The Government has released a discussion paper on proposed changes to employee share scheme arrangements for start-up companies

This proposal follows from a range of reports recommending further work in relation to share or option remuneration for employees of new companies, including the governmental report entitled Advancing Australia as a Digital Economy: An Update to the National Digital Economy Strategy.

The discussion paper raises several

options for reform, including:

  • further deferral concessions;
  • lower taxation rates;
  • greater discounts on taxation; and • valuation concessions.

The current tax system and difficulties for start-ups

Currently, taxation on employee share schemes is borne by employees, with some limited reporting requirements on employers. Unless a deferral concession applies, employees will be taxed upfront when they receive shares or rights under a scheme on the value of the shares or rights at that time. There is currently a $1000 discount on assessable income for certain widely available upfront-taxed schemes. The deferral concession only applies for particular low-value salary sacrifice plans and also for plans under which the employee must satisfy performance or employment conditions which mean that the employee is at risk of losing their shares or options. In that case, the employee will be taxed at a deferred taxing point (usually when the performance or employment condition is satisfied and there are no restrictions on sale of the shares or options).

It is common for start-up companies to provide a component of an employee’s remuneration in shares or options for retention and incentive purposes. One difficulty in relation to the above tax regime for unlisted start-up companies is that there may be no market for the sale of the shares until an IPO or other liquidity event occurs in relation to the shares or options. This presents a problem not only in terms of the employee’s ability to trade their taxable assets, but also the valuation of shares and options for tax purposes in the absence of a market for those assets.

Defining a ‘start-up’

The discussion paper identifies that this proposal is a targeted regime for new and entrepreneurial businesses, and one challenge will be in defining the eligible recipients of the concession. The paper analyses relevant characteristics of a ‘start-up’, including in relation to similar concessions in the UK and Singapore, and proposes the following definition:

  • 15 or fewer employees;
  • aggregate turnover of less than $5 million and not a subsidiary of another corporation;
  • less than 5 (or possibly 7) years old;
  • a test directed at entrepreneurial activity (ie must be providing new products, processes or services based on development and commercialisation of IP); and
  • an “in Australia” test (ie majority of employees and assets must be in Australia).

Proposals for reform

The paper proposes the following alternatives which are aimed at granting concessions to employees of start-ups either in relation to the timing of taxation or the amount of tax payable:

  • a deferral of taxation until the year of sale of shares or exercise of options;
  • a deferral of the time at which tax is payable rather than the time at which the tax liability is valued (which may continue to be on an upfront basis);
  • a lower tax rate (such as 15%); and
  • an increased upfront discount to assessable income (such as $5,000).

The options would continue to tax gains on employee schemes and options as income subject to marginal rates of taxation.

The paper also reiterates previous discussion regarding the difficulties in valuation for start-ups in an illiquid market for the underlying shares. The paper proposes some alternative methodologies that may help to reduce or eliminate valuation costs in such circumstances, such as the endorsement of a “net asset backing” valuation (ie using the company’s balance sheet to value the underlying shares).

As a general observation, one might be tempted to favour the government’s first alternative above, being an extended deferral of taxation to the time of exercise or sale of options or shares, being a time at which the shares can more easily be valued. Not only does this extended deferral provide a significant concession for cash-constrained start-up companies but also goes some way to solving the problem of valuation in many cases. The government has highlighted that one of its main concerns with this alternative is that it may be open for abuse if companies offer a sizeable proportion of remuneration in the form of shares or options or attempt to inappropriately characterise themselves as a ‘start-up’ to obtain the concession. However, the government appears to acknowledge that this latter concern may be addressed in advance by “tightly defining” a start-up company.

As an administrative measure, the paper also raises the possibility of introducing or expanding the use of governmentendorsed “standardised ESS documentation” to reduce compliance and legal costs for start-ups.