• Subject to certain conditions, ASIC Class Order 14/1001 reduces the regulatory burden on unlisted companies operating an employee scheme by relieving them from a range of statutory obligations, particularly in relation to disclosure and licensing.
  • The Federal Government has also announced proposed amendments to the tax treatment of employee schemes, with such changes to take effect from 1 July 2015.
  • The regulatory and tax reforms have not been prepared in tandem, with CO 14/1001 containing narrower requirements that are likely to limit unlisted companies, particularly start-ups, from deriving the full benefits of both reforms.

Employee incentive schemes can play a critical role in the employee-employer relationship by aligning the economic interests of employees with their employer company (and its shareholders) in respect of the financial performance of the business.

The Australian legal and taxation regimes impose detailed and, by comparison to the US and UK, restrictive rules on the implementation and operation of employee schemes for unlisted companies.

Recent regulatory changes and proposed tax reforms have the potential to make employee schemes for unlisted Australian companies easier to implement.

Class Order 14/1001 – in summary

Under the Corporations Act 2001 (Cth), unless an exemption or ASIC relief applies, the issue of shares (or the grant of options or performance rights over unissued shares) by a company to its employees would require the company to issue a prospectus (or some other formal disclosure document). In addition, in some instances, the employer company can be required to hold an Australian financial services licence to offer and issue the equity securities.

Given the administrative cost and burden of preparing a formal disclosure document, unlisted companies wanting to implement an employee scheme are often forced to structure it in such a way so it can only be offered to participants who fall within the statutory exemptions in s708 of the Corporation Act 2001 (Cth) (e.g. small scale offerings, sophisticated investors or senior managers). The consequence of relying on the statutory exemptions can be that not all of the employees that an employer would like to include in the employee scheme are able to participate.

ASIC has recognised that the statutory requirements applicable to employee schemes are, in some cases, disproportionately burdensome for an employer company and that compliance with such requirements can deter employers from establishing an employee scheme. The recognition of this issue by ASIC is manifested by the relief it has granted to unlisted companies though CO 14/1001 (though such relief is more limited than the relief provided to listed companies).

Under CO 14/1001:

  • Offers can be made by unlisted companies and their wholly owned subsidiaries.
  • Offers can be made to full-time and part-time employees, directors (including non-executive directors), certain contractors and casual employees, and prospective participants (provided they fall within one of the aforementioned categories).
  • Offers by unlisted companies may only be in respect of fully paid voting ordinary shares, units in or options over fully paid voting ordinary shares, where no other classes of ordinary shares are offered under CO 14/1001.
  • Offers must be for no more than nominal consideration, and must not, in aggregate, exceed $5,000 in value per participant per year. Valuation of the offer is calculated by reference to a directors’ valuation resolution, which must be disclosed in the offer document along with the methodology used to determine the value.
  • The number of fully paid voting ordinary shares that have been or may be issued under the offer, when aggregated with offers made under ASIC relief in the previous 3 years, should not exceed 20% of the issued capital of the unlisted company.
  • The offer document must include a special purpose financial statement for a 12 month period.
  • The offer document must include a directors’ solvency resolution that is made no later than one month before the offer.
  • Offers can be made by using trusts, but not contribution plans or loans.
  • Notice of reliance on ASIC relief must be given to ASIC no later than one month after first relying on the class order.

Where an offer by an unlisted company to its employees complies with the above requirements, the unlisted company will be relieved from, among other things, the requirement to give a disclosure document and the requirement to hold an Australian financial services licence.

Proposed tax changes

Separate to the ASIC relief under CO 14/1001, the Federal Government has also announced proposed changes to the taxation of employee share schemes under the Income Tax Assessment Act 1997 (Cth), with specific benefits for start-up companies. These changes are set to take effect from 1 July 2015, meaning they will apply to shares and options/rights acquired by employee share scheme participants after that date.

The reforms to the tax treatment of employee share schemes are as set out below, with the key change being the introduction of specific concessions for start-up companies.

For plans generally:

  • Options and rights should generally be taxed when they are actually exercised, rather than earlier at vesting.
  • A risk of forfeiture will no longer be a requirement for tax deferral in respect of options and rights, provided there is a restriction on disposal of the option/right.
  • The maximum tax deferral period for shares and options/rights will be extended from 7 years to 15 years.
  • An employee may hold up to 10% of the ownership interests in the employer, up from the current 5% maximum.

These changes should generally make granting options to employees a more attractive form of remuneration.

For start-ups:

  • For 'at the money' or 'out of the money' options, no tax should be payable until either the options are sold, or the shares acquired on exercise of the options are sold. The options, or shares acquired on exercise, cannot be sold for 3 years from the date of grant of the options (this can be waived by the Australian Taxation Office).
  • For shares issued at a discount of up to 15%, no tax should be payable until the shares are sold, provided the shares are restricted from sale for at least 3 years (also subject to an ATO waiver).
  • In both cases, any gain on sale will be subject to capital gains tax rather than income tax i.e., able to be reduced by any available capital losses and eligible for the 50% CGT discount. The 50% CGT discount will be made available once options have been held for 12 months, and it won’t be necessary to hold shares for 12 months following exercise of options.
  • To qualify as a start-up company, the company must be unlisted, be within 10 years of incorporation and have a turnover of not more than $50 million (subject to grouping rules).

Lack of alignment between regulatory and tax changes

The regulatory and tax reforms summarised above represent positive changes to the implementation and administration of employee schemes and should make it easier for unlisted Australian companies to offer shares and options to their employees. Unfortunately, however, these reforms have not been prepared in parallel and inconsistencies between them mean that many employee scheme structures that unlisted companies may want to adopt may not be able to benefit from both sets of reforms.

In particular, if an employee scheme is structured in order to benefit from the relief available under CO 14/1001 (by complying with its requirements), it may not be possible for the participants in the scheme to receive the full extent of the benefits arising from the tax reforms (and vice versa).

For example:

  • Share subscription price – to benefit from CO 14/1001, the subscription price for shares must be nominal whereas for a start-up to benefit from the proposed tax reforms, the shares must not be issued at a discount of greater than 15%. 
  • Percentage of shares held by employees – CO 14/1001 limits employee participation (via the class order) to 20% of capital over 3 years (i.e. 6.67% per annum on a linear annualised basis). This restriction will not be consistent with the objective of some schemes that will want to offer larger employee stakes. It is also potentially inconsistent with the tax reforms which permit an individual employee to hold up to 10% of the shares in the relevant company.
  • Value of shares – CO 14/1001 limits to value that can be offered to a participant in any year to $5,000 whereas the tax reforms for start-ups do not contain any such restriction. In addition, this restriction will not be consistent with the objective of some schemes, in particular in start-up companies who may wish to offer employees significant equity value in place of material salaries due to limited cash availability.

In circumstances where the proposed terms of an employee scheme cannot benefit from both CO 14/1001 and the proposed tax reforms, it seems likely that unlisted companies and employee scheme participants will look to take advantage of the benefits of the tax reforms while using the existing exemptions to disclosure and licensing to offer shares and options to their intended participants without the need for a formal disclosure document.

Cameron Blackwood