, and the scheme rules expressly state that the scheme is subject to deferred taxation. This means that the taxing point of ESS rights may be deferred, even if the rights have never been subject to a real risk of forfeiture – which is a critical condition for deferral under the existing regime;
  • allow employees to obtain a greater ownership interest in their employer by doubling the existing 5% ownership and voting rights test to 10% (taking into account the holdings an employee could obtain by exercising rights they have over shares in their employer (regardless of whether those rights are ESS interests or not), and the holdings of an employee's associates); and
  • change the refund of income tax rules, so that if an employee decides to let a right lapse, and has previously paid income tax as a result of acquiring the right, that employee will be entitled to a refund, as long as the scheme has not been structured to directly protect the employee from downside market risk.

Concessions for interests in small start-up companies

Employees of certain small start-ups may also receive the start-up tax concession if their employer and the scheme meet a number of conditions, so that:

  • in relation to shares, the discount is exempt from income tax and the share once acquired is then subject to the capital gains tax rules, with a cost base reset at market value; and
  • in relation to rights, the discount is not subject to upfront taxation and the right, and resulting share once acquired, is then subject to capital gains tax with a cost base equal to the employee's costs of acquiring the right.

The concession is intended to be limited to small, unlisted start-up companies with an aggregated turnover of less than $50 million in the income year before the year of the grant, without easy access to capital and which are difficult to value. In addition:

  • the employing company (which may or may not be the company issuing the ESS interest) must be an Australian resident taxpayer; and
  • the ESS interests must be in a company that was incorporated less than 10 years before the ESS interest was acquired.

Other conditions also apply.

Safe harbour market valuation methodologies and updated valuation tables

The exposure draft introduces a new power for the Commissioner of Taxation to approve market valuation methodologies that can be used by taxpayers to more easily comply with the law.

The exposure draft also includes an amending Regulation to replace the safe harbour option valuation tables in the Regulations with new valuation tables to reflect current market conditions.

When the new rules could take effect

If enacted in their current form, the amendments are intended to apply to ESS interests acquired on or after 1 July 2015.

The current law will continue to apply to ESS interests acquired before 1 July 2015.

The Commissioner of Taxation's safe harbour market valuation methodologies will apply from the date specified by the Commissioner in a legislative instrument.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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