On 14 January 2015, Treasury released exposure draft legislation that is aimed at reforming the taxation of Employee Share Schemes (“ESS”).
While the stated aim of the draft legislation is to create special concessions for start-ups to encourage them to reward key employees with equity in the business, there are incentives for all employees to structure salary packages using employee share schemes – particularly schemes involving options.
If the legislation survives the senate and becomes law, the amendments apply to employee shares and options acquired on or after 1 July 2015.
Under the draft legislation all rights acquired under an ESS will be subject to deferred taxation even if the rights contain no real risk of forfeiture. Currently, only shares or rights that are subject to a real risk of forfeiture obtain this deferral.
This is significant and it means in practice that the new rules alter the taxing point for options acquired through ESS so that it occurs not at the point at which an option can be exercised but at the point at which it is exercised.
|EXAMPLE – Assume Melvin is employed by Arafura Ltd, an ASX listed public company.On 1 March 2016, Arafura grants Melvin 1,000,000 options to acquire shares in Arafura. The options have an exercise period of 72 months and an exercise price of $1.30. Arafura’s share price on 1 March 2016 was $1.00.The options have no restrictions attached and Melvin may exercise these options from the date they are granted.Assume that under new safe harbour valuation methodologies (see below), the market value of 1 Arafura option is $0.0078.Assume also, that Melvin does not exercise the options until he retires on 1 March 2021.If the current rules remain in place, Melvin must include $7,800 (1,000,000 x $0.0078) in his assessable income in the 2016 year despite having crystallised no economic gain on the options or underlying shares.If the new rules as currently drafted come into play then Melvin should be able to defer the tax on the options until he has realised the paper gain on the options, which is in the 2021 income year.Crucially, tax will be payable by Melvin when he has the cash from the exercise of the options and subsequent sale of shares rather than in the 2016 income year as is currently the case. This makes options a much more attractive method of packaging salaries and provides employers with a new weapon in the war to retain key staff.
Special concession for start-ups
Under the draft legislation, employees of eligible Australian start-up companies that receive shares or rights under an ESS will not have to include the discount in their assessable income. This is provided the discount is small enough to satisfy the parameters of the legislation.
Eligible companies must be unlisted. They must have been incorporated a maximum of 10 years before the share or right was provided to the employee and must have an aggregated turnover not exceeding $50m for the income year prior to which the share or right was provided.
For shares, the discount will be exempt from tax in the hands of the employee, provided the value of the discount is less than 15% of the market value of the share at the time it is issued. Moreover, the capital growth will be taxed as a capital gain and no part will be taxed as ordinary income and as such CGT concessions, such as, the CGT Discount can be accessed. Finally, when working out the capital gain, the employee shareholder will have a cost base of market value of the share at the time of issue.
For options, the discount will also be subject to deferral provided the strike price is greater than or equal to the market value of ordinary shares in the issuing company at the time the option is provided to the employee. In working out the capital gain on the option, the option will have a cost base equal to the employee’s cost of acquiring the right.
Other improvements to the ESS rules
There are other significant improvements to the ESS under the exposure draft legislation. These include:
- Refunds of overpaid tax. Employees that paid tax upfront but never exercised the options acquired under an ESS will be entitled to a refund of income tax paid, provided the scheme satisfies certain anti-avoidance conditions.
- Employees with significant existing ownership will be able to top up their existing shareholding and remain in the ESS rules. Under the draft legislation, the threshold that limits employee shareholding and voting rights will be relaxed from 5% to 10%, allowing employees to obtain a greater share of ownership in their employer.
- The ATO will work with industry to develop safe harbour market valuation methodologies and the Commissioner will have new powers to approve valuation methods as he sees fit.
- The maximum deferral of the taxing point of the discount on both shares and rights will be increased from 7 to 15 years.
What to do
These changes to the ESS rules represent a significant opportunity for employees of larger organisations that have the ability to structure their salary package using options. Employees and employers of eligible start-ups can also take advantage of the special concessions that are available to them.
While the legislation still needs to get through parliament, it is worthwhile planning for these changes now. Contact myself or your local advisor for more information. Better yet, we will be hosting two breakfast seminars on Tuesday March 24th and Thursday March 26th which will help guide you through these changes and answer some of your questions. Please register now for your preferred date.
Partner, Tax Advisory
James has 20 years of experience in the corporate tax industry in Australia, the UK and New Zealand, including with listed multinational corporations and private groups, and two years in a senior role with the New Zealand revenue authority.
He also has extensive experience dealing with cross-border investments and mergers and acquisitions, including tax due diligence, structuring and execution, and eleventh-hour commercial changes. Before entering the tax profession, James worked in manufacturing and policy.