The Federal Government announced its proposed changes to the taxation of employee share schemes on Tuesday 14 October 2014 as part of its Industry Innovation and Competitiveness Agenda. While the proposals will make life easier for start-up companies, the benefits to be offered from 1 July 2015 are already achievable under the current system. For all other companies, including all listed companies, the changes may mean that deferred taxation is easier to access and more attractive but from a tax perspective, up-front taxation remains the better option.
The major complaint with the current system is that it removed the previous ability for employees to elect whether they wished to pay tax up front or at a deferred taxation point, with this distinction instead dependent on the design of the scheme.
Although up front taxation involves payment of tax at a time when no cash benefit has yet been received, the major benefit of up front taxation is that it enables all subsequent gains in share value to be taxed under the capital gains tax regime, with the associated ability to claim the 50% capital gains tax concession if shares are held for more than 12 months before sale. This represents a major benefit as it reduces what might otherwise be a 49% tax rate to 24.5%.
The current system of taxation of employee share schemes enables an option scheme to be designed with the exercise price and term chosen such that the tax payable up front is minimal. This places employees in the ideal situation of a nominal tax liability before cash benefits are available, and simultaneous access to taxation under the capital gains tax regime for future gains in value. After all, option schemes are sought after because of the expectation that the underlying shares will increase in value.
The Government announcements will make it easier for start up companies to achieve this ideal world, and will even ensure that a small up front tax bill becomes a zero up front tax bill. On this front, the Government is to be congratulated.
All other companies
However, for all other companies, including all listed companies, there will still be a distinction between schemes that attract up-front taxation and those that attract deferred taxation. The major change appears to be that the deferred taxing point is moved from vesting to exercise. However, the disadvantage of deferred taxation, being that tax is paid in accordance with the value of the underlying share at the deferred taxing point at income tax rates, has not been altered.
The announcement foreshadows that there may be greater opportunity to defer taxation on options without necessarily requiring a real risk of forfeiture. Notwithstanding that taxation on any gain would then be at full marginal rates, this may be attractive in situations where deferral is desirable to minimise commercial risks for employees. In particular, the changes may create opportunities for employees to defer the risk or cost of any taxation until the value of the employee’s interest can be crystallised in a realisation event, which are not necessarily possible under the existing rules.
The best strategy from a tax perspective remains to design a scheme that attracts up-front taxation with the exercise price and term chosen so that up front tax is minimal and subsequent gains fall under the capital gains tax regime.
There is no need to wait until 1 July 2015 to implement such a scheme.