Earlier this week the Government released exposure draft legislation in relation to the changes to Australia’s taxation of employee share and option schemes (ESS), which were announced in December last year.

The draft legislation confirms the proposed concessions allowing ‘start-ups’ to issue shares at a discount of up to 15% to market value, or grant of ‘out of the money’ options in circumstances where employees will potentially pay no tax until the shares are ultimately sold.

To qualify for the ‘start up’ concessions certain conditions related to the status of the employer and the terms of the scheme must be satisfied.

Conditions

For the employer:

  • the company must be unlisted, with aggregated (group) turnover of up to $50 million
  • the employer company, its holding company and subsidiaries must have been in existence for less than 10 years, and
  • the employer company (although not necessarily the issuing entity) must be an Australian resident taxpayer.

For the scheme, the general conditions that currently apply to all ESS concessions must be satisfied and the scheme must require employees to satisfy a 3 year holding period in relation to the interests acquired (unless employment ceases earlier).

On sale, the shares will be subject to capital gains tax (potentially providing access to the CGT 50% discount).

While the above concessions will not be available for companies which are not ‘start-ups’, the proposals do allow the deferral period to continue beyond what is allowed under the current rules.

For example, the deferral period in respect of options granted under an employee share scheme may be extended until options are exercised (even in circumstances where any forfeiture conditions have already been removed and options have vested).

Further, while deferral will still end if an employee ceases employment, the maximum time limit on deferral (for both shares and options) will be extended from 7 to 15 years.

The rules also:

  • allow certain rights schemes to access deferred taxation treatment even where they do not contain a real risk of forfeiture (for example, where the scheme genuinely restricts an employee from disposing of their rights and expressly states that it will be subject to deferred taxation)
  • double the existing significant ownership and voting rights limitations from 5% to 10% (but ensuring all interests are taken into account, even those which may not have been exercised), and
  • amend the provisions entitling employees to a refund of tax paid on the grant of options in circumstances where the employee chooses not to exercise that right.

As part of this process, the Government also released updated safe harbour valuation tables, which are currently used in valuing unlisted rights issued under employee share schemes.  Unexpectedly, most of the changes to these tables appear to provide a more favourable result than under the current tables (which were already generally considered to be concessionary).

The Australian Taxation Office has also been given the role of consulting with industry with a view to developing approved safe harbour market valuation methodologies to reduce compliance costs in maintaining an ESS.  Once agreed, use of those methodologies to value an ESS interest in an unlisted entity may be relied upon by the taxpayer – a welcome initiative that has the potential to significantly impact the practicality of private companies issuing shares and options to employees (particularly where the market valuation methodologies adopted are practical).

As foreshadowed by the announcement late last year, the new proposals will only apply to shares or options issued on or after 1 July 2015.  Until that time, shares and options issued to employees will be taxed under current rules.