The tax rules applying to employee share schemes (ESS) can be complex and dependent on the precise terms of each grant. Care must be taken to ensure that unexpected tax liabilities do not inadvertently arise.
Set out below are some current tips relating to ESS grants.
Flexibility for employees to choose taxing point
Pre-2009, employees were able to choose to be taxed upfront on ESS grants with any future gain on the shares then taxed as a capital gain and subject to the capital gains tax (CGT) discount. This choice was removed for qualifying grants, and a key issue that often arises in the design of employee share schemes is the trade-off between deferring the taxing point of an ESS grant, which is taxed on revenue account at an employee’s marginal tax rate, versus allowing the future increase in share price to be taxed as a capital gain which may be eligible for the CGT discount.
Changes in 2015 mean that if an individual employee is granted a right or option, the taxing point will generally not occur until the earlier of either: (a) exercise of that right or option; and (b) cessation of employment. That is, the vesting date may no longer give rise to a taxing point; rather the exercise date may be the taxing point. Further tax deferral may apply if disposal restrictions apply to the shares.
As a result of these changes, performance rights can be structured so that the employee chooses the time of exercise of the right rather than automatic exercise on vesting, providing the employee with control over the taxing point. There will be a balancing act for the employee, as they will not receive any dividends until the rights are exercised.
Employee share trusts
Many companies use an employee share trust to purchase and hold shares for outstanding ESS grants. The commercial benefits for the company in doing so include being able to “recycle” forfeited shares and warehouse shares for future allocations. From a tax perspective, the company should be entitled to a deduction for contributions to the employee share trust. In contrast, a deduction is not available if shares are simply issued to the employee to settle the option.
Provided the employee share trust satisfies the “sole activities test”, capital gains on shares used to settle an ESS grant are generally disregarded and contributions to the trust are not subject to fringe benefits tax. However, tax may be payable by the trust on dividends received on unallocated shares.
In setting up an employee share trust, it is important to build in some flexibility to ensure the trustee is able to tax effectively manage the shares in the trust in the event that grants for a particular plan don’t vest and the trust is left with excess shares. Failure to adequately provide for this scenario can result in tax being payable at 49% on any gains made during the holding period.
Granting shares vs rights
For tax deferral to be available in respect of shares being issued under an ESS, the tax rules still require that at least 75% of permanent employees who have completed 3 years’ service are eligible to participate in an ESS (this does not have to be the same ESS for all 75% of employees).
The same restrictions do not apply to grants of rights. In addition, since 2015 it is no longer necessary that a grant of rights be subject to a real risk of forfeiture to be eligible for tax deferral provided the plan states that it is subject to deferred tax under the relevant tax rules. This potentially provides greater flexibility on the terms of grants.
Where the grant is subject to vesting conditions, it is usually preferable to issue rights rather than shares (particularly where an employee share trust is not being used), as it is simpler from both a corporate and tax law perspective for the options to simply lapse if they do not vest rather than trying to buy back the shares from the employee for a nominal amount.
Dividend equivalent payments
It is common practice for the trustee of an ESS trust to pay tax at the top marginal rate on dividends for income years in which the participant is not entitled to the payment (i.e. years while the shares are subject to vesting). Once the shares vest, the trustee pays the participant the dividend amount net of the trustee tax paid and, to date, the accepted practice of industry is that no further tax is paid by the participant on the dividend equivalent payment.
However, the ATO is considering its position in relation to the payment of accumulated dividends held in ESS trusts to ESS participants when their shares vest. This may result in the payment to the participant also being subject to tax.
Indeterminate rights (being a right to a share that is typically able to be cash settled) are often used to ensure that an employee has the funds to pay any tax arising from a cessation of employment taxing point.
Last year, the ATO provided further guidance on the scope of the rule. One benefit is that it should be easier to grant ESS interests to a person commencing employment without losing access to tax deferral.
Takeovers and mergers
ESS shares are often overlooked in the early stages of a takeover or merger transaction. However, it is important to consider how grants on foot at the time of the transaction will be dealt with to ensure that inappropriate tax outcomes do not arise.
If replacement interests are to be issued, there is potential for tax rollover to be available for ESS participants, but care needs to be taken to ensure the replacement grants are referrable to the old ESS grant (e.g. the market values would be substantially the same).
Differing tax outcomes can arise for the company involved if rights are to be cancelled or cash settled as part of the transaction depending on the timing and structure of the cancellation/settlement.