The amendments to the Employee Share Scheme (ESS) legislation that we discussed in our earlier Tax Update have been passed and are now law.
In brief, the rules:
- Provide new tax concessions - and solely CGT outcomes - for employees who receive shares or options in their ‘start-up’ company;
- Make options more attractive for employees of all companies by deferring the taxing point under the ESS rules to the date of exercise (rather than vesting) or the later lifting of any disposal restrictions.
The changes only apply for new grants made from 1 July 2015 under exisiting or new ESS plans.
In the case of ‘start-ups’ the ATO has also made it easier to take advantage of the new concessions by releasing:
- Guidance on two ‘safe harbour’ approaches to valuing the shares of ‘start-ups’. The guidance is helpful because companies need to form a view on the value of their companies to ensure their employees can take advantage of the new concessions; and
- Option Plan templates for grants of options to employees of start-ups.
New valuation safe harbour methods
The Commissioner has exercised a new power and approved two ‘safe harbour’ methodologies for valuing the ordinary shares in start-ups for the purposes of the ESS rules.
There is no obligation to use the methods, but if used, they are binding on the ATO and thereby provide assurance to corporate employers.
A reminder - the start-ups concessions
The concessions apply to employees of start-ups if:
- The employer company is a ‘start-up’ (i.e. unlisted, less than $50m group turnover and all group companies in existence for less than 10 years);
- There is a minimum three year disposal restriction imposed on the options/shares; and
- Shares issued at no more than 15% discount or, in the case of options, the option exercise price must be set, as a minimum, at the current market value of a share i.e. the options must not be ‘in the money’ on grant.
The net tangible asset (NTA) method: Start-up less than 7 years old or turnover less than $2m
If the start-up hasn’t raised more than $10m in capital in the last 12 months and prepares financial reports in accordance with accounting standards under the Corporations Act, the market value of ordinary shares is calculated by reference to the company’s net tangible assets with adjustments for preference shares.
Click here to view table.
Under the NTA method, the value of the ordinary shares is $1.00 per share i.e. $80,000/80,000.
All other start-ups: The CFO/valuer method
For all other start-ups, the valuation can be made by the company’s CFO or a qualified valuer. The valuation must have regard to the usual factors that are normally taken into consideration when valuing a company, including:
- The value of the company’s tangible and intangible assets;
- The present value of future cash flows;
- The market value of similar businesses, including the use of earnings multiples; and
- Uplifts for control premiums or discounts for lack of marketability and key person risk.
The valuation must be endorsed by the company’s directors.
Other methods can be used, but will generally only be acceptable if they give rise to a value that is at least as much as the two approved methods.
New template ESS documentation
The ATO has also released standard documentation (plan rules and offer letter) for the grant of options to employees of a ‘start-up. The documentation will provide a ‘good start’ for an option plan, but will rarely provide the complete solution because:
- The templates are for a ‘plain vanilla’ option plan. Our expectation is that most companies will want to tailor the option plan for their needs. In particular:
- there are no ‘good leaver’/‘bad leaver’ provisions that most business owners will want
- employers will want to impose vesting conditions that suit their business needs
- Employers will still need advice on navigating the Corporations Law requirements that arise when shares or options are granted to employees. There are exemptions available from these requirements, but each grant needs to be separately considered.
What we expect to see following the changes?
- Start-ups have always been keen on providing equity to staff. The changes reduce the costs in setting up an ESS and make the arrangement more tax effective for employees.
- The changes make options far more attractive, so expect to see the renaissance of option plans.
- Employers will need to compare the commercial and tax benefits of option plans with loan funded share plans.