Following the release of its Industry Innovation and Competitiveness Agenda in October 2014, the Federal Government has now released exposure draft legislation proposing changes to the income tax treatment of employee share schemes (ESS). The changes are intended to apply from 1 July 2015.
Whilst some changes are aimed specifically at encouraging start-up companies to offer employees ownership in the business, other changes apply to all companies, and will have a broader impact on how employers use ESS as incentives.
ESS overview and current rules
Offering remuneration to employees via an ESS is one way of aligning an employee’s (or director’s) goals with the organisation’s goals in a cashflow effective manner. This is particularly useful for start-up companies, or any other company looking to conserve cashflow whilst providing benefits to employees.
The ESS regime seeks to tax employees where they receive shares, options or other rights to acquire shares in the employer (or related) company, at a discount to their market value. The employee is assessed on the discount at their marginal tax rate.
Currently the timing of when the discount is included in the employee’s assessable income depends on the terms of the ESS. Generally speaking, where the share, option or other right is not subject to forfeiture, the employee is assessed up-front (ie. on receipt). Where the share, option or right is subject to a 'real risk of forfeiture' in the hands of the employee, the taxing point is generally deferred until the forfeiture condition and any other restrictions lift, subject to a maximum deferral period of seven years.
Summary of proposed changes
|Current Law||Proposed Law|
|Rights and options will be subject to up-front taxation if issued with no 'real risk of forfeiture'||Rights and options will be subject to deferred taxation if there is no 'real risk of forfeiture', only restrictions on disposal.|
For shares, rights and options subject to deferred taxation, the taxing point is the earliest of:
For shares, rights and options subject to deferred taxation, the taxing point will be the earliest of:
|A refund of tax paid in respect of a right or option received under an ESS is not available where the right or option lapses.||A refund of tax paid will be available where a right or option received under an ESS lapses, provided the ESS had not been structured to protect the employee from downside risk.|
|The ESS rules generally use the ordinary meaning of market value.||The commissioner will be given the power to approve safe harbour valuation methodologies.|
|Taxpayers may elect to use valuation tables in the Regulations to value unlisted options.||The commissioner will be given the power to update the valuation tables to reflect current market conditions.|
|All ESS rules and concessions apply equally to all corporate tax entities and their employees.||
Concessions will be available for ESS interests received by employees of eligible start-up companies, including:
An eligible start-up company will be defined as an Australian resident, unlisted company that has an aggregate turnover of not more than $50m, and the company and all other companies in the corporate group have been incorporated for less than 10 years. This is sufficiently broad, and should give a number of businesses the opportunity to take advantage of the concession.
However, our view is that the 'up-front discount' for shares is insufficient to make participating in an ESS attractive for employees who are effectively being asked to provide 85% of the purchase price of the share to get a tax-free benefit on the remaining price. Given many start-up companies do not progress past start-up phase, we don’t see this as being particularly enticing for employees.
Changes to valuation rules
The government and the Australian Tax Office (ATO) should be commended for this initiative, although having a number of different valuation tables may lead to some confusion for taxpayers, who will need to ensure they determine the correct deferred taxation point for options in order to use the appropriate valuation table.
It remains to be seen whether this will solve the inappropriate taxation outcomes that currently exist where an unlisted option has no value under the ESS valuation tables, but this value is not accepted by the ATO for fringe benefits tax purposes.
Changes to taxing point of options/rights
The government considers this change to be beneficial for taxpayers on the grounds that it will prevent employees being taxed on a benefit they did not effectively receive, where a deferred taxing point is triggered, but the options are not 'in the money'. We note that this issue appears to be dealt with through changes to the refund provisions, so we question whether the removal of upfront taxation for most options or rights is necessary.
We see a downside of this change to be that the discount on most options will be taxed as ordinary income. No capital gains tax (CGT) Discount will be available for the increase in value of the option if it is held by the employee for more than 12 months, and sold before being exercised (eg in a takeover or initial public offering (IPO)). This is contrasted with a grant of shares under an ESS that are subject to upfront taxation. The capital growth on such shares will be eligible for a CGT Discount on sale provided the employee holds the shares for more than 12 months.
Whilst some of the above changes will no doubt benefit employees who participate in an ESS, particularly in the start-up sector, other changes should be viewed with caution by both employers and employees. If you require specific advice on ESS issues, please do not hesitate to contact the RSM Tax Services team.