In recent years, the use of options as an incentive for employees has fallen out of favour. While the reasons are varied, a significant driver of this trend has been the change in the tax laws for employee share schemes (the ESS Rules) that were made in 2009.
The changes mean that, in many cases, employees become subject to tax on vesting of the options. Given the fall in some companies’ share values over the last few years, this meant that there could be a tax liability even though the options were ‘underwater’ (the exercise price was more than the value of the underlying share). Moreover, the taxing point at vesting doesn’t always coincide with the time when cash comes into the hands of the employee, so many employees need to exercise some of their options and sell the resulting shares to pay the tax liability on vesting.
The disadvantages of options gave (re)new(ed) life to alternatives such as performance rights and loan funded share plans. Increasingly, companies are turning to Loan Funded Share Plans (LFSP) as an alternative arrangement for rewarding their employees with equity. Like options, LFSPs enable the employees to share in the capital growth of the company, but without the tax issues that can plague options.
The structure of a LFSP is relatively simple. The employer makes an interest-free limited recourse loan to enable the employee to acquire shares in the employer for market value. The limited recourse feature of the loan means that the employee is protected from downside risk if the value of the shares falls below the outstanding loan balance.
The shares granted under a LFSP will ordinarily be held by a trust operated by the employer to give the employer greater control over the shares prior to vesting. Dividends paid in respect of the shares will typically be applied to pay down the loan.
Employers can make participation in the arrangement subject to the usual vesting conditions, performance hurdles and forfeiture conditions like any other share or option plan.
If structured correctly, there is no taxing point for employees on vesting, unlike in the case of options. The employer also does not have any reporting obligations to the ATO and the employee that would otherwise arise if the arrangement was subject to the ESS Rules.
An employee only needs to pay tax when they ultimately sell their shares. Importantly, this means that the event that triggers the taxing point also generates the means (ie cash) to help pay that tax liability.
Moreover, any gain made on the shares is only subject to tax as a capital gain, so only 50% of the gain is subject to tax, provided the shares have been held for at least 12 months.
Given the benefits of LFSPs, it is no surprise that we are seeing more of these types of plans in the market.
Of course, there are variants of the arrangement described above and the features of each employee equity arrangement need to be considered in order to appropriately consider the tax implications of the plan for the employee and the employer. As LFSPs are becoming more prevalent and arrangements are ‘tweaked’ to achieve certain (and hopefully) optimal outcomes for employees and the company, we are seeing features of these arrangements, from time to time, that give rise to unintended tax outcomes.
Some of the pitfalls we have seen include:
Employee tax risks
The aim of LFSPs is to ensure that employees are only taxed on the ultimate disposal of their shares. In order to achieve this outcome, it is critical that employees acquire their shares at market value. The cost of external independent valuations can often be prohibitive for private companies. If there is even a small discount provided to employees on the acquisition of the shares, they will need to pay tax on that discount and employers will be subject to the reporting and disclosure regime for employee share schemes.
While the ATO accepts that an independent valuation is not compulsory, the basis of the valuation on which the company and the employee rely will need to be supported if challenged by the ATO.
In the case of private companies, if loans are made to shareholders on non-commercial terms, Division 7A may deem the interest-free component of the loan to be a deemed dividend. For this reason, care needs to be taken if a loan is made to an employee who is already a shareholder (such as an employee who has already participated under an earlier grant under the LFSP or another Plan) to avoid a deemed dividend arising to the employee.
Employer tax traps
The main tax concern for employers is the application of the FBT rules to the LFSP. Employers who make interest-free loans to employees will want to ensure that FBT is not payable on the loans. This will ordinarily be the case where the ‘otherwise deductible’ rule is able to be invoked, so that the taxable value for FBT purposes is reduced to nil.
The availability of the ‘otherwise deductible’ rule is subject to certain conditions. In particular, it will need to be shown that the loan is used for income producing purposes. This will be the case if there is a reasonable expectation or likelihood that the shares that are acquired using the loan funds will generate assessable income, typically, in the form of dividends.
Also, the recipient of the loan fringe benefit must be the employee. If the loan is provided to an associate of the employee, say, their super fund or their spouse, the otherwise deductible rule will not apply and FBT will be payable.
In the event that the value of the shares falls below the outstanding loan balance, the arrangement allows the employee to hand back the shares in settlement of the loan. Care will need to taken in structuring this aspect of the arrangement in order to avoid an FBT liability for a debt waiver if the employer is taken (or could be taken) to forgive all or part of the loan.
Other issues to consider
One other important consideration that is often overlooked by companies and their advisers is the application of the Corporations Law. In particular, an employer will need to consider whether the fundraising rules apply to their arrangement and whether or not an exemption from the requirement to prepare a disclosure document is available.
Also, as a loan is being provided by an employer to the employee, the financial assistance rules may also need to be considered and addressed.