In brief - Changes will allow start-ups to incentivise employees while managing cash outlay
On 14 October 2014, the federal government announced that it will reform the tax treatment of employee share schemes (“ESS”). The reform is focussed upon creating greater flexibility in triggering the taxation of ESS benefits. Companies at different, in particular early, stages of evolution will be able to incentivise employees while managing their cash outlay. That is a positive outcome.
Importance of ESS to companies in their growth phase
Companies in their growth phase are usually deploying cash to fund growth and that impacts their ability to incentivise the very employees who are essential to that growth. Non-cash benefits are critical to those companies. ESS are an important element of a non-cash benefits strategy. A softening of the tax blow is therefore most welcome.
Problems with the current taxation regime of equity reward schemes
The system as modified in 2009 is out of step with the reality of ESS by taxing a grant upfront or at the time of the removal of a risk of forfeiture (with a maximum deferral of seven years). That is incompatible with the purpose for which a grant is made, being a reward for contribution to a sustainable increase in enterprise value as a consequence of employee contribution.
Employees are typically taxed in relation to any “discount” they receive - that is, the difference between what the employee pays for the equity (often nil) and the market value of the interest at the time it is liable to be taxed.
Together with the burden of upfront taxation in the short term, there may be little or no market for shares in companies in a growth phase, particularly those that are not listed. An upfront tax liability with no real way to convert the shareholding to cash is no incentive at all.
Current arrangements discourage use of employee share schemes
The negative consequence of upfront taxation is that often a tax liability is imposed at a time when the true potential of a share is not known. Taxation upfront does not factor in the uncertainty of the risk of holding the interests. The outcome can be that tax is paid on a value that is never realised.
While there are some safeguards allowing a deferral of the taxing point, those are insufficient, overly complex and provide no practical relief unless, of course, the interests are ultimately forfeited.
Consequently, this has discouraged the use of these schemes and disadvantaged companies that cannot adequately reward talent with cash. Add to this the requirement for costly valuations of options and performance rights in unlisted companies and the evidence illustrates that the 2009 changes have severely impacted the use of equity reward schemes for employees.
Proposed reforms – concessions for start-ups and removal of upfront taxation
Generally upfront taxation will be removed, with shares and options to be taxed only on sale of shares or exercise of options, subject to a three year holding requirement and a maximum deferral period of 15 years. That is, there will be a taxing point once shares or options have been held for 15 years.
The 15 year deferral is particularly relevant to growth companies, where there would be sufficient time for the growth strategy to deliver the enterprise value outcomes, meaning tax would be payable on interests to which real value has been attributed.
Certain companies (start-ups which are less than 10 years old with turnover under $50 million) would be able to issue shares at a discount of up to 15% without tax consequences for the employee, subject to the satisfaction of the minimum three year holding period.
Lastly, in certain circumstances (basically options issued by start-ups), gains on options will be taxed as capital gains attracting concessional treatment afforded to capital gains in comparison with normal income.
In terms of other matters:
- A new valuation methodology is to be adopted for options
- Various integrity features of the 2009 reforms will be retained
- The $1,000 upfront tax concession will be retained
Matters requiring further clarification
A number of matters are yet to be clarified:
- Whether the 50% discount concession on capital gains would apply to sale of shares or options that have benefited from a deferral of the taxing point
- Limits upon the size of shareholdings in start-up companies that can qualify for tax deferral
- How the proposed valuation methodology for options would work
Review your employee incentive schemes in light of proposed changes
This legislative framework is anticipated to take effect from 1 July 2015. Current employee incentives schemes should be reviewed and assessed in light of the proposed changes. In particular, consideration should be given to whether certain incentive schemes should be converted to arrangements that would qualify for taxation treatment under the newly proposed rules.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2022.