Background

When was the last time Australia’s two major political parties stood united behind an area of reform with unmitigated and unconditional support?  An answer to that question might prove illusive – bipartisan consensus is becoming increasingly rare in the Australian political landscape.  So when the Coalition and Labor parties openly support the same piece of legislation and its safe passage through both Houses of Parliament, it would be expected that the enactment of those laws will go on to have irrefutable and significant positive outcomes for the economy.

It is expected this will be the case when reforms to the tax regime for employee share schemes (ESSs) are formally passed. This opinion, was first articulated in December 2013 in our newsletter publication entitled Employee share plans – Lazarus returns! focused on class order relief offered by the Australian Securities and Investments Commission (ASIC) to encourage the use of ESSs by companies struggling to comply with the related regulatory requirements.  However,  the more prominent disincentive to employers to adopt an ESS was the adverse tax consequences directly flowing from tax reforms made by the Rudd Labor Government in 2009. 

The proposed changes to the 2009 reforms are found in the Tax and Superannuation Laws Amendment (Employee Share Schemes) Bill 2015 (Bill) introduced before Parliament on 25 March 2015, stated to come into effect on 1 July.  The net effect of the passing of this Bill will be not only the reversal of changes made to the tax regime by the Rudd Labor Government, but also the bolstering of benefits and concessions able to reaped by companies (especially small start-up companies) and their employees by implementing an ESS.

A snapshot of employee share schemes

ESSs, sometimes also referred to as employee share option plans, are an invaluable means by which companies are able align their own interests with those of existing or prospective employees, providing an alternative for companies, still in relative infancy, to attract employees and incentivise them to perform.  An employee’s ‘sweat equity’ (representing the employee’s effort and contribution to the company) is exchanged for real financial equity through the issue of shares, options or other rights to allow them the choice to acquire a number of the company’s shares at a specified time or times in the future.  The attractiveness of an ESS when offered to an employee is sweetened by the employer offering the shares at a discounted value when compared to market price.  

One does not need to look far to find noteworthy examples of companies that champion their ESS as pivotal chapters of their overall success stories. Google and Amazon are perhaps the most remarkable examples, but the value of ESSs to small to medium businesses and start-ups companies in Australia cannot be overlooked. It is estimated that over 400,000 Australians own shares in the companies they work for, and research has shown that the alignment of employer-employee interests through an ESS bears a multitude of positive outcomes: boosts to productivity, increased job satisfaction and engagement, reduced staff turnover, robust corporate governance and strong work relationships. For small start-up companies in particular, an ESS is an attractive vehicle for incentivising talent to help grow the company by aligning their interests to those of their employer as an encouragement to stay along for and actively contribute towards the company’s continued growth. 

The need for reform – a brief timeline 

Reforms by the Rudd Labor Government in 2009

In 2009, the Rudd Labor Government identified the use of ESSs as a means by which highly-paid executives could artificially reduce their income tax liability by channelling income that would otherwise be received through a salary towards shares or share options under an ESS, and therefore reduce the income tax bracket that taxpayer fell into.

At the time, employees were able to defer the tax payable on shares (or options or rights in respect of shares) for up to ten (10) years.  The ensuing changes to the Income Tax Assessment Act 1997 (Cth) (ITAA) introduced by Labor resulted in tax instead becoming payable immediately on the issue of the shares and then again also upon the vesting point of an option in respect of additional shares (of which there may have been many, depending on the structure of the ESS). This was designed to detract taxpayers away from the practice of funnelling income into an ESS and it was believed that this reform would increase the Government’s tax revenue by up to $150 million annually over four years.

The reforms, however, came with significant collateral damage. Start-ups and other small to medium sized companies relying on the use of ESSs to recruit and retain talent in lieu of competitive ‘real dollar’ salaries were hit hard, with employees being faced with upfront tax liability at the time they received the shares and again also whenever a vesting point was reached in respect their options. In other words, tax liability would be triggered at the time of issue and not at some later time when the benefit of the share was derived or the share itself was disposed of. The resulting effect was an almost instantaneous diminution in the value of using an ESS in the eyes of employers and employees. In a survey conducted by Deloitte in early 2013, it was found that over 80% of respondent employers agreed that the adverse tax treatment was the main consideration in their reluctance to participate in an ESS.

2013 Federal election 

Heading into the 2013 Federal election, then-Shadow Treasurer, Joe Hockey, denounced the changes to the tax regime for ESSs as being ‘a massive handbrake for start-ups in Australia’ and it became almost unanimously accepted that Labor’s changes went too far and did not differentiate enough between the motives of small, capital-scarce start-ups and those of large, established corporations. Indeed by the time of the Federal election in September 2013, the Rudd Labor Government was already underway with a review of the tax treatment of ESSs. 

In late 2013, the newly-elected Coalition Government announced that it would continue to review the tax treatment of ESSs and maintain its pre-election commitment to reversing Labor’s changes to allow for a tax treatment of ESSs akin to the liberal approaches adopted in the United States and the United Kingdom designed to foster – and not stifle – entrepreneurship and innovation. This commitment was strengthened in the penultimate days of 2013 upon the formal announcement of the Coalition’s landmark National Industry Investment and Competitiveness Agenda (Agenda), where the use of ESSs to encourage economic growth in key sectors, particularly in the technology industry, was one of the areas for investigation by a specially-appointed taskforce. 

The following year of 2014 involved staged consultation periods and calls for submissions to be made by interested parties and industry groups representing the interests of start-ups and small to medium sized businesses. Incorporating these stakeholder views, draft legislation was released on 14 January 2015 with written submissions in response to the draft called to be made by stakeholders. The submission period closed on 6 February 2015. 

The Bill was then finalised and presented to Parliament on 25 March 2015. 

The Bill – the mechanics of ESS reform

The explanatory memorandum (EM) to the Bill states that the overall upside and tangible benefits of ESSs to employers and employees alike will be restored through the passing of the Bill by: 

  1. Amendments to the ITAA – Amending the ITAA to either reverse or improve each of the 2009 amendments in relation to the taxing point for shares, options and other rights under an ESS for all corporate tax entities;  
  2. Small start-up concession – Introducing an additional tax concession for employees of certain small start-up companies; and  
  3. Safe-harbour valuation & standardised documentation – Providing support to the Australian Taxation Office (ATO) in working with industry and key stakeholders to develop and approve safe harbour valuation methods and standardised documentation that will streamline the process of establishing and maintaining an ESS.

Amendments to the ITAA

The proposed amendments to the ITAA will result in virtually all of the changes included in the 2009 reforms being reversed or improved. The key changes to the tax treatment of ESSs that will flow on from the amendments can be summarised as follows:

  • Employees issued with options will be able to defer the taxing point in respect of those options until they are exercised (as opposed to the current position where the taxing point is determined as when the options vest in the employee).  
  • The maximum time for the deferral of the tax point will be extended from seven (7) years to fifteen (15) years.   
  • A tax refund mechanism in respect of shares, options and other rights forfeited by an employee will be introduced. It will apply to employees who had previously elected not to defer the taxing point, paid the tax payable on the discount offered in respect of the securities issued by the employer, and were subsequently forced to forfeit the securities (including, but not limited to, circumstances where the employee ceases employment).

Under the refund mechanism, the forfeited ESS securities are treated as having never been acquired by the employee, allowing them to claim a refund of income tax through an amendment to their income tax assessment. There will be no time limit on amending an assessment to identify and exclude such an amount. The refund will not be available in circumstances where the forfeiture was related to an act by the employee or an element of the ESS designed to avoid downside market risk.  

  • The significant ownership and voting rights limitation thresholds to be eligible for the ESS tax concessions will increase from 5% to 10%. The thresholds limit an employee’s effective ownership and the proportion of votes they control in their employer and are designed to reduce the potential for ESS schemes to be used for improper or tax avoidance purposes. The increase to 10% will provide employees with a greater opportunity to become invested in the success of their employer. 

The opportunity for misuse of ESSs as a result of the amending of these thresholds has been acknowledged by the draftsmen of the Bill, with corresponding amendments requiring calculation of the ownership/voting proportions to take into account any rights to acquire additional shares under options yet to be exercised, as well as shares and options held by an employee’s associates.   

Tax treatment of discounted ESS shares and options

ESS shares and options can be issued to employees at a discount with slightly more complicated tax consequences applying, as is explained below:

Issue of ESS shares at a discount

If shares are issued below their market price with no risk of forfeiture, then the employee pays tax at marginal rates on the aggregate discount value in the financial year of the issue of the shares. If the employee earns less than $180,000 in that financial year, the employee is entitled to a $1,000 tax concession to be applied to reduce the value of the aggregate discount value when the ESS shares are sold. On the assumption that the shares have been held for over 12 months, the employee is also entitled to the 50% CGT discount and will pay tax on the actual aggregated sale price less the aggregated market price of the shares (as at their issue date). 

If there is a risk of the issued ESS shares being subject to forfeiture by the employee (e.g. during the following three (3) year period), the employee can defer liability for the tax payable on the discount received at issue until the forfeiture conditions expire. 

Issue of ESS options at a discount

If no money is paid for ESS options issued to an employee (or where less than market value is paid for those options), then the unpaid value associated with the acquisition of those options will not be taxable in the financial year in which they were issued. 

If the employee is under a deferred tax arrangement covered by the ESS, the employee will: 

  1. be required to pay income tax when the options are exercised, based on the value of the options on the option exercise date, and this will be payable in the financial year for that date; and
  2. when the shares are sold (assuming this occurs at least 12 months after the option exercise date), pay CGT, with the benefit of the 50% CGT discount, based on the capital gain represented by the actual sale value of the shares less the equivalent aggregated value of the exercised options.  

Small start-up concession 

Employees of eligible small start-up companies (SUCs) will be able to obtain the new ‘small start-up concession’ (SSC). An SUC must meet the following criteria:

  1. it must be an unlisted company with no member of its corporate group, including holding and subsidiary companies, being listed;
  2. it must have been incorporated for no more than ten (10) years; and
  3. it must have an aggregate annual turnover of under $50 million (as calculated by reference to the preceding financial year).

Under the SSC, an employee will not be required to include the discount on their ESS interests (shares, options or other rights) in their assessable income (that is, the discount will be tax-exempt),  provided certain conditions relating to the ESS and their employer must be satisfied. These conditions are discussed further below.

Shares to which the SSC applies will be subject to CGT rules. The applicable cost base will be the share’s market value as at its acquisition date. 

The main benefit associated with the SSC in respect of options is that the discount afforded by the employer will not be subject to up-front taxation. CGT rules will also apply to the option or right, with the cost base being equal to the employee’s cost of acquiring the right. The acquisition date shall be treated as the date the option was issued (rather than exercised). 

Eligibility conditions for the SSC

The conditions that must be satisfied (as at the date the relevant share or options is acquired) for a SUC to issue ESS securities are listed and clarified in the EM, and include the following:

  • In the case of an ESS interest that is a:
    • share – the discount offered by the SUC must not be greater than 15% of its market value at the time the employee acquired the ESS interest; or
    • option or other right – the ‘exercise price’ of the option/right must not be greater than or equal to the market value of an ordinary share in the SUC at the time the ESS interest is acquired by the employee;  
  • all of the ESS interests available for acquisition under the ESS relate to ordinary shares;  
  • the SUC must be an Australian resident taxpayer;   
  • at least 75% of the Australian resident permanent employees of the SUC with at least three (3) years of service with the SUC are, or have at the some earlier time been, entitled to acquire shares under the ESS or ESS interests in the SUC (or a subsidiary or holding company of the SUC employer) under another ESS; and  
  • a minimum holding period of three (3) years in respect of an employee’s shares or options under the ESS must be satisfied.  

Benefits derived from the SSC

The benefits to employees of issuing shares or options in a SUC under an ESS can be illustrated by two examples:

Issue of ESS shares by SUC

Provided the SUC meets all of the eligibility criteria, the company can then issue ESS shares at a discount of up to 15% below the actual market value of those shares. That aggregate discount value is exempt from income tax for the participating employee.

If the employee holds those ESS shares for the minimum holding period and then sells those shares, the only tax payable will be CGT (to which the standard 50% CGT concession will apply) on the aggregate capital gain represented by the aggregate sale price less the aggregate undiscounted value of the shares when they were acquired.  

Issue of ESS options by SUC

Again provided that the SUC meets all of the eligibility criteria, the company can issue options to an employee at no cost where the options have an exercise price to be paid to convert the options into shares after three (3) years.

The employee pays no income tax on the unpaid aggregate of the options’ value, which is deferred until the options are exercised and converted into shares, and then sold.

If after three (3) years the employee converts their options into shares and then sells the issued shares, only CGT will be payable. CGT (again, to which the standard 50% CGT concession will apply) will be payable based on the capital gain represented by the difference between the aggregate sale price less the aggregate exercise price. The unpaid value of the options when issued is not taxed. 

Safe harbour valuation & standardised documentation 

Safe harbour market valuation methodologies

The Commissioner of Taxation will also be given a new power to approve, by legislative instrument, market valuation methodologies that can then be used and relied upon by ESS participants, subject to any conditions the Commissioner considers appropriate. 

The methodologies will then become binding on the Commissioner and the ATO, provided that the taxpayer participant has complied with all relevant conditions. Taxpayers that use a methodology approved by the Commissioner and comply with any conditions required by the Commissioner will be able to rely on that valuation as a valid calculation of the market value of an ESS interest. This has been designed to assist taxpayers to more easily comply with the ESS tax regime. 

We also note that the Bill anticipates and allows for taxpayers to adopt their own valuation methodologies, provided that they are based on general valuation principles. 

Standardised documentation to establish and maintain an ESS

To further facilitate the adoption and administration of ESSs, the ATO was asked by the Federal Government, as part of the Agenda, to work with key stakeholders to develop new standardised documentation to streamline and encourage the process of establishing and maintaining an ESS.  The ATO has recently stated that start-up companies, tax practitioners and software providers are amongst the stakeholders they have consulted as part of this process – which is still ongoing.

Conclusion

It is irrefutable that ESSs are an invaluable means by which aspiring yet juvenile companies may attract and retain the talent they need to ensure the continual growth of their business. Additional value can then derive from an ESS in the form of intangible benefits – increased employee engagement and accountability, higher job satisfaction and stronger work relationships – just to name a few. However it is perhaps the greater Australian economy that stands to benefit most from an increased dependence on ESSs through the innovation and entrepreneurship they collectively foster.

Given that the current leader of the Labor party, Bill Shorten, last year publicly acknowledged that the former Rudd Labor Government erred in spearheading the reforms to the tax regime of ESSs in 2009, it is likely that the Bill will have a smooth passage through the House of Representatives and then the Senate. The rationale and expected benefits of the reforms contained in the Bill have also been echoed in the ‘Re:Think’ tax discussion paper released by the Federal Treasurer within several days of the Bill’s introduction to Parliament. There will be great benefits for business following the enactment of the Bill as an official Act of Parliament and the return of ESSs as a valuable tool in the arsenal of small to medium sized companies looking to commercialise their ideas. It is indeed the experience of many growing companies that an ESS, when formulated and administered correctly, can deliver on all of the advantages they are designed to deliver to both employer and employee.

A strong and effective ESS can also bear the added advantage of providing confidence to prospective investors determining whether they should invest in the company in the event that capital raising is required to facilitate the company’s further growth plans. The utilisation of a strong ESS is cogent evidence of an incentivised and motivated base of employees with interests aligned to those of their employer.