Changes to the taxation of employee share schemes

Legislation enacting proposed changes to the taxation of interests in Australian employee share schemes (ESS), intended to ‘bolster entrepreneurship and innovation in Australia’ is now in force and applies to shares and options issued on or after 1 July 2015.

One month in to the new regime, it is a good time for companies to consider whether they are eligible to take advantage of the new start up concessions and whether offering ESS interests is an appropriate tool to reward employees.

Concessions for start ups

The legislation implements the concessions allowing ‘start-ups’ to issue shares at a discount of up to 15% to market value, or grant of ‘out of the money’ options in circumstances where employees will potentially pay no tax – unless and until those interests are ultimately sold.

To qualify, the employer company must:

• be unlisted and hold no interests in listed entities
• be an Australian resident company with an aggregated (i.e. group) turnover in the previous tax year of up to $50 million
• be incorporated for less than 10 years at the time the option is granted, and
• not be part of a group which includes entities more than 10 years old.

For the scheme, the general conditions that currently apply to all ESS concessions must be satisfied and the scheme must require employees to satisfy a 3 year holding period in relation to the interests acquired (unless employment ceases earlier).

On sale, the shares will be subject to capital gains tax (potentially providing access to the CGT 50% discount).

Newer private companies are likely to qualify where the turnover limit is met however it is important to be mindful of older companies in the group which may mean that the group is precluded from accessing the ‘start up’ concessions.

Summary of reforms for all ESS

In addition to the reforms noted above, there has also been a number of changes to the general ESS rules which apply to all entities.  In particular, the ESS rules now:

• allow certain rights schemes to access deferred taxation treatment even where they do not contain a ‘real risk of forfeiture’ (for example, where the scheme genuinely restricts an employee from immediately disposing of their rights and expressly states that it will be subject to deferred taxation)
• double the existing significant ownership and voting rights limitations from 5% to 10% (but ensuring all interests are taken into account, even those which may not have been exercised)
• amend the provisions entitling employees to a refund of tax paid on the grant of options in circumstances where the employee chooses not to exercise that right, and
• extend the maximum tax deferral period from seven to 15 years. 

Integrity provisions and the up-front $1,000 tax concession for employees who earn less than $180,000 per year (introduced as part of the last reforms to the ESS rules in 2009) have been retained.

As part of this process, the Government has released updated safe harbour valuation tables (used in valuing unlisted rights issued under employee share schemes).  Approved safe harbour market valuation methodologies (to reduce compliance costs in maintaining an employee share scheme and valuing unlisted shares) have also now been released.

Implications

Be aware of the following considerations:

Tax liability becomes payable only when exit is possible

An ESS which exposes employees (particularly those of unlisted companies) to material tax costs prior to the employee having an ability to sell the shares are unlikely to be popular.  Although valuation difficulties have all but been removed for ‘start ups’, where the only taxing point is the ultimate share sale, for companies which do not fall within the ‘start up’ concessions it will be important to ensure that employees are not exposed to significant tax costs prior to realisation of the shares.

Aligning employee ownership and corporate control

Private groups should carefully balance employee ownership and incentives against the potential impact of an employee owner exiting the business.  In these circumstances, a robust ESS designed to take advantage of the relevant concessions should also provide a framework that mitigates unintended dilutions of control.

Long-term succession planning

The increased significant ownership and voting rights limitation (from 5% to 10%) now provides some potential for succession planning, where multiple key employees take a 10% interest in the company, with future transfers or exit strategies in mind.

Not a start up?

Deferral is now more generous for rights and options, however full taxation will still arise upon exit of employment.

There are also other alternatives, including loan plans and phantom schemes which may be more appropriate for certain companies to consider.