On 14 January 2015, the Australian Treasury released exposure draft legislation (ED) to amend the employee share scheme (ESS) provisions in Division 83A of the Income Tax Assessment Act 1997 (Cth) (1997 Act) (together with the Income Tax Assessment Act 1936 (Cth) (1936 Act), the Act).
The Federal Government announced in December 2013 that it would look at measures to encourage innovation, including the taxation of ESSs and on 14 October 2014 that it would reform the tax treatment of ESSs ‘to support innovative start-up companies’ and ‘reduce compliance burdens faced by small businesses in setting up and maintaining employee share schemes’.
The proposed changes are intended to wind back some of the changes to the ESS rules made by the former Federal Government in 2009, in particular, to the deferred taxing point for rights.1 Those changes were widely criticised, as they brought forward the deferred taxing point for rights to when they ceased to be subject to forfeiture conditions or disposal restrictions, rather than when the rights were exercised, meaning the employee could be taxed on the value of the right before they were able to exercise it and realise the value.
The 2009 changes also removed the choice previously available to an employee to be taxed up-front rather than at the deferred taxing point. Under the current rules, deferred taxation (if applicable) applies automatically and the employee cannot choose to be taxed up-front, which will continue to be the case under the proposed new provisions.
The ED also provides further concessions for employees of certain small start-up companies and makes various other changes to the ESS rules.
The changes are proposed to take effect from 1 July 2015, applicable to ESS interests acquired on or after that date. A summary of the main changes proposed in the ED is set out below.
When does deferred taxation apply?
Current ESS rules
Deferred taxation means that the employee is taxed on the value of a share or right they acquire under an ESS (ESS interest) at the ‘deferred taxing point’ (on the market value at that time) rather than at the time they acquire the ESS interest.
Under the current ESS rules, deferred taxation automatically applies to a qualifying ESS interest if either:
- there is a ‘real risk of forfeiture’ of the ESS interest under the scheme; or
- the scheme is a qualifying salary sacrifice arrangement.
Otherwise, up-front taxation applies, i.e. the employee is taxed at the time of acquiring the ESS interest.
As noted above, this represented a change from the former ESS provisions in Division 13A,2 under which the employee couldchoose between up-front and deferred taxation for qualifying interests. That is, under the former provisions, the employee could choose to be taxed on the ESS interest at the time of acquisition, based on its market value at that time, rather than at the deferred taxing point.
The proposed new rules will generally continue to provide for automatic deferred taxation where the requirements are satisfied, with no choice of being taxed up-front in those circumstances.
The new rules will also provide for deferred taxation of rights schemes where there is a genuine restriction on disposal in certain circumstances, which will effectively involve a choice of sorts (albeit a choice by the employer, rather than the employee), as discussed below.
Genuine restriction on disposal – rights
Under the proposed rules, rights schemes that genuinely restrict the employee from immediately disposing of the right, or the share acquired on exercise of the right, will be able to access tax deferred treatment, even if they don’t contain a real risk of forfeiture, provided that the scheme rules state that tax deferred treatment applies to the scheme.
This differs from the current rules, under which (as noted above) a real risk of forfeiture or qualifying salary sacrifice arrangement is necessary for deferred taxation to apply and a genuine restriction on disposal, while it may extend the deferral period, is not of itself sufficient for deferral.
A company establishing a rights scheme with a restriction of disposal but no forfeiture risk will effectively have a choice of making the scheme an up-front or a deferred taxation scheme, by determining whether or not to state in the scheme rules that deferred taxation applies.
This will not, however, apply to share schemes, which will continue to require a real risk of forfeiture or a qualifying salary sacrifice arrangement to qualify for deferred taxation. Nor will it apply to a rights scheme where the scheme rules do notexpressly state that deferred taxation applies.
Maximum ownership and voting rights
The maximum ownership and voting rights condition for deferred taxation will be increased from 5% to 10% (although, as noted below, the test will now include shares that can be acquired under rights).
Deferred taxation will not apply (and the employee will therefore be taxed up-front) if the employee and/or their ‘associates’:3
- holds a beneficial interest in more than 10% of the shares in the company (which specifically includes shares that the employee can acquire under an ESS interest that is a right to acquire such shares); or
- is in a position to cast, or control the casting of, more than 10% of the votes that may be cast at a general meeting of the company (which, again, includes the voting power attached to any shares the employee can acquire under an ESS interest that is a right to acquire such shares).
While the increase from the current 5% shareholding limit to 10% appears to be a concession, this may be counteracted by the inclusion of shares that can be acquired on exercise of rights. Also, as noted further below, the 10% limit for the start-up concession will include shares and rights held by associates of the employee, regardless of whether they acquired those shares or rights in relation to the employee’s employment.
Deferred taxing point
The following changes to the deferred taxing point are proposed.
Exercise of rights
Currently, a deferred taxing point arises for rights under s 83A-120(7) when, under the scheme, all of the following apply:
- there is no real risk of forfeiture of the right; and
- if, at the time the right was acquired, there was a genuine restriction on immediately exercising the right – there is no longer any such restriction;
- there is no real risk of forfeiture of the share acquired on exercise of the right if the right is exercised; and
- if, at the time the right was acquired, there was a genuine restriction on immediately disposing of the share acquired on exercise of the right – there is no longer any such restriction.
Under the ED, this taxing point will be changed so that it only arises when the right is exercised and:
- there is no real risk that, under the conditions of the scheme, that the employee will forfeit or lose the share acquired on exercise (other than by disposing of it); and
- no genuine restrictions under the scheme on disposal of the share.
That is, a deferred taxing point under this provision will not arise before exercise of the right.
It should, however, be noted that under s 83A-120(4) (which is not proposed to be amended under the ED) a deferred taxing point for rights will still arise while the right is unexercised. This deferred taxing point arises if and when:
- there is no real risk, under the conditions of the scheme, that the employee will forfeit or lose the right; and
- the scheme does not restrict the employee from immediately disposing of the right.
Maximum deferral period
For all ESS interests, the maximum deferral period under s 83A-120(6) will be extended from 7 years to 15 years after acquisition of the ESS interest.
Employees of certain small start-up companies will obtain the start-up concession (under proposed new section 83A-33) if certain conditions are met. Under this concession, the total amount of the employee’s assessable income under Division 83A for an income year is reduced by the total amounts included under that Division in respect of ESS interests that satisfy the conditions.
What is the start-up concession?
For shares to which the start-up concession applies:
- the discount is exempt from tax; and
- the share, once acquired, is subject to the capital gains tax (CGT) rules, with a cost base equal to the market value at the time of acquisition.
For rights to which the concession applies:
- the discount is not subject to up-front taxation; and
- the right, and the resulting share once acquired, are subject to the CGT rules, with a cost base equal to the employee’s cost of acquiring the right (plus, in the case of a share acquired on exercise of a right, the cost of exercising the right).
What conditions must be satisfied?
For the concession to apply, the following conditions must be satisfied at the time the employee acquired the ESS interest (or as otherwise noted below):4
- The company in which the ESS interests are issued is not listed on any approved stock exchange;
- The company (and any holding company, subsidiary or sister company thereof) was incorporated within 10 years before the employee acquired the ESS interest;
- The company has an ‘aggregated turnover’5 of not more than $50M for the income year before the income year in which the employee acquired the ESS interest;
- In the case of an ESS interest that is a share – the discount is less than 15% of its market value at the time the employee acquired the interest;
- In the case of an ESS interest that is a right – the exercise price of the right is greater than or equal to the market value of an ordinary share in the company at the time the employee acquired the interest;
- The employer is an Australian resident;
- The employee is an employee of the company or a subsidiary of the company when they acquire the interest;
- All the ESS interests available for acquisition under the scheme relate to ordinary shares;
- If the employee is employed by the company and also by another company that is a subsidiary, holding company or sister company of the first company – the predominant business of the company is not the acquisition, sale or holding of shares, securities or other investments (whether directly or indirectly);
- For the whole of the period of 3 years (or until the employee ceases employment, if that is earlier) from when the employee acquired the ESS interest, the scheme is operated so that the employee is not permitted to dispose of the ESS interest, or a share acquired on exercise of the ESS interest, acquired under the scheme before the end of that 3-year period;
- At least 75% of the Australian resident permanent employees of the employer with at least 3 years of service with the employer are, or have at some earlier time been, entitled to acquire ESS under the scheme or ESS interests in the employer or a holding company of the employer under another scheme (i.e. the condition in s 83A-105(2), which is also a condition for the application of deferred taxation under Subdivision 83A-C).
The CGT concessions for temporary residents will be modified so that they do not apply to ESS interests that are subject to the new start-up concession, to ensure that additional and unintended concessionary treatment does not arise.
Acquisition by associates
If an ESS interest is acquired by an ‘associate’ of the employee (other than an ‘employee share trust’)6 in respect of the employee’s employment, the interest will be treated for the purposes of Division 83A as having been acquired by the employee instead of the associate.7
This means that any discount on the ESS interest will be assessable under Division 83A to the employee rather than to the associate
As noted above, it also means that any shares acquired by an associate will be taken into account in determining whether the employee holds more than 10% of the shares, so as to be subject to up-front taxation under Subdivision 83A-B rather than deferred taxation under Subdivision 83A-C.
However, for the purpose of the 10% shareholding limit for the start-up concession in proposed s 83A-45, any ESS interests acquired by an associate will be counted even if the associate acquired them otherwise than in relation to the employee’s employment.
Refund rules – forfeiture of ESS interest
Section 83A-310 provides that Division 83A is taken never to have applied in relation to an ESS interest acquired by an individual under an ESS, such that the individual is entitled to a refund of any tax they have paid under the ESS rules in respect of the interest (for which there is no time limit to claim an amendment), if the relevant requirements are satisfied.
Currently, the requirements are:
- an amount would otherwise be included in the individual’s assessable income;
- the individual forfeits the ESS interest without having disposed of the interest or, in the case of a right, without having disposed of or exercised the right; and
- the forfeiture is not the result of a choice made by the individual, other than a choice to cease particular employment.
Proposed new subsection 83A-310(2)(b) will also exclude a choice not to exercise a right before it lapses, making it clear that a refund is available if the employee chooses not to exercise the right.
Valuation and documentation
Safe harbour valuation rules
The Commissioner of Taxation will be given a new power to approve (by legislative instrument) market valuation methodologies that can be used by taxpayers, subject to any conditions the Commissioner considers appropriate (as specified in the instrument).8
The safe harbour valuation methodologies will be binding on the Commissioner, provided the taxpayer has complied with all relevant conditions. Taxpayers that use the Commissioner’s approved valuation methodology and comply with any conditions required by the Commissioner will be able to rely on the valuation as reflecting the market value of the ESS interest.
Taxpayers will also be able to adopt their own valuation, based on general principles.
The draft Explanatory Materials note the approved safe harbour valuation methodology will apply more broadly than to ESSs (proposed s 960-412 will apply to the market value of any asset or non-cash benefit). They also say it is anticipated the Commissioner will initially only exercise the new power in regard to ESS arrangements for small unlisted corporate tax entities. Consideration may be given in future to whether the power can reduce compliance costs for taxpayers in other circumstances, having regard to ‘revenue and integrity issues that may arise’.
An exposure draft regulation has been released, containing updated valuation tables for rights that are proposed to replace the tables currently set out in sub-regulations 83A-315.08(1) and 315.09(1). The proposed tables assume a risk-free interest rate and dividend yield of 4% and volatility of 12%.
The Government asked the ATO to develop a safe harbour valuation method for unlisted shares. The ATO has sought the views of interested parties on safe harbour valuation and standardised documentation, issuing a list of ‘focusing questions’ on these issues. Submissions were due by 9 February 2015.
The ATO has also been asked to work with industry to develop and approve new standardised documentation that ‘streamlines’ the process of establishing and maintaining an ESS.
Some criticisms that have been raised in relation to the ED include:
- The continued absence of any choice by the employee to be taxed up-front rather than at the deferred taxing point;
- That a taxing point for rights can still arise before exercise (e.g. when the right ceases to be subject to any real risk of forfeiture or any genuine restriction on disposal);
- The retention of cessation of employment as a taxing point, regardless of whether the employee can realise the ESS interest at that time;
- The failure to increase the $1,000 exemption for qualifying schemes;
- Even though the shareholding limit for concessions has been increased to 10%, the inclusion of rights in the calculation could even in some cases reduce the availability of the concessions;
- The conditions for the start-up concession restrict access to the concession, such that it may not provide a substantial boost to the start-up sector;
- Some issues remain in relation to interaction with other provisions of the tax legislation.
In short, some commentators consider that the changes do not go far enough to provide real incentives to employees or useful alternative remuneration strategies for start-ups.
Should all employee share schemes be taxed on capital account?
Apart from the start-up concession, ESS interests will continue to be taxable to the employee on revenue account rather than under the CGT provisions. This means that the CGT discount and other CGT concessions do not apply and capital losses cannot be offset against assessable income arising under the ESS provisions. It has been suggested that all ESS interests should be taxed on capital account, as is the position in the United States and the United Kingdom.
However, as employee shares and rights are a form of remuneration, it is arguably appropriate to tax them on revenue account in the same way as cash remuneration.9 To do otherwise could unduly bias the tax system in favour of remuneration in the form of employee shares and rights, which could be to the detriment of (in particular) small and medium businesses, for whom it may not be viable to offer employee share schemes.
Notwithstanding the criticisms mentioned above, the proposed changes should generally be welcomed, although the Government hopefully will heed some of the useful feedback and suggestions it has received in the consultation period.
The proposed valuation provisions, providing safe harbour rules but allowing taxpayers to adopt their own valuation methodologies (based on sound principles) should also be welcome.