Australia: Tax Update: Recent Changes Affecting Employee Share And Option Plans

Last Updated: 31 March 2006

The appeal of employee share and option plans is set for a boost due to three sets of legislative changes. While many ESOPs have been negatively impacted by having to expense benefits in accordance with AASB 2 Share-based Payments Standard, the new legislation regarding ESOPs illustrates the ATO’s favourable view on the further establishment of ESOPs in Australia.

ESOPs usually provide employees with a benefit based on the difference between the market value of a share (or option) and the consideration paid by an employee (if any) to acquire it. Under certain circumstances, the benefit received by the employee up to $1,000 may be exempt from income tax. In other circumstances, employees not entitled to the $1,000 exemption can elect to be taxed upfront on the benefit, or elect to defer assessment of the benefit for up to 10 years, or until their employment with the company ceases, or until they dispose of the shares (whichever is the earliest of these ‘cessation times’).

Takeovers and restructures

It is common for an employee of a takeover target or a company seeking to restructure, to be given shares or options in the bidder to replace shares in the target. Previously, it was arguable that an employee in this situation is deemed to have disposed of the shares or options in the target company. This disposal would equate to a cessation time and lead to assessment at that time of any discount received by the employee under the ESOP.

Two legislative amendments have provided relief for employees caught in this situation. The introduction of the Tax Laws Amendment (2004 Measures No 7) Act 2005 (Cth) and Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Act 2005 (Cth), enable an employee to roll over the benefit or discount received under the ESOP beyond the takeover or restructure, provided certain conditions are met:

  • The takeover or restructure would ordinarily amount to a ‘cessation time’ in the absence of these roll-over provisions (although this will be removed when the bill passes through parliament).
  • At the time of the takeover or restructure there has been no other event that would trigger a ‘cessation time’.
  • The exchange contemplated by the takeover or restructure involves the employee receiving ordinary shares (or options to acquire ordinary shares) in the bidder in replacement of existing shares (or options to acquire shares) in the target.
  • The new shares or options in the bidder can reasonably be regarded as ‘matching’ the old shares or options in the target, in that they have substantially the same attributes and equivalent value. For the shares to be ‘matching’, the shares must be subject to the same restrictions and conditions.
  • Employees must cease holding their target shares or options as a result of the takeover or restructure.
  • The employee must be employed by the bidder (or a group company of the bidder) after the takeover or restructure (but under the new bill, not for shares or options taxed upfront – see below).
  • The takeover is a 100 per cent takeover or a restructure as defined under the amending act.
  • After the takeover or restructure, the employee must not hold more than 5 per cent of the shares in the target or more than 5 per cent of the votes that can be cast at a general meeting of the target.

Interestingly, a ‘100 per cent takeover’ is defined as an arrangement that is intended to result in a company becoming a subsidiary of another company (or of a holding company or subsidiary of the other company). The use of the word ‘intention’ appears to allow some scope for the roll-over relief to apply in situations where the bidder does not immediately acquire 100 per cent of the target. The issue has not yet been addressed by the tax office, and it will be interesting to see whether roll-over relief will be permitted where less than 100 per cent of the target is acquired, even though there may have been an intention to acquire full ownership. The Explanatory Memorandum seems at odds with the ordinary interpretation of the definition, by indicating that there must be a complete takeover, rather than just an intended 100 per cent takeover.

A restructure is defined as a change in the ownership (or the structure of ownership) of a company as a result of which shares or options held in the company under an ESOP are replaced (or could be regarded as having been replaced) by shares or options in another company (or companies). According to the Explanatory Memorandum, this definition would include a demerger where the shares or options in the principal entity are cancelled in return for shares or options in the demerged company. However, it is common in demergers for employees to continue to own shares or options in the principal company, in which case the roll-over relief would not apply.

A further provision in the bill will, if passed, affect the taxation of ESOPs in the takeover or restructure context. Currently, when an employee holds an option to acquire a share, and the employee loses that option without having exercised it, the employee will be treated as not having had that option (section 139DD). This is especially relevant where an employee has elected to be taxed up-front on an option, but the options are ‘out of the money’, so the employee has paid tax on a benefit that was not actually received. In this circumstance, an employee who receives an exchange of options under a takeover or restructure could not claim they had lost their options without having exercised them.

The problem will be alleviated by proposed section 139DD(2A) which provides that, although a taxpayer who has elected to be taxed upfront will still not be considered to have lost an option on a takeover or restructure, the taxpayer can claim a refund when a subsequent option is lost. Further, at the time of claiming the refund, there will be no requirement that the employment relationship continue beyond the takeover or restructure (a condition where the taxpayer has not elected to be taxed upfront).

Inbound and outbound executives

Executive relocation can create problems for both resident and non-resident executives in relation to ESOPs. The New International Tax Arrangements (Foreignowned Branches and Other Measures) Act 2005 (Cth) seeks to align Australian treatment of discounts on shares or options acquired under ESOPs with taxation treatment of employment income.

Under the changes which became effective 26 June 2005, when an Australian resident pays tax on an employee share or right, and also pays foreign tax due to some foreign service, then that taxpayer may be entitled to either an exemption under S23AF or S23AG ITAA 1936 or foreign tax credits. Also, if an Australian resident becomes a non-resident, a deemed CGT disposal does not occur for their ESOP shares or options that are within the operation of Div 13A.

For non-residents who become Australian employees, Div 13A will apply to their existing employee shares and options. A person becomes assessable in the year in which he or she becomes an Australian employee, but may be able to defer the taxing point.

If the non-resident can, and does, elect to defer taxation under Div 13A, then the cessation time will be determined by reference to the income year in which their Australian employment began. The value of the benefit will be based on the share value at the cessation time. If the non-resident elects to have the benefit derived under an ESOP included in their assessable income in the year in which they become an Australian employee, then the discount is valued as at the acquisition time. Further, they can receive the exemption for the first $1,000 of the benefit, even if only a part of the relevant employment took place in Australia.

The changes ensure that a person will only be assessable under Division 13A for the portion of that benefit that relates to the work performed in Australia. Although there is no legislation on how to apportion the periods of Australian or foreign employment to which the benefit relates, the Explanatory Memorandum suggests an OECD-like model based on the time worked in the foreign country as a proportion of the total period of employment to which the right relates.

Despite the changes, it is important to remember that double tax treaty provisions may also apply to determine whether another country has a right to tax the benefit. Generally, such a right will arise when the employee has performed work in that country and has been present there for more than six months in a 12- month period. Another country may also have a right to tax a benefit when the employee has been present in that country for less than six months in a year but is paid by the employer’s permanent establishment (as defined in the treaty) in that country (and it can deduct the payments); or the employee is a resident of that country.

This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.

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