It feels like it has been a long time coming but the changes to the employee share scheme (ESS) taxation regime have passed both Houses of Parliament.
Taking effect from 1 July 2015, the changes allow taxing points to be deferred for longer and introduce a significant new concession for "start-ups".
Tax deferral period
The maximum period of tax deferral increases from 7 years to 15 years. While many employees will cash in their shares or options well before the end of the 15 year deferral period, this change will have the potential to provide for longer term alignment between the company and its employees and to reduce the risk of employees being hit with unfunded tax liabilities.
Changes to deferred taxing point
The deferred taxing point for options (and for other rights, such as performance rights) broadly moves from vesting to exercise.
This is a significant change for unlisted companies and largely removes the risk of employees being hit with an unfunded tax liability. Under the old regime, unfunded tax liabilities were an issue where the deferred taxing point occurred before an employee could sell their options or shares received on exercise of their options (for example, when the company was sold or listed).
Extending deferred taxation
Deferred taxation is no longer restricted to options (and other rights) issued subject to a "real risk of forfeiture" (RROF). Deferred taxation will now also be available if:
- there is a genuine disposal restriction preventing the immediate disposal of the options (or other rights); and
- the plan rules expressly state that the plan is subject to deferred taxation (there is particular wording that the plan needs to contain for this purpose).
Many employers will of course still wish to retain performance or service conditions for commercial reasons (i.e. to incentivise and retain employees) but this change allows greater flexibility in plan design and may eliminate uncertainty around what constitutes a RROF.
Concessions for "start-ups"
- are unlisted (the same applies to any of its subsidiaries, the holding company and any subsidiaries of the holding company);
- are incorporated for less than 10 years before the share or option is granted, and cannot be part of a corporate group in which any other company has been incorporated for more than 10 years;
- have an aggregated turnover in the previous tax year of $50 million or less, and
- are Australian resident companies.
In order for the "start-up" concession to apply:
- shares must be issued at a discount of no more than 15% to market value; and
- options must have an exercise price equal to or greater than the current market value of a share.
The discount on shares or options issued by an eligible "start-up" is not taxed to the employee under the ESS provisions. Instead, the employee is taxed under the capital gains tax rules, paying tax only on an eventual disposal of the shares or options.
In the case of shares, the cost base for the purposes of calculating the gain is the market value at the time of issue (not the discounted price paid). In the case of options, the cost base is generally the exercise price.
Employees who acquire shares that qualify for the start-up concession will benefit from the 50% CGT discount when they sell their shares (so long as they have held their shares for at least 12 months).
Employees who acquire options that qualify for the start-up concession will benefit from the 50% CGT discount when they sell their shares (so long as they have held their options for at least 12 months). Employees will no longer be required to hold their shares received on exercise of their options for at least 12 months to access the discount. This is a welcome change but does not extend to options that fall outside the start-up concessions.
The changes will apply to ESS interests (i.e. shares, options and similar rights) acquired on or after 1 July 2015. Therefore, the changes will not affect interests already issued (or issued between now and 1 July 2015).
What does this mean for you?
Every company should review their existing employee incentive arrangements to assess whether they are still optimal under the new law.
Option plans are likely to come back into favour. That said, many companies that adopted loan plans following the 2009 changes may decide to continue with them despite their complexity given the taxation benefits they offer.
Companies that choose to retain their existing plans should still review them and consider making amendments to provide employees with access to the full benefits of the new law. Things to consider include:
- whether the plan contains the necessary terms to allow options to be taxed on exercise rather than on vesting;
- whether the plan allows employees to benefit from the full 15 year maximum tax deferral period; and
- whether the plan includes the prescribed wording to ensure access to tax deferral if there is no RROF.
We are pleased to offer companies a free 30 minute consultation to assist with understanding the impact of the new law on their employee incentive arrangements.