Changes to the taxation of employee share and option plans in Australia have caused many businesses to re-think the best ways to attract, retain and motivate staff. New laws effective from 1 July 2009 have created a need to review and reconsider employee share schemes. To avoid the complexity and uncertainty associated with traditional employee share and option schemes, consideration should be given to "phantom" share plans.
Traditional employee share and option schemes
The goal of employee share and option schemes is generally to align the interests of the business with the interests of employees in order to attract, retain and motivate staff. However, in a private company setting, this goal is not always best achieved with traditional employee share and option plans.
Employees only benefit from employee share and option plans where they are able to sell the shares and realise a profit. This can present a problem in a private company setting as there is a lack of a ready market for disposal of shares (i.e. the shares are not listed and hence cannot be traded on a stock exchange). There are potentially three sources of buyers – new shareholders (e.g. on a sale of the company), existing shareholders and the company itself (e.g. on a share buyback – however, the taxation implications can be complicated).
In addition, a company's capital structure can be complicated by issuing shares to employees and business owners are not always comfortable with the subsequent loss of full control. This can create difficulties in a sale/exit scenario, although many of these issues can be overcome with an appropriately drafted shareholders agreement.
Care must also be taken to ensure that such plans comply with relevant exemptions from the prospectus obligations under the Corporations Act.
Finally, there is a need for the company and employees to negotiate the complex and sometimes uncertain employee share scheme tax regime. This regime has been the subject of recent and controversial reforms in 2009 with legislation being passed on 2 December 2009 changing the law effective 1 July 2009. The new provisions mean that:
- the company will be subject to reporting requirements which may require valuations to be done at a number of different points in time
- employees will either be taxed upfront or on a deferral basis depending on the structure of the scheme. The employee no longer has the choice as to which method of taxation applies
- if an employee holds more than 5 per cent of the equity in the company, that employee will not be able to access the deferral concession and upfront taxation will apply
- even if the tax deferral concession can be accessed, the taxing point could be triggered at an inappropriate time for the employee, e.g. on cessation of employment and, without a ready market for disposal of the shares, this can result in an unfunded taxation liability for the employee.
Generally employees will expect to be provided with guidance as to the taxation implications of participating in a plan and this can be burdensome for a small business.
Phantom share plans can overcome many of the difficulties associated with traditional employee share and option plans. In addition, they are likely to be less expensive to implement as the taxation treatment is less complicated.
"Phantom" share plans or "share appreciation rights plans" (SARs) are contractual rights for the employee to be paid a certain amount based on an increase in the company's share price or value. They are sometimes referred to as share tracker plans.
For example, if an employee has 1,000 phantom shares with a $1 base price and the market value of the shares on the exercise date is $2, the employee would be entitled to a payment of $1,000. If the market value of the shares on the exercise date is $4, the employee would be entitled to a payment of $3,000.
Vesting of SARs can be dependent simply on increases in the share price or value. Other performance hurdles (e.g. continued employment, profitability /sales targets or the occurrence of an exit event) can also be applied. SARs can be structured to have a similar economic effect to options.
Based on private rulings issued by the Australian Taxation Office, SARS are taxed as income (i.e. a cash bonus) on exercise of the rights and payment rather than at vesting, as is generally the case with options. SARS are taxed as ordinary income and not under the complex employee share scheme tax regime.
The main drawback of a phantom share scheme from the point of view of the employee is that a phantom share will not entitle an employee to dividend or voting rights in the way that holding shares in the company would. The main drawback from the point of view of the company is that it is required to pay cash to the employee if the requirements of the plan are met rather than issuing shares.
How do I start a phantom share plan?
Norton Rose is able to prepare the rules for a phantom share plan and provide guidance as to the correct taxation treatment. If certainty regarding the taxation treatment is required, Norton Rose can also assist businesses to obtain a private ruling from the Australian Taxation Office.
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.