Employers should start considering new or updated employee share schemes now.
The Federal Government has released new draft legislation designed to improve the taxation of employee share schemes (ESS) by:
- deferring the "taxing point" for shares and rights provided to employees under an ESS deferred scheme;
- introducing a further tax concession for employees of qualifying start-up companies; and
- introducing standardised, "safe harbour" methods of valuing ESS interests and improvements to registration and administration of ESSs.
From 1 July 2015, the changes may offer greater tax concessions to employees who participate in ESSs and, therefore, better business outcomes to employers that are considering implementing an ESS or modifying an existing ESS.
ESSs and taxation – current position
The ESS is an employee incentive and remuneration structure where, commonly, employees of a company are provided with shares, or rights to acquire shares in that company (or its ultimate parent). These shares are offered at a discount that are subject to restrictions on vesting and sale, and are forfeited in some circumstances. An ESS provides an employee with part ownership his or her employer and is intended to increase performance and loyalty.
Qualifying ESSs are subject to concession tax treatment. Without this, the default position is that employees incur income tax liability for any discount offered in the year that they receive their interests in the ESS. The main concessions to the default position are currently:
- $1000/year in discount to market value of shares or rights tax free, provided the employee earns less than $180k per annum;
- tax deferral for the discount tax charge for up to seven years, provided the share or right is subject to a "real risk of forfeiture".
There are a number of basic conditions to be satisfied. An employee can only have a stake of up to 5% in the company – thus it is not open to "controllers" or significant shareholders. ESS which provide shares to employees must shares be open to 75% or permanent employees with three years' service (but ESS granting rights can be selective in who offers are made to).
There are also salary sacrifice ESS but these are rarely if ever used.
The taxation of ESS is relatively fluid – every few years it is rewritten. The current rules date from 2009.
What changes are being proposed?
Changes to the deferred taxing point
In the case of rights provided under ESSs, the proposed amendments:
- increase the maximum deferral period from seven to 15 years; and
- extend the deferral period from when the employee can exercise the right until the employee does in fact exercise the right. This is designed to ensure that employees are not made subject to tax when the right is exercisable, but not exercised.
Increase in ownership and voting rights restriction
The 5% limitation on a single employee's ownership or voting rights in his or her employer is proposed to be doubled to 10%. In determining the employee's ownership and voting rights for this purpose, holdings that the employee could obtain by exercising any rights over shares are included.
Additional tax concession for start-ups
The proposed concession for start-up companies would exempt employees from paying income tax on small discounts to shares or rights offered under an ESS of start-up employers. To qualify for the start-up concession, the ESS must meet the following criteria:
- ESS interests must be in the employee's employer or holding company.
- All ESS interests offered must be ordinary shares.
- An employee cannot own more than 10% of the shareholding or votes of their employer.
- Meet certain integrity provisions for employers whose predominant business is buying and selling shares.
- Employees must hold interests for 3 years or until cessation of employment.
- Scheme must be offered on non-discriminatory basis to at least 75% of Australian resident permanent employees with 3+ years' service.
- The employer must not have any equity interests listed on an approved stock exchange.
- The employer and all companies in its corporate group must have been incorporated less than 10 years before the first ESS was acquired.
- The employer must have an aggregated turnover not exceeding $50 million in the income tax year prior to the income year in which the ESS was acquired.
- The employer must be an Australian resident taxpayer.
- The ESS must:
- in the case of a share, be acquired with less than a 15 percent discount to the market value of the share; and
- in the case of a right, have an exercise price that is greater than or equal to the market value of an ordinary share in the employer company.
These final requirements operate to limit the benefit available – it is not open to simply give shares away (at least, in excess of the $1000 available) on the basis that this is untaxed remuneration. The benefit can therefore be significant but not substantial, either due to the qualifying level of discount, or by counting on the value in the right to depend on the future success of the company.
It is, however, likely to craft some future options having considerable intrinsic value – but subject to the risk of corporate failure.
New safe harbour valuation methods
The proposed amendments would introduce new powers for the Commissioner of Taxation to approve methodologies in valuating ESSs and interests in ESSs schemes with a view to giving employees certainty and lowering compliance costs. Employers and employees may need to value interests in ESSs in a number of circumstances to comply with tax law, but there have been perceived difficulties in selecting a valuation approach that the ATO will accept.
Therefore, it is proposed that the Commissioner would approve, and be bound by, valuation methodologies which would offer certainty while still allowing employers and employees the option to choose alternative valuation methods where more appropriate to do so.
What do I do now?
The Federal Government intends for the legislation to come into effect on 1 July 2015. Submissions on the draft legislation have now closed.
When the final amendments are released, employers should review this legislation carefully as it may provide opportunities for employers to construct a new ESS or update and improve their existing ESSs. Employers should start preparing for these changes before the legislation comes into effect to take immediately the benefit of these reforms.
Summary of the Position following the Proposed Changes
Taxed-upfront scheme: $1000 reduction
Tax-deferred scheme: real risk of forfeiture
Employees can reduce the their taxable discount income by $1000.
Tax on ESS interests is deferred until the "deferred taxing point" which is the earliest of:
Eligibility - General
Eligibility - Specific
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.