On Friday 31 July 2015, the Federal Court handed down its substantive decision in Davies v Deputy Commissioner of Taxation  FCA 775 (Davies)*. The decision is likely to have a significant impact on the application of the employee share scheme (ESS) rules in circumstances where employees acquire conditional rights to acquire ESS interests due to the application of the indeterminate rights provisions. In particular, the taxing point of ESS interests acquired by employees pursuant to an earlier (or conditional) right is likely to be brought forward pursuant to the application of these provisions. Perhaps of even greater impact will be rights acquired just before the introduction of the changes to the ESS rules on 1 July 2009 and 1 July 2015, where those rights become ESS interests after that date.
This case concerns the proper tax treatment of a large quantity of shares and options granted to the trustee of the taxpayer’s family trust (Dalara) under the employee share scheme rules.
Mr Davies was appointed as an executive director of Whitehaven in early 2009. Part of this remuneration package was the issue of 2.5 million shares and options to acquire 5 million shares which would vest in three equal tranches on 14 December 2009, 31 October 2010 and 31 October 2011.
On appointment, Mr Davies acquired a conditional right to acquire shares and options in his employer company (listed on the ASX) during the 2009 year. However as a director of a listed company, the right to acquire shares was subject to the approval of shareholders at the company’s general meeting (which was given in the following income year).
Mr Davies contended that the shares and options should be brought to tax pursuant to the ESS rules in Division 13A Income Tax Assessment Act 1936 (1936 Act) (which operated up to the end of the 2009 income year). The Commissioner’s view was that Mr Davies did not acquire an ESS interest until the grant of shareholder approval. As this only occurred after 1 July 2009, the issue of shares and options should be brought to tax under the new ESS rules in Division 83A Income Tax Assessment Act 1997 (1997 Act).
Justice Perram held that ‘[i]n the case of both the shares and the options, each started life on 27 April 2009 as a contingent right to receive shares. Both became rights to acquire shares after the meeting on 17 November 2009 (in the case of the share package) and on the date of the relevant options’ exercise (in the case of the options). This appears to fall directly within section 83A-15(1) [Income Tax (Transitional Provisions) Act 1997]’’.1
The reasons for this decision were four-fold:
- Section 83A-15 Income Tax (Transitional Provisions) Act 1997 (Transitional Provisions) is satisfied where what is acquired is a contingent right to acquire shares, which upon satisfaction of the condition ‘becomes’ a right to acquire shares
- the decision of the Full Federal Court in Fowler v Commissioner of Taxation2 (Fowler) does not displace this position – in fact, Fowler deals only with whether the taxpayer had a more than a conditional right to acquire shares. In Davies, the taxpayer accepted that his right was conditional upon shareholder approval
- binding authority establishes that the satisfaction of a contingency in respect of a right does not itself create a new right, but merely completes a right which already existed, and
- the explanatory memorandum (EM) to the introduction of the indeterminate rights provisions (specifically, the examples used in the EM [and the legislation with respect to 83A-340 of the 1997 Act] cannot be read so as to restrict the plain reading of the words used in the provision.3
The law prior to the introduction of the ‘indeterminate rights’ provisions
The proper timing of the date of acquisition of ESS interests for the purposes of determining the tax payable in respect of those interests has been the subject of much litigation in recent years.
In cases such as Commissioner of Taxation v McWilliam4 (McWilliam) and Fowler, the Federal Court considered the nature of the rights required in order to fall within the ESS rules – in particular, whether and when an employee will have acquired a beneficial interest in a right to acquire a beneficial interest in a share.
In McWilliam5, the Federal Court considered the nature of rights acquired by Mr McWilliam upon commencing employment with the Seven Network Limited.
Based on findings of fact made by the Administrative Appeals Tribunal (Tribunal), the Federal Court agreed with the Tribunal that Mr McWilliam had acquired an unconditional right to acquire beneficial interest in a share (an option) upon commencing employment with the company. Importantly, the Court accepted that the reference in the ESS rules to ‘rights to acquire a beneficial interest in a share’ was sufficiently wide to include a right to be granted an option. As such, an (unconditional) right to be granted an option was an ESS interest for the purpose of the ESS rules and was not a form of ‘anterior entitlement’6 which did not come within the provisions.
In Fowler7 the Full Federal Court (on appeal from the Federal Court), considered the nature of the rights required to fall within the ESS rules in circumstances where the employee’s right was subject to performance of a condition precedent. The Court’s conclusion in Fowler was that, at the time Mr Fowler agreed his remuneration package with the Board, he did not have a right that was sufficient to amount to an ESS interest because he did not have an enforceable right, directly or indirectly, to acquire shares (or a beneficial interest in shares) in the company.8
Following McWilliam and Fowler, the law was settled as to what is required to amount to a right to acquire a beneficial interest in a share (an ESS interest) for the purpose of the ESS rules.
Based on these decisions, it was clear that Mr Davies did not have an unconditional right to acquire shares and options in Whitehaven at the date the Deed was executed, or at the earlier date when the directors resolved the nature of Mr Davies remuneration package. Yet at the time the shareholders approved Mr Davies’ remuneration package at the AGM in November 2009, he had acquired the requisite interest.
The question for determination in this case was whether the rights acquired by Mr Davies ‘became’ ESS interests when the condition (shareholder approval) was satisfied. If so, the indeterminate rights provision in the Transitional Provisions would operate to bring those interests to tax at the date they were acquired, rather than the (later) date that the condition was satisfied.
By its very nature, the beneficial interest in the right that is acquired prior to the 1 July 2009 must be something less than an ESS interest under the ESS rules.
In both McWilliam and Fowler the Court only considered the operation of the ESS rules in Division 13A 1936 Act. To the extent that those rules were replaced (without amendment) by provisions in Division 83A 1997 Act, it was accepted that the principles laid out in those cases will apply to the new ESS rules in Division 83A. However, Division 13A 1936 Act had no equivalent to the indeterminate rights provision introduced with Division 83A 1997 Act in July 2009. As such, neither case considered the application of this provision, nor the impact such a provision would have upon the application of the ESS rules as set forth in those cases.
Section 83A-15 of the Transitional Provisions (at issue in Davies) applies to determine the timing of the acquisition of ESS interests, in circumstances where a right was granted prior to the commencement of Division 83A 1997 Act on 1 July 2009 but the interest itself (i.e. the share or option) is granted after this date (upon attaining shareholder approval).
Similarly, section 83A-340(1) 1997 Act operates as a timing rule to ascertain the date that employees are deemed to have acquired an ESS interest under the employee share scheme rules.
In late 2014, the Commissioner finalised Tax Determination (TD) 2014/21 which was aimed at providing guidance on the Commissioner’s view of the operation of the indeterminate rights rules in the context of employee share schemes.
The determination concludes that, in circumstances where a right to acquire a beneficial interest in a share is subject to shareholder approval, it will not be an ‘indeterminate right’ for the purposes of the ESS rules in Division 83A. In reaching this conclusion, the Commissioner distinguishes between a right to receive something that is yet to be determined (which will fall within the provisions), and a right in respect of which it has not yet been determined whether the taxpayer will receive anything (which will not fall within the provisions). As noted in the determination, this interpretation is also adopted by the Commissioner in Class Ruling (CR) 2011/19.
Despite the assertion that the position adopted by the Commissioner in TD 2014/16 and CR 2011/19 is supported by the decision in Fowler, as noted by Justice Perram9 , the contrary is true - the decision in Davies is actually supported by statements made by the Court in Fowler.
In particular, when referring to the conditional rights acquired by Mr Fowler prior to shareholder approval, Justice Besanko noted that:
‘at [the date conditional agreement was reached, Mr Fowler] had an entitlement which may have led to the acquisition of shares. It may be said that the directors' resolution was the source of the appellant's right to acquire shares… All of these things may be accepted at a general level, but to my mind they do not address the essential question of the nature of the legal right the appellant had as at 14 September 2006. That was a right that may have led to the acquisition of a right to acquire shares, but it was not a right to acquire those shares'.10 (emphasis added)
The decision in Davies is now in direct contrast to the position adopted by the Commissioner in TD 2014/21, whether aright to acquire a beneficial interest in a share that is granted subject to shareholder approval, is an indeterminate right for the purposes of the ESS rules.
Where to from here?
Based on recent decisions, the law was quite settled on what is required to amount to a right to acquire a beneficial interest in a share (an ESS interest) for the purpose of the ESS rules. On occasion, something less than an option will be an ESS interest (noting that, based on McWilliam, an unconditional right to acquire options will suffice). However, neither a mere right to accept an offer (Fraunschiel v Commissioner of Taxation (1989) 20 ATR 955), nor a conditional right to acquire options (Fowler) will be sufficient to amount to an ESS interest.
Yet, by its very nature, the beneficial interest in the right acquired (to which the indeterminate rights provisions will apply) must be something less than an ESS interest under the ESS rules.
Given the Commissioner has recently confirmed that he will not appeal the Federal Court decision, where does this leave us? When will a conditional right to acquire shares, which later becomes an ESS interest, be enough to trigger a taxing point under the ESS rules? And what is the impact of this decision given the more recent amendments to the ESS rules in the context of interests issued by ‘start ups’?
To the extent that rights are acquired post 1 July 2015 and the taxpayer is eligible to access the ‘start up’ concessions, the decision in Davies is likely to have very little impact, given that no taxing point will be triggered until ultimate disposal of the shares.
However, following the decision in Davies, in circumstances where an employee is granted a conditional (indeterminate) right to acquire shares and that condition is satisfied post 1 July 2015, access to the new concessions may no longer be available, with the date of grant reverting to the earlier time (pre 1 July 2015) when the conditional right was granted. This means that the taxation of such rights will be brought back within the ESS regime which existed prior to this date.
In circumstances where the ‘start up’ concessions do not apply, at the very least, the timing of taxation will be shifted from the date that any conditions are satisfied to the date the conditional rights are granted.
Further, Taxpayers who have completed income tax returns on the basis of having acquired a right to be issued with ESS interests on the date that such interests became unconditional (consistent with the decision in Fowler), may now be required to amend their income tax returns based on the application of the indeterminate rights provisions to include the discount as at the date a right to those interests was first acquired.