Article by Gerry Bean, Louise Boyce, George Marques, Phillip Byrnes and Van Do
On 24 July the Assistant Treasurer announced another review into employee share and option plans (ESOPs). Ever since the 2009 Government Budget measures announced radical changes to the taxation of ESOPs, they have been a topical issue, raising public outcry from business and industry groups, and causing the suspension of many ESOPs in large companies.
The proposed Budget changes were never going to be easily welcomed by the community. Fortunately, the Government has since scaled back the proposed changes, with the release of a consultation paper and exposure draft legislation which are intended to be the rules to apply from 1 July 2009 (discussed below). Comprehensive review measures were undertaken. First Treasury held consultation on the exposure draft and now the Economics Reference Committee is due to report to the Senate on its inquiry into the proposed ESOP changes by 17 August 2009. The high number of submissions in the consultation process is testimony to the depth of industry and community feeling to the changes.
There has been an abundance of articles arguing that even the revised proposed amendments are too harsh, and while these comments could be true, let us not forget that there are also aspects of the proposed rules which are an improvement on the current ESOP taxation regime. However, the proposed rules also do not address certain existing substantive issues, two of which are to be reviewed by the Board of Taxation for reporting to the Assistant Treasurer by 28 February 2010.
The pre- 1 July 2009 law
Under pre- 1 July 2009 law, an employee will receive a discount if they acquire shares or the rights to them below the market price. An employee participating in an ESOP can elect to be taxed upfront or to defer taxation on the discount they receive (if the shares/ options are 'qualifying').
Under the upfront election, the employee is taxed upfront on the discount in the year they acquire the shares or rights. The total of the discount included in the employee's assessable income can be reduced by $1,000 if certain strict requirements are met.
Under the tax-deferred election, there is no $1,000 exemption but the employee defers paying tax on the discount until the earliest 'cessation time'. A 'cessation time' occurs at specified points in time, including when the restrictions on sale are lifted, when the employee sells the shares or exercises the options or when the employment ceases or 10 years after the shares or rights were acquired.
Some employers granted options or issued shares before 1 July 2009 to take advantage of the pre- 1 July 2009 rules but they will need to ensure they have complied with Division 13A's requirements.
The Budget proposed to remove deferral of tax altogether and only allow employees with an adjusted taxable income of less than $60,000 to access the $1,000 exemption. This proposal was faced with considerable uproar and the Government eventually backed down to release exposure legislation, and accompanying material, which now effectively proposes the following new ESOP changes:
- No changes to existing treatment for non-qualifying ESOPs (ie continue to be taxed upfront).
- Shares/options acquired in ESOPs will be taxed upfront unless:
- acquired under a salary sacrifice based schemes (deferral permitted up to $5,000 worth of shares/ options);
- the existing deferral requirements apply and there is a 'real risk of forfeiture', in which case deferral is granted until the earlier of when there is no real risk of forfeiture, there are no restrictions on sale, the options/shares are sold, employment ceases, or 7 years elapses (instead of the 10 years under existing law);
- The $1,000 tax exemption only applies for taxpayers with an 'adjusted taxable income' of less than $180,000.
- Employers are subject to more tax reporting requirements.
Clearly, the current proposed amendments are significantly more favourable to taxpayers than those in the Budget which would have spelt the end for many ESOPs and removed much of the incentive to reward employees through equity based plans. At least now deferral measures are still possible and the $1,000 exemption is available to taxpayers earning under the $180,000 threshold.
A significant benefit of the new rules over the existing regime is that the existing rules required a participant to elect for upfront taxation in order to access to the $1,000 exemption. This meant that all other shares/options acquired in the same year would not be eligible for the exemption or a deferral.
The new rules will permit different ESOPs to be offered to an employee in the same year without the same limitation, as the rules do not require an election. This means that, for example, an employee could technically be part of one ESOP which allows him/her to a $1,000 exemption, obtain tax deferral for another $5,000 and defer taxation on the remaining shares/options until the relevant new cessation time. Employers should consider whether having multiple ESOPs may offer advantages.
The new rules also will be simpler to explain to employees, and the reporting requirements will give employers more certainty of the amounts to be included on their tax returns.
Now the bad. There are a number of potential issues which could arise under the new rules.
- there is no clear definition of the critical concept of a real risk of forfeiture in the proposed legislation;
- the longest cessation time is reduced from 10 years to 7 years;
- the $1,000 exemption will not be applicable for employees earning over the threshold, whereas under the existing rules, no income threshold applies;
- an employee will still face the risk of being taxed on a discount on leaving employment even though there is a real risk that the employee may never get to keep those rewards. This is inconsistent with the tax treatment overseas and the Australian tax treatment of cash bonuses;
- existing problems faced with the complexity of valuation rules will continue to exist, which will particularly be a disincentive for small-medium enterprises; and
- there are concerns that the proposed changes will disproportionately affect start up, research and development and speculative type companies which have limited capital and cash flows, therefore need ESOPs to attract employees.
All in all, there are both good and bad aspects of the ESOPs reforms, but we must await the outcome of the upcoming consultation on the draft ESOP's Exposure Bill expected to be released in early August, 2009. It is critical that the Government continues to encourage employee share ownership and a potential risk is that the number of ESOPs could fall, meaning that there is less ability for companies to potentially attract or retain key important staff. As mentioned, cash poor companies will be particularly impacted by the changes.
The good in this equation is that the proposed rules are undergoing a substantial and regimented consultation process which has attracted the keen interest of key industry players. It is hopeful that this consultation can produce a set of measures which are as good as, if not better than, the existing set of rules.
© DLA Phillips Fox
DLA Phillips Fox is one of the largest legal firms in Australasia and a member of DLA Piper Group, an alliance of independent legal practices. It is a separate and distinct legal entity. For more information visit www.dlaphillipsfox.com
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.