Recruiting and retaining high-quality staff is essential to the success of almost any business. Research suggests that companies in which employees have an ownership interest are more productive than those that do not. In this article I ask – do the new employee share scheme rules provide an opportunity for the savvy employer?
An ESS is a scheme under which shares, stapled securities or rights (e.g. options) to acquire them (ESS interests) in a company are provided to an employee or their associate in relation to the employee’s employment. If these ESS interests are provided at a discount to market value the discount is taxable in the hands of the employee.
Recently the laws surrounding the taxation of ESS interests have changed. These changes apply to ESS interests acquired on or after 1 July 2015. The intention of the new law is to make employee share schemes easier, cheaper and more attractive and by doing so;
- Facilitate better alignment of interests between employers and their employees, thereby leading to more productive relationships, higher productivity and reduced staff turnover.
- Allow Australian businesses to be more competitive in recruiting and retaining talented employees in the international labour market and
- Stimulate the growth of start-ups (which are often cash-strapped)
As an employer, now is a good time to consider whether an employee share scheme should be part of your organisation’s remuneration mix.
The previous state of play (i.e. prior to 1 July 2015)
The default position is that the discount is assessable in full in the year that the ESS interests are granted. However, if conditions are met, one of two concessions may be available;
- A $1,000 reduction or
- Deferral of the taxing point.
In my experience schemes that defer the taxing point are typically the most attractive and so the remaining of the article will focus on them. Deferral will be available when all of the following apply;
- The employee has a genuine risk of losing the interests (e.g. by failing to meet performance criteria or being required to continue employment for a certain period)
- The scheme is made broadly available – i.e. it is available to at least 75% of Australian employees with at least three years of service
- After acquiring the ESS interest the employee does not hold an interest in the company of more than 5%.
Note that the second requirement only applies to shares and therefore employers who wish to target key personnel are advised to issue rights (i.e. options), rather than shares.
Where such conditions are met no tax will be payable until the earliest of one of the following times;
- When the employee ceases employment
- When the risk of forfeiture has been removed and there are no genuine restrictions on the disposal or exercise of the interest and
- Seven years after acquisition
What has changed?
The new legislation introduces a number of significant changes;
- The maximum period of deferral has been extended to fifteen years
- In the case of rights the deferred taxing point is extended, from when the right can be exercised, to when it is actually exercised
- The maximum level of ownership has been increased to 10%
- Access to deferred taxation will be available in a broader range of situations
- The circumstances where employees are entitled to a refund of tax previously paid on forfeited ESS interests has been broadened
- New valuation rules have been introduced
The additional concessions for ‘start-ups’
The new rules also introduce further concessions for small start-up companies. Both ‘small’ and ‘start-up’ are defined very broadly and many employers will qualify. Under the concession an employee does not need to include a discount on ESS interests in their assessable income if certain conditions, beyond the general conditions that apply to all ESS concessions, are satisfied;
- The employer must be an Australian company, it, and all companies in the group, must have been incorporated for less than ten years, it must not be listed on an exchange and the combined turnover of the group must not exceed $50m.
- The employee must hold the interests for three years or until they cease employment
- If the scheme relates to rights, the exercise price (i.e. strike price) must be at least equal to the market value of the share at the grant date and
- If the scheme relates to shares, it must be made broadly available (see above) and the discount cannot be more than 15%
For capital gains tax purposes shares are deemed to have been acquired for their market value and rights for the employee’s cost of acquiring them. Furthermore, the exercise price of rights will form part of the cost base of the resulting shares. When a resulting share has been sold the tax on any gain can be halved if the rights were acquired more than 12 months earlier.
New valuation rules
Calculating the assessable discount requires the employer to determine the market value of the company, possibly at multiple points in time during the year. In the case of unlisted companies this can place a prohibitive administrative burden on the employer.
The regulations to the 97 Act contain safe harbour valuation methodologies. However, these are highly complex and, having not been updated since the 1990s, are based on outdated estimates.
New valuation methodologies have recently been issued by the Commissioner. It is expected that these will be simpler and will result in the value of most options being lower than the previous regulations.
Employer Pty Ltd was established on 1 July 2007. On 1 July 2015 it was not listed, had a turnover of $40m and was not part of a corporate group.
At this time Employer granted, for no consideration, 10,000 options to Bob, an important employee. In three years time, if Bob continues to work for Employer, he may exercise the options for $2 each, being the market value of a share in Employer at 1 July 2015.
On 1 July 2018, with the value of Employer’s shares being $5 each, Bob does in fact exercise all of his options. Immediately afterwards he sells the shares. Effectively, Bob has made a gain of $30,000 but he will not be taxed on this gain under the employee share scheme rules. Instead he will make a capital gain of $15,000, being half of $50,000 proceeds less an exercise price of $20,000.
Recent changes have made issuing ESS interests to employees more attractive, particularly for options. I would encourage all employers to consider if an employee share scheme is consistent with their overall business strategy and their strategy for retaining and recruiting key staff. If so it may be a good idea to include them in your remuneration mix.
Of course not all employee share schemes are created equal and, if you are considering implementing an employee share scheme, I recommend you contact a professional adviser for assistance in formulating the ideal scheme for your business.
This post is intended to be a broad overview for information purposes only. It does not constitute advice. I urge you to seek professional advice that is tailored to your personal circumstances.