Article by Stephanie Barnes, Andrew Spalding and Christine Hutchinson
On 12 May 2009, the Treasurer, as part of the Federal Budget, announced some major changes to the rules governing the taxation of shares and options acquired under employee share and option plans (ESOP). These changes, if passed into law, will apply immediately and will impact most employees who participate in an ESOP. Employers will need to reconsider the viability of their ESOPs and may need to devise different ways to incentivise their employees as they watch the tax benefits that used to exist sink beneath the waves.
Pre-Federal Budget taxation of ESOPs
Before 12 May 2009, an employee who acquired shares or options under an ESOP was required to pay tax on any "discount" on the share or option they received from their employer, subject to the two tax concessions outlined below. The discount is the difference between the market value of the share or option and any consideration paid for the acquisition of that share or option. ESOPs were generally structured as "qualifying" plans to give employees access to one of two tax concessions:
- the "tax deferral concession" – which allowed employees to be assessed on the discount in the income year in which the "cessation time" occurred (generally disposal or exercise) instead of in the income year in which the share or option was acquired; or
- the "$1,000 concession" – which provided employees with an exemption from tax on the first $1,000 of the discount (but with tax payable in the income year of acquisition) where certain conditions were satisfied.
It was announced in the Federal Budget that in respect of any share or option acquired under an ESOP after 7.30pm AEST on 12 May 2009 that:
- the discount will be assessed in the income year in which the share or option is acquired. This means that employees acquiring shares or options under a qualifying ESOP will no longer be able to defer payment of the tax on the discount until a later time. Employees will have to pay the tax in the income year in which the share or option is acquired even if they cannot sell the shares or options to fund the tax payment; and
- the $1,000 concession will be limited to those employees with a taxable income of less than $60,000 after adjustments for fringe benefits, salary sacrifice and negative gearing losses.
The Treasurer stated that the purpose behind these new measures was to ensure that tax concessions "better achieve their objective of boosting the availability and take-up of employee share schemes by low and middle income employees". The Treasurer's media release expressed concern that some taxpayers had previously been able to avoid paying tax on the discount by using the tax deferral method and then not declaring the discount at the appropriate time in his or her income tax return and paying tax.
The announced changes have been criticised by major companies (many of whom have frozen their ESOPs in response to the Federal Budget announcement) and industry bodies.
Implications for employees
The provision of shares and options by an employer to an employee at no cost or at below market value has been a popular way for companies to incentivise their employees. This is because they align employee remuneration with shareholder interests by giving employees a stake in the growth of the company and an incentive to stay. However, as a general rule, the shares and options are subject to a vesting period of between 3 and 5 years. With tax payable in the income year in which the employee acquires the shares or options, in the absence of a loan from their employer, employees will need to fund the tax from other assets.
Employees may find themselves paying tax on a share that is subject to disposal restrictions and that drops in value before they are allowed to sell the share. Likewise employees may find themselves paying tax on options where the share price has dropped below the strike price, with the entitlement to a refund of the tax paid only arising when the option lapses.
While the loss of the tax deferral concession is a negative, it is important to remember that the payment of tax up-front on the acquisition of a share or option can produce a tax benefit for the employee, particularly in a rising share market. If the employee is assessed on the discount in the income year in which the share or option is issued, any gain made on disposal of that share or option will generally be taxed on capital account and not as income under the employee share scheme provisions.
If those shares or options have been held by the employee for more than 12 months before disposal then the employee would generally be entitled to apply the 50% CGT discount, significantly reducing the employee's tax bill.
Implications for employers
Companies with a current ESOP should immediately consider the potential tax liabilities facing their employees as a result of the announced changes and whether their ESOP can or should be restructured. One change that could be considered is the provision of interest-free loans to employees to fund their immediate tax liability. The fringe benefits tax implications of any loan arrangement would need to be considered.
Companies who are considering incentivising employees through the use of an ESOP should consider the impact of the announced changes. Companies may need to consider other forms of equity based remuneration such as share appreciation rights or phantom share schemes.
Ultimately, companies should await the outcome of lobbying by industry associations and major employers as well as the introduction of legislation before taking steps to change or implement an ESOP at this time.
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.