July has been a good month for startups and other companies looking to incentive their staff through employee share schemes (ESSs).
The starting point to understanding the ESS tax laws is that if an employee receives “ESS interests” – shares and rights to acquire shares, such as options – at less than market value, the discount is treated as taxable income.
The first piece of good news is the ESS tax laws1 changed on 1 July 2015 to reverse some unpopular measures imposed by the former Labor government.
Under the old laws, if an employee was granted options for no cash consideration, the discount to the market value of the options was treated as taxable income either at the time of grant or when the options vested, not when they were exercised (or cashed out). This meant the employee had a tax bill on the options without having realised any value from them. In addition, to determine the market value of ESS interests (which is required to calculate the discount), companies often required a professional valuation, which could be costly in the context of the equity being issued.
The new laws2 offer companies more latitude in using ESS interests to attract and retain top talent, by:
- deferring the taxing point of ESS interests issued at a discount to market value, including by deferring the taxing point of options to when the options are exercised, not to when they could be exercised, so long as the employee has a risk of forfeiting the interests (the Deferral Concession); and
- for qualifying startups – no longer treating the discount on ESS interests as taxable income (the Startup Concession).
The ATO continued the good news by outlining a very simple ‘safe harbour’ method to calculate the market value of startups3, which can be relied on by startups seeking to grant options or issue ordinary shares under the Startup Concession. The ATO even threw in some free employee share scheme documents. However, except for this Startup Concession safe harbour, the problem remains that there is no simple method to calculate the market value of ESS interests, to determine whether they are being offered at a discount in the first place. The initial reference point remains the ATO’s 42 page “Market valuation for tax purposes” guide, and a professional valuation may be required.
Ultimately, the type of ESS that best suits a company will be a function of the interplay between tax, accounting and reporting considerations as well as the company's objectives in establishing the scheme. A company must also check that it is exempt from the requirement to prepare a prospectus or other disclosure document under fundraising laws.4
Alternative ESS structures include the following:
Alternative 1: Deferral Concession
There are a number of conditions that a company must meet to establish a qualifying Deferral Concession scheme. The key conditions are:
- employees must be at risk of forfeiting the ESS interests (this may be problematic if the ESS interests are shares and the employee has subscribed real money – albeit less than market value – for them);
- if the ESS interests are shares, the company must offer at least one ‘broad-based’ ESS, meaning that at least 75% of employees with at least three years’ service are offered ESS interests;
- the employee’s shareholding in the company must not exceed 10%; and
- the company must comply with various reporting requirements to both the ATO and the employees participating in the scheme.
The Deferral Concession allows employees to defer the tax payable on the ESS interest discount until the income year in which the 'deferred taxing point' occurs, meaning the earlier of:
- for ESS interests that are shares - when there is no risk of forfeiting the shares and any sale restrictions are lifted;
- for ESS interests that are options:
- when the options vest and any restrictions on sale are lifted (meaning that if sale restrictions are always in place, this limb will not trigger the deferred taxing point); or
- when the employee exercises the options, and any forfeiture and sale restrictions on the shares issued on exercising the options are lifted (meaning that the deferred taxing point could continue under this limb after the options are exercised);
- when the employee ceases employment; or
- 15 years after the ESS interests were acquired.
The tax payable by the employee at the deferred taxing point is the market value of the ESS interests at that point, less their cost base.
Alternative 2: Startup Concession
The Startup Concession is available to employees of eligible startups who receive ESS interests issued at a discount to market value. Eligible startups are those that are less than 10 years old, unlisted and generate no more than $50m in revenue, so high turnover / low margin startups may not be eligible. The key conditions are:
- the startup must offer at least one ‘broad-based’ ESS, meaning that at least 75% of employees with at least three years’ service are offered ESS interests;
- for ESS interests that are ordinary shares – the discount is no more than 15% of market value;
- for an ESS interest that are options – the exercise price (or strike price) of the options is not less than the market value of the ordinary share at the time of granting the options;
- the employee’s shareholding in the company must not exceed 10%; and
- the startup must comply with various reporting requirements to both the ATO and the employees under the scheme.
The effect of the Startup Concession is that the discount on ESS interests is not treated as taxable income (that is, tax is not deferred, but simply not payable by the employee), and the employee moves from the income tax regime to the capital gains tax (CGT) regime.
To qualify for the Startup Concession, a startup will need to determine the market value of its ordinary shares at the time of issuing an ESS interest. This is where the ATO’s valuation 'safe harbour' becomes very useful, as it allows startups to adopt a net tangible asset (NTA) valuation methodology. For most startups, NTA will simply be cash. Moreover, a startup can exclude cash that has been raised from issuing preference shares that carry a liquidation preference over ordinary shares5. Importantly NTA excludes intellectual property, which can be difficult to value under other methodologies.
Alternative 3: Taxed up-front scheme
For many companies and employees, the idea of deferring or eliminating the taxable income of employees is pretty attractive, and most startup employees do not have piles of surplus cash that can be used to pay upfront tax bills. However, there may be situations in which companies cannot take advantage of the concessional schemes, or employees are better off by paying tax up-front to minimise tax in the long run.
One factor in favour of taxed up-front schemes is that, under the Startup Concession, if ESS options are to be exercised and the underlying shares sold immediately, which is common if the startup itself is being sold, no CGT discount will be available in relation to the gain on the sale of the shares. Another factor in favour of taxed up- front schemes is that the new laws allow employees to claim a refund for any upfront tax paid on ESS interests that are subsequently forfeited.
The ESS reporting requirements apply to this option.
Alternative 4: Employee Loan Scheme
A loan scheme involves a company providing loans to employees to subscribe for the company’s shares. A loan scheme is not caught by the ESS tax laws if the shares are issued at market value.
The rights of the company to require repayment of the loan are usually limited to the proceeds of sale of the shares. However, limited recourse loan arrangements may need to be expensed under accounting rules. In addition, loans to existing shareholders may be treated as dividends under tax rules, unless interest is charged and the loan repaid within seven years.
Alternative 5: Restricted rights equity scheme
Another alternative to consider is a restricted rights equity scheme. This scheme involves issuing equity or quasi- equity on terms that initially rank below ordinary shares, but may change to be on par with ordinary shares in the future, for example if a specific event occurs. In working out the market value of the equity, any terms that prevent or restrict the conversion of the equity to money (for example sale restrictions) are to be disregarded. Consequently, the rights attaching to the equity are structured in a way that pushes the value of the equity below that of ordinary shares. The intention is to issue the equity at market value, notwithstanding that it is issued at a discount to ordinary shares.