The Australian Government recently released a Discussion Paper on the administrative and tax arrangements applicable to employee share schemes (ESS) for “start-up” companies. [Employee Share Schemes and Start-up Companies: Administrative and Taxation Arrangements (Discussion Paper, August 2013)].
The Discussion Paper is a welcomed development which will hopefully result in a simpler, fairer and more readily accessible framework for ESS. That said, the potential reforms are only targeted towards “start-ups” (narrowly defined) and the proposals won’t result in any changes to the current ESS regime for other companies.
The benefits of an ESS are well recognised. They help to attract, retain and incentivise employees. They also help to align the interests of the employees with the interests of the company as a whole. For small growing companies in particular, they can also provide a non-cash way to help attract key staff.
Despite all of the benefits offered by ESS, many companies (particularly small or unlisted companies) baulk at the complicated regulatory and tax aspects associated with an ESS. Moreover, the establishment and ongoing costs can be disproportionately high. Depending on how the ESS is structured, individual employees also face the risk of being required to pay tax on shares issued to them under an ESS even though those employees may not have had an opportunity to sell their shares to realise proceeds from which the tax can be paid.
The current difficulties with the existing ESS framework are recognised by the latest Discussion Paper. The Discussion Paper also comes at a time when there have been increasing calls for reform. These calls have particularly been coming from start-up businesses in the IT/IP sector where, because of the difficulties with the Australian system, there has been a growing tendency to set-up business in overseas jurisdictions with comparatively more favourable ESS regimes.
What is a “start-up”?
As mentioned, the proposed ESS reforms will only apply to “start-ups”. The Discussion Paper proposes the following criteria for a “start-up”:
- 15 or less employees;
- less than $15 million of turnover;
- not be a subsidiary or owned or controlled by another corporation;
- must have been in existence for less than a maximum period (the Discussion Paper tentatively suggests 5 or 7 years);
- not undertake “excluded activities” (as defined for R&D tax offset purposes);
- provide “new products, processes or services based on the development and commercialisation of intellectual property” (the Discussion Paper proposes this criteria as a possible alternative to the preceding “no excluded activities” criteria);
- be unlisted; andthe majority of its employees and assets must be in Australia.
Compared to other countries with similar concessions for start-ups, these criteria are generally narrower. For example, in the UK there is a gross assets test of £30 million and a 250 employee threshold. Similarly, in Singapore there is a total assets threshold of SD$100 million (approximately A$85 million).
The requirement that the “start-up” not be a subsidiary or controlled by another corporation is also problematic. This is because many start-ups have a key founding shareholder. This person may be willing to allow equity to be issued via an ESS to some of the employees, but usually the founder will want to retain control and will usually do so by using a corporate shareholder structure. Whilst some other countries have a similarly restrictive requirement regarding share ownership for start-ups, it is suggested that this requirement is excessively restrictive.
Different Tax Treatment
The Discussion Paper outlines several different options for the way in which shares issued by “start-ups” under an ESS could be taxed.
In very high level terms, these include:
- Deferring Tax on the Discount: This option involves deferring the time for payment of tax on the discount (if any) between the market value of the shares when issued and the amount paid for the shares at the time of issue. Under this option, the discount is still taxed, albeit the tax is not paid upfront but is instead deferred until the shares are actually sold. In addition to the tax payable on the discount, capital gains tax would also apply to any gain in value of the shares from the date of issue until the date when the shares are sold. The 50% CGT discount would apply to this capital gain if the period between the issue date and the sale date is more than 12 months. The trade off under this option is that the current $1,000 tax concession would not apply to the discount on issue.
- No Tax on Discount – Just Capital Gain: This option involves dispensing with tax on the discount (if any) on the shares when issued. Rather, tax is only applied when the “deferred taxing point” has arisen. This is the earlier of the date when the employee’s employment ceases or the date which is 7 years after the shares were issued. At this point, tax is applied based on the difference between the amount paid for the shares at the time of issue and the market value of the shares at the deferred taxing point. Under this proposal, the 50% CGT discount on capital gains would not be applied to this gain. Nor would the $1,000 tax concession that currently applies to a discount on issue. Under this option, if an employee subsequently sold the shares after the deferred taxing point, the employee would pay CGT on the gain accruing after the deferred taxing point. If the sale occurred more than 12 months after the deferred taxing point, the employee would be able to claim the 50% discount on that capital gain.
- Lower Tax Rate for Discount: Under this option tax would still be applied upfront to any discount on issue in the same way as currently applies, albeit a lower tax rate would be used. The Discussion Paper uses a 15% tax rate as an example.
- Increase the Tax Concession on Discounts: Under this option, the current tax concession on discounts would be increased from $1,000 to $5,000
The Discussion Paper recognises that it can be difficult in practice to determine the market value of an unlisted company’s securities. The paper also recognises that this poses difficulties (particularly for start-ups) in terms of determining whether shares are issued at a discount to market value or how much gain (if any) is made upon a deferred taxing point. Due to these difficulties, most unlisted companies with an ESS have no real choice other than to engage an expert valuer, and this of course is an added compliance cost. The Discussion Paper proposes a range of alternative valuation methods aimed at reducing the costs and complexity of determining the market value of shares.
Apart from valuations costs, the Discussion Paper states that for a start-up “there may also be the need to engage an accountant and a lawyer to advise on the establishment of an ESS and oversee ongoing administration”. As a practical matter, because of the minefield of issues involved, there are likely to be very few start-ups that could possibly attempt to establish an ESS without obtaining accounting and legal advice.
The Discussion Paper goes on to outline proposals for introducing standardised ESS documents to reduce costs. These proposals have definite merit. Since no two start-ups are the same, it’s always likely that a degree of tailoring will be required. Nevertheless, having a set of Government and ATO endorsed standardised documents would be a significant benefit to most businesses looking to introduce a simple and low cost ESS.
Key Comments and Insights
The Discussion Paper is a welcomed development which will hopefully result in a more palatable ESS regime for start-ups. Whilst it is definitely a step in the right direction, significantly more reform is needed to simplify the tax treatment of ESS. The need for reform applies not just to start-ups, but is particularly needed for unlisted companies more generally.
Reform is needed not just in relation to taxation but other regulatory requirements. For example, various provisions in the Corporations Act make it particularly difficult for unlisted companies to implement an ESS. Whilst the Australian Securities and Investments Commission (ASIC) has already developed Regulatory Guide 49 and issued Class Order 03/184 to provide relief from some of the ESS requirements in the Corporations Act, many of the relief requirements cannot readily be satisfied by start-ups and unlisted companies. If the Australian Government is serious about reforming ESS laws, it is essential that it undertake a coordinated approach. In this regard, it is pleasing to hear that ASIC is now reviewing its ESS policy with a view to possibly broadening the classes of securities and companies that may be eligible for ASIC’s relief. [See paragraph 42 of the Discussion Paper.]
A consultation process is currently underway until the end of August. A final report is not expected until December 2013. Given the upcoming federal election it remains to be seen whether this timeline will be met or whether any of the potential reforms will ultimately be implemented.