Australia: Retaining and incentivising key employees

Last Updated: 29 July 2019
Article by Laszlo Konya

Retaining and incentivising key employees is an issue that nearly all businesses must confront at certain stages of their development and expansion. Generally, multiple options are available with pros and cons that need to be carefully considered based on the circumstances of the relevant business.

The most commonly used incentives are summarised as below.

Incentive: Cash bonus

Operation
  • Employee has contractual right to receive cash bonus based on their individual key performance indicators (KPIs) being achieved, which are usually short to mid-term hurdles
  • Employee does not have any ownership of the business
Tax
  • Employee is taxed on the cash bonus at their marginal rate
  • Employer must withhold PAYG and entitled to a deduction for the cash bonus
Costs
  • Low cost to implement
  • No significant ongoing administrative costs
Termination of employment
  • Right to bonus terminates at the same time
  • In some cases, e.g. breach of employment agreement, a bonus(es) may be repayable

Incentive: Phantom or shadow equity

Operation
  • Employee has contractual right to receive a cash bonus based on financial performance of business over time, usually 3+ years
  • Employee does not have any ownership of the business
  • Employee incentivised by long term financial performance of the business, as opposed to their own short to mid-term performance
Tax
  • Employee is taxed on the cash bonus at their marginal rate
  • Employer must withhold PAYG and entitled to a deduction for the cash bonus
Costs
  • Low cost to implement
  • No significant ongoing administrative costs
Termination of employment
  • If employee resigns prior to specific period, e.g. 3 years, or commits breach of employment contract, then generally the right to the bonus also terminates
  • Otherwise, employee generally entitled to bonus, if it has not been paid previously

Incentive: Options

Operation
  • Employee is granted an option to buy equity (shares / units) directly in the employer or indirectly via a trust controlled by the employer
  • Employer must be a company or unit trust
  • The employee may hold the option via a family trust or other entity, unless the employer lends funds for the acquisition of the option
  • The option is exercisable upon specific triggers being met, e.g. minimum period of employment, KPIs, etc.
  • Employee does not have any ownership of the business, until the option is exercised
  • Employee incentivised by long term financial performance of the business, as opposed to their own short to mid-term performance
Corporations law
  • Disclosure document or product disclosure statement required, unless an exemption applies or ASIC has granted relief
  • A unit trust may be a managed investment scheme and may need to be registered with ASIC
Tax
  • If the option is issued for market value to buy equity in the future at its current market value, then there is no tax implication for the employee or the employer on the granting or the exercise of the option
  • If the option is issued for less than market value, then the amount of the discount will be taxable:
    • to the employee when the option is granted, in the case of an option to acquire shares, subject to the employee share scheme concessions, if applicable (see below)
    • the employer when the option is granted, in the case of an option to acquire units
  • The employer may lend funds to the employee prior to becoming a shareholder on a limited recourse basis to avoid the above tax implications, subject to the financial assistance provisions of the corporations law (if applicable) and the employee personally holding the option
  • Disposal of the option may trigger capital gain or loss for the employee
  • Exercise of the option will not trigger any tax for the employee or the employer, however disposal of the equity will trigger capital gain or loss for the employee
Costs
  • Require an independent valuation to determine the market value of the option and the underlying equity at the time of granting of the option
  • Legal costs involved in granting options, preparing shareholders agreement or unitholders agreement (if applicable) and establishing employee share scheme (if applicable)
  • Ongoing costs will depend on the complexity of the option granted and any scheme for broad employee participation
Termination of employment
  • Unexercised option generally expires upon termination of employment

Incentive: Equity

Operation
  • Employee buys equity (shares / units) directly in the employer or indirectly in a trust controlled by the employer
  • Employer must be a company or unit trust
  • The employee may acquire the equity via a family trust or other entity, unless the employer lends funds for the acquisition of the equity
  • Employee has ownership of business in proportion to their shareholding / unitholding
  • Shareholders agreement or unitholder agreement may be necessary to set out how company / trust will be operated and restrict dealing with shares / units
Corporations law
  • Disclosure document or product disclosure statement required, unless an exemption applies or ASIC has granted relief
  • A unit trust may be a managed investment scheme and may need to be registered with ASIC
  • If employee holds equity directly, then they will have shareholder / unitholder rights
Tax
  • If the equity is issued for market value, then there is no tax implication for the employee or the employer
  • If the equity is issued for less than market value, then the amount of the discount will be taxable:
    • to the employee when the shares are issued, subject to the employee share scheme concessions, if applicable (see below)
    • the employer when the units are issued
  • The employer may lend funds to the employee prior to becoming a shareholder on a limited recourse basis to avoid the above tax implications, subject to the financial assistance provisions of the corporations law (if applicable) and the employee personally acquiring the equity
  • Disposal of the equity will trigger capital gain or loss for the employee
Costs
  • Require an independent valuation to determine the market value of the equity at the time of issue
  • Legal costs involved in issuing equity, preparing shareholders agreement or unitholders agreement (if applicable) and establishing employee share scheme (if applicable)
  • Ongoing costs will depend on the complexity of the options granted
Termination of employment
  • If employee resigns prior to specific period, e.g. 3 years, or commits breach of employment contract, then generally employer has an option to buy back equity at a discount to market value (e.g. 20%)
  • Otherwise, employer generally has an option to buy back equity at market value

Employee Share Scheme concession

Start up – the amount of the discount will not be taxable to the employee

  • The company (or any related company) has been incorporated for less than 10 years and is not listed on a stock exchange
  • The company has aggregated turnover under $50 million
  • For options – the exercise price is at least the market value of the shares when the option(s) is granted
  • For shares – the discount is not more than 15% of the market value of the shares, which may be determined by simplified statutory methods
  • The employer is an Australian resident company
  • The scheme relates to ordinary shares
  • The company is not a share trading or investment company
  • Every acquirer of an option(s) / shares must hold their option(s) / shares for at least three years or until termination of employment (whichever occurs first)
  • The employee must not hold more than 10% of shareholding and voting power when option(s) is granted / when shares are acquired
  • For shares – the scheme must be broadly available to 75% of permanent employees who have completed at least 3 years of service

Deferred taxation – the amount of the discount will be taxable to the employee until the earlier of:

    • no restriction on disposal
    • termination of employment
    • 15 years after acquisition
  • The start-up concession does not apply
  • The scheme relates to ordinary shares
  • The company is not a share trading or investment company
  • The employee must not hold more than 10% of shareholding and voting power when option(s) is granted / when shares are acquired
  • For options – there is a 'real risk of forfeiture' of option(s) or restriction on disposal
  • For shares – there is a 'real risk of forfeiture' of shares or the shares are issued as part of a salary sacrifice arrangement (up to $5,000)
  • For shares – the scheme must be broadly available to 75% of permanent employees who have completed at least 3 years of service

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.

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