In brief: New tax legislation has been introduced to Parliament that contains tax concessions for employees of small start-up companies who are granted employee shares and options. Partner Sarah Bernhardt (view CV) and Senior Associate Shaun Cartoon, members of Allens' Accelerate team, report.
- The proposed changes
- Shares and options which qualify for the start-up tax concessions
HOW DOES IT AFFECT YOU?
- Under the proposed changes, eligible start-up companies will be able to grant (from 1 July 2015) eligible options or shares to employees which will not be subject to Australian tax on grant, vesting or exercise
- Instead, the employee will be subject to capital gains tax (CGT), generally when the shares are sold. This means that the CGT 50 per cent discount will generally be available at that time
- As the proposed tax concessions are significant, there are important limitations to the concessions
The current tax provisions act as a significant disincentive for start-up companies to offer employees shares and options as part of their remuneration.
In October 2014, the Federal Government announced as part of its Industry Innovation and Competitiveness Agenda that it would reform the tax treatment of employee share scheme (ESS) interests 'to bolster entrepreneurship in Australia and support innovative start-up companies'. That announcement led to the Tax and Superannuation Laws Amendment (Employee Share Schemes) Bill 2015 which was introduced to Parliament on 25 March 2015.
THE PROPOSED CHANGES
Under the proposed changes, as of 1 July 2015, eligible start-up companies will be able to grant to their employees certain options or shares where the employee will not be subject to Australian tax on grant, vesting or exercise. Instead, CGT will apply, generally when the shares are sold. This means the employee will not be required to pay tax on the ESS interests until a realisation event occurs. The CGT 50 per cent discount will generally be available at that time.
Limitations to the concessions include a narrow definition of 'eligible' start-ups, a requirement that the exercise price of options be no less than the market value of a share on grant of the option, and a 15 per cent limit on the discount that can be provided on grant of shares. Where the tax concessions are not applicable, the proposed improvements to the taxation of ESS interests more generally may be relevant. For more on this, see our previous publication – Focus: Sensible changes proposed to the Australian taxation of ESS interests.
SHARES AND OPTIONS WHICH QUALIFY FOR THE START-UP TAX CONCESSIONS
An employee who is awarded ESS interests will only be eligible to access the start-up concessions where the start-up company, the offer terms and the employee are all 'eligible'.
Is the start-up company eligible?
- $50 million turnover limit: the ESS interests must be in a company that has an aggregated turnover not exceeding $50 million for the income year prior to the income year in which the ESS interests are granted. The concept of 'aggregated turnover' includes connected and affiliated entities but ignores certain eligible investments;
- The not-listed requirement: no equity interests in the company in which the ESS interests are granted (or its corporate group) can be listed on an approved stock exchange at the end of the company's most recent income year before the ESS interests are granted;
- The 10-year incorporation limit: the company in which the ESS interests are granted (and all other companies in its corporate group) must have been incorporated for less than 10 years before the end of the company's most recent income year before the ESS interests are granted; and
- Australian residence requirement: the employing company (which may not be the company in which the ESS interests are granted) must be an Australian resident taxpayer.
Are the offer terms eligible?
- The ordinary share requirement: all of the ESS interests available for acquisition under the scheme must relate to ordinary shares;
- Minimum holding requirement: the scheme must be operated so that at all times during the 'minimum holding period' every acquirer of an ESS interest under the scheme must not be permitted to dispose of their ESS interest (or share acquired as a result of the ESS interest). The 'minimum holding period' commences on acquisition of the ESS interest and ends on the earlier of (i) when the employee ceases relevant employment, and (ii) the third anniversary of the date of acquisition or such earlier time as the Commissioner allows;
- Broad availability condition: if the scheme relates to shares (as opposed to options), the scheme will also need to satisfy the existing broad availability condition. This condition requires that at least 75 per cent of the permanent employees of the employer who have completed at least three years of service and who are Australian residents are, or at some earlier time had been, entitled to acquire ESS interests in the employer (or a holding company) under an ESS. Practically, this test has no application in circumstances where a company has been operating for less than three years (and therefore has no employees who have completed at least three years of service);
- Minimum exercise price condition (for option concession): the exercise price of an option must not be less than the market value of an ordinary share in the company at the date of grant of the option; and
- Maximum discount condition (for share concession): the discount provided on the share must be no more than 15 per cent of the market value of the share at the date of purchase.
Is the employee eligible?
- The relevant employment requirement: the employee must be employed by the company (or a subsidiary of the company) in which the ESS interest is granted. If the employee is employed by both the company in which the ESS interests are granted and another company in the corporate group – the compa
- ny in which the ESS interests are granted cannot be a share trading or investment company; and
- 10 per cent maximum shareholding and voting power: the employee and their associates must not have greater than 10 per cent ownership or voting rights in the company in which the ESS interests are granted (including vested rights to acquire shares, and possibly also including unvested rights).
Key features of the tax concession for options
Where options are granted to an employee in circumstances in which the start-up company, the offer terms and the employee are all 'eligible' in relation to the start-up concession, the options will not be taxed on grant, vesting or exercise. Instead, the taxing point will generally be deferred until the eventual sale of the shares, at which time CGT will generally apply (and therefore the CGT 50 per cent discount is likely to apply). Further, for the purpose of applying the CGT 12 month holding period rule, the time of acquisition of the shares will be deemed to be the time at which the options were acquired. Therefore, even if the share sale occurs within 12 months after the date of exercise, the employee should still be eligible to access the CGT 50 per cent discount as long as the options were acquired more than 12 months before the date of sale of the shares.
Key features of the tax concession for shares
Where shares are granted to an employee in circumstances in which the start-up company, the offer terms and the employee are all 'eligible' in relation to the start-up concession, the shares will not be taxed on grant or vesting. Instead, the taxing point will generally be deferred until the eventual sale of the shares, at which time CGT will generally apply (and therefore the CGT 50 per cent discount is likely to apply). Further, the cost base of the shares for CGT purposes will include the market value of the shares when the shares were acquired by the employee. This means that the discount on purchase of the shares (which can be no more than 15 per cent) will be received 'tax free' by the employee.
Valuing shares of unlisted companies
As noted above, the concession for options will only be available where the exercise price of the share is at least equal to the market value of the share on grant of the option and the concession for shares will only be available where the discount on purchase of the share is no more than 15 per cent of the market value of the share. It will therefore be important for start-ups to be able to determine the market value of their shares at the time of grant of the relevant shares or options.
The proposed changes introduce a new power for the Commissioner of Taxation to approve safe harbour market valuation methods for use by taxpayers. The Commissioner is currently in the process of consulting with stakeholders on the development of these safe harbour valuation methods. These approved methods will be binding on the Commissioner but taxpayers can choose to adopt other methods.
The proposed ESS tax reforms for start-up companies are significant and are likely to lead to an increase in equity incentives in the start-up sector. However, ASIC's class order for unlisted companies may not accommodate all offers which attract the start-up tax concessions. Amongst other things, the class order only applies where the value of products offered to a participant in reliance on the class order in any given 12 month period is no more than $5,000 (which may particularly prove to be an obstacle in the case of grant of options). In addition, the class order provides that products must be issued for no more than nominal monetary consideration, whereas tax concessions for grants of shares will only be available where the shares are offered at no more than a 15 per cent discount to their market value. We understand that ASIC is aware of these issues so this is clearly a 'watch this space'. We will keep you updated on further developments in this area.