SO IN BROAD TERMS WHAT DO THE CHANGES AFFECT?
As part of its Industry Innovation and Competitiveness Agenda, the Australian Government committed to changing the tax treatment of employee share schemes (ESS) that were introduced by the former Government in 2009. In January 2015, the Australian Government released exposure draft legislation, and following a period of consultation with key stakeholders, draft legislation was introduced into the Australian parliament on 25 March 2015.
Once that draft legislation is passed into law, the ESS tax rules implemented in 2009 will be reversed (at least in part), and a new ESS tax regime will come into effect for ESS grants made on and from 1 July 2015. The current tax rules will continue to apply to grants made before 1 July 2015.
Late last year, the Australian Securities and Investments Commission (ASIC) also released new ESS relief in the form of two new class orders: ASIC Class Order 14/1’000 for listed entities; and ASIC Class Order 14/1’001 for unlisted entities. These new class orders provide relief to companies from disclosure (prospectus), licensing and hawking requirements under the Corporations Act 2001 (Cth) for offers of securities made under employee incentive schemes, and provide more broader relief, in terms of incentives and types of participants covered, than was previously available.
One issue with the current tax rules is that to defer income tax on an ESS discount, the offer to an employee needs to include a “real risk of forfeiture”. This means that in order not to give an employee an “up-front” tax bill, their equity interests needed to be “at risk” of being forfeited, if certain circumstances arise. The most common condition of forfeiture is where the employee leaves employment pre-vesting and this would mean that they forfeit their interests. This can make it very hard for employers to incentivise employees where the employee may have the choice between paying tax up-front, or deferring tax, but practically attributing nominal or nil value to their ESS equity, due to the risk of forfeiture.
The process by which options are valued can also create the situation where “out of the money” options (i.e. where the exercise price is more than the share market value) will still have a positive market value for tax purposes, generally due to the period that the option can be exercised. This creates an unusually unfair outcome as the employee can be taxed when an option vests, even if the option is “out of the money”, and even in circumstances where the option may not be exercised and the employee may never realise any value in the future. Not surprisingly, this saw a movement away from issuing options to Australian employees.
SO WHAT ARE THE PROPOSED TAX CHANGES FOR ALL COMPANIES ISSUING OPTIONS?
Under the proposed tax changes, employees who receive options (or rights to acquire shares) will generally only be subject to income tax on any discount once the option has been exercised by the employee (provided the option itself cannot be traded) and there are no disposal restrictions on the resulting shares. This position is broadly consistent with the treatment of ESS in other countries. That tax deferral may now also extend for up to 15 years.
Tax deferral may also be available in some circumstances even when there is no risk of forfeiture of an ESS interest, but that ESS interest is restricted from being immediately disposed of by the employee. In order to meet this test the scheme documents are required to state that the ESS is subject to specific provisions of Australian tax legislation. This amendment may allow companies to introduce new plans or reintroduce old plans, such as salary and bonus sacrifice plans, where the employee considers that they have already “earned” the award and as a result an employee would not wish to participate where there was a risk of the employee forfeiting the shares granted to them.
ISSUE TO BE AWARE OF!
Unfortunately, the cessation of employment as an earlier taxing point will remain, keeping Australia out of step with most of the developed world. Where an employee ceases employment but continues to hold their options/rights (perhaps because they are a “good leaver”), then they will still be required to pay tax at the time of cessation while not having yet (and maybe never having) realised any value. As a way of partially addressing this issue, if an employee chooses not to exercise those options in the future or allows those options to lapse, the employee will be able to obtain a refund of the income tax they have already paid.
The general eligibility conditions for employees to be able to receive tax deferral will also be relaxed, so that employees who do not own more than a ten percent shareholding in their employer or who do not control more than ten percent of the voting rights in their employer, can access that deferral (an increase from the previous five percent limits). These limits are obviously more relevant for smaller companies operating in the sector.
Capital gains tax (CGT) will remain payable on the sale of shares granted or which are received on exercise of an award, and where the shares are held for more than twelve months and certain other requirements are met, the 50 percent CGT discount will continue to apply to any capital gain. However, for options/rights, any increase in value between vesting and exercise of those options/rights will be subject to income tax and not CGT (and any increase during that period will not attract the 50 percent CGT relief).
ISSUE TO BE AWARE OF!
For those companies who do not meet the start-up criteria (see below), employees may still not be able to readily transfer or sell their shares in any event. This could be the case where private companies restrict the ability of employees to transfer shares outside of a quarantined group of ‘related’ people and entities, and even for listed companies whose shares are thinly traded. For employees of those companies, they can still be left in the position where they are required to pay tax in circumstances where they may not be able to easily realise any benefit. Expert assistance should always be sought in these circumstances.
WHAT ARE THE PROPOSED TAX CHANGES FOR START-UP COMPANIES?
As part of the changes, the Australian Government has proposed specific tax concessions where a “start-up company” meets specific criteria. When those criteria are met, the discount on an ESS interest issued by these companies is not included in an employee’s assessable income. The intention behind these proposals is that start-ups are able to offer employees more attractive remuneration packages to attract more and better talent.
WHAT IS A START-UP?
The term start-up is not itself defined and the rules are not limited to a particular type of business.
- The main qualification requirements for a company to be an eligible start-up company are:
- the company must not be listed;
- the company and all group companies must be less than ten years old;
- the aggregated turnover of the group must not exceed AU$50 million (aggregated turnover including connected entities and foreign entities connected to the group);
- for shares – the discount on the ESS interest must be less than 15 percent of the market value;
- for options and rights – they must have an exercise price that is equal to or greater than the current market value of an ordinary share (i.e. issued at market value or out of the money);
- an employee must be required to hold their shares, options or rights for the ‘‘minimum holding period’’. The minimum holding period is the same period which currently applies (and will continue to apply) for $1,000 tax exempt schemes – the shares, options or rights must be held for three years or until the employee ceases employment. The Tax Commissioner may exercise his or her discretion to reduce this period (and as a result for the concession to continue to apply) in situations where all relevant employees are required to dispose of their options, rights or shares prior to the end of that period (such as on a trade sale or IPO) and where there was an original genuine intention for the minimum holding period to have been met; and
- for shares (but not options or rights) – the scheme must be available to at least 75 percent of the permanent employees with at least three years’ service; and
- an employee must not hold more than 10 percent of the shares in the company (including the shares that could be acquired by exercising options/rights held by that employee).
In applying the listing, the 10-years and aggregate turnover threshold limits, investments by eligible venture capital and early stage venture capital funds can be ignored. This will mean that assets and investments of those kinds of partnerships and funds will not affect an investee start-up company’s ability to access the start-up concessions.
As part of the consultative process, the Australian Government acknowledged that there were strong calls for the start-up company concessions to be extended to cover biotech and other companies (including those incorporated for more than 10 years), but no extension of the concession was made to meet those calls.
The requirement that only a “small discount” apply to the options/rights or shares means that eligible start-up companies wishing to issue options which are immediately “in the money,” performance units or rights (which are akin to an option with a zero exercise price or ZEPOs), or shares at a significant discount to employees, will not be able to take advantage of the proposed tax concession. The Australian Government’s position is that this requirement is necessary to ensure that the concession is appropriately targeted, is not subject to potential abuse through inappropriate salary packaging, and is fiscally sustainable.
Generally where a share is sold, it must have been held for more than 12 months in order for an employee to be eligible to receive the 50 percent CGT relief. The draft legislation makes clear that the 50 percent CGT relief will be available to an employee where they have received options or rights subject to the start-up concession and they have held the options/rights and shares collectively for at least 12 months, even where the shares they received on exercise have been sold by them within 12 months of exercise of their options/rights.
The restrictions in terms of ownership and discount value are not helpful. Often start-ups seek to supplement cash remuneration by offering executives an ESS interest as a way to attract and retain talented individuals. These parts of the rules, in effect, restrict the amount of salary that can be supplemented in this way. In addition, the limitation on the discount will require companies to value the shares of the company to ensure the discount limit is not exceeded (which may increase compliance costs).
WHAT ISSUES DO THE NEW ASIC CLASS ORDERS ADDRESS?
ASIC now provides more standard relief for companies than it has previously (although available relief continues to be more restricted for unlisted companies than that available for listed companies).
The new class orders also address a number of issues previously experienced by companies when seeking standard relief. Some of the key improvements include:
- widening the range of financial products that are eligible for relief, particularly in relation to offers made by listed entities;
- extending the types of participants that can be potentially covered;
- reducing the administrative burden of complying with class order requirements, including those specific to trust structures and the regulatory notification requirements; and
- increasing the cap on the number of shares that may be offered from five percent to 20 percent for unlisted entities in recognition of the greater need for such entities to use these schemes to incentive and retain employees.
However, some issues do remain, including:
- some incentive schemes will remain excluded from coverage (such as schemes that offer phantom/ shadow shares or certain derivative instruments) and specific relief will still need to be sought;
- some contribution plans will remain excluded from coverage (including where contributions can be used to acquire options or “incentive rights”); and
- in relation to loan funded share schemes, coverage is restricted to where interest-free loans are used.
WHAT DO THESE CHANGES MEAN FOR COMPANIES AND PARTICIPATING EMPLOYEES?
The proposed tax reforms are a welcome development, as they will provide some measure of control to an employee as to when their options are taxable (when the options are actually exercised) and reduce the risk of an employee being taxed on options received at a time when they have not actually realised any value. Those employees will now potentially be able to fund their tax bill by selling some of the shares they receive on exercise. Clearly a common sense result.
However, these tax reforms do not appear to go far enough in meeting all of the challenges faced under the current tax regime and to allow Australia to effectively compete with other jurisdictions in relation to attracting and retaining talented employees.
The relief available under the new ASIC class orders should assist companies to continue to offer, and in some cases expand to offering, Australian based employees (and others) participation in ESS.
Companies will need to seek expert guidance on whether any of their current schemes and/or practices need to be modified in order to meet the new ASIC class order requirements and to operate as intended under the proposed tax changes.